Evaluating The Valuators

How to pick an expert to value your closely held business and avoid appraisal problems down the road.

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Finding the right professional to value closely held business may be difficult, but it makes sense, especially if a sale, merger, or acquisition is in the offing. Having a valuation in hand reminds you of assets you may have overlooked or underappraised and provides you with a realistic floor from which to accept or reject offers. As an example, if your company acquired a building in 1972 for $500,000, it could be worth more than $750,000 today.

A valuation also helps those who survive you avoid problems with the Internal Revenue Service. And these are fairly common: In 1981 the IRS audited 18.4% of all estate-tax returns but audited 34.5% of those listing inheritances of $300,000 or more. As Stanley H. Pantowich, a partner in the New York accounting firm of Arthur Young & Co., notes, "That's not huge money anymore."

Having a valuation is important, too, if you are planning to institute a profit-sharing plan or an Employee Stock Ownership Plan (ESOP), Under the federal Employee Retirement Income Security Act, a valuation is required. Also, the IRS annually takes a close look at the value of stock placed in ESOPs, challenging it if it appears too high. "About 10% of our valuations are challenged in some way," says Paul H. Gross, a senior vice-president of the American Appraisal Co., a Milwaukee-based firm specializing in valuing businesses.

Fair or real market value is, by definition, the amount arrived at by a business owner under no compulsion to sell and a buyer free of similar pressure. Included are a company's hard assets (land, buildings, equipment), plus the value of certain intangibles, including a company's good name and its technologies.

Unlike book value, fair market value is not bound to such generally accepted procedures as accelerated depreciation; cost recovery; and last-in, first-out accounting. Fair market value is a realistic appraisal of your company's worth (which is why the courts often choose over book value in disputes between partners or in those involving the IRS).

The first step in valuing your business is to find the right expert. Hiring an outside professional is recommended primarily because your lack of objectivity is likely to affect the accuracy of your assessment. It is also tougher for the IRS to prove that a valuation is self-serving if it is performed by an experienced outsider.

The more remote the connection of the valuator to the company, the sounder and more reliable the IRS will perceive the valuation," observes Leon M. Nad, national director of technical tax services for Price Waterhouse, the Big Eight accounting firm in New York.

To value your business you could choose an insurance appraiser, banker, lawyer, or accountant. You also could employ a valuation professional (they are listed in directories of consultants and appraisers). Valuation experts usually are best, says Richard E. Petersen of SAM Associates Inc., in Chicago, a management consulting firm specializing in valuations of closely held wholesale distribution companies.

In all cases, document the expertise of any prospective appraiser. IRS agents and attorneys are skilled at punching holes in people's credentials, so make sure that the individual you select can back up his work. "Ask your appraiser these quesions," suggests Gross, who is based at American Appraisal's Princeton, N.J., office. "What has been your success in defending your values? Have you ever testified in court? In front of a jury? Where will you be two years from now?"

Checking references is also recommended, as is making sure the person you employ has valued businesses similar to yours and knows federal valuation regulations. One way to find out, says Petersen of SAM Associates, is to ask the valuator about Revenue Ruling 59-60 ("it recites all those factors the IRS believes should be part of a valuation") and Revenue Ruling 68-609 ("the IRS's attempt to reduce the valuation process to a formula").

Seeking a valuator who is a member of the American Society of Appraisers (ASA) is also a good idea. To become a member an individual must pass written and oral tests, have a minimum of two-years' full-time experience as a professional appraiser, and abide by the organization's code of ethics. Distinctions are made by discipline and level of experience: Regular members have worked two to four years as professional appraisers, while senior members have five or more years of experience.

You can obtain the names, addresses, and specialties of all ASA certified members free of charge by writing to the organization (P.O. Box 17265, Washington, DC 20041) and asking for the Directory of Certified Business Valuation Appraisers. A pamphlet, "Information on the Appraisal Profession," is also available free upon request.

Ask your valuator to explain the charges involved -- before the valuation begins. ASA members are prohibited under the organization's code of ethics from charging contingency fees or performing valuations on a percentage basis. Charges are to be levied by the hour, day, or job, and quoted in advance.

The simplest valuation (usually a two-to three-page letter) will cost you upwards of $2,000, while a 30- to 40-page comprehensive report, with graphs and other exhibits included, runs $10,000 to $12,000 or more. As a rule, the bill climbs in proportion to the valuator's time and the length of the final report. "If there is the potential for litigation; with the details of the valuation used in court, as much data as possible should be gathered. That means a complete report," explains John E. Hempstead, president of Hempstead & Co., a valuation firm based in Haddonfield, N.J. "On the other hand, if you have two friendly partners, one who wants to retire and the other who wants to buy him out, a three-page letter will suffice."

What you want for your money is a written document listing your company's tangible and intangible assets. You also want it to describe your company's position in its industry, to state its fair market value, and to explain the basis for the assessment.

The way valuation professionals, bankers, brokers, and accountants arrive at fair market values differs widely, but they all consider trends in a company's earnings. Some methods are specific to industries. Others are peculiar to individual valuators or firms. For example, Pantowich of Arthur Young, and John J. Stockdale, manager of engineering and valuation services for Coopers & Lybrand, in Detroit, like using P/E ratios and discounted cash-flow analysis, a technique popular among MBAs that relies on the notion that the present value of cash flow can be determined by a given discount, such as borrowing costs. Gross of American Appraisal prefers a standard sum-of-assets approach considering both fixed and intangible assets. ("We like to kick the tires," he says.) Petersen of SAM Associates recommends the "triangulation approach."

According to Petersen, the triangulation approach is especially well suited to wholesale distributors, because adjusted net worth is treated equally with the results of other methods. This approach makes use of three factors: adjusted net worth (determined by raising or lowering book value to market levels); the value of intangibles; and average income multiplied by a price/earnings ratio.

Valuations should be reviewed periodically. Some experts recommend performing them as needs arise (the establishment of an ESOP, for example), while others suggest annual assessments. But once your business has been appraised, hold on to the report as a hedge against tax and court challenges. As Gross reports, "We haven't thrown anything away since 1896."

FIVE TIPS ON CHOOSING A VALUATION EXPERT

1. Select someone with documented valuation experience, including a minimum of two years in the field and the references to prove it.

2. Choose an individual who is familar with your industry.

3. Hire a professional who is willing to quote his rates in advance.

4. Pick a person who knows valuation law.

5. Find an expert with experience defending his valuations in court and before Internal Revenue Service agents.