Business Valuation and Calculation Engagements: Which One Does a Business Need?

Business Valuation and Calculation Engagements: Which One Does a Business Need?

For many small business owners, their business is their most valuable asset. As long as it kicks out a healthy cash flow, the value of that business may be irrelevant. 

However, at some point in the lifecycle of many businesses, the value becomes important. Maybe your client is getting a divorce, or gifting a part of the business to children or grandchildren. Maybe a new partner is coming on board or an existing partner wants to be bought out. Perhaps there’s a merger or sale on the horizon – or maybe the owner passed away and it appears that the taxable estate may be close to the 2018 limit of $11.18 million. In these situations, you’ll need to help your client determine the value of that business. 

Business appraisals come in two basic flavors: a valuation or a calculation. A valuation is more complex and more expensive. A calculation is generally simpler and cheaper. Knowing which one is best for your clients’ needs can ensure they don’t overpay when they don’t need a full-blown valuation, and that they’re protected when they need the extra assurance that comes from a valuation. 

Let’s discuss the key differences between the two.

Business Valuation

A business valuation conveys the highest level of assurance, and is the best choice if litigation is possible, or if it needs to stand up to IRS scrutiny for an estate tax or gift tax return. Annual business valuations are also needed for employee stock ownership plans. 

The deliverable in a business valuation is a formal report that may be several hundred pages long. This report will include an opinion of the estimated value of the business plus the analysis, calculations and background information the analyst relied upon to reach that conclusion. 

While certifications or credentials are not required to perform a business valuation, when your client hires an analyst with credentials such as a CVA, ABV or ASA, that analyst will be required to follow the standards of the relevant certifying organization. These standards require the analyst to consider the three usual methods for valuing a business, which I explained here {link to the appropriate article}. The analyst will apply professional judgment and will consider the specific circumstances to decide which method is the most appropriate.

Besides the financial and non-financial attributes of the business, the analyst will also consider the overall economy, current and future industry trends, and the likelihood of long-term success for the business.

Full-blown business valuations are more detailed and more time consuming than calculations, which makes them more expensive. If the appraisal needs to stand up in court or will be filed as support for a tax return, your client will need a business valuation.

Calculation of Value

If your client is in a low-risk situation, and a friendly, handshake-type agreement is anticipated, a calculation might serve his or her needs just fine. Calculation engagements are simpler and take less time, but they don’t carry the same level of assurance.

As the name implies, the result is a calculation of value. Your client and the analyst decide beforehand on the calculation procedures to be used and the extent of those procedures. For example, a multiple of the weighted average of gross revenues over the last five years might be selected. 

This type of engagement leaves out most of the detailed analysis of a complete valuation and does not consider all three valuation methods. Because only one clearly defined method is used, and because the scope of analysis is limited, the resulting value may be quite different from the value that would result from a business valuation engagement.

This method is best for planning purposes or for friendly negotiations outside of court, such as a succession plan where all parties are in consensus. A calculation engagement will not satisfy the IRS for estate or gift tax purposes. If the planned transaction does end up in court, your client may need to upgrade to a valuation. Some firms won’t even perform a calculation engagement if future litigation is more than a remote possibility. 

You and your client will need to determine from the outset which engagement is appropriate for the situation. For low-risk situations, a well-thought-out calculation engagement can serve all parties well and save your client thousands of dollars, while high-risk situations may require a more expensive business valuation. Having a clear understanding of the purpose of the appraisal and the situation is key to helping your client make the right choice.