A business valuation is one of the most manipulation-friendly disciplines in professional services. The stakes are high and because of this, someone, somewhere, could find themselves motivated to move the number. For the valuation expert, understanding where legitimate (and permissible) advocacy ends, and intentional distortion begins is not simply an academic exercise. It is a professional survival skill, and increasingly, a legal one. The author discusses four schemes where fraud may occur and describes the red flags professionals need to recognize to identify fraud.
The Setup
The valuation was delivered to the client and the business appeared healthy. The revenue was trending upwards, compensation to the owner has been “normalized”, and substantial time was incurred to make certain that the discount rate had landed where the client needed it to be. The fee was collected and everyone moved on with their lives. Fast-forward months later and that report finds its way as an exhibit in a bitter divorce proceeding, and is being used to justify a settlement that the expert of the opposing spouse, with all due respect, felt was, “difficult to reconcile with economic reality.”
Was it fraud? Ultimately, that would depend on intent, context, and a set of data and inputs that the analyst accepted without question. One thing is certain: valuation is one of the most manipulation-friendly disciplines in professional services. It is built on a foundation of professional judgment and because of this, it can tolerate a broad range of answers that can be ultimately defensible. We may commonly have to operate in numerous areas such as divorce, estate planning, partner buyouts, tax filings. The stakes are high and because of this, someone, somewhere, can find themselves motivated to move the number.
For the valuation expert, understanding where legitimate (and permissible) advocacy ends, and intentional distortion begins is not simply an academic exercise. It is a professional survival skill; and increasingly, a legal one.
Judgment vs. Intent
Valuation is inherently an exercise that deals with ranges. Two competent analysts can examine identical facts and arrive at conclusions with material differences. It is not because one was wrong, but because discretion is involved at every step. It does not matter if we are discussing the treatment of a non-recuring expense or the selection of a capitalization rate, each decision will be defensible across a range of reasonable values. This is not a methodological flaw. It is the nature of work.
Manipulation does not live in that range. It lives in the intent behind how inputs are selected to engineer a conclusion rather than reach one methodically. The difference matters both ethically and legally. An analyst who applies a discount rate which is higher based on industry reported data and risk factors which have been documented is doing their job. An analyst who selects the discount rate because the client said “I need the value number under two million” is doing something else entirely.
While intent can be notoriously difficult to prove, it is not difficult to recognize. Those in the field that have contested engagements know this feeling far too well. Here we find the client who pushes back not on the methodology of the work but the conclusion it produced. The principal provided documentation in a suspiciously pre-organized and polished form. The engagement that starts with being provided with a target number instead of presenting a question or problem to be solved. While these are not always a red flag, they certainly can be. It is the analyst’s job to know the difference when presented with them.
Four Schemes Worth Knowing by Name
The manipulation of a valuation rarely involves the fabrication of documents or outright lies. The manipulation operates through selection bias when they choose, among legitimate options, those which benefit a desired outcome. There are four schemes that represent this in its most common form.
- Revenue Inflation and Normalization Abuse
In the valuation analyst’s toolbox, normalization is commonly one of the legitimate (and abused) options. The reason for addbacks is to present an economic picture of the business which is independent of owner-specific decisions. This is why it is important that discipline is required. The owner’s cousin that appears to be drawing a salary but does not work, can be a valid normalization. The “one-off” legal expense that appears to recur every 12 months would not be. If you accept a client’s normalization schedule without inserting any scrutiny, it is not conducting a valuation. You are transcribing one. - Rate Manipulation: Discount Rate and Capitalization Rate
As part of the income approach, the rate applied may be the most powerful level to a manipulator. In a capitalization of earnings model, the capitalization rate directly determines the value. For example, $500,000 in normalized earnings capitalized at 20 percent would yield a $2.5 million result. If we move that rate to 22 percent, we will see that the value drops to $2.27 million. Move it the other direction to 18 percent and the value rises to $2.78 million. Now we have a four-point spread that is entirely within the range a professional might defend while also creating a half-million-dollar value swing. In the multi-period DCF, the discount rate operates the same and compounds its effect across the projected periods. Here the red flag is not any rate but instead a rate that cannot be traced to documented risk factors. If it cannot be articulated why 22 percent was chosen over 18 percent, the choice may not have been analytical.
