entrepreneurship

17
Valuations

A valuation analyst should be able to explain and defend his or her valuation, including both the
valuation analysis and conclusion. Further, this explanation and defense may often be performed
within a contrarian’s environment.

-G. S. Gaffen 1

OBJECTIVES

After completing Chapter 17, you should be able to:

1. Understand the importance of business valuation.
2. Determine the many reasons for business valuations.
3. Appreciate why business valuations can be contentious.
4. Understand the basic principles and methods used by business valuation specialists.
5. Comprehend the complexity and rigor involved in business valuations.

17-2 FORENSIC AND INVESTIGATIVE ACCOUNTING

OVERVIEW

Forensic practitioners are asked to perform a variety of economic and accounting measurements for
many important purposes that relate to legal rights. One of the most complex and pervasive measure-
ments made is the business valuation. valuations require professionals who are knowledgeable
and skilled in finance, law, and accounting. Valuations can be so complex that most professionals who
perform them are specialists. Nevertheless, a forensic accountant who is not a business valuation special-
ist may be asked to review specific issues involved in a valuation. Thus, all forensic accountants need to
understand the basic principles involved.

valuation is an increasingly specialized field with a variety of guidelines, case law, and techniques
affecting valuations for different purposes, and continually advancing the state of the art. However, with
adequate training and experience (ideally with a mentor), the field of business valuation is a rewarding
area for practitioners from a variety of backgrounds including accounting, finance, and economics. The
quality of a business valuation and its report findings is directly related to the skill, training, and experi-
ence of the professional.

Entire university and professional seminar courses are devoted to the issues of business valuations and
even those courses do not fully cover the complexities of the topic. This chapter provides an overview
of the most significant business valuation concepts and reviews common methods of valuing businesses.
Much of this chapter is derived from the CCH service entitled Valuation Guide, 2015, by George
Hawkins and Michael Paschall. Specifically, the Fundamentals, The Three Valuation Approaches, Gather-
ing Initial Information, Financial Analysis, Valuation Standards, and Valuation Reports
sections appear in part in the CCH Valuation Guide. The author of this chapter is indebted to
Hawkins and Paschall for its use.

This chapter concentrates on business valuations of specific closely held businesses that are performed
for specifically stated needs at a single point in time. Most publicly traded companies, on the other hand,
have market-determined values at any given date in time.

1117,001

1117,011

BUSINESS VALUATIONS

Fundamentals
VALUATION AND APPRAISER ACCREDITATIONS2

Organizations Certifying Valuation Professionals

17-3

Rapidly growing demand for qualified business valuators has led to the development of a number of na-
tional certifications. Each certification was developed by the associated national accrediting organization,
which provides its own education and testing programs. appraisers have traditionally come from
either a finance or accounting background. Some organizations cater more to individuals with one or the
other background. Some of the most visible designations offered by organizations are as follows:

■ Accredited Senior Appraiser (ASA) and Accredited Member (AM) awarded by the American Society
of Appraisers (ASA).

■ Certified Valuation Analyst (CVA), Master Analysis in Financial Forensics (MAFF), and Accredited
in Appraisal Review (ABAR) awarded by the National Association of Certified Valuators and
Analysts (NACVA).

■ Accredited in Valuation (ABV) awarded by the American Institute of Certified Public
Accountants (AICPA).

All of the organizations provide excellent training for prospective business appraisers, and their certifica-
tions strive to enhance valuation professionalism. Some of these organizations offer additional accredita-
tions with less stringent requirements for those professionals wanting to limit their business valuation
engagements to pursue litigation support engagements that relate to business valuation. Each group offers
an array of introductory and advanced valuation courses, along with continuing education programs,
seminars, and conferences. All of the groups also work closely together in various ways to develop valua-
tion standards and terminology.

