Business%20Valuation

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Business Valuation
Valuation Methodologies Discounts and Premiums
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Business Valuation Common Uses of Business
Valuation

• Tax
• Estate/Gift
• Buy/Sell Agreements
• Bankruptcy and Litigation
• Liquidation or Reorganization
• Patent Infringement
• Partner Disputes
• Economic Damages
• Financial Reporting
• Purchase Price Allocation, Impairment Testing and
  Stock Options and Grants, etc.
• Strategic Planning/Transaction
• Value Enhancement
• Business Plan/Capital Raising
• Strategic Direction, Spin-Offs, Carve Outs, etc.
• Acquisitions, Due Diligence

• Employee Stock Ownership Plan (ESOP)
• Internal Revenue Codes (IRC) 743, IRC 409A, etc.
• Solvency and Fairness Opinions
• Damage Assessment
• Dissenting Shareholder Actions
• Marital Dissolutions

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Business Valuation Valuation Process
1.1 Proposal and Engagement Letter
1.3 Establish Valuation Date
1.2 Establish Standard of Value and Define Purpose
1.4 Data Gathering
Signed Engagement Letter with Retainer
Ongoing Internal Review and Discussion with Other
Professionals and Client
2.1 Company and Industry Analysis
2.3 Adjustments and Recasts (Control)
2.2 Analyze Historical Financial Statements
2.4 Financial Statements Analysis (Ratios, etc.)
Ongoing Internal Review and Discussion with Other
Professionals and Client
3.1 Implement Selected Valuation Methodologies
3.3 Final Internal Review and QC Process
3.2 Narrative Write-up of the Report
3.4 Finalize
Income, Market, Net Asset Approaches
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Business Valuation Standard of Value

• Purpose
• Establish Purpose of the Engagement
• Estate/Gift, Buy/Sell Agreements, etc.
• Standards of Value (i.e. Fair Market Value, Fair
  Value, etc.)
• Interest Being Valued (i.e. Enterprise, Equity,
  Marketable, Non-Marketable, Control, Minority,
  etc.)
• Valuation Date
• Agree on a Appropriate Valuation Date
• Utilize Data Subsequent to the Valuation Date
• Sometimes can Consider Data After the Valuation
  Date if it was Foreseeable as of the Valuation
  Date

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Business Valuation Standards of Value

• Common Standards of Value
• Fair Market Value (Tax) Fair market value
  applies to virtually all federal and state tax
  matters, including estate, gift, inheritance,
  income and ad valorem taxes as well as many other
  valuation situations.
• The fair market value is the price at which the
  property would change hands between a willing
  buyer and a willing seller, neither being under
  any compulsion to buy or to sell and both having
  reasonable knowledge of relevant facts. IRS
  Revenue Ruling 59-60
• Liquidation Value Orderly forced.
• Fair Value (Financial Reporting) Can vary but it
  is generally similar to Fair market value with
  some exceptions.
• The amount at which an asset (or liability) could
  be bought (or incurred) or sold (or settled) in a
  current transaction between willing parties, that
  is, other than in a forced or liquidation sale.
  - FASB 157
• Fair Value (Litigation) Fair value may be the
  applicable standard of value in a number of
  different situations, including shareholder
  dissent and oppression matters, corporate
  dissolution and divorce.

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Business Valuation Gathering Data

• Gathering Company Data
• Articles of Incorporation Operating Agreement
• History and Background
• Products and Services
• Shareholders and Key Personnel Compensations and
  Responsibilities
• Organization/Corporate Structure
• Operations
• Customers/Clients, Target Markets and Suppliers
• Legal, Tax and Other Considerations
• Five Year Historical and Latest Interim Financial
  Statements
• Other Financial Information (A/R, A/P, Fixed
  Asset Ledger, etc. - if needed)
• Adjustments
• Projections (If applicable)

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Business Valuation Analyzing Data

• Researching Economic and Industry Information
• U.S. Economy
• Local Economy
• Target Industry
• Financial Statements Analysis
• Adjustments and Recasts (Control Value)
• Extraordinary Items, Shareholders Perquisites
  (Personal Expenses), Fair Market Value
  Compensation and Rent, etc.
• Ratio and Trend Analysis
• Growth Rates, Liquidity, Leverage, Profitability,
  Efficiency, etc.

