What is Value?
The word “Value” by itself is not very helpful. In business appraisal work, a number of different standards of value are often employed depending on the purpose and use of the appraisal. The following standards of value are the most common:
- Book Value is not really a standard of value. It is an accounting concept used to compute the difference between a company’s total assets and total liabilities. Due to the nature of the accounting process, book value would equal the value of a business only by coincidence. Intangible assets are usually not included in book value.
- Fair Market Value is defined as the price at which a business would change hands between a willing buyer and a willing seller when the former is under no compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. It is generally also understood that the parties have has the ability to buy or to sell and the transaction will be in cash or cash equivalents. In the United States, this value is the most widely recognized and accepted value related to business valuations.
- Fair Value is the statutory standard of value usually used in court cases involving dissenting shareholders and other similar types of litigation.
- Liquidation Value is the expected amount that could be obtained from the piecemeal sale of business assets on either an orderly or forced liquidation basis.
- Investment Value is the value to a specific buyer or investor often based on perceived synergies when the business is combined with another business. This standard of value is often used in merger and acquisitions.
Commonly Used Business Appraisal Methods
A company’s historical financial statements cannot be used by themselves to determine the value of a business. Financial statements are prepared according to generally accepted accounting principles (GAAP). GAAP relies on the historical cost of assets or the price paid for them at the time of acquisition. Additionally, depreciation, amortization, and some other expenses are applied based on accounting rules not on economic realities. Historical financial statements do not show any goodwill or other intangible asset value that may be in place due to the successful operation of the business over a number of years. Other intangible assets that may not be reflected on company financial statements include such things as proprietary lists, beneficial contracts, below market leases, patents and applications for patents, copyrights, trademarks and brand names, subscriptions and service contracts, franchise agreements, and in-house developed software.
When appraising a company, historical financial statements are used to help assess risk and to project likely future returns.
Valuation methods typically fall under one of three basic appraisal approaches: the asset approach, the market approach, or the income approach.
The asset approach uses appraisal methods that consist of a review of the individual assets of the company. The most commonly used asset approach method is called the adjusted book value method. In this method, assets and liabilities are adjusted to the standard of value, for example fair market value. The major weakness of this method is that the intangible asset value of a going-concern business is not measurable. Occasionally, an appraiser may use an asset approach method in combination with a hybrid-method, the excess earnings method, used to value the intangible assets of a company.
The market approach uses businesses in the same or similar industry to develop valuation multiples that can be used to determine a value for the business in question. Several methods may be used—some use information from the sale of private companies, others use the sale of public companies or the price of stock as of the date of valuation for comparable public companies in the same or similar industry.
The income approach consists of two primary methods: the capitalization of cash flow method and the discounted cash flow method. These two methods are mutually exclusive. The basic difference between the two is based on the stability or lack thereof of expected future income. The most difficult part of the income approach is the determination of the appropriate discount or capitalization rate to be used. A discount or capitalization rate measures the risk associated with achieving the projected income or cash flow.
Some formulas exist to give businesses in a particular industry an easy, quick way to estimate a value. These formulas are generally referred to as rules of thumb. Rules of thumb usually provide a range of values—often a wide range of possible values. They are best used as checks for reasonableness instead of appraisal methods.
The appraiser must reconcile the various values determined from each appraisal method to determine a final value for the company.
Control and Marketability Issues
As part of the appraisal process, the business appraiser has to determine if a control premium, lack of control discount or lack of marketability discount is appropriate. Many factors will effect whether or not a control premium, lack of control discount or lack of marketability discount are appropriate to apply to the business ownership interest being valued such as the standard of value, the valuation methods used, the purpose for the valuation, the nature and history of the company with respect to dividends and shareholders’ compensation, among others.
Levels of Valuation Analyses and Reports
The most common types of reports typically issued are described below:
Comprehensive Report: This is a formal presentation of the value of the business in a written format. If a valuation has the potential to go to court, this is the type of report that is usually needed. Also, if the report needs to be reviewed by others, such as the IRS for tax implications, this type of report best explains what was done and how the value was derived.
Limited “Abbreviated” Report: This type of report does not include much of what is in a comprehensive report. It is appropriate for some occasions when a case is not going to court; for example, to assist with structuring a buy-sell agreement between two partners, a limited “abbreviated” report may be all that is necessary.
“Letter Report” or Calculations: This type of report is typically a one page letter with supporting calculations. This type of valuation is often performed to assist an owner develop an “asking” price for the sale of the business or a buyer an “offering” price.
Oral Report: This type of report can be anything from a quick phone call to lengthy meetings. Some attorneys prefer oral reports in litigation.
Fairness Opinion: A fairness opinion is issued when a company has received an offer to be acquired by another firm. The opinion does not express a specific value; rather it states whether or not the appraiser feels the offer received is fair for the shareholders.
Review of an Appraisal: Often, we are asked to review and critique a report issued by another appraiser. A letter describing the review and critique is typically issued.
CONTENTS OF A TYPICAL COMPREHENSIVE BUSINESS APPRAISAL REPORT
A well written business appraisal report should contain the following:
- An introduction, including the purpose and use, the standard of value, description of what is being appraised, and limiting conditions.
- An economic analysis and industry section.
- An analysis and description of the subject business including its history and future prospects.
- A financial analysis of the subject company.
- A financial forecast including assumptions used.
- A discussion of the valuation process and methods used including a detailed explanation of how each method utilized was applied.
- A description of any applicable discounts or premiums applied including justification for amounts selected.
- A reconciliation of indicated values developed from the various business appraisal methods utilized.
- The professional qualifications of the appraiser showing that the appraiser has the qualifications and experience necessary to perform business appraisals.
- Exhibits showing historical financial information, projections, and other information used in preparing the business appraisal.
A valuation professional often serves as either an expert witness or as a consultant. Expert witnesses are often used in situations such as the following:
- Dissolution of business
- Economic loss
- Breach of contract
- Partner disputes
- Dissenting shareholders
Things to check before hiring an expert witness or consultant include:
- Does the appraiser have expert witness experience?
- What professional designations does the appraiser hold?
- Has the appraiser received continuing education particularly in the area needed?
- How long has the appraiser been performing business valuations?
- Has the appraiser published articles, taught classes and lectured on business appraisal topics?
- Are good references readily available for the business appraiser?
A business appraiser also may work as a consultant to assist with such things as:
- Reviewing the valuation clause in a buy-sell agreement.
- Review of other expert’s work.
- Interpreting a company’s financial statements and other information.
- Exploring the strengths and weaknesses of both sides of the case.
- Determining which discovery documents may be useful or necessary for analysis.
- Developing questions to ask opposing expert or principals regarding valuation facts and issues.
As a consultant, a valuation professional is free to act as an advocate for the attorney. In a business appraiser and expert witness role, the appraiser must not be an advocate for either side.