Valuation Issues When Your Market is Faltering Edward A ...

Valuation Issues When Your Market is Faltering Edward A ...

What Every Business Attorney Should Know about Business Valuations Edward A. Wilusz, ASA, CFA Overview of Presentation Overview of Business Valuations Buy/Sell Agreements Shareholder Disputes

Estate Planning What to Expect in Selling a Business Selecting a Business Valuation Expert Overview of Business Valuation General Concepts Value Levels of Value Steps in Appraising a Business

Approaches to Value Introduction Value is the Present Worth of Future Benefits Supply and Demand Reasoned Judgment Substantiated by Fact Types of Value ? Fair Market Value ? Fair Value

? Liquidation Value Reasons for Valuations ? ? ? ? ? ? ?

? Accounting Related Income tax Estate and Gift tax Employee Stock Ownership Plans Employee Incentives (SARs, Options) Litigation Buy/Sell Agreements Sale

Levels of Value ? Synergistic value ? Control ? Marketable Minority Interest ? Non-Marketable, Minority Interest Discounts ? ?

? ? ? ? ? ? ? Minority Lack of Marketability

Key Person Portfolio discount Litigation risk Environmental risk Trapped-in capital gains Voting vs. non-voting Blockage Benefits of Control ? Appoint management

? Determine management compensation and perqs ? Set policy and change course of business ? Acquire or liquidate assets ? Select people with whom to do business ? Declare dividends Benefits of Control (contd.) ? ?

? ? Make acquisitions Liquidate, dissolve, sell out Sell or acquire treasury stock Register the companys stock for a public offering ? Change the articles of incorp. or bylaws ? Block any of the above actions

Degrees of Minority Versus Control ? ? ? ? Majority interest 50 percent interest

Swing vote minority Enough votes to elect a director under cumulative voting ? High enough percentage to bring a minority dissolution action Quantifying Minority or Lack of Control Discounts ? Acquisition premiums for publicly traded stocks

? Ex. Company trading at $10 per share is acquired for $15 per share. There was a 50% premium. The implied minority discount is 33.3%. ? Acquisition prices can reflect elements of strategic or synergistic value. ? In public companies, control shareholders may not have exploited the prerogatives of control at the expense of the minority.

Quantifying Minority or Lack of Control Discounts (contd.) ? Examine difference between market and underlying net asset values for publicly traded holding companies ? Examine closed-end investment companies, real

estate limited partnerships, etc. ? Limited partnership discounts from net asset value Discount for Lack of Marketability ? Marketability means the liquidity of an interest

? The ability to convert to cash quickly ? Lack of marketability means the lack of an established, efficient market. ? Even some publicly-traded stocks suffer from illiquidity Other Factors Affecting Discounts for Lack of

Marketability ? Dividends or distributions ? Pool of potential buyers ? Information access and reliability Other Factors Affecting Discounts for Lack of Marketability ? ?

? ? ? Amount of control in transferred shares Restrictions on transferability of stock Holding period for stock Companys redemption policy Cost associated with public offering

Benchmark for Marketability ? Restricted stock studies ? Pre-IPO studies Restricted Stock Studies ? Examine restricted stock or letter stock of public companies Restricted Stock Studies ? Size makes a difference

Revenues (in millions) Avg. Discount Under $10 32.9% $10 mil.-$30 30.8% $30 mil.-$50 25.2% $50 mil.-$100 19.4% Over $100

14.9% Restricted Stock Studies Study Avg. Price Discount SEC average 25.8% SEC non-reporting OTC companies 32.6

Gelman 33.0 Trout 33.5 Moroney 35.6 Maher 35.4 Std. Research Cons. 45.0

Willamette Mgt. Assoc. 31.2 Silber 33.8 FMV Opinions 23.0 Mgt. Planning Inc. 27.7 Steps in Appraising a

