Appraisals

Summary:

Valuations are vital to a range of business, estate and financial planning
transactions. Buyout agreements rely on valuations – either to establish a
formula, or as the actual means of determining a buyout price. The price for
disability, death, retirement and other buyouts from a closely held business or
professional practice may all be based on different criteria. You can’t make
$12,000 annual gifts of stock in the family widget company to the kiddies and
not value the gift. If your valuation figures are wrong, and no gift tax return
is filed, the statute of limitations for an IRS audit of those amounts never
runs (tolls). The stakes however, can be huge. If you sell 40% of a family real
estate business to a dynasty trust for $20 million and the IRS successfully
challenges that interest as being worth $50 million, you might face a gift and
generation skipping transfer (GST) tax on the $30 million excess. The following
will help guide you through the process of selecting an appraiser, setting the
parameters of the valuation, and getting the end product you need.

SELECTING THE APPRAISER

◙ Do you need a generalist or a specialist? In
medicine, you might have your family practitioner treat an ingrown toenail if
it is not too serious.  If it is
more serious, you should go to a podiatrist.  Definitely don’t have your family practitioner perform brain
surgery!  Generally business
appraisal requires use of a higher level of mathematics and statistics than is
common to accounting.  A valuation
of a very small business that you expect to remain small often can be done most
inexpensively by a CPA who performs business appraisals during his or her slack
season. However, it is impossible to be the best at audit, tax, and business
valuation, or, for that matter, even two out of the three.  The larger the business, the greater is
the consequence of valuation error.
For most midsize and large businesses, the stakes become too high to
trust a valuation to a generalist CPA, and it is important to engage an
appraiser (CPA or otherwise) who is a specialist in business valuation.  ◙  How much experience does the appraiser
have generally? ◙  Are the appraisers credentials sufficient to provide
credibility? ◙   How extensive is the appraiser’s background in
appraising the particular business or asset shouldn’t be relevant as good appraisers
should be able to value any business, but it might impact time or cost.  ◙  Does the appraiser has experience
testifying in court if the matter might be litigated? What is the appraiser’s
track record (an appraiser who has only testified for defendants might be
viewed as biased). ◙   Is the appraiser independent? A CPA must be objective
in the performance of the valuation. AICPA Code of Professional Conduct, Rule
102 . This requires impartiality and being free of both actual and perceived
conflicts of interest. What other relationships does the appraiser have with
the target company? Will these jeopardize independence? How is the appraiser
compensated? The tax laws also include requirements for the appraiser to be
independent. Treas. Reg. Sec. 25.2512-2(f); 25.2512-3.

APPRAISAL ENGAGEMENT

Agreement. A
written engagement letter should be issued identifying the following:  the background of the valuation
assignment, a description of the business, its entity form and state (e.g., a
New Jersey C or S corporation, a Delaware LLC, a New York general or limited
partnership, etc.), a list of the owners and their interests, the business
interest to be valued (e.g., a 30% common stock interest), the services to be
performed (in descending order, the possible services are Complete Appraisal,
Limited Appraisal, or Valuation Calculations), the purpose of the valuation
(transaction, gift tax, estate tax, litigation, etc.), the valuation date (this
is critical, as a valuation is valid only as of a certain date and a limited
time period afterward—generally three months for tax purposes), the standard of
value (e.g., fair market value, fair value, etc.—this is important, as it
determines the valuation premiums and discounts that apply), the level of
documentation (appraisal report or brief letter restricted-use report), timing
of the assignment (deadlines), the client and appraiser’s responsibilities, and
other factors.

Users/Confidentiality.
A list of intended users of the report should be indicated. Should the data and
report be confidential? Who should be privy to the data?. Should your attorney
hire the appraiser to bring the appraiser under the wing of attorney client
privilege? Should confidentiality and non-disclosure agreements be signed?

Scope. ◙  Establish the appraiser’s services. What will and will not be
done. ◙  Is it a “calculation” engagement for which specific
methodologies are agreed to, and which thus has a lower level of analysis and
fewer procedures? Or is a full “valuation” engagement desired? ◙  Are there
any restrictions or limitations (e.g., not to interview certain key employees
when a valuation for purposes of selling the company is undertaken)? How, if at
all, do these restrictions impact the appraisal? ◙  Key assumptions (no environmental violations,
the business will continue to operate as a going concern, etc.). ◙  Are
there restrictions on the use or persons who can access the report?

Value. Beauty is in
the eye of the beholder, and so is value. There are a myriad of ways to define
value. An appropriate definition must be established from the outset. Tax laws
use fair market value. This is defined as the price at which a hypothetical
willing buyer would pay a hypothetical willing seller, when both have knowledge
of all relevant facts and neither is under compulsion to buy or sell. Treas.
Reg. Sec. 20.2031-1(b). If the interest involved is 20% of a family business
that would be subject to a discount for lack of control and marketability.
However, if you’re a 20% partner in an accounting practice you would not want
your interest discounted if you’re disabled. You would want a full payment of
what your 20% interest is worth. If you’re selling your business to a suitor
looking to expand to your unique market niche, a “strategic value”, which may
far exceed “fair market value”.

