BUSINESS VALUATION SERVICES

By Dan L. Goldwasser

In Brief

Much to Consider

Business valuation services are a viable source of additional revenue for CPA firms. However, CPAs should only accept engagements that involve an acceptable degree of risk, taking into consideration the nature of the business to be valued and the extent and reliability of the information upon which the valuation will be based.

Evaluators should also employ a well-crafted engagement letter to minimize the risk of client litigation and include caveats in the final report that call attention to its limitations.

Finally, CPAs should observe the ethical requirements of the accounting profession in whatever jurisdiction they offer the services.

Seeking to develop additional revenue sources, many accounting firms have begun to offer business valuation services. Not only are CPAs well positioned to make inroads into this largely unregulated niche, but the market is rapidly expanding. Nevertheless, business valuation services carry a substantial liability potential. Accordingly, firms interested in offering business valuation services should carefully consider the liability risks and adopt appropriate loss-prevention measures.

Different Engagement Situations, Different Risks

A wide variety of circumstances require business valuation services, and the risks entailed by each potential engagement differ. The evaluator must consider these risks in determining whether to accept the engagement. Contexts in which business valuation engagements arise and their comparative risks include the following:

Testifying Expert. Litigation often requires expert testimony about the value of a business. Common examples include bankruptcies, divorces, and shareholder appraisal proceedings. Such engagements are relatively free of liability risk for two reasons:

* Contradicting the evaluator's testimony with another expert and discrediting the testimony under cross-examination are the only recourses available to the opposing party.
* In most states, even the evaluator's client may be precluded from asserting a claim against the evaluator under the "testimonial privilege," which protects persons that testify in a judicial proceeding from suit based on that testimony. Courts in some states have held that this privilege also protects the testifying expert against claims of malpractice in preparing the report that formed the basis of the testimony.

Valuation of Estate Assets. When an individual dies owning an interest in a nonpublic business, the decedent's executor is usually required to obtain a new valuation of the business to justify the amount at which the decedent's interest is shown on the estate tax return. Because such a valuation is subject to challenge by the IRS and state taxing authorities, a liability claim by a third party is unlikely. The evaluator might possibly be sued by the estate's executor or heirs for overvaluing the decedent's interest in the business. But that possibility is remote, because the executor normally has an opportunity to voice objections well in advance and to obtain a second opinion.

Valuation of a Business Being Sold. Some business owners will seek a valuation either to satisfy minority owners that the price as negotiated is fair or to support their judgment that the business is fairly valued in the transaction.

Providing a business valuation in these circumstances entails certain risks. For example, if the evaluation proves to be too low (e.g., the purchaser immediately resells the business at a substantial profit), the seller might seek to recover the difference between the "true" value and the original selling price. If the valuation is too high and the client, relying on the valuation, passes up otherwise acceptable offers only to find that comparable offers are no longer available, that client might assert a liability claim against the evaluator. Or, a buyer who overpays due to an inflated valuation might assert a liability claim against the evaluator.

Employee Stock Ownership Plan (ESOP) Valuations. ESOP plans require annual valuations to value the interests of participants that are joining or leaving the plan. These engagements are not particularly risky, because a plan participant is unlikely to challenge the valuation unless there is a substantial interest. A class action is also unlikely unless a large number of participants join or leave the plan in any given year. Finally, because the plan must be revalued each year, the possibility of a serious error becomes less likely.

Buy-Sell Agreements. Often, the owners of small businesses enter into shareholders' (or partnership) agreements with a buy-sell provision pursuant to which a withdrawing owner must sell her interest back to the entity or its remaining owners at a price fixed or determinable under the agreement.

These agreements traditionally call for such sales to take place at book value or book value with certain adjustments. But today many such agreements call for the price to be based on an appraisal of the business. These engagements are extremely high risk because one (or even both) of the parties to the sale is almost certain to disagree with the appraised amount. In addition, the CPA performing the appraisal is likely to have a preexisting relationship with the parties, each of which might claim the CPA had a fiduciary duty, unless that point was clarified to all parties at the time of the engagement.

Finally, the valuation is likely to be at least partly based on projections of the enterprise's future sales or operating results, and the parties to the agreement are almost certain to have significant differences of opinion about the enterprise's future prospects. Because of the high-risk nature of these engagements, they should be undertaken with great caution or even avoided altogether.