Business ? Data Gathering Phase ? Analysis and Correlation ? Application of Approaches Data Gathering Phase Company Information ? Financial documents ? Shareholder agreements ? Employment & Management Contracts

? Brochures/Descriptive Materials ? Projections/Budgets ? Details on offers & transactions ? Past appraisals & consultants reports Data Gathering Phase Company Interview ? Nature & History of Business ? Markets & Marketing Efforts ? Competition

? Management ? Operations ? Facilities & Equipment ? Financial Overview Data Gathering Phase ? Industry ? Economy ? Geographic Area

Analysis of Data Financial Statements ? ? ? ? ? Adjust for Discretionary Items Accounting Related Adjustments

Eliminate Non-recurring Items Eliminate Non-operating Items Comparisons Three Approaches to Value ? Income Approach ? Market Approach ? Asset-Based Approach Market Approach Method

? Publicly traded guideline company method ? Guideline merger and acquired company method ? Past transactions method ? Buy-Sell agreement method ? Rules of Thumb method Publicly Traded Guideline Company Method

? Use for valuing companies of a certain revenue level ? Ideal publicly traded guideline companies used for: +Large companies that could go public +Smaller companies as a sanity check Publicly Traded Guideline Company Method ? Examine ideal guideline companies for:

+Line of business +Growth rates +Levels of revenues and income +Capital structure +Profitability > Identify companies sharing similar investment characteristics Compare Subject Company

to Guideline Companies ? Quantifiable Comparison +Adjust for accounting differences ? Non-Quantifiable Factors Based on Analysis & Comparison Select & Apply Multiples ?

? ? ? Price/Earnings (Historical) Price/Cash Flow Price/Projected Earnings Market Value of Invested Capital (MVIC)/Earnings Before Interest & Taxes (EBIT)

? MVIC/Earnings Before Interest & Taxes & Depreciation (EBITDA) Selection of Multiples Impacted By: ? Quantifiable comparison ? Non-quantifiable comparison ? Range of publicly traded company multiples

Advantages ? Reflects arms length transactions between buyers and sellers ? Efficient market (knowledge of buyers and sellers) ? Active market ? Availability of financial information Advantages ? Availability of descriptive material

? Fairly consistent data across companies ? Financial analysts material: +Analysis of company +Analysis of industry information +Analysis of forecasts Advantages ? Simple to understand ? Includes value of all operating

assets of business Disadvantages ? Many times no good guidelines exist ? Can be difficult to properly apply ? Tendency to use shortcuts ? Minority versus majority interest issues Guideline Merger & Acquired Company Method

? Valuation of company in entirety ? Analysis should be applied similar to guideline publicly traded company method Advantages ? For small businesses, can sometimes be a better method than guideline

publicly traded analysis Disadvantages ? Lack of detailed information on transaction +Limited description of acquired company +Limited financial data +Limited transaction data +Terms of transaction not disclosed

> Timeliness of Transaction > Use of this approach with limited information can produce grossly inaccurate conclusion Past Transactions of Subject Company Stock ? Can provide best indication of value Relevance of Prior Transactions

? Need to examine whether arms length transaction involves: +Family members +Distress sale +Other factors Timeliness of Transaction ? Depending on market conditions:

+A transaction may become stale quickly +Older transactions--examine and possibly adjust multiples Knowledgeable Buyer and Seller ? Financial sophistication of parties ? Did the parties have all the relevant facts?

