Avoid misconceptions about business valuations

Nate Fyock
Nate Fyock

Business valuation services are helpful and often required for the purchase or sale of a business, estimating the value of a business for succession or retirement planning, determining values for gift or estate tax purposes or marital dissolution and to value ownership interests awarded to employees for compensation.

There are some misconceptions, though, about what goes into determining value and the appropriate valuation reports to obtain for various situations.

The first common misconception stems partly from the term “valuation.” Many people assume “valuation” means “formula” and there’s a set method in which numbers are plugged in to determine the value of a business. While various formulas eventually could be part of a valuation, the real effort and hours of analysis undertaken by a valuation analyst are spent stepping into the shoes of a buyer or seller to determine what these market participants would likely pay for the subject business interest. To do this, the valuation analyst takes into account the three principles of valuation: alternatives, substitution and future benefits. An analyst also must consider the effects of other variables, such as the various risks inherent in the respective business and the degree of control or lack thereof that could affect value.    

The principle of alternatives states each party in a contemplated transaction has alternatives to consummating a transaction. The principle of substitution states that a prudent individual won’t pay more for something than they would pay for an equally desirable substitute. The principle of future benefits is the most fundamental to the valuation process and states economic value reflects anticipated future benefits. Future benefits are especially important to consider as potential investors are typically interested in the future financial performance of a business. This highlights the importance of preparing or engaging a valuation analyst to assist with preparing forecasted financial statements for at least the five years beyond the valuation date while demonstrating the use of reasonable and supportable assumptions as part of the forecast.

To step into the shoes of a buyer or seller of a business and appropriately consider these principles, a valuation analyst must conduct an extensive analysis of different financial and nonfinancial aspects of a business, including industry and economic data. Businesses aren’t created equal. They all have their own backgrounds, structures, strengths, weaknesses and industry and economic drivers.  A valuation analyst must understand these attributes and ensure significant risk factors affecting the value upon which a buyer or seller would agree are incorporated. There’s no cookie cutter formula that can be used to do this because each business is unique. 

Although this process might not be as simple as many people initially assume, a valuation analyst can assist a business owner or potential business owner with understanding factors associated with their businesses that are increasing or decreasing value for them to enhance or address these items. If the valuation is performed for tax purposes, this process allows a competent valuation analyst to properly quantify and support adjustments to value for risks and the level of control, which in turn could significantly lower the tax burden for gift, estate or equity based compensation purposes.

The second common misconception relates to the level of valuation service necessary and the deliverables associated with such services. Many people aren’t aware there are different levels of valuation engagements and different types of reports associated with those engagements.  Care must be taken to ensure the appropriate engagement type and report are selected for the assignment, especially if the valuation will be provided to such third parties as a court or included as part of a tax return filing.

The business valuation standard of the American Institute of Certified Public Accountants notes that there are two types of engagements: a valuation engagement and calculation engagement.

In a valuation engagement, the valuation analyst estimates the value of a subject interest without restriction or limitation. The valuation analyst is expected to apply any and all of the valuation approaches and methods deemed appropriate in the circumstances.  The valuation analyst then expresses the results of the valuation as a conclusion of value, which could be a single amount or range.

In a calculation engagement, the valuation analyst and client agree on the valuation approaches and methods the valuation analyst will use and extent of procedures the valuation analyst will perform to calculate the value of a subject interest. The valuation analyst calculates the value in compliance with the agreement, which can be expressed as a single amount or range.

A calculation engagement is generally only appropriate if it’s not intended to be relied upon by or provided to a third party such as a court, the Internal Revenue Service or  potential buyer. Otherwise, a valuation engagement should generally be performed with a conclusion of value provided.   

The type of written deliverable or report provided for a valuation engagement can be either a detailed or summary report. A detailed report contains all information considered by the valuation analyst in forming the conclusion of value and will typically be around 50 to 100 pages. A summary report is limited in the information provided and will typically be around 15 to 30 pages. There’s no difference, however, in what a valuation analyst is required to do in a valuation engagement to determine a conclusion of value whether a detailed or summary report is provided. 

The type of written deliverable or report provided for a calculation engagement is a calculation report, which will clearly state a calculation engagement doesn’t include all the procedures required in a valuation engagement or constitute a conclusion of value that would be provided in a valuation engagement.

To fully realize the value that can be obtained from a business valuation, seek out a valuation analyst with a valuation specific credential such as the AICPA Accredited in Business Valuation (ABV) credential or National Association of Certified Valuators and Analysts Certified Valuation Analyst (CVA) credential to help guide you through this process as well as help you gain insight into the factors driving the value of your business.

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