In contrast to companies actively traded in the public stock market, the value or price of a privately held company is not readily ascertainable.

To determine the value of a private company, the business appraiser must obtain a full understanding of the nature of the company, its strengths and weaknesses, its financial condition and its earning capacity.

For business valuations prepared for litigation, the appraiser's assessment of these factors and how he or she applies them within the framework of generally accepted valuation techniques is crucial in developing a credible and defensible opinion.

Different case type, different standards

Some of the more common types of litigation involving business valuations include divorce, damages suits, estate and gift taxes, corporate or partnership dissolutions and dissenting stockholder suits. The type of case may bring into play a variety of factors that collectively determine the definition or standard of value and other mandatory or guiding factors.

For example, in divorce cases and matters before the Internal Revenue Service, the standard of value is fair market value. In dissenting stockholder actions, the standard of value is fair value. The valuation expert must understand the legal environment for the specific case to make sure that the approaches and methods used are appropriate.

Valuation organizations

Attorneys engaging business appraisers as experts or consultants should be aware of various appraisal organizations that confer appraisal designations and promulgate business valuation standards. Appraisal designations should ensure compliance with the applicable standards and provide further proof that the appraiser is qualified to render an opinion of value in a court of law.

Certified public accountants (CPAs) performing a business valuation are required to adhere to the Statement on Standards for Valuation Services (SSVS) as promulgated by the American Institute of Certified Public Accountants (AICPA). The SSVS provides the requirements for developing and communicating a valuation opinion and for what is referred to as a calculation engagement - that is, an assignment that is smaller in scope than a valuation opinion and less costly. In many cases, a calculation engagement may provide the impetus for settlement.

CPAs who have had substantial involvement in a number of business-valuation assignments and have passed a comprehensive exam can receive the AICPA's Accredited in Business Valuation designation. CPAs are also subject to the AICPA's Code of Professional Conduct, which includes rules as they relate to independence, integrity and objectivity, confidentiality, and other ethical considerations.

The American Society of Appraisers is an internationally recognized appraisal organization that publishes its own set of standards and offers the Accredited Senior Appraiser (ASA) designation. To qualify for this designation, the professional must have five years of valuation experience, take four levels of classroom education and pass subsequent exams and submit an actual business valuation report for peer review. The ASA designation is recognized as one of the most prestigious designations in the business-valuation community.

Other organizations such as the National Association of Valuation Analysts and the Institute of Business Appraisers offer designations and promulgate business-valuation standards. All of the organizations require continuing education in the field of business valuations to maintain their respective credentials.

Valuation approaches

There are three approaches to business valuation: the income approach, market approach and asset-based approach.

The market approach relies on observed transactions that have occurred in the marketplace or comparison of similar publicly traded entities. The asset-based approach focuses on the balance sheet of the subject entity, and the income approach focuses on the entity's earning capacity.

Most valuations of companies operating as a going concern will include methods under the income and/or market approaches to value. Selection of comparable companies and transactions, income projections, derivation of the capitalization or discount rate and application of various discounts are based, in part, on empirical data, but are largely the result of the appraiser's judgment.

The appraiser's methodology and support of a given issue may be the determining factor in the outcome of the case.

An axiom in valuation is that the value of an asset is equal to the present value of its future economic benefits. Thus, the future economic benefits must be quantified and then converted (discounted or capitalized) into value.

In valuations for litigation, a significant amount of investigative work might be needed to ascertain the business owner's true or "normalized" income. This involves an analysis of the company's books and records to eliminate discretionary, personal and/or nonrecurring expenditures.

Expert's role in litigation

Depending on the point in the litigation process at which she or he is hired, the valuation expert might assist counsel in performing a preliminary assessment of the valuation issues to determine the merits of the case. In addition, the expert will review and critique opposing expert reports, assist with discovery, assist in depositions and evaluate settlement proposals.

For cases that go to trial, the expert will not only testify but may assist in preparing the attorney for cross-examination of an opposing expert. In addition, the valuation expert may prepare demonstrative evidence to assist the court in understanding various aspects of the case. For example, a line graph showing substantial growth in income can serve as a compelling exhibit in support of a higher value. Conversely, a pie chart illustrating a concentration of revenues as a result of a single customer might support a lower value.

In many cases, the value of a closely held business interest is the only disputed issue of the case at hand. An attorney's familiarity with appraisal standards and valuation methodology will be crucial in the successful examination and cross-examination of valuation expert witnesses.

Louis Cercone Jr. is managing director of Brisbane Consulting Group LLC. A CPA who also holds the Accredited in Business Valuation, Accredited Senior Appraiser, Certified Valuation Analyst and Certified in Financial Forensics designations, he can be reached at lcercone@briscon.com.