Business Valuation Presentation

Business Valuation

Valuation MethodologiesDiscounts and Premiums

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Business Valuation: Common Uses of Business ValuationTax Estate/GiftBuy/Sell AgreementsBankruptcy and Litigation Liquidation or ReorganizationPatent InfringementPartner DisputesEconomic DamagesFinancial Reporting Purchase Price Allocation, Impairment Testing and Stock Options and Grants, etc.Strategic Planning/TransactionValue EnhancementBusiness Plan/Capital RaisingStrategic 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 OpinionsDamage AssessmentDissenting Shareholder ActionsMarital Dissolutions

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Business Valuation: Valuation Process1.1 Proposal and Engagement Letter1.3 Establish Valuation Date1.2 Establish Standard of Value and Define PurposeOngoing Internal Review and Discussion with Other Professionals and ClientOngoing Internal Review and Discussion with Other Professionals and ClientIncome, Market, Net Asset ApproachesSigned Engagement Letter with Retainer1.4 Data Gathering2.1 Company and Industry Analysis2.3 Adjustments and Recasts (Control)2.2 Analyze Historical Financial Statements2.4 Financial Statements Analysis (Ratios, etc.)3.1 Implement Selected Valuation Methodologies3.3 Final Internal Review and QC Process3.2 Narrative Write-up of the Report3.4 Finalize

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Business Valuation: Standard of ValuePurpose Establish Purpose of the EngagementEstate/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 DateUtilize Data Subsequent to the Valuation DateSometimes can Consider Data After the Valuation Date if it was Foreseeable as of the Valuation Date

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Business Valuation: Standards of ValueCommon Standards of ValueFair 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 59-60Liquidation 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 157Fair 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 DataGathering Company DataArticles of Incorporation; Operating AgreementHistory and BackgroundProducts and ServicesShareholders and Key Personnel Compensations and ResponsibilitiesOrganization/Corporate StructureOperationsCustomers/Clients, Target Markets and SuppliersLegal, Tax and Other ConsiderationsFive Year Historical and Latest Interim Financial StatementsOther Financial Information (A/R, A/P, Fixed Asset Ledger, etc. - if needed)AdjustmentsProjections (If applicable)

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Business Valuation: Analyzing DataResearching 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 AnalysisGrowth Rates, Liquidity, Leverage, Profitability, Efficiency, etc.

Valuation Methodologies

Income ApproachMarket ApproachNet Asset Approach

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Business Valuation: Valuation ApproachesIncome ApproachThe 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 ApproachSingle Period Discounted Cash Flow AnalysisSimplest 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 debtNI + 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 borrowingsNet Income + Depreciation +/- Non-Cash Items +/- Change in Working Capital CAPEX +/- Net BorrowingsCost 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 CAPMFor 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 companiesInputs 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 EquityBeta (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 valuesUnlevered beta is the beta a company would have if it had no debtLever 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 DebtWe = Weight of EquityWc = 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 RatioControl Value: Target/Optimal or Industry Average Debt to Capital RatioLack 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 AnalysisThe Guideline Publicly Traded Company Method indicates the value of the subject company by comparing it to publicly-traded companies in similar lines of businessValuation Multiples Vary Based on Industry and States of GrowthProblem is that there are rarely perfect matchesEquity MultiplesFair Market Value of Equity (Stock Price x Outstanding Number of Shares) Common Equity Level MultiplesPrice / Earnings (P/E)Price / Tangible Book Value (P/B)

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Business Valuation: Market Approach

Publicly-Traded (Guideline) Comparable Company Analysis Enterprise MultiplesEnterprise Value = (Stock Price x Outstanding Number of Shares) + Total Debt/Preferred Securities Cash and Short-Term InvestmentsCommon Enterprise Level MultiplesEV / RevenueEV / EBITDAEV / EBIT

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Business Valuation: Market Approach

Publicly-Traded (Guideline) Comparable Company AnalysisOther MultiplesEV / R&D Expenses; # of Phase I, Phase II and Phase III products in pipeline Early Stage BiotechnologyEV / # of Licenses and Rights Shell Company, etcAppropriate Multiple Depends on Company Characteristics

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Business Valuation: Market Approach

Market Transaction (M&A) ApproachIn 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 ApproachPublic Buyer or Seller TransactionsControl Value Private Market Transaction ApproachPrivate to Private TransactionsControl Value Common Transaction DatabaseMergerStat, 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:SizeGrowth RateProfitabilityLeverageOther Company Specific FactorsDiscounts and Premiums

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

Discounts and Premiums

Control PremiumLack of Control/Minority DiscountsLack of Marketability/Illiquidity DiscountsOthers Discounts

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Business Valuation: Lack of Marketability DiscountsLet the Fireworks Begin!!Often subject to wide disparity among practitionersDetermination based on analogyData sources problematicReasonable range

