If you are preparing a high quality business valuation, standard compliance is very useful indeed. Business appraisals are governed by a number of professional standards with one of the most detailed being the AICPA Statement on Standards for Valuation Services or SSVS No 1 for short.

SSVS is a relatively new standard, at least when compared with the venerable USPAP that is well known not just in business valuation but in the real estate appraisal industry.

Authors of the SSVS standard studied the needs of clients and CPAs alike and came up with some new ideas. One such notion is the different formats of business valuation known as the valuation and calculation engagements.

Many business appraisers know that the scope and cost of a valuation project can vary dramatically depending on the needs of an individual client.

Does the client management team need to have a general idea of business value to file away for future reference? Or do business owners require a serious study of business value in order to raise essential capital for business expansion? Is legal challenge on the horizon? Do business partners consider buying out a retiring team member and need to know a fair market value of the partners’s ownership share?

All these reasons for business appraisal are very different and often call for a highly specialized valuation.

In many cases business owners approach their professional advisors with questions about business value but do now need a formal business appraisal. Imagine a meeting in your CPA’s office talking about your business value drivers and what you can do to increase your business worth going forward. Odds are you can hash out a very focused project with your CPA in order to get to the bottom of this question.

To save time and money, you may be willing to agree on a specific set of valuation methods your CPA will use to estimate the company’s worth. This may be enough for your purposes and has the big advantage of reduced complexity and cost savings.

On the other hand, some business owners may feel uncomfortable getting involved in choosing the valuation methods. Perhaps they would be concerned that some proverbial stones would be left unturned and important details missed if the owners roll up their sleeves on valuation. In such situations, the business appraiser is best left to make the right choices in order to determine the business value.

SSVS standard lets you make such decisions at the outset of your valuation project. Calculation engagement is defined as the limited scope appraisal where you agree with your advisor on the choice of valuation techniques to be used. Remember that there are three fundamental business valuation approaches, each offering you a number of methods.

Excluding any of the valuation approaches from your appraisal should not be taken lightly. Indeed, the USPAP standard frowns on such restrictions because a business appraisal could be too limiting and miss important insights. The standard requires that you explain why any one of the approaches is omitted from your analysis.

There are situations where it may be justified. Consider, for example, valuing an emerging technology company that is blazing a new path in the industry. There may not be any real competitors just yet to compare this company against. Hence, it makes little sense to use the market approach when valuing such a business. You can state in your business valuation that the market approach is not suitable and your appraisal would focus on the income and asset approach valuation instead.

The alternative is to let your CPA choose the methods used in valuation of the company. This is the essence of the valuation engagement under the SSVS No 1 standard. This hands-off handling of the project has its benefits – you provide the needed input in the form of business information to your professional advisor who uses his or her knowledge to structure the appraisal in the best way possible.

When in doubt as to which way to go, consider using the letters of engagement to outline your appraisal project. This way there are no surprises down the road, and the choices made early on help you manage expectations for both the client and the professional advisor.

Valuation of goodwill often comes about in the context of business selling price allocation. In the past, business goodwill was one of the intangible assets recorded on the books when the company changed hands. This acquired asset was then amortized over time.

The new rules of handling goodwill have been published in 2001 by the Financial Accounting Standards Board (FASB). The rules state that goodwill is no longer amortized. Instead, goodwill is assumed to have indefinite life.

Goodwill impairment – is your business value holding up?

Businesses now conduct the so-called goodwill impairment test, at least yearly. You determine the overall value of the business and compare it to the carrying amounts of business assets. If the business value falls below the sum total of all the business assets, the value of business goodwill is reduced by an appropriate amount.

This means that business goodwill continues to be shown on your company’s books as long as the company’s value is high enough. If the business value drops, you can write off all or part of the business goodwill accordingly.

The write-down is against the company’s earnings for the year and reflects the drop in the company’s value.

Goodwill impairment or amortization – which one is best?

Whether this accounting strategy is an improvement on goodwill amortization is debatable. You now avoid the reduction in business earnings due to the amortization charge. On the other hand, goodwill write-downs are not exactly good news as they clearly state that the company’s value is going down.

Six of one, half a dozen of the other? You decide.

Most professional business valuations these days are done in compliance with the Uniform Standards of Professional Appraisal Practice, or USPAP for short. The USPAP standards have evolved to keep pace with the changing demands of the appraisal profession.

