To Cesare and Giacomo, may they appreciate the value of what really matters in life
If you are leafing through this book you might wonder whether a new textbook on business valuation is really necessary, as so many books have been published on this subject in recent years. In my opinion there is still something to say; let me try to explain why. First, many textbooks address business valuation as if the valuation method were all that mattered. In fact, most business valuation textbooks are specifically focused on calculation methods. Unquestionably, these play a very important role, as they are the formal part of the entire process. The risk, however, is to place too much emphasis on the quantitative dimension, without adequately considering the context in which the valuation is made. The method chosen is the result of a broader analysis through which the characteristics of the firm are investigated. It is the method that must adapt to reality not the other way around.
The purpose of this textbook is to offer a guideline for the application of an integrated approach, thereby avoiding “copy and paste” valuations, based on prepackaged parameters and the uncritical use of models. Specifically, an Integrated Valuation Approach (IVA) should be adopted that encompasses, within any specific method, a wide range of elements reflecting the characteristics and specificities of the firm to be valued. Secondly, many textbooks do not adequately consider the role of valuation standards. In both the literature and professional practice, business valuation is now circumscribed to some specific models, although many variations can be found in their practical application. Valuation standards allow for an alignment of both the methods and their application, providing a common basis for valuers. This book is based on the International Valuation Standards vii
(IVS) issued by the International Valuation Standards Council. These standards significantly help the valuation work, both generally (scope of the work, investigation and compliance, reporting, basis of value, valuation approaches and methods) and specifically (business interests, intangibles, plant and equipment, real property, development properties, financial instruments), and provide useful indications. To write this book I had to take time away from my family; thus, I am grateful to my wife Laura and my children for their patience and to whom I dedicate this book. Rome, Italy
Marco Fazzini, PhD
1Value, Valuation, and Valuer 1 2Integrated Valuation Approach (IVA) 23 3Financial Statement Analysis 39 4Income-Based Method 77 5Market-Based Method 123 6The Cost Approach 175 7Intangible Assets Valuation 183 8Premiums and Discounts in Business Valuation 209 Index 219
Range of plausible values General requirements of a valuation report Investments and financial sources Functional reformulation of the balance sheet Relationship between assets and liabilities Reclassification example Net assets Working capital Business assets Non-current net debt Current net debt Net debt Financial statement at a glance The income statement Reclassified income statement Gross margin distribution Cash flow statement Example of financial statement Business assets Turnover of individual assets Mismatch between profit and cash flow Balance between investments and financial sources A part of current assets is covered by long-term sources A part of non-current assets is covered by current debt Asset-side and equity-side valuation The logic of discounting Comparison between the returns of different government bonds
CAPM at a glance Cash flows and EBITs trend Asset-side and equity-side approaches EV/EBITDA % change over one year EV/FCF and EV/Sales regression Basics of value. (Source: NACVA, Valuation Discount and Premiums, 2012) Fig. 8.2 Control premium and discount for lack of control
Facebook financial key figures and market value (2013–2016) Amazon.com statement of operations (in $ millions) Cost of sales Operating working capital turnover Dividend payout ratio and sustainable growth rate Effect of a decrease in revenues US Treasuries yields (first semester 2017) Euro Area Yield Curve (November 2017) Beta by industry in the US, Europe, and Japan Peer group beta Business unit key data Business unit’s levered betas ERP by country Sensitivity analysis on CAPM Sensitivity analysis on total value Rating definitions Example of expected cash flows series Cash flows versus EBIT Value of the firm without growth rate Value of the firm with growth rate Value of the firm using an EBITDA multiple Cash flow statement Asset-side valuation Equity-side valuation Expected earnings Expected dividend per share Value per share Key statistics of food and beverage industry
