A Reviewer's Handbook to Business Valuation: Practical Guidance to the Use and Abuse of a Business Appraisal

Foreword xvii

Preface xix

Highlights of This Book xix

Who Should Read This Book? xix

About the Book xix

Acknowledgments xxiii

Part l foundations: Valuing a business 1

Chapter 1 Fundamental Concepts for Defining Value 3

Standard of Value 3

Level of Value 9

Premise of Value 11

Conclusion 12

Chapter 2 Defining the Engagement 13

The Importance of Defining the Engagement 13

Defining the Client 15

The First Call 15

The Subject Entity and Entity Type 16

Entity Distinctions and Entity Significance in the Valuation 18

State of Entity Organization or Incorporation 19

Principal Business Location 19

Description of the Subject Interest 20

Purpose and Intended Use of the Valuation 21

Date of the Valuation 23

Scope of the Work Product 24

Summary Assignment Definition Table 26

The As-Of Date of the Appraisal and the Date of the Appraisal Report—Added Thoughts and Perspective 26

Conclusion 28

Chapter 3 Information Collection and Due Diligence 29

Importance of the Information Collection and Due Diligence Phase 29

Industry and Economic Considerations 30

Financial Information and Analysis 31

The Management Interview 35

Preparation 37

Agenda of a Typical Management Interview 38

Conclusion 40

Chapter 4 An Overview of Valuation Approaches 41

Recognized Valuation Approaches 41

Methodology and Level of Value, Direct and Indirect Methodology 42

Chapter 5 Valuation Approaches: The Cost Approach 47

The Cost Approach 47

Typical Adjustments in the Cost Approach (Using Tangible Net Asset Value Methods) 53

To Tax Affect or Not 54

Chapter 6 The Income Approach to Value 59

Direct Capitalization and Discrete Projection Methods 60

Reconciliation of Income Methods to Market Methods 61

Typical Adjustments to the Income Statement 62

Adjustments That Correspond to Balance Sheet Treatments 63

Reconciling or Reclassifying Interim-Period Measures to Fiscal-Period Measures 63

Income Statement Adjustments and Considerations 65

Matching the Cost of Capital to the Benefit Stream 69

Developing the Cost of Capital 70

Summary Examples of Developing the Cost of Equity Capital 74

Growth Rate of Earnings/Net Cash Flow 77

Finishing the Direct Capitalization Equation 83

Developing the Single-Period Benefit (Ongoing Earnings and Ongoing Net Cash Flow) and Preparation for the Discounted Future Benefits Method 84

Example of a Single-Period Capitalization to Derive the Market Value of Total Invested Capital 86

