by Maureen M. Rutecki, CPA/ABV/CFF, ASA, MBA Words on Worth, Fall 06, published by CPAmerica Shareholder buyouts occur frequently in closely held businesses because of retirement, death, divorce or disagreement among shareholders. These buyouts can be costly to parties who feel they receive too little or pay too much for the transfer of shares. They can also be costly if the ownership interests transferred are not valued properly, primarily due to the time and expense associated with litigating shareholder disputes or resolving transactions with the Internal Revenue Service. Even when a buy-sell agreement exists, it may be prudent for the shareholders to engage the services of a trained and accredited valuation professional. Valuation professionals help mitigate the risks associated with a shareholder buyout by preparing a sound valuation report that is based on a well-defined assignment, comprehensive data gathering and a thorough analysis of the factors affecting the value of the business.
Defining the assignment
Confusion and misunderstandings arise in shareholder buyouts when the valuation assignment is not carefully defined between the appraiser and the shareholders for whom the valuation is being prepared. The most critical aspects of defining the assignment are choosing the appropriate standard of value and properly addressing the impact to value of control and minority interests. A common standard of value is fair market value, under which a minority interest is valued with the appropriate lack of control and lack of marketability discounts. However, shareholders in a buyout situation may prefer that 100 percent of a company be valued regardless of the ownership interest that will be transferred, since they may be negotiating based on the pro rata value of the entire corporation. Another standard of value used in shareholder buyouts is fair value, which is commonly used in dissenting shareholder valuations and minority oppression cases. Because fair value is a statutory standard defined by state case law, the business appraiser should further clarify in the engagement letter what discounts will or will not be considered in a valuation under the fair value standard.
Gathering the data
After defining the assignment, the business appraiser gathers information on the company being valued, its industry and the economy. As part of the data gathering process, the appraiser interviews management, which may include the shareholders involved in the buyout. Because management or shareholders may have divergent views on the future of the business, the appraiser should corroborate their views with industry and economic research. In addition, the appraiser will determine whether management’s outlook makes sense based on the company’s position within its industry and the market factors that drive the industry.
Analyzing the data
The next step in the appraisal process is for the appraiser to analyze the data gathered and to develop valuation models. The asset approach involves determining a value indication using the value of the assets of the business less the liabilities. Since the net asset value does not include the intangible value of the company, the business appraiser typically would consider the net asset value to be the minimum value for an operating company. The income approach involves determining a value indication using anticipated benefits – commonly cash flows – of a business. The anticipated benefits are usually based either on historical income statements, adjusted to reflect the ongoing earnings of the business, or forecasted income statements. The business appraiser should support adjustments to the historical or forecasted earnings stream with industry research and benchmark information. The appraiser should also review adjustments with management and shareholders, since the adjustments can have a significant impact on value. Market transactions involving either sales of entire businesses or minority interests in their securities can provide objective, empirical data for developing value measures that apply to the valuation. This empirical data is critical in valuations for the purpose of shareholder buyouts, because it provides support for values derived under the income approach.
Even if a shareholder does not agree with the opinion of value, the shareholder is less likely to challenge a comprehensive valuation report by an accredited professional. When the shareholders involved in a transaction understand and agree with the valuation process, they are more likely to negotiate successful transactions and avoid potentially costly and lengthy disputes. Maureen M. Rutecki, CPA/ABV/CFF, ASA, MBA Maureen is a manager in EFPR Group’s Business Valuation, Forensic & Litigation Services Group. Article republished with the permission of CPAmerica.