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Part One – Fundamentals and Form
WHAT EVERY CPA SHOULD KNOW ABOUT BUSINESS VALUATION
By Marcie D. Bour, CPA/ABV, CVA, CFE, BVAL, CFFA, AWSCPA South Florida Affiliate Board Member

The field of business valuation has become more sophisticated and complex over the past twenty years.  In the early days, there were very few books published on the subject and limited research was available.  As more professionals developed expertise, the business valuation body of knowledge evolved and expanded.  As a CPA, it is useful to have a basic understanding of business valuations so that you can provide guidance to your clients with valuation needs. 

What is a business valuation?

First and foremost, every CPA should know what a business valuation is.  This seems like an easy starting place, but many practitioners are not aware when they are unknowingly valuing business.  Take a quick quiz to see if you can identify which situations involve a business valuation:

1. You are preparing an intangible tax return for your client’s company and you decide to use book value of the company stock on the line that says “fair market value of capital stock”.
2. You are doing some planning for a client and are asked how much life insurance should be purchase to fund the existing buy-sell agreement.  You tell your client to purchase a $1 million policy to cover her 50% of the business based on historical earnings of $250,000 and on a multiple of four times earnings.
3. Your client is interested in transferring stock to her son.   You advise her to sell 10% of company stock for $2,500 because the value is low enough to stay under the radar of the IRS.
4. Your client purchased a business, which includes a number of different intangible assets.  You prepare a purchase price allocation pursuant to Internal Revenue Code Section 1060. 
5. Your client made a Subchapter S election and you calculate the built in gains to report on the Form 1120S.
6. You estimate the value of a business for a prenuptial agreement for a client because she is in a hurry to complete the agreement so she can marry. 

In each of the situations above, you would be providing valuation services. 

So what are valuation services?  In plain English, business valuation is the application of valuation principles and methods, combined with the valuator’s judgment, to arrive at a value (or range of values) for a business or interest in a business.  The American Institute of Certified Public Accountants’ Statement of Standards on Valuation Services No. 1 defines business valuation to include valuing a business, business ownership interest, security or intangible asset.

Foundational elements

The foundational elements of the valuation process are just as important to understand as being able to identify a business valuation.  The three elements which need to be defined at the start of an engagement are:

• Standard of value
• Premise of value
• Purpose

These elements set the stage for the type of valuation that is necessary.  The date of the valuation and the subject interest to be valued are equally important.  However, the date and the subject interest are usually easily identified.

Standards of value

The standard of value is how value is defined for a particular valuation.  Not all value is the same.  There are a number of types of value, each having its own nuances.  Fair Market Value, the mostly widely know value, is defined in Revenue Ruling 59-60 as “…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.”  Although this definition is one of the most frequently quoted ones, there are other versions that are substantially the same. 

Fair Market Value is characterized as the price between a hypothetical financial buyer and seller.  This type of value can be the underlying basis for other types of value.  For example, in divorce cases many states refer to Fair Market Value or Market Value.  In some jurisdictions, however, case law may provide for certain interpretations to arrive at their own version of Market Value. 

States provide minority owners in businesses protection by allowing them to bring suit to have their shares appraised and to be paid a Fair Value.  State statutes also provide for the dissolution of corporations under certain circumstances, such as when the shareholders have reached a deadlock in the management of the company.  There are similar statutes that apply to partnerships and limited liability companies.  The appropriate value in these types of actions is usually Fair Value. 

Some state statutes define Fair Value, while others do not provide a clear definition.  It may be necessary to look to case law for guidance in states without clear definitions.  Judges, in their opinions, may refer to Fair Value and Market Value interchangeably, without regard to the potential differences.  One significant difference between Fair Value and Fair Market Value, depending upon the jurisdiction, is the application of discounts for lack of control (minority discounts) and discounts for lack of marketability.  Another difference is the concept of a willing buyer and willing seller.  In litigation, the buyer and the seller may not be willing parties to the ultimate transaction; they are bound by the ruling of the court.

To further confuse the matter of Fair Value, FAS 157 defines Fair Value for purposes of financial reporting differently than Fair Value in a litigation context.  Any time an asset or liability is reported at Fair Value, it means that it is reported at “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants as of the measurement date.” 

Investment Value is “The value to a particular investor based on the individual investment requirement and expectations” as defined in the International Glossary of Business Valuation Terms.  Investment Value can capture the benefit of synergies that a buyer brings to the transaction or it can factor in required rates of return based on investment criteria.  This type of value is specific not only to the transaction, but also to the buyer or seller as well.

Range of values

Value is often thought of as a definite number.  This is a common misconception.  Not only can a singe type of value be expressed in terms of a range, different types of value create a range of values.  Everyone has heard the phrase “Beauty is in the eye of the beholder”.  Value is influenced by the perspective of the interested party.  Different interested parties will arrive at different values.  Each value may be reasonable for its purpose and in the proper context.

It is important to distinguish between price and value.  Price is the dollar amount at which a transaction takes place.  In order for a transaction to occur, the buyer and seller have to arrive at an agreeable price.  Often the negotiating skills of the buyer or seller, as well as their access to information, will determine whose value is closer to the price. 

The purpose

How do you determine the appropriate type of value?  Very often the purpose will dictate the appropriate type of value.  Valuation engagements are purpose specific.  Valuation reports usually include language that states that the valuation is valid only for the purpose or purposes specified and use for any other purpose invalidates the results of the valuation.  Since the purpose can dictate the type of value, different types of value may apply in different circumstances.

