Chapter 24 Questions to Ask Business Valuation Experts Summary Qualifications Financial Statement Adjustments and Analysis Economic and Industry Data Site Visits and Interviews General Questions about Methodology Discount and Capitalization Rates in the Income Approach Projections Used in the Income Approach The Market Approach Asset-Based Approach Entity-Level Discounts Minority Interest Discounts/Control Premiums Discounts for Lack of Marketability Voting/Nonvoting Stock Questions about Contradictory Prior Testimony SUMMARY This chapter consists of a partial list of questions that are useful to ask potential valuation ex- perts. The questions are applicable in all types of valuation cases including family law, state dissenting stockholder or minority oppression actions, bankruptcy cases, ad valorem cases, and tax cases, regardless of the standard of value. QUALIFICATIONS Are you employed? Where? Please describe your employment history. Please describe your educational background. Did your work experience allow you to get involved in ____________? Did you have occasion to focus on ____________? 400 Since you began your career, what work have you done in the area of ____________? Do you have a copy of your curriculum vitae? Please describe any articles you published. Have you ever been recognized as an expert in any court on the subject of ____________? Have you previously authored articles, presented opinions in any form, or offered any tes- timony that is contrary to the opinion you intend to give here? What professional designations do you hold that relate to business valuation? American Society of Appraisers ❐ FASA ❐ ASA ❐ AM Institute of Business Appraisers ❐ MCBA ❐ CBA ❐ BVAL American Institute of Certified Public Accountants ❐ ABV National Association of Certified Valuation Analysts ❐ CVA ❐ GVA CFA Institute ❐ CFA The Canadian Institute of Chartered Business Valuators ❐ FCBV ❐ CBV What percentage of your time do you spend doing business valuations? If less than 100 percent, what do you do with the rest of your time? Qualifications 401 FINANCIAL STATEMENT ADJUSTMENTS AND ANALYSIS What adjustments to the subject company’s financial statements did you make? For each adjustment, why did you make it and how did you arrive at the amount? Were there any adjustments you considered making, but didn’t? If so, why not? If you used the market approach, what adjustments did you make to the guideline com- pany financial statements? (If none, why not? Analysts should be able to say that they have reviewed guideline company statements and determined that no adjustments were necessary.) ECONOMIC AND INDUSTRY DATA Many valuation reports have lengthy economic and industry analysis sections, but no dis- cussion of their impact on value. The questions should establish the connection between conditions external to the company and the conclusion of value. They should also reveal in- consistencies, if any. What industry sources did you use? How specifically did the data in the industry sources impact your conclusion of value? What economic information sources did you use? How, specifically, did your economic analysis impact your conclusion of value? SITE VISITS AND INTERVIEWS What did you learn about the subject company on your site visits and interviews? How did what you learned affect your methodology and/or your value conclusion? GENERAL QUESTIONS ABOUT METHODOLOGY For which method(s) did you use the market value of invested capital (MVIC) procedure, and for which did you use the equity procedure? For each, why was that the best procedure to apply in this case? DISCOUNT AND CAPITALIZATION RATES IN THE INCOME APPROACH Note: In the income approach, the capitalization rate is a function of the discount rate. Specif- ically, the capitalization rate is equal to the discount rate, minus the long-term sustainable 402 QUESTIONS TO ASK BUSINESS VALUATION EXPERTS growth rate in the variable being capitalized (net cash flow, net income, pretax earnings, etc.). Therefore, to arrive at a capitalization rate in the income approach the analyst should first de- velop the discount rate applicable to the variable, then estimate the long-term sustainable growth rate for the variable and subtract the estimated long-term growth rate from the dis- count rate. In the market approach and the excess earnings method, capitalization rates are developed differently from those in the income approach. In the market approach, the capitalization rate is the reciprocal of the valuation multiplier for the variable. In the excess earnings method, two capitalization rates are used, one a reasonable return on tangible assets and the other a capitalization rate for the excess earnings, if any. Although developed differently in the vari- ous approaches, a capitalization rate for any given economic variable developed for one ap- proach should be reconcilable with the capitalization rate for the same variable used in the income approach. How did you develop your equity discount rate? Components Source for each component To what income variable is your equity discount rate applicable? How did you develop your weighted average cost of capital? What components did you include in the capital structure? One or more classes of equity One or more classes of debt How did you estimate the cost for each component? Sources Rationale What weight did you assign to each component? How did you arrive at the relative weights? There are two issues here: 1. Market values or book values. They should be at market value. 