Financial Analyst Accreditation
Another accreditation and organization is the Chartered Financial Analyst (CFA) awarded by the CFA
Institute. Although not specifically a business valuation certification, the CFA covers valuation in depth,
both of public and private companies, along with a broad-based, inclusive study of other investment
subjects. Some believe the CFA is among the most prestigious of all certifications in the field of corporate
finance and on Wall Street.

Certified in Entity and Intangible Valuations
A relatively new certification, Certified in Entity and Intangible Valuations (CEIV), has recently been
developed to help bring some certainty to the fair value measurement process for financial statement ac-
counting worldwide. “To address regulator concerns and protect the public interest on a global scale, the
American Society of Appraisers (ASA), the American Institute of Certified Public Accountants (AI CPA)
and the Royal Institution of Chartered Surveyors (RICS) have championed the co-development of (the)
credential to demonstrate member competency and enhance their professional standing.” 3 Accountants
involved in “estimating the fair values of businesses and/or business interests for goodwill impairment
testing and stock compensation purposes, and intangible assets for purchase price allocation and impair-
ment testing purposes” may find this certification helpful with implementing the requirements of FASB
ASC 820. 4 This credential is offered to members of the ASA, AICPA, and RICS organizations, and the
website is: https:l/ceiv-credential. org.

ENGAGEMENT AGREEMENTS THAT CREATE
SUCCESSFUL CLIENT RELATIONSHIPS5

An engagement agreement is needed in any valuation or client-related undertaking. An engagement
agreement should:

■ Clearly set forth the expectations of the business valuator and client
■ Reduce the chance for misunderstanding and, therefore, the risk of malpractice litigation and claims

against the business valuator
■ Increase the likelihood of the valuator being paid, since it establishes a clear obligation on behalf of

the client

,J17,011

17-4

,J 17,021

1117,021

FORENSIC AND INVESTIGATIVE ACCOUNTING

A standardized engagement agreement should be drafted and reviewed by an attorney to meet the needs
of the valuation practice. Although attorneys draft many types of contracts, they may not be familiar wi th
issues chat are unique to business valuation.

The following items should be considered in drafting an engagement agreement:

■ Identify the client
■ Specify the interest, dace, purpose, and intended use of the valuation
■ Define the standard of value
■ Assign responsibility for fees and coses
■ Price the engagement
■ Specify responsibility for real estate and ocher appraisal costs
■ Obtain a retainer
■ Protect against the use and misuse of forecasts by clients
■ Include indemnification language
■ Include other terms and conditions

PURPOSES FOR OBTAINING BUSINESS VALUATIONS
Valuations are needed for various purposes:

■ Tax purposes (estate tax, gift tax, charitable contributions, casualty loss, sale of securities, state tax, ad
valorem tax)

■ Divorce distributions (often referred to as marital distributions)
■ Liquidations (partnerships, sole proprietorships, and corporations)
■ Employee stock ownership plans (ESOPs)
■ Lost business value
■ Mergers, reorganizations, and acquisitions
■ Minority shareholder distributions
■ Buy-sell agreements
■ Bankruptcies
■ Recapitalizations
■ Management buyouts
■ Allocations of purchase price (financial reporting and tax)
■ Incentive/Restricted stock options
■ Insurance disputes
■ Fairness opinions
■ Damages disputes

In business valuations, a practitioner is asked to provide a valuation for a business or some other eco-
nomic unit. The vast majority of all businesses in the United Scates are privately held companies in which
ownership (stock, partnership, LLC, LLP, or proprietorship interests) is held by a small number of people.
These types of ownership rights are not typically traded on any market such as che New York Stock Exchange
(NYSE), the NASDAQ, or the NYSE MKT, LLC (formally known as the American Stock Exchange) .

Conflicts Giving Rise to Valuations

Many situations involving business valuations of partnerships are resolved quite amicably with departing and
remaining partners agreeing on the amount that is paid for the departing partner’s interest. Sometimes, the
partnership’s value or methodology for determining the value is spelled out in advance in the partnership agree-
ment. Many other times, however, there are differences of opinion about the amount chat should be paid for
the business interest chat is being sold. Such disputes are often litigated in a legal forum in “forensic” fashion.