The requirement for reliable, defensible, and transparent business valuation has led the USPAP standard authors to develop a set of guidelines under the so called Ethics Rule. In addition to the management of appraisal engagements and ensuring client confidentiality, the Ethics Rule specifies a set of professional conduct rules.

Considering taking on a business valuation engagement? These are the guidelines of what it takes to complete a professional business appraisal that makes the grade under the USPAP standard:

You must perform business valuations in an objective, impartial manner and without seeking to satisfy your personal interest. The standard specifically states these requirements:

  • You must show no bias in your valuation analysis.
  • You must not act as an advocate of any party, including your client.
  • You should refrain from agreeing to a certain valuation result before your analysis is complete.
  • You must steer clear of any attempts to mislead or defraud the recipients of your business appraisal.
  • No fake business valuation reporting is allowed.
  • You must not be influenced in your valuation conclusion by any considerations as to the personal attributes of client or other parties such as race, ethnic background, religious preferences or gender.
  • Your business valuation must demonstrate the appropriate level of due diligence and prevent negligent mistakes.
  • You should have no ownership interest in the business being valued to avoid conflicts.

Essentially, a business appraiser should conduct valuation at arms length and remain impartial throughout the project. Any bias or motivation to arrive at a predetermined result is obviously suspect and you should avoid it. This holds true even if you have had a long term relationship with the client and are quite familiar with the needs behind the business appraisal.

Buckling to your client’s pressure to come up with a figure is a bad idea. Your client would be better served if you prepared an objective business valuation and communicated the results and reasons behind them clearly.

You can then help your client understand what can be done to enhance their business value and develop a plan to achieve these goals over time.

If you ask a business appraiser why clients show up, you will hear that there is some type of business transaction that drives the need for business valuation.

Rarely do business people spend money on a business valuation just out of curiosity. The situation is similar to getting your personal or real property appraised.

Why appraisals are essential – avoiding asset overpricing or underpricing

If you are looking to buy or refinance your house, you would need to appraise the property to get the loan or make sure the asking price is realistic. Your lender would want to know that the house offered as a collateral for the loan is worth the money. As well, you would want to know that the asking price for a house you are considering is in line with the market rates.

If the price is right, you can feel good about making a fair offer. If not, especially in the case of for sale by owner or FISBO sellers, you may need to resort to negotiating the price if you still want the house. Your ability to convince the seller to come to a reasonable compromise can make or break the deal.

Either way, there is tension in the air as the buyer and seller come from two opposite directions. The buyer wants to pay the lowest price possible. The seller looks for the highest selling price the market will bear. It can get quite intense in the heat of negotiations.

Overshooting the asking price can land the seller in trouble as the house languishes on the market with no serious offers. Buyers get a sticker shock and look elsewhere. The overpriced house does not sell, until the seller comes around and lowers the price.

On the other hand, the valuable asset that is seriously under priced may fly off the shelf, but leave sour taste in the seller’s mouth. Just consider all that money left on the table.

The situation gets even more serious with business valuations. For one thing, businesses do not sell nearly as often as homes or cars. In addition, no two companies are the same. Just finding the right buyer for a business is a major project.

Dumb money in business buying – how to wreck successful companies

Anybody with money can in theory buy a house and occupy it without difficulty. But assuming that any buyer with money is a good candidate to buy your business is a bad idea. Whether the buyer is capable of taking over the company is by no means obvious. You may see your life’s work driven into the ground by an incompetent new owner shortly after the business sale.

Reserve seller financing for qualified business buyers

This concern over the future prospects of the business is one key reason business owners are reluctant to offer seller financing. A chunk of the business selling price may depend upon the new owner’s ability to run the business successfully after the purchase. If they fail, the seller is out of money and often needs to regain control of a failing company.

So in addition to business valuation, transactions often require due diligence to maximize the chances of successful ownership transition.

A solid business appraisal is very helpful here. In your business valuation report, you describe your company, its value drivers, competitive position, and future prospects. Your buyer candidates need to understand what they are up against if they decide to move forward with an offer.

No 1 reason for business failure – under-capitalization

The business selling price and terms are key to a successful sale. One important question that must be addressed is whether the new owners have sufficient capital on hand to both fund the purchase and cover the cash flow needs for operating the business. Under-capitalization is perhaps the greatest danger the new business owner faces.

