By James Boland, CPA, CVA Will Your Business Valuation Stand Up to Scrutiny?
There are many reasons a dealership may require a business valua on; buy- sell agreements, shareholder disputes, employee stock ownership plans (ESOPs) and estate planning and gi ing strategies.
In many instances, there will be an opposing party who ques ons the validity of the final value, James Boland, CPA, CVA whether it be a dissen ng stockholder or the Internal Revenue Service (IRS). It is impera ve that the dealer be aware of the basic characteris cs of a valua on so he is able to make sure that the Partner valua on analyst is using sound judgments and that, if challenged, the value will be defensible. T (732) 572 3900 [email protected] The Basics Uniform Standards of Professional Appraisal Prac ce (USPAP) were developed by the Appraisal Standards Board (ASB) of the Appraisal Founda on to provide guidelines to be adhered to in The informa on contained herein is not necessarily all inclusive, does performing a valua on. Most professional valua on analysts will conform to these standards. not cons tute legal or any other advice, and should not be relied upon without first consul ng with appropriate qualified professionals In addi on, the IRS issued Revenue Ruling 59-60 to document relevant factors to be considered for your individual facts and circumstances. when performing a business valua on, which are:
The history and nature of the business The economic outlook of the United States and that of the specific industry in par cular The book value of the subject company's stock and the financial condi on of the business The earnings capacity of the company The dividend paying capacity of the company Whether or not the firm has goodwill or other intangible value Sales of the stock and size of the block of stock to be valued The market price of publicly-traded stock or corpora ons engaged in similar industries or lines of business
Adhering to the above standards and addressing all relevant factors are the first elements that will be scru nized by someone ques oning the valua on. But what other elements will be examined?
Normalization Adjustments Adjustments may have to be made to historical financial statements to present them in "realis c" terms. For example, abnormal officer compensa on or unreasonable rent paid on self-rented property would have to be adjusted to an amount typical in the industry. These adjustments are called normaliza on adjustments.
Other normaliza on adjustments that are common when valuing a dealership might be:
LIFO Inventory Valua on Adjustments: Favorable tax treatment is afforded to dealerships that u lize the LIFO (last-in first-out) method of inventory valua on. However, for valua on purposes, the effect of changes in the LIFO reserve does not present a true picture of the dealership's earning poten al. Therefore, a normaliza on adjustment must be made to reflect income as if the specific iden fica on inventory valua on method was used.
Uniform Capitaliza on (Sec on 263A) Adjustments: The IRS also requires that costs associated with carrying inventory be capitalized (Sec on 263A— Capitaliza on Period of Direct and Indirect Costs). A por on of expenses such as salaries, employee benefits, rent, telephone, insurance Capitalization Rate and data processing must be reclassified and reflected as an addi onal One of the most subjec ve areas of the business valua on is the asset on the balance sheet. If not for the IRS requirement, one hundred forma on of the capitaliza on rate. The dealership's financial posi on percent of these expenses would be reflected and a reduc on of economic must be analyzed to iden fy strengths and weaknesses. The valua on income would result. Again, where the books are kept on an income tax analyst must assess the risk associated with an investment in the basis, normaliza on adjustment is needed to reverse this entry. company. This risk assessment must then be converted into a capitaliza on rate. This is another area that could be challenged if Unusual Commission Structure Adjustments: Commission structures can scru nized. It is important to have detailed backup for all conclusions vary greatly from dealership to dealership. Unconven onal and reached in formula ng this rate. uncommon structures may be used as a way of pacifying salespeople or to create addi onal selling incen ves. Whatever the reason, if the Intangible Value of Goodwill commission expense is not considered within the parameter of the In every valua on of a dealership, considera on should be given to the industry norm, a normaliza on adjustment would be required. intangible value of goodwill. Franchise, agreements, customer contracts, customer lists and customer rela onships all have an intangible worth Non-opera ng Income and Expenses: When a dealership has non-opera ng that must be translated into a goodwill or blue sky value. items of income and/or expense, they should be removed to reflect a normalized income statement. For example, if a dealership owns real The capitalized excess earnings method is the most commonly estate from which it is deriving net income that is unrelated to the used method for es ma ng a company's goodwill. U lizing opera on of the business, such net income should not be included on the this method will determine what por on of the total value of normalized income statement. Then the dealership can be valued on an the company is a ributable to goodwill. opera ng basis. The fair market value of the non-opera ng assets can be added to the opera ng value. An important part of the computa on when using this method is the Related Party Rent Adjustments: In many cases, dealership property is selec on of an excess earnings, capitaliza on rate. This is the rate which owned by related real estate en es. It is common that rent paid by the is used to convert excess earnings into a goodwill value. Again, this is a dealership is tax-mo vated and is not comparable to the going rate of the very subjec ve judgment that will be a prime area of scru ny. real estate market. If this is the case, a normaliza on adjustment will be made to adjust this expense to the rent charged in the market area. Many dealers have an unrealis c expecta on of their dealership’s goodwill value. Public companies, such as Penske and Lithia, have been These are just some of the normaliza on adjustments that may be paying very high mul ples of earnings for dealerships around the required. Each valua on must be analyzed independently. country. But is this an indica on of the true value of the dealership or a reflec on of the premium the public companies are willing to pay to It can be expected that the adequacy of these types of adjustments will be enhance their en re organiza on for such items as increased overall examined. revenues or the addi on of a par cular franchise?
The standard of value in a valua on report is usually fair market value, true when valuing an interest of more than fi y percent. This person which is defined in the IRS Revenue Ruling 59-60 as "the price at which would be expected to pay a premium for control of the company. property would change hands between a willing buyer and a willing seller Therefore, a control premium would be appropriate. when the former is not under any compulsion to buy and the la er is not under any compulsion to sell, both par es having reasonable knowledge The stock of a dealership, other than a public company, is not equivalent of relevant facts." to stock of, say, IBM. It cannot be bought and sold on the open market. Because of this restric on, a discount would be appropriate to account A dealer should want his valua on report to adhere to this concept. for the lack of marketability. Using high mul ples of earnings based on transac ons of public companies for most dealerships' valua ons would be inappropriate. The The applica on of these premiums and discounts are con ngent upon financial data of the dealerships involved in public company transac ons what valua on methods are being used. The valua on analyst must must be comparable to the dealership being valued. This is usually not guard against inappropriate usage. the case. If an unreasonable or unsubstan ated percentage is used, the en re Premiums and Discounts valua on is in jeopardy of being deemed worthless. An important part of any valua on is the selec on of appropriate premiums or discounts. The marketability of the dealership, or the lack Conclusion thereof, and the interest being valued (either controlling or minority) Much of the planning and strategies developed by the dealer to would have to be determined. A proficient valua on analyst will use a minimize taxes and maximize wealth will revolve around the value of the number of resources including prior court cases to help in determining business. Once the decision is made to have a business valua on what premiums or discounts are applicable. performed, the dealer must make certain that the valua on analyst is going to adhere to the professional standards established and that The purpose of a valua on is to value some por on of the stock of the reasonable judgments will be used so that the valua on work product company. Valuing less than fi y-one percent of the stock is considered a will stand up to tough scru ny. minority interest value. A purchaser would not be willing to pay the same amount for stock if they are unable to exercise control. Therefore, a minority interest discount would be appropriate. The reverse of this is
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