Business valuation is both an art and a science, requiring not only accurate financial data but also thoughtful analysis and professional judgment. Whether valuing a general business or a specialized professional practice, such as a dental office, experts must often adjust financial statements and critically evaluate valuation reports to arrive at a fair, defensible conclusion. These processes are especially important in high-stakes situations such as litigation, divorce proceedings, or business sales.
Adjusting financial statements for accurate valuation
Before determining a company's value, valuation experts frequently modify financial statements to better reflect economic reality and improve comparability. These adjustments typically fall into three primary categories.
Michael Lehner, CPA, ABV.
Normalizing adjustments
Normalizing adjustments align financial statements with generally accepted accounting principles (GAAP) or industry standards. For example, a dental practice using the cash method of accounting may need adjustments that reflect receivables, payables, accrued expenses, and other items consistent with accrual accounting.
Additionally, companies may use accounting methods that differ from industry norms -- a common example being last in, first out (LIFO) versus first in, first out (FIFO) for valuing dental supplies.
Because LIFO can result in higher costs and lower reported profits during inflationary periods, failing to adjust these figures may undervalue a business compared to its peers that use FIFO. Normalizing ensures meaningful comparisons when benchmarking performance or selecting comparable companies.
Eliminating nonrecurring and nonoperating items
Valuation focuses on future earning potential, so unusual or one-time events are typically removed from historical financial results. Examples include litigation settlements, gains or losses from asset sales, and investment income. These items do not reflect ongoing operations and can distort a practice's true earning capacity.
Similarly, nonoperating assets -- excess real estate or unrelated investments, for example -- are separated from core business operations. Since these assets carry different risk profiles and valuation methodologies, they are analyzed independently to avoid skewing the practice's valuation.
Adjusting discretionary spending
Discretionary adjustments are often the most subjective. They address items such as owner compensation, which may not reflect market rates. If an owner pays themselves significantly above or below fair market compensation, an adjustment may be necessary to estimate the cost of replacing that individual.
However, these adjustments depend heavily on context. For example, when valuing a minority interest, experts may avoid adjustments outside the shareholder's control. Future management plans -- such as an owner's retirement -- can influence whether such adjustments are appropriate.
The importance of critical analysis in practice valuation
While adjustments improve financial accuracy, the valuation process does not end there, particularly for professional practices. A thorough critique and analysis of a valuation report can be equally as important as the valuation, especially in legal settings.
The role of goodwill in practice valuation
One of the most complex and contested elements in professional practice valuation is goodwill. Goodwill generally represents the intangible value of a business beyond its tangible assets, but it must often be divided into two components:
- Personal goodwill is tied to the individual professional's reputation, skills, and relationships.
- Enterprise goodwill is associated with the business itself, such as brand recognition, systems, and the workforce.
This distinction is critical in legal contexts, like divorce proceedings. In many jurisdictions, enterprise goodwill is subject to marital distribution while personal goodwill is not. Therefore, how goodwill is classified and valued can significantly affect the outcome for both parties.
Common flaws in valuation reports
Bruce Bryen, CPA, CVA.
Valuation reports frequently fall short in adequately analyzing and explaining goodwill. A simple allocation -- such as assigning a large portion of value to goodwill without detailing its components -- can leave courts without sufficient insight to make informed decisions.
For example, a practice valued at $1 million might allocate $700,000 to goodwill; however, without clearly distinguishing between personal and enterprise goodwill, that figure becomes difficult to interpret in a legal context. This lack of clarity can lead to inconsistent or subjective decisions by judges, many of whom have limited experience with dental practice valuations.
Why critique matters
A detailed critique of a valuation report can highlight these weaknesses and provide clarity for courts or mediators. By examining assumptions, methodologies, and allocations, a critique helps ensure that the valuation reflects economic reality and adheres to relevant legal standards.
This analysis becomes particularly important in equitable distribution states, where courts must fairly divide marital assets. A well-supported critique can influence how assets -- including goodwill -- are allocated, ultimately affecting the financial outcome for both parties.
Integrating adjustments and analysis for reliable valuation
The reliability of any valuation depends on both accurate financial adjustments and rigorous analytical review. Adjustments ensure that financial data reflects true economic performance, while critique ensures that valuation methodologies and conclusions withstand scrutiny.
Disagreements among experts often arise from differences in these areas, whether in the choice of adjustments, the handling of goodwill, or the interpretation of financial data. Therefore, supporting all assumptions with objective market evidence and clear reasoning is essential.
Business and practice valuation is a multifaceted process that extends beyond simple calculations. From normalizing financial statements and removing nonrecurring items to carefully evaluating goodwill and critiquing valuation reports, each step plays a vital role in determining a fair and defensible value.
In complex scenarios -- particularly legal disputes -- understanding these elements can make a significant difference. A well-prepared valuation, combined with a thoughtful and thorough critique, provides the clarity and credibility needed for informed decision-making and equitable outcomes.
Michael Lehner is director of forensic, litigation and valuation services at Baratz & Associates PA. A seasoned expert with more than 30 years of experience, he specializes in business valuations for shareholder disputes, matrimonial proceedings, acquisitions and sales of businesses, gift and estate planning, succession planning and commercial litigation. He can be reached at [email protected].
Bruce Bryen is a certified public accountant with more than 45 years of experience. He specializes in providing litigation support services to dentists, with valuation and expert witness testimony in matrimonial and partnership dispute cases. Bryen assists dentists with financial decisions about their practice, practice sales, evaluating whether to join a dental service organization, practice evaluation during divorce proceedings and questions about the future or financial health of dental practices. He can be reached at [email protected].
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