The Top 10 Things Estate Planners Should Know About Business Valuation
Estate planners work with business appraisers every day. Experience suggests that there are numerous aspects of business valuation that when known to estate planners greatly benefit the proposal and execution processes. We have compiled a “top 10” list of things every estate planner should know about business valuation. While a few of the items might seem obvious, to many they are not.
1. Define the Project
In order for the appraiser to plan the assignment, estimate the fee, and understand the client’s specific needs, the estate planner needs to provide some basic benchmark information, such as: a description of the specific ownership interest to be appraised (number of shares, units, bonds); a clearly stated understanding of the “level of value” for the interest being appraised; a specific valuation date, which may just be current, or may be a specific historical date, and a description of the purpose of the appraisal (inform the appraiser why your client needs an appraisal and how the report will be used).
2. Understand the Standard and Premise of Value
There are different standards of value for appraisals under certain circumstances and in different jurisdictions. Corporate and owner-level tax compliance appraisals are based on “fair market value,” certain jurisdictions require “fair value” in dissenters’ rights cases; and “liquidation value” may be appropriate in certain cases. Most appraisals are developed using a premise that the subject entity of the appraisal is a “going concern” in which business assets are used to conduct business versus being liquidated in a piece meal sale of assets.
3. Involve the Appraiser Early On
Even in straightforward buy-sell agreements, family limited partnerships, or corporate reorganizations, it is usually helpful to seek the advice of the appraiser before the deal is finalized to see if there are key elements of the contract document that could be modified to provide a more meaningful appraisal to your client.
4. Distinguish Between a Business Appraisal and a Real Estate Appraisal
Many of the corporate entities appraised either own or rent the real estate where the business is operated. For a successful operating business, the most meaningful valuation is typically based on some measure of income, rather than the value of the underlying real estate. However, one should recognize that the value of some businesses, due to the nature of the subject business model, is better characterized by the value of underlying assets, and less so by the ongoing income. This is true for asset holding entities, and for some older family businesses with marginal earnings but with appreciated real estate on the books. Many business appraisers are not asset appraisers, and therefore, may need to consider a qualified real estate appraisal in the business valuation process.
5. Establish a Reasonable Time Frame
Each client’s business appraisal is a custom piece of work. Clients rarely have available all the information requested at the outset of a business valuation assignment. Typically, a valuation project takes several weeks to complete once the engagement is authorization to proceed. Timing can be accelerated to meet special needs, but it is usually a good idea to avoid rushing the production of a complex appraisal project.
6. Insist on an Appraisal Firm with Experience and Credentials
Each business appraisal is unique and experience counts. Most business valuation firms are generalists rather than industry specialists. However, the experience gained in discussing operating results and industry constraints with a broad client base helps an appraisal firm understand each client’s special situation. While credentials are no guarantee of performance, they do indicate a level of professionalism for having achieved and maintained them.
7. Know the Primary Business Valuation Methods
Business valuation is an art as well as a science and appraisers utilize various valuation methods and treatments as required to appropriately address the unique considerations of each assignment. Key methods typically include: transactions method (focuses on actual transactions in the security being appraised); underlying net asset value method (considers estimates of fair market value of the entity’s net assets, on a tax-adjusted basis); capitalization of earnings method (based on estimates of underlying earning power times a derived capitalization factor); guideline company method (similar to the capitalized earnings method, but uses comparable, or guideline companies to derive the appropriate capitalization factor) or discounted cash flow (derives the present value of future cash flows, based on a combination of projected future cash flow and a derived discount rate appropriate to the situation). Other valuation methods may be appropriate to certain companies in specific industries where particular comparable transaction data may be available.
8. Consider the Appraisal as a First Line of Defense
A well-reasoned and documented appraisal report serves as an indication of the seriousness and professionalism with which you address a client’s needs. Having an independent valuation in a transaction situation provides a level playing field for negotiations in good faith on both sides. For tax-compliance cases, the appraisal serves notice to the other side that they need to be equally prepared to support a contrary opinion of value.
9. Litigation Support Issues
The business appraiser cannot serve as advocate for your client, but it is always helpful to have an experienced business appraiser available for expert opinion testimony. In addition to providing a well-reasoned and documented report, the appraiser must be able to articulate the reasonableness of valuation and investment conclusions to the court and be able to deal with intensive cross examination.
10. Expect the Best
In most cases, the fee for appraisal services is nominal compared to the dollars at risk and the marginal cost of getting the best is negligible. You can help your appraiser do the best job possible by ensuring full disclosure and expecting an independent opinion of value. The best appraisers have the experience and credentials described above, but recognize the delicate balance between art and science that enables them to interpret the qualitative responses to due-diligence interviews and put them in a stylized format that quantifies the results.