Comparison between two peer groups 138 Peer group’s standard deviation 139 Standard deviation of EV/EBITDA 139 Correlation between multiples and EBITDA margin 140 Application of the EV/Sales 142 Application of the EV/EBITDA 144 Application of the EV/EBIT 145 EV/EBITDA and EV/EBIT in automotive industry (Q1 2016, Source: Capital IQ) 147 The peer group 150 Evolution of the EV/EBITDA multiple 154 Evolution of the EV/EBIT multiple 156 YoY percentage change of the EV/EBITDA multiple 158 YoY percentage change of the EV/EBIT multiple 160 Multiples standard deviation (2005–2015) 162 Application of P/E ratio 165 Application of P/E ratio 166 Beverage companies multiples ($ mil) 171 Multiples statistics 171 Distribution in quartiles 171 Multiples statistics without outliers 173 Distribution in quartiles without outliers 173 Target company’s income statement 173 Enterprise value of the target company 173 Stress test matrix 174 Book value of the firm 176 Adjustment to book value 176 Investments in intangible assets (% officially measured value added) 184 Factors considered in the adjustment of the royalty rate 192 Comparable transactions royalty rate 193 Value of the patent 194 With and Without scenarios 197 Value of the brand by comparing the “With” and “Without” DCF197 Value of the brand by comparing the value of the firm in the “With” and “Without” scenarios 197 Revenue and expenses related to the contributory assets 199 Contributory assets charges (fixed assets and working capital) 200 Contributory assets charges (fixed assets and working capital) 200 Greenfield method 201 Average salary per person 205
List of Tables
Table 7.13 Statistics on recruitment cost and on unproductive training period Table 7.14 Value of the workforce calculation Table 7.15 Replacement cost of software Table 7.16 Replacement cost new Table 7.17 Functional obsolescence Table 7.18 Economic obsolescence Table 7.19 Value of software Table 8.1 Control premium and controlling interest
205 206 207 207 208 208 208 215
1 Value, Valuation, and Valuer
1.1 What Does Making a Valuation Mean? In life we continuously make valuations. When we go shopping, for example, we make sure that the proposed price reflects quality; when we book a room, we make sure that the rate is in line with the hotel features and the services it offers; when we choose a school for our kids, we assess the quality of the programs and the teachers’ standing; when we buy a house, we make sure that the value is in line with that of other houses in the neighborhood. In short, valuations are part of our daily experience; generally, they consist of two components: an objective one, which regards the intrinsic value, and a subjective one, linked to the valuer’s perception of the object to be valued. Separating these two components is difficult, as our choice is never entirely based on either the subjective or the objective component, but on a mix of both. For example, when buying a house, we do not choose the house with the best price per square foot, regardless of its characteristics; nor do we solely rely on our aesthetic perceptions, neglecting the price. Not surprisingly, we make choices based on a trade-off between objective circumstances (price) and subjective perceptions (location, finishes, interior design, etc.). This mechanism is easy to find in contemporary art auctions. Given an objective value, based on previous auctions, expert judgment, quality of the work, and so on, the results may differ significantly, reaching amounts that have little to do with the characteristics of the work or with the prices attained in previous auctions.
Business valuations work in the same way. There is an objective component of value, based on valuations methods, and a subjective one, based on the valuer’s experience and ability to capture reality. This means that two equally knowledgeable persons, with similar sensitivity, will hardly get the same result, although they start from the same assumptions and quantitative inputs. To make a comparison, think of two chefs who are given the same ingredients to prepare a certain dish. The result may appear similar, but the different combination of timing, cooking processes, doses, creativity, experience, and dish presentation will lead to different outcomes. In this book, we will deal with the objective component, which is how we determine the value of a business based on generally accepted valuation methods. What does it mean to value a business? We can respond that valuation is the act of estimating or setting the potential value of a business by considering both internal and external variables. The internal variables look at the results a firm has achieved in the past; for example, the debt-to-equity ratio, EBITDA (earnings before interest, tax, depreciation, and amortization), revenues, and cash flow provide us with an understanding of what characterizes the business and constitute a basis for determining its value. The external variables look at the environment in which the company conducts its business and include, for example, market features, the company’s competitive positioning, distribution channels, or consumers’ tastes. In short, it is necessary to develop a comprehensive opinion that encompasses in one single model both the theoretical business value and the value that considers the environment where that business develops and performs its activity. This is why the method presented in this volume is called integrated valuation approach (IVA). According to this approach, the evaluation process does not end with the application of a model, but requires considering the business as a whole.
