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(As Published by the American Institute of Certified Public Accountants: Chapter 8)
There is no asset that appears to confound advisors more than ownership in a business enterprise; perhaps, more so, a partial interest in a business or real property. The sheer number and impact of legal and financial issues has a myriad of implications on value. It is human nature to steer clear or minimize the net result of these issues, as they can be daunting. However, in the absence of substantial and independent conclusions that are empirically supported, opinions of value are mere guesses. Such estimates can lead to egregious losses of thousands, if not millions of dollars for your clients. A working relationship with a seasoned business valuation analyst (appraiser) can secure your advisory role with clients who require your advice in areas ranging from estate and succession planning to enhancing value via a thorough review of current operations.
Business appraisal and economic damages analysis is a niche. The CPA credential, in of itself, is unlikely to provide the requisite skills and resources to render opinions of value and may pose some conflicts of interest as well. Even after performing well over 350 written business valuation and damage assessment reports; holding membership and/or accreditation in all of the national business valuation organizations and providing testimony in over 100 depositions and court, there is much to learn about this industry. This chapter will provide insights to many of the issues confronting the business valuation analyst in the context of estate related work.
Thinking like an investor
Regardless of the property held, the business appraiser's role may be simplified by attempting to simulate and quantify the most likely decisions made by a pool of investors. Obviously, marketable securities of publicly traded companies represent highly liquid, minority interests that can be bought and sold in minutes with cash changing hands in a matter of days. An investor principally examines several factors, but inevitably is concerned with the degree of risk compared to the economic benefit or return. Returns may be achieved by growth (capital appreciation), income (distribution of dividends) or both. The greater the likelihood that growth and income will be achieved, the lower the risk. The lower the risk, the higher the value of the property and the investment expected to acquire it. In simple terms, how much cash can be readily and consistently received during what time frames? This is basic financial theory where the property owner has to be aware of the market and economic climate for the specific investment as well as others, which may offer less risk or higher returns.
The second issue is one concerning holding period and liquidity. If the asset cannot be readily sold due to the impairment of having a limited pool of buyers, then the holder of an interest in this property may not be readily able to achieve a “cash equivalent” value as of a specific date when (s)he wishes to sell without adjusting price sufficiently to attract a buyer. Therefore, the adjustment or “discount” becomes more profound in cases where the interest held generates little or no income or when the investor has little or no control over the performance and subsequent sale of the asset.
This is certainly the case when one holds an undivided 10% interest in raw land, which may have appreciated in value, but the interest holder is unable to find a buyer without the consent of the majority of other interest holders. The absence of the legal “bundle of rights” places restrictions on liquidation, sale or transfer, which, in turn, emphasizes why the 10% interest is not simply worth one-tenth of the pro rata value of the entire property held. These concepts are the underpinning thoughts that lead to the establishment of Trusts, Tenancy-in-Common, LP/LLCs and subsequent gifts of partial interests in everything ranging to an operating manufacturer to an LP holding marketable securities and income producing real estate.
The Fair Market Value Standard is where it all starts
Premise
Valuation methodology is built upon the following basic premises: The value of property is equal to the present worth of the estimated future benefits to be derived from its ownership. This is a fundamental premise of business valuation. A rational buyer normally will invest only if the present value of the expected benefits of ownership is at least equal to the purchase price. Likewise, a rational seller normally will not sell if the present value of those expected benefits is more than the selling price. Generally, a sale will occur at an amount equal to the benefits of ownership.
Value is not always a single number. The valuation process is full of judgments and estimates. No one can predict with certainty the amount of benefits a company's owner(s) will receive. Informed investors may have different opinions about the amount of those benefits; hence the differences between asking and offering prices. Value will depend not only on these benefits, but also on growth, profitability, size of interest appraised, number of interest holders and other risks. Investors may require different rates of return based on their opinions with respect to the risks of ownership. The business appraiser's task is to determine a “most likely” conclusion where a hypothetical buyer and seller will agree.
Valuation Date(s)
Value is based on a specific point in time, the valuation date. An investor's required rate of return and amount of available benefits are based solely on the information that is discernible and predictable at the valuation date. This is highly relevant in estate tax valuations when events that would be unknown to the decedent are taking into consideration. Opinions may differ if another valuation date is used.
Definition of Value Used
Reports written for consideration by the Internal Revenue Service are to be supported by documentation, which explains the methods, procedures, quantitative and qualitative analysis, calculations as well as assumptions used to arrive at an impartial opinion of the Fair Market Value of the property. As used below the definition incorporates some of the following assumptions and standards:
