Active Passive Appreciation – Market Forces

As discussed previously, once it has been determined that a separate business interest appreciated in value during a marriage, learned treatises and case law often delineate the active passive analysis into the following elements:

  • Identifying and quantifying market forces that caused the separate property appreciation.
  • Identifying and quantifying the separate property appreciation caused by the active efforts of third party managers, employees or owners (other than the divorcing parties).
  • Identifying and quantifying the separate property appreciation caused by the active efforts of the divorcing parties (typically including efforts of either the business owner or the non-owner spouse).

A market force can be defined in general as a measurable economic factor that affects the price, demand, or availability of a product or service. These economic factors can include basic economic factors such as interest rates, population growth, inflation rates, commodity prices or foreign currency exchange rates. In the context of an active passive analysis of a business interest, a market force is more specifically defined, but can include a broad array of factors beyond basic economic factors. For example, a favorable government regulatory change can also be a market force. A market force in an active passive analysis context can be defined as a factor that reflects the following attributes:

  • It is a measurable factor that caused appreciation in a separate business interest either during a marriage or between the date of separate (sometimes called the date of filing) and the date of distribution.
  • It is a factor that is outside the control of subject company managers, employees or owners.
  • It can be analyzed distinctly from appreciation caused by the efforts of individual managers, employees or owners of the business (who might be either third parties or one of the divorcing parties).

For a factor to be a market force in an active passive analysis, there necessarily must be an identification of the relevant “market” on which the factor is a “force”. In the context of an active passive analysis of a business interest, the “market” is typically defined to include a sample of comparison companies exposed to a reasonably similar business environment as the subject company. A study of the impact of the factor on the performance and value of comparison companies helps to identify whether the factor has been a market force during the relevant time period. The business appraiser can then compare the increase in value of the subject company interest to the increase that would reasonably be expected based upon the market force impact on the value of the comparison companies

If the value of the subject company interest increased during the relevant period at a rate that was at or below the value increase of the comparison companies related to the market force, then much or all the subject company value appreciation was likely caused by the market force. On the other hand, if the value of the subject company interest increased at a greater rate than what would be expected from the market force, then the part of the increase over the expected impact of the market force is often attributed to the active efforts of one or more individual managers, employees or owners of the business. To the extent that one or both divorcing parties are among the individuals whose active efforts caused part or all the appreciation during the marriage in excess of the increase expected to be caused by market forces, then that part of the increase is often included in divisible assets.

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Active Passive Appreciation – Causation

The business appraiser performing an active passive appreciation analysis looks to their engaging legal counsel to define and interpret state law in the particular jurisdiction. An active passive analysis is performed when state divorce law requires a determination of whether, and under what circumstances, appreciation in otherwise separate property is classified as a divisible marital asset. A commonly recurring requirement in such jurisdictions is that separate property appreciation during the marriage is divisible marital property to the extent it was caused by marital efforts.

There can be many different types of property in a divorce case (e.g. real property, furnishings, retirement plans), but this discussion focuses on property consisting of business interests.

A jurisdiction requiring the isolation of separate business interest appreciation caused by marital efforts necessarily requires the business appraiser to also identify and quantify appreciation caused by factors other than marital efforts. Separate property appreciation during the marriage caused by marital efforts is called active appreciation and is typically included in divisible property. Separate property appreciation during the marriage caused by other factors is known as passive appreciation, and typically remains separate property.

Once it has been determined that a separate business interest appreciated in value during a marriage, learned treatises and case law often delineate the active passive analysis into the following elements:

  • Identifying and quantifying market forces that caused the separate property appreciation.
  • Identifying and quantifying the separate property appreciation caused by the active efforts of third party managers, employees or owners (other than the divorcing parties).
  • Identifying and quantifying the separate property appreciation caused by the active efforts of the divorcing parties (typically including efforts of either the business owner spouse or the non-owner spouse).

From an overall perspective, while case law differs on the market forces and efforts of individuals given weight based upon case facts and the particular jurisdiction, almost uniformly learned treatises and case law have required causation. There must be a reasonable connection or relationship such that market forces and/or the efforts of individuals caused separate property appreciation. In many jurisdictions, for example, merely because a party was active in a business going to work and laboring daily does not mean that that labor reasonably caused some or all the separate property appreciation.  In practice, in most equitable distribution jurisdictions, causation is determined not by a single mathematical formula, but rather by a more flexible facts and circumstances analysis.

While there is near uniformity among equitable distribution jurisdictions to require a reasonable causal link, differences in classification can arise when appreciation in a separate business interest has been caused both by market forces and by efforts of individuals during the same time period. The range of case outcomes varies by specific case facts and jurisdiction, but often the outcome reflects an allocation among the various factors.

If you are interested in learning more about how you can strengthen your case with a business valuation expert, or want to learn more about our services and our team, please contact us.

Working Capital Changes in a Free Cash Flow Forecast– Part III

Part II of my working capital blog identified methods often used by business appraisers when forecasting working capital. In this installment, I will present some additional thoughts regarding this topic.

