Scoping an Engagement: Questions to Consider Before Any Appraisal

Difficulties Sometimes Complicate a Valuation Engagement. Here’s How to Anticipate and Derail Potential Disasters With Solid, Upfront Client Conversations

Conversations with clients, both current and prospective, are critically important to ensure both owner and appraiser are in agreement about what standards will be used to produce the final report, how long the process will take, and what it will ultimately look like and cost.  In the first of a two-part series, Rand Curtiss takes us through a set of questions valuators should ask of clients, as well as some they should expect to be asked themselves.

This article first presents some common and basic questions that we business appraisers should ask and get answered in order to define our engagement. It is followed by “FAQs” (Frequently Asked Questions) that turn the tables on us to ask the right questions. My thanks to the huge number of friends who contributed to this compilation! This list of questions does not supplant those that appear in the literature. Rather, it highlights complexities that arise from time to time and can derail you if you do not handle them at the outset (I confess to have foundered on almost all of them at some point, but only once on each!).

Screw Up These Questions and Founder

1. How will the appraisal be used?  (Note that an anagram of “used” is “sued.”)

Early in my career, a good friend asked me to appraise his business for tax purposes. I did so, but then found out that he was getting divorced (his wife was also a good friend). Trying to be a good Samaritan, I allowed myself to be dragged into court as an unpaid fact (not expert) witness. I was deposed and viciously cross-examined by both attorneys, each of whom attempted to paint me as a hired gun for the other side. The trier of fact accepted my valuation on its merits, but I lost two good friends, a lot of time and money and, temporarily, self-esteem as a result of failing to limit the use of my appraisal solely to tax purposes.  I have learned that, in disputes, no good deed goes unpunished.

2. Is all of the information I need available now?

This covers a multitude of potential challenges, including as-yet incomplete financial statements, fixed asset appraisals (on a premise of value inconsistent with what is needed for the engagement), full disclosure of the circumstances surrounding previous transactions in the subject entity’s securities (Were they at arm’s length? Were other things like covenants not to compete or severance pay involved? Was the price based on an outside appraisal? Was counsel involved?, etc.), and whether I will have access to and cooperation from business principals on the “other side” of the case.

I once encountered the opposite problem―data overload in a corporate damages case. There were boxes and boxes of un-indexed information, and I had to spend hours sifting through all of them to find what I needed.  Fortunately, I was being paid on an hourly basis, but unfortunately, it meant a lot of late nights.

3. Failure to ask catchall questions.

Ask, for example:

1. Can you think of any significant problems, strengths, or areas of the business we have not talked about?
2. Are there any aspects of the business you think I might not properly understand and what are they?  Let’s go over them again.
3. Is there anything else I have not asked about that you think might have a material effect on the valuation?
4. Are you aware of anything coming down the road, such as a change in the industry, a new customer, a buyer for your company, or something else that might be relevant (This gets at the subject of potential events subsequent to the valuation date that might indicate or influence value.)?

4. Missing accounting, reporting, and tax nuances.

Any time you are working with compiled financial statements, there will be a host of questions to ask. Even with reviewed or audited statement footnotes, you may not fully understand deferred taxes, whether lease obligations are capitalized, pension fund accounting, contingent assets or liabilities and how they are disclosed and valued, or industry-specific  practices like contractor (percentage of completion) or automobile dealer (the 13^th month that contains yearend and other adjustments) accounting. If there are fully-depreciated assets still owned by the business, make sure they are valued appropriately.

5. Misunderstood fundamentals.

This covers a host of sins, such as not asking whether the company is in multiple lines of business, has recently added or dropped any, has subsidiaries, provides consolidated as well as consolidating financial statements, whether it is an “S” or “C” corporation (with reference to Gross valuation issues), whether there are agreements concerning the valuation and transfer of shares (buy-sell, articles of incorporation, shareholder agreements…these go by many names), the valuation date (a major headache in many divorce matters), and whether a pass-through entity like a family limited partnership (FLP) owns minority interests in other pass-throughs that might also be valued at discounts. A final challenge is complex capital structures. If there are multiple classes of equity, options or warrants, understand the rights and restrictions of each. If there is debt, what are its covenants (and how might they influence the valuation)?

