The value of a valuation Featured

8:00pm EDT August 26, 2008

Business owners and executives who do not allot the time and budget for valuations could suffer unexpected consequences, including tax penalties and lack of compliance with financial reporting rules.

“Post Sarbanes-Oxley, auditors are taking fair value measurements and related requirements seriously,” says Donna Beck Smith, who leads the financial advisory services (FAS) practice at Brown Smith Wallace LLC.

But, before enlisting a professional for a valuation, check for certification and, for highly specialized or regulated industries like health care, banking or insurance, be sure the individual is experienced in those fields.

“Valuations require extra training and experience, and it’s risky if you consult with someone who does not have that expertise,” says Brad Pursel, a principal in the FAS practice at Brown Smith Wallace LLC.

Smart Business spoke with Smith and Pursel about how to prepare for a valuation and how to select a reputable appraiser.

When should business owners or executives call on a professional for valuation services?

Closely held businesses cannot easily convert their interests into cash equivalents for gifting to individuals or charitable organizations. A proper valuation establishes the worth of interests so owners can pursue estate tax planning. To comply with tax and financial reporting rules, there are requirements related to the granting of stock-based compensation. Those grants must be at fair value or the recipient and grantor may suffer negative tax consequences. Valuation frequency will depend on how often the company grants equity-based compensation but the valuation must not be more than 12 months prior to the grant date. Additionally, whenever a company makes an acquisition, financial reporting rules require a fair value analysis of assets and liabilities acquired as part of any transaction. Valuations are also necessary when a company owner wants to buy out a partner or invite another individual to take ownership in the company.

How should you prepare for a valuation?

First, a valuation professional will ask for audited financial statements, and if those are not available — which is often the case with smaller, privately held companies — the owner will be asked to supply past tax returns. Owners should prepare to discuss their projections for the future and goals. Where do they see the business going? What are the company’s cash flow drivers? Who is its customer base and supplier base, and who are key industry competitors? Common mistakes business owners make is waiting until the last minute to find a valuation professional and choosing a service provider based on price. In most instances, owners should really plan on a minimum of four weeks for a proper valuation. Six weeks or more is even better. Rather than shopping price, find a professional who is best qualified to work up a valuation that will withstand scrutiny. Getting an inferior product that might be lower-cost can have serious implications down the road if the IRS reviews the valuation and assesses penalties. For valuations necessary for financial reporting purposes, an inferior work product may lead to increased accounting and valuation fees if the company’s auditor finds problems with the methodologies and/or assumptions used by the appraiser.

What due diligence is necessary before performing a fair value measurement?

Start by checking credentials. Valuation experts should have a long history of relevant experience. They must keep abreast of changes in the appraisal and valuation industry, which is ever-changing. Valuation should not be an area of occasional practice. With evolving financial reporting rules, there is a pretty good chance that an accountant moonlighting as an appraiser will overlook details. That said, find out if the person you want to hire for the valuation is a member of the American Institute of Certified Public Accountants, the American Society of Appraisers or the National Association of Certified Valuation Analysts. These organizations require a course of education with written exams, field experience and continuing education to maintain accreditation.

What do business owners need to watch for in the financial reporting world?

There are new standards that will be effective at the end of this year that could have significant implications for companies that make acquisitions and the financial reporting consequences associated with those acquisitions. In the past, companies have not had to value certain contingent considerations that were included in the transaction. If the seller was eligible to receive an earn-out based on post-acquisition performance, in most instances, there was no recognition of the earn-out as of the acquisition date. Going forward, companies must value such contingent considerations of the acquisition date and any changes in value will flow through the income statement. In this situation alone, the scope of valuations will increase.

Also, as baby boomers that are running privately held or family businesses begin to pursue succession planning, there will be greater ownership turnover and, as a result, demand for valuations to ensure fair measurement of company interests. You know the saying about being ‘penny wise and pound foolish’? That applies to valuation. You may be enticed by a low-priced valuation service, but on the back end, after you go through an IRS review, you may rue the day you made the decision to go with a less qualified purveyor.

DONNA BECK SMITH leads the financial advisory services practice at Brown Smith Wallace LLC. BRAD PURSEL is a principal in the FAS practice at Brown Smith Wallace LLC. Reach Smith at DSmith@bswllc.com or (314) 983-1259. Reach Pursel at BPursel@bswllc.com or (314) 983-1344.