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Business Valuation

Valuation Methodologies Discounts and Premiums

Business Valuation: Common Uses of Business Valuation

Tax Estate/Gift Buy/Sell Agreements Bankruptcy and Litigation Liquidation or Reorganization Patent Infringement Partner Disputes Employee Stock Ownership Plan (ESOP) Internal Revenue Codes (IRC) 743, IRC 409A, etc.

Solvency and Fairness Opinions

Damage Assessment Dissenting Shareholder Actions Marital Dissolutions

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

Business Valuation: Valuation Process

1.1 Proposal and Engagement Letter

Signed Engagement Letter with Retainer

1.2 Establish Standard of Value and Define Purpose

1.3 Establish Valuation Date

1.4 Data Gathering

Ongoing Internal Review and Discussion with Other Professionals and Client
2.2 Analyze Historical Financial Statements 2.3 Adjustments and Recasts (Control) 2.4 Financial Statements Analysis (Ratios, etc.)

2.1 Company and Industry Analysis

Ongoing Internal Review and Discussion with Other Professionals and Client
3.1 Implement Selected Valuation Methodologies
Income, Market, Net Asset Approaches

3.2 Narrative Write-up of the Report

3.3 Final Internal Review and QC Process

3.4 Finalize

Business Valuation: Standard of Value

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, NonMarketable, 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

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.

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)

Projections (If applicable)

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

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)

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 = (r-g) CF = Free Cash Flow (FCFF or FCFE) r = Discount Rate Cost of Capital or Cost of Equity g = Expected Growth Rate


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)


Business Valuation: Income Approach

Discounted Cash Flow Analysis

More General and Flexible Than Capitalized Earnings Method
CF1 Value = (1+r) CF TCF R G = = = =

CF2 + (1+r)

CFn + (1+r)n +

TCF / (r-g) (1+r)n

Cash Flow Terminal Cash Flow Discount Rate (Weighted Average Cost of Capital) or (Cost of Equity) Long-term Growth Rate


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


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


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
Build-up Cost of Equity Capital Risk-free rate (Rf) Equity premium (RPm) Size premium (RPs) Industry risk premium Company-specific premium (RPu) Indicated Cost of Equity Capital 4.5% 5.0% 6.0% -1.1% 2.0% 16.4%

Generally similar to CAPM after adjustments for size and specific risks

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. 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 B

Bu (Unlevered Beta)

= 1 + ( 1 - t ) W d / We
Wd = Weight of Debt We = Weight of Equity Wc = Weight of Capital

BL (Relevered Beta)

= Bu ( 1 + ( 1 - t ) Wd / Wc )

The result will be a market-derived beta specifically adjusted for the degree of financial leverage of the subject company

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


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


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)


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 ShortTerm Investments Common Enterprise Level Multiples EV / Revenue EV / EBITDA EV / EBIT


Business Valuation: Market Approach

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


Business Valuation: Market Approach

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


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

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

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


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


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


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

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


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

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.


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

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


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


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

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


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:

1 Minority Discount = 1 1 + Control Premium

This is overly simplistic. Ignores hubris and synergy and other factors that impact take-over premia

Must deal with negative premia in databases


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


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

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)

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


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