A Reviewer's Handbook to Business Valuation Practical Guidance to the Use and Abuse of a Business Appraisal
L.PAUL HOOD, JR. TIMOTHY R. LEE
WILEY
John Wiley & Sons, Inc.
Contents
Foreword
xvn
Preface
xix Highlights of This Book Who Should Read This Book? About the Book
Acknowledgments
PARTI
FOUNDATIONS: VALUING A BUSINESS
CHAPTER 1
Fundamental Concepts for Defining Value
CHAPTER 2
xix xix xix xxiii
Standard of Value Level of Value Premise of Value Conclusion
3 9 11 12
Defining the Engagement
13
The Importance of Defining the Engagement Denning the Client The First Call The Subject Entity and Entity Type Entity Distinctions and Entity Significance in the Valuation State of Entity Organization or Incorporation Principal Business Location Description of the Subject Interest Purpose and Intended Use of the Valuation Date of the Valuation Scope of the Work Product Summary Assignment Definition Table The As-Of Date of the Appraisal and the Date of the Appraisal Report—Added Thoughts and Perspective Conclusion
13 15 15 16 • 18 19 19 20 21 23 24 26 26 28
vu
Contents
VU1
CHAPTER 3
CHAPTER 4
CHAPTER 5
CHAPTER 6
Information Collection and D u e Diligence
29
Importance of the Information Collection and Due Diligence Phase Industry and Economic Considerations Financial Information and Analysis The Management Interview Preparation Agenda of a Typical Management Interview Conclusion
29 30 31 35 37 38 40
An Overview of Valuation Approaches
41
Recognized Valuation Approaches Methodology and Level of Value, Direct and Indirect Methodology
41
Valuation Approaches: The Cost Approach
47
The Cost Approach Typical Adjustments in the Cost Approach (Using Tangible Net Asset Value Methods) To Tax Affect or Not
47
The Income Approach to Value
59
Direct Capitalization and Discrete Projection Methods Reconciliation of Income Methods to Market Methods Typical Adjustments to the Income Statement Adjustments That Correspond to Balance Sheet Treatments Reconciling or Reclassifying Interim-Period Measures to Fiscal-Period Measures Income Statement Adjustments and Considerations Matching the Cost of Capital to the Benefit Stream Developing the Cost of Capital Summary Examples of Developing the Cost of Equity Capital Growth Rate of Earnings/Net Cash Flow Finishing the Direct Capitalization Equation Developing the Single-Period Benefit (Ongoing Earnings and Ongoing Net Cash Flow) and Preparation for the Discounted Future Benefits Method Example of a Single-Period Capitalization to Derive the Market Value of Total Invested Capital The Discounted Future Benefits Method (DFB) Conclusion
60 61 62
42
53 54
63 63 65 69 70 74 77 83 84 86 88 93
Contents
CHAPTER 7
IX
The Market Approach
95
Valuation Methods under the Market Approach Rules of Thumb Transactions Method Guideline Public Company Method The Fundamental Adjustment Guideline Transactions Method
96 97 98 99 105 110
Correlation of Value
113
Global Considerations in the Correlation Process Examples of Correlating a Value Indication Conclusion
113 118 124
Valuation Discounts and Premiums
125
The Levels of Value Revisited Perspective on the Control Premium Control Premiums—Substance Over Form Perspective on the Minority Interest Discount Marketability Discounts Conclusion
125 127 129 130 132 133
PART II
BUSINESS VALUATION STANDARDS
135
CHAPTER 10
Uniform Standards of Professional Appraisal Practice (USPAP)
137
Overview of USPAP Valuation Standards . USPAP Ethics Rule 2010-11 USPAP Competency Rule 2010-11 USPAP Scope of Work Rule 2010-11 USPAP Jurisdictional Exception Rule USPAP Business Appraisal Review (USPAP Standard 3) Business Appraisal Development: USPAP Standard 9 Business Appraisal Report Standards USPAP Standard 10 USPAP Certification Requirement USPAP Statements on Appraisal Standards and Advisory Opinions
