April 1997

Where do they come up with those capitalization rates?

Capitalization rate can be defined as the annual rate of return a prudent investor would demand from the amount of money invested in a business purchase. By way of example, if a business generates $100,000 a year in profits and an investor demands a 25% annual return or capitalization rate, the resulting business value would be $400,000. In other words, a 25% annual return on a $400,000 investment is $100,000.

The most common way appraisers of closely held businesses develop capitalization rates is to use the "build-up method". The build-up method is based on the principle that a company's capitalization rate is composed of a number of identifiable risk (return) factors.

There have been times when I thought appraisers have pulled capitalization rates from a hat (or worse places). In a perfect world, capitalization rates would be based 100% on objective empirical data. As a practical matter, all capitalization rates contain an element of subjective judgment by the appraiser. The difference between a good job and a bad job of developing a capitalization rate, in my opinion, is using all available empirical data to objectively quantify identifiable risk and to limit, as much as possible, the subjective element of the capitalization rate.

Litigation Services

To maintain a claim for lost profits, a plaintiff must generally prove three things:

1. The defendant breached a legal duty to the plaintiff

2. The defendant's actions or failures to act damaged the plaintiff

3. The plaintiff's damages are "proximately related" to the defendant's actions

The "before and after" method. Under this method, the accounting expert compares the plaintiff's profits before the alleged breach or tort to the profits after the event.

The "yardstick" method. This method compares the plaintiff's earnings against those of a similar business, product, or comparable measure.

The "but for" method. The above two methods are acceptable when the facts are fairly straightforward. The fallacy in the above approaches, however, is that they may fail to consider other factors that would tend to increase or decrease the amount of the plaintiff's lost profits. A proper "but for" analysis will consider all potential relevant factors that may affect profits and segregate those caused by the defendant.

Mediation

Last month we explored positional bargaining. This month we look at interest-based bargaining.

Attitudes of interest-based bargainers

• Resource is seen as not limited
• All negotiators' interests must be addressed
• Focus on interests not positions
• Parties look for objective or fair standards that all can agree to
• Belief that there are probably multiple satisfactory solutions
• Negotiators are cooperative problem-solvers rather than opponents
• People and issues are separate. Respect people, bargain hard on interests
• Search for win/win solutions

• Produces solutions that are tailored to specific needs or interest
• Builds relationships
• Promotes trust
• Promotes cooperative behavior that may be valuable in the future