For small business owners, your business is likely your most valuable asset. But unlike an investment portfolio, you can’t determine its value by just looking up a few numbers online. Most of the time this uncertainty is just fine, as long as your business is producing enough income to meet all your needs.
But what if you’re getting a divorce? Or you want to gift part of your business to your children? What if your business partner wants out? Or you want to bring in a new partner? What happens if the owner of a family-run business unexpectedly passes away? These are just a few of the situations where you’ll need a professional business appraisal.
Business appraisals come in two basic flavors: a valuation or a calculation. They differ in the levels of assurance, cost, and complexity. Here are the key differences between the two to help you determine which one is right for you.
A business valuation gives you the highest level of assurance and is the best choice if your appraisal needs to stand up to IRS scrutiny, or if it might end up in court.
The result of a business valuation is an opinion of the estimated value of a business. The value and analysis will be presented in a formal valuation report, which may be several hundred pages long.
Analysts with credentials from the National Association of Certified Valuators and Analysts (NACVA) or the American Institute of Certified Public Accountants (AICPA) are required to follow the standards of those organizations. These standards require that the analyst consider the three methods for valuing a business (asset-based, income-based and market-based approaches). Using professional judgment and taking into consideration the specific circumstances, the analyst applies the method they consider most appropriate for valuing the business.
In addition to the attributes of the business itself, the analyst may also consider the potential impact of the overall economy and of current and future industry trends on the long-term success of the business.
A valuation report is more detailed and time-consuming than a calculation, and thus more costly. If the value needs to stand up to IRS scrutiny, or if litigation is possible, this is a better choice.
Calculation of Value
A calculation is simpler and less expensive than a full-blown valuation, but it doesn’t carry the same weight of assurance. For low-risk situations where friendly agreement is anticipated, a calculation will serve just fine. The reduced complexity also means the turnaround time is generally faster.
A calculation engagement doesn’t result in an opinion of value, but, as the name implies, a calculation of value. A calculation engagement omits much of the analysis of a full-blown valuation. The analyst is not required to consider all three valuation methods, but instead uses a narrow set of calculation procedures. The analyst and the client decide beforehand which procedures are to be used and the extent of those procedures. Because this is limited in scope, a calculation engagement may result in a different value than would be determined in a valuation.
The limitations of this method make it best when used for planning purposes or for friendly negotiations outside of court. This method will not satisfy the IRS for estate or gift tax purposes. Many firms won’t perform a calculation engagement if there is a chance the case will end up in court. If litigation does occur, an upgrade to a valuation may be required.
The differences between these two engagements mean that you’ll need to determine in advance which one is best. The reduced cost for a calculation may be tempting if you’re on a budget but be aware that you may need to upgrade to a more expensive valuation if this faces legal or IRS scrutiny. The best way to ensure you receive the right kind of appraisal is to tell your analyst as much as possible about your situation.
Email the firm Principal, Jason L. Crace, CPA, if you think you may need a Calculation performed on your small business.