What You Should Know When You Need a Business Valuation
The demand for business valuations is growing, in large part due to aging Baby Boomers planning for retirement and gifting their business interests, selling outright, or passing away. Other owners are looking to sell out due to economic conditions whether good or bad.
As I meet with business owners looking for a business valuation, the most common question I hear is, “How much will it cost?”
To answer their question I first ask them why they need a valuation. Is the valuation for divorce or litigation? Gift or estate purposes? Or are they looking to sell the business and need a starting point for the asking price?
The reason I ask why the valuation is needed is because there are two types of valuation engagements that result in two very different reports: a calculation of value report (calculated value) and a valuation report (conclusion of value).
Let’s look at the characteristics of these two different kinds of reports.
Calculation of Value Report
- The methods used in a calculation of value are discussed and agreed upon between the valuator and the client (usually the business owner) before the start of the engagement
- Usually omits economic and industry data and the underlying work is not comprehensive
- The valuator does not opine on the value of the business or business interest but rather arrives at a value based on the agreed upon procedures
- Used for discussion, negotiation and settlement purposes
- Costs significantly less than a conclusion of value report
Conclusion of Value Report (Full Valuation Report)
- All three valuation approaches (asset, income, and market) need to be considered
- Need to follow extensive valuation reporting requirements including economic and industry data, company background and financial analysis, and walk the reader through the process, assumptions, and conclusions
- An opinion of value is rendered for the business or business interest
- Costs significantly more than a calculation of value
It is also important to note that in a calculation of value report, the valuator is required to declare that a calculation does not include all of the procedures required for a valuation engagement and had a valuation been undertaken, it could have different results. The report also states that had a valuation been performed, the results may have been different and the difference may have been significant.
You Want to Sell Your Business … What Kind of Valuation Report Is Needed?
Let’s now go into each example listed above. Many people thinking about selling their business will get a valuation done in order to get an outside, professional opinion about what the business is worth. Usually a calculation of value is sufficient, as it is used primarily for internal purposes and to give the seller support for negotiations in the sale of their business.
In these cases, I usually recommend a calculation of value report for the business owner, and if he or she needs a full valuation report down the road, then I will upgrade the original report. However, very rarely do I see business owners who want a full valuation report from the beginning, due to the additional cost.
Litigation and Divorce Cases Require Careful Consideration
When it comes to litigation and divorce cases, the answer to “What type of report is necessary?” is “it depends.”
Most disputes get resolved outside court, which saves money and time for all parties. If you think your case can be settled amicably or negotiated outside the courthouse, then a calculation of value may be sufficient. It can give each side enough information and data in order to work out a dispute and reach a settlement.
However, if a settlement seems unlikely and it looks like you are heading to court, then you will need a full valuation report. The report will be looked at extensively by the judge and the other side will usually bring in an expert to dissect and analyze the report. Since a calculation of value report is not considered a full and adequate report, it won’t be given much weight, if any, in court.
This can be especially problematic if the other side’s expert has prepared a full report, as they will certainly use this to promote their valuator as an expert while discrediting the one who performed the calculation. To protect against this, our engagement letters for litigation or divorce engagements specify that if we are required to testify we will first prepare a full report.
Valuation Reports in Estate Planning
Valuation reports are frequently used when preparing gift and estate returns. When shares in closely held businesses are gifted, or when an owner of a closely held business dies, it is necessary to value his / her shares or interest in the business.
The valuation report is then subsequently attached to the gift or estate return and a tax liability results if the gift or estate is above the exclusion amounts. According to the IRS only a full valuation report issuing a conclusion of value is considered a full and adequate report enabling the IRS to replicate the report and the conclusion of value the analyst reached.
This can have significant implications because the IRS has adequate disclosure requirements that must be met before the statute of limitations will begin to run. A calculation of value report does not satisfy the IRS requirements and it is therefore advisable to prepare a full valuation report for gift and estate purposes.
That being said, if the gift or estate is so small that it could not possibly exceed the applicable exclusion or result in any tax no matter what changes the IRS might make to the valuation, then a calculation of value report could suffice. I understand why a client would elect to use a calculation of value in these situations.
Recently I did a valuation for a small auto repair shop. After the sole owner died his daughter asked us to prepare the estate tax return and the valuation. I explained to her that there is no way that it would be a taxable estate (under $5.3 million dollars in 2013), and therefore there would be no tax ramifications. I went on to explain the IRS requirements regarding valuation reports. After carefully explaining to her both sides of the spectrum in the two types of reports, she decided to have us prepare a calculation of value report. She felt comfortable with this decision since it was not a taxable estate. She did not see much inherent risk in attaching a report that the IRS does label as “inadequate,” since it wasn’t a taxable situation to begin with.
When an estate’s value will come out significantly under the exclusion limits, we often will steer a client toward choosing a calculation of value report, which costs less than a full valuation report. However, if we think there is any risk involved or exposure to the IRS, then we recommend a full valuation report to our client. This is considered adequate by the IRS, and starts the clock for the statute of limitations.
The most important thing when seeking a business valuation is to meet with an experienced valuation professional, preferably a Certified Valuation Analyst. An educated and experienced analyst can guide you toward a wise decision as to what type of report is most beneficial for you in your circumstances.
The last thing you want to do is leave yourself exposed by going with a calculation of value when the situation dictates that a full report is required. Likewise, you don’t want to pay for a full report when a calculation of value will clearly suffice.
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Published on July 10, 2014