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Valuation Methodologies
Income Approach Market Approach Net Asset
Approach
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Business Valuation Valuation Approaches

• Income Approach
• The Income Approach is a valuation technique that
  provides an estimation of the value of an asset
  based on the present value of expected cash
  flows.
• The various forms
• Capitalization of Earnings/Cash Flow Analysis
  (Gordon Growth Model)
• Discounted Cash Flow Analysis (DCF)
• Dividend Discount Model (DDM)

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Business Valuation Income Approach

• Capitalization of Earnings Approach
• Single Period Discounted Cash Flow Analysis
• Simplest for Companies with Stable Growth
• Next Year Free Cash Flow to Firm (FCFF)
• Next Year Free Cash Flow to Equity (FCFE)
• Apply Appropriate Discount Rate

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Business Valuation Income Approach

• Common Levels of Value
• Enterprise Value Free Cash Flow to Firm (FCFF)
• This is the total cash flow a 100 owner would
  receive assuming no debt
• NI Depreciation /- Non-Cash Items Interest
  Expense(1-Tax) /- Change in Working Capital
  CAPEX
• Weighted Average Cost of Capital (WACC)
• Equity Value Free Cash Flow to Equity (FCFE)
• This is the cash flow a shareholder would expect
  to receive after interest and net borrowings
• Net Income Depreciation /- Non-Cash Items /-
  Change in Working Capital CAPEX /- Net
  Borrowings
• Cost of Equity (higher than WACC for the levered
  company)

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Business Valuation Income Approach

• Discounted Cash Flow Analysis
• More General and Flexible Than Capitalized
  Earnings Method

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Business Valuation Weighted Average Cost of
Capital

• Weighted Average Cost of Capital (WACC)
• WACC Weight of Equity (Cost of Equity)
  Weight of Debt (Cost of Debt (1-Tax)) Weight
  of Preferred Security (Cost of Preferred
  Security)
• Provides Overall Cost of Capital to Whole
  Company
• Assumes Constant Debt to Capital Over Time

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Business Valuation Weighted Average Cost of
Capital

• Cost of Equity Capital Asset Pricing Model
  (CAPM)
• Simple CAPM
• For larger publicly-traded companies
• Re Rf B(Rm Rf)
• Risk Free Rate (Rf)
• Risk free rate as of the valuation date (20-year
  U.S. Treasury)
• Equity risk premium (Source Ibbotson/Morningstar)
  
• Size adjustments often are appropriate (Source
  Ibbotson/Morningstar and Duff Phelps Risk
  Premium Reports)
• Beta is a systematic risk measure

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Business Valuation Weighted Cost of Capital

• Cost of Equity Build-up
• For smaller closely-held companies
• Inputs are same as CAPM except for the
  application of industry risk premium instead of
  Beta coefficient
• Industry risk premium based on Morningstar
  (Ibbotson) Yearbook
• Generally similar to CAPM after adjustments for
  size and specific risks

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Business Valuation Weighted Cost of Capital

• Cost of Equity and Leverage
• Companies with More Debt Relative to Equity are
  Riskier and Have Higher Costs of Equity
• Beta (B)
• Beta is a measure of the sensitivity of the
  movement in returns on a particular stock to
  movements in returns on some measure of the
  market (i.e. SP 500, etc.)
• Published and calculated betas typically reflect
  the capital structure of each respective company
  at market values
• Unlevered beta is the beta a company would have
  if it had no debt
• Lever the beta for the subject company based on
  one more assumed capital structure
• The result will be a market-derived beta
  specifically adjusted for the degree of financial
  leverage of the subject company

Wd Weight of Debt We Weight of Equity Wc
Weight of Capital
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Business Valuation Weighted Cost of Capital

• Cost of Debt
• Cost of Debt Based on Subject Companys Credit
  Rating and Borrowing Rate (i.e. Prime rate 1,
  BBB, BB, B-, Prime Rate, etc.) at Valuation Date
• After Tax Cost of Debt
• Cost of Debt x (1 Target Companys Tax Rate)
• Debt to Capital Ratio
• Control Value Target/Optimal or Industry Average
  Debt to Capital Ratio
• Lack of Control/Minority Value Company Specific
  Debt to Capital Ratio

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Business Valuation Other Notes About Income
Approach

• Other Notes on Income Approach
• Generally on a Control, Marketable Basis
• Levels of Value
• Synergy Level Cash Flow
• Control Level Cash Flow
• Minority Level Cash Flow
• Publicly-Traded Company Derived Discount Rate
• Minority and Marketable Level Discount Rate
• Many Consider it to be Appropriate for Control
  Level

