Frequently Asked Questions
- Why should I have my business valued?
- I am gifting shares of my company’s stock to my children (or my company is converting from a C Corporation to a Subchapter S Corporation). Why should I hire a business appraiser?
- What is the difference between an appraisal and a valuation?
- When I hire an accountant, I typically expect that s/he is a CPA. What do I look for in hiring a business appraiser?
- Can I have my company’s CPA value my business instead of hiring an independent business appraiser?
- How long should it take to get my business appraised?
- How much does a business appraisal cost?
- Can a ballpark estimate of value be determined just by looking at the numbers?
- How do you value a closely-held business?
- What are some of the most common methods to value a business within these three approaches?
- Why aren’t you valuing my equipment and other fixed assets individually as part of valuing my business?
- What is “fair market value” and how might it differ from what a buyer might pay for a business?
- What is Revenue Ruling 59-60?
- Given the fact that I am obtaining an appraisal in connection with a litigation situation, will you be able to testify about your value conclusion?
- Once I obtain a business valuation report, how long is it good for?
- Is my company impacted by FASB’s Statement of Financial Accounting Standards Nos. 141 and 142?
- Our firm will be needing a valuation of its common stock in connection with IRC Section 409A and SFAS No. 123(R). Given that we have both preferred and common stock, how will you approach the valuation of our common stock?
1. Why should I have my business valued?
While business and personal circumstances vary, it is important to consider the value of your business as part of your overall strategy and decision-making process. It is necessary to identify and recognize the need that fits your plans and purpose, and conduct the valuation accordingly. Defensible opinions of value are necessary for many reasons and each reason may require a different approach and utilize different assumptions. These include tax, litigation, financial reporting, strategic planning, mergers and acquisitions, among many others. Examples of situations where a business valuation is needed are outlined in our list of services.
2. I am gifting shares of my company’s stock to my children (or my company is converting from a C Corporation to a Subchapter S Corporation). Why should I hire a business appraiser?
If the IRS audits the gift or challenges the value for any reason, the burden of supporting the value of the business or business interest rests with the taxpayer. Without a well-reasoned valuation from a qualified appraiser, the taxpayer has virtually no basis to dispute what may prove to be an unrealistic IRS valuation claim. If a qualified appraisal has not been obtained before filing the tax return, the taxpayer will ultimately have to pay for such a valuation when the valuation dispute arises. The existence of a well-reasoned valuation from a qualified analyst can sometimes prevent a valuation challenge. When faced with a taxpayer valuation based on the opinion of a well-respected, independent analyst, the IRS is essentially forced to hire an equally qualified analyst who can credibly attack the valuation opinion of the taxpayer’s analyst and who can produce an opinion of value different enough to generate a tax revenue advantage for the government. The IRS will only allocate resources to pay for valuations if there is an expectation that the allocation will be more than reimbursed. It is difficult for the IRS to justify spending money to challenge a reasonable valuation from a qualified expert that is based upon widely used valuation methods.
In a 2007 Second Circuit Court decision for Thompson v. Commissioner, the Court held that the decedent's minority interest in a closely held family business was severely undervalued (the estate claimed the interest was valued at $1.75 million; the Court held that the proper value of the interest was $13.5 million), and reprimanded the executors of the estate who chose to obtain an appraisal from an attorney and an accountant, neither of whom had experience in valuing interests in closely held family companies, thus underscoring the importance of obtaining a qualified appraisal performed by an independent valuation professional.
If the IRS does challenge the value reported on an estate or gift tax return, and determines that the value was underestimated, not only can a larger tax be assessed on the value the IRS feels is more accurate (substantiated by a qualified appraisal obtained by the IRS), but an underpayment penalty of 40 percent of the total tax owed can be assessed if the value claimed on the return is 50 percent or less of the correct value of the asset. Costs of such added taxes and penalties are likely to be significantly higher than the cost of obtaining a qualified appraisal.
3. What is the difference between an appraisal and a valuation?
Nothing. The terms are used interchangeably. In a business valuation context, an appraisal or a valuation is the act or process of determining the value of a business, business ownership interest, security, or intangible asset.
4. When I hire an accountant, I typically expect that s/he is a CPA. What do I look for in hiring a business appraiser?
Professional designations are one of the most important factors to consider in selecting a business appraiser. Appraisers who have earned top-quality designations through testing and rigorous peer review of their work product have decisively established their competence. Most members of the business community do not understand the differences in the rigor of and difficulty of obtaining various designations available to business appraisers. However, they are aware of the proliferation of “professional” designations in many fields of specialization, and the ease with which many of them can be obtained. What is even more confusing is when various professional societies (read business brokers, finance societies, and accountants) award designations that involve activities peripheral to a profession (read business valuation). Four professional societies currently offer designations in business valuation:
- American Society of Appraisers: ASA’s senior designation is the ASA (Accredited Senior Appraiser) which requires that appraisers have 10,000 hours of business valuation experience, pass up to four levels of exams, pass a standards exam and an ethics exam, and submit two actual appraisal reports for peer review. As such, it is one of the most difficult credentials to obtain. The junior designation is AM (Accredited Member). ASA generally focuses on the valuation of mid-sized and larger businesses.
- Institute of Business Appraisers: IBA’s primary designation is the CBA (Certified Business Appraiser), which requires that appraisers have either 10,000 hours of business valuation experience or 90 credit hours of valuation education, pass one examination, and submit two actual appraisal reports for rigorous peer review. An MCBA (Master Certified Business Appraiser) is a CBA with over ten years of business valuation experience who has been endorsed by his/her peers as a leading contributor to the profession’s body of knowledge. The junior designation is the AIBA (Accredited by Institute of Business Appraisers). IBA generally focuses on the valuation of small to medium-sized businesses.
- American Institute of Certified Public Accountants: CPAs can qualify for the ABV (Accredited in Business Valuation) designation by passing a rigorous exam and demonstrating involvement in at least ten appraisals. The AICPA has recognized business valuation as a separate profession so that a CPA requires separate training and experience to value businesses.
- National Association of Certified Valuation Analysts: NACVA members
can qualify for the CVA (Certified Valuation Analyst) designation
by completing a seminar, passing an examination, and submitting a case study
appraisal report. This designation is available only to CPAs. NACVA also
awards an AVA (Accredited Valuation Analyst) for non-CPAs.
Some professional designations are more difficult to obtain than others.
The consuming public, however, is unaware of differences from one designation
to another, and will therefore tend to assume that one professional designation
is about as meaningful as any other. In summary, while all have recertification
requirements, only an ASA or CBA has undergone a stringent peer review
process of their appraisal work product; only an ASA, CBA or ABV is required
to have a specified level of business valuation experience. So this may
suggest, for example, that if you are considering hiring an appraiser who
is not an ASA and/or a CBA, you may want to ask for a sample report to
assess work product, since that work product is unlikely to have undergone
peer review. While these designations are important in selecting a business
appraiser, the amount of experience in the profession and the amount of
time spent doing valuation work must also be considered. Nonetheless, given
the opportunities to earn a designation in business valuation, the consumer
should question the appraiser who has not earned one.
To understand more about designations within the business valuation profession,
please request our “Appraising
Business Appraisal Designations” issue of our internal quarterly publication, The
Valuation E-Column.
5. Can I have my company’s CPA value my business instead of hiring an independent business appraiser?
If your CPA has received formal training in business valuation (including the
particular situation at hand) and there will be no perceived conflict
of interest in the situation for which you are getting your business appraised,
sure.
However, while most CPAs have achieved a high level of competence in accounting
and/or tax matters, the vast majority of CPAs do not have the necessary expertise
and training to value a business. In fact, as an illustration, only about 2,700
(as of January 2008) of approximately 350,000 CPAs in the country (less than
1%) have earned the Accredited Business Valuator (ABV) designation (discussed
above in the response to the preceding question) awarded to members of the
AICPA who have passed a rigorous exam and have demonstrated involvement in
at least ten appraisals.
Accounting and appraisal skills, although overlapping, are fundamentally different.
Accountants are trained to focus on historical information. In addition to
that, appraisers look sideways at comparable businesses in the marketplace,
and forward at expected future performance.
In terms of a perceived conflict of interest, little else needs to be said
given events several years ago with Enron and other companies.
Throughout most valuation engagements, we work closely with our clients’ CPAs
(as well as attorneys and other trusted advisors) to ensure a complete and
thorough appraisal of your business.
6. How long should it take to get my business appraised?
Depending on need, scheduling, availability of information, cooperation of management of the company being valued, type of report required, it typically takes about 4 to 8 weeks to render an opinion of value, and less to complete a limited appraisal.
7. How much does a business appraisal cost?
Most appraisers quote a range of fees or cite a straight hourly rate. Expenses are billed separately. It is a direct violation of ethics and professional standards to be paid on contingency (outcome of the valuation). All professionals will give consideration to the time they will spend on an engagement. To properly value a business, the appraiser must do an extensive qualitative and quantitative assessment of the business. That means, among other things:
- analyzing the current economic environment and how it impacts the company being valued and the industry in which it operates;
- analyzing the industry in which the company operates;
- interviewing company management and interacting with management and their advisors throughout the valuation engagement;
- understanding the history and current and future prospects of the company, its competitive environment, its customer base, its management, its strengths, weaknesses, opportunities, and threats, its suppliers, its possible contingencies, etc.;
- conducting a full financial analysis of the company’s liquidity, activity, profitability, and solvency position;
- understanding future prospects, including a financial forecast of the company’s expected future performance;
- researching guideline public company multiples as well as guideline M&A transaction multiples;
- conducting sensitivity analysis and sanity checks; and
- writing a report.
As such, the business valuation process is a time-consuming one, of which the use of computer software programs comprises a relatively small portion. Professionals expect to be well compensated for their time. If a quote seems low, you might want to consider whether your appraiser is doing everything s/he needs to in order to provide a well-thought out and defensible opinion of value.
“It is unwise to pay too much, but it is worse to pay too little. When
you pay too much, you may lose a little money — that is all. But when you pay
too little, you stand to lose everything, because the thing you bought was
incapable of doing the thing it was bought to do. If you deal with the lowest
bidder, it is well to add something for the risk you run; and if you do that,
you will have enough to pay for something better.” (John Ruskin)
To understand more about the cost of an appraisal, please request our “How
Much Should a Business Appraisal Cost?” issue of our internal quarterly
publication, The Valuation E-Column.
8. Can a ballpark estimate of value be determined just by looking at the numbers?
Perhaps, but that is akin to a residential real estate appraiser driving by a house rather than looking inside. Two identical and adjacent homes could have materially different values if one is in relatively poor condition on the inside and the other has undergone several renovations and additions that are not visible from the outside. The business valuation process is far more sensitive and complex than just plugging numbers into a computer software package or spreadsheet, requiring material professional judgment. The numbers in a business (for example, the pre-tax profits) may need to be adjusted for certain factors such as excess compensation, fair market rent, etc. These numbers may not necessarily reflect certain risks (e.g., dependence on a key person or on one customer) that would need to be factored in valuing a business.
9. How do you value a closely-held business?
There is no single method for determining the fair market value of a business or individual interests in its equity; the method depends upon the circumstances surrounding the business and its individual characteristics. Traditionally, the development of a fair market value opinion of a business enterprise and corresponding equity interest is based on the consideration of three basic approaches to value, after a full qualitative and quantitative assessment of the underlying business. Value indications derived through one or more of these approaches are then analyzed in order to formulate an objective opinion as to the fair market value of the equity interest under valuation. A brief description of the three approaches follows:
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The Income Approach measures the value of a business based on the expected
stream of monetary benefits attributable to the subject company. Generally,
the present value of the income stream to be generated for the benefit of the
shareholders over the business’ remaining economic life is determined.
This approach assumes that the income derived from the business will, to a
large extent, control its value.
The Market Approach arrives at an indication of value by comparing the company being appraised to comparable publicly traded companies or to comparable businesses which have been recently acquired in arm’s-length transactions. The market data is then adjusted for any significant differences, to the extent known, between the guideline companies and the company being valued.
The Asset Based (or Cost) Approach is a general way of determining a value indication of a business’s assets and/or equity interest using one or more methods based directly on the value of the assets of the business, less liabilities.
10. What are some of the most common methods to value a business within these three approaches?
Within the income, market and cost approaches are several methods, and within those methods are several procedures. The most commonly applied include:
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The Multiple Period Discounting Method within the Income Approach involves
projecting all expected future economic benefits (e.g., net cash flow, net
income, etc.) and discounting each expected benefit back to a present value
at a discount rate which represents the time value of money plus risk. Two
examples of procedures within this method are discounted cash flow (“DCF”)
and discounted future earnings (“DFE”).
The Single Period Capitalization Method within the Income Approach involves dividing a single historical or projected economic benefit by a capitalization rate that represents the discount rate for that variable less the expected sustainable long-term growth rate in that variable. An example of a procedure within this method is the capitalization of cash flows.