Additionally, many business sales or dissolutions are fraught with conflict from che start. Family business
dissolutions chat result from divorce are ofren contentious. Typically, divorces involve significant conflict
already, and when the issue of valuing large commonly owned assets such as a business is involved, there
are major disagreements.

m
,J 17,031

BUSINESS VALUATIONS 17-5

Even in the best of situations, however, generally the seller of the business interest wants to receive
payments based on a high value, while the buyer wants to pay as less as possible for purchasing chat busi-
ness ownership interest. To resolve such differences, business valuators are asked to provide an impartial
valuation chat is developed in a professional and systematic manner.

Often business valuations are presented in court where they may be attacked or defended. For example,
the business appraiser who performs the valuation for the seller is one expert, but the buyer may introduce
another expert to give testimony on the possible flaws in the valuation report of the seller’s business ap-
praiser. Some experts may be brought in to look at only specific pares of the appraisal, and some expercs
may be asked to look at the entire appraisal. Thus, in some situations, expert appraisal witnesses may
need extensive and broad understanding of the process and issues; in other disputes, the expert may need
specialized knowledge on a narrow portion of the appraisal or specific issues regarding it.

General Types of Valuations
In general, there are three types of valuations:

■ Asset-based. This type of valuation is used to value asset-intensive businesses such as retail and manu-
facturing. The focus is on what the inventory, equipment, and real estate are worth .

■ Income approach. This type of valuation is useful for service companies. The focus is on how much profit
or cash a buyer can earn from the business.

■ Market approach. This type of valuation looks at what the market is paying for similar businesses and
is used to value many different types of businesses. The focus is on the marketplace: what others have
paid for similar type of companies.

Alt hough most bus iness va lua ti ons are performed for close ly held co mpa ni es, publicly t raded co mpanies wit h
establis hed market va lu e may have issues t hat require add iti onal analysis. For exam ple, t he ma rket price at a
parti cular dat e may have bee n det ermin ed usi ng fina ncial info rm ation t hat was distorted, fra udu le nt, or now out
of date. Additiona lly, investors look for firms t hat they believe are underva lu ed by the market for investment op-
portuni ties, and some bus iness ap praisals may be do ne in invest ment research situations.

STANDARDS OF VALUE 6

The standard of value used in a business valuation is crucial because it determines the guidelines under
which the valuation is performed. The use of different standards may result in vastly different values for
the same company; therefore, the forensic accountant must know the standards under which he or she
should proceed. In many valuation situations, statutory or case law dictates the standard of value.

The fo llowing six standards of value and their common uses are explained below in more detail:

■ Fair market value (often used for gift/estate taxes, purchase or sale, buy-sell agreements, and divorce
valuations).

■ Fair value-100 percent controlling interest value (commonly used in dissenting minority shareholder
valuations).

■ Fair value-minority interest and marketable value (often used in dissenting minority shareholder
valuations).

■ Fair value-minority interest and nonmarkecable value (commonly used in dissenting minority share-
holder valuations) .

■ Investment value (sometimes used in the purchase of businesses in examining the value to a specific
buyer).

■ Intrinsic value (often used in equitable distribution valuations).

Fair Market Value
The Internal Revenue Service (IRS) defines fair market value (FMV) as the amount at which property
would change hands berween a willing seller and a willing buyer when neither is acting under compulsion
and when both have knowledge of the relevant facts. FMV is usually the governing standard for gift and
estate tax valuations, asset purchase or sale, divorce, and ocher situations calling for a valuation.

