There Is a Problem in Business Appraisal Land
There were significant changes in Standards Rule 9-4 of the Uniform Standards of Professional Appraisal Practice regarding the development of business appraisals between 2005 USPAP and 2006 USPAP. The changes relate to moving from following procedures and considering approaches to a focus on developing “credible appraisal results” and analyzing “the effect on value, if any” or a number of quite specific valuation factors.
There were changes to Standards Rule 9-4(a) and 9-4(b) that shift emphasis to credible appraisal results and to introduce a focus on intangible assets for the first time. Standards Rules 9-4(c) and 9-4(d) were completely new and require appraisers to “analyze the effect on value” of a number of very specific factors that we will discuss in the comparisons below. I have focused on the changes and additions, which remain essentially unchanged in the 2020-2021 USPAP (the current version).
I have discussed these changes and additions in numerous speeches and publications, including on this blog. They are important because, as I have said many times over the years, appraisers who must follow USPAP, and that includes all members of the American Society of Appraisers and any appraisers conducting appraisals for gift and estate tax purposes or for other purposes involving the federal government, these standards apply. The rules apply, practically, to almost all appraisers, including those holding ABV and CVA designations.
And now for a bold conclusion at the outset:
Many appraisers who focus on using restricted stock studies and pre-IPO studies as a basis for determining marketability discounts for illiquid minority interests have historically not been and are currently not providing standards-compliant appraisals for their clients.
And that’s a problem.
Changes to USPAP Standards Rules 9-4(a) in 2006
The first figure sets Standards Rules 9-4(a) and 9-4(b) side by side so we can focus on what changed and, perhaps, discuss some of the whys of the changes. I have placed comments regarding changes in brackets in the figures that follow. They will be available to anyone choosing to copy the figure for quotation or other use. I will also discuss those comments in the text of this post for flow and completeness.
The change in the Introduction to Standards Rule 9-4. The first change is a shift from focus on collecting and analyzing appropriate information subject to the “scope of work” to a focus on collecting and analyzing information “necessary for credible assignment results.” The term “credible assignment results was mentioned four times in USPAP 2005. The term is used some 30 times in 2006 USPAP through Standards Rule 10. This was a significant change to the standards. What is the purpose of standards anyhow but to encourage appraisers to provide credible assignment results. This guidance is unchanged to the present.
The change in Standards Rule 9-4(a). The 2005 version on the left provided potential confusion for appraisers. It was necessary to use “one or more” and “all relevant approaches” with sufficient data. The 2006 version says to use “one or more approaches that are necessary for credible assignment results.” The importance of this shift is emphasized by the fact that the term “credible assignment results” is used only four times in 2005 USPAP. It is used some thirty times through Standard 10 (Business Valuation, Reporting). This guidance is unchanged to the present.
The definition of “Credible” in USPAP 2006 is:
CREDIBLE: worthy of belief.
Comment: Credible assignment results require support, by relevant evidence and logic, to the degree necessary for the intended use. (emphasis added)
USPAP 2006 tells appraisers that to be worthy of belief, assignment results must be supported by appropriate evidence and logic “to the degree necessary for the intended use.” The definition remains unchanged through 2020-2021 USPAP. What, though, is “relevant evidence?” We will see shortly.
Standards Rule 9-4(a) was changed in 2006 to state that appraisers should select valuation approaches that are necessary for credible assignment results, rather than, as in 2005, the guidance was to use approaches that apply to the specific engagement. The overriding goal of USPAP beginning with USPAP 2006 has been credible assignment results.
The Comment to Standards Rule 9-4(a) was deleted. It stated that all relevant approaches should be used, but that “inapplicable” approaches did not have to be used. The absence of this Comment and the change in Standards Rule 9-4(a) make it clear that the goal is, indeed, credible assignment results over any other guidance.
Changes to USPAP Standards Rules 9-4(b) in 2006
Standards Rule 9-4(b) provides a list of specific factors that need to be considered. In 2005 USPAP, appraisers had to “include in the analysis, when relevant, data regarding” the seven factors. In USPAP 2006, the mandate is: “An appraiser must, when necessary for credible assignment results, analyze the effect on value, if any, of” the factors. The standards have gone from “including data” to required analysis to ascertain the effect on value. Changes to Standards Rule 9-4(b) are shown in the following figure.
There are seven specific factors in USPAP in both the 2005 and 2006 editions. 2006 USPAP adds consideration of intangible assets (b)(ii). It also changes (b)(v) to refine guidance from 2005. The factor is not “sales of capital stock or other ownership interest in similar business enterprises.” The other business interest could be privately owned or publicly traded based on this guidance. This guidance, together with (b)(iv), which pertains to transactions in the stock of the business being appraised, eliminated the need for the guidance in the second half of the Comment in 2005 USPAP.
