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Business Valuations

Dissecting a Business Valuation Report: What to Look for in Your First Reading Through

Charles W Clanton

Summary

  • Getting a business valuation report is only part of the process; the family lawyer then needs to understand what has been provided.
  • First look for the qualifications and certifications of the appraiser.
  • Watch for compliance with the standard of value that was employed in the valuation, sources of information, correct time periods, the business valuation approaches, and the appraiser’s rationale for the weight given to each method.
Dissecting a Business Valuation Report: What to Look for in Your First Reading Through
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The first time you read a business valuation report, be on the lookout for the following elements, all explained briefly here.

The appraiser. Review the qualifications and certifications of the appraiser. Does he/she have one or more of the major certifications, for example, the ABV (Accredited in Business Valuation) given by the American Institute of Certified Public Accountants (AICPA), the ASA (Accredited Senior Appraiser), given by the American Society of Appraisers (ASA), and the CVA (Certified Valuation Analyst) given by the National Association of Certified Valuation Analysts (NACVA)? If not, what other training or experience qualify them to give an expert opinion, under either the Daubert line of cases or applicable state statutes?

Review the education and experience of the appraiser. First, does the appraiser have education and training in accounting and/or finance? Is the appraiser a CPA (certified public accountant) or CFA (chartered financial analyst)? The holders of these two certifications differ as to which is the most useful training for business valuation. Looking at the appraiser’s entire experience, does their training or work/life experience add something to their ability to understand the subject company, the relevant industry, the market in which it sells its goods/services, the universe of possible buyers that make up the hypothetical willing buyer, or how the hypothetical willing buyer will view the company and decide how much to pay for it? Or does the appraiser lack the experiences that would be important for that understanding? Look for whether the appraiser can testify that they have the real-world experience of (1) working with privately held businesses with respect to their operations and planning and (2) being involved in actual purchases and sales of interests in privately held businesses. This experience is important to the appraiser’s credibility as to judgment calls made throughout the appraisal.

Professional standards. Does the report state that the valuation complies with the standards of the association(s) that certified the appraiser? The certifying organization usually requires that the reports of its members comply with its standards. For example, the reports of ASA-certified appraisers must comply with USPAP (the Uniform Standards of Professional Appraisal Practice). ABVs must comply with the AICPA Standards for Valuation Services, and CVAs must comply with the NACVA Professional Standards.

Cross or rebuttal may include pointing out every divergence from the applicable standards. Non-compliance not only impacts credibility, but could also provide some grounds for a Daubert challenge to admissibility of the expert’s testimony. Remember that an appraiser is not required to follow the standards of an organization of which they are not a member. It does no good to ask an appraiser who holds only an ABV if he followed USPAP.

Standard of value. The report should state what standard of value was employed in the valuation (e.g., fair market value or fair value) and should state a definition for that standard of value. Check the definition against the case law and the definition given in the professional standards of the certifying organization.

Sources of information. There should be a section in every report listing the sources of information. This should include the sources for the factual information on the subject business, and also the reference materials the appraiser employed or relied on. Did the appraiser conduct management interviews? Did the appraiser interview all of the key persons in the company, or at least those with knowledge of the facts critical to the valuation? If in litigation, did the appraiser attend or at least read the transcripts of all of the relevant depositions in the case? If in litigation, was the appraiser provided information that was not produced to the other side?

Note the business valuation authorities cited. In reviewing every part of the valuation, check the methodology employed against the authorities cited in the report. Further consult other publications by the authorities cited, even if those publications are not listed in the report. If the appraiser creates their own methodology for some part of the valuation, it may be subject to challenge under the Daubert lines of cases or related state case law.

Discussions of economic conditions and of relevant industry. Did the appraiser use the correct time period and not include periods of time after the valuation date? What is the source of the discussion? Did the appraiser do any independent research or just insert a discussion purchased from a commercial service? The report should disclose the source.

