NINE VALUATION MISTAKES THAT CAN HARM BUSINESS-OWNER CLIENTS
Evan Levine & Nainesh Shah
“For your business owner clients who have plans to sell or transfer their business in the next few years, obtaining a proper business valuation is critical to knowing where they stand. A professional valuation performed by a certified specialist and based on accurate modeling and sound numbers puts business owners in a more advantageous position to make the next best move and maximize their financial returns. In this newsletter, we explore common mistakes related to business valuation and offer some helpful guidance that business owners and their advisors can use to avoid them while navigating the complexities of transferring a business.”
Evan Levine and Nainesh Shah provide members with commentary that reviews nine business valuation mistakes.
Evan Levine is a Chartered Financial Consultant with over 30 years experience. He has given dozens of educational seminars on retirement and estate planning. His articles have appeared in the CPA Journal, The National Public Accountant, and Advisor Today.
Nainesh Shah is a Chartered Financial Analyst with over 25 years experience. He is a member of the CFA Institute and has presented to over 100 audiences of financial advisors and non-profits on macroeconomic conditions, capital markets, portfolio construction, and risk management.
Here is their commentary:
For your business owner clients who have plans to sell or transfer their business in the next few years, obtaining a proper business valuation is critical to knowing where they stand. A professional valuation performed by a certified specialist and based on accurate modeling and sound numbers puts business owners in a more advantageous position to make the next best move and maximize their financial returns. In this newsletter, we explore common mistakes related to business valuation and offer some helpful guidance that business owners and their advisors can use to avoid them while navigating the complexities of transferring a business.
Mistake #1: Failing To Value The Business
Every business should have a professional valuation done, but many do not. A large percentage of business owners often fail to take the necessary steps to plan for the eventual sale of their company. According to a 2018 report by the Exit Planning Institute, many business owners “lack of readiness prevents them from harvesting the value of their business…” Of those surveyed, 91 percent had no written personal plan for what they would do after transitioning their business, and 30 percent had not even thought about it.[i]
If an owner is planning to sell their business anytime soon, obtaining a formal valuation or appraisal has a multitude of benefits, including funding buyout agreements and estimating estate tax obligations. Even if there are no plans to sell, a valuation can assist in negotiating with lenders, attracting key employees, and more.
Mistake #2: Valuing The Business Too Late
Much too often, businesses who do get valuations done do them too late. A hasty valuation performed shortly before a sale is common. Valuing a business earlier — perhaps several years before an exit — offers owners many advantages and opportunities.
Once an owner knows what the business is worth, they can also choose to implement value enhancement measures to increase its value in the long run. The owner and his or her advisors can focus on small adjustments to various aspects of the business, including people, planning, sales, marketing, legal, operations, and more. These adjustments can increase the business value, resulting in a better outcome and a more secure future for the owner. Choosing a valuator who has experience with value enhancement can help streamline this process. Also, getting valuations done earlier allows for proper tax and estate planning, which can benefit both the owners and the owner’s heirs in the long run.
Mistake #3: Not Having Valuations Performed By A Qualified Professional
There are a lot of complex variables that factor into the proper business valuation. When not performed by a qualified professional, the likelihood of mistakes and inaccuracies increases significantly. Several organizations offer professional certification designations, including ASA (American Society of Appraisers), AICPA (American Institute of CPAs), and NACVA (National Association of Certified Valuators and Analysts.)
Moreover, if a qualified person doesn’t perform the valuation, a valuation challenged in court likely won’t hold up in a legal dispute. Opposing attorneys can file a motion for a Daubert Challenge[ii]. A Daubert Challenge is a hearing held before a judge where the opposing counsel can challenge an expert witness’s expertise. In the case of valuation, the expert would be required to demonstrate that he/she is qualified and that the valuation methodology is sound and valid.
Although many business brokers and CPAs offer valuation as a service, they may lack the experience, expertise, and depth of knowledge to be as thorough and detailed as certified professionals.
Mistake #4: Overlooking The Benefits Of The Software
In years past, valuations were traditionally done on spreadsheets. However, today, there are many professional-grade valuation software programs available such as Valusource (https://www.valusource.com/) or ValuAdder ( https://www.valuadder.com) that are making the process more accurate and comprehensive. When hiring a valuation professional, make sure the person you choose has an expert command of one or more of respected valuation programs. They tend to reduce omission and calculation errors. And the numbers they generate are easier to defend in court than those made using more “low-fi” solutions.
Mistake #5: Incorrect Or Insufficient Data Gathering
Unsatisfactory due diligence and insufficient data gathering are common mistakes in the valuation process. Proper diligence requires taking the time and effort to understand a company’s industry and business in detail. Interviewing the owner and other key stakeholders, visiting the company’s offices, and getting versed in all business aspects are necessary measures to ensure a comprehensive valuation analysis with thorough, accurate numbers. Furthermore, it is imperative that data utilized to formulate calculations are always readily verifiable from current and credible sources. Data that are unreliable or dated can be more easily challenged by opposing counsel in legal disputes.
