By Jeffrey R. Kinderman, CVA
When considering embarking on a valuation, you will save time and avoid confusion if you “speak the same language” as the valuation analyst and know what to expect. Here are basic terms and concepts you should understand.
Why get a valuation?
Valuations are useful if not necessary in many scenarios, including a shareholder buy-in/buy-out, a buy-sell agreement, gift tax and estate tax reporting, management planning, exploring a potential sale, financial reporting, and litigation.
These are the acronyms you should look for when considering the credentials of a valuation analyst.
- ABV — Accredited in Business Valuation, American Institute of Certified Public Accountants
- ASA — Accredited Senior Appraiser, American Society of Appraisers
- CVA — Certified Valuation Analyst, National Association of Certified Valuation Analysts
Valuator Standards and Practices
A business lawyer should be aware of the names of the different standards and practices, and their sources, used by credentialed valuation analysts.
- Statement on Standards for Valuation Services No.1 (SSVS), American Institute of Certified Public Accountants
- Uniform Standards of Professional Appraisal Practice, The Appraisal Foundation
- Principles of Appraisal Practice and Code of Ethics, The American Society of Appraisers
- ASA Business Valuation Standards, American Society of Appraisers
- NACVA Professional Standards, National Association of Certified Valuation Analysts
Two Types of Engagements
There are two types of engagements for which you would retain a valuation analyst: a valuation engagement and a calculation engagement.
- “Valuation engagement — A valuation analyst performs a valuation engagement when “(1) the engagement calls for the valuation analyst to estimate the value of a subject interest and
“(2) the valuation analyst estimates the value and is free to apply the valuation approaches and methods he or she deems appropriate in the circumstances. The valuation analyst expresses the results of the valuation as a conclusion of value; the conclusion may be either a single amount or a range.” (SSVS)
- “Calculation engagement — A valuation analyst performs a calculation engagement when “(1) the valuation analyst and the client agree on the valuation approaches and methods the valuation analyst will use and the extent of procedures the valuation analyst will perform in the process of calculating the value of a subject interest (these procedures will be more limited than those of a valuation engagement) and
“(2) the valuation analyst calculates the value in compliance with the agreement. The valuation analyst expresses the results of these procedures as a calculated value. The calculated value is expressed as a range or as a single amount. A calculation engagement does not include all of the procedures required for a valuation engagement.” (SSVS)
Types of Reports
When developing the scope of work for a valuation analyst, it’s helpful to know the types of reports valuation analysts typically produce.
- Valuation Engagement (see above) — This engagement typically results in a detailed report, a summary report, or an oral report.
- Calculation Engagement (see above) — This engagement typically results in a calculation report or an oral report.
Note that the Statement on Standards for Valuation Services No.1 provides for a valuation “litigation exemption.” That exemption applies to “[a] valuation performed for a matter before a court, an arbitrator, a mediator or other facilitator, or a matter in a governmental or administrative proceeding, is exempt from the reporting provisions of this Statement. The reporting exemption applies whether the matter proceeds to trial or settles.” (SSVS)
To complete the valuation engagement with professional competence, the valuation analyst should consider, at a minimum, the following. Use this as a checklist when you preview or check your valuation analyst’s work.
- Subject entity and its industry
- Subject interest
- Valuation date
- Scope of the valuation engagement
- Purpose of the valuation engagement
The Three Approaches to Valuation
The three approaches to valuation are the Cost Approach, the Market Approach, and the Income Approach. Each approach serves a different purpose and is used in a different scenario.
- The Cost Approach — The cost approach places primary emphasis on the value of the assets and liabilities of the company by revaluing each of the assets and liabilities of a business to the values that could be realized upon a sale to a disinterested third party.
The cost approach is an appropriate method used for holding companies, or companies with no established earnings history. This approach is useful when the majority of revenues are derived from tangible assets with little emphasis on labor. Generally considered the weakest of the three methods.
- The Market Approach – The market approach is a general way of determining a value indication of a business, business ownership interest, security, or intangible asset by using one or more methods that compare the subject to similar businesses, business ownership interests, securities, or intangible assets that have been sold.
The basic premise of the market approach is the principle of substitution, i.e. a prudent buyer will pay no more for a property than it would cost to acquire a substitute property with similar utility.
- The Income Approach — The income approach is a a general way of determining a value indication of a business, business ownership interest, or intangible asset by focusing on the income-producing capability of an asset/business. This valuation is based on the expected economic after-tax income stream of an asset or business over the estimated life of the asset or business.
The basic premise of the income approach is the present value of the future economic income stream, which can be net income, net cash flow to equity owners, net cash flow to debt and equity owners, etc.
The Most Commonly Used Methods for Privately Held Companies
The most commonly used methods for determining the value of privately held companies are Guideline Publicly Traded Companies Method, Guideline Transactions Method, Recent, Investment in Subject Company, Discounted Future Earnings Method, Capitalization of Historical Earnings.
Fair Market Value vs. Fair Value vs. Investment Value
- Fair Market Value Definition — “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.” (IRS)
- Fair Value Definition — “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” (Accounting Standards Codification 820) Note: This is an accounting definition not a legal definition.
- Investment Value Definition — The value to a particular investor based on individual investment requirements and expectations.
Types of Discounts
- Discounts for Lack of Control — The International Glossary of Business Valuation Terms defines this type of discount as “an amount or percentage deducted from the pro rata share of value of 100% of an equity interest in a business to reflect the absence of some or all of the powers of control.”
- Discounts for Lack of Marketability — The International Glossary of Business Valuation Terms defines as “an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability due to the ability to quickly convert property to cash at a minimal cost or the ability to quickly convert property to cash or pay a liability.”
Caution: “Back of the Napkin” or “Rule of Thumb” Reports
- These types of “reports” are not considered or contemplated in ASA, USPAP, or AICPA valuation literature.They do not meet the, valuator competence rules, valuation standards from ASA, ASPAP, or AICPA, valuation development standards, or valuator report requirements.
- They often fail to adequately consider important components of the business.
- Credentialed valuators do not and should not provide these types of reports.
- Credentialed valuators who provide these types of reports could be subject to malpractice.
Another MSBA Member Resource You May Find Useful: Business Valuation for Lawyers
Jeffrey Kinderman is a principal with SC&H Capital, where he leads and manages the Business Valuation Advisory team.