Business Appraisal Services
All business appraisal services and valuations experts must abide by the IRS document, Ruling 59-60 for appraisal purposes. To date, it is the most cited, referenced, and adhered to portion of the tax code when it comes to developing a business valuation report. The law requires that professionals understand and adhere to it when performing a valuation on any company. In today’s business world, Ruling 59-60 plays a role in determining the fair market value of stocks in a closely held company. A business valuation report for purposes of litigation for a closely held company must follow the IRS Ruling 59-60 of the United States Tax Code for services in business valuation reporting methods.
Business Appraisal Services & Reports For Closely Held Company
A closely held company has a strict definition in which only a limited number of shareholders have ownership or that all shares of stock are within a single family or small group. As a result of the small group, stock trading is not likely. Essentially, there is no way to determine the actual fair market value of the stocks in a closely held company. As such, experts must use other means to value these stocks.
Stock Appraisal Report
The IRS Ruling 59-60, or ‘The Ruling’ deals with the appraisal of common stock when its market quotation is unavailable or scarce. When the common stock is available and scarce, its very low or very high value does not accurately represent the fair market value of the stock itself.
This situation is typical among closely held companies, and nearly everyone will have a different opinion or definition of the value in question. Disputes over what a fair market value report is and what should count as part of the valuation for common stock for the closely held company are common.
The 59-60 Valuation Ruling is key as it deals with determining what can or cannot be used when determining the fair market appraisal value of a closely held corporation’s common stock. In fact, the ruling specifically states that data and other factors possibly relevant to the stock’s value must be used when determining the appraisal of the stock if it were to be traded within a publicly traded market. However, business appraiser services have different ways to interpret what “relevant financial data” means depending on who is reading the statements and making the business and stock valuation report.
Fair market valuation would be easier to calculate if the stocks of the closely held corporation were publicly traded on the stock exchange. However, because they typically are not traded publicly, a business appraiser must consider these fundamental factors when determining value:
- Nature history of the enterprise from inception
- Condition an outlook of the industry
- Business’ earning capability and ability to pay dividends
- Economic climate
- Stock’s current book value, including the stock sales and size of the stock block current in the valuation report.
- Intangible or goodwill value of a company
- Publicly traded stock prices of similar corporations
These factors are critical in determining a stock’s fair market value, especially when determining the overall appraisal of a business. However, this list is not all-inclusive. According to the Ruling, a business appraiser must also consider any other financially relevant data when determining the stock’s valuation.
Business Appraisal Services & Reports
A business appraisal relies on standardized processes, procedures, and guidelines used to determine the value of a business. As with most processes and procedures, there are objective and subjective factors that influence the outcome. The variability of these factors may cause different outcomes for the appraisal report.
An example of variables given economic conditions which impact how people perceive the appropriate valuation of a business. One example of these variable factors would be economic conditions, which can affect how people perceive the appropriate valuation of a business.
The circumstances of a business sale or merge will also affect the business value. In the case of a business sale or merger, an appraisal can vary as a result of how the business was marketed. For example, if the marketing was perceived as focused, long term, and with a degree of expectancy than the selling price would be higher than if the marketing implied there was a need for a quick sale or auction. If the marketing insinuated that the seller needed to get out of the company quickly, then the selling price would end up rather low.
A business appraisal report is based on how value is defined in an open market. The report should consider that there are informed buyers willing to pay for a business based on the available investment options, personal limitations, and goals. Therefore the business appraisal services and approaches may vary depending on the use of the business appraisal report methods and the perceived value of the informed buyer.
The Three Basic Business Appraisal Report Methods
Experts use three standard ways to appraise the value of a business when producing simple business appraisal services. The three basic business valuation reports include:
- Asset approach
- Market approach
- Income approach
Listed below is an overview of each of the basic business appraisal reporting methods with insight into what business owners should expect from the process.
The Asset Appraisal Approach
Asset appraisal looks closely at the business’ assets and liabilities. Through the asset business appraisal approach, the company’s assets and liabilities make up the framework for a business appraisal. The asset approach uses the concept of the economic principle of substitution, which asks:
“What will be the efforts and costs to replicate an existing business which would produce the same economic benefits for its owners?”
Every business, including service businesses, has assets and liabilities. The temptation is to value the assets and liabilities and end the appraisal. Not so fast. The challenge of any appraisal is in the details, and determining which assets and liabilities are included in the appraisal is only one step. An appraiser must also choose the right standard for determining their value and then determine the worth of each asset and liability on the open market.
For example, business balance sheets will often miss some of the most important business assets. These missing assets usually include company developed products or services, proprietary processes, and procedures. If the business owner did not pay for them, they would not be recorded on the cost-basis balance sheet. The reality is that the real value of these assets could be far greater than all the assets listed on the balance sheet. It is apparent that the business’ value could be far greater than the value of only its hard assets.