Mistake #6: Errors In The Calculation Of Discount/Capitalization Rates
The discount and/or capitalization (cap) rate is among the most critical factors in the income approach to valuation. Numerous errors in multiple places can occur while computing discount or cap rate calculations. Figure 1 illustrates the components of discount and cap rate calculations where errors often occur.
When utilizing the build-up method to calculate these rates, it’s essential to apply the rates to their correct and corresponding benefit streams. CAPM rates reflect the expected equity return of the business. When the wrong beta is used to calculate discount/cap rate, this can distort the numbers. For example, using historical industry data or an average of similar companies’ betas can be inaccurate because they don’t necessarily reflect the company’s dynamics being valued.
Failing to assess proper company-specific risk.
Risk assessment is a critical factor in any business valuation. Using discount or cap rates that don’t account for a company’s specific risk can lead to misleading results. Every company has business-specific operational and financial factors that contribute to its risk profile. This risk indicates that a company’s discount and cap rates are unique. Additionally, due to a great deal of subjectivity and nuance involved in arriving at these rates, an experienced valuator’s knowledge and skill are needed to ensure an accurate estimate of value.
Subjectivity in minority and marketability discounts .
Two major forms of discount are discount for lack of control(DLOC) and discount for lack of marketability (DLOM). DLOC is applied when an analyst is calculating a valuation for a minority owner, and DLOM is applied when there are issues that affect the marketability of the business. Depending on the circumstances, the discount and cap rate are adjusted by DLOC and DLOM. Some valuators have resorted to reliance on case law for the determination of valuation discounts. In Berg Estate v. Commissioner (T.C. Memo 1991-279), the Tax Court was unimpressed with this practice. As such, a common mistake is failing to reconcile discount numbers with outside data sources and available studies that provide a quantitative reference point. But, because these numbers can impact the valuation number significantly, extra attentiveness is essential.
Mistake #7 Errors In Valuation Approaches And Methods
There are three overall approaches to valuation: the income approach, the market approach, and the asset approach. The IRS revenue ruling 59-60[iii] requires that all three approaches are considered in a valuation.
The purpose of a valuation assignment is not to create an average of the numbers from the three approaches, but rather to ensure that a rigorous and comprehensive process is undergone so that each approach is considered, compared, and used to help inform the final valuation.
Where different valuation methods yield different indications of value, the valuator must be very clear about how they arrive at a conclusion of value. While it is sometimes tempting to weigh the indications equally, it is more important to factor the weight of each particular indication of value appropriately. In Hendrickson Estate v. Commissioner (T.C. Memo 1999-278)[iv], the Tax Court criticized the work of a valuator who gave the indications of value equal weight without explaining why.
Income Approach Mistakes:
Many errors can occur in the Income approach to valuation.
Benefit stream mismatch errors. The right benefit stream should be adjusted for tax impact and interest payments so that the matching discount rate can be appropriately applied. Errors can occur by using accounting or book profit instead of discretionary cash or net cash flow numbers, as shown in Table 1. Using a cash flow number for the entire company when valuing the company for an equity holder would produce errant numbers.
Terminal value calculation errors. Terminal value is the value of the company at the end of the discounted cash flow period. The terminal value should be reflected as a present value. Not discounting the terminal value to the valuation date will inflate the value of the business significantly.
Growth rate factor errors. Many companies experience periods of growth that exceed underlying economic growth rates. Using a growth rate that is significantly higher than current economic conditions needs to be considered carefully as it likely cannot be sustained for long periods of time. The valuation difference created by calculating with an incorrect growth rate is significant. (see Table 2)
Market Approach Mistakes:
Using incorrect multiples in the market approach to valuation also leads to many common errors.
Improperly applying valuation multiples. When utilizing the market approach, many different multiples are used to calculate a company’s value, such as revenue multiples, EBITDA multiples, or earnings multiples. Each of these relates to a specific measure of financial performance. However, when the wrong multiple is applied to the wrong benefit stream or factor, the resulting numbers will be incorrect. For example, multiple based on EBITDA shouldn’t be applied to the net profit.
Not understanding changes in the company’s industry. A market approach valuation requires referencing historical transactions. Often, however, market factors in a given industry can change significantly in a short period. This change can render historical transaction numbers less useful or even inaccurate.
Selecting only the lowest multiples. Using only the lowest multiples to generate value can raise red flags in court. It can look as if the company’s value is being artificially “low-balled” for tax advantages.
Asset Approach Mistakes:
Including a company’s operating assets in valuation calculations seems obvious. Operating assets are a necessary part of the business, and they help drive revenue and profits — and without them, the business can’t continue. As such, in the asset approach to valuation, ignoring to account for all assets will distort the numbers.
Ignoring non-operating assets. Many companies also own high-value assets that aren’t essential to their operations. These non-operating assets are sometimes overlooked in valuations. The company may own unused land, access vehicles, or art investments; while these don’t directly impact the daily business operation, leaving them out of calculations can suppress the business’s total valuation.