Advantages ? Simple ? Involves transactions in subject company Disadvantages ? Without proper examination, can result in grossly inaccurate conclusion

? Sometimes given excessive weight in conclusion Buy-Sell Agreements ? Generally use a formula approach ? Often based on book value ? May only be applicable in certain instances ? May involve related parties ? Stipulated values are often not updated

? Frequency of transactions Buy-Sell Agreements ? Can be controlling or irrelevant Rules of Thumb ? Supposedly market derived ? Quoted as a multiple of some financial measure Examples:

? 1.5 times revenue ? 3.0 times owners cash flow ? Generally more applicable in valuing small companies ? MUST BE AWARE OF THEM Advantages ? For some industries, can be given significant weight

? Can be a good sanity check on other valuation methods Disadvantages ? Rules may not change over time ? Too many factors impact value to be contained in a rule of thumb ? Often rules are not clear what assets and liabilities are included

Asset-Based Approaches ? Going concern basis ? Liquidation basis ? Excess earnings Going Concern Basis ? Value the tangible assets--common adjustments include: +Adjust investments to market value

+Inventory valuation -- LIFO vs. FIFO +Accounts receivable -- accurately reflect collectibilty +Prepaid expenses +Land and building -- may need real estate appraisal +Machinery & equipment --may need appraisal > Intangible assets

. Generally captured under other approaches Adjust Liabilities ? Fair value of debt ? Contingent liabilities ? Built-in gain liability Liquidation Basis

? Sometimes used when company has very low earnings or losses ? For machinery & equipment appraisals: +Forced liquidation value +Orderly liquidation value +Fair market value in place Advantages

? For investment or holding company, asset based method may be given the greatest weight ? May establish minimum values ? Can be used for any business ? May be controlling value for very small businesses Disadvantages ? Book value is not net asset value

? Costs ? Use appropriate standard ? Usually given little in valuing a going concern Excess Earnings Method ? Adjust companys tangible assets to current value ? Estimates amount of income needed to support the net tangible assets

? Excess earnings are capitalized to produce value of intangible assets ? Add tangible and intangible asset amounts together Advantages & Disadvantages ? Advantages-- +Seems reasonable

? Disadvantages-- +Two guesses to get one good answer +Not recognized financial theory--formula derived by IRS during prohibition The Income (Cash Flow) Approach ? Present worth of future benefits

? Most widely utilized valuation method Discounting ? Projecting economic income ? Discounting each income increment to present value at investors rate of return (known as the discount rate) Capitalizing ? Estimate a single periods economic

income ? Then divide by rate of return known as capitalization rate Discounting ? Opposite of compounding Present Value Time Period Rate $925.93 $857.34

$793.83 Future Value 1 year at 8% $1,000 2 years at 8% $1,000 3 years at 8% $1,000 Compounding $793.83 x (1.08) = $857.34

$793.83 x 1.083 = $1,000.00 Discounting 1 $1,000 x (1.08) = $925.93 1 $1,000 x (1.083) = $793.83 Capitalizing ? Shortcut form of discounting

? Implicit assumptions: +Income remains constant or +Income will either increase or decrease at some constant annual rate Constant Income Model (Preferred Stock) ? Income stream remains constant (no growth)

? Dividend is expected to continue in perpetuity Constant Growth Model PV =D = $5 = $50.00 C .10 Where: PV = Present Value D C

= Dividend (Distribution) = Capitalization Rate Income Capitalization Model (Gordon Model) ? Cash flow or income is expected to increase over time ? Future growth and predictions can be estimated (inflation and/or

volume increases) Income Capitalization Model PV = E x (1+g) k-g Where: PV = E g

k Present Value = Baseline Income = Growth rate = Discount rate PV = E1 + E2 + ... EN 1+k (1+k)2 (1+k)N

PV = Present Value EEN = Expected income in each of periods l through m k = Discount rate Application of Income Capitalization Model PV = $10 x (1+.03) = $10.30 = $68.67 .18 - .03

.15 ? Long term growth rate must be reasonable Determination of Future Economic Benefits ? Current earnings/cash flow ? Simple average ? Weighted average ? Trend line

? Formal projection Discounted Cash Flow (DCF) Model ? Used in valuation of limited life investments (e.g. bonds) ? Used in valuation of businesses where cash flow may change (e.g. high growth companies)