The Discounted Future Benefits Method (DFB) 88

Conclusion 93

Chapter 7 The Market Approach 95

Valuation Methods under the Market Approach 96

Rules of Thumb 97

Transactions Method 98

Guideline Public Company Method 99

The Fundamental Adjustment 105

Guideline Transactions Method 110

Chapter 8 Correlation of Value 113

Global Considerations in the Correlation Process 113

Examples of Correlating a Value Indication 118

Conclusion 124

Chapter 9 Valuation Discounts and Premiums 125

The Levels of Value Revisited 125

Perspective on the Control Premium 127

Control Premiums—Substance Over Form 129

Perspective on the Minority Interest Discount 130

Marketability Discounts 132

Conclusion 133

Part II Business Valuation Standards 135

Chapter 10 Uniform Standards of Professional Appraisal Practice (USPAP) 137

Overview of USPAP Valuation Standards 138

USPAP Ethics Rule 139

2010–11 USPAP Competency Rule 140

2010–11 USPAP Scope of Work Rule 141

2010–11 USPAP Jurisdictional Exception Rule 142

USPAP Business Appraisal Review (USPAP Standard 3) 142

Business Appraisal Development: USPAP Standard 9 146

Business Appraisal Report Standards USPAP Standard 10 148

USPAP Certification Requirement 149

USPAP Statements on Appraisal Standards and Advisory Opinions 150

Chapter 11 American Society of Appraisers (ASA) Business Valuation Standards 153

ASA BVS General Preamble 153

ASA BVS-I (General Requirements for Developing a Business Valuation) 154

ASA BVS-II (Financial Statement Adjustments) 156

ASA BVS-III (Asset-Based Approach to Business Valuation) 156

ASA BVS-IV (Income Approach to Business Valuation) 157

ASA BVS-V (Market Approach to Business Valuation) 158

ASA BVS-VI (Reaching a Conclusion of Value) 159

ASA BVS-VII (Valuation Discounts and Premiums) 159

ASA BVS-VIII (Comprehensive Written Business Valuation Report) 160

ASA BVS-IX (Intangible Asset Valuation) 161

ASA SBVS-1 (Guideline Public Company Method) 161

ASA SBVS-2 (Merger and Acquisition Method) 162

PG-1 (Litigation Support: Role of the Independent Financial Expert) 163

PG-2 (Valuation of Partial Ownership Interests) 163

Chapter 12 The American Institute of Certified Public Accountants (AICPA) Statement on Standards for Valuation Services 165

Introduction and Scope 165

Overall Engagement Considerations 165

Development 168

Valuation Approaches and Methods 170

Detailed Report 176

Summary Report 180

Calculation Report 181

Oral Report 181

Chapter 13 National Association of Certified Valuation Analysts (NACVA) Professional Standards 183

Preamble—General and Ethical Standards 183

Valuation Services 184

Development Standards 184

Reporting Standards 185

Miscellany 186

Chapter 14 The Institute of Business Appraisers (IBA) Business Appraisal Standards 187

Standard One: Professional Conduct and Ethics 187

Standard Two: Oral Appraisal Reports 190

Standard Three: Expert Testimony 190

Standard Four: Letter Form Written Appraisal Reports 191

Standard Five: Formal Written Appraisal Reports 192

Preliminary Reports 193

Chapter 15 Canadian Institute of Chartered Business Valuators Practice Standards 195

Practice Standard 110—Valuation Reports 195

Practice Standard 120—Scope of Work 198

Practice Standard 130—File Documentation 200

Practice Standard 210—Advisory Reports 201

Practice Standard 220—Scope of Work for Advisory Reports 202

Practice Standard 230—File Documentation for Advisory Reports 202

Practice Standard 310—Expert Reports 202

Practice Standard 320—Scope of Work for Expert Reports 204

Practice Standard 330—File Documentation Standards in Expert Reports 205

Practice Standard 410—Limited Critique Reports 207

Practice Standard 420—Scope of Work for Limited Critique Reports 209

Practice Standard 430—File Documentation Standards for Limited Critique Reports 210

Practice Bulletins 210

Chapter 16 Internal Revenue Service (IRS) Business Valuation Standards 215

IRM 4.48.4.1—Introduction 215

IRM 4.48.2—Development Guidelines 215

IRM 4.48.4.3—Resolution Guidelines 218

IRM 4.48.4.4—Reporting Guidelines 218

Addendum A USPAP 3 Comparison Chart 219

Addendum B USPAP 9 Comparison Chart 220

Part III Lessons From The Trenches 221

Chapter 17 Alleged Errors of Omission by Appraisers 223

Failure to Comply with USPAP 224

Valuation Credentials 225

Too Much Involvement by Counsel in the Appraisal Report Preparation 225

Standard of Value 225

Valuation Date 226

The Subject Property Interest 227

Bias 228

Sources of Data 229

Independence 230

Pure Reliance on Case Law 230

Site Visits and Management Interviews 231

Failure to Provide Sufficient Explanation 232

Disregard of Material Facts 232

Failure to Find Available Information 233

Failure to Adequately Support Selection of Beta 234

Improper Sampling Techniques 235

Off Financial Statement Items 236

Failure to Sufficiently Explain Assumptions 236

Insufficient Due Diligence 237

Failure to Make Inquiries with Significant Third Parties 237

Failure to List All Appraisers’ Qualifications 238

Failure to Consider the Small-Stock Premium 238

Failure to Factor in Income Tax 239

Failure to Set Forth the Adjustments to Financial Statements in the Appraisal Report 239

