Valuation methods requirements for a formal appraisal

A formal appraisal asks more of you than a valuation done to orient yourself. The appraiser needs a defined basis of value, a stated date and purpose, and records that fit the method chosen. A method fed the wrong inputs still runs, and still produces a number that describes nothing.

This page is for an owner about to commission an appraiser. It covers what to settle before the work starts, which standards may govern it, and what to hand over for each family of method.

What to take away

Appraisal or range: decide before you hire anyone

When a figure is needed for something other than orienting yourself, the requirements multiply. A valuation for a tax matter, an estate, a divorce, a partnership dispute or a lending decision is prepared under a defined basis of value, as at a stated date, for a stated purpose.

For a sale, the requirement is different and lighter: a range with reasons you understand well enough to defend under questioning. A sale this size warrants an intermediary, an accountant and a lawyer.

The accountant produces the inputs, and the intermediary tells you what buyers of your kind of business have actually paid. The lawyer is not involved in the number at all until it becomes a contract.

Seven items to settle in writing

Which standard and which appraiser

There is no single standard or credential for every assignment, so the engagement should name the one that applies. The table lists the sources a closely held business valuation may meet.

For an estate, the federal regulation on valuing business interests says the net value turns on all relevant factors, including a fair appraisal of all the assets, tangible and intangible, and the demonstrated earning capacity of the business.

Credentials such as the ASA (American Society of Appraisers), the ABV (AICPA's Accredited in Business Valuation) and the CVA (National Association of Certified Valuators and Analysts) help you assess an appraiser. None automatically applies to every assignment.

What an appraiser brings is not a better formula. It is the standing to be relied on, and liability if they are wrong.

What to hand over for each family of method

Each family has its own required inputs and its own disqualifiers. The appraiser chooses the method, but only the record you supply decides whether it can be used honestly.

A method applied to a business it does not fit does not give a rough answer. It gives a confident wrong one, and a formal appraisal carries that wrongness into the report.

Earnings-based methods

Named earnings methods include SDE or EBITDA multiples, capitalization of earnings and discounted cash flow (DCF). A multiple needs normalized earnings on a clearly stated basis. Capitalization needs normalized maintainable earnings and a capitalization rate; DCF needs projected cash flows, a discount rate and a terminal-value assumption.

State the earnings basis in the engagement before any method is applied. The figure must match the buyer's basis: either the owner's total benefit from working in the business, often called seller's discretionary earnings (SDE), or the operating result after paying a market-rate manager, often expressed as EBITDA. A figure on the wrong basis is not comparable with anything.

Tax filings alone are not enough. They show what was declared, on the tax rules' basis. Add management accounts and bank records that reconcile to them.

Asset-based methods

An asset-based method, such as adjusted net asset value or liquidation value, needs what things would fetch, not what the accounts say they cost. Book value records historic cost less depreciation, and it can sit far above or far below what a buyer would pay today.

Hand over a current register with each item's realizable value, ideally from someone who sells such things, plus a complete liabilities list including guarantees and anything secured over the assets. For equipment that matters to the total, get a professional valuer or at least a dealer's written view. Your own estimate is the input a buyer discounts first.

Say which basis you want. Adjusted net asset value considers assets and liabilities on a going-concern basis; liquidation value considers what could be realized from selling assets, net of liabilities and relevant sale costs.

Market comparison

Market comparison requires completed transactions in the same kind of business, at a similar scale, recently, with the terms known. Every word in that sentence is a requirement.

This is the input the owner rarely has. Genuine comparable data is generally held in transaction databases used by appraisers and intermediaries. Ask the appraiser where theirs comes from, and do not substitute asking prices. The businesses for sale examples show what listings leave out.

Do not hand over a calculator output

A tool asks for what is easy to type. Before you accept any figure from any source, ask which of the inputs above it had. If the answer is none, the figure is a guess with decimal places.

When the sale closes, a separate record follows. Both seller and purchaser of a group of assets that makes up a business must use Form 8594 to report the sale if goodwill or going concern value attaches, or could attach, to those assets and the purchaser's basis is determined only by the amount paid.

Common questions