The Guideline Publicly Traded Company Method (a/k/a the Market Multiple Method) within the Market Approach relates market value multiples for public company stocks to fundamental financial variables for the subject company (e.g., P/E, EBIT multiples, etc.).
The Guideline Merger & Acquisition Method (a/k/a the Transaction Multiple Method) within the Market Approach relates value multiples from sales of entire companies or controlling interests to fundamental financial variables for the subject company (e.g., P/E, EBIT multiples, etc.).
The Direct Market Data Method within the Market Approach is a broader market based valuation method whereby all transactions for which market data is available are considered as a statistical ensemble that defines the market for businesses of the same general type (e.g., SIC category) as the target business.
Prior Transactions within the Market Approach relate ways to reach value based on prior transactions in the subject company’s stock to current data for the subject company.
The Adjusted Net Asset Method within the Asset Based Approach involves individually adjusting all assets and liabilities (including those off balance sheet, intangibles, and contingencies) to current values and computing a resulting net asset value.
The Excess Earnings Method, a hybrid between the Income and Asset Based Approaches, involves a collective valuation of all intangible assets as a group by capitalizing returns over and above a reasonable rate of return on tangible assets and adding the capitalized value of intangibles thus estimated to the value of tangible assets. It was originally created for valuing the intangible component of a business, not for valuing the company as a whole, and is not considered appropriate, according to the IRS, except if there is no better basis available for making the determination.
11. Why aren’t you valuing my equipment and other fixed assets individually as part of valuing my business?
A business is valued either on the basis of what it owns less what it owes, or on the basis of the benefits it generates. Assets are valued the same way. Your equipment is essential to generate the sales and profits an appraiser uses to value the business, and its value is included on that basis. Assets like extra cash, idle equipment, or a vacation condo that are not necessary to support operations and generate those benefits are added to the value.
12. What is “fair market value” and how might it differ from what a buyer might pay for a business?
Fair market value is typically defined based on the definition prescribed under Internal Revenue Service (IRS) Revenue Ruling 59-60, several other pronouncements, and a large body of case law as follows:
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The price at which the property would change hands between a willing buyer
and a willing seller when the former is not under any compulsion to buy and
the latter is not under any compulsion to sell, both parties having reasonable
knowledge of relevant facts. Court decisions frequently state in addition that
the hypothetical buyer and seller are assumed to be able, as well as willing,
to trade and to be well informed about the property and concerning the market
for such property.
In other words, in applying the standard of fair market value, we assume that:
- the equivalent of cash is being paid for the subject being appraised as of the Valuation Date;
- it refers to ‘price’ rather than the proceeds of the sale of a property;
- the company (interest) being valued has been placed on the open market for a reasonable amount of time enough for all potential purchasers to be aware of its availability;
- the hypothetical buyer is prudent but without synergistic benefit (i.e., potentially very different from investment or strategic value) — as such, it reflects the consensus of rational pricing, rather than the highest price that might be obtained;
- a seller is not forced to sell (i.e., accept an offer that represents a “distress sale”) and a buyer is not compelled to buy (i.e., necessary to earn a living); and
- the business will continue as a going concern and not be liquidated.
To understand more about fair market value and the other standards of value, please request our “Standards of Value” issue of our internal quarterly publication, The Valuation E-Column.
13. What is Revenue Ruling 59-60?
Revenue Ruling 59-60 is an official pronouncement of the national office of the
IRS, written in 1959, regarding the valuation of closely held common stock. It
is the most widely referenced IRS revenue ruling in a business valuation context,
and is also often referenced for non tax valuations.
Within 59-60, the standard of fair market value is defined and
the following eight basic factors to consider in a business valuation
are outlined:
- the nature of the business and the history of the enterprise from its inception;
- the economic outlook in general and the condition and outlook of the specific industry in particular;
- the book value of the stock and the financial condition of the business;
- the earning capacity of the business;
- the dividend-paying capacity of the company;
- whether or not the business has goodwill or other intangible value;
- prior sales of the stock and the size of the block to be valued; and
- the market prices of stocks of corporations engaged in the same or a similar
line of business as the subject company and whose stocks are actively traded
in a free and open market, either on an exchange or over-the-counter.
View Revenue Ruling 59-60 (113k PDF).
14. Given the fact that I am obtaining an appraisal in connection with a litigation situation, will you be able to testify about your value conclusion?