Failure to Produce a Replicatable Report 240

Failure to Identify the Multiples Selected 240

Failure to Discuss Weightings in the Appraisal Report 240

Failure to Distinguish between Tax and Book Depreciation 240

Failure to List Guideline Companies 241

Failing to Separate Operating and Nonoperating Aspects of a Company 241

Failing to Lay Foundation for Small Stock Premium 241

Failing to Justify Capitalization or Discount Rates 242

Failure to Think Like an Investor 242

Failure to Define Capital Structure 243

Failure to Adequately Consider the ‘‘Willing Buyer’’ 243

Failure to Adequately Consider the Willing Seller 243

Failure to Accurately Describe the Subject Property 244

Failure to Properly Classify the Subject Company 244

Failure to Explain the Basis for a Valuation Discount 245

Failure to Properly Consider the Subject Company’s Growth Rate 245

Failure to Explain Market Multiples Selected for Guideline Companies 245

Failure to Explain Equal Weighting of Conclusions of Value 246

Failure to Consider Differences between the Subject Company and the Guideline Companies 246

Failure to Utilize Data from a Guideline Company That the Appraiser’s Own Summary Chart Reflects Is Closest to the Subject Company 246

Failure to Explain the Selection of the Range of Performance Ratios Selected 246

Failure to Adequately Explain Why Companies Selected as Guideline Companies Are in Fact Comparable to the Subject Company 247

Failure to Explain Why So Few Comparable Properties or Guideline Companies Were Selected 247

Chapter 18 Alleged Errors of Commission 249

Retrospective Appraisals 249

Use of Past Publications of an Appraiser against the Appraiser 250

Using Untested Methodology 250

Improper Reliance on a Draft Appraisal 251

Conclusion of Value Offends Common Sense 251

Mathematical Errors 252

Inconsistency 253

Double Counting 253

Conflicting Conclusions of Value 254

Sole Reliance on a Valuation Model 254

Incorrect Usage of Discounted Cash Flow Method 256

Skewed Assumptions 256

Overemphasis on Buy-Sell Restrictions among Related Parties 256

Using Historic Book Value of Assets in Net Asset Value Approach, Even Though Asset Appraisals

Had Been Obtained 257

Misapplication of Pre- and Post-Tax Figures 257

Ignoring the Hypothetical Nature of the Willing Buyer or Willing Seller 257

Inconsistent Use of Commercially Available Data 258

Use of Commercially Available Data That Warns of Statistical Inaccuracy 258

Misstatement of Methodology Employed by Appraisers on Whose Work the Appraiser Has Relied 259

Undue Reliance on the Work of Another Appraiser 259

Using a Valuation Method without Laying a Foundation That It Is a Legitimate Method (for Example, the Business Broker Method Using Data from the IBA Market Database) 259

Improper Reliance on a Study That Does Not Completely Provide All Relevant Data 260

Failure to Apply Discussion of Economic Factors to the Subject Company 260

Using Commercially Available Data in a Manner Contrary to How the Data Source Says the Data Should Be Used 261

Failure to Proofread Report Prior to Issuance 261

Apparently Conflicting Assumptions Used for the Same General Purposes without Sufficient Explanation 261

Use of Different Valuation Methods in Valuing the Same Interest in Valuation Reports Offered at

Different Times without Adequate Explanation 262

Making Improper Adjustments to Financial Statements 262

Reliance on the Pre-IPO Studies and the Restricted Stock Studies to Determine the Discount for Lack of

Marketability for a Controlling Interest 263

Misreading or Failing to Properly Consider Revenue Ruling 59–60 263

Failure to Accurately State the Number of Shares Outstanding in the Subject Company 264

Inconsistency in Valuation Methodology Expressed in Testimony versus the Appraiser’s Methodology as

