This post introduces the topic of Business Valuation Standards and how they inform the discussion of marketability discounts. Given the amount of information to cover, we’ve broken the information related to business valuation standards into several posts:
- #7: An Introduction to Marketability Discounts and Business Valuation Standards
- #8: Business Valuation Standards: Valuation Methods Under the Asset Approach
- #9: Business Valuation Standards: Valuation Methods Under the Market Approach
- #10: Business Valuation Standards: Valuation Methods Under the Income Approach
- #11: Business Valuation Standards: Additional Factors in Developing DLOMs
- #12: Business Valuation Standards & DLOM Conclusion
In this post, we introduce the standards of the major business valuation professional associations and then discuss how the standards define a marketability discount as well as the concept and application of discounts and premiums. We end this post with an introduction to the three basic valuation approaches: asset, market, and income.
Prevailing Business Valuation Standards
In the United States, business appraisal standards from four appraisal organizations provide guidance for business appraisers. These standards include:
- Standards 9 and 10 (pertaining to Business Appraisal, Development and Reporting, respectively) and Standard 3 (pertaining to Appraisal Review, Development and Reporting) of the Uniform Standards of Professional Appraisal Practice (USPAP). USPAP is promulgated by The Appraisal Foundation, which first published standards in 1987.
- ASA Business Valuation Standards (ASABVS). These standards are published by the Business Valuation Committee of the American Society of Appraisers. The ASA Business Valuation Standards have evolved since the publication of the first standards in 1992. The latest version of the standards was published in 2009.
- Professional Standards of the National Association of Certified Valuators and Analysts (NACVA). These standards reflect a merging of the business appraisal standards of the NACVA and the Institute of Business Appraisers that occurred in June 2011.
- Statement on Standards for Valuation Services 1: Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset. SSVS-1 was published by the American Institute of Certified Public Accountants in 2007.
A fifth set of North American valuation standards is published by the Canadian Institute of Chartered Business Valuators (CICBV) (Practice Standards and Practice Bulletins). Finally, the International Valuation Standards Council (IVSC) publishes the International Valuation Standards 2011.
I served on the Standards Subcommittee of the Business Valuation Committee of the American Society of Appraisers for many years and was its chair at the time of the publication of the last major revision of the ASA Business Valuation Standards in 2009. I currently serve on the Professional Board of the IVSC.
Our analysis of marketability discounts in the context of prevailing business appraisal standards will focus on the four sets of standards promulgated by the major business appraisal organizations in the United States. The Professional Standards of NACVA are stated to be in parity with SSVS-1 and are very high level. The Uniform Standards of Professional Appraisal Practice have two short standards directly applicable to business appraisal. We will address these standards specifically as the discussion continues. The initial discussion, however, will focus on the ASABVS and SSVS-1.
Business, Business Ownership Interest, Security and Intangible Asset
The ASA Business Valuation Standards evolved to pertain to standards relating to the valuation of a “business, business ownership interest, security, or intangible asset.” Over time, we realized that the standards should relate not only to the appraisal of businesses, but to pieces of businesses as well. The discount for lack of marketability is that valuation discount that “moves” from a value indication at the marketable minority level (or financial control level), which is a value indication for a business, to the nonmarketable minority level of value. This latter level is a valuation at the level of the shareholder and reflects value indications of business ownership interests or securities.
The point is, prevailing business appraisal standards relate specifically to the valuation of business ownership interests and securities as well as to the development of marketability discounts applied in the process of valuing them.
Marketability Discount in the Standards
The Glossaries of the ASA Business Valuation Standards, SSVS-1 and the Professional Standards of NACVA are similar, if not identical. According to the Glossary of the ASA Business Valuation Standards, the Discount for Lack of Marketability is defined as:
An amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability.
Marketability is further defined as:
The ability to quickly convert property to cash at minimal cost.
The capability and ease of transfer or saleability of an asset, business, business ownership interest, security or intangible asset.
