Deconstructing a [Business-Valuation] Engagement Letter

 

MK Logo ShortDeconstructing a [Business Valuation] Engagement Letter

The starting point for any quality-based business-valuation assignment requires two things:

  1. The Initial Discussion, followed by
  2. The Engagement Letter

The Engagement Letter defines the assignment in enough detail to serve both appraiser and client….before, during and after the engagement.  It is the Engagement Letter that outlines the work to be performed – by both parties. The Engagement Letter acts as a legal document, should disputes arise. Further, the engagement letter is a project management tool, used to remind client and appraiser of the solution, or deliverable, especially if either party veers off task.

 

INITIAL DISCUSSION

Our engagement details are often revealed by listening to our clients.

I have learned that it is best to first ask three questions, and then listen: intently and patiently.   The Elements of the engagement will generally always proceed from asking the following three questions.

Discussion Topics:

  1. Why do you require this valuation, and, who has advised you to have a business valuation completed?
  2. What precise legal interest needs to be valued?
  3. What deliverable do you seek from this engagement?

 

ELEMENTS OF THE BV ENGAGEMENT LETTER

  1. The Purpose and Objective of the Engagement.

Inadequate specification of the valuation assignment often results in misdirected efforts and invalid conclusions.[i]

The Purpose defines the engagement in plain language.

MK Example:  “The overall objective of this engagement is to determine the “fair value”, for US GAAP Financial Reporting purposes, of the following intangible assets of Company as of a contemporaneous 2016 valuation date as required by ASC 805, Business Combinations.  This valuation will include an assessment of the fair value of the acquired assets, and where necessary an estimate of the economic useful lives of these intangible assets for financial reporting purposes only, as required by ASC 805, Business Combinations and ASC 820 Fair Value Measurements and Disclosures.”

  1. Intended Use and Intended Users.

Business valuations are provided to solve a distinct problem and to answer a specific question.  These solutions are provided under unique circumstances.  A quality appraiser will always carefully define the Intended Use and Intended Users of our reports.  This protects you and it protects us, lest our reports end up in the hands of an audience who might misrepresent or abuse them.  Multi-use valuations are examples where Intended Use and Users must be defined, e.g.  tax-compliance FMV valuation, and a financial-reporting report.   (MK Appraisal Group does not provide dual-standard valuations under single reports).  You may wish to provide our valuations to potential investors, which – unless our efforts and our conclusions are specifically intended for those users – could undermine the integrity of the valuation opinion in your possession.

  1. Source of Work Effort.

Many appraisal firms will utilize out-sourced, even off-shored, personnel to complete certain tasks of valuations.  Most credentialing agencies require that these appraisers include the names of persons who have assisted them.  I recommend that you ask that this be provided.  As well, some appraisal firms will utilize business-valuation software in the completion of a significant portion of their engagements, especially when they lack bona-fide valuation experience and acumen.

MK Appraisal Group does not offshore any portion of its valuation engagements nor utilize business-valuation software.

  1. Defining the Valuation-Engagement (Details Below)
  • Names of Client (legal name and address) and names of recipients of the deliverable.
  • Description of the Legal Interest(s) being Appraised.
  • Valuation Dates (Contemporaneous, Retrospective or a mix of both).
  • Valuation Standard.
  • “Premise of Value”.
  • Description of Ownership Characteristics.
  • Form and Extent of Report.
  • Special Requirements.
  • To-be-Determined Elements (Valuation Dates are often uncertain at the outset).

5. Fee Arrangement & Appraiser Independence.

The fee may be a fixed-fee or a range of fees.  Rarely will appraisers arrange to be compensated by the hour, except in litigation support situations. If expert testimony in litigation is required, our fees must be set in a manner that is independent of the outcome.  In my valuations, I will never make my fee arrangments contingent on the outcome or results of my reports; such arrangements undermine independence.  For example, business-brokers often provide highly simplified valuations in connection with their agreement to buy or sell businesses; but these professionals are generally always compensated with a portion of the transaction proceeds, making these valuations clearly conflicted.   Financial institutions or individuals that have invested in your company should never provide business-valuation services where independence is required, regardless of their claims of “Chinese Walls”.

 6. Contingent or Limiting Conditions, Confidentiality & Indemnification.

Appraisers must limit our efforts to the specific tasks required.  For example, I will not provide litigation support if a valuation report makes its way into that arena unless properly retained and adequately compensated.   I will require additional compensation if your auditor burdens me excessively during their review, and then ‘only’ if I agree to be burdened (audit reviews can quickly grow unwieldy – and will sometimes exceed my fee for the valuation).

We can use this section to define the levels of confidentiality in the engagement, which limits my sharing of sensitive information.  I will also use this section to define my intellectual property rights, related to my valuation models.  Also included here are other legal protections such as indemnification clauses and cancellation requirements.