- Comparable Selection Bias
The market approach lives and dies by the quality of its guideline companies. Here we can find another area where manipulation is most easily hidden. If a high valuation is sought by the analyst, they could make the decision that low-multiple comparables could be excluded on profitability grounds. While the analyst who might be seeking a low valuation can just as easily exclude high-multiple comparables under the guise of them being non-representative outliers. When done honestly and ethically, this is a good practice. Done selectively, it is outcome engineering. The discipline test: Can you articulate a consistent screening criterion that was applied before looking at the multiples, or did the screening happen afterwards? - Suppressed Earnings for Tax or Divorce
Manipulation does not occur in all cases under the guise of returning a higher number. In gift and estate tax contexts, the incentive would run in the opposite direction because a lower value means a lower tax liability. In divorces, a business owner seeking to minimize the marital estate would then have a strong motivation to present a company that looks less profitable than it is. Suppression schemes often involve accelerated expenses a year or two preceding a valuation, timing of capital expenditures, or even strategic compensation decisions. The analyst who accepts historical financials at face value without asking what was different in recent periods is missing the most tell of potential misstatements.
Where It Happens: High-Risk Contexts
Like other forms of manipulation, valuation manipulation does not occur randomly. It will commonly occur where the parties have high financial stakes, limited external oversight, and access to the inputs that drive the levers and the analysis. Here are many of the environments that should produce a heightened professional skepticism.
- Marital Dissolution: Many would agree this is the most contested arena in a valuation practice. One party controls the books; the other relies almost entirely on what is produced. Sound familiar? The problem is that these are not symmetrical positions. The valuation expert that is retained by the controlling owner faces a manipulation risk because their client controls all of the source data. While on the other side, the valuation expert retained by the non-controlling spouse has an entirely different problem. They are working from documents obtained through discovery, which may (and likely will) be incomplete, produced selectively, or even pre-filtered. Both sides of this contest will be cross-examined and neither is low risk.
- Buy-Sell Agreement Triggers and Minority Squeeze-Outs: When a partner buyout is triggered, frequently, the controlling owner controls both the financial records and near-term decisions of the business. Suppression of short-term earnings in the period that proceeds with a mandatory buyout is a known documented pattern.
- Gift and Estate Tax Planning: You will be happy to know that the IRS has seen every possible discount strategy in existence and now they are the counterparty here. Aggressive minority and lack of marketability discounts that are applied without documented support are among the most litigated positions in estate tax valuation. The analyst should know that the work product is subject to audit and potentially even to penalty.
- ESOP Formations and Annual Updates: ESOP valuations contain a conflict of interest embedded within its structure that is worth directly addressing. In this scenario, the trustee holds a fiduciary obligation to plan participants while being legally required to pay no more than the fair market value. The conflict arises when the trustee fails to act independently, which is commonly done by relying on a valuation advisor who was selected by, or has loyalty to, the selling owner. When this occurs, the valuation then effectively serves the seller’s interest at the expense of the participants the trustee is supposed to protect. In fact, the Department of Labor has brought enforcement actions against both advisors and trustees in these situations, while the scrutiny on ESOP valuations has increased materially in recent years.
Red Flags the Analyst Should Recognize
None of the following observations is, on its own, evidence that fraud has occurred. However, when clustered together, or in some manner of pattern, would be enough reason to give pause.
- When the client directs or pressures specific inputs such as discount rates, addbacks, and comparable sections, instead of engaging with the methodology itself, or when the desired conclusion is communicated prior to the work getting underway.
- When source documents arrive pre-organized, with prior-year comparisons already stripped or highlighted in a particular direction.
- When earnings appear suppressed in one or two years immediately preceding a triggering event such as a divorce filing, partner dispute, or ownership transfer. Does accelerated expenses, unusual compensation, or deferred income mirror historical patterns?
- When the engagement was referred by legal counsel that provided a specific outcome framed into the referral.
- When prior valuations performed appear to show a trend that consistently benefits the same party in the same direction, regardless of the performance of the business.
- When prior to the engagement formally begins, a target number is communicated either directly or indirectly.
