What is the business valuation process?

What is the business valuation process?

Canadian Institute of Chartered Business Valuators (CICBV) provides the following basic steps that a valuator should follow when conducting a valuation assignment.

Initial Meeting with the Client and setting the fundamental terms of reference

The business valuator determines:

1. The context of the assignment (i.e., the purpose of the assignment, the details of any applicable legislation and established jurisprudence; governing contracts and agreements; and other relevant factors).
2. The anticipated role of the valuator (expert vs. advocate vs. arbitrator).
3. The valuation/loss date.
4. The appropriate definition of value to be used.
5. The subject shares/assets/business/heads of economic loss
6. The timeframe
7. Determining who will be responsible for payment of fees and estimate the approximate fee for the assignment
8. The final reporting details, including matters such as review and discussion of draft reports, management representations, the type of report to be issued, to whom the report is addressed, etc.

Engagement Letter

The valuator prepares an engagement letter summarizing his/her understanding of the terms of the engagement. The client should acknowledge agreement with the arrangements by signing the letter. The details collected during the initial client meeting should form an integral part of the engagement letter.

The engagement letter forms the contract pursuant to which the valuation work will be performed. Its purpose is to safeguard both the valuator and the client. Important details which should be included in the engagement letter are as follows:

• The client (name, address)
• The purpose of the assignment (valuation/litigation etc.)
• The role of the valuator (expert vs. advocate vs. arbitrator)
• The valuation or other key date
• The appropriate definition of value to be used
• The subject shares/assets/business interest
• The time frame in which the assignment must be completed

Identification of the party responsible for payment of fees and an estimate of the approximate fees for the assignment, including any fee constraints imposed by the client or agreed to by the valuator. Certain engagements may be hard to assess in terms of the number of hours that will be required because, as an example, it is not known if all information will be available. In these cases, a fee estimate might not be possible, but it is advisable to provide hourly rate information.

Final reporting details, including matters such as review and discussion of draft reports, management representations, oral reporting versus short-form reports versus detailed reports, to whom the report is addressed, limitations as to the use of the report (and other general terms and conditions to manage professional liabilities), any statutory reporting or practice requirements that might apply.

Qualitative Analysis

Once the engagement letter is signed by the client and returned, relevant information that will support the conclusion should be gathered and reviewed. The valuator must ensure that the scope of review and documentation undertaken is in accordance with the CICBV Standards for Scope of Review and File Documentation. For instance, should a valuator be engaged to perform a Valuation Report, the research and background study for a Calculation Valuation Report would be less than that of an Estimate Valuation Report, which would in turn be less than that of a Comprehensive Valuation Report.

Quantitative Analysis

Once the available documentation concerning the company has been substantially gathered, as well as information on the industry and the economic environment, a detailed financial review of the company must be made. The general objective of this process is to compile information that has an effect on the return, risk and growth factors of the company as they affect and contribute to the quantification of the company’s value (within the economic context of the analysis).

Types of Quantitative Analysis. The following are some examples of the types of quantitative analysis that may be done:

• Trend Analysis
• Common-Size Analysis
• Ratio Analysis
• Comparative Financial Analysis

Management Discussion

The process of evaluating the relevant quantitative and qualitative considerations is brought together through discussions with shareholders and/or management and, where appropriate, with certain key employees. The valuator should attempt to review each activity of the business with a management official who is directly associated with the subject area, although this may not always be possible due to restrictions on access to individuals.

Preparation of Draft Calculations

Once the pertinent information has been gathered, the valuator needs to determine the best course in which to use this information. For valuation assignments, this includes determining the appropriate valuation methodology in relation to the type of company being valued considering such things as the underlying value of the assets, whether the business is capital intensive, whether the business predicts stable earnings or anticipates a period of fluctuation, and so forth.

The same process for loss quantification assignments must be completed, though it is beyond the scope of this course to discuss the variety of methodologies applicable to these assignments.

Draft Report

Once the fieldwork, information documentation, and preliminary calculations have been completed, the valuator is ready to prepare a draft report setting out his/her conclusions. The report must be objective, unbiased, fully documented and must include certain key components. The valuator must ensure that his/her report is in accordance with the CICBV’s Practice Standards.
The first report should be a draft to be reviewed with the appropriate parties to:

• Confirm that certain assumptions made by the valuator are warranted and not unreasonable.
• Confirm that the valuator has correctly interpreted representations made by management.
• Ensure that nothing of a material nature has been misinterpreted or omitted that might materially change the valuation conclusion.

As noted earlier, the valuator must keep in mind that management and/or the business owners may have a bias for a higher or lower dollar conclusion. As such, during the review of the draft report, the valuator should always maintain a level of professional scepticism.

That is, the valuator should be satisfied that she/he has remained objective and has adequately dealt with both the seller and purchaser’s sides of the price discovery process in developing the value conclusion.

Letter of Representation

Following the draft report review process, the valuator should obtain a letter of confirmation from management officials upon whose representations reliance was placed in reaching the conclusion. Letters of representation not only serve a legal purpose in protecting the valuator but also act as a psychological tool; if management knows they will be asked to attest to the validity of their answers, they may take more care in providing answers.
Specifically, the appropriate management officials should confirm, in writing, that:

• They have made specific representations.
• That they have reviewed the draft report and are satisfied with the explanations as to the approach used and the factors considered.
• That they have no information or knowledge of any facts that are not included in the draft report that, in their view, might affect the valuation conclusions.

A valuator should be sceptical of representations made by an individual if that individual refuses to sign a letter of representation.