By Matt H. Connors CPA/ABV, CFE
Questions related to the value of a partial or 100 percent business interest can become central issues of disputes. These questions frequently arise in connection with the value of a privately held business for which no market price is readily available. Identifying an appraiser who is experienced in applying the appropriate methodologies and who delivers a work product that is detailed and thorough can help provide the best result for disputing parties.
Commercial disputes that commonly require a business appraisal include:
- Oppressed or dissenting shareholder
- Economic damages
- Estate or gift tax disputes
- Bankruptcy proceedings
- Condemnation or eminent domain proceedings
The retained expert generally must coordinate closely with counsel to establish a number of relevant factors that impact not only the business value, but the relevance of the resulting opinions to the overall case. Such factors include the appropriate valuation date and the appropriate definition of “value,” known as the standard of value.
The valuation date is the date “as of” which the appraiser estimates value. Economic forces, market forces, business fluctuations, product substitutes, product obsolescence and regulatory considerations are just a few examples of forces that can impact the value of a business over time. Failure to determine the appropriate valuation date or damage date can render an opinion of value less meaningful.
The standard of value defines the type of value being sought. The premise of value defines the circumstances under which the value is sought, such as on a going concern or liquidation basis. The appraiser should discuss with counsel the appropriate standard of value. Standards of value include fair market value, fair value, investment value and intrinsic value.
FAIR MARKET VALUE
Fair market value is the most widely recognized standard. It is defined by the International Glossary of Business Valuation Terms as, “the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.” Fair market value generally requires consideration of valuation adjustments to account for marketability and the level of control.
Other situations call for the fair value standard of value, which is often used in the case of a dissenting or oppressed shareholder. When used in the legal context, appraisers generally consider fair value as it is defined by state statute. When cases arise related to a dissenting or oppressed shareholder, the appraiser should work with counsel to determine the legal precedent which may affect the valuation procedures and adjustments required.
Investment value is most easily distinguished from other standards because it is the value to a particular party as compared to the value to the hypothetical population of willing buyers and sellers used in the fair market value standard.
Finally, the intrinsic value is known to represent the value of a security based on fundamental analysis of expected earnings, dividends, management, capital structure, etc. If the analyst determines that the intrinsic value of the company based on a thorough fundamental analysis is below the market value the analyst suggests selling the stock.
After defining the valuation date, standard and premise of value, the business appraiser will generally consider three valuation approaches: the income approach, the market approach and the net asset approach.
The value of a business enterprise under the income approach is expressed as the present value of future economic benefits. The present value of future benefit streams are arrived at using a discount rate. Therefore, two principal components overarch the income approach: 1) the expected future economic cash flow applicable to the valuation interest and 2) the discount rate appropriate for the measure of income and valuation subject.
The market approach seeks to value a private company based on certain value measures identified in securities of publicly traded companies, transaction data involving other companies or equity transaction data of the subject company itself. Transactional data is used as market representations of prices from which value measures are derived. The appraiser then applies the value measures to the subject company as of the valuation date.
The net asset approach requires the identification and restatement of all company assets and liabilities to fair market value (or other appropriate standard). This approach is based on the principle of substitution of a hypothetical buyer acquiring similar assets under current market terms including the current costs of debt. The net value of the restated assets and liabilities is considered to be the enterprise value.
Identifying the appropriate valuation date, the appropriate standard of value and employing the proper methodologies will help ensure that the business appraiser develops a thorough and defensible valuation opinion that can withstand the scrutiny of litigation.