CHAPTER 12
Details for Business Valuators

This chapter discusses topics of particular relevance to business valuators. They include final selection and weighting of the valuation method, standards relating to calculations and conclusions of value, meeting clients' wishes for multiple purposes, engagement agreements, and more on professional judgment.

SELECTION OR WEIGHTING OF METHODS

Often multiple methods will be used to calculate indications of value. As part of a conclusion of value, one method needs to be selected or several methods need to be weighted in order to select a final value.

If the purpose is for estate and/or gift tax, or if you agree with its philosophy, Revenue Ruling 59-60 specifies selecting the best method.1 The ruling argues that multiple methods muddy the water.

Many analysts support, and standards allow a weighting to select a final value. After all, this is an opinion and multiple methods may contribute to the logic and value found. Therefore, for many purposes, valuators perform a weighting of two or more credible methods. Some purposes allow the selection of a range of values. Again, it is important to explain how and why the range was selected.

Method Indication of Value Weight Weighted Value
Asset Method $120,000 0.00%  $0   
Market Method – Revenues $900,000 25.00%  $225,000   
Market Method – Cash Flow $860,000 75.00%  $645,000   
Income Method – Cap. of Earnings $960,000 0.00%  $0   
Estimate of Value 100.00%  $870,000   

Notes: Example of basic weighting of estimates of value to calculate final value. The calculation is simple. Clarity in the explanation for why the weighting was selected is essential.

When a range of values makes sense, some valuators will select two values as a high and low for the range. An example might be to select the high value as $960,000 and the low value as $860,000. Again, the logic and judgment for the selection are key.

Revenue Ruling 59-60 mentions selecting one method but it also mentions that the valuator

should apply common sense specific to the facts when determining value.

FIGURE 12.1 Selection and Weighting of Valuation Methods

An example of a weighting of methods is shown in Figure 12.1.

Along with the fairly simple presentation comes the explanation of the process and reasoning for the weighting. Typically, valuators will provide a final summary of the logic of the method and the logic of the weighting. This is a final check on the sensibleness of the value found. Some factors to consider are listed below.

  • Are there strong reasons to choose the selected or weighted methods compared with other methods?
  • If there are large variations between the methods, is the choice made reasonable?
  • Why is there a large variation, should it be explained?
  • What would the effect have been if one method was selected over the other?
  • Is the other method or is the less weighted method likely to be materially more correct?

In most cases if there is a large variation, one method should be selected. It is one thing to weight a reasonable range and another to pick a mid-point that is highly unlikely to be correct.

Finally, is the selected method weighting reasonable?

Weighting four or seven methods or more indicates a lack of thought and selection. At a minimum it looks like averaging of rules of thumb. Blind averaging is not supportable.

CALCULATIONS AND CONCLUSIONS (OPINIONS) OF VALUE

Formal business valuations are classified by two different standard levels: a calculation of value and a conclusion of value. Conclusion of values are commonly thought of as opinions of value but the American Institute of Certified Public Accountants reserves the word “opinion” for audits exclusively. Conclusions must meet all valuation standards. Calculations of value cover a large range of work product agreed to by the valuator and the client.

In addition to the work produced to estimate a conclusion or calculation, a report is also produced. Generally, reports are written to standards. The Standards are somewhat but not completely interchangeable. The National Association of Certified Valuators and Analysts (NACVA) publishes a guide showing the relationships of the differing Standards.2 The NACVA Standards are based on principles. Principles-based systems state the principles that are to be met and leave more of the details to the valuator. The AICPA SSVS (Statements on Standards for Valuation Services) standards are much more rules-based. Uniform Standards of Professional Appraisal Practice (USPAP), developed by The Appraisal Foundation, of which the American Society of Appraisers is a member, are a mixture of both.

While principles-based standards may work best with the fluid and varying nature of valuation work, rules-based systems tend to have more detail and in this case work better as an outline. For that reason, the AICPA SSVS No. 1 standard will be used for convenience. Because rules are rigid, if you are a certified public accountant, make sure you follow SSVS. In all likelihood the other standards will be met.

Valuations prepared for litigation are exempt from the reporting standards but not from the developmental standards. There is also a reporting exception if a governmental body has specified a different work product. Conclusion reports are submitted as a summary and in detailed format. They may be oral or written. In general, calculation reports can vary greatly, based upon the agreed-upon procedures with the client.

According to SSVS 1:

This is further refined in .04

The SSVS has many examples of when professional judgment is used and not used, but it is a fine line. If valuations are being prepared and you have a certification, it is probably prudent to assume that even a back of the napkin estimate is using your professional judgement. (Presumably, at some point, even choosing a rule of thumb is a judgment.)