1117,031

17-6

1]17,031

FORENSIC AND INVESTIGATIVE ACCOUNTING

Fair Value
The fair value concept is used most often in conjunction with dissenting minority shareholder situations.
Fair value is generally a judicially determined concept of value that can vary widely in interpretation in
various states. “Fair value” can be interpreted in at least three different ways:

■ Minority shareholder’s pro-rata share of the 100-percent controlling interest value. This concept of fair value
is perceived as favoring the minority shareholder because it affords the maximum protection to the
dissenting minority shareholder and does the most harm to the remaining shareholders in the business
(as well as to the business itself).

■ Fair market value of the minority shareholder’s specific shares, discounted for minority interest status only,
without discounts for lack of marketability. This approach is a compromise view that attempts to give
some value to the shares of the dissenting minority shareholder without unfairly penalizing the busi-
ness and its remaining shareholders.

■ Fair market value of the minority shareholder’s specific shares ordinarily discounted for minority interest
status and lack of marketability. This view of fair value tends to favor the company at the expense of
the minority shareholder, because it does not give the minority shareholder anything more than he or
she already has.

Investment Value
Investment value is the value to a specific buyer of a business. Investment value incorporates all of the

synergies and other factors that arise from a particular purchase of a business. The extra value may be
because a business is far more attractive to a particular buyer due to various advantages that the purchase
of that business brings to the buyer. Examples include a beverage distributor trying to purchase a fellow
distributor to fill in its geographic territory or a manufacturer/wholesaler trying to purchase a retailer to
form a more integrated company.

To accurately estimate investment value, a forensic accountant must analyze and predict what the par-
ticular benefits of ownership will be to the potential purchaser. Often, investment value may be above fair
market value, and “backward-looking” valuation techniques, such as capitalization of income method, m ay
be oflitde use in arriving at an accurate value. “Forward-looking” valuation techniques, such as a discounted
future income method, are more likely to be better. The advantage of a forward-looking valuation model
is its ability to capture the anticipated competitive advantages and synergies expected by a potential buyer.

Intrinsic Value
Intrinsic value is the value to a particular individual. Intrinsic value often arises in a divorce situation where
the sale of a business may not be possible, however, the court still finds that the business has value to its
owner or owners. Although this approach may be an appealing concept, in reality, the ability to support
a logical conclusion of value under the intrinsic value standard can be quite difficult.

Size of Ownership Interest Affects Final Value
The percentage of ownership interest being valued is of crucial importance to an interest’s ultimate value.
The key issue is the amount of control:

■ How much power and influence does the ownership interest have by virtue of its size and its relation-
ship to the overall distribution of ownership?

■ Can the ownership interest force the sale or liquidation of all or a part of the company’s assets?
■ Can the ownership interest declare and pay dividends?

With control, ownership interest is able to potentially receive some value (e.g., immediate cash divi-
dends) from the interest. If the ownership interest does not have such power (e.g., to declare dividends),
the owner has fewer and more difficult avenues to realize immediate value for the interest.

Shareholder value can occur along various levels of value, ranging from 100-percent control to minor-
ity interest status.

A middle level is called “minority marketable” because the price-earnings multiples or capitalization
rates applied to a private company’s earnings are derived from the returns on public company stocks. Public
company stocks are fully marketable and represent small minority interests (e.g., one share of Exxon). ·

BUSINESS VALUATIONS 17-7

Enterprise or 100-Percent Controlling Interest Value
The owner of a 100-percent controlling interest has unilateral control of all the decisions affecting the
company, including the sale and liquidation of the company as well as the declaration and payment of
dividends.

A 100-percent controlling interest value often includes a premium for control. Some data suggests
that this premium may be about 30 percent to 40 percent above the value afforded to freely traded
minority interests. One excellent source of control premium data is FactSet MERGERSTAT® Review.
Control premium data is developed by comparing the market price per share before any takeover of-
fer has been made (a minority value) to the price later paid in the takeover (a 100-percent controlling
interest value). Any increase in price represents the premium for control.