The takeaway from this review of changes to Standards Rule 9-4(b) is that we have moved from a world of “including in the analysis, when relevant data regarding” the factors to one of “when necessary for credible assignment results, analyze the effect on value, if any” of the factors.
New Standards in Rules 9-4(c) and 9-4(d) in 2006
2006 USPAP added two entirely new rules, Standards Rules 9-4(c) and 9-4(d), which have been ignored, for the most part, by business appraisers. The new rules are provided in the next figure. While this focus in on changes made in 2006, there has been virtually no change in Standards Rule 9-4 since then, so the comments are as appropriate in 2022 as they were in 2006.
Standards Rule 9-4(b) provided a list of factors to analyzed. Standards 9-4(c) and 9-4(d) extend the list of factors in meaningful ways while maintaining the guidance about analyzing the effect on value, if any, if needed for credible assignment results. Factors required for analysis in Standards Rule 9-4(c) include:
- Buy-sell and option agreements
- Investment and letter stock agreements
- Restrictive corporate charter or partnership agreement clauses
- Similar features or factors that may influence value
Standards Rule 9-4(c) requires analysis of the impact of buy-sell agreements, operating agreements, partnership agreements, restrictions in corporate charters, restrictions in partnership agreements and, by implication, restrictions in any other type of corporate agreement. It then goes on to add that appraisers should consider (i.e., analyze the effect on value, if any) similar features or factors that may influence value. This would include applicable laws and regulations.
USPAP 2006 does not tell appraisers the how of analyzing these factors required by Standards Rule 9-4(c), but the mandate to do so is clear. One good place to go for additional factors to consider under 9-4(c) is “PG-2 – Valuation of Partial Ownership Interests,” a Procedural Guideline in the ASA Business Valuation Standards.
Standards Rule 9-4(d) goes beyond corporate documents and laws and regulations. It begins to address specific factors that influence the values of illiquid minority interests (and perhaps, businesses and intangible assets as well). The new factors include:
- The extent to which the interest has elements of ownership control
- The extent to which the interest is marketable and/or liquid
- Holding period (i.e., the expected holding periods of investment for illiquid minority interests)
- Interim benefits (i.e., the expectations for dividends or distributions to the illiquid minority interest over the expected holding periods of illiquid minority interests
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- A broad variety of facts and circumstances that could influence the degree of control, marketability and/or liquidity (or lack thereof) must be analyzed when applicable.
Each of Standards Rules 9-4(c) and 9-4(d) begins with the instruction:
An appraiser must, when necessary for credible assignment results, analyze the effect on value, if any, of – the factors.
A good place to go to find a list of a broader list of facts and circumstances that could influence value would be the same “PG-2 – Valuation of Partial Ownership Interests” noted above. This procedural guideline provides six detailed pages of discussion of the valuation of partial ownership interests.
What Is the Problem in Business Appraisal Land?
The problem raised by changes in USPAP between 2005 and 2006 and continuing to the present is that the required analysis to determine the effect on value, if any, cannot be accomplished using comparisons with dated restricted stock and/or pre-IPO transactions. It is just that simple. The required analysis can only be accomplished using methods under the income approach.
The value of an interest in a business is the present value of all “interim benefits” (expected future benefits to the interests, or dividends and distributions), discounted to the valuation date over the “holding period” (i.e., a reasonable estimate of the expected holding period or a range of estimates). The terminal benefit is implied, because illiquid minority investments are assumed to be liquidated at the end of their expected holding periods to achieve the objectives of the investments. The discount rate (or required holding period return) should reflect “the difficulty and cost of marketing the subject interest” and the risks of the holding period of the “degree of control, marketability and/or liquidity (or lack thereof.” In other words, the the discount rate should include the risks of the expected holding period that are in addition to the risks of the underlying business (or assets, if the entity is an asset holding company).
The problem raised by the changes in USPAP between 2005 and 2006 and continuing to the present is that appraisers cannot deliver standards compliant appraisals of illiquid minority interests using traditional (market approach) guideline public company or transactions methods involving comparisons with restricted stock and/or pre-IPO transactions. And yet every appraisal I have seen by other appraisers using only these methods has averred compliance with USPAP.
A number of methods have been developed under the income approach to valuation. The Quantitative Marketability Discount Model (QMDM) is one of them. The QMDM is a shareholder level discounted cash flow model. This model will help appraisers to follow the guidance of Standards Rule 9-4(c) and render standards-compliant appraisals of illiquid minority interests in business entities. QMDM focuses on interim benefits, the holding period, and the risks associated with marketing, as well as enabling appraisers to “analyze the effect on value, if any” of the various factors mentioned in the standard.
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