CALCULATIONS OF VALUE

A calculation is produced when:

The difficulty with trying to show what is in a “typical calculation” is that a calculation to a large extent is what is agreed upon to be provided between the valuation analyst and the client. This can and does range from a simple “almost or barely” calculation to a calculation just short of the opinion of value. In fact, some analysts (and they may well be right) will insist that what is shown in the companion documents on the website as an opinion is just a fairly complete calculation.3

Calculation Report

AICPA SSVS No. 1 paragraphs .73 through .77 describe the requirements of a calculation report. A sample calculation report is included as part of the materials included with the book on the website. The sample includes information useful for an internal exit planning situation. The report also is annotated to further show applications of the concepts discussed in the book.

VALUATION ENGAGEMENTS

Regarding a valuation engagement, AICPA SSVS No. 1 paragraph .21a. states this occurs

Valuation engagements result in a conclusion of value. Note that there are no exceptions when performing a conclusion. All work that the valuation analyst feels must be performed along with all work required by the standards must be performed.

Valuation Reports

Valuation reports are broken down into a detailed report and a summary report. Detailed report requirements begin at SSVS .51 and run through .70. Summary reports are covered in .71 and .72. The Standards again provide a high level of clarity about what must appear in a detailed report.

When the valuation is prepared for controversy purposes, then the reporting requirements are exempted. The developmental standards still apply. Remember for litigation your report is all or part of your testimony so make sure the report is credible. Check for the requirements for the jurisdiction you are working in. Some do not require a report be filed, just testimony. Others only allow information in the report to be testified. A big swing in requirements and possible strategy.

If you are subject to the AICPA SSVS or NACVA, USPAP or other standards, do review them carefully to ensure compliance.

A sample Summary Report is included as part of the materials included with the book on the website. The sample was prepared for a bank loan approval purpose. The report is also annotated to show applications of the concepts and methods used in the book.

MEETING CLIENTS' NEEDS

In many small business valuations, the client is the small business owner or his attorney representing him. For many small business owners, cost is a huge factor in business valuation. Most clients do not begin to comprehend the complexity of this specialized work, the theoretical framework or the standards that are to be followed. They believe a rule of thumb is all that is needed and they know their cash flow (or at least believe they do), so what is the big deal?

Most small business owners are practical people who just want an answer. In addition, being human, they usually want the answer they want which may or may not be a supportable value. Clearly, working for clients who are creating fee pressure for you and have strong desires, which may be beyond your opinion, can lead to ethical pressures. Yet that is the reality for most practitioners on most assignments. How do we as professionals resolve this?

In business valuation, valuators represent their “opinion” of value. Valuators represent the work. They should be as persuasive as possible about the opinion of value. (Sometimes that includes being understated.) What should not be done is attempting to sway the opinion or findings to represent what any other party wants. Independence necessitates that the analysts be an advocate only for the opinion. Analysts owe the client, and if different, the users, an accurate calculation or opinion. As specified in the engagement agreement letter, that user has the right to rely on our findings.

A few circumstances for small business valuations and questions to determine “what is important”:

  • Internal planning––usually calculations of value will do. If truly for internal planning purposes only, or early planning purposes, a low level of verification of add-backs and adjustments may be warranted.
    • How is the tool of the business valuation going to be used by the client?
    • Are they going to just use “the number” or are they looking for guidance on how to improve the business?
    • Are they seeking guidance on what market transaction terms will look like?
    • Your ultimate report or notes or oral guidance should be directed to meaningfully assist the client with their uses in addition to finding the correct number.
  • Mediation/negotiation that may or may not lead to litigation
    • What quality level documents are being worked from?
    • Are clients both parties, a company representative, a third party? (Should that matter?)
    • What is the cost/benefit of whatever level of work we are doing?
    • What are the rules of engagement for the parties and for the valuation analyst?
  • Litigation (often divorce)
    • What is the standard of value and premise of value?
    • For smaller entities, is this a business?
    • What other tasks might be performed as part of the service (e.g., available funds reports, support tests)?
    • What documents are available?
    • Is there access to the same documents as the opposing side?
    • What is customary or required in the jurisdiction for computations and/or reports or exhibits as it becomes full litigation? For example, is a full report required early or is no report required at all? Will a calculation report suffice?
    • Are forensics likely to be required?
    • Does the valuation date move during the process?
  • Compliance (SBA Loans, ESOPS, Fair Value Appraisals, Estate, Gift Tax Matters)
    • What is the size of the business?
    • What is the purpose or use of the report?
    • What expectations or requirements has the user provided through publications, court cases, and so on?

Valuation professionals are not reviewers or auditors or even compilers of financial statements for direct use of the statements as such. But, we are providing an assessment of the value and providing an opinion based on the data. When performing work for third parties, we must recognize our third-party obligations and apply professional prudence to our work.