Cash Divide Flow by Factor PV Year 1 $100 (1+.20) = $83.33 Year 2 $130 (1+.20)2 = $90.28 Year 3 $150

(1+.20)3 = $86.81 Terminal $150x(1.05) (1+.20)3 = $607.64 Value .20 - .05 $868.06 DCF Model Application for High Growth

? Assume three years of high growth ? Terminal (final) years apply Gordon Model with lower growth (5%) ? Advantages: ? Used for variable cash flows/limited life investments ? Disadvantages:

? Growth rates and discount rates must be realistic ? Small changes in g and k can result in significant change in value Estimation of Equity Discount Rate (k) ? Represents rate of return available

for investments that have similar degree of risk ? Total return reflects cash payouts and capital appreciation Estimation of Factors for Discount Rate (Build-Up Model) ? Start with Risk Free Rate--long term government bonds ? Add: General equity risk premium

? Add: Size Premium--Size of specific company ? Add/Subtract: Specific company risk factors Application of Build-Up Model Risk Free Rate = 2.6% Equity Risk Premium

= 8.0% Size Premium = 4.4% Specific Company= 2.0% Discount Rate = 17.0% Other Factors Used in Build-Up of Discount Rate ? Beta--measure of correlation with market risk

(S&P 500) ? General equity risk premium is multiplied by Beta ? Beta reflects industry risk + + + Beta > 1 = Greater than market risk

Beta < 1 = Less than market risk Beta = 1 = Market risk ? Beta is controversial Estimating Capitalization Rates (c) C = k - g = discount rate - growth rate ? Discount rate determined by build-up method

? Growth rate includes inflationary growth and volume growth Valuing Invested Capital ? Invested capital valuation represents total debt and equity value ? Invested capital valuation is useful when debt levels of a company are different than average (too low or too high) ? Invested Capital

Less: Debt Equals: Equity Value Invested Capital Valuation Requires Blended Discount Rate Using Weighted Average Cost of Capital WACC = Weighted Avg. Cost of Capital WACC Calculation Component

Equity Debt* Cost .20 .07 Weight

Weighted .60 .12 .40 .03 .15 = 15% *Debt cost is after tax

Net Cash Flow vs. Income Cash Flow Net income Plus: Depreciation & Amortization Less: Capital Expenditures Less: Working Capital Requirements Equals: Net Cash Flow Net Cash flow

? Amount that can be taken out without impacting operations. ? In many small businesses, net income and cash flow are the same. ? May add interest (total affected) to arrive at cash flow on a pre-debt basis. Mid-Year Discounting Convention ? Used when proceeds are received evenly

throughout year. ? Produces a higher indication of value. Buy/Sell Agreements Reasonable resolution to event that triggers the buy-sell: Resignation Termination Retirement

Disability Death Change of control Factors to Consider Valuation of entity Relative ownership Age of owners Relative financial position of owners Health and insurability of owners

Importance of owners participation in the business Availability of assets for redeeming the interest

Fixed Price Buy-Sell Agree to a price at a point in time Often state that it will be updated periodically Define the conditions that will cause the provisions to be triggered Fixed Price Buy-Sell Advantages

Easy to understand Easy to negotiate Inexpensive Disadvantages Out of date shortly after they are signed (continued)

Formula Buy-Sell Agree to a formula typically base on: Book Value Sales Earnings (EBIT, EBITDA, etc) or Cash Flow The formula can be an average of two or more calculations The formula can change depending on certain

factors Based on the then-current financial statements Formula Buy-Sell (continued) Advantages Easy to understand (initially)

Easy to negotiate Inexpensive Disadvantages No formula selected at a given point in time can provide reasonable and realistic valuations over time Shotgun Agreements One party establishes a price at which he/she will buy or sell The other party then has the right to buy or sell

at that price Shotgun Agreements (continued) The shotgun aspect of the agreement requires that there be a transaction, but the initial offer does not know whether they will be the buyer or seller at the time the offer is made

