People who own businesses often need to have the business appraised. Sometimes it’s for a specific purpose, like post-sale retirement; Other cases may involve estate tax planning, the acquisition of shares by a co-owner, or inclusion in financial statements. Whatever the reason, there are many ways a business can be valued just before an actual sale.
This article describes different ways a company can be valued. Most requirements fall under the financial planning umbrella, and this article provides a guide for CPA personal financial planners on how to conduct preliminary discussions with business owners about the assessment process and how it works. This article does not explain how the value is calculated, which is best done by a trained and licensed professional.
Before an appraisal can be made, it is necessary to determine the actual value of the company’s tangible assets and its net income. In some cases, a projected net income may also be required. The starting point is the last annual financial statement.
Asset values start at book value and adjustments need to be made for assets such as machinery that are over or under valued on a replacement cost basis. The book value reflects the unamortized acquisition costs. If the machine is now worth more than the book value, the difference is added to the book value, and deducted if it is lower. If there are undisclosed or contingent liabilities, the carrying amount shall be reduced by those amounts; If there are liabilities that are not settled, e.g. B. Loans to owners, the book value should be increased by this. When it comes to gear, it’s not always easy to determine its value; in such cases, an expert must be commissioned if this is essential for the overall assessment. Otherwise, simple estimates by the owner should suffice.
premise of the assessment
There are two possible assumptions for a valuation: that the company will continue as an operating unit or that it will be liquidated. For most valuations of a viable business, the liquidation alternative should not be considered unless the assets are significantly underutilized and have an individual value that significantly exceeds the value at which the business could be sold on the basis of its earnings . This is usually only determined at the end of the evaluation process.
With respect to the company’s net income, adjustments must be made to normalize the income based on what it would be if the company were more normally or appropriately owned or operated. An example is when owners receive salaries well in excess of what an employee in similar roles would receive. Other adjustments could include paying above market rent to an owner who is also the landlord; fringe benefits beyond what would be considered normal for this type of business; Advertising, marketing or PR costs incurred for reasons of ego; relocation, restructuring, legal or special consultant costs that were one-off events and will not recur; or personal expenses that would be eliminated by a new owner. This results in a “normalized” net income, which is the starting point for every assessment. Individuals should understand the process of income normalization as certain adjustments could indicate a lack of income tax compliance.
purpose of the assessment
While official appraisals can be more than 50 pages long and contain numerous calculations, the appraisal is ultimately an opinion based on certain facts and assumptions. In addition, depending on the purpose of the assessment, there can be many different values that need to be clarified before starting. For example, valuing a company for estate tax reporting purposes is done differently than for gift tax purposes, although the two issues are intertwined in the minds of many individuals. Furthermore, an evaluation for a divorce would be made in a very different way than for board compensation purposes or a sale to a buyer interested in working at the company. Yet another method would be used for a partner’s post-death settlement, and possibly another for the same partner’s retirement.
The purpose of the rating affects the measure of value used, which in turn determines the basis of the rating. Gift and estate tax assessments use the market value standard, while divorce uses fair value. In addition, fair value for divorce differs from fair value for valuing assets in an audited balance sheet. Likewise, a different standard is used for valuing employee stock options than for valuing built-in gains when a C corporation converts to an S corporation. When it comes to divorce, the state in which the divorce is being conducted determines the standard. Determining the appropriate standard requires patience.
Many assumptions are necessary for an evaluation. As described above, various assumptions were made when determining the normalized net income. Once the normalized net income is reached, the owner must decide whether to look backwards or forwards at the income. In the case of fair market valuations, a type of average income from previous years is usually required. Depending on the circumstances, this could be the last two, three, four or five years, disregarding expected current year revenues (which would also be an assumption). Whether to use a mean or a weighted average is another assumption. Assumptions must also be made to determine whether forecast revenue is used and these reports may need to be provided by the client or performed as a separate order.
Other assumptions include discount rates and capitalization rates. A discount rate is used to determine the present value of future earnings used in valuation, while a capitalization rate is required to determine the value based on the buyer’s or acquirer’s expected earnings. For example, if an investor expects a 15% return on their investment, the normalized net income should be divided by 15% to determine the value of the company. So a higher capitalization interest rate leads to a lower value and vice versa. Determining a capitalization rate can involve numerous variables, each of which is also an assumption.
Fair value business valuations include adjustments for minority or swing voting interests and the marketability of minority or non-controlling interests. These adjustments are also assumptions, as is the decision to make such adjustments.
No evaluation can be made without an understanding of how the company is organized and operated: its capital structure, ownership, employment, customer and supplier contracts, leases, revenue generation, competition, key employees, special formulas, brand equity, warranty obligations, specific customer or supplier relationships , industry situation and market share, competitive and disruptive pressures and many other elements characteristic of the company. A valuer must check all of this in addition to the financial statements and dates.
Once all data has been collected, reviewed, examined and evaluated, assumptions made, and information organized and tabulated, an estimated value can be determined. In the absence of an actual sale, this is only an indication of value. Calling it an “educated guide” would be a misnomer given the number of assumptions used, but it does indicate a best-case evaluation.
CPAs can create two types of assessment reports. A value conclusion is an official opinion and carries the greatest weight of any rating produced by CPAs. For estate and gift tax purposes, divorce proceedings and many other purposes where the appraiser is expected to testify in court, this is the only acceptable valuation report. Another type of valuation report, a value calculation, can be used for informal purposes, comparative discussions, determining a parameter or benchmark for enterprise value, and for most financial planning purposes. AICPA members must follow the value conclusion and value calculation rules in the Statement on Standards for Valuation Services 1. CPAs that are not AICPA members should indicate in their reports which standards they follow and whether they have references from other bodies. Without references, it is difficult for an appraiser to establish credibility, but their wealth of experience in these matters would carry weight. To save on fees, many CPAs conduct “informal” assessments, particularly for financial planning purposes. These typically do not follow any standards and accordingly may not include all of the procedures and steps necessary to obtain a fair rating, potentially resulting in a rating that would not be in the best interests of the client.
If a CPA financial planner is also qualified to conduct assessments, there may be an independence issue with the assessment when a formal value judgment needs to be issued.
parties to the assessment
Most financial planning occurs between the individual client and CPA (and occasionally family members) and is conducted in an informal manner. However, if there is a specific purpose, other parties might be of interest and distribution to them should be considered; For example, estate, gift and succession planning may require reports to be submitted to the IRS. Evaluations for employee compensation purposes would include employees and their advisors, while premarital and divorce-related evaluations would include the intended or current spouse. While receipt of an assessment report is usually restricted, these restrictions are often not complied with by the individual or their advisors and the reports may be obtained by unauthorized persons. Ads can also end up in a court case and then be admitted as evidence. Individuals should be cautioned about these possibilities for their own protection.
The Role of the CPA
As mentioned above, CPA financial planners face a dilemma when advising business owners. When such individuals require an assessment, CPAs should recommend hiring a suitably accredited assessment professional. CPAs must also carefully consider what valuation premise is appropriate and what type of valuation opinion is required in the given circumstances. The guidance above is designed to help CPA financial planners understand the assessment process and how best to convey this information to clients who own businesses.