BVS-VII Valuation Discounts and Premiums of the ASA Business Valuation Standards (ASABVS) discusses certain concepts of valuation discounts and premiums (for ease of reference I will refer to page numbers, rather than paragraphs):
II. The Concepts of Discounts and Premiums (ASABVS, p. 16)
A discount [or premium] has no meaning until the conceptual basis underlying the base value to which it is applied is defined.
A discount or premium is warranted when characteristics affecting the value of the subject interest differ from those inherent in the base value to which the discount or premium is applied.
A discount or premium quantifies an adjustment to account for differences in characteristics affecting the value of the subject interest relative to the base value to which it is compared.
The base value from which a marketability discount is taken is typically the marketable minority level of value. SSVS-1 uses a different term for the same concept. Pre-adjustment Value is defined in its Glossary of Additional Terms (SSVS-1, p. 53) as:
The value arrived at prior to the application, if appropriate, of valuation discounts or premiums.
In any event, it should be clear that an appraiser must reach a conclusion of value that is clearly defined prior to the application of a marketability discount. We will see later that when the income approach is used, analysts may develop value indications at both the marketable minority level and at the nonmarketable minority level and determine the marketability discount as the difference. Nevertheless, the base value has to be defined.
BVS-VII goes further to discuss the application of discounts and premiums.
III. The Application of Discounts and Premiums (ASABVS, p. 16) [emphasis added below]
The purpose, applicable standard of value, or other circumstances of an appraisal may indicate the need to account for differences between the base value and the value of the subject interest. If so, appropriate discounts or premiums should be applied.
The base value to which the discount or premium is applied must be specified and defined.
Each discount or premium to be applied to the base value must be defined.
The primary reasons why each selected discount or premium applies to the appraised interest must be stated.
The evidence considered in deriving the discount or premium must be specified.
The appraiser’s reasoning in arriving at a conclusion regarding the size of any discount or premium applied must be explained.
SSVS-1 addresses valuation adjustments more succinctly, but the message is the same (SSVS-1, p. 28) [emphasis added]
63. This section should (a) identify each valuation adjustment considered and determined to be applicable, for example, discount for lack of marketability, (b) describe the rationale for using the adjustment and the factors considered in selecting the amount or percentage used, and (c) describe the pre-adjustment value to which the adjustment was applied (paragraph 40).
Both the ASABVS and SSVS-1 call for specificity of analysis, the discussion of evidence, and an explanation of the reasoning behind any concluded marketability discount (or any discount or premium). Vague, unsupported conclusions of opinion regarding a DLOM are simply not in conformity with business appraisal standards.
There are three basic approaches to valuation, the asset approach, the market approach, and the income approach. Appraisers normally consider each of the three approaches in enterprise valuations. SSVS-1, which applies not only to businesses, but to business ownership interests, securities and intangible assets, states this need for consideration (SSVS-1, p. 16):
31. In developing the valuation, the valuation analyst should consider the three most common valuation approaches:
32. The valuation analyst should use the valuation approaches and methods that are appropriate for the valuation engagement. General guidance on the use of approaches and methods appears in paragraphs 33-41, but detailed guidance on specific valuation approaches and methods and their applicability is outside the scope of this Statement.
Most valuation analysts do, in fact, consider all three valuation approaches when they develop valuations of enterprises. What about when marketability discounts are being developed? The ASABVS provide guidance on this question in its Procedural Guidelines (PG). In PG-2 — Valuation of Partial Ownership Interests, we find this specific guidance (ASABVS, p.47):
Appraisers should consider all three approaches to value (asset-based, income and market) when valuing partial interests. If an approach is excluded in an assignment the appraiser should explain the reason for such exclusion in the appraisal report.
This is interesting guidance, because many appraisers do not really consider or discuss the valuation approaches under which the methods used to develop marketability discounts fall. However, every method used to develop marketability discounts can be classified under either the asset approach, the market approach, or the income approach (or a hybrid).
Our next post will discuss valuation methods under the asset approach.