Business valuation of pass through company entities

A number of small business forms are available that allow owners to avoid the pass through the taxes and avoid double taxation associated with large public companies.

Example is a US S corporation, a typical small corporate form adopted by many business owners. The individual shareholders get a pro-rate share of taxes they report on their individual tax returns. The same goes for partnerships and limited liability companies.

For business valuation, you may wonder if such companies should be valued on a pre-tax cash flow. Or should you impute some level of corporate tax to adjust the earnings? In truth, business appraisers differ in their approach to this issue. As the saying goes, it depends.

If the intent is to value a pass through entity in order to prepare for acquisition by a public company, then an appropriate corporate tax rate should be used. After all, you expect the company to become part of a larger business that already pays corporate tax.

But what about valuations for other purposes, such as a buy-sell agreement? Here, your plan is to transfer company ownership to private owners that have no intention of paying corporate tax. So the company value can be properly determined based on a pre-tax cash flow.

It is clear that using pre-tax earnings in your business valuation will raise the company value somewhat. This is tempered by the fact that most pass through companies are small businesses. Hence, their value is affected by a relatively high discount rate which reflects the additional risks of owning a small private business.

Business valuation reporting and USPAP Standard 10

One of the most important standards you need to consider when writing a business appraisal report is USPAP Standard 10, published by the Appraisal Foundation. USPAP stands for the Uniform Standards of Professional Appraisal Practice.

As the name implies, the standard seeks to provide a set of ground rules that are widely applied in professional quality reports. If you pick up a USPAP compliant business appraisal document, you should see the reasoning and coverage expected of a well considered, comprehensive business value analysis.

USPAP standards are widely used by professional appraisers all over the world, either as the major guiding principle or as part of national appraisal standards. This makes the report reader’s job much easier when reviewing valuations of foreign or domestic companies.

Most of the requirements in USPAP have emerged through the experience of many appraisers gained over the years. The main objectives that USPAP lays out are that the report should represent the appraisal in a way that is not misleading, contain enough information to enable the reader to understand the report, and clearly disclose all assumptions and limitations the appraiser has made.

USPAP standards are a work in progress. The standards are continuously updated to help business people and professional advisers overcome new challenges in valuing companies. The latest updates have spelled out two main report formats:

• Restricted report
• Appraisal report

The Restricted report format is designed to be followed when the report is intended for the client only. Suppose that a business valuation is advisory in nature and prepared for information purposes of the business owners. Since the owners are quite familiar with the company, much of the information can be assumed understood and does not need to be included in the report. The resulting document should contain sufficient background to make sure the client can grasp the reasoning behind the appraisal results.

Now imagine that a business valuation is done in order to communicate with prospective investors. You can no longer make the assumption that they are familiar with the company the way the owners are. So to comply with the USPAP standards, you need to follow the Appraisal report format. Importantly, your report should indicate that the intended audience now includes outside investors. The report must disclose more information about the company to make sure these outsiders can understand what the company is about.

This example brings up another key point. Business valuation conclusions may be different depending on the purpose of the appraisal. Your report should clearly state why business valuation is done and what is being valued.

The selection of standard and premise of business value is another important element to mention in your report. It is one thing to value the company on a fair market value business and assume that is a going concern, i.e. will continue running after the valuation. Your result for valuing the same company under the assumption of liquidation is likely to produce a very different result.

Typical business valuation should include methods under each of the major approaches: asset, income and market. If you choose to omit some approaches from your analysis, you should explain to the reader why you did so. For example, you might be valuing a unique technology company that has no competitors to compare against. If so, you might opt for dropping the comparative market methods from your valuation, and focus on the income and asset methods instead. Your report should point out the reasons for making this choice.

The latest USPAP standard update requires a signed statement from the appraiser at the end of the report. The statement clearly spells out what the report scope and limitations are to avoid misunderstanding between the client and the appraiser.