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Buy-Sell Agreements Vital in the Age of COVID

A smartly crafted buy-sell agreement can spare you and your business from complications down the road. Photo by Marcelo Dias from Pexels

When a business is owned by more than one person, it’s generally advisable for the owners to enter into a contractual agreement that prescribes what will happen if an owner dies, becomes disabled, retires or otherwise leaves the company.

Some market analysts predict that the COVID-19 crisis may trigger an increase in buyouts. For example, some struggling owners may decide to throw in the towel after months of teetering on the verge of bankruptcy. Or squabbling partners may disagree about the future of the business and decide to part ways.

So, now is a good time for owners to draft or update a buy-sell agreement. Here’s a look at common valuation issues and potential pitfalls to avoid.

Valuation Considerations

“Buy-sells,” as they’re often called, may be standalone agreements or a provision within a broader agreement (such as a partners’ or shareholders’ agreement). To avoid misunderstandings and delays when redeeming a departing owner’s interest, a buy-sell should address the following key elements:

  • Appropriate standard of value (such as fair market value or fair value)
  • Definition of the standard of value
  • List of applicable valuation adjustments and discounts
  • Relevant method of quantifying valuation adjustments and discounts
  • Effective date of the valuation (for example, the year-end nearest the triggering event)
  • Buyout terms (including who will buy the interest and how payments will be made), and
  • Appraisal/redemption deadline (for example, within 30 or 90 days of the triggering event).

The buy-sell should also specify the parties’ preferred method of appraisal. Examples include a fixed price, a prescribed formula or the use of credentialed business valuation professionals.

In some cases, the owners agree to use the company’s CPA firm to perform an independent valuation of the departing owner’s interest. Other buy-sells require two outside appraisals: one for the buyer and another for the seller; the value of the departing owner’s interest is then determined by averaging the results of the two conclusions.

Potential Pitfalls

Ambiguous or outdated buy-sells can cause problems when it’s time for a buyout. For example, an agreement containing undefined valuation terminology — such as “earnings” or “value” — may be subject to different interpretations.

Likewise, the use of a prescribed formula that’s based on a simplistic industry rule of thumb might cause problems when a buyout happens several years after the agreement was executed. Industry and economic conditions may have changed, or the company’s product or service lines might have evolved.

For instance, some companies have pivoted during the COVID-19 crisis to take advantage of new market opportunities, automate certain processes, or minimize face-to-face interactions with customers.

Fixed valuation formulas that were valid before the pandemic may no longer be relevant in the new normal. This underscores the importance of creating a “living” buy-sell that’s reviewed and updated regularly to stay current.

One More Word of Caution

During a buyout, the buyer is typically either the company or the remaining owners. The seller is usually either the departing owner or the departing owner’s heirs. Because the buyer controls how financial results are reported after the seller leaves the business, the seller should be wary of the potential for financial misstatement. Financial statements often are used to value the departing owner’s interest. So, the buyer has an incentive to understate revenue and assets or overstate expenses and liabilities. These manipulations can lower the buyout price, unless adjustments are made to the company’s financial statements.

Outside Expertise

There is no one-size-fits-all buy-sell agreement. The input of a business valuation professional when drafting or updating a buy-sell can help achieve the owners’ buyout objectives and reduce disputes when and if the agreement is triggered. If you have any questions, the professionals at Advent Valuation Advisors are here to help.

For more information on buy-sell agreements, read our previous blog post here.

COVID Poses Challenges in Business Valuation

Determining the effects of the COVID-19 pandemic on the value of a business may involve a high degree of complexity. Photo by Sarah Pflug from Burst

Business valuation is a prophecy of the future. That is, investors typically value a business based on its ability to generate future cash flow. However, with so many uncertainties in the current marketplace, forecasting expected cash flow can be challenging.

Income Approach

Under the income approach, the value of a business interest is a function of two variables:

1. Expected economic benefits, and

2. A discount rate based on the risk of the business.

Economic benefits can take many forms, such as earnings before tax, cash flow available to equity investors and cash flow available to equity and debt investors. Likewise, discount rates can take many forms. Examples include the cost of equity or the weighted average cost of capital (WACC).