Professional and Legal Exposure
It should not come as a surprise that valuation experts are not immune to the legal consequences of the reports they produce. The Professional Standards established by the NACVA create obligations around such areas as independence, objectivity, and disclosure. Violations related to these standards could result in disciplinary action, loss of credential, or in some cases both. However, the higher risk associated from case manipulation is not in the form of loss of credential, it is the potential legal ramifications.
The preparer of a work product used to support a fraudulent transaction can find themselves a fact witness in subsequent litigation. If the analyst knew, or more to the point, reasonably should have known, that the engagement was designed to produce a predetermined result, that exposes continued upward in severity. The courts have found valuation professionals civilly liable in ESOP, divorce, and tax fraud cases where the analysis was found to be not only materially incorrect, but deliberately biased to one side.
This is why the language contained in the engagement letter is far more important than many of the practitioners in the field give it credit for. The well-constructed engagement letter establishes the scope clearly, identifies the intended use and users of the report, and acts to limit the responsibility of the analyst for representations made by management. It does not, however, provide relief from potential liability when the report was drafted with the intent to deceive. Ultimately, the document trail made up of workpapers, communications, client-provided production and materials tell the real story. Make sure that yours tells the right one.
What To Do When You Suspect It
Suspicion is not a finding. When you find yourself with the appearance of the first red flag, your first responsibility is to simply ask more questions. Can they provide all the underlying support for the addbacks? Have you asked why prior year numbers look so different? Ask for a complete, unredacted financial statement package when necessary. Be certain to document what was provided, what was withheld, and what was the client’s response to each request. This type of documentation will be your front line of potential protection regardless of what you ultimately conclude.
What do you do if the pattern of concern deepens? The next step would be internal escalation to a supervisor, a firm partner, or even legal counsel prior to the report being issued. This is not to be confused with making an accusation to the client or opposing counsel. This is a professional conversation about whether the engagement can be completed with its integrity intact given what is currently known.
As may have been anticipated, in some cases, the correct answer will be to withdrawal. NACVA’s Professional Standards address situations where an analyst cannot complete the engagement in accordance with professional requirements, and withdrawal is a recognized option when necessary. Applicable standards should be reviewed prior to action, and it may be prudent to consult with legal counsel if the engagement has already produced documentation that may be subpoenaed later. It is important to make the distinction that a withdrawal is not a finding of fraud. It is a professional decision that the engagement cannot be completed as scoped. Document the decision and its basis, and do not simply stop communicating.
Under no circumstances should an analyst issue a report they do not believe, modify conclusions to satisfy client pressure, or depart from standard methodology without providing an explanation for doing so within the workpapers. While these decisions might feel small in the moment, they are not.
The Analyst’s Advantage
Let us return to the opening scenario for a moment. The analyst who delivered that report may have done nothing wrong. As there are often multiple ways to arrive at the final number, valuation opinions are allowed to differ. The outcome of contested litigation is not evidence of fraud by the analyst who took the loosing position. Consider what the analyst had that no one else in the transaction did: access to the financials, the normalized earnings, the discount rate assumptions, and the client’s stated motivations. No attorney, no judge, no opposing party had that vantage point before the report was issued.
That access is both a privilege and a responsibility. The CVA is not a gatekeeper in the criminal justice sense. But the CVA is, in many engagements, the only independent professional who will ever look closely enough at the numbers to see what is there. How the professional uses or fails to use that vantage point has real consequences for the client, counterparties, and institutions that rely on the work.
The manipulation of a valuation is not always obvious, and it is not always intentional, but it is always worth looking out for. The number on the final page of the valuation report will be used to make real decisions with real financial consequences. The analyst who produced it has an obligation to know what went into it and to be able to defend not only the conclusion, but every assumption that drove it.
The number should never lie.
Jeff A. Kolbfleisch, MSFFE, CFE, CCI, is a Forensic & Valuation Services Consultant with Dean Dorton, providing litigation support in areas of business valuation, forensic accounting, fraud detection, and cryptocurrency tracing. He currently holds advanced degrees in Fraud and Forensic Examination as well as in Anti-Money Laundering and Compliance Investigations.
Mr. Kolbfleisch can be contacted at (904) 479-0108 or by e-mail to jkolbfleisch@deandorton.com.
