Business Valuation

Business ValuationValuation 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

Ongoing Internal Review and Discussion with Other Professionals and Client

Ongoing Internal Review and Discussion with Other Professionals and Client

Income, Market, Net Asset Approaches

Signed Engagement Letter with Retainer

1.4 Data Gathering

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.)

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

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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.

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

Value =

CF = Free Cash Flow(FCFF or FCFE)

r = Discount RateCost of Capital orCost of Equity

g = Expected Growth Rate

CF1

(r-g)

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

CF1 CF2 CFn TCF / (r-g)Value = + + … +

(1+r)1 (1+r)2(1+r)n (1+r)n

CF = Cash FlowTCF = Terminal Cash FlowR = Discount Rate (Weighted Average Cost of Capital) or (Cost of Equity)G = Long-term Growth Rate

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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

Build-up Cost of Equity Capital

Risk-free rate (Rf) 4.5%

Equity premium (RPm) 5.0%

Size premium (RPs) 6.0%Industry risk premium -1.1%Company-specific premium (RPu) 2.0%

Indicated Cost of Equity Capital 16.4%

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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. S&P 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

Bu (Unlevered Beta) =BL

1 + ( 1 - t ) Wd / We

BL (Relevered Beta) = Bu ( 1 + ( 1 - t ) Wd / Wc )

Wd = Weight of Debt

We = Weight of Equity

Wc = Weight of Capital

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Cost of Debt –Cost of Debt Based on Subject Company’s 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 Company’s 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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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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Publicly-Traded (Guideline) Comparable Company Analysis– Other Multiples

»EV / R&D 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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Market Transaction (M&A) 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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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.

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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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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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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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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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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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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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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Factors Affecting Discounts for Lack of Marketability

– Company’s Financial Performance and Growth

– Size of Distributions

– Prospects for Liquidity (Expected Liquidity Event)

– Restrictions on Transferability

– Company’s 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

– Company’s Management

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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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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 company’s stock for a public offering

» Declare and pay dividends

» Change the articles of incorporation or bylaws or operating agreement

37


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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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

1Minority Discount = 1

1 + Control Premium

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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

41

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%

• O’Shea and Siwicki Study – 3.5%

• Houlihan Lokey Howard & Zukin Study – 3.2% (average), 2.7% (median)

42

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

Documents

Business Valuation