Common valuation methods falling under the income approach include:

Capitalization of earnings. Under this method, economic benefits for a representative single period are converted to present value through division by a capitalization rate. The cap rate equals the discount rate minus a long-term sustainable growth rate. This technique — sometimes referred to as the capitalized cash flow (CCF) method — is generally most appropriate for mature businesses with predictable earnings and consistent capital structures. It’s also commonly used to value real estate with a predictable stream of net operating income.

Discounted cash flow (DCF). This method derives value by discounting a series of expected cash flows. The “cash flow” at the end of the forecast period is known as the terminal (or residual) value. Terminal value is typically calculated using the market approach or the capitalization of earnings method. It represents how much the company could be sold for at the end of the forecast period, when the company’s operations have, in theory, stabilized.

DCF models are generally more flexible than the capitalization of earnings method. For example, the DCF method is well-suited for high-growth companies and those that expect to alter their capital structure over the short run.

Adjusting for COVID-19 Impact

During the pandemic, many valuation professionals are using DCF models, rather than the capitalization of earnings method, to better capture temporary changes in the marketplace. In addition to detrimental effects of the pandemic, these temporary changes may include benefits from government loans or grants. The appropriate time frame for a DCF analysis depends on how long the subject company expects its operations to be disrupted. Some experts are using two- or three-year DCF models; others prefer to use a longer time frame.

In addition, it’s important for valuators not to double-count COVID-19-related risk factors in both the company’s expected economic benefits and the discount rate.

Evaluating Inputs

A business valuation is only as reliable as the inputs on which it’s based. Business valuation professionals typically rely on management to prepare forecasts. But, in the COVID-19 era, those estimates may not necessarily be reliable. That’s because managers tend to use the prior year’s results as the starting point for forecasting the current year. Then it’s assumed that revenue, variable expenses and working capital will grow at a moderate rate, while fixed expenses will largely remain constant.

However, these simplistic models may no longer be valid in today’s volatile, evolving marketplace. Many businesses — including resorts and casinos, sports venues, schools and movie theaters — have temporarily shut down or scaled back operations during the pandemic. Others are using new methods of distribution or devising pivot strategies to stay afloat. Examples include doctors and therapists who are providing telehealth services, restaurants and retailers that are offering online ordering, delivery and curbside pick-up, and food-processing facilities that are selling directly to consumers rather than to cruise lines and high-end restaurants.

In addition, cost structures have changed for many types of businesses. For example, most white-collar workers are working from home instead of commuting to offices, people of all ages are converting from in-person to online learning, companies are eliminating nonessential travel, and some organizations have become increasingly reluctant to work with overseas suppliers. In the face of a contentious, divisive presidential election, there is also significant uncertainty about the future of federal tax laws and other government regulations.

Which changes will be temporary, and which will last beyond the COVID-19 crisis? No one has a crystal ball, but it’s likely that some changes — including work-from-home arrangements and other cost-cutting measures — will be part of the new normal. Other aspects of everyday life — such as attending sporting events, going on vacations and dining out — are expected to eventually return to normal. But it’s still unclear how long recovery will take.

So, before discounting expected earnings, it’s important to evaluate whether management’s forecasts seem reasonable. Oversimplified models and unrealistic assumptions can lead to valuation errors.

Outside Expertise

Estimating how much cash flow a business will generate is no easy task in today’s unprecedented conditions. A trained valuation professional is atop the latest trends and economic predictions and can help management create comprehensive forecasts that are supported by market evidence, rather than gut instinct and oversimplified assumptions.

The professionals at Advent Valuation Advisors stand ready to help you understand the implications of the pandemic on the value of your business. For more information, please contact us.