The Market Appraisal Report
The market appraisal approach uses the value norms of the marketplace to analyze and calculate the valuation of the business. Using this approach, appraisers rely on the economic principle of competition with the premise:
What is the worth of other businesses in the marketplace that are similar to the business being valued?
In the effort to understand business market values, the business valuation services and experts must study and evaluate norms, averages, and trends of business values by size, industry, and many other variables. Buyers seeking to buy a business should carefully look at other similar businesses and compare pricing ranges with respect to risk and investment returns for their money. When planning the sale of a business the owner will want to also carefully watch and review the market. They can review how much similar businesses have sold for, and look into the listing prices for other businesses available for sale. Many refer to this type of approach as the fair market value.
The simplified definition of fair market value is the price that a willing buyer would pay and a willing seller would accept for the business. There is the assumption that both parties act with full knowledge of all the relevant facts, and that neither is under coercion to conclude the sale. Therefore the market approach to an appraisal of a business is a good way to determine its fair market value in the open market via an arm’s length transaction. The concept here is that the buyer and seller are both acting in their best interest.
The Income Appraisal Report
The income business appraisal approach looks at the primary reason for running a business; to make a profit and a good return on investment. From an economic perspective there is an expectation that through time, money, and effort invested into the business there should be economic benefits in the future.
This approach analyzes the likely return the business will bring and the possible risk of the investment compared to other investment opportunities. Because the business valuation uses the present time frame, the expected income and risk are analyzed for the present moment. The income business appraisal approach uses two methods to perform this analysis. Appraisers can use the capitalization or discounting methods.
From a novice perspective, the capitalization method basically divides the business’ expected earnings by the so-called capitalization rate. That capitalization rate is the expected rate of return on the business. The concept is that it’s reasonable to define the business value by the business earnings and the capitalization rate. As an example, if the capitalization rate is 25% then the business is worth about 4 times the company’s annual earnings. An alternative is to use the capitalization factor and used to multiply the income. In either method, the outcome is what the business is worth today.
The discounting method takes a different approach. This method uses projections of the business’ income stream over the upcoming years. The next part is to determine the discount rate to represent the risk of receiving this income over time. Finally, a calculator will determine the value of the business at the end of the projected period. Many refer to this approach as the residual or terminal business value. The discounting calculation will yield the present value of the business. Both income appraisal methods will produce the same results.
For example, if the discount rate is 25% while the company’s projections show the profits growing at a steady 8% each year, the capitalization rate is 25-8=17 or 17%.
The key difference between the capitalization and discounting approach is which income input the appraiser uses. The capitalization method uses the single income measure such as the average of the earnings over several years. The discounting method uses a series of income values, one for each year of the projection period. The capitalization method can be a good choice for businesses that have consistent and steady profits each year. While the discounting method provides the most accurate results for businesses that have rapidly changing profits.
The outcome of a business appraisal report using the income approach can produce different results based on the varied opinions on projections and risk assessment. Therefore, the capitalization and discount rates will differ. Additionally, potential buyers might have different plans for the business, which will affect how they treat the income stream projections. Buyers will inherently differ on how they view the investment value, and that will impact how they view the value of the business. The income appraisal approach has a great strength. It allows for some flexibility in measuring the business’ value or appraisal to correlate with the buyer’s circumstances and objectives.
Creating a Reliable & Defensible Business Appraisal Report
It is absolutely key to have a reliable and defensible business appraisal report. To accomplish this, there are multiple steps including preparation, selecting the appropriate appraisal service providers, and applying the selected business valuation method group. Skilled professionals that provide business appraisal services should explain each step and outline expectations for different kinds of reports they may receive. Of course, everyone has to start with proper planning and preparation.
Step 1: Planning and preparation for a business appraisal
Creating a reliable and defensible business appraisal requires proper expertise in business appraisal services, extensive experience, and high-levels of attention to detail. A proper business appraisal depends on how the valuator measures the business value and what factors impact that value. It’s also vital that the valuator have extensive knowledge regarding the standards and guidelines provided by several business appraisal and valuation associations.
Business facts will always impact a business valuation report. Accurate financial statements and tax returns are critical for demonstrating the business is earning power. Businesses with steady or above industry norm earnings will definitely translate into a higher business valuation. In addition to strong financial documents, there are other financial factors that can have a push-and-pull effect on the business appraisal.
During this step, the valuator and seller should develop a good marketing plan to help support and strengthen the business. If the plan provides some reliable future earning projections, then a marketing plan could be even more important. Another element of the step is the review of revenue concentration by customers, which can have an effect on the business appraisal. Businesses which rely on one or two customers are seen as high-risk to buyers and it could negatively impact the appraisal of the business. Finally, the preparation process will look at other factors that could have a positive impact on business appraisals such as having motivated and field employees with long tenure.
Step 2: Normalizing financial statements
Financial statements don’t always provide an accurate representation of all the company’s assets, and similar ailments that could come up during valuation. A business appraisal is primarily an economic analysis exercise within a given economy and time frame. The key drivers of value lie in the company’s financial information. Not financial information is used as key data during the business valuation process. The two main financial statements used during this stuff are the income statement, or tax returns, and the balance sheets from the last three to five years.