Expressed in another Writing 264

Unreasonably Low Projections 264

Failure to Add Back Depreciation Included in Costs-of-Goods-Sold Computation in the Computation of EBDIT 264

Combining the Discount for Lack of Control with the Discount for Lack of Marketability 264

Utilizing an Assumed Income Tax Rate That Differed from the Actual Past Tax Rates of the Subject Company 265

Disconnect between Assumption about When Revenues or Expenses Would Be Received or Incurred and When Those Items Were Actually Received or Incurred 265

Error in Computing Terminal Value When Using the Income Approach 265

Discounting an Income Stream Only at or Close to the Risk-Free Rate 266

Modifying or Abandoning Positions Taken in the Written Appraisal Report during the Appraiser’s Testimony 266

Referring to a Standard Industrial Code in the Appraisal Report without Identifying That Number in the Report 267

Relying upon Guideline Companies That Were Not Comparable to the Subject Company 267

Preparing and Utilizing Earnings Projections That Vary Significantly from the Earnings Projections Prepared by the Subject Company 268

Use of Only One Year’s Worth of Guideline Company Data 269

Inappropriate Employment of a Discount to Make a Conclusion of One Valuation Approach Appear

More in Line with Another 269

Failing to Properly Calculate a Valuation Discount 269

Inappropriate Use of a Price-to-Asset Multiple Where the Difference between Book Value and Asset Fair

Market Value Is Not Close 270

Selection of Too Few Guideline Companies or Comparable Properties 270

Selection of Too Few Performance Measures in the Guideline Company Method 270

Cherry Picking Valuation Multiples 271

Using an Inexcusably Old Comparable Sale 271

Inappropriate Reliance on Governance Document Restrictions in Establishment of Valuation Multiples 272

Stating the Wrong Date from a Comparable Sale 272

Mismatching the Valuation Dates of the Guideline Companies and the Subject Company in Computing

Price Multiples 272

Defining ‘‘Guideline Company’’ Too Narrowly 273

Chapter 19 Ten Burning Issues within the Appraisal Profession 275

Issue 1: Methods of Determining the Discount for Lack of Marketability 276

Issue 2: Applicability of Discount for Lack of Marketability to a Controlling Interest 286

Issue 3: Validity of Discount for Imbedded Capital Gains 288

Issue 4: Shift of ‘‘Comparability’’ from the Publicly Traded Arena to the Private Arena 289

Issue 5: Efficient Market Hypothesis and Exceptions (For Example, Small-Firm Effect) 290

Issue 6: Value of Control versus Value of Synergy 291

Issue 7: Do Public Company Stock Prices Indicate a Marketable, Minority or a Marketable,

Control Position? 298

Issue 8: S Corporation Tax-Affecting 299

Issue 9: Factoring Financial Statement Adjustments When Estimating the Value of a Noncontrolling

Interest 301

Issue 10: Validity of the Capital Asset Pricing Model for Valuing Interests in Closely Held Businesses 301

Conclusion 303

Chapter 20 Random Practical Valuation Tips and Thoughts 305

Discovery and Privileges 305

Attorney-Client Privilege 307

Attorney Work Product Privilege 308

Tax Practitioner Privilege 309

A Free Standing, Complete Report, or a Mere Letter or Restricted Use Appraisal Report? 309

Those Business Appraisers Must Be Identified in Time 311

Should a Business Appraiser Always Follow USPAP? 311

How Much Input Can a Client’s Advisor Have in the Preparation of a Business Appraisal Report? 312

Types of Appraisers; Appraisal Associations 312

Random Strategy Tips 315

Appendix a Appraisal standards chart 321

Appendix b Information request list 325

Appendix c Management interview checklist 327

Appendix D Sample Engagement Letter 329

Glossary 335

Bibliography 343

Business Valuation Texts 343

Business Valuation Journals and Newsletters 344

Cost of Capital 345

Equity Risk Premiums 345

Articles 346

About the Authors 361

About the Web Site 363

Index 365