Yes. We have the specialized knowledge, skills, experience, training, and education to testify and assist the court in coming to a decision, and have been qualified as business valuation experts in court proceedings. It is important to note that even valuations in a non-litigation matter may end up in legal dispute.
15. Once I obtain a business valuation report, how long is it good for?
A valuation is valid as long as its
methodology is sound and its assumptions hold firm. It could be a day, a week,
a month, a year, or any time period, depending on the facts and circumstances
of the situation. As a practical matter, this extends to a maximum of a year
(in more certain times), when an appraisal must be updated to reflect subsequent
company performance and current economic/industry conditions. The old adage, “timing is everything,” very
much applies to business valuation. In the extreme case, given 9/11, in 2001,
the valuation of a hotel or an airline company was significantly different
on September 10th as compared to September 15th.
To understand more about how long an appraisal report is valid, please request our “How
Long is a Valuation Valid?” issue of our internal quarterly publication, The
Valuation E-Column.
16. Is my company impacted by FASB’s Statement of Financial Accounting Standards Nos. 141 and 142?
If your financial statements are issued in accordance with Generally Accepted
Accounting Principles (“GAAP”), you have goodwill on your balance
sheet, and/or you plan to make acquisitions in the future, the answer is “YES.” These
Statements require more explicit disclosure of the fair value of past and future
acquisitions in relation to their actual cost. This means companies (both publicly and privately
owned) will no longer have the option to leave overvalued goodwill assets on
their balance sheets.
To understand more about these Statements, please request our "FASB
141/142 Quick Reference Guide."
17. Our firm will be needing a valuation of its common stock in connection with IRC Section 409A and SFAS No. 123(R). Given that we have both preferred and common stock, how will you approach the valuation of our common stock?
The exact manner in which we value the common stock of a company with a complex capital structure consisting of multiple classes of stock and different rights and claims on its equity will depend on its stage of development and history in terms of rounds of financing. While there are many ways to value the common stock in such situations, the AICPA has published a Practice Aid titled the Valuation of Privately-Held Company Equity Securities Issued as Compensation, which presents three methods intended to cover a range of different scenarios. Brief descriptions of these three methods that are commonly used to allocate the total equity value of a company to the components of its capital structure follow:
- The current value method — This method is appropriate when a liquidity
event is anticipated in the near future. It determines the value of the common
shares by relying on the assumption that 100 percent of the equity of the
subject company is sold. That equity value is reduced by the senior claims
of preferred shares, and the remaining balance is allocated to the common
shares. In situations in which the senior claims exceed the value of 100
percent of the equity, the common stock is deemed to be worthless. This method
is generally considered appropriate to use in the following two circumstances:
Companies with an imminent liquidation or acquisition event; or
When an enterprise is at such an early stage of development that:
i.) No material progress has been made on the enterprise’s business plan;
ii.) No significant common equity value has been created in the business above the liquidation preference on the preferred shares; and
iii.) There is no reasonable basis for estimating the amount and timing of any such common equity value above the liquidation preference that might be created in the future. - The option-pricing method (“OPM”) — This method treats common stock and preferred stock as call options on the equity value of the subject company. Essentially, the common stock is treated as a call option that gives the owner a right, but not an obligation, to buy the underlying enterprise at a predetermined exercise price. This method is sensitive to certain key assumptions, including the expected volatility, or the standard deviation of expected returns on the equity of a company, which can be difficult to estimate. This method may be appropriate when a liquidity event is not anticipated in the near future, as the method recognizes that common stock may have little or no value if the subject were to be sold in its entirety on the Valuation Date, but has a claim on future values of the company in excess of the senior claims of the preferred stock.
- The probability-weighted expected return method (“PWERM”)
— Under this method, an analysis of future values of a company is performed
for several likely liquidity scenarios. Those scenarios may include a strategic
sale or merger, an initial public offering, the dissolution of the company
in which the preferred shares receive all of the proceeds and the common
shares are worthless, as well as the company’s private enterprise value
(no liquidity event). The value of the common stock is determined for each
scenario at the time of each future liquidity event and discounted back to
the present using a risk-adjusted discount rate. The present values of the
common stock under each scenario are then weighted based upon the probability
of each occurring to determine an indication of the value of the common stock.
This method is generally considered appropriate to use when there are several
distinct liquidity scenarios to be considered.
