Reviewing Business Appraisals: The Devil is in the Details!

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By L. Paul Hood, Jr.

Napa, CA

It is always a daunting task for a non-appraiser to review a business appraisal report, whether it is in draft form or in final form, although the former is far preferable. It is virtually impossible for a layman to review a business appraisal report except by asking the business appraiser pertinent questions and trying to determine whether the answers square with the facts and with common sense. Here are a few questions that one should always ask. It should be noted that these questions and more are contained in the Resources Section of A Reviewer's Handbook to Business Valuation (Wiley 2011).

Does any position taken in the business appraisal report conflict with any article or paper the appraiser has ever written? If yes, is this conflict explained? Many business appraisers publish articles and professional papers for their peers. In a conflict, one can virtually guarantee that the other side will be searching to see if the business appraiser has taken opposing public positions in print. Few things are more embarrassing than to find out later that your business appraiser has in fact taken some positions that run contrary to those taken in his appraisal report and not disclosed that previously, and few things can undermine a business appraiser's credibility more.

What is the range of value for the property being valued? Why is that the range? Does the conclusion of value fall on either end of the range? If so, why? Is that rationale sufficiently explained in the report? If not, would it be helpful to do so? Business valuation is best expressed as a range of values. However, the tax law and developed custom force appraisers to come down with "a value." If that value is close to either end of the range of values, one should want to know why and would prefer to see that discussed in detail in the business appraisal report.

Does any application of valuation theory in the opinion run counter to current reasonably accepted valuation theory as applied to this assignment? If yes, how? Is that discussion in the report? If not, why not? If a business appraiser utilizes a method that is novel or cutting edge that has not yet been reviewed by the peers of the business appraiser, there is a risk of a Daubert challenge to admission of the business appraiser's report. It would be horrible for the appraiser that one has hired to not even be permitted to testify! If the appraisal report has any novel or cutting edge techniques in it, one should want to know about it as early as possible. Obviously, one would far prefer that novel or cutting edge methods not be used unless those methods are absolutely necessary. One should encourage the business appraiser to first publish a paper or article on the matter for his or her peers in order to get some feedback on the method, which also is one of the requirements in Daubert, i.e., peer review of method.

What methods did the appraiser consider in developing a discount for lack of marketability? Is this discussion in the report? If not, why not? Despite the myriad of methods for determining a discount for lack of marketability, there are two basic approaches for a business appraiser to arrive at a discount for lack of marketability: a market approach and an income approach. Within each approach, there are several different methods and models. There also are some methods that don't fit into either the income or market approach. One should like to know what approaches and methods that the business appraiser considered, even if that information is not contained in the business appraisal report. Just as often, one should want to know why certain methods or models were not used too. Ideally, the business appraiser should employ several different methods and at least one market approach and income approach, if for no other reason than to corroborate the result that the business appraiser's chosen method produced.

Have you received, or are you aware, of any other business appraisal report pertaining to an interest in the subject company? Is that report still relevant? If such a report exists, was the current appraiser supplied with a copy? If yes, did he/she reconcile or explain the differences, if any, with the prior report? Is the reconciliation/explanation in the report? If not, why not? Differences in appraisal reports of interests in the same subject company issued by different appraisers that are fairly close in time must be well explained in the business appraisal report. While a business appraiser might not know that other business appraisers have appraised interests in the same subject company, this must be a part of the business appraiser's due diligence.  If there are significant differences in methodology or approach, e.g., a prior appraisal disregarded a guideline company approach because the appraiser could not find any suitable guideline companies, while the subsequent appraisal relies upon a guideline company approach and cites several guideline companies, this could signal a significant problem with either or with both reports. This is a significant difference that must be explained.

Appraisal reports of valuations of interests in the same subject company that are issued by different appraisers at the same time with one another should be explained and coordinated. Again, a business appraiser must inquire in the due diligence phase as to prior and even ongoing appraisals and must explain any significant differences in methodology, particularly if the IRS has accepted the prior business appraisal methodology for interests in the subject company in the past. This can happen in any number of different contexts, e.g., an annual business valuation engagement, a change in business appraisers or a prior business appraiser retiring or dying.