6. Not identifying the “players.”

Be sure to learn who the client’s attorney, accountant, and other advisors are, discuss the valuation with them, understand and address their concerns. If there are disagreements among them, get them resolved before you issue a draft. If there are other stakeholders (such as heirs), you may want to contact them as well. By doing so, you ask for their advice, and by so doing, anticipate their concerns. Ask up front if the attorney, rather than the client, wants to retain you for purposes of privilege.

7. Missing the value standard.

Every state determines its definition of fair value. Be sure the attorney explains it to you, and keep asking questions if you do not understand. In my experience, every judge has a different understanding of the standard of value in divorce, so pin the attorney down and cite what they tell you to assume in your report.

8. Having a strong basis for adjustments.

Every business has unanticipated expenses every year. By eliminating every individual non­recurring item, you are assuming something contrary to common sense. Look at the historical ratio of non-recurring to recurring expenses, and build in a contingency factor for this in your projections. By the same token, sometimes non-recurring events are so major that, rather than trying to deconstruct their impact, it might be better to simply ignore (give a zero weight) to the affected time period. Yes, the company wrote off $X in 1999 because of the fire, but what about management and staff time devoted to recovery and its impact on profits? You may not be able to quantify this, but you know it had a bigger effect than the non-recurring expenses might indicate.

Frequently Asked Questions 

Selling

1. The business broker told me my company is worth five times earnings.  If   he or she can value it so fast, why should I pay you to do the same thing?

The broker’s opinion may be reasonable, but without knowing the basis for their opinion, I cannot assess that. You are aware, of course, that in taxation and litigation matters, as well as in transactions, the burden is on you to justify your value claim, and the stakes are high. If you wish to proceed without the benefit of a well-researched and documented independent and professional appraisal, the choice and risk are yours.

2. But do you think the broker’s opinion is reliable?

Brokers are in the market daily and can be very knowledgeable about values. But the law requires independent appraisals by qualified third parties. What valuation qualifications and experience does your broker have? May I see their report?

3. My company makes a lot of money that I do not report on my tax return. How will your appraisal reflect that?

It won’t. I decline this engagement. See ya.

 4. I got my house appraised for $300. My accountant will appraise my business for $1000. How can you justify charging me $5,000?

Residential appraisals are facilitated by access to the multiple listing service and public records, neither of which are available for private businesses, so much more work is required. I am sure you are aware of the law, particularly the new Sarbanes-Oxley Act that requires accountants providing valuation services to be qualified and independent and imposes significant non­compliance penalties.  Have you discussed these issues with her?

5. By the way, are you an accountant?

No. Accounting and appraisal skills, although overlapping, are fundamentally different. Accountants are trained to focus on historical information. Appraisers are trained to do that, but also look sideways at comparable businesses in the marketplace and forward at future performance. These are the keys to proper valuations. An accountant is like a baseball scorekeeper, knowledgeable about determining earned run averages (ERAs) and hits versus errors. Appraisers are like scouts, skilled at evaluating players’ abilities to hit, hit for power, field, run, and throw.

6. Just give me a “ballpark estimate” of the value. I won’t hold you to it.

I am sorry, but professional regulations and common sense don’t permit this. Would you trust your doctor to make a snap diagnosis to operate on your heart without careful examination, testing, and analysis? And would you waive your right to claim malpractice against them?

 7. Just give me a “ballpark estimate” of your fee. I won’t hold you to it.

I am sorry, but until I have a better understanding of your situation and needs, I cannot quote a fee that is fair to both of us.  If we could meet or talk for an hour, at no obligation on your part, I will be happy to promptly send a written proposal and fee quote for my services. I will probably be able to give you a better price!

8. I do not know how I am going to use the appraisal: just make it general.

A business can have legitimately different values depending on why and when it is appraised. There is a big difference between valuing it for sale to a strategic buyer and, for example, valuing a minority interest for estate and gift tax purposes (Go on to explain standards and levels of value.). We have to decide on the purpose of the appraisal, because it dictates everything we do.

9. I don’t want a 50-page report: I just need the value. Just write me a one-page letter.

Sure. That is part of my report, a short letter summarizing the value conclusion and its basis. But I still have to do the analysis and write it up in detail to support it. You pay me (the full fee) for the value and the letter; the long report is free!