Types of Businesses: Some Easier Than Others

Issues to consider before accepting a business valuation engagement include the following:

Type of Industry. Certain industries do not lend themselves to valuations due to factors largely outside the control of the industry participants. For example, the construction industry is prone to periods of feast and famine, depending upon the state of the economy. Similarly, the transportation industry is largely hostage to the price of petroleum and the financial services industry thrives or withers depending on the level of interest rates.

Predicting the future results of operations of companies in these industries is difficult to impossible. Thus, accountants should think carefully before accepting an engagement to value a company in a volatile industry and should only accept engagements relating to companies that have several years' operating results available.

History of the Business. A principal means of valuing a business is to measure the entity's future cash flows. This measurement is extremely difficult for entities with little or no earnings history, even if they are in a stable industry. Equally important, without an earnings history an entity cannot be compared to other companies whose values are evidenced by a market capitalization.

Quality of Management. The quality of management can greatly affect a business's value, as can be seen from the rapid increase in the stock prices of IBM after Louis Gerstner assumed the helm and at AT&T after Michael Armstrong became CEO. Accordingly, establishing an accurate value for a company that has had a recent change in management may be difficult.

Lack of Available Capital. Current capital assets and access to capital resources greatly affect a company's ability to continue or expand its operations. It will be difficult to establish a value if a fair assessment of the entity's access to capital resources cannot be made.

Business Risks. Every business faces different types and levels of risks, including--

* competition,
* technological obsolescence,
* loss of key employees,
* adverse regulatory actions, and
* dependence on major customers and suppliers.

The greater the potential risks faced by a company, the greater the chances that a valuation of the enterprise may prove inaccurate and the greater the liability risks in accepting the engagement.

The Engagement Letter

After determining that a proposed business valuation engagement does not entail unacceptable risk, the CPA should fix the terms of the engagement.

Because the accounting profession has no established standards for performing business valuation services, engagement letters are even more important. The engagement letter is the evaluator's best protection against client lawsuits and deserves considerable effort. A thorough engagement letter for business valuation services will--

* identify the client and the intended purpose and users of the valuation. This will limit the parties that might later bring a claim against the CPA. The more narrowly defined the purpose, scope, and users, the better.
* specify the valuation methodologies to be employed. The engagement letter should also explain common methodologies that will not be used and how that will impact the valuation. For example, if the subject company has no publicly held comparables, the engagement letter should make that point.
* state significant weaknesses of the valuation methodologies employed. For example, the discounted cash flow and economic value-added methods depend greatly upon financial projections and the future cost of capital, both of which are inherently difficult to estimate. Pointing out these weaknesses in the engagement letter properly emphasizes that business valuation is an inexact science.
* list types of information the valuation will use, especially information needed from the client.

In addition, a well-written engagement letter for a business valuation contains the following provisions:

* Limitation on liability,
* Basis of the fees charged,
* Compensation in the event the CPA is required to provide information relating to the engagement, and
* No duty to update the resulting valuation report.

Performing the Engagement

Although CPAs are accustomed to dealing with financial data, compiling and auditing historical financial data is qualitatively different from deriving an economic value for an ongoing enterprise based, at least partly, on expected future performance. Thus, CPAs interested in business valuation services must appreciate that their background does not automatically qualify them for this type of engagement.

In the past, most valuations were based on the company's book value or a multiple of its historical operating results. Business valuations now tend to be based on projected future cash flows, which is in part why Internet companies with no earnings can be accorded such high market capitalizations. CPAs that want to perform business valuation services need to be knowledgeable about modern valuation techniques, such as discounted future cash flows and economic value-added computations, in addition to traditional techniques. As much as possible, an evaluator should employ all applicable techniques, then reconcile and evaluate the results of each methodology.

Just as important, a CPA performing a business valuation must carefully determine and document significant underlying assumptions. In fact, many Federal judges, applying the Daubert doctrine, refuse to admit expert testimony if the evaluator's conclusions are supported, even in part, by untested underlying assumptions. Important examples include the following:

* Projected future revenues of the enterprise--
* projected size of the market serviced by the enterprise, and
* projected market share to be achieved by the enterprise;
* Cost of capital to the enterprise; and
* Selection of comparable companies and how the subject enterprise matches up.