Normalization of the historical income statements. The report should discuss adjustments to (or normalization of) the historical income statements and show adjusted historical income statements. The purpose of normalization is to adjust individual line items in the historical income statements, primarily expenses, to the level that the hypothetical willing buyer expects to experience once they have control of the business. Check for adjustments for the following:

  • Executive compensation. This should be adjusted to a market level of compensation for at least key executives. The report should show the source of the data for determining market compensation.
  • Depreciation. If depreciation is added back to income, check to see that the appraiser considered including an expense for expected capital expenditures.
  • Rent paid to related parties. If the business leases its facilities from an entity owned by parties related to the owner of the business, the appraiser should evaluate whether the rent paid is at a market rate and adjust it to market if necessary.
  • Non-recurring expenses that are legitimate business expenses, but not expected to recur, such as unusual legal fees, settlements of lawsuits, unusual capital expenditures. For some unusual capital expenditures, such as purchasing a new computer system, the appraiser may adjust to spread the cost out over a period of years equal to the useful life of the item.
  • Expenditures that are discretionary by the owner and that a hypothetical buyer would likely not continue, such as charitable contributions or lavish or unusually expensive travel arrangements.
  • Payment by the business of personal expenses of the owner or others, such as family members, or provision by the business of benefits outside of compensation to the owner or others.

Consideration of All Approaches

Does the report show that the appraiser at least considered each one of the three approaches (asset approach, income approach, market approach)? If the appraiser declined to perform calculations under one or more approaches, does the report show the reason?

Asset approach. There are two primary methods under the asset approach: the adjusted asset value method and the liquidation value method. Use of the liquidation value method is rarely appropriate when there is no reason to anticipate liquidation in fact. The adjusted asset value method should be conducted even if it is not given any weight. If the methods employed under the income approach or market approach yield significantly larger values, one would expect the adjusted asset value to receive no weight. If it is given any weight in such a situation, there should be a reason, other than just to reduce the conclusion of value.

Income approach. There are two broad categories of methods under the income approach: discounted future income methods (the discounted future cash flow method is most common, but other measures of income could be used), and capitalization of some measure of income (e.g., cash flow and net income).

Discounted future income methods. If a discounted future income method is employed, the report should justify its use. In a discounted future income method, the appraiser projects a stream of future income for the company for a period of years, together with a “terminal value” in the final year of the period, and discounts all of those values back to present value using a discount. These methods are subject to attack as being overly speculative. They may, however, be appropriate if the subject business lacks an adequate history of financial performance on which to base a capitalization method. If historical financial information for the company is available, the report should state why it is not reasonable to capitalize some measure of historical income instead of projecting future income.

The report should show the basis for the determination of the projected future income. If management projections of income are used, the report should show why those projections are reliable. Management projections can obviously be self-serving if prepared for the valuation. The report should also show how the discount rate was selected, and how the capitalization rate for the terminal value was selected.

Capitalization of income methods. After normalization of the historical income statements (see above), the appraiser select the measure of income to capitalize (e.g., net income, cash flow, EBITDA). Note whether the measure of income is before taxes or after taxes. The capitalization rate should match the before-tax or after-tax nature of the measure of income. The common methods of building up a cap rate yield an after-tax rate. If the appraiser capitalizes an after-tax measure of income, how is the tax rate determined? Is it the corporate rate or is it the individual rate (if the business is a pass-through entity for tax purposes)? Does it include the qualified business credit for an individual rate (which is currently due to sunset)? Note whether the measure of income is debt-free or not. If the appraiser capitalizes, for example, debt-free cash flow, did he/she also account for the actual debt in the result?

Determination of capitalization rate. First evaluate the appraiser’s choice of the method to determine the capitalization rate (cap rate). This article discusses below the build-up method variation of the capital asset pricing model (CAPM). Some appraisers employ the Weighted Average cost of capital method (WACC), where the cost of capital = after-tax weighted cost of debt plus weighted cost of equity.

If appraiser uses some unusual or novel method to arrive at the cap rate, what is the source given for the method? Does the report indicate it is a commonly accepted method in the field of business valuation, or did the appraiser just come up with it? (making the entire method subject to a challenge under Daubert or similar state case law). Consult the section on sources of information for the reference materials or authorities listed (for example, books or articles on valuation by authorities in the field), and check those authorities to see if they contain any support for or guidance as to the novel methodology employed.

Assuming that a conventional method is chosen to determine the cap rate, consider whether that method is appropriate for the measure of income that was chosen to capitalize, the capital structure of the subject business, and the interest being valued. Then consider whether the appraiser employed the correct methodology. For example, the published rate-of-return data in a source such as Kroll (previously Duff & Phelps) is derived from publicly traded companies paying income taxes at the corporate rate. If the appraiser used that data and capitalizes EBITDA or before-tax earnings, was an adjustment made? For another example, if the appraiser uses the WACC method to determine the cap rate, and he/she assumes that the buyer will change the debt structure to lower the cost of capital (which yields a lower cap rate), that is not appropriate for valuing a minority ownership interest. The minority interest has no power to cause a change in the capital structure of the business.