Uncertainty as to the final outcome Right of First Refusal Form of a Buy-Sell If a shareholder has a concrete offer: Corporation has right of first refusal Shareholders then has right of refusal Last opportunity to purchase may go back to

corporation or to shareholders If all of the prior rights are refused, then the original shareholder can sell to third party Right of First Refusal (continued) Discourages third parties from making

offers Gives corporation control over inclusion of new shareholders If a third party offer is low, corporation or shareholders will purchase Process Buy/Sell Agreements Agreements where a valuation process is used to establish value

Single appraiser Two appraisers with an option for a third appraiser Two appraisers who then select a third appraiser Process Buy/Sell Agreements (continued) If using multiple appraisers:

Agree on qualifications of appraisers Who bears the cost Set deadlines Process Buy/Sell Agreements (continued) Advantages Can provide the best indication of value

The general process is commonly known and relatively simple Parties should believe they are protected by the process since they will have a voice in the selection of the appraiser Process Buy/Sell Agreements (continued) Disadvantages

Potential for dissatisfaction with the ultimate results for all parties Danger of the perception of advocacy with single appraiser Some uncertainty regarding the process & the final price More costly in the short-term

Defining Elements of BuySell Standard of value Level of value The as of date

Qualifications of appraisers Funding mechanisms Standards of Value Value Investment Value Fair Value Fair Market Value (recommended) Level of Value

Strategic Control Control Marketable Minority Nonmarketable Minority The As Of Date of the Appraisal Can be the most important issue Date of the triggering event (quit, fired, retires,

etc.) Current date Change of control Date determined by availability of financial statements As agreed upon by the parties Appraiser Qualifications Professional designation specified Appraiser experience (full-time)

Industry experience Education and training Appraiser Qualifications (continued) Specify Appraisal Standards Uniform Standards of Professional Appraisal Practice

Business Valuation Standards of the American Society of Appraisers AICPA Business Valuation Standards Funding Mechanism Life insurance If a company-owned policy, should it be treated

as a company asset Corporate assets Shareholder or company notes Combination of cash and notes

External borrowings ConclusionBuy/Sell Agreements Consider events that trigger the buy-sell Formula Buy-Sell for smaller businesses Process Buy-Sell for larger businesses Use Fair Market Value Standard Agree Upon Level of Value and the As Of date

Funding Mechanism Valuation of FLPs & LLCs If done right, provides opportunity to transfer an interest in assets at a discounted value

Avoid Death bed transfers Transfer of personal use assets to FLP Transfer of substantially all of taxpayers assets Valuation of FLPs & LLCs Avoid Transfer of FLP interest until all assets have been properly transferred to FLP

Making non-pro rata distributions to partners Using FLP funds to pay personal expenses Being overly aggressive with discounts Valuation of FLPs & LLCs Establish business purpose of entity Joint management of family assets Pooling the assets to allow for investment opportunities that would not be otherwise available

Providing additional protection from potential creditors Other Issues Treatment of imbedded capital gains Courts have accepted dollar for dollar reduction for tax liability Structured Settlements, Lottery Winnings

Some cases say use IRC annuity tables Others have left it open saying the annuity tables do not account for lack of marketability and not reflective of fair market value Selling A Business Seek Professional Assistance Early Timing

Owners Objectives The State of the Business Market Conditions Value of the Business Selling A Business Sale Time Line

Owners Time Confidentiality Company Information Competition Management & Employees Selling A Business Prepare Sale Literature

Determine Primary & Secondary Prospective Buyers Seller & Prospective Buyer Interaction Selling A Business Negotiate the Deal Financial terms Legal & accounting Buyer & Seller Temperament

Due Diligence The Purchase Agreement The Closing QUESTIONS?? www.ValueManagementInc.com Phone: 215-343-0500 0501

Fax: 215-343- 2370 York Rd, E2 Jamison, PA 18929

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