What Defines the Limits of a Valuation Report

Valuations differ in scope and intent. There is no such thing as a catchall valuation that suits every purpose, addresses every possible contingency or remains valid indefinitely.

And some valuations have surprising limitations. For instance, a client may request that the appraiser use the income approach exclusively to keep costs at bay or an adversarial owner may prevent the valuator from performing a site visit.

The bottom line is that, to be able to fully understand an appraisal, one must first know its purpose, parameters and limitations.

3 documents - Each valuation has specific parameters that are laid out in three main documents:

1. The engagement letter - These legal contracts narrowly define the assignment. They address elements such as the appraisal’s effective date, the name of the business, the size of the business interest, the standard of value, and the purpose and fees.

Engagement letters also restrict report distribution to internal management, the IRS and/or the court (in a litigious setting). Most strictly prohibit clients from sharing reports with undisclosed third parties — especially potential creditors or investors.

2. A statement of contingent and limiting conditions - This is an appendix included in most valuation reports. Although the possibilities are endless, frequent contingent and limiting conditions include the accuracy of financial statements, the exclusion of subsequent events and full compliance with all applicable federal, state and local regulations.

This statement also indicates whether the valuator (or his or her firm) has any present or contemplated interest in the subject company or any other related party.

3. The management representation letter - A valuation is only as reliable and accurate as its underlying assumptions, particularly the information management provides. Upon completion, the valuator usually requires the client to sign a management representation letter, which recaps the assignment’s parameters and confirms that there have been no intentional errors or omissions. Appraisers sometimes attach the representation letter as an appendix to their report or file it away in their work papers.

The case of the recycled report - To illustrate a misuse of an appraisal, consider Sid McFrugal, the owner of a niche chemical manufacturer. McFrugal hired a valuator while settling a dispute with a minority shareholder. The valuator estimated the fair market value of a 5% interest on a minority, nonmarketable basis as of Dec. 31, 1994.

Last year — during subsequent divorce proceedings — Sid committed a major faux pas. He reused the old valuation report without telling the preparer or requesting an update.

Although prior valuations often have relevance in subsequent assignments, McFrugal’s old report was off the mark for several reasons. Most obviously, the valuation was outdated. The chemical industry and the subject company had evolved dramatically over the last decade.

McFrugal’s 60% interest also possessed elements of control, unlike the minority shareholder bought out in the 1990s. Finally, the initial valuation didn’t address the chemical company’s sizable goodwill. In McFrugal’s jurisdiction, family courts bifurcate professional and business goodwill to equitably distribute marital assets.
Because of these shortcomings, the court excluded McFrugal’s outdated valuation from evidence and, instead, relied exclusively on the opposing expert’s report. Although McFrugal saved some up-front costs, his recycled valuation cost him substantially more in the long run.

Abusing, misunderstanding or just not knowing the limits of an appraisal can lead to misguided business decisions, as Mr. McFrugal learned, and may even cause courts to dismiss a value estimate out of hand.
A valuator should be sure that his or her client understands and agrees to these parameters, and that they’re reflected in the proper documents, before beginning the engagement.