Closely Held Business Valuation (Portfolio 5147)

BNA Tax and Accounting Portfolio 5147, Mastracchio and Niculita, Closely Held Business Valuation (Accounting Policy and Practice Series), discusses the procedures and methodologies used by valuation specialists when they value a closely held business.

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BNA Tax and Accounting Portfolio 5147, Mastracchio and Niculita, Closely Held Business Valuation (Accounting Policy and Practice Series), discusses the procedures and methodologies used by valuation specialists when they value a closely held business. Like other professionals, valuation specialists must follow professional standards when conducting valuations and issuing valuation reports. This Portfolio integrates the standards of the five primary professional valuation associations into its description of the procedures and methodologies for valuing closely held businesses.
The Portfolio explains best practices in creating an engagement letter and the issues a valuation specialist should consider at the inception of an engagement. It then explains how to evaluate a closely held business qualitatively by performing a company analysis, and how to evaluate the business quantitatively through the different types of valuation methodologies available. Specifically, it delves into the methodologies available under the three common valuation approaches — the market-based, earnings-based, and asset-based approaches. It also explains the premises of value — such as fair market value v. fair value.
The Portfolio discusses the often controversial topic of discounts and premiums. Because closely held businesses often have key personnel and are not readily valued in the marketplace, their values are frequently determined using discounts vis-à-vis the value of comparable companies whose value is more readily determined in the marketplace. The common discounts are lack of marketability, key person, and either trapped or built-in capital gains tax discounts. Moreover, when a noncontrolling interest is being valued, a lack of control discount may be appropriate and when a majority interest is being valued, a control premium may be appropriate. The Portfolio explains when such discounts and premiums are appropriate and discusses controversies in the courts concerning some of the discounts. A comprehensive discussion of case law involving these discounts and premiums is contained in the following tax portfolio — T.M. 831-3rd, Valuation of Corporate Stock.
This Portfolio discusses the various types of valuation reports and how the format of these reports differ under the standards of the five main valuation professional associations. Lastly, it explains common mistakes valuation specialists make when valuing closely held businesses and when testifying as expert witnesses in court.
This Portfolio may be cited as BNA Tax and Accounting Portfolio 5147, Mastracchio and Niculita, Closely Held Business Valuation (Accounting Policy and Practice Series).

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Nicholas J. Mastracchio, Jr., BBA in Accounting, Siena College (1964); Masters in Accounting, University at Albany (1977); Ph.D., Union College (dissertation: Valuation of Closely Held Businesses) (1993). Dr. Mastracchio practices in Marco Island, Florida and Adirondack, New York and limits his practice to valuations and related areas. He is a member of the American Institute of Certified Public Accountants and The New York State Society of CPAs; author of How Much Is It Worth? Valuing a Profession or Closely Held Business (AICPA 1995) and Mergers and Acquisitions of CPA Firms: A Guide to Practice Valuations (AICPA 1998); author of chapters on Mergers and Acquisitions in Management of an Accounting Practice (AICPA 2001); reviewer of several books on valuation; and frequent contributor to Journal of Accountancy, CPA Journal, The Practicing CPA, Family Law Review, Journal of Small Business Management, ABA Banking Journal, The Trusted Professional, Trial Lawyer and The Practical Accountant. Dr. Mastracchio is a member of the Auditing Standards Board and the National Association of State Boards of Accountancy. (NASBA)

Alina V. Niculita, CFA, MBA, B.S. in Economics, Academy of Economic Studies, Bucharest, Romania; MBA in Finance, University of Pittsburgh and from the Czech Management Center, Czech Republic. Ms. Niculita is the president and chief operating officer of Shannon Pratt Valuations. She is a chartered financial analyst and a candidate for the American Society of Appraisers designation in business valuation. She is also a member of the Chartered Financial Analyst Institute, the American Society of Appraisers, and the Licensing Executives Society; co-author of Valuing a Business, 5th edition; Business Valuation Body of Knowledge Workbook, 2nd Edition and the Cost of Capital Workbook. She is the former managing editor of Shannon Pratt's Business Valuation Update©, BVLibrary™ and the Economic Outlook Update.™


