By Robert Carter¹
Business valuations are utilized in litigation and other proceedings, which are often crucial tools for proving the legitimacy of a claim. Still, the topic of business valuations can be daunting and many misunderstand the development and intrinsic value of business valuations. For simplification purposes, a valuation encompasses the following components: gathering and analyzing relevant information, determining appropriate valuation approaches, applying the corresponding financial models, and report preparation.
As mentioned, valuations can be helpful in the litigation arena, such as a marital dissolution if one spouse owns all or part of a business or stockholder disputes centering around a buy-out. A business valuation can also resolve a multi-party dispute regarding the value of a company. Further, a business valuation can be used to calculate business damages or an impairment loss by comparing the value of a business before and after the impairment event. Additionally, valuations are generally required for tax purposes and may be vital when presenting a case in tax court.
Before a valuation can begin, the valuation analyst will need certain information, including the purpose, effective date of the valuation, and the interest to be valued. The analyst may also request company-specific information, such as financial statements and/or tax returns for the last 3-5 years, a current depreciation schedule, and information regarding expense accounts (officer compensation, rent, personal expenses) where it is likely that adjustments will be needed. Other company information may include organizational documents, stockholder agreements, buy/sell agreements, or details on prior transactions. In many cases, an analyst will perform research to gain an understanding of the relevant industry and economic factors that may affect the value of a business.
Once an analyst has the necessary information, they will decide which approach is the most reliable for determining a business’s value. This involves an analysis of the company, both in isolation and in comparison to others in its industry. The approaches generally available are based on either assets, income, or market comparables. Under the asset approach, the assets and liabilities of the company are adjusted to their fair market value as of the date of the valuation and the net equity is the resulting value of the company. This approach is typically used for holding companies or for a company with operating losses. The income approach utilizes earnings, adjusted to reflect a standard level of after-tax profit, which are then capitalized using a normal rate of return to determine the value of the company. This approach is used in connection with companies that have a history of strong profits or are expected to see a significant change in their earning power. The market-based approach uses various metrics (revenue, gross profit, net income, etc.) to create market multiples based on the sale price of previously-sold similar companies and applied to the subject company’s metric. This results in a value for the company based on actual transactions. The market-based approach is best utilized when there is an abundance of recent transactions with enough comparability to the subject company. Each of these approaches has their benefits and drawbacks, thus a certain approach may not be reasonable in some situations.
After the valuation approach component is completed, the analyst will generally prepare a report. Generally, there are three types of reports: schedule, summary, and detailed. The schedule report is the analyst’s final schedule with a brief explanation of the attached schedule. A summary report is more comprehensive, but allows for the omission of certain language within the report regarding financial analysis and company overview, among others. The detailed report is the most comprehensive and complete valuation report and is generally required for specific purposes, such as gift and estate tax valuations. Typically, a schedule or summary report is utilized for settlement purposes, whereas a detailed report is prepared when litigation is expected. All of the reports include a curriculum vitae and a section that describes the documents reviewed during the valuation process.
It is important to note that a valuation analyst may be engaged to perform a calculation of value, rather than a business valuation. Although this can be used for many of the same purposes as a valuation, it is generally not given the same weight as a valuation since the analyst may not have considered all of the relevant factors when calculating value. Essentially, in a calculation of value, the client and analyst agree which approaches and factors are to be considered and which are to be ignored. As a result, the value calculated might not be equivalent to the value determined independently by the analyst.
Overall, business valuations have a myriad of uses both in and out of the courtroom. It is important to understand their method of preparation and the level of service required from the analyst to ensure that the valuation is meaningful and accurate.
¹Robert W. Carter, CPA, CVA, CFE
Manager – Valuations, Forensics, and Litigation Support
Hertzbach & Company, P.A.
Mr. Carter manages the Business Valuation, Forensic Accounting, and Litigation Support Department for the Baltimore area accounting firm of Hertzbach & Company, P.A. and specializes in valuation and expert witness services for marital dissolutions, gift and estate tax transactions, shareholder disputes, and lost profit claims. He also has extensive experience managing forensic accounting investigations involving misappropriation of assets, fraud, and embezzlement claims. In addition to his practical experience, Mr. Carter teaches for the National Business Institute and the Maryland Chapter of the National Association of Certified Valuators and Analysts and is currently a member of the Advisory Council for the Association of Certified Fraud Examiners.