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Valuation Mistakes That Business Owners Need To Avoid
Getting an accurate business valuation is essential whether or not a business owner intends to sell or transfer their company in the upcoming years. A certified specialist’s professional assessment that is founded on precise modeling and reliable data is more likely to yield the business owner the highest possible financial rewards, whether through continued operation or a potential sale. This article looks at nine frequent valuation errors and provides advice for business owners and their advisors on how to deal with the difficulties of owning, selling, or transferring a firm.
Undervaluing an Active Business
A continuing concern value of the business is crucial, even if the owner has no immediate plans to sell or transfer the company. A formal value or appraisal is highly important at this point so the owner is not caught off guard by triggering circumstances. For instance, if there are buyout agreements in place (i.e., a buy-sell agreement), it will be possible to plan ahead and estimate the purchase price as well as develop financial sources (such as insurance). A highly valued firm is also likely to have estate ...
... tax implications, which may necessitate complex estate planning. A current, reliable professional valuation for an established company may also be important for other reasons, such as getting a loan or luring top talent.
Once a company’s value has been established, the owner can concentrate on making value-enhancing changes to the many components of the company, such as the staff, business planning, sales, marketing, legal, and operational factors. These changes might boost a company’s ongoing profitability and probably raise the asking price when the company is sold. Selecting a qualified appraiser with knowledge of value improvement helps speed up this procedure.
Last Minute Valuation
Too many business owners, unfortunately, fail to create a plan for the eventual sale of their firm. The day before the transaction is typically when business owners commission an appraisal. They might not be able to find the greatest expert valuator by doing this. Furthermore, because time is of the importance, a final appraisal generated in a hurry might not meet expectations.
Valuation Done Not by a Qualified Professional
Numerous intricate elements must be taken into account in order to do a proper, accurate business appraisal. Without the assistance of a skilled specialist, there is a much higher chance of errors and inaccuracies. Despite the fact that many business brokers and CPAs provide business valuation services, it’s unlikely that they have the depth of knowledge, experience, or competence of a valuation professional. A number of organizations, such as the ASA (American Society of Appraisers), AICPA (American Institute of CPAs), and NACVA, provide professional certification designations (National Association of Certified Valuators and Analysts).
Furthermore, if a Daubert challenge is used to contest a value in court, it is more likely that the valuation was not created by a competent expert [see Daubert v. Merrell Dow Pharmaceuticals (92-102), 509 U.S. 579 (1993)]. A judge will hold a hearing if a lawyer opposing the valuation submits an application for a Daubert challenge, giving the lawyer the chance to contest the credentials and subject matter expertise of an expert witness. It is much less likely that someone who is not a qualified professional would be able to demonstrate the necessary competence to generate a workable company valuation or to establish that the valuation technique utilized is sound and legitimate in defending the credibility of the expert and the value.
Improper Due Diligence, Insufficient Data Collection, and Insufficient Data Analysis
Common errors in the valuation process include inadequate data collection and analysis as well as improper due diligence. An in-depth knowledge of the business and industry of the company is necessary for doing proper due diligence. The qualified professional conducts interviews with the owners and other important stakeholders, visits the company’s headquarters, and becomes knowledgeable about all pertinent business issues to guarantee the appropriate level of due diligence for the business is being evaluated. Regarding data collection, it is essential that the information used to create computations may always be easily verified from reliable, up-to-date sources. In legal disputes, opposing counsel may more readily contest information that is suspect or out of date.
Errors in Discount/Capitalization Rate Calculation
One of the crucial elements in the income approach to valuation is the discount or capitalization (cap) rate. There are numerous places where discount or cap rate calculations can go wrong.
These rates must be applied to the proper and appropriate benefit streams when they are computed using the build-up method. The estimated equity return of the company is reflected in the capital asset pricing model (CAPM) rates. The results may be skewed if the incorrect beta is used to calculate the discount/cap rate.
For instance, using past industry statistics or an average of the betas of companies that are similar can be misleading because they do not always account for the dynamics of the company.