138 139 140 141 142 142 146 148 149 150
American Society of Appraisers (ASA) Business Valuation Standards
153
CHAPTER 8
CHAPTER 9
CHAPTER 11
ASA BVS General Preamble ASA BVS-I (General Requirements for Developing a Business Valuation) ASA BVS-II (Financial Statement Adjustments) ASA BVS-III (Asset-Based Approach to Business Valuation) ASA BVS-IV (Income Approach to Business Valuation)
153 154 156 156 157
Contents
ASA BVS-V (Market Approach to Business Valuation) ASA BVS-VI (Reaching a Conclusion of Value) ASA BVS-VII (Valuation Discounts and Premiums) ASA BVS-VIII (Comprehensive Written Business Valuation Report) ASA BVS-IX (Intangible Asset Valuation) ASA SBVS-1 (Guideline Public Company Method) ASA SBVS-2 (Merger and Acquisition Method) PG-1 (Litigation Support: Role of the I n d e p e n d e n t Financial Expert) PG-2 (Valuation of Partial Ownership Interests) CHAPTER 12
CHAPTER 13
CHAPTER 14
CHAPTER 15
158 159 159 160 161 161 162 163 163
The American Institute of Certified Public Accountants (AICPA) Statement o n Standards for Valuation Services
165
Introduction and Scope Overall Engagement Considerations Development Valuation Approaches a n d Methods Detailed Report Summary Report Calculation Report Oral Report
165 165 168 170 176 180 181 181
National Association of Certified Valuation Analysts (NACVA) Professional Standards
183
Preamble—General and Ethical Standards Valuation Services ' Development Standards Reporting Standards Miscellany
183 184 184 185 186
The Institute of Business Appraisers (IBA) Business Appraisal Standards
187
Standard One: Professional Conduct and Ethics Standard Two: Oral Appraisal Reports Standard Three: Expert Testimony Standard Four: Letter Form Written Appraisal Reports Standard Five: Formal Written Appraisal Reports Preliminary Reports
187 190 190 191 192 193
Canadian Institute of Chartered Business Valuators Practice Standards
195
Practice Standard 110—Valuation Reports Practice Standard 120—Scope of Work Practice Standard 130—File Documentation
195 198 200
Contents
Practice Standard 210—Advisory Reports Practice Standard 220—Scope of Work for Advisory Reports Practice Standard 230—File Documentation for Advisory Reports Practice Standard 310—Expert Reports Practice Standard 320—Scope of Work for Expert Reports Practice Standard 330—File Documentation Standards in Expert Reports Practice Standard 410—Limited Critique Reports Practice Standard 420—Scope of Work for Limited Critique Reports Practice Standard 430—File Documentation Standards for Limited Critique Reports Practice Bulletins CHAPTER 16
201 202 202 202 204 205 207 209 210 210
Internal Revenue Service (IRS) Business Valuation Standards
215
IRM A AS A.I—Introduction IRM 4.48.2—Development Guidelines IRM 4.48.4.3—Resolution Guidelines IRM 4.48.4.4—Reporting Guidelines Addendum A USPAP 3 Comparison Chart Addendum B USPAP 9 Comparison Chart
215 215 218 218 219 220
PART III
LESSONS FROM THE TRENCHES
221
CHAPTER 17
Alleged Errors of Omission by Appraisers
223
Failure to Comply with USPAP Valuation Credentials • Too Much Involvement by Counsel in the Appraisal Report Preparation Standard of Value Valuation Date The Subject Property Interest Bias Sources of Data Independence Pure Reliance on Case Law Site Visits and Management Interviews Failure to Provide Sufficient Explanation Disregard of Material Facts Failure to Find Available Information Failure to Adequately Support Selection of Beta Improper Sampling Techniques Off Financial Statement Items