Depending on the facts and circumstances, it is typically appropriate to consider the company’s historical working capital ratios and industry working capital metrics at the composite level (e.g. total working capital), as well as each separate component of working capital (e.g. accounts receivable, inventory, accounts payable, etc.). If the company’s metrics exhibit a large variance from the industry, the comparability of the companies in the industry group to the operations of the company being valued should be analyzed. If the subject company is not comparable, its historical ratios are more relevant for valuation purposes (this is often the case for very small companies, particularly depending upon how they choose to capitalize themselves). For larger companies that appear to be comparable to those included in the measurement of industry data, further analysis may still be necessary. For example, if the analysis of the company’s financial ratios show that the company’s speed of collections is slowing in relation to its historical collection ratio or in comparison to the industry, the individual components of the working capital change may need to be looked at separately.

Other items that may be implicit in a company’s working capital forecast and require a conversation with company management include:

  1. Payment strategy – As a source of cash flow, a company may negotiate longer payment periods with suppliers (typically a positive) or delay payments to suppliers (can be a negative, indicating questionable liquidity). Reducing the payment period has the opposite effect and reduces cash flow.
  2. Collection strategy – A company may tighten the terms of payments offered to credit customers or become more aggressive in its collection policies, which reduces accounts receivable and increases cash flow. However, tighter credit policies may cause loss of customers. Loosening credit terms and/or less aggressive collection policies increases accounts receivable and reduces cash flow, but may gain additional customers who desire longer payment terms.
  3. Inventory management strategy – A company may increase its inventory levels to improve fulfillment rates (which initially decreases cash flow, all else held constant) or may reduce inventory levels to reduce holding costs (which initially increases cash flow, all else held constant). However, reducing inventory levels beyond a certain point may increase stockouts, which can lead longer-term to declining sales and/or a reduced sales growth rate.
  4. Purchasing strategy – A company may negotiate discounts for paying more quickly, or it may receive reduced prices for purchasing larger volumes, both of which initially lower cash flow, all else held constant.

Overall, in the context of cash flow forecasting for business valuation purposes (as opposed to forecasting for capital or operating budgeting purposes), estimating a change in overall working capital is definitely simpler to do, as it avoids the detailed analysis necessary to forecast a number of inputs and may be reasonably accurate. However, the assumptions imbedded in each working capital component that comprise the overall change in working capital still often need to be considered.

The level of working capital has a direct influence on the value of a company. Tying up cash in excess working capital may cause cash flow and profits to suffer. Insufficient working capital reduces a company’s liquidity, potentially increasing a company’s risk and the cost of obtaining capital, thereby potentially reducing its value.

If you are interested in learning more about how you can strengthen your case with a business valuation expert or want to learn more about our services and our team, please contact us.

Working Capital Changes in a Free Cash Flow Forecast– Part II

Part I of my working capital related blog addressed the impact on free cash flow of changes in current assets and changes in current liabilities, which are the two components that comprise working capital (calculated as current assets minus current liabilities). The combined impact of changes in current assets and changes in current liabilities equals the impact of changes in working capital on free cash flow. Part II of this blog identifies methods often used by business appraisers when forecasting working capital.

At the core, working capital changes are analyzed and projected to ensure changes in cash are correctly forecast. Merely because a company produces a net profit of $100,000 does not mean the company has $100,000 in cash available to distribute to its owners.

The ratio of sales method is commonly used to forecast the impact of working capital changes on free cash flow in a business valuation where the subject company utilizes the accrual basis of accounting.  This method is readily understandable and can reflect these variations:

  • Use the change (in currency) in working capital from the two years before the valuation date and grow working capital at the expected sales growth rate.
  • Use the ratio of working capital to sales reflected in the year prior to the valuation date to forecast working capital levels needed to support forecast sales levels.
  • Use the ratio of working capital to sales based on a historical multi-year period using a simple average, a weighted average or a median. While this method can smooth out year-to-year changes and allow a complete business cycle to be included, it may not be appropriate for companies exhibiting a consistent downward or upward trend in working capital in the years preceding the valuation date.
  • Forecast working capital using industry average ratios of working capital to sales. This method may be useful when a company has volatile historical working capital and/or is a start-up or in high-growth mode, for example, and the analyst is not comfortable making a forecast based on the company’s historical working capital levels.

Two key caveats are in order. Under the first three methods, the inherent assumption in applying historical average working capital levels is that the historical levels reflect expected future working capital levels. Since a business valuation should reflect expected future cash flows, expected variations between historical and future working capital levels must be considered. Second, if a non-controlling interest is being appraised, the assumption that the company’s working capital levels will be changed to industry averages might not be reasonable if the company rarely reflects industry-average working capital levels and the interest being appraised does not have the unilateral power to compel changes at the company.

Other considerations include:

  • The company’s historical working capital ratios and industry working capital metrics
  • Historical and industry normal metrics of the individual components of working capital (e.g., accounts receivable, inventory, accounts payable, etc.)
  • Comparability of companies in the industry group to the operations of the subject company when the subject’s metrics exhibit a large variance from the industry
    • In the case of very small companies, historical ratios may be more relevant
    • For larger companies that appear to be comparable, further analysis may still be necessary

My next blog will present additional thoughts on forecasting working capital.

If you are interested in learning more about how you can strengthen your case with a business valuation expert or want to learn more about our services and our team, please contact us.