Identifying and avoiding business valuation pitfalls

Do-it-yourself business valuations and the use of unqualified financial experts can increase the odds of making an error, misstatement or erroneous deviation from customary valuation practice. These faux pas could trigger (or worsen) an IRS inquiry or perhaps lead to an embarrassing courtroom mishap. Here are three common valuation pitfalls that qualified valuation professionals are specifically trained to avoid.

1. Outdated data

Business valuations are contingent on the subject company’s financial health, industry trends and general economic conditions on the valuation date. Like the balance sheet, they’re valid as of a specific point in time. As conditions change, a company’s value may change.

To illustrate: Consider the novice appraiser who valued an event planning company using comparable data from the last 20 years. In the wake of the COVID-19 pandemic and with the advent of online vacation rental platforms, the industry has changed significantly over the last two decades, leaving many older comparables irrelevant.

Similarly, in compliance with IRS Revenue Ruling 59-60, valuators customarily review the subject company’s financial performance over the last five years. If the business discontinued a product line or lost a key person in the last year, the company’s historic data may not accurately indicate its future performance.

1. Overlooked adjustments

The subject company’s financial statements may need to be adjusted to reflect industry norms, arm’s length transactions and unrecorded items. Appropriate adjustments vary from one valuation to the next but often include:

• Related-party expenses (such as rent or interest income from family member loans),
• Unusual or nonrecurring expenses (such as a change in accounting method or a gain from the sale of equipment),
• Income and expenses related to nonoperating assets (such as art, unexploited patents, real estate or surplus working capital), and
• Valuation discounts and premiums (such as discounts for lack of marketability and control, key person discounts and swing vote premiums).

The need to make these kinds of adjustments varies based on case facts. However, overlooking any of these adjustments (or other appropriate ones) can leave a valuation report with critical flaws.

1. Incomplete valuation procedures

When impractical in adversarial situations or when resources are limited, valuators sometimes omit certain routine procedures. For example, in a divorce case, a spouse who owns a business may refuse to permit the opposing expert to conduct a routine site visit or management interview. Alternatively, some clients specifically ask for the company’s value exclusively using a discounted cash flow analysis or an analysis of comparable private transactions.

Although it may suggest slipshod work, the omission of a step in the valuation process isn’t necessarily an error. However, the valuator should clearly disclose the omission as a caveat to the value estimate.

Exposing mistakes

When you receive a valuation commissioned by another party, such as in litigation or a divorce, consider the expert’s qualifications and look for these valuation pitfalls. But reviewing a valuation report can be a daunting task. For a more complete assessment of a questionable report, contact us to prepare an independent review or a rebuttal report.

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