2. Existing capital structure or proposed capital structure. This is controversial, but usually should be at existing cap structure for minority interests and some industry average for controlling interests, because minority has no power to change the capitalization structure, but controlling interest does. If the capitalization method was used, what growth rate, if any, did you subtract from the discount rate to arrive at the capitalization rate? Discount and Capitalization Rates in the Income Approach 403 How did you arrive at the growth rate that you used? If the discounting method was used, how did you arrive at the terminal value? (market multiples, Gordon Growth Model, liquidation value, etc.) If market multiples were used, what variable did you use a multiple of? Why was that the best variable to use in this case? How did you arrive at the multiples used? If the Gordon Growth Model was used, how did you arrive at the sustainable growth rate following the specific projection period? If liquidation value was used, how did you arrive at the liquidation value? PROJECTIONS USED IN THE INCOME APPROACH What income variable did you use in the numerator of your discounting or capitalization method (net cash flow, net income, etc.)? Why was that the best measure of economic benefits to use in this case? What was the basis for using that (those) amount(s) in the numerator? MARKET APPROACH What methods did you use within the market approach? ❐ Guideline publicly traded method ❐ Guideline transaction (merger & acquisition) method ❐ Prior transactions or offers ❐ Buy/sell agreement ❐ Rules of thumb What population of guideline transactions did you consider? What databases did you use in your search for guideline transactions? What were the criteria (parameters) for selection of guideline companies? How (and why) did you select the variables to be used in the market approach (net cash flow, net income, book value, adjusted book value, etc.)? For each variable, how (and why) did you select the multiple to apply to the subject company? How (and why) did you select the weightings to apply to each variable? 404 QUESTIONS TO ASK BUSINESS VALUATION EXPERTS ASSET-BASED APPROACH What assets did you adjust? Why? Did you tax-affect the adjustments? Why or why not? For each adjustment, what was the basis for the amount of the adjustment? Did you bring any assets onto the balance sheet that were not there before? Why or why not? What was the basis for the amount assigned to each? What liabilities did you adjust? Why? For each liability adjustment, did you tax-affect the adjustment? Why or why not? Did you bring any actual or contingent liabilities onto the balance sheet that were not there before? Why or why not? What was the basis for the amount assigned to each? ENTITY-LEVEL DISCOUNTS If the appraiser applied any of the following discounts: • Key person • Contingent liability • Portfolio (nonhomogeneous assets) • Trapped-in capital gains Why did you apply that particular discount? How did you quantify the amount of the discount? MINORITY INTEREST DISCOUNTS/CONTROL PREMIUMS What data did you rely on to quantify the minority discount or control premium? Why was this data appropriate in this case? How did you quantify the amount of the minority discount/control premium? DISCOUNTS FOR LACK OF MARKETABILITY What data did you rely on to quantify the discount for lack of marketability? ❐ Restricted stock studies or databases (list studies or databases relied on) ❐ Pre-IPO studies or databases (list studies or databases relied on, i.e., Emory, Valu- ation Advisors) ❐ Partnership Profiles (state which issue, and dates of transactions covered) Discounts for Lack of Marketability 405 Did you use averages from the studies or did you select specific transactions that most closely matched your subject? If specific transactions were used, what were the criteria for selection of the transactions? Why were the data on which you relied appropriate for the particular subject? What factors affected the size of the discount? (e.g., risk factors, size of block/expected holding period) VOTING/NONVOTING STOCK If nonvoting stock, what data did you use to quantify the discount from the voting stock? How did you arrive at the amount of the discount? QUESTIONS ABOUT CONTRADICTORY PRIOR TESTIMONY In some cases, the expert may have given prior testimony contradicting the expert’s current litigation position. If so, it would be appropriate to read from the opinion or testimony in the prior case and ask something like, “Did you say this?” 1 406 QUESTIONS TO ASK BUSINESS VALUATION EXPERTS 1 The most comprehensive search of experts’ testimony in business valuation cases is found at BVLibrary.com. Even if the experts are not named in the case opinion, the staff of Business Valuation Resources researches the names of the experts and adds them to the case opinions. Appendix A IRS Business Valuation Guidelines 1 TABLE OF CONTENTS 1.0 Introduction 2.0 Development Guidelines 2.1 Planning 2.2 Identifying 2.3 Analyzing 2.4 Workpapers 2.5 Reviewing 3.0 Resolution Guidelines 3.1 Objective 3.2 Arriving at Conclusions 4.0 Reporting Guidelines 4.1 Overview 4.2 Report Contents 4.3 Statement INTERNAL REVENUE SERVICE BUSINESS VALUATION GUIDELINES 1.0 Introduction The purpose of this document is to provide guidelines applicable to all IRS personnel engaged in valuation practice (herein referred to as “valuators”) relating to the development, resolution and reporting of issues involving business valuations and similar valuation issues. Valuators must be able to reasonably justify any departure from these guidelines. This document incorporates by reference, the ethical and conduct provisions, contained in the office of government ethics (OGE) standards of ethical conduct, applicable to all IRS employees. 407 1 These Guidelines are continually updated. The latest version may be obtained by calling the IRS at (954) 423-7346. 2.0 Development Guidelines 2.1 Planning 2.1.1 Valuators will adequately plan and their managers will supervise the staff in- volved in the valuation process. 2.1.2 Quality planning is a continual process throughout the valuation assignment. 