Virtually all midsized companies consult with an attorney before drafting new contracts or renegotiating existing agreements. But they often fail to consult a professional when seeking to define the value of a key business transaction.

Experts say such an oversight can lead to expensive consequences. For example, a midsized bank agreed to buy an insurance company that also offered a wealth management service. After signing the purchase documents, the bank learned the insurance and wealth management businesses operated as separate financial entities, and the wealth management business wasn’t part of the transaction. As a result, the bank overestimated the value of the intellectual assets it purchased—an oversight a valuation expert could have identified beforehand.

“A full-time business valuation professional offers experienced judgment about risk factors and reasonable assumptions, which can help ensure midsized business leaders receive sound valuation projections,” said Mike McLain, a director with RSM McGladrey Consulting who focuses on business valuations.

A business valuation differs from a real estate or equipment appraisal because it includes a review of both tangible assets such as physical plant or equipment and intangible assets, which may include environmental or economic forces that affect a company’s future prospects.

A company may seek business valuation assistance to:

• Establish a transaction price. A well-designed valuation can help prospective business buyers and sellers by creating a baseline for a reasonable asking price. A valuation also can serve as a due-diligence consideration in a merger or acquisition.

• Conduct business planning. A business valuation process can improve performance by identifying a company’s strengths and weaknesses. Additionally, valuation can define “exit clauses” in partnership agreements, protecting the financial interests of individuals and the company.

• Make estate plans. In many closely held businesses, the net worth of key employees ties to the value of the company. For that reason, a solid financial plan should include an accurate business valuation, which can be a critical component to defend against an IRS audit of estate taxes.

• Meet legal requirements. Changes in business structure or operations occasionally trigger the need for a business valuation. For example, IRS rules require a business valuation when a company converts to an S corporation from a C corporation. And, if business owners enter divorce proceedings, many states require a valuation to divide business assets.

Business valuation tools generally fall into two categories: fair market value and investment value. Establishing fair market value, McLain said, involves determining what a willing buyer would pay a willing seller—assuming neither is compelled to buy or sell and has reasonable knowledge of relevant facts about the transaction in question. Fair market value is the accepted tool to establish a price for gift and estate-related transactions.

Investment value, on the other hand, employs a more specialized approach. For example, if a business owner is preparing to sell the company, a calculation of investment value will consider any “special benefits” that make the firm worth more than fair market value to a buyer. To establish those possible benefits, a valuation expert may use a variety of approaches—including balance sheet analysis, market comparisons with similar businesses, and discounted cash flow—to arrive at a price that reflects the value of the investment.

Once business leaders agree on the right valuation target and tools, the next step is to determine the appropriate report. Valuation reports typically fall into three categories:

• Appraisal reports. This report involves a full analysis of the company using IRS-required procedures and methods. The appraisal report is helpful when an objective, third-party opinion on the value of a business, an ownership interest, or a security is required. An appraisal report may provide appropriate documentation for estate or gift tax returns, validation for bank financing, or development of employee stock ownership plans.

• Summary letter reports. A summary letter reflects the research of a full appraisal but in a condensed letter format. The letter typically outlines the selected valuation procedures, the information used to form opinions, and the reasoning behind analyses and conclusions of value. This approach is appropriate when the business needs a third-party valuation for internal discussion or decision-making. Summary letter reports can facilitate transactions between shareholders, validate a change to an S corporation from a C corporation, or support buy-sell agreements, among other uses.

• Calculations. A calculation is an approximate indication of value—not a formal opinion. Instead of providing extended valuation research, a calculation reflects a limited review of business procedures as agreed upon by the company and the third-party consultant. Calculations are appropriate in situations where a company seeks an estimated value for a business—not a formal, legally defensible opinion of value. Calculations may be a good tool for estate planning, price estimates in connection with the sale or purchase of a business, or value-based planning, especially as a tool to help drive business strategy.

Is your company in need of business valuation services? If so, experts offer the following tips:

• Verify professional credentials. Not all business consulting firms have dedicated, full-time staff who specialize in business valuation. Look for business partners who can offer specific industry certifications—such as the elite Accredited Senior Appraisers (ASA) and Accredited in Business Valuation (ABV) credentials—that will stand up under the scrutiny of contending parties.

• Look for strong litigation experience. Occasionally, if a valuation is contested, litigation support is necessary to protect a company’s interests. Firms with strong valuation credentials can offer expert testimony—usually given in depositions or as trial witnesses—that supports the conclusions from their business valuation research and assessments.

• Seek valuation partners that understand midsized businesses. Business valuation is more than number crunching. It’s also the art of understanding industry and business issues that may affect fair market or investment valuations.When interviewing prospective firms, ask about their experience with midsized companies and details on how they’ve solved valuation issues. IBI