One of the standard ways to adjust for risk of poor financial documents is to reduce the value or increase the marketability discount. Certainly, this is how buyers in market transactions deal with uncertainty.

That may be fair (but is it really correct?) when the “keeper” of the documents, namely, the owner will be negatively impacted by the reduced value. But what if you represent the out-spouse in a divorce? Or if a value is being determined for cashing in stock options? Or if you are retained for a mediation to do work for both parties? While every case is different, it would be unfair to in effect penalize a party for someone else's refusal or inability to clean things up. Easy to say here and yet this requires a high level of professional judgment and experience to solve.

DETERMINING WHAT MATTERS

Again, as stated earlier:

How Do We Determine What Matters?

Clearly determining what matters ties in with professional judgment. In accounting parlance, what matters is what is “material” to the work. What matters are those things that lead to a finding that is “approximately right.” It is the Art of Business Valuation. It also includes those things that will allow you to sanity-check and reasonableness-test your findings, increasing your likelihood of being reasonably right. Reasonably right is accurate in business valuation applications.

How Do We Really Know What Matters?

Businesses at their simplest are: People, Processes, Profits.4

Simplicity can be deceptive.

What matters are understanding the major building blocks of measuring cash flows or profits and evaluating the risk of those cash flows that come from people and processes, to estimate value for any given purpose.

Of major importance is the interaction of people and systems to maintain relationships with customers, suppliers, regulators, and others to create resiliency around the numbers or perhaps indicate weakness. Can these systems withstand change and uncertainty? Again, what is the company story and how does it affect the analysis and treatment of the numbers.

The numbers and profits are a score. The financial results over time produce trends that are used to judge the likelihood of the results of the next “game” or financial period. The exact building blocks will vary with each engagement based on the business, industry, economy, actual financial statements and other components of a proper business valuation. Finally, a liberal dose of “Does this make sense?” is needed at every step.

Emphasis is placed on the purpose of the business valuation. The valuator may use very different methodologies and levels of documentation depending on the purpose. For instance, let's look at a small business valuation being developed for litigation versus preparing a valuation to price a business for market sale.

In both cases, the “correct” number or value is important. But in litigation, surviving cross-examination may sway the selection of valuation methods and create a real need for excessive detail in working out some portions of the business valuation. For instance, a site visit to an office of an engineering firm might be performed simply to avoid the cross-examination challenge of “not knowing what the place looks like.”

When possible, in litigation, determine who the judge is and find out what the judge's preferences in prior valuation cases were. Some jurisdictions have reporting services for unpublished cases. These can be very helpful.

In market sale estimates of value for small and very small business calculations, it probably just makes sense to use a market multiplier and, for the smallest businesses, maybe even a rule of thumb and apply this against an adjusted cash flow as a proper sales process will determine the real price. Since the valuation for possible mergers and acquisitions work here is for internal planning, there is no third party reliance on backup documentation. (A “fair value opinion” valuation for a buyer or seller with third party users is a very different engagement.) Purpose also ties into the standard of value that is to be used by the valuator and in many cases whether an opinion or calculation is required.

What matters is what will materially affect the estimate of value. That includes its believability and supportability where credibility may be questioned.

How is the valuation work seen, measured, recorded, analyzed, and then explained to the user? Items that materially affect the analysis and the ability to support the analysis are what matters. Business valuators build an argument for their concluded business value. When properly completed, the argument addresses weaknesses and problems with the analysis, as these always exist.

PROFESSIONAL JUDGMENT

Business valuation uses more professional judgment than most accounting functions which tend to look backwards at the past. The past happened. There are a finite number of choices and outcomes about the past. Business valuation is really about the future with unlimited choices and options. Business valuation is more of a finance function looking at financial stability and growth or contraction in the future than it is about compiling accounting data.

But what is professional judgment? Merriam Webster's dictionary does not treat it as one word or phrase.

Boiling it down, an engaged professional in a learned profession is characterized by his technical or ethical standards. Certainly, those both apply to valuation. Most people who engage in business valuation belong to at least one professional association and follow standards both as to ethics and technical matters.

Judgment is the hard part. What does, “the process of forming an opinion or evaluation by discerning and comparing” really mean? Discerning and comparing what to what? Which also begs the question of what is it that is being discerned and compared? When valuing smaller businesses, we have issues both with the relevance and correctness of what is being compared and the comparable. Namely, both sides of the equation or model are flawed.

In simple terms, professional judgment (yes, this is the art) becomes how we best improve the overall equation to get the best answer possible even if it is not likely and in fact will never be perfect. Over time many practitioners do learn how to do this in a variety of situations.

