Business valuation experts will usually provide formal written reports that explain how they arrived at their conclusions. Asking seven questions can help you determine whether an expert’s report is comprehensive and on-point.

(1) Did the expert properly define the engagement?

Most valuation reports start with a detailed description of the assignment. Beyond the name of the subject company, the definition includes:

• The size of the interest (the ownership percentage of the number of shares or units),
• Effective date of the valuation,
• Intended uses of the report,
• The standard of value (for example, fair market value, fair value or strategic value), and
• The basis of value (minority vs. controlling basis and marketable vs. nonmarketable basis).

If the expert applied discounts for lack of control or marketability, a substantial section of the report should detail how these discounts were quantified, including any selection criteria and statistical analyses conducted on empirical data.

(2) Did the expert consider all three valuation approaches?

Revenue Ruling 59-60 provides guidance on valuing private businesses that extends beyond valuations prepared for tax purposes. It requires valuators to consider whether three approaches — asset-based (or cost), market and income — apply to the subject company. Valuation reports typically describe all three methods and explain why each is (or isn’t) relevant for the subject company.

(3) Were the company’s financial statements properly adjusted?

Valuators typically base their analyses on the subject company’s financial statements. The numbers may require adjustments for discretionary, unusual, nonrecurring and/or nonoperating items.

For example, some businesses pay shareholder-employees extra salary in lieu of booking dividends (or vice versa). Or a company may own investments that are unrelated to its core business operations. Financial statement adjustments may normalize results to provide insight into the company’s true earnings capacity. But adjustments don’t always apply; rather, they’re a matter of professional judgment.

(4) Did the expert consider alternate sources of valuation evidence?

Business owners and attorneys should disclose other value indicators, such as buy-sell agreements, purchase offers, prior transactions and personal loan applications. These sources may provide sanity checks for a conclusion.

If these indicators conflict with a valuation, the report should explain why. For example, a prior transaction may have occurred too long ago or involved a different basis of value than the current valuation.

(5) Does the report list key assumptions and limiting conditions?

The statement of assumptions and limitations may reveal a report’s Achilles’ heel. Usually an attachment to the main report, this statement may disclose, for instance, potential conflicts of interest or limitations on the data used to prepare the valuation.

For instance, a valuation firm may own a minority interest in the subject company. Or the expert may have relied exclusively on last year’s tax return, without reviewing any other financial data.

(6) Did the expert conduct a site visit?

Site visits enhance a valuator’s understanding of business operations. In addition to interviewing management, it’s important to assess such factors as the condition of fixed assets, workflow, morale, signage, parking and asset security.

Adversarial situations, such as a divorce or shareholder dispute, make site visits harder to schedule. If an expert was unable to conduct a site visit, he or she typically discloses it in the statement of assumptions and limiting conditions.

(7) Is the expert qualified and in compliance with applicable professional standards?

If you engaged the expert, you should have on file a biography, resumé or curriculum vitae detailing the expert’s qualifications, including professional affiliations, professional designations and years of experience. If you’re reading an opposing party’s valuation report, request this information if it’s not already included in an appendix.

(This is Blog Post #1372)