1.2 The Business Valuation Valuing a business is a complex exercise for various reasons. First of all, the characteristics of the business change quickly. Over time, changes may occur that affect the value of the business, for example, a reduction in profit, higher investments, new debts, different revenues. Value, therefore, is neither constant nor immutable, but must refer to a specific date and situation. A valuer is like a photographer who has to take a picture of a moving
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object. To obtain a clear image he or she needs the right camera and the right setup and must have enough experience for this type of shot. Likewise, valuers must be able both to choose the model that better interprets the value and to apply it correctly. Secondly, the value of a firm can be seen from different perspectives. As we will see further on, we can use methods that are based on expected cash flows (income methods, see Chap. 4), market values (market methods, see Chap. 5), and reproduction/replacement cost (cost method, see Chap. 6). Each of them considers some specific aspects of the firm and can lead to partially different results. As mentioned in IVS 105 (International Valuation Standard 105) “the goal in selecting valuation approaches and methods for an asset is to find the most appropriate method under particular circumstances. No one method is suitable in every possible situation.” Valuers must therefore apply their experience and judgment to identify the most suitable approach; it means that value depends not only on business characteristics but also on the model applied. Furthermore, not all assets can be measured. The value drivers of a firm are often based on elements that can only be quantified through the output they produce. For example, the value of Facebook is linked to assets such as the number of users, competitive positioning compared to other social networks, the ability to innovate, and integration with other platforms such as Instagram and WhatsApp. Evaluating Facebook based on financial figures only could be an oversimplification. As shown in Table 1.1, the market value of Facebook rose by 109.80% from 2013 to 2014, from $66.4 billion to $139.3 billion. Assuming there is no constant relationship between market value and financial data (otherwise we would now have the “safe” investment formula), none of the key figures have changed in the same way as market value. Expectations about the company’s value were evidently higher than the results achieved. Market value increased more than proportionally compared to key financial figures also from 2014 to 2015. Table 1.1 Facebook financial key figures and market value (2013–2016) Consolidated data ($/Mil) Revenues Income from operations Free cash flow Market value
YoY growth (%)
$3458 58.91 $66,420 109.80
YoY growth (%)
$5495 41.89 $139,350 56.39
YoY growth (%)
$7797 48.99 $217,930 39.19
It was only from 2015 to 2016 that the increase in market value was lower, probably due to investors’ perception of a stronger alignment between key financial figures and market value. Hence, financial results do not perfectly reflect the value of a firm and, although they are the basis on which business valuation is built, there are other aspects that cannot be measured reliably. Finally, there is a difference between price and value: in an ideal world they should coincide, but in practice they may differ, and the gap can be significant. Price is the amount requested to purchase an asset. It is an empirical quantity that is influenced by supply and demand. Value, on the other hand, is the result of an estimate and may reflect a potential price in a transaction between two independent parties. Here are some examples to help you better understand this price/value gap. A cotton T-shirt made by an haute couture company, with a modest intrinsic value of a few dollars, is put on the market at a price of tens or hundreds of dollars. In this case, price is higher than the value of the good. Here is another example: in a crisis situation, people may have to sell out some of their property (e.g. jewelry, buildings, art collections) for amounts lower than their intrinsic value. In this case, price is lower than value. We face the same problem when valuing a company. How much is 2% of a small firm’s equity worth when another shareholder owns the other 98%? In theory, that stake is worth 2% of the total value of the company; in practice, the price may be impossible to define or close to zero, as there would be no buyer due to lack of marketability. Indeed, who would want to spend money to buy a minority interest that (a) is difficult to sell and (b) has absolutely no influence on the majority shareholder? In this case, again, price and value may have no correlation at all. If we generalize the concept, value reflects a potentiality; price, on the other hand, reflects the here and now. The misalignment between value and price is sometimes significant, but no amount is “truer than another”. They can both be justified, depending on the characteristics of the good to be traded and the circumstances. Moreover, as Oscar Wilde once said, “nowadays people know the price of everything and the value of nothing”.
1.3 What Is Value? “Value” is not a concept that can be easily enclosed in a universally valid definition; there is no unique measure for it, not even from a quantitative standpoint, since, depending on the instruments used, the data taken as reference,
Value, Valuation, and Valuer
Range of plausible values
Not realistic values Fig. 1.1 Range of plausible values
and the interpretation proposed, we may obtain different results, all of them equally plausible and consistent. Correctly applying a formula is not enough to reach the reasonable certainty that the result is the value of the entity, since it is highly unlikely that an equation can capture the complex set of conditions surrounding a firm. A value is much more likely to be defined, in quantitative terms, through a range of plausible values, the breadth of which depends on methodological accuracy and the ability of the model to interpret the business specificities (Fig. 1.1). Value, therefore, is neither an absolute nor a unique concept. There is, actually, more than one configuration of value, depending on the purpose of the assignment and the characteristics of the business. This is precisely why referring to bases of value is more appropriate, as suggested by the IVSs. According to IVS 104, “bases of value (sometimes called standards of value) describe the fundamental premises on which the reported values will be based”. The standard adds that “it is critical that the basis (or bases) of value be appropriate to the terms and purpose of the valuation assignment, as a basis of value may influence or dictate a valuer’s selection of methods, inputs and assumptions, and the ultimate opinion of value”.
1.3.1 Common Elements of the Bases of Value As described in IVS 104, while there are different bases of value used in valuations, most have certain common elements: 1 . an assumed transaction; 2. an assumed date of the transaction; and 3. the assumed parties to the transaction.
188.8.131.52 Assumed Transaction According to IVS 104, depending on the basis of value, the assumed transaction could take different forms: (a) a hypothetical transaction; (b) an actual transaction; (c) a purchase (or entry) transaction; (d) a sale (or exit) transaction; and/or (e)a transaction in a particular or hypothetical market with specified characteristics. A transaction is hypothetical when the other party has not yet been identified or the time is not ripe to initiate a transaction. For example, a valuer could be appointed by the shareholders to evaluate a company in the event of a potential sale, in order to identify a range of plausible values to be used as reference for the deal. A transaction is actual if both the asset to be valued and the parties are known, there being, however, no specific constraints regarding the type of transaction. A purchase transaction or a sale transaction imposes greater constraints on valuers, as they may be required to consider the value of potential synergies or potential valuation discounts or premiums. Finally, a transaction in a particular or hypothetical market with specified characteristics requires that the valuer examines and is familiar with some specific aspects. For example, in a transaction involving financial assets in a Middle Eastern country, a valuer should be familiar with the fundamentals of Islamic finance and be able to distinguish between legal (halal), non-risky (gharār), and non-speculative (maysīr) investments.
184.108.40.206 Assumed Date of the Transaction The assumed date of a transaction influences what information and data a valuer has to consider in a valuation. Value is indeed a matter of timing and the assumed date is a relevant variable, especially in a dynamic context characterized by frequent changes.
220.127.116.11 Assumed Parties to the Transaction Identifying the parties also plays an essential role in the valuation process, since, as noted in IVS 104, “most bases of value reflect assumptions concerning
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the parties to a transaction and provide a certain level of description of the parties”. IVS 104 underlines that “in respect to these parties, they could include one or more actual or assumed characteristics, such as: hypothetical, known, or specific parties, members of an identified/described group of potential parties; whether the parties are subject to particular conditions or motivations at the assumed date (e.g. duress), and/ or: an assumed knowledge level”.
1.3.2 Bases of Value IVS defines to following bases of value: 1. 2. 3. 4. 5. 6.
According to IVS 104, market value is the “estimated amount for which an asset or liability should exchange on the valuation date between a willing buyer and a willing seller in an arm’s length transaction, after proper marketing and where the parties had each acted knowledgeably, prudently and without compulsion”. Market value, in accordance with the IVS conceptual framework, is “the most probable price reasonably obtainable in the market on the valuation date”. In other words, it is the best price reasonably obtainable by the seller and the most advantageous price reasonably obtainable by the buyer. The market value of an asset reflects its highest and best use, that is, the use of an asset that maximizes its potential and that is possible, legally permissible, and financially feasible. According to IVS 104, market rent “is the estimated amount for which an interest in real property should be leased on the valuation date between a willing lessor and a willing lessee” at the same conditions of the market value. According to IVS 104, equitable value is “the estimated price for the transfer of an asset or liability between identified knowledgeable and willing parties that reflects the respective interests of those parties”. The value in this case reflects the respective advantages or disadvantages that each part will gain from the transaction. This value is different from market value, which excludes any advantage that is not accessible to all the parties.