Detailed Analysis

I. Introduction and Background

A. Purposes, Role, and Structure of Portfolio

B. The Valuation Profession

1. History and Current State

2. The Professional Associations

II. Standards and Premises of Value

Introductory Material

A. Going Concern Premise of Value

1. Fair Market Value

2. Fair Value

a. GAAP Definition of Fair Value

b. State Statutory Definitions of Fair Value

3. Intrinsic Value

4. Investment Value

B. Liquidation Premise of Value

1. Orderly Disposition

2. Forced Sale

III. Starting the Engagement

A. Determining the Purpose and Objectives of Valuation

1. The Purpose and Intended Use of the Valuation

a. Actual Transfer of Ownership Interest for Consideration

b. Certain Gifts of an Interest in a Closely Held Business

c. Valuation Used for the Preparation of an Estate Tax Return

d. Matrimonial Action Requiring Equitable Distribution

e. Oppressed Minority Shareholder Action

f. Dissenting Shareholder Action

g. Fairness Opinion

h. Financial Reporting

i. Personal Financial Planning or Estate Planning

2. Objective of Valuation and Scope of Work

3. Identification of the Nature of the Interest Being Valued

a. Attributes of Entity to Be Valued

b. Identification of the Ownership Interest to Be Valued

c. The Rights and Obligations of the Ownership Interest

4. Valuation Date

5. Parties to the Engagement

6. Limitations on Information Available

B. Determining the Standard and Premises of Value

1. Actual Transfer of Ownership Interest for Consideration

2. Gift of an Interest

3. Estate Tax Valuations

4. Personal Financial Planning

5. Litigation

C. Determining Ability to Perform the Engagement

1. Checking for Conflicts

2. Representation Letters

3. Due Date of the Report

4. Access to Information

5. Hypothetical Conditions

D. Determining the Type of Report

E. Writing the Engagement Letter

1. Requesting a Retainer

2. Contents of the Letter

3. Professional Standards Regarding Engagement Letters

a. American Institute of Certified Public Accountants (AICPA)

b. American Society of Appraisers (ASA)

c. Institute of Business Appraisers (IBA)

d. National Association of Certified Valuation Analysts (NACVA)

e. Canadian Institute of Business Valuators (CICBV)

IV. Company Analysis

Introductory Material

A. Analysis of the Economy

1. Gathering Economic Data

2. Linking Economic Data to the Subject Company

3. Professional Standards

a. American Institute of Certified Public Accountants (AICPA)

b. American Society of Appraisers (ASA)

c. Institute of Business Appraisers (IBA)

d. National Association of Certified Valuation Analysts (NACVA)

e. Canadian Institute of Business Valuators (CICBV)

