Business Value Affected by Purpose of Valuation

By Patrick Braley, CPA

Many assumptions are inherent in performing a valuation. They typically vary with the purpose of the valuation, ranging from conservative to aggressive.Such assumptions also arise from legal precedents, regulations and rulings, and business or marketplace practices.

Assumptions that are purpose-based are different from assumptions that are specific case-based. Thus, one entity, with the same set of facts and assumptions, can be valued at a different amount depending on the purpose of the valuation, which has different assumptions. However, it is important to remember that the value derived, no matter the purpose, must be supportable based upon the facts and circumstances of the case.

Transaction Related

In many cases a valuation is prepared in connection with the purchase or sale of a n operating business. When a business is being put up for sale, the seller places a value on the business. The assumptions of value determined by the seller include the value in the current owners hands as an operating concern, with risks relating to continuity of customer relations, stability and longevity of the earnings stream, and knowledge of the industry.

The buyer may evaluate the usefulness of the business as an addition to current operations, presuming incremental value. Conversely, the buyer may look at the business as a new venture, estimating risk and analyzing uncertainties to determine the future benefits the business can bring .As the negotiations continue, in a free and open market, the buyer and seller attempt to agree on a value and consummate the deal. This becomes the meeting-point for the buyers and the sellers assumptions.

The reporting for this purpose is typically in summary form with the appropriate schedules supporting the analysis and conclusions. However, the users determine how they would like the results communicated in this case.

Financing Related

Another purpose of a valuation is to obtain financing. The lenders valuation presumes projected future cash flow to meet the banks interest and principal payments, and sufficient liquidation value of the related collateral should the deal become a losing proposition. This differs from the assumptions of the seller and buyer, who presume going-concern values and evaluate earnings. They are also different from the actual assumptions used to calculate projected future cash flow.

The reporting for this purpose is typically in summary form with the appropriate schedules supporting the analysis and conclusions. However, the users determine how they would like the results communicated in this case.

Tax Related

Much of the valuations performed stems from the reporting requirements put upon taxpayers by the Internal Revenue Service. The IRS regulations dictate the use of a fair market value standard of value in tax cases. The term fair market value is defined by Internal Revenue Service Revenue Ruling 59-60, 1959-1 C.B. 237, Gift Tax Regulation 25.2512-1 and Estate Tax Regulation 20.2031-1(b) as follows:

The price at which the property would change hands between a willing buyer and a willing seller, neither being under a compulsion to buy or sell and both having reasonable knowledge of relevant facts and the ability to buy or sell. Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.

Tax valuations clearly presume the loss of what may have been a key employee, and that the prospective buyer and seller are hypothetical in nature with no motivation or specific incentive to enter into a transaction as well as the possibility of liquidation of the investment to pay taxes. Valuations for tax purposes typically require a much lengthier and more detailed report to be prepared in connection with the matter than for other purposes.

Tax valuations differ from the previously mentioned valuations as they tend to be hypothetical whereas transaction and financing related valuations deal with actual transactions.The value of an investment included on an estate or gift tax return would in all probability be different from the valuation in an initial public offering registered with the Securities and Exchange Commission. It may be the same company, but it is unlikely to be the same value.

Tax valuations also set their own particular standard, which may be inappropriate for other purposes. This causes problems when a litigator points to a previously determined tax value and attempts to propose comparability for another issue.

The reporting for this purpose is typically in a detailed, formal written report as dictated by the regulation and rulings.

Ownership Related

Valuations between partners/shareholders also have different assumptions. If a buy- sell agreement is designed to penalize a shareholder for termination of ownership or employment, the valuation method would clearly not reflect market value, even though the agreement may refer to the buyout price as being at market value.

For intra-family transfers, book value is often the transfer value, but rarely does book value correspond to value for any other purpose.

At the other end of the spectrum, when the buy-sell agreement is funded with the proceeds of life insurance, the controlling presumption in determining the market value is often the life insurance and estate needs of the owner rather than the value of the company.

The reporting for this purpose is typically in summary form with the appropriate schedules supporting the analysis and conclusions. However, the users determine how they would like the results communicated in this case.

Litigation Related

Lastly, valuations for litigation purposes create a situation where the assumptions a valuator selects may be impacted by the nature of the claim and the legal interpretations by counsel for the side of the litigation being represented.

Valuators can point to many of these examples to substantiate the appropriateness of their opinions. In shareholder disputes, for example, the market value multiple of a multinational, public company may not be representative in determining the value of an entrepreneurial business. In domestic relations matters, the parties involved may not be contemplating a sale, so the tax definition presuming a willing buyer and a willing seller will not apply. In fact, the business owner/spouse really may be an unwilling seller and, at the same time, a particular buyer.

The reporting for this purpose is typically based upon the specific jurisdictional rules that exist for the type of litigation and venue in which the matter is being tried.