Eminent Domain Law and Business Valuation
By: Robert J. Strachota
This article is the second in a two-part series on Eminent Domain Law and its application to Business Valuation. Part I focused on the history of Eminent Domain Law and the most current reasons for its application within business valuation. Part II will discuss the actual valuation approaches used to measure Business Loss.
Approaches to Value for Measuring Business Loss
The traditional valuation approaches used in most appraisals, whether real estate or business valuations, are the Cost Approach, the Income Approach, and the Market Approach to value.
The Cost Approach is a method of determining the cost to create a new business with new equipment and optimum functional utility. The appraiser estimates the cost to assemble all of the tangible assets (accounting for direct and indirect costs) as well as an appropriate entrepreneurial profit. When the business has assets, such as existing equipment, the appraiser must deduct accrued depreciation from the reproduction costs as of the appraisal date. After the depreciated value of all assets is measured, an adequate rate of return is assigned to each asset. It is customary in business valuation, especially with very large companies, to give little weight to the Cost Approach because each asset and each liability must be assigned not only a value, but also an applicable rate of return. It is precisely this level of detail that makes the Cost Approach so relevant in condemnation cases.
The Cost Approach is critical to condemnation cases because just compensation is awarded on a component basis relative to what is actually taken. For example, the condemner will take land, buildings, and equipment, with a corresponding loss of goodwill. The business is likely to have goodwill value if there is excess income available after providing an adequate return to assets. The condemner will not take tangible assets such as cash, receivables, or payables, as the owners traditionally keep these. Anything not taken by the condemner is then excluded from the value. The key to a successful business condemnation case is the appropriate allocation of value to each and every asset, including the intangible assets. The Market and Income Approaches add up all of the assets to produce one, inclusive sum for the condemner's starting value. The Cost Approach becomes particularly significant because each component of the total value can be scrutinized with regard to the actual taking.
The Income Approach to value directs the appraiser to convert anticipated benefits (i.e., cash flows or net operating income) into business value. This conversion can be accomplished in one of two ways: one year's income or an average of several years' income expectancies may be capitalized at a market-derived capitalization rate (or other, specified cap rates) or the annual cash flows may be discounted for the holding period and a reversionary value at a specified yield rate. Essentially, there is a single-year or a multi-year method of measuring value by the Income Approach. From an investor's point of view, the earning power of a business is the critical element affecting its value. The fundamental premise is that the higher the earnings, the higher the value. In the income capitalization approach to value, the business appraiser analyzes the capacity of a business to generate benefits and converts these benefits into an indication of present value.
The income capitalization approach is typically used in market value appraisals of businesses which have the goal of being income-producing. It is most relevant when it represents the thinking and actions of the equity investors; investors purchase businesses for the future dollars they will produce. The Income Approach is also useful when it is difficult, if not impossible, to adjust comparables in arriving at the true value of a business. When using the Income Approach to determine value in a condemnation case, the appraiser must break down the overall value into its component parts because only certain assets are compensable. Most condemning authorities award value on a before debt basis for businesses and on a before tax basis for real estate. The wise appraiser uses the same methodology on either a "before" or "after" basis consistently rather than attempting an "after the fact" adjustment: risking misinterpretation and confusion.
The Market Approach to value is the process in which a market value estimate is derived from analyzing market variables from similar businesses and comparing these to the subject business. Privately-held businesses which have recently sold, are listed for sale, or are under contract are viewed as important sources of market information. This market information determines the value estimate, is admissible in court, and is superior to the guideline company approach.
The major premise of the Market Approach is that the value of a business in the marketplace is directly related to the prices of comparable, competitive businesses. It is only reliable, however, if there are sufficient recent transactions to indicate current value patterns or trends. The Market Approach provides a supportable indication of value for types of businesses which are bought and sold on a regular basis. When the data base is large, the Market Approach is the most direct and systematic method of determining value and is often preferred by the court. It is less useful for businesses which are relatively unique, because few similar businesses may be sold in a given market, even if the appraiser's search is geographically broad.