If you want your business appraisal to be taken seriously, you should consider compliance with a major appraisal standard, such as the USPAP. The Uniform Standards of Professional Appraisal Practice govern valuations of all kinds of property – including real estate, business personal property, and business enterprises.

Creating trustworthy business valuations

The reason USPAP exists is to promote public trust in business valuation results. If your appraisal follows the guidelines of this venerable standard, chances are your clients and anyone else reading your valuation report would feel comfortable that the conclusions of value are based on sound, well reasoned thinking.

While some jurisdictions may require that your business valuation comply with USPAP, the standard by itself is not enforced by law. Business valuation experts and seasoned business people may opt for a USPAP compliant business valuation whenever they anticipate challenges to their conclusions, or feel the added credibility of a professionally done business appraisal is called for.

In some situations, compliance with a standard may be mandatory. Examples include business valuations required by lenders, courts, or tax authorities.

So what does it mean to create a business valuation that measures up to the USPAP requirements? Here is the list:

  • The appraiser must be prepared by an independent party who is competent in valuing businesses.
  • The appraiser must gather and maintain all the supporting information used in business valuation.
  • Your valuation must be done in accordance with the major USPAP Rules: Ethics Rule, Competency Rule, Scope of Work Rule, and Record Keeping Rule.

Rules of the game: Ethics, Competence, Scope of Work, Accurate Record Keeping

The Ethics Rule is made up of three parts: conduct, management and confidentiality.

Your business valuation should be done in an impartial, objective way, and be independent of any personal interest. For example, you should not stand to benefit from a certain business valuation result, such as a higher or lower valuation.

If you are hired to do an appraisal by a client, you should disclose that you are paid to do the work. In addition, you should seek to protect your client’s confidentiality by not disclosing the business valuation data or results to anyone other than the intended parties.

Reselling client data violates the USPAP Ethics Rule

Be sure you or your service providers do not try to profit from reselling the client’s data. This is strictly in violation of the USPAP Ethics Rule! If you are using Web-based software vendors, check to make sure they don’t resell your client’s data without permission.

Under the Competency Rule, the business appraiser must possess the necessary skill and experience to take on a business valuation assignment. Business appraisal calls for serious financial analysis. If you do not have the know-how, you should bow out.

To meet the Scope of Work Rule, you should clearly state what you intend to do in your business appraisal. The amount of information gathering, research, and analysis you do should be clearly stated in your business valuation report.

The Record Keeping Rule requires that you keep the complete records of what has been done in the course of your business valuation engagement. Some elements your records must include:

  • Identity of your client and anyone else who will be receiving the business valuation report.
  • Copies of written reports.
  • Synopsis of any oral communications with your client.
  • All data you have gathered in the course of your business valuation engagement.

It is a good idea to retain the documents for some time. USPAP Record Keeping Rule calls for a 5 year retention on all completed appraisals. Watch out – mishandling the documents or failing to produce copies on demand could invalidate your business appraisal and put you in violation of the USPAP Ethics Rule.

It is axiomatic that no business operates in a vacuum. General industry conditions are perhaps the biggest part of systematic risk a company faces. The reason it is called systematic is that you cannot avoid it by diversifying your business investment. The entire economy is affected, so you have to ride out the rough spots as best you can.

Every time you see a business valuation report, the appraiser has made a set of assumptions about the economy going forward. In fact, professional valuation reports contain a section dealing with the economic conditions. This discussion forms the basis of earnings and expenses forecasts that you see further down in the report.

On occasion, you may run across the economic discussion that seems too lengthy or complicated. Indeed, what future holds is anyone’s guess. Looking into the future beyond a couple of years is fraught with potential errors. Overall market indicators such as the national or regional economic growth prospects are probably more important than tactical decisions made by the Federal Reserve.

Remember that historic performance is just that – a point in history. It will never be repeated so the economic conditions and business outlook will differ from years past. If your business appraisal dwells exclusively on the past, it is likely to miss significant developments that could substantially change your business prospects.

Business value is about risk and returns. As such, business valuation is a forward looking exercise. History is a guide, but accurate business valuation depends on how well you can envision what the business will be able to accomplish in the future.

If you take a look at the highly efficient capital markets such as the NYSE or NASDAQ exchanges, the prices per share of public company stock are actually the minority share prices. What this means is that the buyers and sellers typically trade a small number of shares. Each block of shares sold does not represent control of the entire company.