© 2020, Powered by Thomson Reuters Checkpoint 

First Round Goes to Insurers in COVID-19 Court Fight

More than 140 lawsuits have been filed against insurers over claims for business interruptions caused by the COVID-19 pandemic. Photo by Matthew Henry from Burst

An insurer scored a significant win in what is believed to be the first court decision involving a COVID-19-related business interruption claim. 

On July 1, 2020, 30th Circuit Judge Joyce Draganchuk in Ingham County, Michigan, dismissed a lawsuit by the owner of two restaurants in Lansing Michigan, siding with the insurer’s decision to deny a claim for business-interruption coverage because the eateries did not sustain “direct physical loss or damage.”

The decision in Gavrilides Management Company v. Michigan Insurance Co. was previously reported by the National Law Review, among others.  Gavrilides Management sought $650,000 from Michigan Insurance Co. for losses it sustained after Gov. Gretchen Whitmer issued executive orders in March that limited its two restaurants to delivery and take-out orders.

Judge Draganchuck said it is clear from the wording of the insurance policy that only direct physical loss to the properties is covered. She rejected as “simply nonsense” the plaintiff’s claim that the restaurants were damaged “because people were physically restricted from dine-in services.”

“Direct physical loss of or damage to the property has to be something with material existence, something that is tangible, something … that alters the physical integrity of the property. The complaint here does not allege any physical loss of or damage to the property,” the judge said during the July 1 video court session. “The complaint alleges a loss of business due to executive orders shutting down the restaurants for dining … in the restaurant due to the COVID-19 threat, but the complaint also states that, at no time has COVID-19 entered the Soup Spoon or the Bistro through any employee or customer.”

The judge noted that the insurance policy also has a virus and bacteria exclusion, and that loss of access to the premises due to government action is not covered. 

You can watch a recording of the virtual court appearance here.

Testing the Limits of Coverage

Business interruption insurance typically covers the loss of income that a business suffers due to the disaster-related closing of the business and the rebuilding process after a disaster. The COVID-19 pandemic is testing the limits of this coverage and its applicability to unprecedented circumstances.
Countless businesses were forced to close as a result of the COVID-19 pandemic and the ensuing emergency orders. While many businesses have been able to reopen since, often on a limited basis, the losses sustained have been steep and, in many cases, ongoing. 

Several state legislatures, including New York’s, have introduced bills that would require insurers to cover business-interruption losses stemming from COVID-19, even if the policies specifically exclude such coverage. Meanwhile, more than 140 COVID-19-related business interruption cases have been filed in federal courts nationwide, including several filed in U.S. District Court for the Southern District of New York. To read three of the complaints, click on the links below.

Broadway 104, LLC, dba Café Du Soleil, v. Axa Financial, Inc.; XL Insurance America, Inc., No. 1:20-cv-03813, SDNY

Food for Thought Caterers Corp. v. The Hartford Financial Services Group, Inc., and Sentinel Insurance Company, LTD., No. 1:20-cv-03418, SDNY

Gio Pizzeria & Bar Hospitality LLC v. Certain Underwriters at Lloyd’s, London, No. 1:20-cv-03107, SDNY

Advent Valuation Advisors provides a variety of litigation support services, including the assessment of damages from business interruption. For more information on business interruption claims, read our blog posts here and here. If you have any questions, please contact us.

Valuations in Divorce Cases Can be Tricky

Business valuations completed in connection with divorce proceedings can be especially complex. Photo by Kelly Sikkema on Unsplash

The South Carolina State Supreme Court weighed in recently on the long-simmering tension between recognized standards of business valuation and the goal of equity in dividing marital assets in divorce proceedings.

The decision In Clark v Clark (Appellate Case No. 2019-000442), addresses the division of marital assets, specifically the valuation of a minority interest in a family business. The Supreme Court reiterated a lower court’s assertion that the applicability of discounts for lack of control (DLOC) and marketability (DLOM) are to be determined on a case-by-case basis, then affirmed one part of that court’s ruling regarding discounts and reversed another.