First consult the authorities listed by the appraiser in the section on sources of information before moving to other authorities. Also consult the section on sources of information to find the source for the figures employed in the method used in the report. For example, if the appraiser lists Kroll as a source, go online to the Kroll Cost of Capital Calculator and check the figures that the appraiser uses for the components of the method used.

Review of the Build-Up Method

Safe rate (aka risk-free rate of return). Check to see if both appraisers use the same safe rate. Does the report indicate the source of the safe rate employed? Check the rate employed against historical Treasury bill rates on the valuation date. The appraiser could use a normalized safe rate that does not depend on the exact valuation date. Kroll’s Cost of Capital Calculator gives a normalized safe rate in addition to historical rates.

Equity risk premia. The appraiser may employ a single combined equity risk premium or he/she may list separately an equity risk premium plus a size risk premium (a/k/a small stock risk premium). Some may include a separate industry risk premium. In either event, compare the total equity risk premium that the two different appraisers employ. Check the figures employed by the appraiser against the source for the risk premium data. The source should be contained in the sources of information section of the report. Kroll’s Cost of Capital Calculator offers a variety of choices in each category. It also offers a regression analysis tool to derive a small-company size adjustment that is specific to characteristics of the subject business.

Specific company risk. The amount of this risk figure is entirely a judgment call. It is potentially the most significant variable in the cap rate determination. This call will directly raise or lower the cap rate, which will in turn lower or raise the conclusion of value under this method. The appraiser should include some discussion of the risks that the business faces as of the valuation date, such as key person risk, customer concentration, etc. Compare the discussion of risks between the two appraisers and the specific risk figure chosen. Check for any indication of what weight was placed on what risks, although that does not usually appear in a report, because it provides such good material for cross-examination. Consider whether there is an argument that some or all of the risk factors listed by the appraiser are already taken into account in the size risk premium, and the appraiser is double-dipping with the specific risk. This is especially the case if the appraiser uses the regression analysis tool and inputs such factors as key person risk and customer concentration. Consider using the regression analysis tool as a means of cross-examining the appraiser’s specific risk determination.

Growth rate. The growth rate is subtracted from the total to yield the capitalization rate to apply to the next year’s income. It should represent an estimate of the long-term growth rate of the business into perpetuity. A higher growth rate raises the value result, and a lower growth rate lowers the value result, all other things being equal. Check for the reasons the appraiser gives for the figure chosen, whether sources are cited, and whether the reasons given conforms to facts. Compare the growth rate to the actual growth of the business (income and revenue) over its history. (For example, the appraiser uses a 2.5% growth rate because it is the long-term expected inflation rate according to the source cited. This assumes that the business itself will have no more actual growth above inflation for the rest of its existence. It also disregards current actual inflation rates.)

Mid-year convention. The build-up method yields an end-of-year cap rate. If the business owner receives his return from the business only at the end of the year, an end-of-year rate would be appropriate. However, if the owner has the ability to receive returns throughout the year, a mid-year rate could be appropriate. If the appraiser converted to a mid-year rate, there will be an entry in the calculation of the cap rate, and it will lower the cap rate somewhat. The resulting increase in the value result reflects the higher present value of receiving a future income stream quicker. Check the authorities listed in the sources of information, including other publications (not listed in the report) by those same authorities.

Selection of the stream of income to capitalize. How does the appraiser select the stream of income to capitalize, based on the prior years of adjusted historical income statements? This could be viewed as the stream of income that the hypothetical buyer expects to achieve in the next year after the valuation date (the date of hypothetical purchase). Depending on the facts of the case, the appraiser could be justified in choosing a variety of options: selecting only the most recent period or periods as most likely representative of the likely future income and giving no weight to earlier years; taking a weighted average of the past five years; and taking a weighted average of only certain years and rejecting certain years because they are anomalies. The report should show the calculation. Check for a discussion of the appraiser’s rationale for the option chosen. Consider whether the appraiser’s choices make sense in light of the history of the performance of the business, including any significant changes in the operation of the business, the industry in which the business operates, the market for the business’ product, and other factors. If the appraiser takes a simple average of all of the past years considered in the report, the report should indicate why. If there is a consistent upward trend in profits over five years, and the appraiser doesn’t give more weight to the most recent years, the report should state the reason.

