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Business Valuation

Valuation Methodologies
Discounts and Premiums

Business Valuation: Common Uses of Business Valuation


Employee Stock Ownership Plan (ESOP)

Buy/Sell Agreements

Internal Revenue Codes (IRC) 743, IRC

409A, etc.

Bankruptcy and Litigation

Liquidation or Reorganization

Solvency and Fairness Opinions

Patent Infringement

Damage Assessment

Partner Disputes

Dissenting Shareholder Actions

Economic Damages

Marital Dissolutions

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
Signed Engagement
Letter with Retainer

2.1 Company
and Industry

1.3 Establish

1.2 Establish
Standard of
Value and
Define Purpose

1.4 Data

Ongoing Internal Review and Discussion with Other

Professionals and Client
2.3 Adjustments
and Recasts

2.2 Analyze

2.4 Financial
(Ratios, etc.)

Ongoing Internal Review and Discussion with Other

Professionals and Client
3.1 Implement

3.2 Narrative
Write-up of the

3.3 Final Internal

Review and QC

Income, Market, Net

Asset Approaches

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
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 =
CF = Free Cash Flow
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
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


Value =






TCF / (r-g)



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

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


Generally similar to CAPM after adjustments for size and specific


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,
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

Bu (Unlevered Beta)

1 + ( 1 - t ) W d / We

BL (Relevered Beta)

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

Wd = Weight of Debt
We = Weight of Equity
Wc = Weight of Capital

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

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
Common Equity Level Multiples

Price / Earnings (P/E)

Price / Tangible Book Value (P/B)


Business Valuation: Market Approach

Publicly-Traded (Guideline) Comparable Company

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


Business Valuation: Market Approach

Publicly-Traded (Guideline) Comparable Company

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:
Growth Rate
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

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

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

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
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

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


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:

Minority Discount

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


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%

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
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