The Family Business

George and Patricia Clark were married in 1987. During the marriage, Mr. Clark began working for the family business, Pure Country, a manufacturer of custom tapestry blankets and other items. His father founded the business and eventually transferred his 75 percent interest in it to Mr. Clark. A family court determined at the time that the transfer was a gift, and therefore the interest was not marital property. Mr. Clark purchased the remaining 25 percent of the business from his sister. In 2009, he transferred a 25 percent interest to Mrs. Clark. The related stock agreement limited any subsequent sale of that interest to other shareholders, immediate family members or the business.

In 2012, Mr. Clark filed for divorce. Both spouses hired experts to value Mrs. Clark’s interest in the business. The husband’s expert applied a DLOC and a DLOM. In support of the DLOM, she noted that the sale of interests in privately held companies require more time and resources and involve higher transaction costs than do sales of publicly traded interests. She also considered the restrictive language in the stock agreement from the 2009 transfer.

The wife’s expert applied a smaller DLOM, but later argued that the value should not be discounted at all. He did not apply a DLOC.

The family court found the husband’s expert more credible and agreed with her use of discounts. While it did acknowledge the “debate as to whether … discounts should apply in a divorce setting as the business is actually not being sold,” the court recognized that the valuation standard in such cases is fair market value, which assumes a hypothetical transaction between two willing parties. 

Mrs. Clark appealed the decision to the court of appeals, which agreed that a minority shareholder would not have control over the company and therefore upheld the family court’s decision to apply a DLOC, but reduced the size of the discount. The court of appeals rejected the DLOM, noting the husband did not intend to sell the business and relying on a precedent set in Moore v Moore. “To the extent the marketability discount reflected an anticipated sale, Moore deems it a fiction South Carolina law no longer recognizes.” The court found that because the husband did not plan to sell the business, the restriction on transfers of stock was moot. 

The decision compelled both parties to file appeals to the State Supreme Court.

Split Decision

The husband argued that the court of appeals erred in rejecting the DLOM when each party’s expert had applied one. The wife contended that the DLOM should not be considered because a DLOM accounts for the higher transaction costs inherent in a sale of an interest in a private company, and her husband did not intend to sell.

The Supreme Court affirmed the family court’s decision to apply a DLOM and a DLOC and the appeals court’s decision to reduce the DLOC. The decision states that a party’s interest in a closely held company is valued based on its fair market value, which has been well established as “the amount of money which a purchaser willing but not obligated to buy the property would pay an owner willing but not obligated to sell it, taking into account all uses to which the property is adapted and might in reason be applied.”

That said, the court acknowledges the tension between this principle of valuation and “the desire to fairly and justly apportion marital assets.” The court refuses to draw a bright line on the issue, stating that the applicability of such discounts is to be determined on a case-by-case basis.
The Supreme Court’s decision was not unanimous. Two of the five justices issued a dissenting opinion rejecting the application of either discount, stating that “under certain facts, faithful adherence to the concept of fair market value must yield to reality.”

The decision, while not directly applicable to New York cases, speaks to the complexities involved in divorce-related valuations and the need for valuation professionals to weigh competing considerations. If you have questions regarding the valuation issues in a divorce or another context, Advent’s professionals are here to help.

Read the Decision

You can read the rather colorful decision here:

https://adventvalue.com/wp-content/uploads/2020/06/Op.-27969-George-W-Clark-v.-Patricia-B-Clark.pdf

Changes in Bankuptcy Law a Lifeline for Struggling Businesses

Recent changes to U.S. Bankruptcy Law may provide additional relief for some struggling businesses. Photo by Melinda Gimpel on Unsplash

The novel coronavirus pandemic has caused many businesses to temporarily shut down or scale back operations. Slowly, states are allowing businesses to reopen to the public. But it may be too late for some businesses to bounce back. As a result, the number of businesses filing for bankruptcy is expected to skyrocket this summer.

Two recent changes to the U.S. Bankruptcy Code may provide greater relief for small businesses that seek to use the bankruptcy process to reorganize their finances and continue operating. The Small Business Reorganization Act (SMRA) increases access to Chapter 11 for small businesses. The Coronavirus Aid, Relief, and Economic Security (CARES) Act raises the debt threshold that qualifies for this protection. Here’s what small business owners should know.  

