A business appraisal could make an enormous difference in assessing your clientís financial plans.

Three years of anemic economic growth and falling equity prices have taken their toll on the sprawling but less visible market for privately held businesses. That makes an accurate business appraisal all the more important because it helps small-business owners understand the value of what usually is their largest asset: their company, says John P. Murphy, a senior vice president for Atlantic Management Co. Inc., a valuation firm based in Portsmouth, N.H.

The gap between perception and reality probably has widened in recent years, as evidenced by the dramatic decline in merger and acquisition activity. Unfortunately, many small-business owners don't know what their firms are worth and wait too long to get appraisals-or never get one. That can result in a nasty surprise when they or their heirs find they are getting a lot less money from the enterprise than expected, experts say.

Philip M. Hamilton, a certified public accountant and business appraiser whose Austin, Texas, practice focuses primarily on business valuations, tells this real-life nightmare: A friend's husband had a 50% interest in each of three businesses. He and his partner did not have a buy-sell agreement, which could have made it clear how the value of the firms would be determined. They had not purchased life insurance on each other to cover buying out the other's interest. They had not had professional business appraisals done. The friend's husband became terminally ill and died in January. The three businesses turned out to be worth about $400,000, but the widow was shocked to learn that she was getting $30,000 for her half.

Unbeknownst to the woman, her husband of 25 years-who most recently had been earning $100,000 annually-had agreed at one point that $30,000 would be paid for his share when he died.

Hamilton doesn't think the husband intended to shortchange his wife. But he does think the man didn't know what his businesses were worth. A financial advisor would have been able to play a key role in this story-and others like it-having a happier ending, he says.

"An advisor could say, 'Let's get a buy-sell agreement, let's get an idea of what the company is worth, and let's put in for life insurance,'" Hamilton says.

Getting an idea of value is an important part of that package, but most small-business owners don't get appraisals done unless there's a specific reason, such as a divorce or a buyout, Murphy says. But a valuation done in advance of life-changing events may benefit business owners in many ways and help their advisors make better recommendations.

Although an appraiser should be independent, Murphy adds, he or she can still work as part of a team with an advisor and provide a lot of helpful feedback. "A good valuation will go into the value drivers and subtractors," Murphy says. "It will not only provide the value, but the analysis will tell the owner and the advisor the issues and factors that are driving the value and the issues that are taking away from it."

Many advisors rely on people specializing in business valuations and certified by one of the industry's national associations (see sidebar) to perform a good appraisal. But planners sometimes get help valuing businesses from others, too.

Philip J. Capell, an advisor and lawyer who is president of Piermont Financial Inc. in Melville, N.Y., says he tends to refer his clients to appraisers he knows personally, have good reputations and are in good standing with the Internal Revenue Service. "Some clients say, 'Why can't my accountant do it, someone who is on the payroll?' In some circumstances, that may suffice, but generally a business appraiser is the way to go," he says.

Sometimes appraisals can help private business owners increase the value of their company. Advisor Pat Horan, founder and managing partner of Horan & Associates in Towson, Md, remembers when a corporate attorney/CPA with a master's in taxation helped him value a client's business. The client thought his manufacturing firm was worth $10 million, but Horan was doubtful and sought bids from brokers, who put its value in the $4 million to $6 million range.

The attorney/CPA and Horan then worked with the client to find ways to increase the business' profit margins. They identified jobs that required less labor and would have fewer chances of returns from defective parts. They also look at ways processes could be automated. The client made the changes, was able to increase his profit margins and eventually sold the business for $12 million, Horan says. His firm now manages the proceeds from the sale through a customized, tax-efficient, managed portfolio that generates income and capital growth for the client, who is now retired.

Like Horan, other advisors say clients often start with an inflated value of what their businesses are worth. "It's a fair observation that most buyers do have an inflated view of market value because they remember the value during the good times three or four years ago. And the buyer wants to take advantage of the leaner times to purchase a business at a lower amount, so it's a little harder to find a reasonable price in between," says Mary Durie, a certified financial planner licensee with Quest Capital Management Inc. in Dallas. "Actually, I had a client who was about to buy a business, and in looking at the numbers, because the free cash flow was so tight, the value he was willing to pay was no where near what the owner was willing to sell it for. This was a graphic design firm."

Advisors and appraisers agree that when it comes to buying or selling a business, an appraisal is essential. "The value of a business represents both a tremendous investment for both the buyer and seller, and it's shortsighted not have a professional appraiser working with both the buyer and seller so they understand the valuation issues involved," maintains Steven F. Schroeder, an attorney and professional appraiser who is president of American Business Appraisers, a division of EVS Group in Marysville, Calif. "It's very easy in the emotion and passion of buying a business to make a mistake. And competent professional business appraisers bring a dispassionate view of value that should be important to all buyers and sellers of businesses."

In addition to buying or selling a firm, valuations often are needed for other potential or actual changes in ownership, says Laura Jane Tindall, Ph.D., a CPA and full-time business appraiser in Loxahatchee, Fla. They could include determining insurance coverage necessary upon an owner's death, establishing employee stock option plans, bringing in a new partner and passing the business on to heirs.