2.2 Identifying 2.2.1 In developing a valuation conclusion, valuators should define the assignment and determine the scope of work necessary by identifying the following: 2.2.1.1 Subject to be valued 2.2.1.2 Interest to be valued 2.2.1.3 Effective date of valuation 2.2.1.4 Purpose of valuation 2.2.1.5 Use of valuation 2.2.1.6 Statement of value 2.2.1.7 Standard and definition of value 2.2.1.8 Assumptions 2.2.1.9 Limiting conditions 2.2.1.10 Scope limitations 2.2.1.11 Restrictions, agreements and other factors that may influence value 2.2.1.12 Sources of information 2.3 Analyzing 2.3.1 In developing a valuation conclusion, valuators should obtain and analyze the relevant information necessary to accomplish the assignment, including: 2.3.1.1 The nature of the business and the history of the enterprise from its inception 2.3.1.2 The economic outlook in general and the condition and outlook of the specific industry in particular 2.3.1.3 The book value of the stock or interest and the financial condition of the business 2.3.1.4 The earning capacity of the company 2.3.1.5 The dividend-paying capacity 2.3.1.6 Whether or not the enterprise has goodwill or other intangible value 2.3.1.7 Sales of the stock or interest and the size of the block of stock to be valued 2.3.1.8 The market price of stocks or interests of corporations or entities engaged in the same or a similar line of business having their stocks or interests actively traded in a free and open market, either on an exchange or over-the-counter 2.3.1.9 Other information deemed to be relevant 2.3.2 The three generally accepted valuation approaches are the asset-based ap- proach, the market approach and the income approach. Consideration should be given to all three approaches. Professional judgment should be used to se- lect the approach(es) ultimately used and the method(s) within such ap- proach(es) that best indicate the value of the business interest. 2.3.3 Historical financial statements should be analyzed and, if necessary, adjusted to reflect the appropriate asset value, income, cash flows and/or benefit 408 APPENDIX A stream, as applicable, to be consistent with the valuation methodologies se- lected by the valuator. 2.3.4 The valuator should select the appropriate benefit stream, such as pre-tax or after-tax income and/or cash flows, and select appropriate discount rates, capitalization rates or multiples consistent with the benefit stream selected within the relevant valuation methodology. 2.3.5 The valuator will determine an appropriate discount and/or capitalization rate after taking into consideration all relevant factors, such as: 2.3.5.1 The nature of the business 2.3.5.2 The risk involved 2.3.5.3 The stability or irregularity of earnings 2.3.5.4 Other relevant factors 2.3.6 As appropriate for the assignment, and if not considered in the process of de- termining and weighing the indications of value provided by other proce- dures, the valuator should separately consider the following factors in reaching a final conclusion of value: 2.3.6.1 Marketability, or lack thereof, considering the nature of the busi- ness, business ownership interest or security, the effect of relevant contractual and legal restrictions, and the condition of the markets 2.3.6.2 Ability of the appraised interest to control the operation, sale, or liquidation of the relevant business 2.3.6.3 Other levels of value considerations (consistent with the standard of value in section 2.2.1.6) such as the impact of strategic or synergis- tic contributions to value 2.3.6.4 Such other factors which, in the opinion of the valuator, are appro- priate for consideration 2.4 Workpapers 2.4.1 Workpapers should document the steps taken, techniques used, and provide the evidence to support the facts and conclusions in the final report. 2.4.2 Valuators will maintain a detailed case activity record (form 9984) which: 2.4.2.1 Identifies actions taken and indicates time charged 2.4.2.2 Identifies contacts including name, phone number, subject, commit- ments, etc. 2.4.2.3 Documents delays in the examination 2.4.3 The case activity record, along with the supporting workpapers, should jus- tify time spent is commensurate with work performed. 2.5 Reviewing 2.5.1 In reviewing a business valuation and reporting the results of that review, a valuator should form an opinion as to the adequacy and appropriateness of the report being reviewed and should clearly disclose the scope of work of the review process undertaken. 2.5.2 In reviewing a business valuation, a valuator should: 2.5.2.1 Identify the taxpayer and intended use of the valuator’s opinions and conclusions, and the purpose of the review assignment 2.5.2.2 Identify the report under review, the property interest being valued, the effective date of the valuation, and the date of the review IRS Business Valuation Guidelines 409 [...]... 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C Industry Valuation Update Volume 2: Eating and Drinking Places Business Valuation Resources, 7412 S.W Beaverton-Hillsdale Hwy, Suite 106 , Portland, OR 97225; ph: 888/BUS-VALU (888/2878258) or 503/291-7963; fax: 800/846-2291 or 503/291-9755; www.BVResources.com Industry Valuation Update Volume 3: Construction Business Valuation Resources, 7412 S.W Beaverton-Hillsdale Hwy, Suite 106 , Portland, OR 97225;... 62 taxpayer’s burden, 55, 59 Business broker method, market approach, 219, 220 Business entities See also specific entities comparison chart, 77 generally, 70–72 Business risk ratio, 165, 166 Business Valuation Guidelines, 398, 399, 407–411 Business valuation reports, 383–399 Business Valuation Standards, 384, 390, 391 Buy-sell agreements market approach, 181, 211, 228–229 and value definitions, 6 BVMarketData,... 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