SMRA Basics

Effective on February 19, 2020, the SMRA creates a new subchapter (Subchapter V) of the Bankruptcy Code. To be eligible for relief under Subchapter V, a debtor, whether an entity or an individual, must have total debt not exceeding $2,725,625 (subject to adjustment every three years). The SMRA contains provisions for the following key improvements:

Streamlined reorganizations: The new law will facilitate small business reorganizations by eliminating certain procedural requirements and reducing costs. Significantly, no one except the business debtor will be able to propose a plan of reorganization. Plus, the debtor won’t be required to obtain approval or solicit votes for plan confirmation. Absent a court order, there will be no unsecured creditor committees under the new law. The new law also will require the court to hold a status conference within 60 days of the petition filing, giving the debtor 90 days to file its plan.

New value rule: The law will repeal the requirement that equity holders of the small business debtor must provide “new value” to retain their equity interest without fully paying off creditors. Instead, the plan must be nondiscriminatory and “fair and equitable.” In addition, similar to Chapter 13, the debtor’s entire projected disposable income must be applied to payments or the value of property to be distributed can’t amount to less than the debtor’s projected disposable income.

Trustee appointments: A standing trustee will be appointed to serve as the trustee for the bankruptcy estate. The revised version of Chapter 11 allows the trustee to preside over the reorganization and monitor its progress.

Administrative expense claims: Currently, a debtor must pay, on the effective date of the plan, any administrative expense claims, including claims incurred by the debtor for goods and services after a petition has been filed. Under the new law, a small business debtor is permitted to stretch payment of administrative expense claims over the term of the plan, giving this class of debtors a distinct advantage.

Residential mortgages: The new law eliminates the prohibition against a small business debtor modifying his or her residential mortgages. The debtor has more leeway if the underlying loan wasn’t used to acquire the residence and was used primarily for the debtor’s small business. Otherwise, secured lenders will continue to have the same protections as in other Chapter 11 cases.

Discharges: The new law provides that the court must grant the debtor a discharge after completing payments within the first three years of the plan or a longer period of up to five years established by the judge. The discharge relieves the debtor of personal liability for all debts under the plan except for amounts due after the last payment date and certain nondischargeable debts.

CARES Act Provision

In addition to the improvements under the SMRA, Congress decided to temporarily increase the debt ceiling for eligibility to $7,500,000 from $2,725,625 for new Subchapter V cases filed between March 28, 2020, and March 27, 2021. Thereafter, the debt limit will revert to $2,725,625.This change will make more small businesses eligible for Chapter 11 in the midst of the novel coronavirus crisis. However, the CARES Act permanently eliminates the eligibility to file for Subchapter V relief for any affiliate of a public company.

We Can Help

Businesses contemplating bankruptcy often benefit from the input of an experienced business valuation expert. Specialists with experience in accounting, valuation and mergers and acquisitions can help assess the severity of the financial crisis, determine whether liquidation or reorganization makes sense, and provide financial insight on everything from selling assets to shareholder disputes. Contact one of Advent’s business valuation professionals to facilitate the bankruptcy process and, if possible, get your business back on track.

© 2020, Powered by Thomson Reuters Checkpoint 

Are Your Company’s COVID-19 Losses Covered?

Business interruption insurance may provide some relief to owners forced to close their businesses because of the COVID-19 pandemic. Photo by Alexander Kovacs on Unsplash

The restrictions put in place to stop the spread of COVID-19 – such as limiting crowd size, closing restaurants and bars and canceling sporting events – are critically stressing many businesses.

One possible form of relief to this financial crisis is insurance coverage, including business interruption and contingent business interruption coverage. Business interruption insurance (also known as business income insurance) is a type of insurance that covers the loss of income that a business suffers after a disaster.