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Business Valuation: Lack of Marketability DiscountsLack of Marketability Discounts (LOM)Marketability (liquidity) is valuable. Other things equal, investors will pay more for the more liquid (marketable) assetThe discount for lack of marketability is the largest money issue in many, if not most, disputed valuations of minority interests in closely-held, private companiesThe 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 anotherNeed to carefully study the recent case law in the relevant jurisdictionThe quality of the expert evidence and testimony presented in the Tax Court makes a big difference in the outcomeThe 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 DiscountsLack of Marketability DiscountsThe highest discount that the Tax Court has allowed purely for lack of marketability is 45%, and most discounts have been considerably lessThe 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 marketabilityThere is little case law on discount for lack of marketability in divorce cases, and what exists is also quite mixedIf 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 DiscountsLack of Marketability/Illiquidity Discount for Minority Interest Restricted Stock StudiesRestricted stocks are, by definition, stocks of public companies that are restricted from public trading under SEC Rule 144Although 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 datePrice differences are attributed to liquidityMany feel the discounts are a reliable guide to discounts for LOMEmpirical 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 DiscountsRestricted 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 debtThese data are most appropriate for valuing restricted stocks and are difficult to apply to private companiesThe 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 droppedStatistical studies can explain at best 1/3 of the discount

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Business Valuation: Lack of Marketability DiscountsPre-IPO Stock StudiesA 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 marketabilityThe application of pre-IPO studies heavily debated and criticized because comparisons are apples to orangesThe dates of the transaction differ at a time when the company is changing rapidly (in the year before the IPO)Discounts are very largeDiscounts/premium should be based on specific to the subject case and not past court cases

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Business Valuation: Lack of Marketability DiscountsOther StudiesModified 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 DiscountsFactors 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 DiscountsLack 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 DiscountControl PremiumOther things equal, an interest with control is worth more than one that lacks controlAn 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 companiesSome suggest that valuations of controlling interests be adjusted upward if they are based on publicly-traded stock prices which are minority interestsHubris and synergy may explain premiaNot needed if cash flows are estimated at the control level

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Business Valuation: Control Premium and Minority DiscountControl PremiumCommon Prerogatives of ControlElect directors and appoint managementDetermine management compensation and perquisitesSet policy and change the course of businessAcquire or liquidate assetsSelect people with whom to do business and award contractsMake acquisitionsLiquidate, dissolve, sell, leverage or recapitalize the companySell or acquire treasury sharesRegister the companys stock for a public offeringDeclare and pay dividendsChange the articles of incorporation or bylaws or operating agreement

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Business Valuation: Control Premium and Minority DiscountControl Premium DatabaseControl Premia Based on Market TransactionsIdentify 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 difficultAppropriately adjust for other qualitative factors based on control prerogatives

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Business Valuation: Control Premium and Minority DiscountLack of Control/Minority DiscountSome 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 premiaMust deal with negative premia in databases

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Business Valuation: Control Premium and Minority DiscountLack of Control/Minority DiscountSupermajority 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 appropriateSwing 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 valueInterest 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 prerogativesMany experts feel that publicly-traded stocks generally sell at a control value

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Business Valuation: Other DiscountsOther Discounts Key Person DiscountMeasure potential negative impact to the projected cash flows in the absence of Key Personnel Trapped-in Capital GainsA 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 disappearUse with Caution, it depends on expected time of liquidity event (usually applied when liquidity event is imminentConsult a tax expert to analyze the situations Block DiscountA large interest may be less liquid than a smaller one

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Business Valuation: Other DiscountsOther DiscountsVoting vs. Non-VotingIf 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 stockBased 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-votingEmpirical studies indicates premium for voting sharesLease, 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 PremiumsCommon Errors in Applying Discounts and PremiumsGreed produces inconsistencies with economic realityLow value desiredConservative projectionsHigh discount rateLarge DLOM, etc.Higher value desiredAggressive projectionsLow discount rateSmall DLOM, etc.Conservative projections should be accompanied by a lower discount rateAggressive projections should be accompanied by a higher discount rate

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Business Valuation: Discounts and PremiumsCommon Errors in Applying Discounts and PremiumsUsing synergistic acquisition premia to quantify premiums for controlAssuming that the discounted cash flow valuation method always produces a minority valueAssuming that the guideline public company method always produces a minority valueValuing underlying assets instead of the stock or partnership interestsUsing minority interest marketability discount data to quantify marketability discounts for controlling interestsUsing only pre-initial public offering studies and not restricted stock studies as benchmark for discounts for lack of marketabilityIndiscriminate use of average discounts or premiums applying (or omitting) a premium or discount inappropriately for the legal contextApplying discounts or premiums to the entire capital structure Quantifying discounts or premiums based on past court casesUsing a tangible (real property, fixed assets, etc.) appraiser to quantity discounts and premiums