Pepperdine University’s recently released Private Capital Markets Project (“PCMP”) reveals some interesting statistics derived from their survey of the current marketplace for privately-held business sales. One of the key topics is how a failure to come to terms on valuation conclusions often prevents deals from closing. For instance, investment bankers surveyed report that a valuation gap was the number one reason that their deals did not close. Over 60% had a valuation gap greater than 20%. It is precisely this reason that business valuation requires thoughtful analysis and expert advice. However, a surprising proportion of angel investors surveyed (41%) simply relied on “gut feel”, which is not likely to be an area of common ground.
The failure by market participants to come together regarding valuation standards is an ongoing challenge. The Uniform Standards of Professional Appraisal Practice (“USPAP”) provide the most highly regarded quality control guidance for the conduct of appraisals. USPAP is promulgated by the Appraisal Foundation. Congress established the Appraisal Foundation in 1989 in connection with Title XI of the Financial Institutions Recovery and Enforcement Act (FIRREA). This legislation gives a unit of the Appraisal Foundation responsibility to ensure that all certified appraisers meet certain qualifications, and that all appraisals for federally related transactions conform with USPAP.
Sponsors of the Appraisal Foundation include the Appraisal Institute, the American Society of Appraisers, and other appraisal organizations that have a more narrow and focused membership (e.g. farm appraisals, tax assessors, right of way appraisals). Generally, organizations sponsoring the Appraisal Foundation insist that their members follow USPAP, and will discipline any member that fails to do so.
By virtue of Notice 2006-96, the Internal Revenue Service (IRS) effectively endorsed USPAP as the preferred guidelines for appraisals, indicating that any USPAP compliant appraisal is deemed “qualified”. This is the only standard given this recognition and generally elevates appraisals that follow USPAP over those that do not. Even if the federal government does not regulate the transaction, clients benefit when their appraisal work and reports comply with USPAP. Unfortunately, there are numerous people providing valuation services who are do not follow a set of standards and provide low cost opinions based only on generalized rules of thumb.
USPAP does not require specific methods to be used and it is not uncommon for different approaches to indicate different results. Instead, USPAP requires that appraisers be familiar with and correctly utilize those methods acceptable within the industry and to the intended users of the appraisal. According to the PCMP, the most popular methods of valuation generally utilized across survey participants were discounted future earnings and guideline company transaction approaches. When using multiples, the most popular applications were EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) and revenue multiples. These are all valid approaches to valuation, but require expert analysis of how the different results should be weighted given the facts and circumstances of the particular property being valued, the forecasts available and the similarities with the available comparable transactions. In this regard, USPAP requires that the appraiser obtain relevant preliminary information at the onset of an assignment in order to inform the workplan design, such as the nature of the property to be appraised, the basis of value (e.g. market value, investment value), the interests appraised (e.g. controlling, partial), important assumptions or hypothetical conditions, and the effective date of the valuation.
When evaluating options for your appraisal provider, it is important to remember your goals. Unless for purely compliance purposes (like a home financing), appraisals are generally undertaken to provide solid advice regarding the true value of an important asset you are buying or selling. If you get advice that is not thoughtful and complete, you have just wasted your money and failed to get an accurate picture of the opportunity being offered to you. Certainly, if there will be someone on the other side of the transaction who may be opposed to your conclusion, or if the appraisal is a subject of litigation, you will want your professional’s report to withstand scrutiny.