Two Levels of Appraisal Services: Calculations vs. Valuations

Did you know that business valuators offer two types of appraisal services? Formal valuations are the most common service valuators provide, requiring significant time and in-depth analyses. But sometimes a less formal "calculation" of value will suffice -- just don't expect it to stand up to outside scrutiny. Calculations are only as reliable as the assumptions and scope limitations upon which they are based.

2 Types of Business Valuations

Key Differences

Formal valuations generate an official "conclusion of value" in conformity with the valuator's professional standards. In contrast, calculations provide an "indication of value" based on assumptions and procedures to which the client and the appraiser have agreed.

In addition, one of the most time-consuming -- and costly -- steps in the valuation process is drafting a detailed appraisal report. But a calculation engagement may call for only an abbreviated letter report, numerical exhibits or verbal presentations in lieu of a comprehensive written report.

Situation Dictates Choice

Calculations may suffice when a written report may not be necessary, such as for an owner who's curious about business value for strategic planning or retirement purposes. Calculations also may facilitate settlement talks in shareholder disputes or divorces. Or they might help a client decide whether it's worthwhile to pursue a lawsuit. Before testifying in court or if settlement appears unlikely from the get-go, the appraiser is likely to recommend a formal valuation report, however.

Take note that calculations may raise a red flag when they accompany gift, estate or charitable donation tax forms. Most valuators recommend a formal report that adheres to IRS guidelines for tax purposes and meets the IRS's Adequate Disclosure requirements. A calculation wouldn't meet those requirements, which can have negative consequences in gift tax situations. This is because the written report typically serves as a valuator's direct testimony, should the tax return wind up in front of the U.S. Tax Court.

Narrowing the Engagement

Clients also can save time and money by omitting specific valuation procedures from a calculation engagement. Or they may specifically prescribe a method they deem most appropriate for the calculation's intended use.

To illustrate: Suppose two disputing partners opt for a calculation -- rather than a full-blown valuation report -- to facilitate an out-of-court settlement. They specifically agree to omit the guideline public company method when calculating the value of their small private accounting firm. They also stipulate in advance concerning discounts for lack of marketability and control.

However, again, the cost and time savings may be for naught if the partners don't settle. To withstand courtroom scrutiny, calculations generally must be upgraded to formal valuation engagements. If they're not taken to the next level, an appraiser may refuse to testify in court. Be aware, too, that the appraiser's value conclusion after completing the omitted steps or analyses may differ materially from his or her calculation.

Disclosure Is Key

Some clients have limited access to the subject company's financial data, personnel or facilities. Lack of relevant information can be especially problematic when the client owns a noncontrolling business interest or is a nonmonied spouse in divorce.

But a valuator can perform a calculation without complete access to information. For example, he or she may base the value exclusively on, say, the past two years' tax returns. A calculation also could be performed without interviewing management or conducting site visits. However, all omissions and limitations must be fully disclosed in the calculation letter.

Know the Limits

When an appraiser is engaged to perform a calculation, communication is critical. The engagement letter -- a legal contract between the client and appraiser -- establishes expectations up front. Additionally, valuators specifically list scope limitations in their engagement letters, spreadsheets and written reports.

It's imperative that clients and professional advisors understand the limitations of value calculations. Further, in considering whether a calculation engagement is appropriate, the most important factor is the ultimate use (and users) of the appraisal. In some cases, a value conclusion can differ materially from a value calculation.

When All Is Said and Done

The next time you or a client requires a business appraisal, consider whether performing a calculation might be a better alternative. After all, it might provide the needed results for less expense. Your valuation adviser can help make that determination. Be aware, though, that certain circumstances -- such as gift and estate tax filings or disagreements that are bound for the courtroom -- lend themselves to opting for a formal valuation.

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