Bias in business valuations: Guard against this top kind
Minor differences in the inputs of a business valuation can have a monumental impact on the final value. Therefore, it is vital that valuation professionals analyze valuation reports critically, watching for biases and guarding against the manipulation of key value drivers, according to Grassi & Co. Valuation Manager Pasquale Rafanelli, CPA/ABV, ASA, CVA, CBA, CFE, MAFF. This is true whether evaluating your own valuation or reviewing that of another expert witness in a litigation matter.
“Valuations are all about judgment,” says Rafanelli, who is leading the Sageworks-hosted webinar, “How to Critically Analyze a Valuation Report.” At the same time, differences in judgment can be magnified in the final value. A difference of 1 percentage point in the capitalization rate used for the income approach, for example, can be significant when extrapolated as part of a multimillion-dollar valuation. That’s why it is important to understand what goes into making a judgment.
Rafanelli performs appraisals of interests in privately held companies for estate and gift tax planning, marital dissolutions, shareholder dissolutions, buy/sell transactions, mergers and acquisitions and litigation support. He says that the most common bias his firm sees in its valuation assignments relates to the financial projections received from clients.
Business valuation professionals can utilize spot-on market multiples and discount rates, but those won’t result in an accurate valuation if the process begins with inaccurate financials. “It’s garbage in, garbage out,” Rafanelli said.
Bias in financials
“The projections that we take from the client need to be looked at with a critical eye,” he says. Because the valuation professional isn’t involved in the day-to-day operations of the business, it can be hard to determine if the projections are realistic. Clients seeking a valuation for an estate and trust may want a lower value, while those looking to sell the business hope for a higher one, so it’s important to identify possible bias in the financials, Rafanelli says. Do this by asking questions.
“If the company has been growing 3 percent for the last five years, and the industry is expected to be growing 3 to 4 percent over the next five years, and the client projects their business will grow by 15 percent, we could potentially come up with a value that’s much higher than it should be if we relied on those numbers,” Rafanelli says. “If the industry is pointing at slow, steady growth, you have to ask the client, what’s changed? What’s caused them to have a spike” in their projections?
Similarly, if business has been increasing steadily but the owner is now projecting a decline, the valuation professional should consider whether this is because the owner is looking for a lower value.
“You have to sit down with management and explain, ‘Here’s the historical rate, here’s how the industry’s doing and here’s what you’re showing. Why do you expect this much decline or increase? Is there something happening in the company or the industry? Has there been a removal of a division or an addition of a division?’”
Asking questions of the client can also reveal information previously unknown to the valuation professional. Rafanelli recalls that one client’s projections appeared to be on the higher end of what made sense based on historical performance. However, it turned out the client knew of a new regulation that was going to drastically increase work in the coming year. “So their projections, which appeared to be on the higher end, are on the higher end for a valid reason,” he says.
Rafanelli says educating clients about how inaccurate financials can hurt them also promotes a foundation of accurate information for the valuation.
“I explain to clients that I’m going to give them a neutral unbiased value that I can defend,” he says. When clients say they’re seeking a lower value or a higher value, he asks whether they are considering the consequences. For example, if the owner is seeking a valuation for gift purposes and desires a low valuation, what happens in five months if they decide to sell to an outside party and then seek a higher valuation? If the IRS finds the business was valued at $10 million for gift purposes and six months later it is valued at $40 million for a sale, it’s likely the IRS will flag the return for an audit to scrutinize the increase, which could lead to additional taxes, penalties or other problems if the agency determines fraud was involved.
Join Rafanelli as he discusses this and other common biases in valuations. Register for the webinar, “How to Critically Analyze a Valuation Report.”
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