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Business Valuation Market Approach

• Publicly-Traded (Guideline) Comparable Company
  Analysis
• The Guideline Publicly Traded Company Method
  indicates the value of the subject company by
  comparing it to publicly-traded companies in
  similar lines of business
• Valuation Multiples Vary Based on Industry and
  States of Growth
• Problem is that there are rarely perfect matches
• Equity Multiples
• Fair Market Value of Equity (Stock Price x
  Outstanding Number of Shares)
• Common Equity Level Multiples
• Price / Earnings (P/E)
• Price / Tangible Book Value (P/B)

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Business Valuation Market Approach

• Publicly-Traded (Guideline) Comparable Company
  Analysis
• Enterprise Multiples
• Enterprise Value (Stock Price x Outstanding
  Number of Shares) Total Debt/Preferred
  Securities Cash and Short-Term Investments
• Common Enterprise Level Multiples
• EV / Revenue
• EV / EBITDA
• EV / EBIT

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Business Valuation Market Approach

• Publicly-Traded (Guideline) Comparable Company
  Analysis
• Other Multiples
• EV / RD Expenses of Phase I, Phase II and
  Phase III products in pipeline Early Stage
  Biotechnology
• EV / of Licenses and Rights Shell Company,
  etc
• Appropriate Multiple Depends on Company
  Characteristics

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Business Valuation Market Approach

• Market Transaction (MA) Approach
• In the Guideline Merged and Acquired Company
  Method, the value of the business is indicated
  based on multiples paid for entire companies or
  controlling interests.
• Public Market Transaction Approach
• Public Buyer or Seller Transactions
• Control Value
• Private Market Transaction Approach
• Private to Private Transactions
• Control Value
• Common Transaction Database
• MergerStat, Pratts Stat, Biz Comps, Capital IQ

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Business Valuation Market Approach

• Market Approach Adjustments
• Most Companies Differ from the Subject Company
• Need to Adjust for Differences between Market
  Comparables and Subject Company
• Common Adjustments are Based on
• Size
• Growth Rate
• Profitability
• Leverage
• Other Company Specific Factors
• Discounts and Premiums

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Business Valuation Reconciling Items

• Reconciling Items and Adjustments
• Appropriate Weighting Value Conclusions from
  Different Approaches
• Non-Operating Assets/Liabilities and Excess
  Working Capital/Cash
• Pass-Through Entity Tax Adjustments
• Adjustment for Discounted Cash Flow Analysis and
  Publicly-Traded Guideline Comparable Company
  Analysis
• Depends on Hypothetical Buyer (C-Corp.? S-Corp.?,
  etc.)
• Interest-Bearing Debt and Contingent Liabilities
• Discounts and Premiums
• Apply to Equity Level
• Lack of Marketability and Minority Discounts, Key
  Person Discount and Control Premium, etc.

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Discounts and Premiums
Control Premium Lack of Control/Minority
Discounts Lack of Marketability/Illiquidity
Discounts Others Discounts
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Business Valuation Lack of Marketability
Discounts

• Let the Fireworks Begin!!
• Often subject to wide disparity among
  practitioners
• Determination based on analogy
• Data sources problematic
• Reasonable range

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Business Valuation Lack of Marketability
Discounts

• Lack of Marketability Discounts (LOM)
• Marketability (liquidity) is valuable. Other
  things equal, investors will pay more for the
  more liquid (marketable) asset
• The discount for lack of marketability is the
  largest money issue in many, if not most,
  disputed valuations of minority interests in
  closely-held, private companies
• The U.S. Tax Court normally allows discounts for
  lack of marketability for non-controlling
  interests in closely held companies, but the size
  of the discounts varies greatly from one case to
  another
• Need to carefully study the recent case law in
  the relevant jurisdiction
• The quality of the expert evidence and testimony
  presented in the Tax Court makes a big difference
  in the outcome
• The Tax Court expects good empirical evidence,
  relevant to the subject at hand simple averages
  are insufficient

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Business Valuation Lack of Marketability
Discounts

• Lack of Marketability Discounts
• The highest discount that the Tax Court has
  allowed purely for lack of marketability is 45,
  and most discounts have been considerably less
• The ESOP discounts for lack of marketability are
  generally low because most ESOP stock has a put
  right to sell the stock back to the sponsoring
  company, thus enhancing its liquidity and value.
• Dissenting shareholder and shareholder oppression
  cases are quite mixed on the matter of discount
  for lack of marketability
• There is little case law on discount for lack of
  marketability in divorce cases, and what exists
  is also quite mixed
• If the standard of value is clearly stated as
  fair market value, then a discount for lack of
  marketability is appropriate