10. I need the appraisal next week: We are going to court!/have a tax deadline!/am negotiating with a buyer.  Why does it take so long?

I am sorry that you waited until the last minute to contact me. Neither I nor any reputable, competent appraiser can do what you ask in the time allotted. Appraisals are complex projects with high stakes that require significant research, analysis, judgment, and reporting. There will be plenty of time after the fact for others to scrutinize and challenge it. We need to spend the time up front to make it bulletproof. Ask around: You will find my lead time to be competitive or better. You will need to arrange for a trial continuance/tax extension/delay in negotiations (Note: close the door firmly for tax or litigation valuations. Offer limited calculations, if appropriate, to help with negotiations, not a full appraisal.).

11. Can’t you and my spouse’s appraiser get together and work it out?

That may be possible, but the problem is that you are blurring the lines between the job of the appraiser, who has to be independent and unbiased, and your attorney, who is your advocate. Who are the attorneys involved and who is the other appraiser? Will they agree to this (Note: most of the time, they will not, unless coerced by the trier of fact. This also depends on how far apart the two appraisers are, their skills and integrity, and on a number of other factors. You need more information to make this decision: ultimately trust your gut.)?

12. What do you mean, cash or accrual?

Accounts are kept on one of these two general bases. Under the cash system, which is how we run our personal checkbooks, sales are not recorded until payment is received, and expenses are not recorded until checks are written. For example, a pure cash system will not show receivables or payables. Using accruals, which are complicated, accountants match revenues and expenses, benefits and costs based on predetermined rules, not on when cash changes hands.

13. It will cost how much?  That is absurd, this is a simple business!

That may be the case, but business appraisals precede major high-stakes life decisions such as tax matters, selling or buying, and litigation. Because of this, a qualified appraiser will not take shortcuts that could put you at risk. I want your appraisal to be as bulletproof as possible, and that takes time and effort on my part. It also reduces your risk exposure and may allow you to capture extra benefits such as tax savings. Ask around and check me out; you get what you pay for.

14. Why can’t you use the multiple of seven that Joe told me about at the club and multiply it by the earnings and give me a letter to that effect?

I know nothing about Joe’s business, but I can assure you it is different from yours, and that means its multiple will be different and that will have to be thoroughly researched and explained. I have no idea what Joe’s multiple refers to (pretax profits, cash flow, etc.) or the circumstances in which it came up, or even if Joe was boasting. If you want to rely on hearsay like that, that is your choice, but the risk is yours. The IRS and the courts will reject such weak evidence.

15. I can’t spend more than $1,000 …what can you do for me at that price?

If you need an appraisal for tax or litigation purposes, where the stakes and risks are high, nothing, not even close. No reputable professional can meet your needs at that budget. Ask around. If you need limited calculations (explain what those are) to help buy or sell a business, then maybe there’s a way I can help.

16. Don’t you just look at numbers and use formulas?   What’s the formula? Why do you have to do all that research and interview me?

The numbers are part of what we do, but not everything, just like blood is part, but not all, of your body. The formula, such as a multiple of earnings, is based on the other research we do regarding the economy, the industry, the company, and the facts and circumstances of your situation that influence the risk and profitability of the business. It requires judgment. It is essential, and a professional requirement, that we interview management (you) to help assess these factors.

17. In this industry, businesses are valued at (a rule-of-thumb formula).

That may well be the case, and we will research that to verify it. We have access to databases of sales that may confirm it. However, you have to be careful with rules of thumb because no two thumbs are alike! Every business has unique characteristics that influence its value. One size of thumb does not fit all. Also, many rules apply to companies in the industry buying each other. This may create extra value. A tax- or litigation-related valuation where fair market value is required may make these multiples less relevant (Note: if you have done pre-meeting homework on selling multiples, discuss it right now!).

18. I need to sell my company for $1,000,000 to retire.

I understand your need, and it is not unreasonable. I feel the same way about my business. Business values are determined in the marketplace, based on what buyers will pay, not just on what sellers need. Perhaps I can help you with limited calculations to see if your asking price is justified (Explain limited calculations.).