The loss of income covered may be due to disaster-related closing of the business facility or the rebuilding process after a disaster. Coverage may include lost revenues, rent or utilities, among other things. A contingent business interruption provision generally provides coverage for a loss of income related to a problem experienced by a supplier or vendor.

However, there are likely some hurdles to obtaining coverage based upon disruption from COVID-19. For example, a typical business interruption provision reads:

“We will pay for the actual loss of business income you sustain due to the necessary suspension of your ‘operations’ during the period of ‘restoration.’ The suspension must be caused by the direct physical loss, damage, or destruction to property. The loss or damage must be caused by or result from a covered cause of loss.” 

A “direct physical loss” has been held to exclude economic losses unaccompanied by a distinct and demonstrable loss of the physical use of the business property. Furthermore, after the SARS epidemic in the early 2000s, insurance companies began to exclude viral outbreaks from typical coverage, though exclusions for losses in connection with viruses may not be ironclad.

Coverage depends on the particular policy, and a policy review may prove useful. Not all insurance policies are identical in the coverage they provide.

You will likely find that more expensive policies often provide better coverage than lower-cost policies. Also, coverage for COVID-19 related losses might be contingent on whether the policy provides business interruption coverage as a basic term of the policy or as an endorsement. An endorsement will often provide broader coverage than the base policy because of the additional premium for the endorsement.

Insurance companies will certainly oppose paying business interruption losses in connection with COVID-19, though with advice from your insurance broker and/or attorney, filing a claim may be a good first step. In addition to filing the claim, Advent believes business owners ought to:

  • Analyze your policy and review the law. Don’t be afraid to consult your company attorney if you have questions. For example, if the policy does not adequately define “physical damage” (which can be required to recover business interruption losses) and that term presents ambiguity in the specific context of your company’s loss, you may be covered. 
  • Make note of virus exclusions. One can imagine this law is undeveloped and there is not clear precedent on coverage. Also, some policies may contain civil authority provisions, which could offer coverage for losses suffered in connection with government-ordered shutdowns.
  • Stay informed regarding legislative developments and any other pertinent changes. Finding every possible basis for recovery under your business’s policy will only enhance any potential recovery.

To learn more about the quantification of lost profits, please contact one of the experienced professionals here at Advent.

The Difference Between Price and Value

Photo by Mackenzie Marco on Unsplash

When a business is sold, it often sells for more (or less) than the appraised value. This may come as a surprise to laypeople, but valuators understand that there are many valid reasons that “price” and “value” may differ. Businesses that understand this subtlety are better positioned to make informed decisions.

Price is specific to an individual buyer and seller. It’s the amount of cash (or its equivalent) for which anything is bought, sold or offered for sale. It requires an offer to sell, an acceptance of that offer and an exchange of money (or other property). Some strategic or financial buyers may be willing to pay more than others because they can benefit from economies of scale or synergies that aren’t available to all potential buyers.

The term “value” often refers to “fair market value” in a business valuation context. The International Glossary of Business Valuation Terms defines fair market value as:

The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms-length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.

Fair market value is essentially a consensus of what the universe of potential buyers would agree to pay for a business, a business interest or an asset. In the real world, sales may occur for more (or less) than fair market value, because the individual parties have their own perceptions of the investment’s risk and return, are under duress to buy (or sell), or lack relevant knowledge about the transaction or the subject company.

Another reason that value and price frequently differ is timing. In many cases, a valuator’s work is done months or years before the company is sold. Differences in market conditions or the company’s financial performance between the two dates could cause the company’s selling price to vary from its appraised value.

Real World Example

To illustrate how price and value may differ, consider the sale of a medical practice. There are primarily three potential buying groups for medical practices:

  • Another physician,
  • A physician group, or
  • A hospital.

To determine fair market value, a valuator would consider potential transactions to purchase the practice by all three of these groups, under the cost, market and income approaches. But in the real world, only one specific buyer would make an offer. So, for example, the analyses involving a physician or physician group wouldn’t be relevant if a hospital is buying the practice.

