Specialty Valuation: Cannabis, Dealerships, and Fraud/Forensics Debbie Foister Stacey D. Udell / Rhonda L. Czifra


Highlights from the January 19, 2022, webinar presented by Stacey D. Udell, CPA/ABV/CFF, CVA; Rhonda L. Czifra, ASA, CPA, MFE; and Debbie A. Foister, CPA, CFE, CIRA, CVA

Valuing a Cannabis Business
We’re seeing more and more states legalizing cannabis for medical and/or recreational use. Valuing a cannabis business is different from valuing other businesses, though fundamental appraisal concepts still apply.

Valuation methods include asset, income, and market approaches.
– An asset approach is typically used when a business hold a great deal of assets, such as in holding companies.
– Income approaches are based on the business’s income. The capitalized approach is used if income is expected to be stable, and discounted when there are going to be income ups and downs.
– A market approach includes considering transactions compared to other similar businesses. A guideline public company market approach looks at public companies in an industry and applies a multiple from them to your company.

In the public company method, especially for cannabis companies, the public companies are so volatile that transactions don’t set an expectation of future earnings. Larger, multi-state operators will make acquisitions to get into additional states, so a value determined by an income approach is not what a business will sell for. Companies are paying multiples to get into the industry. The market is different in every state and jurisdiction where the business operates. Factors like approval for retail stales or distances between businesses will impact performance.

Access to banking and capital are among the biggest obstacles in the industry. Many banks don’t want to spend the time to ensure they are in compliance serving cannabis businesses. Therefore, there is a lot of cash in the businesses and the related risks can affect value.

In the income approach, we determine the present value of the expected future cash flows: risk free rate + equity risk premium + size premium + specific company risk. Because of cannabis industry uncertainty, risk can be as high as 30 to 40 percent; increased risk increases rate of return, which lowers value. We often use the discounted cash flow to value a cannabis business where it will take some time to get up to full capacity, such as with a cultivator.

Valuing an Auto Dealership
New car sales were at $50 billion in April 2020, and peaked at $107 billion in March 2021. Auto and light truck sales were at 8.6 million units per month in April 2020 to 18.3 million in April 2021. The inventory-to-sales ratio, which typically runs between 2 and 3, peaked at 3.9 in April 2020 and was at .24 in November 2021. Translates to limited supply among unchanged demand. Public entities’ three-year average compound annual growth rate in price per share is 43 percent.

In valuations of auto dealerships, we consider all three approaches: assets, income, and market. It is an asset-intensive business with investment in equipment, machinery, in the service department, and we want to capture that investment. But it is also worth more than the tangible assets. There is a “blue sky” component to add into the total value: the fair market value over the tangible assets, also often referred to as good will; the intangible value that differentiates the dealership from other sellers of homogenous or substitute vehicles. When dealerships are bought and sold, it’s the blue-sky value that is negotiated.

We value blue-sky through quarterly Kerrigan Advisors and Haig reports that provide pre-tax earnings for dealerships based on the transactions of large private and public dealerships. They represent both buyers and sellers. We also use an income approach to look at the risk factors that pertain to blue-sky value and what kind of return the buyer would want. We can convert income to a multiple or capitalize earnings, relying in either case on normalized net income as a proxy for future income.

How do we adjust multiples or estimate risk and return?
-Historical performance factors include size and growth potential; manufacturer performance metrics and market share; operations expenses and cost control; profitability; and the balance sheet in terms of liquidity, leverage, and working capital requirements as stipulated by the manufacturer
-Location/market factors, including competition and the condition of the regional and local economies
-Management factors, such as experience and stability
-Facility compliance in terms of meeting standards
-The demands of the manufacturer in terms of the perception and value of the brand
-Upside potential

Common adjustments to dealer statements include:
-“13th period” adjustments to sales and expenses
-Expense in building last-in, first-out reserve
-Used inventory write-downs as trade-ins cars remain unsold
-Fixed assets and depreciation
-Personal assets to be deducted
-Chargebacks, such as from insurance companies
-Compensation for officers and family members
-Contributions to improve product
-Packs as they balance out with liability
-Over remits as related to insurance companies which can flow back to dealer
-Personal/non-operating items
-Non-recurring income and expense items

Additional Considerations:
-Is dealership reporting losses? Blue sky might be higher on depressed earnings.
-Is performance sustainable?
-Is the dealership meeting working capital requirements as established by the manufacturer?
-If dealership isn’t meeting manufacturer requirements, could the manufacturer terminate the agreement?
-Will the manufacturer approve the buyer?

Forensic Services
Some of the forensic services provided by HBK: misappropriated asset analysis; forensic audits; investigations of white collar crime, bankruptcy, insurance claims, embezzlement, and tax fraud

Occupational Fraud: the use of one’s occupation for personal enrichment through deliberate misuse of misappropriated organization resources or assets.

Trust is always a major factor in fraud cases. Manipulation of accounting records is proof of attempt to hide the crime.

Three ways to divert assets from a company:
-Skimming, an off-book scheme where sales are not recorded or understated; occurs most often in cash businesses, like bars
-Larceny, taking cash after it has been recorded on the books; leaves an audit trail
-Fraudulent disbursements, the most common form of asset misappropriation; traceable and generally easy to prove; most cases involve doctored documents

Embezzlement involves four factors:
-A fiduciary relationship between two parties
-The perpetrator acquiring the property through the relationship
-The perpetrator taking ownership or transferring to another
-The action intentional

Behavioral red flags to identify a perpetrator:
-Living beyond their means
-Big spender
-Close relationship with a customer or vendor
-Lied on resume
-Legal or financial problems
-Refuses to delegate
-Divorced or having family problems
-Has an addiction
-Refuses to take vacation days
-Unusual work schedule
-Intimidates subordinates to keep them from asking questions

We have seen an uptake in motivation-related cases due to gambling addictions. The Fraud Diamond methodology illustrates the psychology behind modern-day frauds, including opportunity, temptation, entitlement, and boldness.

Pro-active steps to reduce the risk of becoming fraud victims:
-Segregate duties
-Cleared checks through bank statement or online
-Concise and consistent with policies, including expense reports and travel
-Financial statement transparency
-Criminal background checks
-Bonding for insurance money to prepare investigation and recoup losses
-Surveillance cameras as deterrent
-Inventory tracking
-Original documents
-Eliminate cash transactions
-Tone at the top: moral and ethical
-Spot checks of records
-Mandatory vacations
-Educated board; financial statement accountability
-Dual signatures; no rubber stamps

The length of a fraud scheme averages 14 months from start to discovery. The length for occupational fraud schemes averages 24 months, less for larceny and skimming. Median loss in $100,000. Most commonly detection comes from tips.