 19. I know what my company is worth.

Fine, then why are we meeting (Note: whatever the person next says will be their need, the key to making the sale!)?

 20. Your fee is too high.

• I am not the cheapest appraiser in town, and there are many good reasons for that. After all, business appraisers, of all people, should know what their services are worth (Thanks to David Bishop for contributing these immortal responses!).
• What can you do for me to earn a lower fee (Note: nobody has answered this!)? 

21. You’ve never valued a business in my industry.

I have valued many businesses in similar ones, and the hallmark of an expert appraiser is their ability to quickly get up to speed on the industry and its special characteristics. I have done this in hundreds of engagements and have a wide network of experts and data sources to draw upon to help you.

22. What’s the difference between an asset sale and a stock sale, and how does it affect the value?

A stock sale is the easiest to understand and what we normally think of. You sell your company’s stock to someone else, you surrender your stock certificate, and you get paid for it. The buyer gets every asset and every liability. This is how we buy and sell publicly traded stock. An asset sale is different. Here, you retain ownership in your company (and keep your stock certificate), but you sell selected assets and/or liabilities. There are many legal and tax aspects associated with both types of transaction; your attorney and accountant should explain those to you. Suffice it to say, however, that most of the time, buyers want to buy assets, not stock. We will value your business on both bases, if need be, at no extra cost.

23. How long is the valuation good for? Will you have to redo it in full each year and will it cost that much?

A valuation lasts as long as its assumptions, data, and methodology remain valid. For many a business, that will probably be at most a year, after which, the valuation will need to be updated to reflect the latest financial results. If the other assumptions and methodology remain valid (which is usually the case), this means just updating the relevant value calculations, not redoing the analysis from scratch, and the cost is much less. If, however, major assumptions or methodologies have changed (in light of changing conditions), then more work will be required. In my experience, this does not happen very often.

24. We think we are going to get a huge new customer that will increase the value of the business.

I hope you do! We need to explore how likely that is, and what its impact will be in order to properly reflect it in our valuation. I am glad that you mentioned that because even if we decide that it is unlikely, we have to disclose this possibility and our assessment. The worst-case scenario (from a tax or legal standpoint) would be not to disclose that we knew this might happen and then to have it occur, which would undermine the credibility of the appraisal. If there are any other developments like this that might occur, it is very important that you disclose them to me now (Note: an important exception occurs in litigation where the valuation date precedes the current date. Ask that information subsequent to the valuation date that was not known or reasonably knowable, like the next year’s financial results, not be disclosed to you, and put that in writing.).

25. We‘re going to go public in a year.

a)     I hope so, but at present the initial public offering (IPO) market is virtually dead and even if your company does as well as you project, it is a long way from here to there. An IPO a year out is too speculative to contemplate and value at this time.

b)    Not!

26. My business has huge potential. It should be reflected in my selling price.

Buyers will not pay cash today for tomorrow’s potential. Their first question will be why you have not achieved it. The most realistic goal in this case is to negotiate  earnout payments contingent upon the attainment of that potential. The buyer is taking all of the risk of achieving it and will not pay you for it up front. If you want to ask for that high price, heed the dictum “seller’s price, buyer’s terms,” and expect the buyer to counter with an earnout.

27. I don’t have fixed asset appraisals. Just assume those assets are worth $X

I can do that, but I will have to disclose that in my report. It will be fully your responsibility and risk to defend that assumption. It would be best to get those assets independently appraised (assuming they are material). I would be pleased to arrange for an independent appraiser to do that, but it will be at additional cost. I am not a certified fixed asset appraiser.

Next Week:  Rand Curtiss wraps up with a series of common client objections (e.g., “Why do we need to use comparables?  There’s really no other company out there compares to mine!”; “Why do we need a discount—that seems unfair!”; or even, “Can’t you cite some points of law my attorney recommended in your report?”’) and includes his assessment of the best way to respond to such requests.  Stay tuned!

Rand M. Curtiss, MCBA, FIBA, ASA, ASA is the President of Loveman-Curtiss, a business appraisal firm located in Shaker Heights, Ohio.

This article first appeared in the Spring/Summer 2004 edition of Business Appraisal Practice (BAP), published by the Institute of Business Appraisers (IBA).  For more information, go to www.Go-IBA.org