B. Analysis of the Industry

1. Gathering Industry Economic Data

2. Industry Structure and Risk Factors

a. Porter Model

i. Rivalry

ii. Threat of New Entrants

iii. Bargaining Power of Customers

iv. Bargaining Power of Suppliers

v. Threat of Substitute Products

b. Checklist

3. Professional Standards

C. Analysis of the Company

1. Company Ratios

a. Analytical Review

b. Trend Analysis

c. Liquidity Ratios

d. Profitability Ratios

e. Activity Ratios

f. Coverage Ratios

2. Nonrecurring and Non-Operating Items

a. Nonrecurring Items

b. Non-Operating Items

3. Forecasts

4. Site Visits

5. Management Quality and Depth

6. Customer Satisfaction

7. Company Position on Quality of Products and Services

D. Use of Specialists - Professional Standards


2. American Society of Appraisers

3. Institute of Business Appraisers

4. National Association of Certified Valuation Analysts

5. Canadian Institute of Chartered Business Valuators

V. Business Valuation Methods

Introductory Material

A. Market-Based Methods

1. Prior Sales of the Same Company

2. Comparable Sales of Similar Companies

a. Criteria for Determining Comparability

b. Pros and Cons

3. Guideline Companies

a. Criteria for Selecting Guideline Companies

b. Types of Valuation Multiples

i. Equity Multiples

ii. Market Value of Invested Capital Multiples

c. Application of Multiples

d. Pros and Cons

e. Sources of Data

f. Applicability of Method

g. Example

B. Earnings-Based Methods

1. Determining Earnings

a. Forecasts

b. Simple Average of Historical Earnings

c. Weighted Average of Historical Earnings

2. Normalizing Income

a. Related-Party Transactions

i. Compensation

ii. Benefits

iii. Real Estate Rent

iv. Other Leases

v. Travel and Entertainment Expense

vi. Loans

vii. Tax Consequences

b. Unusual Items

c. Multi Operations and Non-Operating Assets and Liabilities

d. GAAP Adjustments

i. Different GAAP

ii. GAAP Adjustments

iii. Departures From GAAP

3. Adjusting for the Degree of Leverage

4. Assessing Risks

a. Consideration of Risk

b. Systematic Risk

c. Unsystematic Risk

d. Size Risk

5. Establishing Discount and Capitalization Rates

a. Capital Asset Pricing Model

i. Pros and Cons of CAPM

ii. Applicability of CAPM

b. The Build-Up Method

i. Risk Free Rate

ii. Equity Risk Premium

iii. Size Premium

iv. Specific Company Risk

c. Discount Versus Capitalization Rate

6. Determining the Present Value of Earnings

a. Capitalization of Earnings Method

b. Discounted Cash Flow Method

c. Excess Earnings Method

i. Determining Capitalization Rate

ii. Determining Net Asset Values

7. Tax-Affecting Earnings of Pass-Through Entities

a. S Corporations

i. Tax Advantages of an S Corporation

(a) Pass-Through All the Income

(b) Distribute Tax Money

(c) No Distribution

ii. When Tax-Affecting Is Appropriate

(a) Minority Interests

(b) Estate and Gift Tax Purposes

b. Partnerships and LLCs

C. Asset-Based Methods

1. Going Concern Net Asset Value

a. Current Assets

i. Cash and Cash Equivalents

ii. Accounts Receivable

iii. Marketable Securities

iv. Inventories

v. Plant, Property, and Equipment

b. Other Assets

c. Liabilities

2. Liquidation Value

3. Built-In Gains

4. Minority Interest

D. Industry Rules of Thumb

VI. Non-Operating and Excess/Deficient Operating Assets

A. Determining the Value of Excess Operating Assets

1. Short-Term Investments

2. Inventory

3. Cash

4. Other Assets

B. Determining Deficient Operating Assets

C. Determining the Value of Non-Operating Assets and Liabilities

1. Real Property Used in Operations

2. Cash Surrender Value of Officer Life Insurance

3. Marketable Securities

4. Other Assets

5. Debt

VII. Discounts and Premiums

Introductory Material

A. Discounts

1. Lack of Marketability Discount

a. Empirical Studies

i. Restricted Stock Transaction Studies

ii. Pre-Initial Public Offering (IPO) Studies

b. Company-Specific Factors

i. Private Versus Public Sales of the Stock

ii. Financial Statement Analysis

iii. Dividend Policy

iv. Nature of Company and Similar Factors

v. Company Management

vi. Restrictions on Transferability

vii. Amount of Control Transferred

viii. Holding Period for Stock

ix. Company's Redemption Policy

x. Costs Associated With Making a Public Offering

c. Court Treatment of the Discount

2. Lack of Control Discount

a. Factors Affecting the Lack of Control Discount

b. Determining the Amount of the Discount for Lack of Control

c. Court Treatment of the Discount

3. Key Person Discount

a. Determining the Amount of the Discount

b. Court Treatment of the Discount