Failing to Evaluate Risk Unique to the Company
Risk evaluation is a crucial component of every business appraisal. Discount/cap rates that do not take into consideration the unique risk faced by a corporation can produce false results. Each company’s risk profile is influenced by operational and financial aspects of its business, such as the risk associated with key personnel, client concentration, or patent expiration. This risk reveals the distinctive discount/cap rates of a corporation. In addition, an expert valuator’s knowledge and skill are required to assure an accurate estimate of value due to the high degree of subjectivity and nuance involved in determining these rates.
Valuation Approaches and Methods Errors
The income approach, the market approach, and the asset approach are the three main methods of valuation. The IRS ruled that all three methods have to be taken into account when performing a value in Revenue Ruling 59-60.
The goal of a valuation assignment isn’t to average the values from the three different ways; rather, it’s to make sure that a thorough and rigorous process is followed so that each approach is taken into account, compared, and used to guide the final valuation.
The valuator must express clearly how they arrived at a judgment of value when multiple valuation procedures produce varied indications of worth. The weight of each specific signal of worth should be taken into account independently, despite the temptation to weigh the indications equally at times. In Hendrickson Estate v. Commissioner (T.C. Memo 1999-278), the Tax Court condemned the work of a valuator who gave all indications of value equal weight without providing any justification.
Errors in Using the Income Approach Method
When using the income approach to valuation, many mistakes can be made.
Benefit stream mismatch mistakes. So that the proper capitalization rate or discount rate can be used, the right benefit stream needs to be adjusted for capital expenses and working capital.
Errors in calculating the terminal value. Discounted future earnings and capitalization of earnings are the two techniques used in the income approach. The value of the company at the conclusion of the discounted cash flow period is its terminal value, which is represented as a present value. The worth of the business will be greatly inflated if the terminal value is not discounted to the valuation date.
Growth rate factor errors. Many businesses go through growth spurts that are greater than the pace of underlying economic expansion, and capitalization rates—that is, the discount rate minus the long-term growth rate—depend in part on these growth projections. It is important to think carefully before using a growth rate that is much higher than the existing state of the economy because it is unlikely to be maintained for an extended period of time.
Errors in Using the Market Approach Method
Many common mistakes in the market approach to valuation are also caused by the use of inappropriate multiples.
Applying valuation multiples incorrectly. The market approach uses a variety of multiples, including revenue, earnings before interest, taxes, depreciation, and amortization (EBITDA), or earnings, to determine a company’s value. Each multiple has a connection to a certain financial performance indicator.
But the numbers will be incorrect if the incorrect multiple is applied to the incorrect benefit stream or component. For instance, it is inappropriate to multiply net profit by an EBITDA multiple.
Not being aware of business trends. Reference to prior transactions is necessary for a market approach appraisal. However, market variables in a particular business frequently undergo major change quickly. Historical transaction numbers may become erroneous or less relevant as a result of this change.
Merely choose the smallest multiples. A company’s value may look to have been artificially “low-balled” for advantageous tax purposes if only the lowest multiples are used to generate value. This can raise red flags in court.
Errors in Using the Asset Approach Method
It would seem simple to include a company’s operating assets in valuation estimates given that they are required to produce revenues and profits. The company couldn’t run as a going concern without operating assets. Therefore, failing to revalue assets (and liabilities) with respect to an ongoing firm will cause the statistics in the asset approach to valuation to be skewed.
Failing to value non-operating assets once a business has ceased to exist. When a firm is no longer a going concern and its assets are worth more than if the company were valued as an operational corporation, the asset approach is more frequently applied. Many businesses also own highly valuable assets in these circumstances that are not necessary for their operations. Sometimes, these non-operating assets are forgotten. The firm might, for instance, own idle property, access vehicles, or investments in works of art that have no bearing on regular operations. Excluding them from computations can bring down the overall value of the company.
Underestimating intangible assets or overestimating goodwill. A typical error is assuming that an established company has positive goodwill. Business goodwill is only present when a company makes profits that are higher than the fair rate of return on its tangible assets. On the other hand, failing to take into account or individually value the company’s intangible assets, such as created software or patents, will also result in an incorrect valuation.