The Market Approach provides the best indication of value for many high-tech companies that have yet to make a profit in today's business environment. In a market with rapidly changing economic conditions and legislation, the Market Approach tends to lose some of its reliability. However, the information flow of the 1990s is much greater than it was in the past; appraisers are much more well informed about the economic factors which influence buyers and sellers. As the volume and reliability of the comparables improve, the appraiser is able to arrive at a realistic figure which complements the valuation derived from the Income Approach. The application of the Market Approach is problematic for the court because it does not typically itemize which assets are compensable and which are not. For the Market Approach to be useful in condemnation cases, the appraiser must value each asset or component separately.
Appraiser's Function and Responsibilities in Condemnation
When an appraiser takes an assignment that involves a condemnation, it is important to have a clear idea about the purpose of the appraisal, what valuation principles apply, and what standard of valuation applies. Valuation is a fascinating subject because like beauty, value is in the perception of the beholder. However, despite the subjectivity surrounding the issue of valuation, we continually strive to measure value precisely and objectively. From my perspective, anyone approaching the subject of valuation should be aware of certain truisms as a frame of reference. Each valuation assignment is unique. One case is rarely on point with another and a significant differentiation of the facts can usually be discerned. In valuation, there are no absolutes. There are general guidelines to which individual judgments must be applied. Furthermore, an appraiser should remember that experts will and do differ in their opinions. There are generally accepted methods of valuation which are recognized and accepted by the appraisal profession as well as the courts, and it is wise to adhere to these. Yet in the final analysis, there is no irrefutable answer in business valuation within the context of eminent domain law. Nonetheless, the appraiser should be aware that in eminent domain, the valuation of real estate provides the foundation of the law and is the context in which most attorneys are accustomed. Business valuation reports should then be tailored to this type of audience if the appraiser wants to improve the probability of success.
Business valuation in the context of litigation necessitates that the appraiser is clear and understandable in his application of methodology. The Competency Provision of the Uniform Standards of Professional Appraisal Practice (USPAP) requires the appraiser to have either the knowledge and experience necessary to complete a specific appraisal assignment competently, or to disclose the appraiser's lack of knowledge or experience to the client and take all steps necessary or appropriate to complete the assignment competently. Failure of an appraiser to disclose to the client a lack of knowledge or experience with respect to a particular business appraisal is an unacceptable practice. The appraiser is required to clearly and accurately disclose any extraordinary assumptions or limiting conditions that directly affect the appraisal and to indicate impact on the value. Furthermore, the appraiser should give an explanation which supports the exclusion of any one of the traditional approaches to value if it is not used in the business valuation.
In condemnation assignments, there are some general principles that apply and are common to litigation assignments. If an attorney has reviewed the condemnation appraisal report and does not have any questions or comments, it is generally a negative indication. It usually means that the attorney did not understand the appraisal report, or the report was, in fact, not read at all. If, during direct testimony in a condemnation, the question-answer session goes smoothly, the attorney has probably read the appraisal and understands it as well as the appraiser. On the other hand, if the direct testimony seems disconnected, it is likely that the attorney is reviewing the appraisal report for the first time while attempting to conduct the direct examination. Sometimes direct examination is more difficult than cross-examination if the attorney does not understand the appraisal witness' report. The toughest cross-examination comes from a knowledgeable attorney who understands the appraisal as well as the appraiser. Usually, the opposing attorney will avoid asking open-ended questions and will resist the temptation to pose a last summary question. Summary questions often provide the appraiser with a welcome opportunity to elaborate, and possibly close the door on the attorney's strategy. Wise attorneys often finish their arguments in briefs or closing arguments, as opposed to trying to accomplish them in cross-examination. In any litigation matter, but particularly in condemnation, demonstrative evidence is a useful tool for explaining to the court the appraiser's approach to the measurement of damages. It is recommended that the appraiser prepare exhibits of the analysis in oversized formats suitable for use as demonstrative evidence in the courtroom. These exhibits should be reduced and included with the appraisal whenever possible.
