September 11, 2018
How to Understand Valuation Reports
by Chris Burand
Just arriving at a reasonable number is inadequate if the report parameters are missing. It is kind of like buying the wrong insurance policy.
Most owners of small businesses, many executives/owners of medium businesses and even quite a few executives/shareholders of large businesses think the most important aspect of a business appraisal is the final number. The business is worth X dollars.
Obviously, the dollar amount is important. Getting the right dollar amount is even more important (I make this distinction because, in my experience, some business owners/executives and even quite a few bankers do not understand or sometimes even care about the difference between A Number and the Right Number). However, the number is arguably, especially if contested, only half of the requirement.
Depending on the reason for the business being appraised, the actual valuation report MUST meet specific parameters. If the report does not meet these parameters, the value arrived upon by the appraiser may be found meaningless or an opportunity to litigate by tax authorities or plaintiff attorneys. Just arriving at a reasonable number is completely inadequate if the report parameters are missing. It is kind of like buying the wrong insurance policy. The coverage amount might be right, but coverage may not exist because the policy is wrong.
Matching the correct report with the need is vital. Not knowing or understanding the difference makes business owners vulnerable to con jobs. And many business owners are conned each and every year.
How to Avoid Being Conned
First, I advise hiring an accredited business appraiser. All accredited business appraisers must sign a code of ethics, and most believe in their code. Some, though, do not quite believe in ethics as much as others. Some run the same con, but with accreditation. To be fair, I think some complete their reports mistakenly because they do not know any better. They are like insurance people with credentials who can barely spell insurance, much less business income coverage.
The better path is to understand the three basic types of Fair Market Value reports and to also understand the huge difference between Fair Market Value (FMV) and Fair Value (FV). FMV and FV are not synonymous. I have seen agency owners, and even accountants and attorneys treat these critical terms as if their meaning was the same. However, many courts treat the values calculated using these two terms quite differently.
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Relative to the three types of valuation reports (there are other types that are generally less applicable to most agency owners that I won’t address here), generally there is (exact terms vary depending on the professional association standards to which the appraiser is credentialed or belongs and sometimes depending upon the court, if being litigated):
- Summary reports, which are often referred to as letter reports (the entire valuation is in the form of a letter) or short-form reports. These reports contain little detail.
- Informal or Calculation Reports. The report writing standard, the analysis, the degree of confidence that applies to these reports are all relatively low. The margin of error is relatively high. The cost of these reports should therefore be relatively low. These reports rarely discuss the applicability of different valuation methods.
- Detailed, Written Reports. As the name implies, these are highly detailed reports usually combined with considerable analysis and a thorough discussion of the applicable valuation standards. These should cost the most, all else being equal.
Do not confuse a low price with high quality. Some appraisers charge a stiff penny for lower-quality reports because the customer does not understand the relatively low quality. Customers tend to think the appraiser just charges less. They think they are getting a Cadillac for the price of a Chevy. They are really just getting a Chevy that might not even be new.
The con occurs when appraisers fail to offer clients options, especially the most rigorous option, and clients do not know they are comparing apples with oranges when one proposal is for a lightweight appraisal and the other proposal is for a high-quality, heavy weight appraisal. One cannot always tell by the price, either, because the con is to charge as if the lightweight appraisal will be of high quality but just enough less money to get the job.
Courts have recognized this problem to some extent. For specific purposes, especially estate taxes, the courts can actually penalize the appraiser. For most purposes, though, once the valuation contract is signed, the damages will fall on the client and not the appraiser.
I am not suggesting all reports need to meet the highest standard, because they do not. When someone truly needs a decent, back-of-the-envelope valuation that has a large margin of error that is acceptable to all parties, a low-standard report should suffice. If litigation, a sale, taxes or compensation are directly tied to the value, then usually the best option is to spend the money and obtain a high-quality valuation right from the get go. Having a low-quality report in the hopes that everyone will agree can only complicate the situation if a high-quality report is eventually required. Then one may find it necessary to explain all the factors the low-quality appraisal inadequately addressed.
My key point, though, is that it pays to understand some basic valuation differences. It pays to understand that a low-quality report has severely limited acceptable uses, including that one cannot easily dispute the resulting value because the margin of error is so acceptably high. If the calculated value is $1,000,000 plus or minus 50%, then any value between $500,000 and $1,500,000 is okay.
See also: 5 Ways Data Allows for Value-Based Care
These are not easy differences for the uninitiated to understand, either. My short summary is a summary of thousands of pages of textbook differentiation. Sometimes, especially when the attorneys and accountants involved do not understand the differences, I think clients should consider hiring someone to just explain their valuation report options. The complexity goes far beyond getting a home appraised, and choosing the wrong standards rarely is beneficial to any party other than the attorneys involved.
You can find the article originally published here.