This step of normalizing financial statements is important because most small and midsize businesses operate to show lower profits to reduce taxable income. This means that standard operating practices often reduce the value of the business. But when it comes to having the business valued, these financials are not usable. It’s important to show the true picture of the company using historical financial statements, but those financial statements will need to be adjusted or re-casted to show an accurate profit of the business.
Step 3: Choosing the appropriate appraisal services providers
Basic business valuation methods used to produce a somewhat reliable appraisal will use of the following approaches:
- Asset approach
- Market approach
- Income approach
The valuation approach or approaches that receive the heaviest weight depend on the following factors:
- The complexity and value of the company’s assets
- Availability of comps on businesses sold
- Business historical earnings performance
- Availability of reliable business earnings projections into the future
- Availability of data on the business cost of capital both debt and equity
Using the asset method
If a company is asset-rich then it would likely justify the cost and complexity that comes with an asset-based valuation. However, if they show a high cost and they don’t show a high return on investment because of low revenue or profit, then the asset-based valuation may not be accurate or reliable. Valuators should use great caution when using the asset-based valuation method if the assets are valued high, but the business has marginal earnings.
Using the market-based business appraisal method
The market-based business appraisal method reviews various businesses sold in the past. There are two types of businesses sold records, including similar public companies that were sold in the past, and similar privately held companies sold in the past.
Public company comparisons and records are more readily available than records of privately held businesses. There should be some caution when using records on private companies, many of these sales are reported with mistakes and don’t present clear data. If the records for private companies are trustworthy, provide a good way to estimate the business appraisal.
There are more records of privately sold companies reported with the challenge of finding enough comparison records to provide valid comparison. All market-based methods rely on market multiples of discretionary earnings or EBITDA to assist in estimating the business valuation. These market multiples for discretionary earnings or EBITDA offer comparison for business economic performance.
The common pricing multiples used for small and mid-sized business valuations include the selling price correlating to revenue (with great caution), and the selling price correlating with the business earnings such as net income, SDCF, and EBITDA.
Using the income valuation
Income business valuation methods determine the business value based on the business’s potential earning power. Business appraisal service experts agree that this method is usually the most reliable approach to conducting an appraisal or valuation of a business. An income based business valuation report will utilize a discounting or capitalization method to measure the business’ earnings.
The discounted cash flow method is the ideal choice for appraising a new or quickly growing business with inconsistent earnings. However, the capitalization or multiple of discretionary earnings method is an excellent choice or businesses that are established with consistent earnings and a good growth record.
Step 4: Calculating & applying the selected business valuation method group
After an appraisal service professional has assembled and carefully considered all the valuation information, and they’ve chosen the proper business valuation report method, they can move on to calculating and applying the method group.
The results should be a business valuation which is both accurate and defensible. The purpose of using several business valuation methods is to cross-check the valuation. This level of scrutiny will help identify input errors and reveal missing information if one of the valuation methods for very different results.
Step 5: Reaching the business valuation assessment conclusion
Once the individual business valuation methods are complete it’s time to administer the proper degree of weight for each of the methods to derive the business valuation conclusion. The weight assigned to the results for each of the business valuation report methods will reflect their relative importance in reaching a defensible business valuation.
American Fortune Appraisal Services & Reports
At American Fortune we happily offer 3 different types of Business Appraisal Services and Reports. These reports include:
Business Value Estimate: Using this business appraisal service allows business owners to obtain a fast and easy estimate of value for a business. The report uses a combination of 8 valuation methodologies and comparative data analysis to help verify the estimation of value. Based on proven methods and reliable data, the Business Value Estimate is configured via a customized 38-page report.
This report is not a professional valuation of a business and is not suitable for estate planning, divorce proceedings, buy-sell agreements, ESOP’s, IRS dealings, or legal proceedings. Price: $ 1,250
Preview a sample Business Value Estimate Report.
Calculation of Value: This business appraisal service report uses basic value drivers to produce a semi-formal valuation. Utilizing 4 or 5 valuation methodologies, this report produces a moderately defensible valuation. This report is approximately 30-35 pages. Price: $ 2,300
Request a sample Calculation of Value Report.
Comprehensive Business Valuation: A comprehensive appraisal service report that will incorporate broad and complex business reviews with financial reviews and analysis. This report is a very defensible valuation that utilizes 7 to 10 valuation methodologies. The valuation is extremely accurate and extraordinarily defensible.
The full Comprehensive Business Valuation Report is 40 to 45 pages long. Price: $ 4,000
American Fortune Business Appraisal Services follow the requirements as defined by the American Institute of Certified Public Accountants Statement on Standards for Valuation Services No. 1 (SSVS No. 1) and performed in accordance with the Uniform Standards of Professional Appraisal Practice (USPAP) as promoted by the Appraisal Foundation and the International Valuation Standards (IVS).
M&A, Exit Planning, Business Valuations