The valuation engagement. (High Net Worth: The Accoutrements of Success) (Cover Story)
Define What Is To Be Valued
One of the least understood facts about the valuation of closely held companies is that a minority interest is rarely worth its pro rata percentage of the value of the total business. The value of a minority even for majority interests. The value of a minority interest should reflect two separate and distinct discounts from the value of a 100% interest--a minority interest discount and a discount for lack of marketability. A majority interest with less than complete control also could have its value affected by discounts resulting from a lack of certain control rights or certain marketability discounts. Therefore, it is important to be clear from the beginning about the interest being valued. Commissioning a valuation of the enterprise and arbitrarily dividing the results into pro rata segments could result in distortions or outright mistakes in interpretation, all with far-reaching consequences.
Define the Purpose of the Valuation
A second significant dimension of business valuation is that the value of a block of closely held stock or an entire business can be different, depending on the purpose of the valuation. This is because the purpose will dictate the premise of value and the valuation method selected; different methods are appropriate for different purposes. For example, the purpose determines to a great extent whether the appraiser will rely more heavily on an analysis of historical financial data or on projections of future operating results. The purpose of the valuation also determines the types and amounts of discounts or premiums applied. Valuations of ESOP stock are a case in point. Because of the unique "put" provision required by Federal law, a minority interest block of ESOP stock tends to be worth more than an indentically sized block of closely held stock valued for other tax purposes because the marketability discount applied to ESOP stock trends to be smaller than the marketability discount applied for non-ESOP purposes.
Select the Data of the Valuation Carefully
There are certain valuation engagements whose valuation date is set by law-for example, an estate tax valuation. However, Federal law permits valuing the assets of the estate on one of two dates, either as of the date of death of six months later.
If a closely held business or block of securities forms a material portion of the estate, and there has been volatility in the stock market or some other material event within the six-month period, valuation of the business or stock on both dates is recommended.
Decide on the Standard of Value
Generally speaking, for tax related matters, the standard of value for closely held corporations is fair market value. For other purposes, such as dissenting shareholder litigation or fairness opinions performed in connection with corporate mergers and acquisitions, the standard of value is fair value. Fair value in this context is defined by appropriate state and case law.
Define the Terms and Conditions of the Engagement
A financial valuation of a corporation should fulfill the business objectives as well as the legal needs of the corporation. Key items that should be discusssed and committed to writing include:
* The Valuation Report. A report may be oral or written, or a combination; the format should be determined at the beginning of the engagement. An oral report can be a brief telephone conversation or a formal presentation before a board of directors. A written report can be a one-page document or an extensive narrative buttressed by charts, graphs, and exhibits. The purpose of the valuation determines the type of report needed. For tax-related engagements, such as ESOPs, estate and gift filings, charitable contributions or recapitalizations, the report should satisfy the requirements of Rev. Rul. 56-60 thoroughly.
* The Schedule. Often, an appraisal is required to meet a looming tax filing deadline, or the services of an appraiser as an expert witness are need on a specific and very close trial date. As a general rule, the appraiser will need six to eight weeks after receipt of the necessary financial information to complete the valuation and prepare a narrative report. If the parameters of the engagement change during the course of the assignment, additional time may be needed.
* The Fee. Common sense suggest that any appraisal fee based partially or solely on a percentage of the value of the property being appraised raises, at best, the appearance of a possible conflict of interests. In fact, IRC Sec. 170 expressly prohibits such arrangements for tax-related valuations, as do the ethical standards of the business valuation industry. The standard fee arrangement in the industry is either a pre-diem rate or a fixed fee per assignment, agreed to at the beginning of the engagement. Naturally, fixed fees may fluctuate subsequently if the nature of the engagement changes during the course of the assignment.
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