If, on the other hand, someone wants to buy a controlling share of the company, they would need to pay a premium over the current share market price. This is usually done in the form of a tender offer.

Controlling ownership interest is valuable

Why is a controlling block of shares more expensive? First, because the acquirer needs to induce many small shareholders to sell their stock. Second, because the acquirer gets to control the company, including making such momentous decisions as hiring and firing executives, distributing dividends, raising capital, merging with other companies, or selling the business.

In the public market, there is plenty of data on such tender offers. The premium paid over the market price is reported in regulatory disclosures. As a rule, the control premium typically falls somewhere in the 30% – 40% range. Put another way, to buy the entire company you would need to pay up to 40% more per share than if you just bought a single share of stock in the firm.

From control premium to minority discount

The opposite side of this is the minority discount. This discount usually arises in the context of valuing private companies. The reason is that private businesses do not sell their stock to the public, so their valuation is typically done on the business enterprise basis. The value of the whole company is determined. If you want to know what a partner’s ownership interest is worth, you first figure out the value of the pro rata share, then apply the minority discount.

Why is this discount important? Since there is no public market for ownership of private companies, there is no way to observe the price per share for a privately owned business. Think about it – how valuable would a 10% ownership of a small company be to an outside investor? You cannot make any decisions in a business controlled by the owners of the remaining 90%.

All you can hope for is an occasional dividend payout by the board. If the board is controlled by the same 90% owners, you should be lucky to see any money. More often than not, the controlling owners pay themselves in salaries and generous perks, and minimize the taxable income. If you object to the board, you are out of luck.

Adjusting for DLOM

If you use guideline public company comparables to figure out the value of a private firm, you would need to make the adjustments for lack of marketability (DLOM) first. Assuming your comparable companies are close enough to the target firm financially and operationally, you can work out the valuation multiples and determine the value of the private company on a per share basis. But remember that this guideline public company approach prices in the minority discount! In other words, your private company value could actually be 30% – 40% higher than this calculation shows.

On the other hand, you can use a set of valuation methods directly to value the entire private company. The business enterprise value you come up with is on a controlling ownership basis. If you want to figure out the value of minority ownership interests, you can apply the minority discount to the per share price you calculated.

If you look at either the build-up or CAPM cost of capital models for discount rate calculation, the elements can be broken down into two major groups: systematic and unsystematic risk.

Systematic risk is unavoidable, you cannot diversify away from it as it affects the entire market. Unsystematic risk, on the other hand, is something the investors should handle by diversification. In other words, you should not expect additional returns just because you put all your eggs in one basket.

Yet this is precisely what many small business owners do. Their company is the major source of their investment and commands their undivided attention to run successfully. Even if the public capital markets are silent about the company specific risk, it is quite real.

In the eyes of a financial expert, company specific risk premium or CSRP for short, cannot be observed. That’s because public company investors do in fact diversify from risks inherent in any particular company or asset. But if your company is more or less risky than the market as a whole, you are incurring the additional risks every day.

So a realistic approach when valuing a private firm that is expected to continue in private ownership is to account for this additional risk element. The typical factors that contribute to make a company more or less risky are these:

  • Earnings growth expectations: is the firm likely to be more or less profitable than its industry peers?
  • Financial leverage: can the company service its debt without financial failure?
  • Operational risk: can the operations be successfully scaled to meet the market demand and sustain growth?
  • Profitability: will the firm be able to generate profits in line with investor expectations?
  • Customer concentration: does the company depend on just a few customers for most of its sales?
  • Competitive position: does the firm operate in a well defended market niche or can it be easily replaced by competitors?
  • Management and key staff: what is the quality of the management team when compared to the industry peers?

Successful private companies with smooth, predictable earnings operating in a market niche they can defend skillfully tend to be less risky. On the other hand, a firm that is likely to experience competitive headwinds from well funded, large companies without a strategy of defending its turf is likely to be far more risky. The way to assess this level of risk is to analyze the company specific risk factors and adjust your discount and capitalization rates accordingly.

The debate about how to assess company risk and calculate the discount and cap rates rages on. While the CAPM and Build Up cost of capital models remain widely accepted, the devil, as usual, is in the details.

None as obvious as when using the risk premia for building up the equity discount rates for valuation. There seems no argument among the industry mavens that the risk free rate of return and so-called equity risk premium, or ERP for short, are the gold standard.

Company size premium – does size matter?

