Closely Held Business Valuation, written by Nicholas J. Mastracchio, Jr., Ph.D., CPA., Practitioner, and Alina V. Niculita, CFA, MBA of Shannon Pratt Valuations, 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 premises of value include: 1) value on a going concern basis, and 2) value on a liquidation basis. The standards of value include: 1) fair market value, 2) fair value, 3) intrinsic value, and 4) investment value.
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 vs. fair value.
Closely Held Business Valuation explains the relationship between the valuation purpose and the standard of value used in the valuation. It also considers when an assignment should not be accepted for reasons of lack of independence or lack of professional expertise. Also discussed is how to work with available information and provides some guidelines for reaching an agreement with the client. Moreover, the terms that should be addressed in an engagement letter are presented in that section, and sample engagement letters appear in the worksheets.
This 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 minority 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.
This Portfolio explains when such discounts and premiums are appropriate and discusses controversies in the courts concerning some of the discounts.
Closely Held Business Valuation 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. It discusses the types of services the valuation expert might offer in the litigation support arena and his or her role in such a setting.
Professional standards are discussed throughout the Portfolio where applicable and the various professional organizations' standards are contrasted where there are differences.s
Closely Held Business Valuation allows you to benefit from:
This Portfolio is included in the Accounting Policy & Practice Series, a comprehensive series of titles which explain, explicate, and offer commentary on a wide range of accounting and financial management topics, including revenue recognition, income taxes, leasing, business combinations, debt instruments, risk management, internal controls and more.
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
A. Analysis of the Economy
1. Gathering Economic Data
2. Linking Economic Data to the Subject Company
3. Professional Standards
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
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
1. AICPA
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
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
5. Debt
VII. Discounts and Premiums
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
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
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
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
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
TABLE OF WORKSHEETS
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
Bibliography
OFFICIAL
Internal Revenue Service
Treasury Department
Cases
Financial Accounting Standards Board (FASB) Statements
American Institute of Certified Public Accountants
Accounting Principles Board
UNOFFICIAL
Business Valuation Standards
Web Sites
Books, Articles, and Periodicals
BNA Tax Portfolios