Ignoring the built-in gains tax. It is possible to make a mistake by failing to take the built-in gains tax into consideration with regard to the appreciating assets of a S corporation (formerly a C corporation) that are still inside the five-year lookback period. The Built-In Gains Tax by Scott B. Johnson, Manatt, acknowledges the economic reality that capital gains taxes are taken into account by both purchasers and sellers when determining the acquisition price of enterprises.
Minority and Marketability Discounts are Subjective
Inability to market (DLOC) and lack of control (DLOC) are two significant valuation reductions (DLOM). DLOM is relevant when there are problems that impair the marketability of the business, and DLOC is applicable when determining the value of an interest owned by a minority owner. The discount and cap rate are altered by DLOC and DLOM depending on the situation. Some valuators base their estimation of valuation discounts on case law rather than data pertinent to a specific assessment. [The Tax Court rejected this strategy in Berg Estate v. Commissioner (T.C. Memo 1991-279) since every case is unique.] Therefore, failing to reconcile discount assessments with external data sources and published research that offer a quantitative reference point is a common error. However, extra attention is required because these figures could have a major impact on the valuation amount.
Presentational Mistakes in Valuation Reports
A full report or a summary report could be used as the final valuation document. Either a calculation or a conclusion assignment is possible. However it is presented, it must have a clear, logical flow and be devoid of grammatical and mathematical errors. Additionally, it must to be cogent and consistent.
All assumptions should be argued and supported, and it is also important to properly describe the methodologies that were both used and rejected in the value computation. The Tax Court reprimanded the appraiser in Bailey Estate v. Commissioner [T.C. Memo 2002-152, 83 TCM 1862 (2002)] for neglecting to do so. This is crucial because lawyers contesting values will highlight errors, omissions, and other faults to cast doubt on the accuracy of the appraisal and the valuator’s qualifications.
It is crucial that readers understand that the valuation analysis is the judgment of the certified professional, not truth, due to the subjectivity of valuations. No matter how “right” the valuation’s conclusion may seem, a court will not accept it in the absence of a thorough and in-depth investigation. The valuation also needs to be repeatable by another valuator who has looked over the pertinent valuation records. The Tax Court made one of the strongest arguments in Winkler Estate v. Commissioner [T.C. Memo 1989-231, 57 TCM 373 (1989)], which is considered to be one of the best cases for a freestanding, thorough appraisal report.
Employing a Valuator Who Isn’t Current
Anyone employed to perform the valuation must be up to date on their knowledge and abilities. The practice of valuing is dynamic and ever-changing. A valuator needs to be informed of any new precedents or regulations that the IRS or courts have issued recently. New risk categories need to be taken into account when valuing assets. For instance, there is a chance that a business’s value could be negatively impacted by cyber-data breaches.
Private company valuations have traditionally used conventional valuation techniques. Since public company valuators have become more creative in their assessments of various firms and industries, new approaches that can be taken into consideration for some private companies have emerged.
Customer-based corporate valuation is one illustration of a cutting-edge valuation technique (CBCV). This appraisal uses a bottom-up approach rather than the conventional top-down approach and takes into account the value of each customer. Businesses with recurring income sources, such as subscription models, can use CBCV. A CBCV valuation could yield a greater valuation of a corporation than more conventional techniques if it is done correctly. A valuator who disregards newer and more cutting-edge techniques risked losing money.
Valuation is Not a One-off Thing
Both art and science are involved in valuing businesses. Credible and accurate values are based on a range of criteria, including historical facts, computations using historical and current data, and subjective assessments. They are not a one-size-fits-all proposition. A qualified specialist with in-depth knowledge of the firm and industry should do the valuation in order to ensure accuracy.
Numerous frequent errors, omissions, and mistakes that are made during the lengthy assessment procedure might cause a final valuation estimate to be erroneous and legally insufficient. It takes careful, extensive thought to select an accredited, knowledgeable, and respected assessment partner when hiring a business valuation consultant.
Avail of Credo’s Business Valuation Services
The most precise appraisals in the market result from our unrivaled global experience in purchasing and selling properties. Gain complete faith in your assessments. Contact Credo now to have a better understanding of our team’s capability to provide accurate and useful valuation guidance.
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