Nathan A. Fyock, CPA, ABV
Grand Junction Audit Office
Business valuation services are very helpful and many times required for such things as 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 for marital dissolution, and to value ownership interests awarded to employees for compensation. Although business valuation services are needed in many situations, there are some common misconceptions about what goes into determining a value and the appropriate valuation reports one should obtain for various situations.
The first common misconception stems partly from the term “valuation” as many will assume that “valuation” means “formula” and that there is a set formula that numbers are plugged into to determine the value of a business. While various formulas may eventually be part of a valuation, the real effort and hours of analysis undertaken by a valuation analyst are spent by stepping into the shoes of a buyer or seller to determine what value 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: the principles of alternatives, substitution, and future benefits. In the process of considering these basic principles, the analyst also has to consider the impact of other variables, such as the various risks inherent in the respective business and the degree of control or lack thereof that may affect value.
The principle of alternatives states that each party in a contemplated transaction, has alternatives to consummating a transaction. The principle of substitution, indicates that a prudent individual will not 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 that economic value reflects anticipated future benefits. Future benefits are especially important to consider as potential investors are typically interested in 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 next 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 the aforementioned principles, a valuation analyst is required to conduct an extensive analysis of many different financial and nonfinancial aspects of a business, including industry and economic data. All businesses are not created equal, and all have their own unique background, structure, strengths, weaknesses, industry and economic drivers. The valuation analyst has to understand these attributes and ensure that significant risk factors that would affect the value a buyer or seller would agree on, are incorporated into the conclusion of value using the most appropriate combination of valuation approaches and methods based on the facts and circumstances of the assignment. There is no “cookie cutter” formula that can be used to do so, as each business is unique.
Although this process may not be as simple as many people initially assume, by going through this process, a valuation analyst can assist a business owner or potential business owner with understanding factors associated with their business that are increasing or decreasing value in order for them to enhance or address these items. Additionally, if the valuation is performed for tax purposes, this process will allow a competent valuation analyst to properly quantify and support adjustments to value for risks and the level of control related to the subject business interest being valued, which could significantly lower the tax burden for gift, estate, or equity based compensation purposes.
The second common misconception is related to the level of valuation service necessary and the deliverables associated with such services, as many people are not aware that 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 third parties such as a court of law or included as part of a tax return filing. The business valuation standard of the American Institute of Certified Public Accountants (AICPA) notes that there are two types of engagements, (1) a valuation engagement, and (2) a calculation engagement.
In a valuation engagement, the engagement calls for the valuation analyst to estimate 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 she or he deems appropriate in the circumstances. The valuation analyst then expresses the results of the valuation as a conclusion of value, which may be a single amount or a range.
In a calculation engagement, 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, and the valuation analyst calculates the value in compliance with the agreement, which can be expressed as a single amount or a range.
A calculation engagement is generally only appropriate if it is not intended to be relied upon by or provided to a third party such as a court of law, the Internal Revenue Service, potential buyer, etc. Otherwise, a valuation engagement should generally be performed with a conclusion of value provided.
The type of written deliverable or report that can be provided for a valuation engagement can be either a detailed report, or summary report. The detailed report contains all information considered by the valuation analyst in forming their conclusion of value and will typically be around 50 to 100 pages in length. The summary report is more limited in the information provided and will typically be around 15 to 30 pages in length. However, there is no difference in what a valuation analyst is required to do in a valuation engagement to determine a conclusion of value despite whether a summary or detailed report is provided.
The type of written deliverable or report that can be provided for a calculation engagement is a calculation report, which will clearly state that a calculation engagement does not include all the procedures required in a valuation engagement and does not 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’s Accredited in Business Valuation (ABV) credential or the National Association of Certified Valuators and Analysts’ Certified Valuation Analyst (CVA) credential to help guide you through this process as well as to help you gain insight into the factors driving the value of your business.
Nathan “Nate” Fyock, CPA, ABV is an Associate Principal with Dalby Wendland’s audit office in Grand Junction, CO. He has expertise in providing attest and accounting services such as financial statement audits, reviews, compilations, and agreed upon procedures for a variety of clients. His industry specialties include life and health insurance, third party health plan administrators, construction, manufacturing, nonprofit organizations, institutions of higher education, governmental entities, and employee benefit plans. Fyock attained accreditation in business valuations (ABV) from the American Institute of CPAs in 2016 and provides valuation services in a variety of areas. He is a member of the Colorado Society of CPAs and the American Institute of CPAs and serves on the finance committee of local nonprofit Marillac Clinic and Federally Qualified Health Center in the Grand Valley.