Failure to Sufficiently Explain Assumptions Insufficient D u e Diligence Failure to Make Inquiries with Significant Third Parties Failure to List All Appraisers' Qualifications Failure to Consider the Small-Stock Premium Failure to Factor in Income Tax Failure to Set Forth the Adjustments to Financial Statements in the Appraisal Report Failure to Produce a Replicatable Report Failure to Identify the Multiples Selected Failure to Discuss Weightings in the Appraisal Report Failure to Distinguish b e t w e e n Tax and Book Depreciation Failure to List Guideline Companies Failing to Separate Operating and Nonoperating Aspects of a Company Failing to Lay Foundation for Small Stock Premium Failing to Justify Capitalization or Discount Rates Failure to Think Like an Investor Failure to Define Capital Structure Failure to Adequately Consider the "Willing Buyer" Failure to Adequately Consider the Willing Seller Failure to Accurately Describe the Subject Property Failure to Properly Classify the Subject Company Failure to Explain the Basis for a Valuation Discount Failure to Properly Consider the Subject Company's Growth Rate Failure to Explain Market Multiples Selected for Guideline Companies Failure to Explain Equal Weighting of Conclusions of Value Failure to Consider Differences b e t w e e n the Subject Company and the Guideline Companies Failure to Utilize Data from a Guideline Company That the Appraiser's O w n Summary Chart Reflects Is Closest to the Subject Company Failure to Explain the Selection of the Range of Performance Ratios Selected • Failure to Adequately Explain Why Companies Selected as Guideline Companies Are in Fact Comparable to the Subject Company Failure to Explain Why So Few Comparable Properties or Guideline Companies Were Selected CHAPTER 18
Retrospective Appraisals Use of Past Publications of an Appraiser against the Appraiser Using Untested Methodology Improper Reliance on a Draft Appraisal
249 250 250 251
Contents
xiii
Conclusion of Value Offends Common Sense Mathematical Errors Inconsistency Double Counting Conflicting Conclusions of Value Sole Reliance o n a Valuation Model Incorrect Usage of Discounted Cash Flow Method Skewed Assumptions Overemphasis o n Buy-Sell Restrictions a m o n g Related Parties Using Historic Book Value of Assets in Net Asset Value Approach, Even Though Asset Appraisals Had Been Obtained Misapplication of Pre- and Post-Tax Figures Ignoring the Hypothetical Nature of the Willing Buyer or Willing Seller Inconsistent Use of Commercially Available Data Use of Commercially Available Data That Warns of Statistical Inaccuracy Misstatement of Methodology Employed by Appraisers on Whose Work the Appraiser Has Relied Undue Reliance on the Work of Another Appraiser Using a Valuation Method without Laying a Foundation That It Is a Legitimate Method (for Example, the Business Broker Method Using Data from the IBA Market Database) Improper Reliance on a Study That Does Not Completely Provide All Relevant Data Failure to Apply Discussion of Economic Factors to the Subject Company . ' Using Commercially Available Data in a Manner Contrary to H o w the Data Source Says the Data Should Be Used Failure to Proofread Report Prior to Issuance Apparently Conflicting Assumptions Used for the Same General Purposes without Sufficient Explanation Use of Different Valuation Methods in Valuing the Same Interest in Valuation Reports Offered at Different Times without Adequate Explanation Making Improper Adjustments to Financial Statements Reliance o n the Pre-IPO Studies and the Restricted Stock Studies to Determine the Discount for Lack of Marketability for a Controlling Interest Misreading or Failing to Properly Consider Revenue Ruling 59-60 Failure to Accurately State the Number of Shares Outstanding in the Subject Company Inconsistency in Valuation Methodology Expressed in Testimony versus the Appraiser's Methodology as Expressed in another Writing
251 252 253 253 254 254 256 256 256
257 257 257 258 258 259 259
259 260 260 261 26l 261
262 262
263 263 264
264
xiv
Contents