Overestimating goodwill or underestimating intangible assets. Assuming that an established business has positive goodwill is a common mistake. Business goodwill only exists if the company can generate earnings over and above a fair return on its tangible assets. conversely, not considering or separately valuing the business’s intangible assets, such as developed software or patents, will also lead to inaccurate valuation numbers.
Leaving out key assets and liabilities. Most small business transfers are done as asset sales. The seller pays off all business liabilities and retains the cash and accounts receivable. As a rule, any additional assets acquired by the buyer increases the business value; any liabilities assumed decrease what the business is worth. Inaccuracies are created when you assume the value of these liabilities is equal to their book value without performing additional analysis.
Not considering built-in gains tax[v]. Not accounting for built-in tax gains on the appreciated asset of an S-corporation that is still within its lookback period can be a mistake. The tax courts have recognized the economic reality that capital gains taxes are considered by both buyer and sellers of businesses in the real world.
Mistake #8 Errors In Valuation Report Presentation
The final document can be a summary report or a full report. It can be a calculation assignment or a conclusion assignment. But the report should follow a clear, logical flow and be free of mistakes and calculation errors.
A good valuation report should be consistent and cohesive. Approaches both used and rejected should be appropriately explained, and all assumptions should be defended and supported. In Bailey Estate v. Commissioner (T.C. Memo 2002-152),[vi] the Tax Court criticized the appraiser for failing to do so. This is critical because, in instances where a valuation is contested, opposing attorneys will focus on errors, omissions, and other mistakes to discredit the validity of the valuation and the skill of the valuator. The report should demonstrate that the valuation is informed by detailed, rigorous analysis and useful, verifiable data. Due to the subjectivity of valuations, make sure the report reader finds it obvious that the valuation analysis is an opinion not fact.
No matter how “correct” your conclusion of value may seem, it is unacceptable in the court without sufficient details and explanations of that conclusion. Additionally, your work must be replicable by another valuator upon their reviewing of your report. In Winkler Estate v. Commissioner (T.C. Memo 1989-231), the Tax Court provided perhaps one of the best arguments for a free-standing, comprehensive appraisal report.[vii]
Mistake #9: Hiring A Valuator Who Does Not Keep Up With Changes In The Valuation Space
Ensure that any valuator you hire is someone who stays current in their knowledge and skills. The valuation space is dynamic and continually evolving. Courts and IRS sets new precedents regularly, and there are always new legal cases that can be studied and analyzed.
There also are new types of risks that need to be incorporated into valuations. For example, cyber risk is an increasingly important business risk that analysts should consider because a data breach incident can be detrimental to the value of a business.
Historically, valuations for private companies have utilized traditional valuation methods. However, public companies have coined innovative ways to look at different businesses and industries. This approach has led to new valuation methods that private companies should consider when computing a valuation.
One example of such a method is CBCV or Customer-Based Corporate Valuation. This valuation approach is a bottom-up method rather than the traditional top-down method. It starts by looking at each customer’s value and can be applied to businesses with recurring types of revenue streams, such as subscription models. If performed correctly, CBCV can potentially bring the valuation of business higher than other methods. A valuator who fails to consider newer and more modern approaches could be leaving money on the table for their clients.
Business valuation is both an art and a science. Valuations are based on historical facts, calculations using past and current data, and subjective judgments that require the touch of an experienced professional who is immersed in the facts and details of the company they are valuing.
Each stage in the complex valuation process is prone to a multitude of common mistakes, errors, and omissions that can skew a final valuation number and render it inaccurate and legally contestable. Hiring a business valuation professional is a decision that should be taken with great care and consideration. Thorough, diligent care upfront in the process to make sure you choose a certified, experienced, and reputable valuation partner can save you hassles, time and money later.
Reproduced with permission of Liemberg Information Services, Inc. (LISI)
[i] For more information about the survey please see THE STATE OF OWNER READINESS 2018 GEORGIA REPORT http://exit-planning-institute.org/wp-content/uploads/2018/04/GA_SOOR_FINAL-full-report-content.pdf
[ii] For more information please see Daubert v. Merrell Dow Pharmaceuticals at law.cornell.edu https://www.law.cornell.edu/supct/html/92-102.ZS.html
[iii] For more information please see Rev. Rul. 59-60 at wfu.edu (https://bityl.co/3Q0C).
[iv] For more information pl see US Tax Court T.C.Memo 2000-191 https://www.ustaxcourt.gov/UstcInOp2/OpinionViewer.aspx?ID=3754
[v] For more information on the built-in gains tax see manatt.com tax law newsletter January 26, 2016 titled “The Built-In Gains Tax” (https://bityl.co/3Pzt).
[vi] For more information please see ESTATE OF BAILEY v. COMMISSIONER https://www.leagle.com/decision/2002194583eutcm186211795
[vii] For more information please see ESTATE OF WINKLER v. COMMISSIONER https://www.leagle.com/decision/198943057cktcm3731342
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