According to IVS 104, investment value is “the value of an asset to a particular owner or prospective owner for individual investment or operational objectives”. The value of an investment is linked both to the characteristics of the asset being valued and to those of the buyer and the seller. It may consider specific synergies or whether there are any advantages for a specific party. According to IVS 104, synergistic value is “the result of a combination of two or more assets or interests where the combined value is more than the sum of the separate values”. In this book we mainly look at stand-alone valuations, that is, those that are independent of potential synergies. Synergistic value is often associated with the evaluations made by a potential buyer who estimates not only the value of the asset but also the contribution that an asset may bring to the other assets already held. It is therefore an internal evaluation that can only be appreciated by those who can determine the benefit from combining several assets together. According to IVS 104, liquidation value is “the amount that would be realised when an asset or group of assets are sold on a piecemeal basis”. A business can be liquidated as a natural or forced process. A business would be “naturally” liquidated when it reaches the end of its life cycle and this condition is accepted by its shareholders. Forced liquidation occurs when the seller is forced to sell, which places the seller in a weak position with an obvious adverse impact on value.
1.3.3 Objective and Subjective Component of Value Given these definitions, we can conclude that there are two dimensions of value: an objective dimension, which reflects the value of the asset per se, that is, the intrinsic value that is assigned to an asset in an efficient market, and a subjective dimension, linked to the characteristics of the parties to the transaction, each of whom seeks to maximize their own benefits. In general, each valuation contains both an objective and a subjective element. A valuer should stick to the objective dimension as closely as possible, by making use of the generally accepted methods. Inevitably, however, the subjective element that is linked to our own perception and experience also plays a role in the valuation process; such element, however, should be nothing but a background noise that does not affect the stand-alone perspective. The more the valuer can count on a complete set of information, the less is the risk associated with the subjective variable. When asked to make a valuation based on limited information, valuers will tend to fill the information gap using their own experience and making analogies
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with similar cases they may have dealt with in the past. A valuer should therefore point out any lack of information, especially if it can influence the choice of the valuation method and the processing of data.
1.4 Valuation Methods at a Glance Various business valuation methods have been developed over the years. Each of these reflects a very precise logic and no one method is better than another in absolute terms. Rather, there are methods that, in certain circumstances, are more appropriate than others in interpreting the value of a business. According to valuation standards, the various methods can be grouped in three main areas: cost-based approach, income-based approach, and market- based approach. If we compare them based on the assumption that evaluating a company is not so different from evaluating a used car, we can better understand the logic of these approaches: there is no single metric to establish a fair value, but multiple perspectives that we need to consider. When you go to a dealer, you will first check the car and see if there are any scratches or dents on the bodywork, check the tire wear, the brake and engine operation, and any optional features such as air conditioning, safety devices, sunroof, and so on. In short, you will examine the car “as is”, adjusting the price accordingly. Not unlike a car, a firm can have its “scratches on the bodywork”, which can reduce its book value, such as receivables that are difficult to recover, obsolete equipment, contingent liabilities, and so on; at the same time, there may be enhancing elements, such as trademarks and goodwill that give the firm a competitive advantage, although they are not necessarily recorded in the financial statement. As for a car, it is possible to estimate the value of a firm “as is”, based on a reasoned examination of its assets and liabilities. To do this, we must examine the items in the financial statements and check whether their book value reflects their fair value; in case of discrepancies, if the book value is lower than the fair value, we should make an upward adjustment, and, vice versa, if the book value is higher than the fair value, a downward adjustment. The valuation method in question is known as cost-based method. Going back to the car example, we cannot simply look at its current condition; we must also consider expectations on its future use: purchasing a five- year-old car with 200,000 miles is quite different from purchasing a car of similar age, but with 20,000 miles. In the first case, the car certainly has a
shorter residual life and we will likely face higher maintenance costs; in the second case, the car is relatively new and will presumably require less expensive maintenance. The expected benefit, that is, what is expected from the vehicle taking into account its intrinsic characteristics, is therefore anything but secondary. If we apply this reasoning to businesses, we can determine the value of a business based on future expectations, that is, based on the results it could potentially achieve. This valuation method in question is known as income-based method. Finally, we can determine the value of the car by comparing the price proposed by the dealer with the values found in magazines and specialized websites, to make sure that the requested price falls within a range of plausible amounts, taking into account the characteristics of the car such as age, wear and tear, optional features, and so on. A company can likewise be evaluated based on a comparison with comparable entities. This valuation method in question is known as market-based method. When we buy a used car, many valuation methods should be applied. Looking at the conditions of the car does not exclude an estimate of its future use nor a comparison with the prices published on specialized websites and magazines. Indeed, it is precisely through several approaches that we can assess if the price of a car is fair. When valuing a business, on the other hand, we must choose a specific method. In fact, depending on the method, the results may be very different from one another. How is it possible? First, a business is more complex than a car, which is obvious. Second, the approaches refer to different parameters: • the cost-based method looks at the present and evaluates a business “as is”; • the income-based method looks at the future and evaluates a business based on “what it will do”; • the market-based method is based on the value of similar companies or transactions involving comparable companies; in practice, it evaluates a business based on “what others do”. When using more methods, the results obtained may be similar, but this is not a foregone conclusion. Each method is based on different logics and parameters and the value of the same business may differ due to the different perspective inherent in each method. Sometimes a combination of a main method and a control method can be used, to base the valuation on an increased number of variables. If the two methods correctly interpret the value of the business, the result can be similar; otherwise the values may differ significantly.