In conclusion, it is recommended that a business valuation prepared for eminent domain purposes be written in such a way that the data in the report is clear and accurate. The appraiser must use extreme care to ensure that the reports and methodologies applied are consistent with the law and not misleading in the marketplace or to the public.
Do's and Don'ts of Business Valuation in Eminent Domain Law
Before accepting a condemnation appraisal assignment, the appraiser must investigate the facts and issues of the assignment. Check for conflicts of interest or past appraisals that you may have completed for the opposing side or the same business. Try to determine if your client has a pre-established damages agenda and if so, whether you want to deal with the case at all. If you find yourself working hard to justify your position with your own client, you will have an even more difficult time on the witness stand explaining it to the court. Assure your potential client that you always follow proper appraisal principles and that you will come to your own value conclusions. Be mentally prepared, upon taking the initial information about an assignment, to decline the assignment if necessary. Always prepare an engagement letter outlining the scope of the assignment, the fee structure, and the estimated completion date. Finally, be candid about your qualifications and limitations with regard to your knowledge about the law and what is compensable in the law.
In the preparation of the valuation report, take the opportunity to affirm your methodology, the key issues, and any opposing positions or claims. Make sure that your valuation does not contradict any facts of the case. It is important to be even-handed and interview all knowledgeable parties in condemnation litigation if possible. Have a clear understanding of the court system and how the procedures differ from venue to venue. Justify critical elements of your analysis with facts and use your opinion as a guide, not a foundation. As a reputable appraiser, always remember to present a solid valuation position rather than a "negotiation position." Do not fall into a trap of thinking that you do not need to worry about this appraisal assignment because it will settle, or if it does not settle that you will figure out how to deal with the appraisal inconsistencies in the future. In recent years, the introduction of a solid valuation report has become a critical element in most condemnation cases. High-quality market evidence, formatted in a good, written report, is more powerful than verbal testimony. This is true primarily because the potential for inaccuracies to occur in the record is much greater during actual testimony. Once the report is admitted into evidence, it remains there, as is. For almost all condemnation litigation, it will be necessary to prepare a complete, self-contained report per USPAP requirements. It goes without saying that your report must be mathematically and grammatically correct. The report should be reader-friendly with plenty of charts, graphs, and pictures to aid in the presentation of what can sometimes be large quantities of data. Present your data as you find it; avoid underlining and highlighting what you believe to be critical elements in your report. Always remember that you are not an advocate in your analysis.
The preparation for a deposition or examination in a condemnation hearing must be taken seriously. Show your file to your attorney before you appear for a deposition because the entire file is discoverable at the deposition. Remember that although depositions are generally taken under relaxed circumstances, you are still under oath. Not all states practice the use of depositions in condemnation, so in some instances this may not be applicable. You must be just as well prepared for a deposition as you would be for a trial. It is important for the appraiser to be thoroughly apprised of the rules governing a particular court system prior to the day of testimony.
As a business appraiser in condemnation, you should remember that the attorney is an advocate for the case. It is his or her job to champion the position of the client. As a witness, do not take on the attorney's duty by being an advocate for the client. You will only interfere with the process and confuse the commissioners, judge, or jury. Above all, do not carelessly adopt a hypothetical circumstance (to suggest high or low damages) that is proposed by an attorney but is not market-supported. It is your goal as a witness to answer all of the questions as concisely and completely as possible so that the commissioners, judge, or jury clearly understand you and your testimony. Measuring damages in condemnation is often very sophisticated. It is your responsibility to explain sophisticated financial techniques in a simple, understandable manner. Attempt to contain the length of your responses to three or four sentences so that the commissioners, judge, or jury can easily follow your valuation testimony.
Finally, some attorneys like to have their condemnation experts seated at the counsel table during the cross-examination of the opposing expert. This has become more common around the country in recent years. Careful consideration should be given to the potential appearance of advocacy that may occur if you choose to do this. The author believes that adequate preparation could eliminate the need to have the expert present at the counsel table, and thus, advises against this practice in all but the most unusual circumstances. 
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