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Business Valuation Lack of Marketability
Discounts

• Lack of Marketability/Illiquidity Discount for
  Minority Interest
• Restricted Stock Studies
• Restricted stocks are, by definition, stocks of
  public companies that are restricted from public
  trading under SEC Rule 144
• Although they cannot be sold on the open market,
  they can be bought by qualified institutional
  investors. Thus, the restricted stock studies
  compare the price of restricted shares of a
  public company with the freely-traded public
  market price on the same date
• Price differences are attributed to liquidity
• Many feel the discounts are a reliable guide to
  discounts for LOM
• Empirical Studies McConaughy, SEC Institutional
  Investor, Gelman, Trout, Moroney, Maher, Standard
  Research Consultants, Siber, FMV Opinion,
  Management Planning, Johnson, Columbia Financial
  Advisors Studies

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Business Valuation Lack of Marketability
Discounts

• Restricted Stock Studies
• General Findings
• Show that restricted shares are worth less than
  unrestricted shares generally ranging from 10
  to 30. Discounts as high as 55 have been
  observed
• Discounts are larger for smaller companies and
  companies with more volatile stocks and more debt
• These data are most appropriate for valuing
  restricted stocks and are difficult to apply to
  private companies
• The value of the studies is that the comparisons
  are apples to apples (i.e. liquid stock value vs.
  illiquid stock value of the same company at the
  same time).
• Restrictions have been relaxed and discounts have
  dropped
• Statistical studies can explain at best 1/3 of
  the discount

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Business Valuation Lack of Marketability
Discounts

• Pre-IPO Stock Studies
• A pre-IPO transaction is a transaction involving
  a private company stock prior to an Initial
  Public Offering (IPO)
• The pre-IPO studies compare the price of the
  private stock transaction with the public
  offering price. The percentage below the public
  offering price at which the private transaction
  occurred is a proxy for the discount for lack of
  marketability
• The application of pre-IPO studies heavily
  debated and criticized because comparisons are
  apples to oranges
• The dates of the transaction differ at a time
  when the company is changing rapidly (in the year
  before the IPO)
• Discounts are very large
• Discounts/premium should be based on specific to
  the subject case and not past court cases

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Business Valuation Lack of Marketability
Discounts

• Other Studies
• Modified put option model (i.e. Finnerty and
  Chaffee)
• Modified cost of capital total beta (McConaughy
  and Covrig)
• Private Company Discount by Koeplin, Sarin
  Shapiro, Journal of Applied Corporate Finance
  Winter 2000.
• Find approximately a 30 discount. Perhaps the
  best study, but limited sample size makes it
  difficult to apply to a specific case.

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Business Valuation Lack of Marketability
Discounts

• Factors Affecting Discounts for Lack of
  Marketability
• Companys Financial Performance and Growth
• Size of Distributions
• Prospects for Liquidity (Expected Liquidity
  Event)
• Restrictions on Transferability
• Companys Redemption Policy
• Costs Associated with a Public Offering
• Pool of Potential Buyers
• Nature of the Company, Its History, Other Risk
  Factors
• Amount of Control in Transferred Shares
• Companys Management

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Business Valuation Lack of Marketability
Discounts

• Lack of Marketability/Illiquidity Discounts for
  Controlling Interests
• Still a controversial concept
• A company with control can be marketable, but
  illiquid
• More marketable and liquid than the minority
  interest Higher lack of marketability discount
  for smaller blocks (for closely held companies)
• Super majority requirement for certain States
• Typically, private companies sell in 6 months
  which is shorter than the restriction period of
  restricted stocks

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Business Valuation Control Premium and Minority
Discount

• Control Premium
• Other things equal, an interest with control is
  worth more than one that lacks control
• An amount by which the pro rata value of a
  controlling interest exceeds the pro rata value
  of a noncontrolling interest in a business
  enterprise that reflects the power of control
  often associated with takeovers of public
  companies
• Some suggest that valuations of controlling
  interests be adjusted upward if they are based on
  publicly-traded stock prices which are minority
  interests
• Hubris and synergy may explain premia
• Not needed if cash flows are estimated at the
  control level

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Business Valuation Control Premium and Minority
Discount