In 2016, Microsoft purchased Linked In for $26.2 billion, representing a 50% premium over Linked In’s stock price

just a day before the proposed acquisition was announced. Note: Discounts and premiums are discussed later. A

minority discount is the opposite of a control premium.

Control, But Less Than 100-Percent Interest
In some situations, an ownership interest ofless than 100 percent may still be able to exercise a significant
amount of control over a business, therefore warranting a control premium adjustment to the ownership
interest.

51- Percent Own ership Interest

A 51-percent ownership block in a company where the corporate bylaws and relevant state law call only
for a majority vote for all corporate action has the same force and impact on control as a 100-percent
owner. Because of the power and influence held by the 51-percent owner under this scenario, an added
premium value for control may be appropriate. However, a 51-percent interest is not as valuable as the
100-percent interest on a pro-rata basis. Whereas the 100-percent owner has unfettered control over the
company and can do as he or she wishes, a 51-percent owner still must deal with the rights and concerns
of minority shareholders. This factor may limit the 51-percent owner from specific actions that a 100-per-
cent owner could do.

SO-Percent to 100- Percent Ownership Int erest

There are situations where ownership of interests between 50 percent and 100 percent does not carry all
the benefits of full, 100-percent control of the business. For example, a greater-than-50-percent inter-
est may not always give an owner full control of the business if bylaw provisions or state laws require a
greater-than-majority vote for various corporate actions. Although a 51-percent-and-above interest is often
called a “controlling interest,” this may not actually be the case if, for example, the corporate bylaws call
for a two-thirds majority to effect various corporate actions. In this instance, the 51-percent block may
be effectively powerless if owners of at least 34 percent of the other shares oppose the action desired by
the 51-percent holder.

Minority Interest: Technically Less Than 50 Percent
The value of a minority holder’s interest might be worth less (and possibly substantially less) than a pro-rata
share of the total 100-percent value. The major factor influencing the value of a minority interest is the
amount of control that the minority interest can exert over the corporation. Minority interests limited in
their power to influence corporate action are worth less than the pro-rat~ sh~re ~f the total 100-perc~nt
value because they generally cannot force the corporation to allow the mmonty mterest holder to rea!1ze
any value from his or her interest (generally through payment of dividends or salaries; the implementation
of business strategy and plans; or the merger, sale, or liquidation of the company).

The influence of a minority interest may be limited by a combination of statute, case law, and the gov-
erning corporate documents. A minority interest does not necessarily have to be as small as one percent
or less to lack the ability to influence corporate action.

1] 17,031

17-8 FORENSIC AND INVESTIGATIVE ACCOUNTING

If the corporate bylaws call for a supermajority voting approval of 80 percent for various corporate actions, a
79-percent interest is essentially a minority interest, because its holder cannot by himself or herself affect corpo-
rate action.

“Swing Vote” Interests

There may be times when a miniscule minority interest is worth more than a pro-rata share of the total
100-percent value. A small minority share may be the “swing vote” in a business.

Example 17.1 There are two 49-percent ownership interests and one 2-percent ownership interest. Assuming that
the relative statutes and corporate bylaws call for a simple majority for approval of various corporate action, the
2-percent interest becomes much more valuable because without its vote, the 49-percent interests are powerless
to direct the corporation. The 2-percent interest, thus, becomes extremely valuable to the 49-percent interest
holders who would be willing to pay a premium (i.e., a value greater than its pro-rata share of the total 100-per-
cent value) to acquire the 2-percent interest.

Analyzing the Distribution of Ownership

In determining the proper discount (if any) for a minority interest, one must analyze the distribution of
ownership. There may be other situations in which the dynamics of share ownership call for a smaller or
larger discount for minority interest than would be considered “normal.”

Example 17.2 One shareholder of Public Corporation A owns a 30-percent interest, with all other shareholders
owning less-than-1-percent interests. If the other minority shareholders cannot consolidate their stock for a vote,
conceivably, this factor justifies a lower minority interest discount for the 30-percent block. In this scenario, even
an ownership level far higher than any other individual shareholder may not be as valuable if other needed votes
cannot be counted upon to gain the required percentage for a corporate vote (e.g., 51%).