Price and Value Aren’t Synonymous

It’s critical for buyers and sellers to understand that the appraised value of a business interest may not reflect its future selling price. Value can vary substantially, depending on the effective date and the purpose(s) specified in the appraiser’s report.

When the purpose of a valuation is to establish an asking (or offer) price, valuators may provide a range of values that considers various buyers and transaction scenarios. This range can help a buyer and seller arrive at a reasonable selling price that’s based on the individual parties’ expectations of risk and return.

If you’re planning to buy or sell a business interest, the professionals at Advent Valuation Advisors are here to help.

© 2020, Powered by Thomson Reuters Checkpoint

Understanding the Terms of Engagement

When you need to know how much your business is worth, one of the first questions to ask is, how much work – and how much expense – will it take to get the job done?

In many circumstances, a comprehensive valuation is required or preferred. Sometimes, however, a relatively straightforward, and less costly, calculation of value may be sufficient. The purpose of the valuation will often dictate the scope of work that is appropriate.

Both the American Society of Appraisers (ASA) and the American Institute of Certified Public Accountants (AICPA) have defined the scope of various assignments used to value a business, business ownership interest, security or intangible asset. In its Business Valuation Standards, The American Society of Appraisers (ASA) defines three types of engagements:

  • An appraisal engagement is the most comprehensive. It considers all relevant information as of the appraisal date and results in the expression of an unambiguous opinion of value, which is supported by all procedures the appraiser deems relevant.
  • A limited appraisal engagement is based on consideration of limited relevant information and limited procedures deemed necessary by the appraiser. It results in an estimate of value.
  • In a calculation engagement, the appraiser and the client may agree on the procedure or procedures to be performed. The appraiser collects limited information, performs limited procedures and provides an approximate indication of value.

The American Institute of Certified Public Accountants defines two types of engagements:

  • In a valuation engagement, the valuation analyst applies the approaches he or she deems appropriate. The result is a conclusion of value.
  • In a calculation engagement, the analyst and the client agree ahead of time on the procedures the analyst will perform, and these procedures are generally more limited than in a valuation engagement. The result is a calculation of value.

A full appraisal or valuation engagement will generally result in the production of a comprehensive report that describes in detail the procedures performed, while a calculation may result in an estimate, with limited additional information provided to the client. In any of the engagements described above, the resulting value may be a single amount or a range.

So, how does a business owner determine which type of engagement is appropriate?

The right tool for the job

There are times when a calculation may be sufficient. For instance, a small business owner who receives an offer to sell his or her business may simply want to gauge the fairness of that offer. According to the AICPA’s Statements on Standards, a calculation engagement also may be acceptable when acting as a neutral party in a dispute. For a matter involving the IRS or the Tax Court, a full valuation resulting in an opinion/conclusion of value is generally preferred.

The use of calculations in court matters has become a contentious matter. In a piece in the November 2019 issue of Business Valuation Update, Michael Paschall, an accredited senior appraiser and attorney, criticizes a phenomenon he terms “calculation creep,” the increased use of calculation engagements in litigation settings.

He claims the “incomplete and potentially biased aspects of calculation engagements represent a dumbing down of the valuation process and profession,” and calls on the governing bodies in business valuation to bar calculations for litigation, ESOPs, IRS purposes “or any other context where a reliable opinion of value is needed or third-party reliance is present.”

In Hanley v. Hanley, a case decided in June 2019 in New York State Supreme Court in Albany, the court rejected a value calculation produced by an accountant retained by one of the parties. The decision cites several concerns, including questions about the independence of the valuation professional and the lack of documentation in the valuation report, which did not describe the limited procedures or approaches used in the calculation.

At the end of the day, any valuation is only as credible as the professional who renders it. The judgment of the valuation professional is a key ingredient in every phase of the assignment, from determining the appropriate scope to selecting the best methods, reconciling the results of different procedures and, ultimately, deriving the indicated value.

Advent’s valuation professionals can walk you through the process and help you determine what type of engagement will best meet your goals.