After calculating the selected income stream, the appraiser should show the calculation of income taxes, unless the appraiser is using a before-tax method. If that is the case, the cap rate should be adjusted accordingly. Check the accuracy of the tax rates employed.

Capitalization calculation. The report should show the capitalization calculation. Did the appraiser, before capitalizing the selected income stream, converted the income stream to next year’s income by multiplying by 1 plus the growth rate?

Adjustment for non-operating assets. Did the appraiser make any adjustment to the value conclusion for non-operating assets? Review the date-of-valuation balance sheet for non-operating assets such as excess cash or securities held in accounts (“excess” meaning in an amount greater than that needed for normal working capital), or receivables representing loans to officers, employees, or related parties. The appraiser should add the value of the non-operating assets to the conclusion of value under the capitalization method, because either the owner would retain the non-operating assets in a sale, or if they were conveyed the buyer would be expected to pay for them separately.

The report may include a discussion as to the determination of the appropriate amount of working capital for the subject business. If not, look to the section of the report for financial analysis of the business, or comparing the business to the industry, and the financial ratios developed there. Note the source of the industry data, which will probably be obtained according to the NAICS (North American Industrial Classification System) code or the superseded SIC (Standard Industrial Classification) code for the business. Check the business tax return for the code reported by the business. Also check online for lists of the codes (naics.com has look-up tools for both). Is the category represented by the code so broad that the service is reporting results from businesses that are not really comparable to the subject?

Market Approach

There are generally three methods available under the market approach: the prior transactions method, which uses actual prior transactions involving the subject business; the guideline public company method, which uses comparisons of the subject business to comparable publicly traded companies; and the guideline merged and acquired companies method, which utilizes data from past transactions in comparable businesses.

Prior transactions method. This method obviously will not be employed unless there are prior transactions in the ownership of the subject business. The first question is whether the prior transaction(s) is/are relevant to the value of the business in its current form. How remote in time are the transactions? Has the business changed significantly since the time of the transactions, in its operations or the nature of its business or its financial performance? Review the historical financials to see how the business has changed since the time of the transactions. What were the purposes of the prior transactions, and what were the motivations of the sellers and buyers? Were the circumstances such that a transaction may not represent an arms-length transaction? For example, were interests in the business sold to raise capital desperately needed by the business? Were the transactions between family members? Was there a valuation performed at the time of the transaction? What was the structure of the prior transactions?

Next, how are the prior prices translated to an indication of the current value of the business? If the prior transactions were structured as something other than cash, how are the non-cash elements of the purchase price converted to current cash value?

Guideline public company method. Under this method, the appraiser develops multiples of earnings, EBITDA, and revenue from analysis of publicly traded companies that are supposedly comparable, or reasonably similar, to the subject business. If this method appears in a family law case valuation, and if the result is given any weight in the conclusion, it should draw scrutiny. It would be unusual to find publicly traded companies comparable in size and operations to a privately held business in a family law case. Also, compare the multiples under this method, which are derived from stock market prices, with those developed from sales of privately held companies in the guideline transactions method. If the multiples developed in this method are much higher, why use this method at all?

Guideline transactions method (or guideline merged and acquired company method). Under this method, the appraiser develops multiples from actual transactions in companies that are supposedly comparable, or reasonably similar, to the subject business. The reliability of the method is dependent on the availability and quality of information about transactions of comparable companies. The databases that collect information on sales of businesses or business interests (e.g., Bizcomps, ValuSource, DealStats) differ in the type and quality of the information they collect. Bizcomps, ValuSource, DealStats (formerly Pratt’s Stats), and the Goodwill Registry (for medical and dental practices) all have individual websites. Consult the individual websites for the nature of the data each reports and in some cases instructions on use of the data reported. Compare to the methodology employed by the appraiser. Did the appraiser choose the database(s) with the best information for the subject industry?

Determine the total transactions that the appraiser obtained from the initial database search, and how the appraiser selected supposedly comparable transactions from the search results. If the report doesn’t disclose this, seek it in discovery. Did the appraiser reject transactions in companies that could be more comparable to the subject than the ones selected? Could the appraiser have performed a broader search and obtained more transactions that might be more similar to the subject business? The searches are likely to be done according NAICS code or the superseded SIC code. Visit naics.com to use the look-up tools for the codes to evaluate whether the search could be broader or incorporate different codes.