Data. ◙  Gather
information tailored to the specifics of the asset being valued, and the
purpose for the valuation. ◙  Conduct site visits. ◙  Use
questionnaires and interviews as appropriate. ◙  Collecting financial statements, tax
returns and other reports for the business. ◙  Obtain copies of all key legal
documents: shareholders’ agreement, buyout agreement, insurance policies,
bylaws, certificate of incorporation, key employment agreements,
customer/vendor agreements, etc.

Research. ◙  Identify relevant industry and other data and compare it to
data for the target company. ◙  Identify comparable firms or assets. ◙  Assess
general economic trends. ◙ For closely held
businesses total compensation (salary, bonus, perquisites, etc.) is a critical
issue to address. Identify industry data and/or data from similar types of
businesses as a touchstone to evaluate and adjust figures for the target firm. ◙  Determine rates of return for the industry and comparable
businesses. ◙  Identify industry and comparable capitalization rates. ◙  Identify recent sales of comparable businesses, or market
value of public companies in similar lines of business.

Analysis. ◙  Review
key provisions of the governing documents for the entity to determine if and
how they impact value. ◙  Analyze financial data for 3-5 years or
more, depending on the circumstances. ◙  Adjust income, expenses and other items
to normalize for unusual years or events (e.g. one time events, insurance
recovery, etc.). ◙  Adjust for unreasonable perquisites and inappropriate
personal expenses (travel, entertainment costs, “employment” of family members,
etc.). ◙ Analyze and adjust for related party
transactions, loans (are the terms arm’s length? Do they suggest other issues
that need to be evaluated? Do they identify related parties that affect the
valuation?), etc. ◙  History of the company (review with an emphasis on
identifying trends that affect future prospects, strengths and weaknesses). ◙  Products or services offered (identify industry, and nature
of business). ◙  Nature of the industry (is the subject business a significant
player, or a little fish in a big pond? How competitive? Future prospects for
the industry as a whole will help evaluate prospects for the target company). ◙  Personnel and management (unionized or not, contract
provisions, tenure, depth of management, etc.). ◙ Analysis
of revenues and profits by different product or service categories. Identify
trends or circumstances that might make separate analysis of lines preferable
to aggregate analysis. ◙  Nature and loyalty of customers (size of
average company, dependence on large customers, variation in large customers
over the years, etc.). ◙  Competition (identification, strengths
and weaknesses, impact on future prospects, etc.). ◙  Expenses (e.g., is production at a
maximum unless a new facility is acquired requiring a substantial cost
increase? What costs are fixed versus variable and how does this impact future
prospects?) ◙  Regulatory environment (is the business regulated and how
does that impact the future prospects of the company? Large increases in costs
because of recent regulatory changes will have a very different impact that
regulations serving as a barrier to larger competitors). ◙  Financing and credit sources (What sources of financing does
the business use and how might this impact future growth and costs?). ◙  Other
relevant factors appropriate to the valuation at hand. Every business or assets
has unique nuances. No checklist or flowchart on valuation, and no rule of
thumb, can be more than just a guide. While sometimes rules of thumb (2 x gross
and other formulas, may be useful checks on a valuation, they are no more than
that). Independent and detailed analysis of the financial and non-financial
data, and circumstances, and their impact on value are always essential.
Valuations for tax purposes should include an analysis of the factors in
Revenue Ruling 59-60 (and successor rulings such as Rev. Rul. 68-609). Each of
the factors in this Ruling should be expressly addressed in the report.

Valuation Approaches.
The three most common general valuation approaches are:
◙  Market. This
involves a comparison to similar entities or assets, what would it cost to
acquire the asset. The guideline pubic company method, guideline company transaction
method and the guideline sales of interests in the subject entity method are
commonly used. ◙  Income. This involves estimates the future earning
stream, capitalization of the earnings; etc. What are the expected economic
benefits from owning the asset or business in the future? Another approach
involves calculating an expected value of future earnings for some time period,
and then a present value of the terminal value at that future date. ◙  Asset.
This involves estimating the cost of constructing or replicating the asset or
business interest. Another approach is to adjust each asset and liability of
the business to its current fair market value.

Valuation Methodology.
Evaluate all possible valuation methodologies. Accept, modify or reject each
based on the particular engagement. Value the asset or business based on the
appropriate methodologies. If more than one methodology is applied analyze and
reconcile the findings to arrive at a single conclusion or range as to value.
If different results are weighted, explain the rationale for favoring one
method over another.

Discounts. Should
discounts or premiums be attached to the asset or business interest involved?
These could include: discounts for dependencies (key person, limited vendors,
key client), excessive concentrations, lack of marketability (inability to sell
in a timely manner), lack of control (e.g. for a non-voting equity interest, or
minority non-controlling equity position; inability to pay distributions;
inability to select management). The determination of valuation discounts
should evaluate all relevant factors, which might include: prospects for
growth, degree of control over operations and distributions, restrictions on
transferring equity interests, prospects of the particular business,
expectations for the industry, etc. A premium might be appropriate if, for
example, the asset involved is a block of stock that can be the swing vote in a
fractious business. Is the interest involved that of an assignee or a
substitute member or partner? For tax purposes, Code Section 2703, which
requires that in certain instances restrictions in the governing documents for
the entity must be ignored, should be addressed.

Review. The
preliminary valuation findings should be reviewed with you and all your advisers.

CONCLUSION

Appraisals are an integral
part of estate, financial and business planning. The process is complex, yet
those seeking to obtain values, will be better served by having an
understanding of the process, assumptions and issues involved.