 

DEFINING THE VALUATION ENGAGEMENT

The Client – Who is Retaining Me?:    The names and titles of the client is important, especially in situations where a litigation support is sought (note: most appraisers will prefer to be retained by the clients’ attorney, not the client).  Other times, I will be retained by a trustee, or a board-of-directors, perhaps by the single owner of the enterprise, or by the CFO or Controller of a public-company.  This is an important detail because it clearly defines to whom I am engaged, and to whom I report.  My relationship to other parties involved must be made clear in the engagement letter.  This can be particularly important in a complex valuation assignment.

MK Example: I was retained to appraise a limited and general partnership interest in a location-dependent assisted living facility that had been sold in Central California.  The general partner and the limited partners were at an impasse as to the allocation of the sales proceeds and both agreed to utilize a valuation to settle the issue (although my client was defined as the limited partner).  My task was to bifurcate the value between the operating component and the real-estate, the latter appraised by a commercial property appraiser.   The intended-users of my report included both partner parties, ‘however’ my client was clearly defined as the limited partner: a nuance that served my client and I well when the general partner (who refused to participate in my valuation effort) requested that I make several costly revisions to my report, months after its delivery.

What am I Valuing – Description of the Legal Interest:    This section clearly specifies the unique legal interest and the bundle-of-rights being appraised. If a business entity is the subject of the valuation engagement, I will define the legal structure (incorporated, LLC, general or limited-partnership, etc) and the state of residence.  The “form” of the business structure must be identified.   Or, we may define the interest as an asset or collection of assets or as security-interest?  A security-interest differs significantly from direct-asset-ownership, and should be clearly identified.  It is here that I will specify any valuation of partial interests, and the proportional interest to the whole.  Further, in the valuation of partnership interests, we must define the partners’ capital adequately (class or classes of partnership interests).  Care should be also used where the term “Enterprise Value” is used in a business valuation because the definition lack codification, even across business-valuation credentialing organizations.  In most of my valuations, this question is answered at the very outset of our first discussion, but complex situations exist and questions should be posed by the appraiser.

Description of the Ownership Interest (Control & Marketability):   Control of an interest goes to the legal rights afforded control shares that are not available to minority shares.  This additional bundle of legal rights (e.g. the right to appoint or change operational management) make control shares generally more valuable than minority shares.  Marketability suggests that an ownership interest has less value if it is not readily marketable, and may be even less so where sales restrictions apply.  I will often review your company’s articles of incorporation, partnership agreements or other documents in order to identify control rights; whereas marketability (lack of) is often defined by the purpose of the valuation. These concepts are complex, and will require considerable judgement and experience by the valuation professional.

Valuation Date(s):  Setting the valuation date is generally completed by the circumstances, but not always; and I will need to be informed if multiple valuation dates are required.  Changes in the valuation date are important because circumstances can cause values to vary significantly.  Materially significant events can also impact the cost-of-capital, earnings projections; and in some litigation cases can be resolved only by the court.

Standard of Value:  While clients do not give much thought to Standard of Value decisions, the determination of Standard can be critical.  The Standard answers the question: Value to Who?  Perhaps the most commonly recognized Standard is [Fair Market Value] because it has been accepted as the standard in most Federal and State tax matters for several decades.  Other Standards include [Fair Value] (state-statutory or fair-value-reporting), [Investment Value], and [Intrinsic Value].

An important Standard of Value decision must be made if you are requiring a valuation for tax-compliance purposes (FMV) AND for financial reporting use (FV).  This arises most often in the completion of equity-compensation valuations assignments, IRC-409a and ASC-718.  I rarely will agree to provide one single equity-compensation valuation report for both purposes.  (The reasons for this are complex, please contact me to learn more).

Premise of Value:  Related to the Standard is the notion of Premise, which answers the question: Value under what circumstances?  Determining Premise is sometimes more important because value can change vastly, for the same company, by changing the Premise assumptions.  It is usually the appraiser who decides this element.  Common Premise of Value include:

  1. Value as a Going-Concern
  2. Value as an Assemblage of Assets
  3. Value as an Orderly Disposition
  4. Value as a Forced Liquidation

Form of Work Product:   My report to my client can be oral, written or both.  An oral report is generally provided in certain stages of litigation support engagements, but care must be taken to ensure that preliminary or draft results are treated as such (another topic).   Most credentialing organizations include their own unique reporting requirements and some appraisers (ASA’s) are required to comply with USPAP (Uniform Standards of Appraisal Practice) in  the delivery of their valuation reports.  Note: I will comply with USPAP in certain of my reports (but not in all) after discussing such with the client.

Common Report Forms include:

  • Detailed Reports
  • Summary Reports
  • Calculation Reports
  • Appraisal Report & Restricted-Use Report (USPAP)
  • Comprehensive Reports

The level of services – and sometimes the amount of fee – will often determine if I provide you with a “full” detailed report, or something less.  Our initial discussion will determine the work product.

[i] Shannon P Pratt, Valuing a Business, The Analysis and Appraisal of Closely-Held Companies, Fifth Edition (McGraw Hill, 2008), p. 30.

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