Review the selected transactions for comparability of the acquired company to the subject business. Review for proximity in time, similarity in size, profitability, nature of the business conducted by the acquired company. Note whether the sales are sales of assets or of the stock of the company. If an asset sale, note if the information reveals whether all of the assets were conveyed or if the seller retained certain assets, such as cash or receivables. Does the data reveal whether the sellers retained any of the debt of the company? If the data does not reveal exactly what was conveyed in the transactions, how does the appraiser justify making assumptions about what is conveyed or retained by the seller?

Did the appraiser exclude any “outliers,” transactions with prices that are far out of line with the remainder of the transactions? Or did the appraiser average the results from all transactions to arrive at the multiples then applied to the subject? Did that affect the multiples in a way that favored the appraiser’s client?

If the method yields only a small number of transactions, how does the appraiser justify placing any weight on the result? This is especially important if the conclusion of value differs significantly from the results of the income approach.

Discount for lack of control (minority discount) or control premium. If adjustments are made to the income statements as if the buyer has the ability to change the expenses or structure of the company, the resulting value conclusion is on a controlling basis, for 100% of the ownership of the business. The appraiser should state under each method whether the value is for a 100% controlling interest or otherwise.

The appraiser may apply a discount for lack of control if the interest being valued is less than 50%. Likewise, if the interest being valued is more than 50% but less than 100%, the appraiser may apply a control premium. The majority interest has the ability to determine dividends and could be worth more per share than the minority interest to a buyer. In either event, the report should show the calculation of the discount and the source for the methodology employed, which can be checked against the authority cited. Also check for whether the business has a history of paying dividends or distributions, so that the minority interest historically receives income despite the lack of control.

S corp premium. Appraisers differ as to whether to apply a premium for the subject company being a pass-through entity for tax purposes, such as an S corporation or limited liability company. The income of C corporations is taxed at the corporate level and again at the individual level when dividends are paid. The income of a pass-through entity is taxed once at the individual level. The argument is that the capitalization methods and market approach yield values for C corporations (the cap rates used in the income approach are based on rates of return from publicly traded companies, which are C corporations), and do not capture the benefit of pass-through tax status.

If the appraiser applies a premium to the result for pass-through tax status, the appraiser should include a section showing the method by which that premium was calculated, such as the S Corporation Economic Adjustment Model (SEAM), which can be checked against the authority cited for the method. Check the tax-effecting of the income stream for consistency of the tax rate applied. Consider the argument that in every transaction of a business interest, regardless of the corporate structure of the seller, the buyer has the ability to make an asset purchase instead of a stock purchase.

Discount for lack of marketability. Lack of marketability refers to the inherent illiquidity of privately held business interests. There is no ready market for them like publicly traded stocks. If the appraisers applies a lack of marketability discount, the report should show how the discount was determined and cite the source(s). One source often cited is studies of the cost of a public offering of stock.

Appraisers and authorities differ as to whether any discount for lack of marketability should be applied to a 100% controlling interest. Check the authorities cited in the sources of information section. See if the appraiser is citing authorities who have argued that no discount for lack of marketability is ever appropriate for a 100% controlling interest, for example, James Hitchener or Christopher Mercer. Reasons for opposing such a discount include: During the time required to market and sell the ownership interest, the owner enjoys the benefits of ownership, including cash distributions, and so receives the same return on investment as always. To the extent the seller incurs costs of the marketing and sale (such as broker’s commissions), why would the seller lower his price and give the buyer a break for costs that the buyer never incurs (a point made by James R. Hitchner in Financial Valuation: Application and Models)? If the appraiser used the guideline transactions method and gave it any weight, the multiples derived in that method already incorporate any effect of illiquidity on the sale prices in the transactions considered. Also, studies concerning the costs of initial public offerings of stock include many expenses not encountered in private sales, and do not involve the sale of 100% controlling interests. For a minority ownership interest, these arguments do not all apply to the same degree.

Overall conclusion of value. Review the appraiser’s weighting of the results of the different methods employed. What rationale is given in the conclusion or in the respective sections for the weight given to each method? Did the appraiser simply average the results, or give thought to the weight given to each (if any weight was given at all) and give reasons? Did the appraiser include a result from a method which constitutes an outlier in comparison to the other methods, which would raise or lower the overall value? If so, was a reason given?

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