Unreasonably Low Projections Failure to Add Back Depreciation Included in Costs-of-Goods-Sold Computation in the Computation of EBDIT Combining the Discount for Lack of Control with the Discount for Lack of Marketability Utilizing an Assumed Income Tax Rate That Differed from the Actual Past Tax Rates of the Subject Company Disconnect b e t w e e n Assumption about W h e n Revenues or Expenses Would Be Received or Incurred and W h e n Those Items Were Actually Received or Incurred Error in Computing Terminal Value When Using the Income Approach Discounting an Income Stream Only at or Close to the Risk-Free Rate Modifying or Abandoning Positions Taken in the Written Appraisal Report during the Appraiser's Testimony Referring to a Standard Industrial Code in the Appraisal Report without Identifying That Number in the Report Relying u p o n Guideline Companies That Were Not Comparable to the Subject Company Preparing and Utilizing Earnings Projections That Vary Significantly from the Earnings Projections Prepared by the Subject Company Use of Only O n e Year's Worth of Guideline Company Data , Inappropriate Employment of a Discount to Make a Conclusion of O n e Valuation Approach Appear More in Line with Another Failing to Properly Calculate a Valuation Discount Inappropriate Use of a Price-to-Asset Multiple Where the Difference b e t w e e n Book Value and Asset Fair Market Value Is Not Close Selection of Too Few Guideline Companies or Comparable Properties Selection of Too Few Performance Measures in the Guideline Company Method Cherry Picking Valuation Multiples Using an Inexcusably Old Comparable Sale Inappropriate Reliance o n Governance Document Restrictions in Establishment of Valuation Multiples Stating the Wrong Date from a Comparable Sale Mismatching the Valuation Dates of the Guideline Companies and the Subject Company in Computing Price Multiples Defining "Guideline C o m p a n y " Too Narrowly
264
264 264 265
265 265 266 266 267 267
268 269
269 269
270 270 270 271 271 272 272
272 273
Contents
CHAPTER 19
xv Ten Burning Issues within the Appraisal Profession Issue 1: Methods of Determining the Discount for Lack of Marketability Issue 2: Applicability of Discount for Lack of Marketability to a Controlling Interest Issue 3: Validity of Discount for Imbedded Capital Gains Issue 4: Shift of "Comparability" from the Publicly Traded Arena to the Private Arena Issue 5: Efficient Market Hypothesis and Exceptions (For Example, Small-Firm Effect) Issue 6: Value of Control versus Value of Synergy Issue 7: Do Public Company Stock Prices Indicate a Marketable, Minority or a Marketable, Control Position? Issue 8: S Corporation Tax-Affecting Issue 9: Factoring Financial Statement Adjustments When Estimating the Value of a Noncontrolling Interest Issue 10: Validity of the Capital Asset Pricing Model for Valuing Interests in Closely Held Businesses Conclusion
CHAPTER 20
275 276 286 288 289 290 291 298 299 301 301 303
Random Practical Valuation Tips and Thoughts
305
Discovery and Privileges Attorney-Client Privilege Attorney Work Product Privilege Tax Practitioner Privilege A Free Standing, Complete Report, or a-Mere Letter or Restricted Use Appraisal Report? Those Business Appraisers Must Be Identified in Time Should a Business Appraiser Always Follow USPAP? How Much Input Can a Client's Advisor Have in the Preparation of a Business Appraisal Report? Types of Appraisers; Appraisal Associations Random Strategy Tips
305 307 308 309
APPENDIX A
Appraisal Standards Chart
321
APPENDIX B
Information Request List
325
APPENDIX C
Management Interview Checklist
327
APPENDIX D
Sample Engagement Letter
329
309 311 311 312 312 315
xvi
Contents
Glossary
335
Bibliography
343 Business Valuation Texts Business Valuation Journals and Newsletters Cost of Capital Equity Risk Premiums Articles