Most compliance work, including valuations for tax purposes, must use Fair Market Value.  Engagements to value interests for gift or estate tax purposes must be based on Fair Market Value.  ESOP valuations are based on Fair Market Value.  Valuations to determine the value of charitable contributions must also be based on Fair Market Value. While purchase price allocations for tax purposes requires the use of Fair Market Value, purchase price allocations for financial reporting purposes require the use of Fair Value as defined in FAS 157.

In the case of an owner who has nurtured a business for 30 years, Investment Value will most likely capture what the business is worth to her.  Similarly, participants involved in transactions interject their own investment objectives into the valuation process.  Investment Value is often most appropriate because it accommodates the specific characteristics of the buyer or seller.  Buyers and sellers can arrive at different values for the same interest based on their different criteria and expectations.  The buyer or seller may expect synergies that they bring to a transaction to enhance the value of a business.  The perceived right to the benefits generated by synergies from a business combination can also influence the resulting value. 

In litigation situations, the courts, either by statute or by case law, often provide guidance in determining value.  Valuations for divorce are usually based on some sort of Fair Market Value.  Shareholder disputes are governed by state statute and case law, which dictate the use of Fair Value. 

The premise

The last foundational element is the premise of value. The International Glossary of Business Valuation Terms defines premise as “an assumption regarding the most likely set of transactional circumstances that may be applicable to the subject valuation; for example, going concern, liquidation.”  Unless a business is going to be liquidated, either voluntarily or by force, the premise of value is usually going concern based on the assumption that the business will likely continue to operate. 

It is necessary to establish what is being valued and why it is being valued in order to move forward with the valuation process.  Once these foundational elements have been determined, the valuator and the client need to determine the type of valuation services that will be provided and the form of delivery.

Valuation reports

There are generally two levels of services that a valuator can provide: a conclusion (or opinion) of value and a calculation of value.  These types of valuation services can be delivered in either a written report or in an oral report. 

A conclusion (or opinion) of value is the result of a business valuation engagement where the value is determined by applying appropriate valuation procedures combined with professional judgment.  In arriving at a conclusion of value, there are valuation standards that can be followed including the American Institute of CPAs, the American Society of Appraisers, the Institute of Business Appraisers, the National Association of Certified Valuation Analysts and the Appraisal Foundation.  This is in addition to any other application rules or regulations issued by regulatory bodies that may apply.  Engagements for tax purposes, litigation purposes and financial reporting purposes usually require a conclusion of value. 

There are times when it is appropriate to provide a lower-level engagement than a conclusion of value.  In those cases, the valuator may reach an agreement with the client to limit the engagement.  Limited engagements, which result in a calculated value, are distinguished from engagements which result in a conclusion of value by the procedures performed.  In a calculation of value engagement, the valuator and the client specifically agree to limit the application of valuation procedures, including the application of specific approaches and methods in arriving at a calculated value.  Calculation engagements are often done for budgetary reasons.  If a valuation engagement to reach a conclusion of value had been performed, the resulting value may have been different.

A written report can take the form of a full report or a summary report.  Different valuation organizations have different descriptions for the full report and summary report, although the essence of the reports is the same.  In general, valuation reporting standards and IRS regulations require that a full report must meet minimum disclosure requirements, and present the appraiser’s findings and conclusions in a manner that an informed reader can replicate the appraisal process and arrive at appraised value. 

Although a report could always contain additional information, the exclusion of such information does not necessarily mean that the report has failed to meet the requirements of a full report under valuation reporting standards.  The work necessary to complete and reach a conclusion of value is the same for a valuation report that provides the required information in great detail, as that of a report that provides a summary presentation.  The distinction between what some call a summary report and a full appraisal report has to do with the length and detail of the narrative discussion of the description of the subject investment, its environment, the economy, and the industry; not the procedures performed.  The reporting standards of the various valuation organizations apply whether the report is presented in a written format or an oral format.  Calculation of value reports are typically shorter than reports for conclusions of value due to the limited work done to reach a calculated value. 

Conclusion

The best service you can give your client is to make sure that your client understands that all value is not the same and all valuation reports are not the same.  When a client has the need for valuation services you can assist your client by ensuring that your client receives a valuation report that is suited for his or her purpose:

• The report should be for the correct valuation date,
• The report should be for the appropriate standard of value,
• The report should be based on a reasonable premise for the situation,
• The type of engagement should be appropriate for the purpose; and
• The report should be in a form that is acceptable for the purpose.

Educating your client will enable him or her to make an informed decision in evaluating his or her valuation needs.

Marcie D. Bour, CPA/ABV, CVA, CFE, BVAL, CFFA is President of the Florida Business Valuation Group, an affiliate of the National Business Valuation Group, LLC™.  She provides business appraisal services, forensic accounting and litigation consulting services for small and mid-sized businesses.   Ms. Bour has been involved with a variety of commercial cases and has testified at deposition or trial in damage, shareholder dispute, usury and criminal sentencing cases.  She also consults on valuation and other issues for divorce cases.  Her valuation and litigation experience have covered a wide variety of industries including: healthcare, retailers, professional practices, Internet-based companies, wholesalers/distributors, travel, trucking, packaging, manufacturing and fast food-franchises.  Marcie is on the Board of the South Florida Affiliate of the AWSCPA, President-elect of the Gold Coast Chapter of the FICPA, a Board Member of the Litigation Forensics Board of NACVA as well  as being involved in numerous other appraisal and professional organizations.