One of the goals of this book has been to speed up that learning curve and assist practitioners at least in specific areas that are frequently encountered by small and very small businesses. That is why the question of “how does the analyst improve the equation or model?” has repeatedly been brought up. This directly impacts professional judgment.

In addition to the exercise of professional judgment is the question of how the valuator's file should be documented and supported to demonstrate the process of professional judgment.

Simplicity: The Law of Parsimony

Occam's razor and the “Law of Parsimony” form the theorem that the simplest problem-solving method tends to be the correct one. Namely, the most accurate solution tends to be the one with the fewest assumptions. This theory relates to the fact that each assumption tends to bring in a huge number of new alternatives, making it harder to prove a hypothesis wrong. Therefore, simpler theories are more testable and verifiable. Basically, the complex way may be correct but it is almost impossible to prove. With the simpler way it is easier to prove that it is probably not wrong.

The other extreme is the advent of the black box. The black box is where a computer algorithm calculates the answer. Plug in defined variables and get an answer. This appears to involve no judgment by the analyst at all (which begs the questions of how the variables were selected and what biases may be in the algorithm). There is a lot of concern about using black box solutions since they cannot easily be verified. Sometimes a variation of a black box is all there is.

The use of statistics can also fall into this category. If simple statistics, medians and means were all there was to business valuation, valuators would have been replaced by interns with calculators and certainly computers at this point. Statistics does have a place along with the black box in some situations but most businesses are not “average” and even if they were, we still have the problem of comparison, namely, is our comparative data from average companies? In many cases it is not. Finally, statistics can show correlation but not causation.

Conclusions as to Professional Judgment

The problem with professional judgment and business valuation is that a business valuation has so many layers of professional judgment that it is almost impossible to consider them all.7 Most of these layers are materially important.

The following is a recommended process for working with professional judgment:

  1. How important or material is the determination to what we are estimating? This may have to be reviewed several times in the valuation process as importance may increase or decrease as the entire valuation comes together.
  2. Assuming 1. above, that the matter is material, do you have experience with the matter at hand? If not, who does and what books and documents do? The more material there is, the more you should research and document.
  3. Is there a consensus view? If the consensus view does not apply, clearly document what you have done to verify that and why. The factors listed above are a good outline for that process.
  4. Are there other factors or procedures or tests that support or invalidate your view? If they do not support your view, how are you adjusting or justifying your final determination?
  5. If a particular user or reviewer is involved (e.g., the Internal Revenue Service (IRS), the Securities and Exchange Commission (SEC), local judge), have they stated a position on this matter? While it may be against ethical standards to vary your opinion for them, certainly it could impact how you present your report and analysis.
  6. Document your process to the appropriate level considering the level of the estimate of value (calculation or opinion), the materiality of matter, and your reasoning for variance (if any) from the consensus review. If appropriate, put a summary of the analysis in the report.

Many very important assumptions, such as the economic outlook for cyclical companies, while very material, are usually going to be a consensus view and will require little or no documentation, particularly in a calculation. On the other hand, material adjustments beyond the consensus view (say, a 60% discount for marketability) need to be thoroughly vetted, supported, and backed up in work papers and when appropriate in the report.

For another take on professional judgment, see the “,” released August 1, 2008.

NOTES

  1. 1.  While I do not agree with this statement, Revenue Ruling 59-60, Section 7, Average of Factors states that, “Because valuations cannot be made on the basis of a prescribed formula, there is no means whereby the various applicable factors in a particular case can be assigned mathematical weights in deriving the fair market value. For this reason, no useful purpose is served by taking an average of several factors (for example, book value, capitalized earnings and capitalized dividends) and basing the valuation on the result. Such a process excludes active consideration of other pertinent factors and the end result cannot be supported by a realistic application of the significant facts in the case except by mere chance.”
  2. 2.  See http://web.nacva.com/TL-Website/PDF/DomesticStandardsChart.pdf
  3. 3.  Currently, there is some controversy over what work can be performed as a calculation. See AICPA Valuation Services, VS Section, “Statements on Standards for Valuations Services, VS Section 100, Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset Calculation Engagements, Frequently Asked Questions (FAQs), Non-Authoritative”. In summary, calculations can be used for a wide range of purposes.
  4. 4.  My partner, Eddie Davis's favorite refrain
  5. 5.  “Professional” in Merriam Webster's dictionary : see https://www.merriam-webster.com/dictionary/professional
  6. 6.  “Judgment” in Merriam Webster's dictionary: see https://www.merriam-webster.com/dictionary/judgment
  7. 7.  Ron Rudich states while teaching business valuation that he constantly is juggling many balls concerning valuation theory in the air (in his mind) before he is able to conclude an opinion.
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