With this pretty much settled, the lively debate ensues as soon as you venture into the murky world of company size risk premia. The idea behind this additional element of discount rates is that smaller, less capitalized companies are inherently more risky than the larger, more established competitors.

Big business advantages and size effect on company’s value

Other things being equal, a large competitor is likely to enjoy better access to capital investment, greater acceptance of their products and services by customers, more flexibility in dealing with regulatory compliance (yes, the lobbying does pay off quite often), handsome war chests for fending off legal challenges, and much more.

Market acceptance of established companies is well known. Consider the power of a brand from a major competitor and compare it to a functionally equivalent product from a less known, smaller company. Study after study shows that customers prefer to go with the better known brands from larger companies.

In the business to business space, customers may hesitate to commit to purchases from a new vendor for fear of the company failing and leaving them high and dry without a critical supply. Often the procurement managers would demand to see the start-up’s balance sheet just to make sure they are not going belly up any time soon. The old adage of ‘show me the money’ plays right into the hands of larger, established deep pockets competitors.

Bigger companies also tend to enjoy the economies of scale, unavailable to their smaller industry peers. Ever wonder how come a large software company can come up with a working prototype by lunch time, while a smaller company has to invest ‘all-nighters’ to show similar progress?

That’s because the big company has plenty of talent on board with many pre-existing solutions lying around ready for reuse. They don’t need to reinvent the proverbial wheel, plenty of spare parts ready to be plugged into a new solution.

Smaller companies – trail blazers often fly under the radar screen

As a result, smaller companies often thrive in the netherworld of emerging markets. Big companies are generally not interested in such opportunities until they become large enough to warrant their attention. If and when that time comes, the bigger company usually has the luxury of either making their own competitive offering or buying a start-up’s technology and bringing the key talent on board.

All these and many other factors add up to making the larger companies a safer place to conceive and bring to market new products and services. Common sense tells us that this lower level of operational and financial risk should translate into measurable evidence of lower cost of capital.

Dilemma – when data analysis fails to back the company risk premium

Some financial analysts focus on data evidence exclusively to validate this idea. Smaller companies historic returns must be higher in order to demonstrate their higher cost of capital. The problem with this approach is that if your data analysis fails to show up the difference in returns between companies of various sizes, you would be tempted to assume that smaller companies are about as risky as their larger competitors.

The mindset behind this is ‘if I can’t see it, it does not exist’.

To a seasoned business person this would sound like being asked to suspend disbelief. A pragmatic response would be, ‘if you don’t see evidence of an obvious trait, your analysis is flawed, or you are not looking hard enough in your data collection’.

When a business sells, the owners are supposed to allocate the purchase price across all tangible and intangible assets. The overage is then deemed to be due to goodwill.

In the past, it mattered little if some of the important intangible assets were lumped together with business goodwill. The reason? There used to be little difference in how business intangible assets, such as intellectual property or customer contracts, were handled in the company’s financial records.

Business goodwill impairment

Along come the SFAS 141 an 142 published by the Financial Accounting Standards Board (FASB), and everything changes. No longer is business goodwill amortized. Rather, companies must conduct the goodwill impairment test and adjust their income statements accordingly. In addition, the Generally Accepted Accounting Principles (GAAP) now require that all intangible assets be amortized. In other words, such assets as software, technology, customer and vendor contracts, patents, copyrights and trademarks, all are expected to be gradually used up in business operations.

With these new financial reporting rules, companies have an incentive to put high values on goodwill and reduce the values of other intangible assets. The benefit of this strategy is that you can increase the reported earnings without any effect on the business cash flow. Earnings per share go up, so the company stock value increases.

According to the US Securities and Exchange Commission (SEC), there are several types of business intangible assets that must be valued:

  • Customer related intangibles
  • Creative intangibles
  • Marketing oriented intangible assets
  • Technology specific intangibles
  • Contractual intangible assets

All these assets must be recognized as distinct from business goodwill. Contract specific assets do not need to be actually separable. However, all other intangible assets must be capable of being sold on their own.

This sounds a bit tricky. The plain English meaning is that an intangible asset must be either based on a legally enforceable right, such as a customer contract, or be sellable by itself, such as a license to use a patented invention.

To see the difference, imagine the problems with trying to transfer a trained and assembled workforce to another company. You are unlikely to have this valuable asset preserved intact, in contrast to the licensing of a trademark.