• Control Premium
• Common Prerogatives of Control
• Elect directors and appoint management
• Determine management compensation and perquisites
• Set policy and change the course of business
• Acquire or liquidate assets
• Select people with whom to do business and award
  contracts
• Make acquisitions
• Liquidate, dissolve, sell, leverage or
  recapitalize the company
• Sell or acquire treasury shares
• Register the companys stock for a public
  offering
• Declare and pay dividends
• Change the articles of incorporation or bylaws or
  operating agreement

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Business Valuation Control Premium and Minority
Discount

• Control Premium Database
• Control Premia Based on Market Transactions
• Identify one month to six months control premium
  prior to announcement date for public and private
  transactions from Mergerstat, Capital IQ, etc.
• Control premia should exclude potential synergies
  associated with selected transactions, but this
  is extremely difficult
• Appropriately adjust for other qualitative
  factors based on control prerogatives

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Business Valuation Control Premium and Minority
Discount

• Lack of Control/Minority Discount
• Some feel that the control premium and the
  minority discounts should have the relationship
  as shown below
• This is overly simplistic. Ignores hubris and
  synergy and other factors that impact take-over
  premia
• Must deal with negative premia in databases

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Business Valuation Control Premium and Minority
Discount

• Lack of Control/Minority Discount
• Supermajority Requirement About a quarter of
  the states require something more than 50 plus 1
  share vote to approve certain major corporate
  actions, such as selling out or merging. Thus, a
  discount for a lack of supermajority may be
  appropriate
• Swing Vote Potential Depending on distribution
  of the stock, a minority, swing block could have
  the potential to gain a premium price over a pure
  minority value
• Interest of 50 - Discount from lack of control
  value should be less for the interest with some
  control prerogatives and a little greater for the
  interest without the control prerogatives
• Many experts feel that publicly-traded stocks
  generally sell at a control value

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Business Valuation Other Discounts

• Other Discounts
• Key Person Discount
• Measure potential negative impact to the
  projected cash flows in the absence of Key
  Personnel
• Trapped-in Capital Gains
• A company holding an appreciated asset would have
  to pay a capital gains tax on the sale of the
  asset. If ownership of the company were to
  change, the liability for the tax on the sale of
  the appreciated asset would not disappear
• Use with Caution, it depends on expected time of
  liquidity event (usually applied when liquidity
  event is imminent
• Consult a tax expert to analyze the situations
• Block Discount
• A large interest may be less liquid than a
  smaller one

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Business Valuation Other Discounts

• Other Discounts
• Voting vs. Non-Voting
• If a company has both voting and nonvoting
  classes of stock, there may be a price difference
  between the two, usually in favor of the voting
  stock
• Based on level of influence by the voting
  shareholders, restrictive agreements, state laws
  and policies and the total number of block of
  shares between voting and non-voting
• Empirical studies indicates premium for voting
  shares
• Lease, McConnell and Mikkelson Study 5.4
• Robinson, Rumsey and White Study 3.5 4.5
• OShea and Siwicki Study 3.5
• Houlihan Lokey Howard Zukin Study 3.2
  (average), 2.7 (median)

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Business Valuation Discounts and Premiums

• Common Errors in Applying Discounts and Premiums
• Greed produces inconsistencies with economic
  reality
• Low value desired
• Conservative projections
• High discount rate
• Large DLOM, etc.
• Higher value desired
• Aggressive projections
• Low discount rate
• Small DLOM, etc.
• Conservative projections should be accompanied by
  a lower discount rate
• Aggressive projections should be accompanied by a
  higher discount rate

43
Business Valuation Discounts and Premiums

• Common Errors in Applying Discounts and Premiums
• Using synergistic acquisition premia to quantify
  premiums for control
• Assuming that the discounted cash flow valuation
  method always produces a minority value
• Assuming that the guideline public company method
  always produces a minority value
• Valuing underlying assets instead of the stock or
  partnership interests
• Using minority interest marketability discount
  data to quantify marketability discounts for
  controlling interests
• Using only pre-initial public offering studies
  and not restricted stock studies as benchmark for
  discounts for lack of marketability
• Indiscriminate use of average discounts or
  premiums applying (or omitting) a premium or
  discount inappropriately for the legal context
• Applying discounts or premiums to the entire
  capital structure
• Quantifying discounts or premiums based on past
  court cases
• Using a tangible (real property, fixed assets,
  etc.) appraiser to quantity discounts and
  premiums