Has the appraiser documented his/her due diligence and research for this engagement in the report or workpapers? If not, why not? Ideally, one should see the checklists and requests for information that the business appraiser used. It is preferable to know that the business appraiser followed his or her standard operating procedure for due diligence, as tailored for this particular engagement. From time to time, the attorney or CPA has to get involved in the information gathering phase of a business appraisal engagement, often acting as an advocate for the business appraiser in getting the subject company to release important requested information to the business appraiser.  There simply is no excuse for a subject company to withhold information requested by the business appraiser. Quite often, the withheld information would have had a material effect upon the conclusions that the business appraiser reached, which can spell doom for that business appraisal report.

Are all data sources referenced in the report, particularly websites, accurate and current? Is the date of access to those websites current? Few things are more irritating in a draft business appraisal report than to see stale references to data sources, particularly websites. There simply is no excuse for not having the most up-to-date data. It can be a sign of sloppy work and possibly suggests that the section in which the stale reference was made was simply lifted from another business appraisal report. The reviewer should check the website links in draft business appraisal reports, and if some time elapses between circulation of the draft business appraisal report and issuance of the final business appraisal report, one should expect to see the references updated in the final report.

Has the appraiser ever appraised any interest in this entity (or any successor entity) previously? If yes, please describe. Differences in appraisal reports issued by the same appraiser of interests in the same subject company that are fairly close in time to one another must be well explained.1 One must assume that all prior business appraisal reports will be discovered and plan in advance to explain these differences in detail before the opposition even asks about it. If there are significant differences in methodology or valuation approach used by the same appraiser to value an interest in the subject company, the opposition, e.g., IRS, could argue that the results were predetermined. 

Therefore, it is imperative that these differences be well explained.  One should assume that the opposition will attempt to exploit those differences and take preemptive action to explain them in detail before those differences are called into question. The existence of secondary or recent appraisal work product from a given appraiser regarding a given subject interest is rising given the recent USPAP disclosure requirements.

Even though there usually is a significant difference in the knowledge level of the business appraiser and the person who is reviewing the business appraisal report, by asking the right questions, such as the ones discussed above, one usually can improve the business appraisal report by forcing the business appraiser to explain more of what he or she obviously did in order to prepare the business appraisal report. One should prefer to see an all-encompassing business appraisal report. Unfortunately, not all clients see the value in this approach.  One's mantra should be that one must to be able to understand the appraiser's rationale and conclusions, because that is what a court may well have to do at some point in the future. If one doesn't understand the rationale as it relates to the conclusions, how can one reasonably expect a court to do so?

Is the appraiser consistent within the same valuation approach or method and across all valuation approaches? If not, why not? Is that explanation in the appraisal report? It is common for a business appraiser to examine more than one appraisal approach in an appraisal. It is essential that the business appraiser be consistent between valuation approaches because if he is not, a court will find that inconsistency. Courts frown on appraisal inconsistency.2 For example, suppose the business appraiser dismisses the market approach because she couldn't find any guideline companies that were similar enough to the subject company to be a good comparison, which is very common in business appraisals for small companies.  However, in the appraiser's income approach, the appraiser uses a valuation method in developing a discount rate that considers the discount rates of guideline companies. And there are other examples of inconsistency. These should jump out at first blush. It is imperative that any such inconsistency be explained very well in the appraisal report.

In conclusion, one should very conservatively assume that, in a tax or litigation business appraisal, the appraiser's report will be the only chance that the appraiser has to tell her story. This is certainly usually true in the U.S. Tax Court. Therefore, it behooves those who have probably hired the business appraiser to carefully vet and understand the entire business appraisal report before it goes final, because after that, the genie is out of the bottle, and it may be too late to repair it.

 For more information, in the Tax Management Portfolios, see Hood, 830 T.M., Valuation: General and Real Estate,  and in Tax Practice Series, see ¶6290, Valuation—Generally.


1 See, e.g., Mosher Est. v. Comr., T.C. Memo 1988-24.

2 See, e.g., Gallagher Est. v. Comr., T.C. Memo 2011-148.