For gifts of closely held stock over $10,000, the Internal Revenue Service requires a qualified valuation report to validate the value of the gift. Valuation reports are conducted by a qualified business appraiser and typically take three to four weeks to complete. The process starts with reviewing documents from the subject and interviewing the client and/or company management. From there, the appraiser conducts an economic and industry analysis, financial statement analysis, valuation analysis and reconciliation of values – all of which provide crucial information that will be used to create a credible and defensible business valuation report.
Engagement
The first step of a valuation involves defining the scope of the assignment. This includes defining the appraisal subject, the interest being gifted (100% interest, 15% interest, etc.) and the date of the gift.
During this stage, the appraiser and client sign an engagement agreement that outlines the scope of the valuation, estimated time to completion, the obligations of each party, relevant fees and any other pertinent information.
Obtaining Documentation
The second step of the process involves providing the appraiser with several documents:
3-5 years of historical profit and loss statements
Current year-to-date profit and loss statement
3-5 years of year-end balance sheets
Current balance sheet
3-5 years of historical tax returns
Management forecasts (if available)
Other documentation may include: inventory lists, asset lists, lease contracts, real estate appraisals, information on contingent liabilities and any other pertinent information that may help the appraiser fully assess the company.
Interview with Client
The appraiser will meet with the client and/or key managers for an in-depth interview about the subject company. The interview typically takes two to three hours to complete and covers a broad range of topics, including: a history of the business, the state of the industry, products and services offered, employee information, company’s financial statements and balance sheets, real estate ownership and rental agreements. The interview can be done at the client’s office, the appraiser’s office or via conference call.
Economic and Industry Analysis
In addition to performing a careful analysis of the company, the appraiser will research the economy and its impact on the company’s value. The appraiser will also research the company’s industry, reviewing current trends, obstacles and other issues to determine how they affect the value of the business.
Financial Statement Analysis
The appraiser will compile the company’s financial statements, based on the documentation provided, and then s/he will make normalizing adjustments to the financial statements to determine the true earnings of the business. All trends, discrepancies and points of interest that could influence the company’s value will be identified and analyzed.
Valuation Analysis
There are three approaches to business valuation:
Market Approach – determines the value of a business by using methods that compare the business or business interest to similar businesses that have sold in the marketplace.
Income Approach – values a business based on the present value of its expected future cash flows.
Asset (Cost) Approach – determines the value of a business by taking the fair market value of the company’s assets, less the fair market value of its liabilities.
Several appropriate valuation methods, within each valuation approach, will be utilized based on the characteristics of the company and the scope of the appraisal report.
Determination of Relevant Discounts
Gifts of closely held stock are generally minority interests (less than 50 percent of the company’s stock). When valuing these interests, the final value will generally be less than the pro rata share of a 100% interest in the company. The reason for this is that minority shares have an inherent lack of control and a lack of marketability applied to them. The appraiser will determine the amount of the discount to apply to the subject interest. The discount amount depends upon the degree of control and marketability of the gifted interest. [Note: these discounts, and factors that can decrease the discounts, are detailed in Section 4.0.]
Reconciliation of Values
To arrive at a final estimate of value for the gift of stock, the appraiser will reconcile the values derived in each of the valuation methods and combine them with appropriate discounts.
Creation of the Valuation Report
Once a value for the company has been determined, the appraiser will create a detailed report that compiles all of the data and analysis performed during the valuation process. The report will include:
Information gathered through the interview with the client
Economic and industry research and analysis
Financial statement analysis
Each of the valuation methodologies used and their resulting value
Analysis of the appropriate discounts
Analysis of the reconciliation to arrive at a final value for the gifted interest