4. Trapped-in Capital Gains Discount

a. Factors Affecting Trapped-in Gain Discounts

b. Determining the Amount of the Adjustment

c. Court Treatment of the Discount

B. Control Premium

1. Factors Affecting Control Premium

2. Determining the Amount of the Adjustment

a. Court Treatment of the Control Premium

VIII. Valuation Reports

Introductory Material

A. The Valuation Report by AICPA Standards

1. Types of Reports

a. Detailed Report

b. Summary Report

c. Calculation Report

2. Common Elements

a. Detailed, Summary and Calculation Reports

i. Introduction

ii. Assumptions and Limiting Conditions

iii. Representations of Estimates and Conclusions of Value

b. Detailed and Summary Report

3. Additional Elements in the Calculation Report

4. Additional Elements in the Summary Report

5. Additional Elements in the Detailed Report

6. Oral Reports

B. The Valuation Report by Uniform Standards of Professional Appraisal Practice

1. Minimum Requirements

2. Appraisal Report or Restricted Use Appraisal Report

a. Appraisal Report

b. Restricted Use Appraisal Report

c. Oral Reports

C. The Valuation Report by American Society of Appraisers Standards

1. Signed by the Appraiser

2. Assumptions and Limiting Conditions

3. Definition of Valuation Assignment

4. Business Description

5. Financial Analysis

6. Valuation Methodology

D. The Valuation Report by Institute of Business Appraisers Standards

1. Formal Written Business Valuation Reports

a. Basic Elements

b. A Certification

2. Letter Valuation Reports

3. Oral Reports

E. The Valuation Report by National Association of Certified Valuation Analysts Standards

F. The Valuation Report by the Canadian Institute of Chartered Business Valuators Standards

1. Types of Reports Permitted

a. Comprehensive Valuation Report

b. Estimate Valuation Report

c. Calculation Valuation Report

2. Common Elements of Reports

a. Comprehensive, Estimate and Calculation Report

b. Comprehensive and Estimate Report

3. Additional Elements in Estimate and Comprehensive Reports

4. Additional Elements in a Comprehensive Report

G. Documentation and Retention

IX. Common Errors and Litigation Services

Introductory Material

A. Common Errors in Valuation Reports

1. Asset Versus Stock Sales

2. Guideline Companies That Are Not Comparable Enough

3. Mismatch Between Standard of Value and Discounts

4. Five Years Earnings Use

5. Full Explanation in Report

6. Minority Interest Consequences

7. Other Normalization Issues

8. Reality Check

9. Rules of Thumb

10. Reliance on Past Results

11. Site Visits and Management Interviews

12. Use of the Gordon Growth Model

13. Working Capital Adjustments

14. Whose Synergy Is It?

B. Common Errors Encountered in Litigation

1. Understanding Statutes

2. Equitable Distribution Double Dipping

3. Verifying That Foundation Will Be Laid

C. Avoiding Traps in the Courtroom

1. Alert Attorney to Prior Testimony, Reports or Writings That Can Be Construed as Contradictory

2. Competence of Attorney

3. Daubert Case

4. Don't Stipulate Qualifications or Overstate Credentials

5. Eye Contact

6. Keep It Simple

7. Know Professional Standards

8. Listen and Answer the Question and Explain as Much as Possible

9. Professional and Respectful

10. Read Own Deposition

11. Visual Aids

Working Papers



Worksheet 1 International Glossary of Business Valuation Terms

Worksheet 2 The American Institute of Certified Public Accountants (AICPA) Standards Statement on Standards for Valuation Services No. 1

Worksheet 3 American Society of Appraisers (ASA) Standards

Worksheet 4 The Institute of Business Appraisers (IBA) Standards

Worksheet 5 The National Association of Certified Valuation Analysts (NACVA) Standards

Worksheet 6 The Canadian Institute of Chartered Business Valuators (CICBV) Standards

Worksheet 7 Internal Revenue Service (IRS) Guidelines

Worksheet 8 IRS Revenue Ruling 59-60

Worksheet 9 Engagement Letter To Target Company Client

Worksheet 10 Engagement Letter to Prospective Buyer Client

Worksheet 11 Engagement Letter to Attorney Client

Worksheet 12 Client Representation Letter

Worksheet 13 Sample Detailed Business Valuation Report

Worksheet 14 Sample Business Valuation Summary Report

Worksheet 15 Sample Business Valuation Calculation Report



Internal Revenue Service

Treasury Department


Financial Accounting Standards Board (FASB) Statements

American Institute of Certified Public Accountants

Accounting Principles Board


Business Valuation Standards

Web Sites

Books, Articles, and Periodicals

BNA Tax Portfolios