Tindall says business appraisals also are used to identify value for legal reasons, such as divorce, bankruptcy, breach of contract and minority-shareholder complaints. In 2002, the Financial Accounting Standards Board issued rules that require intangible assets to be valued. They also require annual appraisals to identify any changes in the value of goodwill or other intangible assets, Tindall says. Also, appraisals sometimes are needed businesses seeking financing, she adds.

Some reasons for appraisals, and the considerations that go along with them, are discussed here.

Estate Planning And Taxes

Attorney Mark Shepard, a partner in the law firm of Williams Mullen in Richmond, Va., says appraisals often are necessary when valuing an interest in a closely held business for estate tax purposes. For a decedent with a gross estate of more than $1 million, his or her assets must be reported at fair market value on an estate tax return. Also, if lifetime gifts of business interests are made, Shepard says, it is generally prudent to obtain an appraisal and attach it to a gift tax return.

Shepard adds that appraisers often apply entity discounts when determining the value of closely held business interests. Because there is not a ready market for such interests, a lack-of-marketability discount may be appropriate, he explains. If the interest is not a controlling one, then a minority-interest discount (sometimes called a lack-of-control discount) also may be appropriate. Often, one appraiser is used to value the business and another to value the discounts, Shepard says. Typically the combined discounts range from 20% to 40%, he says, but he has seen them as high as 60%.

But in some circumstances, Shepard adds, the IRS may disallow a minority-interest discount and apply a swing-vote premium. For example, if a 2% interest in a business is being valued for gift tax purposes and there are two other shareholders each owning a 49% interest, the fair market value of that 2% interest may have significant and valuable controlling aspects, he says.

Erich Sylvester, managing director of The Financial Valuation Group in Los Angeles, says he finds the first and foremost reason small-business owners have appraisals done is to prepare for making gifts of shares to their children.

The IRS rules generally mean Mom and Dad each can give a child a gift every year worth $11,000, or $22,000 total, before the gift tax kicks in. That gift could be shares of their company. "But they can give $22,000 of discounted value, so they can get maybe $30,000 of the value out of the estate," advisor Durie says.

If gifts of shares are done yearly and timed right, an appraisal may only be needed every two years, Durie adds, because a valuation done at the end of a year could also be used for giving in the following January. "Let's say you did a valuation in December 2002. You could use it for 2002 and 2003 gifting. Then you wouldn't need to do another valuation until the end of 2004," she says.

Buy-Sell Agreements

Murphy of Atlantic Management says it's important for business partners to have a buy-sell agreement and to have an appraisal done when it's put together. "It's recommended that two or more shareholders put together a buy-sell agreement together when everyone is getting along. When one person is leaving, for whatever issue, at that point in time, people aren't going to agree upon terms. So you put agreements in place to set the ground rules for the eventual buyout," he says. "An appraisal sets a starting point for value, and then every two or three years you should re-establish the buyout value. The appraisal provides independence and integrity to the transaction."

But often, buy-sell agreements and appraisals aren't done at the outset, Murphy says. "The standard scenario is that the professional relationship deteriorates between the partners and now neither party comes to an agreement about buying the other out. The one who wants to get out wants a high price, but there's no benchmark," he adds. "The business operation suffers, employee morale starts to suffer, and it spills over into the office. You get two camps. One group of employees sides with one partner, and the others side with the other one. It creates a Chinese wall in the company, and the company basically starts to implode."

Even when buy-sell agreements are in place, they often are unclear about what standard an appraiser should use to value the business, Hamilton says. "There are several different ones. Should it be fair market value, investment value or fair value?" he says. Fair market value is an estimate of how much the business would likely exchange hands for in the open market, investment value is the price one actual buyer will pay based on his or her own needs, and fair value is a legal concept defined differently by different states.

Also, the agreements often fail to specify how the appraiser is to value a noncontrolling (minority) interest, Hamilton says. In the case of three partners, for example, their shares could be appraised at one-third of the company's total value or at a one-third interest, which could result in very significant discounts being applied, he says.

Partnership/Shareholder Disputes

Appraisals sometimes are needed to establish a business' value for feuding shareholders. And often, such fighting can involve family members.

Consider this example, says Sylvester of The Financial Valuation Group: Suppose parents give equal shares in a business to their four children, but only one ends up working in the business. The other three eventually decide the business is providing them with no economic benefit because they get no dividends and there's no market for their minority interests. The shareholders could very well wind up in a courtroom and need a business appraisal.

State law would apply to these situations, and remedies can vary greatly, Sylvester says. "Some states might be quite draconian in the sense the minority shareholder might have almost no leverage to force a buyout and may be stuck until they die-and their children may be stuck," he explains. "I'll say most states do provide some kind of escape hatch ... But one of the issues that comes up is the minority discount."

Even when minority-shareholder issues don't end up in court, they can cause great unhappiness.

