Six Things You Need to Know Before You Go Through a Valuation Analysis
A standard business appraisal provides a reasonable estimate of a market price for something that is not sold on a public market, such as shares of a closely held company. If there were an actively quoted price on a public market, you could just refer to that price and do without an appraisal.
A valuation exercise always involves some kind of model of a market -- an assumed context for estimating a price. The “value” of the business asset depends on what the market is and who the market participants are assumed to be. This, in my experience, is the most important thing to understand when starting a valuation assignment.
- Define the assignment carefully. The results of a valuation model will differ significantly depending on the purpose and other key assumptions. For example, is it the sale of the company as a whole to a competitor company (seller cedes control, buyer can change organization and controls cash flows); or is it the sale of minority shares of the company (the seller does not control, and the buyer will not control, the company)? If it is for IRS purposes, the definition of “fair market value” explicitly recognizes discounts for lack of control and lack of marketability inherent in a non-controlling, non-marketable interest.
Here are five more things clients need to know before going through a professional valuation of their business or business assets:
- For an IRS valuation, the valuation report provides evidentiary as well as valuation support. That is, the IRS wants documentation showing the history and financial condition of the company as well as a clearly described valuation methodology and conclusion. The process, and the cost of the valuation report, reflects the need to “dot the i’s and cross the t’s” in describing the company, its operations, ownership, past transactions, financial condition, and comparability to other companies in its industry.
- Valuations are developed, and valuation reports are written, according to well-recognized business valuation standards such as USPAP (the “Uniform Standards of Professional Appraisal Practice” of the Appraisal Foundation) and SSVS (the “Statement of Standards for Valuation Services” of the AICPA). The standards have two parts: rules for developing the valuation, and rules for describing and documenting that procedure in a written report. The work product is impaired if it is not consistent with these standards.
- Valuation analysis is forward-looking. Value is defined in modern finance as the present value of the future economic benefits provided by the ownership interest. You will probably be asked to assist the business appraiser in assessing whether historical results are a reasonable proxy for future results.
- There are many valuation methods that may be appropriate; the most accurate appraisals typically employ more than one method, and harmonize or reconcile the results of different methods. An appraiser that relies on only one method should be able to explain why other methods were not used. “Cherry picking” a method does not represent best practices.
- Whereas valuation is forward-looking, accounting is historically oriented. Accounting book value must be considered in the valuation analysis, but it will rarely equal the valuation conclusion.