Value, Valuation, and Valuer
1.5 Types of Valuation There are different types of valuation according to the purpose of the assignment. Specifically, the following types can be identified: 1. 2. 3. 4. 5. 6.
A valuation performed for a third party is a document containing an opinion on the value of a business that is obtained through an independent and complex valuation process. In this case, valuers rely on the information gathered and on their personal experience, in order to carry out a comprehensive valuation, in accordance with the purpose of the assignment. If the valuation is commissioned by a seller, it is a sell-side valuation; if it is commissioned by a buyer, it is a buy-side valuation. The purpose of the work can partially influence the choice of method and the final assessed value. For example, in a sell-side valuation, the valuer may have access to internal documents, such as a business plan, which may point toward a DCF (discounted cash flow) method. On the other hand, a buy-side valuer could tend to use multiple methods, given the absence of internal information. There may be various reasons for making an in-house valuation, such as assessing whether selling the business, in whole or in part, is a good deal, or to test a subsidiary company for impairment. The technicalities used are the same as those of the valuation performed for a third party and internal information may obviously be used. The valuation opinion, also called expert opinion or expert report, consists in an assessment process limited to some aspects or based on unverified inputs provided by the client. It may concern, for example, determining a discount rate to be applied to the cash flows provided by the client and not reviewed; updating some parameters of a previous valuation; determining value based on a limited information base; and so on. This group includes equity research carried out by external analysts. A fairness opinion consists in verifying the reliability of a valuation process carried out by another party, given the inputs used, the method applied, and the conclusions reached. The aim of this opinion is to assess how reasonable a third-party valuation or a valuation opinion is.
A calculation engagement is not a real valuation, but a check of specific inputs used by another party. For example, this opinion may concern the development of a peer group to be used in the multiples method, or the analysis of the coefficients contained in the weighted average cost of capital (WACC) formula. Finally, the valuation review consists of a critical analysis of the work carried out by another valuer, to verify its correctness or to update it. Sometimes a valuation review involves a second opinion by an expert valuer, to verify the results; in other cases, it is a review carried out months or years after the valuation was made, with the aim of verifying whether the data or conclusions are still valid or whether they need an updating.
1.6 Who Is the Valuer According to the International Valuation Standards Council (IVSC), a valuer is “an individual, group of individuals or a firm who possesses the necessary qualifications, ability and experience to execute a valuation in an objective, unbiased and competent manner”. As mentioned, a valuation arises from a reasoned opinion based on estimates and is never the mere application of a mathematical calculation. Therefore, an expert should not just be able to “apply the formulas”, but also satisfy a broader set of requirements, including: 1 . respect for professional ethics; 2. independence; 3. objectivity in researching and selecting information; 4. expertise and diligence in carrying out the assignment. The respect for professional ethics involves complying with a series of requirements, such as those contained in the “Code of Ethical Principles for Professional Valuers” issued by the IVSC. According to the IVSC, a professional valuer is expected to comply with the following ethical principles: (a) integrity: to be straightforward and honest in professional and business relationships. (b) objectivity: not to allow conflict of interest, or undue influence or bias to override professional or business judgment.