Buy-Sell Agreements May Impact Value

Another situation influencing the value of a minority interest to become equal to or greater than its pro-rata
share of the total 100-percent value occurs when a buy-sell agreement governs the disposition of a depart-
ing or deceased shareholder’s interest. In this situation, a “formula” calculation of value may be mandated
by the agreement that yields a value equal to or greater than the pro-rata share of the total 100-percent
value. Alternatively, the buy-sell agreement may specifically require the departing minority shareholder
to be paid his or her pro-raca share of the total 100-percent value of the company.

Other Discounts and Premiums Applied to Valuations
The information above provides a number of reasons why premiums might be added to a valuation, or
discounts might be deducted from a valuation in response to some characteristic of the business level
of ownership (e.g., controlling interest or a minority interest). However, there are many other business
characteristics or personnel characteristics having an impact on the application of premiums or discounts
in arriving at a business valuation. Some of those issues include the general lack of marketability for non-
trading stocks, loss of key or critical personnel, the company’s lack of diversification, restrictive agreements
of the company, exposure from pending litigation, potential environmental liability, the cost ofliquidation,
and the risk associated with being a small company, or a non-crucial supplier. The preceding examples
are only a few issues that may cause a business valuation expert to adjust a value upward or downward
to compensate for some characteristic chat has not already been included in the calculations. Of course,
the adjustments rest heavily on the valuation expert’s knowledge of the facts and an understanding of the
relevant issues in assigning appropriate premiums or discounts under the circumstances. Some experts
believe that “discounts and premiums” are the result or “fallout” of using data in the valuation analyses
that are “less-chan-perfecc.”7

Although the concept of premiums and discounts are intuitively logical in many valuation situations,
one must be cognizant that some valuation factors can be addressed in more than one way. For example,
some valuation professionals adjust for known or expected business risks by applying a discount to their

,i 17,035

BUSINESS VALUATIONS 17-9

base valuation, while other valuation professionals may factor known or expected risks into the discount
rate used in the business valuation. One challenge facing a valuation professional is to not incorporate
risk measure into both components of the valuation process , thereby double counting the risk impact.

The AI CPA, in Statement on Standards of Valuation Services No. 1, suggests chat any adjustments
(discounts or premiums) should be made to the pre-adjustment value. According to the guide, examples
of valuation adjustments for businesses, business ownership interest, or security include a discount for lack
of marketability or liquidity and a discount for lack of control. A valuation adjustment for an intangible
asset is needed when the asset is obsolete. 8

Given the large number of possible reasons for applying premiums and/or discounts to the base valua-
tion of an organization, valuation professionals must carefully weigh the issues giving rise to the valuation
adjustments , and they must fully understand the purpose of each valuation that is performed.

Flow-Through Valuations
Flow-through or pass-through business structures can raise a variety of interesting and challenging valua-
tion issues. Some people argue that flow-through businesses, such as Subchapter “S” corporations, have a
greater value than an identical corporation that is organized as a traditional “C” corporation. The primary
reason for this difference is that C corporation earnings are taxed at applicable corporate tax rates, and then
when a C corporation’s after-tax earnings are distributed to its stockholders as dividends, stockholders pay
taxes on the dividends (distributed earnings). C corporation earnings, then, are taxed twice, and S corpora-
tion earnings are taxed only once. Using this logic, one can argue that two corporations that are identical,
except that one is a C corporation and the other is an S corporation, would cause the S corporation to
be valued higher than the C corporation because of the tax effect. The IRS and Tax Court suggest chat
the valuation of flow-through entities should include a premium over traditional C corporation entities.

As per Tax Court decisions and the IRS ,9 no deduction should be made for the income tax of a pass-
through entity because the taxes …