Advisor Bob Maloney, who owns R.E. Maloney Associates in Annapolis, Md., and bills himself as "chief listener," says he has a client involved in one such dispute. She is 90% owner of a beauty-related business in which she's worked for 27 years. Her sister, who doesn't work in the business, owns 10%. The parents left them the firm, and there was a verbal understanding that the 90% sister would buy out the 10% sister, Maloney says. The majority owner did make an offer, but her sister is asking for seven times that, he says.

"It has the potential of destroying the family," Maloney adds. "We suggested we hire a valuation firm to come up with a realistic price. We're offering the full 10% value, no minority discounts."

However, Maloney suspects the sister probably won't accept the offer, and a mediator may need to be hired. The minority owner already has threatened to sue her sister-as well as all of her advisors.

Sometimes, minority shareholders themselves look to business appraisals to confirm the value of their investment. But the news isn't always good. For example, Schroeder says, he worked on an appraisal last year of a credit card company. "The minority shareholders thought the business was very valuable, mostly because they had invested tremendous amounts of money in its future prospects," he recalls. "They had a vested interested in the future of the business. However, the business was only marginally profitable. And its prospects were far less optimistic than the minority shareholders' viewpoint. The business turned out to be only of modest value. This is case where the appraiser was unable to solve the minority shareholders' problems created by their bad investment decisions."

Appraisals also are used to clarify value in other kinds of partnership disputes. For example, Tindall says she recently worked on a breach-of-contract case in which she did an appraisal for a medical practice. The doctor she was hired by believed his former partner breached their contract. The doctor maintained the former partner left the practice and violated a noncompete covenant by opening an office in the same area. The doctor's revenue didn't fall after his partner's departure, Tindall said, but her appraisal showed the doctor's revenue stabilized because his insurance reimbursements had increased. Other factors verified he had, in fact, lost business-more than he anticipated. For example, the numbers of procedures he was performing and patients he was seeing had both dropped after the partner left, she says.

Divorce

Couples getting divorced should get an appraisal if a business is involved. Johanne M. Floser, manager of BST Valuation & Litigation Advisors in Albany and New York City, says either side may hire her, although sometimes the court will appoint an appraiser to provide a neutral valuation. In doing such valuations, she considers court discovery rules, as well as IRS requirements for closely held businesses. The IRS requires that she look at eight elements: the business' nature and history, estimates of risk and future returns, economic and industry conditions, book value and financial condition of the company, earnings capacity, dividend-paying capacity, goodwill and other intangibles, and previous stock sales of not only the company but comparable firms.

Sometimes, the nonowner spouse also will want an appraiser to evaluate the lifestyle of the owner spouse to see if there are any indications of unreported or underreported income, Floser adds.

"There also are instances where an owner spouse alleges that the company no longer exists, that it was dissolved prior to the date of commencement-that it did not exist at the time of divorce," she explains. Different states have different rules regarding the appropriate valuation date for a business. In New York state, for instance, she says, the valuation date is the date the divorce action was commenced. "If the business was not in operation or no longer existed at commencement of the divorce, it would have no value," she adds. Whatever the valuation date, appraisers can't look at events subsequent to that date unless those events were known or knowable, Floser observes.

"A family law judge often is the final arbiter of two different valuations," says Sylvester. "This is where state law applies, and there may be 50 different nuances on what fair value means between spouses."

Finding A Qualified Appraiser

Finding a qualified business appraiser isnít always easy. Many arenít qualified, and their reports are deficient because they donít include the proper analysis and detail to support their conclusions, says Philip M. Hamilton, a CPA and business appraiser who is president of the Austin chapter of the Texas Society of CPAs.

Philip J. Capell, an advisor and lawyer who is president of Piermont Financial Inc. in Melville, N.Y., recommends: ìYou look at whether their appraisals are generally accepted by the IRS and if they have a proven track record with the government. When you get a written report, it must substantiate valuation. You want to make sure the person who does the appraisal will qualify as an expert witness, is presentable on the witness stand and can substantiate value if the valuation is contested.î Also ask for references, as well as examples of reports with client references, says Johanne M. Floser, manager of BST Valuation & Litigation Advisors, with offices in Albany and New York City. Itís also a good idea to ask an appraiser if she or he has an extensive business valuation library and relevant experience in publishing, lecturing or teaching valuation, she adds.

Organizations that accredit business appraisers include:
ï American Institute of Certified Public Accountants, www.aicpa.org. The AICPA provides the Accredited in Business Valuation (ABV) for CPAs only.
ï American Society of Appraisers, www.appraisers.org. It offers the ASA accreditation for business appraisers.
ï Institute of Business Appraisers, www.go-iba.org. It awards designations for Certified Business Appraisers (CBA), Master Certified Business Appraisers (MCBA) and Business Valuators Accredited in Valuation (BVAL).
ï National Association of Certified Valuation Analysts, www.nacva.com. It awards designations that include Certified Valuation Analysts (CVA), Accredited Valuation Analyst (AVA) and Certified Forensic Financial Analyst (CFFA).

Some appraisers feel certain organizations set the bar for certification significantly higher than others. The ASA Web site at www.appraisers.org offers a comparison of the accreditation criteria required by all four organizations.