Skip to content
Picture of Ed Pratesi Managing Director

Ed Pratesi Managing Director

We help business owners with one of the most important decisions they will make – how can I transition my business?

Contact me to learn more on our valuation and transition advisory services.

Top Critical Errors in Business Valuation Reports – Part 1

Facebook
Twitter
LinkedIn

The business valuation profession has any number of controversial issues that perplex not only business appraisers but the users of their reports; including attorneys, business owners and not to be ignored, the Courts.

No matter the purpose of a business appraisal or the venue in which it will be used; fair market value vs. fair value for example; there are “big deal” controversies or what we will label errors that are worth examining further. In this post, we will examine the first 5 of these errors.

Let’s stop for moment and focus on 6 words that describe how a business appraiser should conduct his or her work. The words come from Revenue Ruling 59-60 – so let the words do the work:

“Common Sense, Informal Judgment, and Reasonableness”

Due Care

Factual errors and mistakes, whether unintentional or not, undermine an appraiser’s work product.   Boltar, LLC v. Commissioner decision points directly to an appraiser unwilling to change his opinion on a conservation easement valuation when faced with factual inconsistencies and other problems. Ultimately, both the valuation report and the appraiser’s testimony were thrown out under a Daubert challenge.

Another factor, the overreliance on valuation models and spreadsheet templates has increased the possibility for errors and incorrect calculations.

Trust Me!

The appraiser who states “in my experience” or “in my judgment” that the appropriate adjustment for a marketability discount for example, is asking for trouble if it does not include compelling data and reasoning to support these claims.

The “trust me” or some similar statement of experience/judgment does not gain traction without substance, either in the form of peer reviewed valuation theory, valuation practice, and/or empirical data.

Witness for example, Judge Stan Bernstein’s blistering commentary of an appraiser’s valuation methods in Chartwell Litigation Trust v. Addus Healthcare:

The Court (Eastern District of New York Bankruptcy Court) cannot accept the testimony of an alleged expert in business valuations when he failed to employ the necessary peer-reviewed methods of business valuation, when he based his analysis on inadequate data, and when he thoroughly conflated the discreetly different concepts of gross cash flow and net cash flow from operations.”

This Court declines to find that Mr. Peltz’ thin record is an adequate and reliable substitute for extensive and direct experience in value businesses….

…not only does Mr. Peltz fail to qualify as a business valuation expert, but in performing its gatekeeper role, this Court must also exclude Mr. Peltz’ testimony as unreliable because he did not employ the same level of intellectual rigor that characterizes the practice of an expert in the field of business valuation.”

While the instant case was heard in bankruptcy court, the same standard of performance by an appraiser is necessary in the FMV world and in all other venues.

Ultimately, any appraiser toiling in the mines of FMV must recognize that the resultant opinion of value is of a hypothetical transaction and the opinion may in fact be a mythical expression of value!

Simply stated, a defensible appraisal and opinion of value under Fair Market Value is everything! (See Estate of Hall v. Commissioner).

ROT Did You Say?

Many practitioners, investment bankers and business owners continue the use and abuse of Rules of Thumb (ROT).

While the results from the use of ROT may be somewhat insightful, the multiples are usually simplistically applied. It is important to note for the most part many rules of thumb are determined on an Ex Post Facto basis – after a transaction has occurred.

Rules of thumb are developed based on completed transactions. In many cases the multiple can be one of x times revenue or y times EBITDA, but very importantly ROT multiples do not indicate or provide insights into the terms of sale.

For example, was transaction all cash? Was there a Consulting contract? An Earn-out? Was it an asset purchase? Were specific assets excluded? Without considering or understanding the terms of sale, ROT metrics are just not useful misapplied and lead to incorrect valuation results.

Be wary of ROT!

Failure to Consider Non-Operating or “Excess” Assets

More than once, we have seen very conservatively run businesses carry unusually high amounts of cash relative to their working capital needs or operating cycle. Is the cash excess or necessary for future needs – growth or an acquisition for example?

Other companies may carry excess inventory or extend unusual terms for AR.  To ignore these assets and not question the need for and potential  use of, is a fatal flaw for an appraiser and may under value a subject company.

In some cases, assets such as land for expansion or other non-business-related assets may be present – they need to be valued separately or excluded perhaps in the report depending on the purpose of the valuation.

Failure to Accurately Assess Risk

The determination of the appropriate level of sustainable cash flow is critical in a valuation engagement as indicated above.  Just as critical is a reasoned approach to assessing risk – i.e. the appropriate rate of return required by the marketplace.

How was the discount rate or cap rate determined?  What is the specific company risk factor and how is it captured in the rate of return?  What growth rate is appropriate?  How does it compare to industry rates of return? What are the competitive dynamics at work and how does it impact the subject’s future?

Valuation is a futures-oriented process, the need to assess risk is essential to an opinion of value that is worthy of use no matter the venue.

We have presented above a listing of critical errors that we have encountered over the years in appraisal reports. The list is not all-inclusive but provides an overview of important considerations in the performance of business valuation appraisal.

Stay tuned for part 2 where we will go over the next 5 critical errors in business valuation reports!

Need a Business Appraiser?

You have options when you retain a business appraiser, I would like to be one of them.

The best way to understand my value proposition is to contact me when you have a need for a business valuation. I will give you my best estimate of what is needed, the type of report options you have and a price once I have all the facts needed to provide a quote.

Please contact me if you would like to discuss a client valuation issue.

Book an Appointment with Ed

Call or email me for an initial one hour consult to see if I can help and how we can work together. Phone: 860.558.0453