In the realm of business, valuation and appraisal are crucial processes, offering insights into the financial health and worth of a company. Whether it is for selling, buying, litigation, taxation, or even internal strategic planning, having a clear understanding of a business's value is essential. However, arriving at an accurate valuation or appraisal requires a comprehensive collection of data and information. Here is some comprehensive information regarding the key pieces of information needed for a business valuation or appraisal.
Letter of Engagement:
It is always best for the client and the business appraiser to sign a Letter of Engagement that clearly outlines the scope of the engagement along with the fee that is required to do the business valuation. Some engagements may be fixed fee while other may rely on an hourly fee. Many valuation engagements are done on fix fee while any additional work, including Court appearances for expert witness testimony, would be hourly. Most fee structures require full payment in advance before the work begins.
Financial Statements:
At the heart of any business valuation or appraisal are the financial statements. These statements can be company compiled (UN-audited), CPA reviewed, CPA compiled, or CPA audited. These documents provide a snapshot of a company's financial performance over a specific period with the valuation being only as good as the data provided. Business appraisers typically assume the data that is handed them is accurate. It is not their job to audit financials unless that is explicitly stated in the engagement.
Key financial statements include:
Income Statement: Also known as profit and loss statement, it details the revenues, cost of goods sold (COGS), expenses, and profits or losses over a given period. Annual financial statements are typically used for business valuations and can be either on a calendar year or a fiscal year (a 12-month period used by businesses for financial or tax reporting purposes). Using three to five years’ historical data is commonly seen in business valuation engagements to give a brief history of revenue and expense trends along with the volatility of both to help determine risk and estimate future profitability. Historical Income Statements will need to be provided by the client.
Balance Sheet: This document presents a company's assets, liabilities, and shareholders' equity at a particular point in time, offering insights into its financial position of the business. It is common for business appraisers to use three to five years’ historical data to determine asset accumulation or depletion, book value of equity, liquidity, and debt leverage among other things including financial ratios for comparison to industry norms. Historical Balance Sheets will need to be provided by the client.
Cash Flow Statement: It tracks the inflow and outflow of cash within a company during a specific period, providing visibility into its liquidity and ability to generate cash. This statement, if not provided by the client, will be generated by the valuation analyst or appraiser.
Client Questionnaire:
Most Certified Business Appraisers or Certified Valuation Analysts will provide their clients a comprehensive business valuation questionnaire to help gather general information about the business. This helps in assessing ownership percentages, owner salaries, non-recurring income or expenses, non-business assets on the books, competition, history of the company, etc. This process also helps the client get familiar with the valuation process and it opens discussion regarding how the business is being operated; which may or may not be how a third-party buyer would operate the business. For instance, there may be personal expenses placed on the books to reduce taxes (e.g., travel or vehicle expense). This would be viewed as additional income to a new owner. Further, the current owner may be under-paying or over-paying themselves in compensation for a variety of reasons. Owner salaries/wages will have to be adjusted to industry norms. This Questionnaire is a valuable tool for the appraiser to be fully informed of the status of the business.
Historical Performance:
Understanding a business's historical performance is vital for assessing its current value and predicting future potential. Analyzing trends in revenue growth, profitability, and cash flow stability can help evaluators gauge the company's resilience and growth trajectory. Any insight the client can provide the business appraiser will help in assessing risk regarding future income volatility.
Industry and Market Analysis:
Every business operates within a broader industry and market context. Evaluators need to assess industry trends, market dynamics, and competitive landscape to understand how the business fits into the broader ecosystem. Factors such as market growth rates, industry regulations, and competitive positioning can significantly influence a company's valuation. Business appraisers tend to use a four-digit Standard Industrial Classification (SIC) assigned by the U.S. government that categorizes companies and their business activities into specific industries. Some business appraisers will also use North American Industry Classification System (NAICS) code used by Federal statistical agencies. The NAICS code groups companies by their processes used to produce goods or services. Both codes are an excellent means to gather industry data for comparisons.
Growth Prospects:
Future growth potential is a critical factor in determining a business's value. Evaluators need to analyze factors such as market demand, expansion opportunities, product/service innovation, and competitive advantages to forecast the company's growth trajectory accurately. An appraiser needs to determine if the future the business is bright or bleak and adjust the analysis accordingly.
Intellectual Property and Intangible Assets:
For many modern businesses, intangible assets such as intellectual property (patents, trademarks, copyrights), brand reputation, customer relationships, and proprietary technology contribute significantly to their overall value. Evaluators need to assess the strength, uniqueness, and marketability of these intangible assets. There may be situations or circumstances where the business is not profitable but still has substantial value based on these types of assets. It is important for the client to identify these assets to the best of their ability.
Management Team and Human Capital:
The strength and competence of a company's management team play a crucial role in its success and, consequently, its valuation. Is there depth in management or is there a high level of importance placed on key personnel? Business appraisers consider factors such as leadership expertise, industry experience, and succession planning when assessing the management team's impact on the business's value. Additionally, evaluating the quality and skill set of the overall workforce is essential, as human capital often drives innovation and operational efficiency.
Legal and Regulatory Considerations:
A thorough assessment of a business's legal and regulatory compliance is necessary for accurate valuation and appraisal. An appraiser needs to review contracts, licenses, permits, litigation history, and regulatory filings to identify any potential legal or compliance risks that could impact the company's value. It is important for the client to identify any legal or regulatory issues that could affect the business’ value.
Economic and Market Conditions:
External economic factors, such as interest rates, inflation rates, and overall market conditions, can influence a business's value. Appraisers need to consider macroeconomic indicators and market trends when assessing the risk factors and growth opportunities associated with the business.
Comparable Transactions and Market Multiples:
One common approach to business valuation is using comparable transactions or market multiples. Evaluators analyze recent M&A deals, public company valuations, or private company industry-specific benchmarks to determine a reasonable valuation range for the subject business. This approach may include multiples of revenue, seller’s discretionary earnings (SDE), earnings before tax (EBT), earnings before interest and tax (EBIT), and/or earnings before interest, tax, depreciation, and amortization (EBITDA).
Risk Assessment:
Assessing and quantifying the risks associated with a business is crucial for arriving at a realistic valuation. Evaluators consider factors such as industry volatility, competitive threats, operational risks, and financial leverage when assessing the overall risk profile of the business. More specifically, the valuator will consider company specific risks relating to the size of the company, the management team, operations, financial structure, geographic location, product mix, product/service differentiation, stability of suppliers, diversification of customer base, growth opportunities, contracts, and upcoming regulations or litigation.
Consider using a certified business appraiser:
A comprehensive business valuation or appraisal requires a thorough analysis of various factors, including financial performance, industry dynamics, growth prospects, intangible assets, management quality, legal compliance, economic conditions, and risk factors. By gathering and analyzing these key pieces of information, stakeholders can gain valuable insights into a business's worth and make informed decisions regarding investment, divestment, or strategic planning. A certified business appraiser or certified valuation analyst is highly trained and skilled in doing this type of work. A thorough review of the information detailed above can lead to untapped value and can give current owners valuable insight to make fully informed decisions regarding their business.