Many of these assumptions, in turn, are based on information supplied by the management of the company being evaluated, such as--

* new products,
* expected growth in target markets,
* relative competitive position,
* means available for financing future growth, and
* prior operating results and the reliability of that data if audited financial statements are not available.

The evaluator should include this information in the workpapers along with representations from the enterprise's management attesting to the information provided.

Writing the Report

Even the most perfectly drafted engagement letter will not protect against claims by third parties. This protection can be achieved only by limiting the dissemination of the valuation report and by including certain caveats that put the reader on notice of the report's limitations and the inherent weaknesses of the evaluation process.

The report should include the following provisions:

* "This report has been prepared solely for [the estate of ------ to facilitate the preparation of estate tax returns] and is not intended for any other purpose."
* "This report has been prepared using multiple valuation methodologies, as business valuation is not an exact science. Accordingly, the valuation amount determined is the approximate amount that a financially motivated buyer is likely to pay for the subject business when neither party is under economic or temporal pressure to conclude the transaction. It should be appreciated that a purchaser in the same or a related business may be willing to pay a greater amount for the subject business owing to the synergies that might be achieved."
* "This report speaks only as of the date of its issuance, as the value of businesses will change as the prevailing economic climate changes. Of particular importance in this regard is the cost of capital, which has an inverse effect on the value of business enterprises. Thus, as the cost of capital increases, the value of businesses decline. Equally important, technological changes may have a great impact on the value of a given business enterprise. Accordingly, this report should not be relied upon as an estimate of value of the subject business as of any other date."
* "This appraisal is based upon the information that has been made available to the undersigned (including projections of future operations and industry changes), which information has been assumed (and not verified) to be materially accurate and complete. To the extent that this assumption may be unwarranted, the resulting appraisal may not be a reasonable estimate of value."

Regulatory and Ethical Considerations

Although no licensing is required for performing business valuations, CPAs that perform these services are subject to legal and ethical rules, which differ from state to state.

Under the laws of many states, business valuation services, if performed by a CPA holding out as a CPA, may be deemed to constitute the practice of accountancy, therefore subjecting the CPA to prohibitions against the use of contingent fee arrangements.

While most states have adopted the less restrictive contingent fee prohibitions of the Uniform Accountancy Act, some states continue to proscribe all uses of contingent fees by CPAs. Even in states that have adopted the Uniform Accountancy Act, the state board of accountancy may view business valuation services as a form of attest engagement subject to the state's prohibition against contingent fees. Therefore, CPAs that perform business valuation services should avoid contingent fee arrangements.

CPAs must also comply with practice and ethical standards promulgated by the AICPA and state CPA societies. Although the AICPA has published no practice standards for the performance of business valuation services, general standards for the performance of all engagements require that work be--

* properly planned and supervised;
* performed by persons with the requisite competence; and
* performed with diligence, objectivity, and integrity.

Under these requirements, the CPA must have a working knowledge of the various business valuation methodologies and approach the engagement in a scientific manner by--

* gathering all relevant facts,
* evaluating those facts by the various valuation methodologies,
* reconciling the results of each methodology based on their respective advantages and disadvantages, and
* recording the efforts in workpapers.

The requirements of objectivity and integrity also mandate that the CPA be free of conflicts of interest and be independent of the parties to the transaction that the business valuation is intended to facilitate. The requirement of independence and proscriptions against conflicts of interest do not mean that the CPA cannot have other dealings with the parties--only that the CPA should have no dealings that might create a fiduciary relationship that would require the CPA to subordinate her own interests to those of the client. If such a relationship exists, the CPA should obtain a letter from the client stating that no such relationship exists with respect to the performance of the subject engagement.

The performance of a business valuation engagement could impair a CPA's independence with respect to various attest engagements, particularly in SEC engagements and engagements in which the valuation becomes part of the client's financial statements. An example would be when a business has been acquired for non-publicly traded securities. Under such circumstances, independence would be deemed impaired for various types of attest engagements. *

Dan L. Goldwasser, Esq., is a partner of Vedder, Price, Kaufman, & Kammholz in New York City.

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