Bar News - February 17, 2012
Tax Law: Business Valuation Methods
By: Jeffrey A. Graham
How will the company Facebook be valued? How was the estimated value recently set by the firm Arcstone at $ 134 billion dollars? The answers to these questions are complex and require professional judgment and the application of a variety of economic, market and asset based business valuation techniques.
Providing a business valuation, or business appraisal, is defined as the act or process of determining the value of a business, business ownership interest, security or intangible asset. There are many business valuation techniques available to utilize in the determination of a businessís fair market value, including asset, income or market based valuation approaches. The selection of an appropriate business valuation method will depend on a variety of inputs to the business valuation calculations and consideration of the facts and circumstances behind the business, its owners, and the driving forces behind the sale of the business. For instance, a business valuation in preparation of a liquidation of assets occurring in only a matter of days will often generate a fair market value that would be much lower than a fair market value that is calculated to transfer ownership over an appropriate period of time. The additional time spent to properly evaluate all significant inputs gives the seller the opportunity to expose the business to the marketplace for a period long enough to attract a wider range of potential buyers. Also, a forced sale over a relatively few number of days often results in a businessís calculated fair market value and price that is a fraction of the otherwise fair market value. Many tools are available to the valuation analyst. These tools include Databases that record and categorize types of business sales by region, industry, price, debt load, year, and length of time on the market prior to a sale, among others.
During the course of a valuation engagement the analyst will require a multitude of financial documents. These financial documents will yield the economic data typically required to complete the valuation engagement. They include:
There are two types of business valuation engagements, as follows:
- audited or unaudited financial statements or business tax returns;
- internal accounting documents;
- fixed asset ledgers;
- intangible asset documentation.
1. valuation engagement which yields a conclusion of value (full scope of work);
2. calculation engagement, which is considered less in scope and yields, typically, a range of calculated values (partial scope of work) Fair Market Value.
Revenue Ruling 59-60 (the 60th ruling during the Year 1959) defines fair market value as the amount at which the property would change hands between a willing buyer and a willing seller, when the former is not under compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts. Professionals providing business valuation services perform their due diligence procedures with the goal of deriving a fair market value that approximates the businesses actual fair market value as defined by Federal tax regulation.
Many professional organizations promote and license the business valuation or appraisal field. They include the American Institute of Certified Public Accountants (AICPA), American Society of Appraisers (ASA), Institute of Business Appraisers (IBA), National Association of Certified Valuators and Analysts ("\NACVA) and others. The AICPA has formed an entire section, the Forensic and Valuation Services (FVS) within its organization to promote and provide technical and ethical guidelines for the business valuation area, including the current official designations of Accredited Business Valuation (ABV) analyst and the former Certificate of Educational Achievement for Business Valuation (CEA-BV). The AICPA recently opened its national business valuation school at sites across the country to assist in the training and competencies of its members who provide business valuation services.
The valuation analyst is required to assess a wide variety of topics when conducting a business valuation. These often include:
The Daubert case seems to be an area of interest to the legal community. This case, along with other landmark cases invoking the Daubert decision, have changed the nature of testimony since a so-called "Daubert Challenge" can undermine or exclude the testimony of a valuation expert.
- the equity interest being valued which may be an entire interest or a fractional one;
- an assessment of how the business entity derive its revenues;
- are the primary assets of the business tangible assets (machinery, inventory) or are the assets of an intangible nature (goodwill, patent, intellectual property);
- assess and calculate the business value given the fluctuations in the economic conditions present in the industry or in its (wide or narrow) operating region(s);
- assess any interaction for the variety of tangible and intangible assets which interact to produce economic activity, which in turn produces value through a mix of valuation methods or approaches;
- understand the matrix of business expenses and whether or not these expenses are due to managerial discretion or required of the operation to produce its core and ancillary revenue bases;
- normalize, or adjust, to depict the core requirements of the theoretical outside investor the various assets, liabilities, revenues and expenses to produce free cash flows or a normalized operating Income for use with the capitalization of those normalized earnings.
One area that causes much discussion and can produce wide variations in a valuation report value is the area of discounts or premiums for control (or lack thereof) interests. Control interests can affect the final determination of a businessís fair market value under the theory that an equity interest of the entire business entity is worth more, in terms of cash flow control and decision making, than an equity interest of less than one hundred percent. The logic behind this is similar to the concept that one may own an interest in its entirety and control all aspects of operations and direction while an equity holder who possesses a small to moderate fraction of the equity interest may have a seat in the board room but unless they possess more than a majority interest will have to accept the decisions and cash flow and direction decided by a majority equity owner.
Valuation reports have many users. These include The Internal Revenue Service (IRS) and the Tax Court, estate planners, the Small Business Loan Administration (SBA) and other business lenders, mergers and acquisition groups, Employee Stock Ownership Plan (ESOP) Trustees, current and potential shareholders who may be creating buy-sell agreements, individuals who require personal financial statements, family and civil courts, those trying to calculate lost business opportunities or business interruptions, dissenting stockholder and shareholder oppression parties, stock option or warrant holders, entities required to measure identifiable assets at fair value during acquisitions or those required to assess asset impairments.
Whether your business appears to be valued at $134 billion or $134 thousand, undertaking this valuable business valuation procedure can often make the difference between a resulting fair and balanced business sale or acquisition with an approximate fair market value, or an improperly valued business and its assets which could jeopardize the future operational ability of the business or its assets.
Jeffrey Graham is a principal at Graham & Graham, Certified Professional Accountants in Laconia and Concord. Learn more at www.grahamcpa.com.