A BVR Special Report

MONTE CARLO Simulations Advanced Techniques

BVRWhat It’s Worth

Second Edition

Excerpt from

Monte Carlo Simulations: Advanced Techniques

SECOND EDITION

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Copyright © 2016 by Business Valuation Resources, LLC (BVR). All rights reserved. Printed in the United States of America.

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Information contained in this book has been obtained by Business Valuation Resources from sources believed to be reliable. However, neither Business Valuation Resources nor its authors guarantee the accuracy or completeness of any information published herein and neither Business Valuation Resources nor its authors shall be responsible for any errors, omissions, or damages arising out of use of this information. This work is published with the understanding that Business Valuation Resources and its authors are supplying information but are not attempting to render business valuation or other professional services. If such services are required, the assistance of an appropriate professional should be sought.

Editor: Janice Prescott

Publisher: Sarah Andersen

Managing Editor: Monique Nijhout Rowe

Senior Copy Editor: David Solomon

Chair and CEO: David Foster

President: Lucretia Lyons

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Customer Service Manager: Retta Dodge

ISBN: 978-1-62150-051-3

Library of Congress Control Number: 2015937488

Special thanks to Neil J. Beaton, CPA/ABV, CFA, ASA, for his expert guidance and contributions to this special report.

Table of Contents

INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5By Neil J. Beaton, CPA/ABV, CFA, ASA

CHAPTER 1. WHY MONTE CARLO? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7By David Dufendach

CHAPTER 2. MODELING: ASSUMPTIONS AND PROCESSES . . . . . . . . . . . . . . . . . . . . 11By David Dufendach and Jason Andrews

CHAPTER 3. USEFUL APPLICATIONS AND ‘MISAPPLICATIONS’ . . . . . . . . . . . . . . . . . . 39By David Dufendach and Jason Andrews

CHAPTER 4. DIAGNOSTICS AND INTERPRETING RESULTS . . . . . . . . . . . . . . . . . . . . . 47By David Dufendach and Jason Andrews

CHAPTER 5. ADVANCED CASES: USING MONTE CARLO FOR IN-PROCESS R&D VALUATIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65By David Dufendach and Randy Heng

CHAPTER 6. USING MONTE CARLO SIMULATION TO VALUE WARRANTS WITH DOWN-ROUND PROTECTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83By Oksana Westerbeke and Jared Hannon

APPENDIX 1. DEFENDING THE USE OF A MONTE CARLO ANALYSIS IN COURT . . . . . . . . 111

APPENDIX 2. MONTE CARLO IN BV: A VALUABLE TOOL … IN THE RIGHT CIRCUMSTANCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115

APPENDIX 3. GAAP ISSUES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119By David Dufendach

APPENDIX 4. APPLICATIONS OF ORACLE CRYSTAL BALL IN BUSINESS VALUATION . . . . . 125By Steve Hoye, CFA, MBA

Editor’s Note: BVR is pleased to present the second edition of this special report, which is based on two webinar workshops.

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Introduction

By Neil J. Beaton, CPA/ABV, CFA, ASA

Valuation professionals are constantly presented with challenging client needs, such as valuing new, often exotic securities with a variety of features that defy standard valuation techniques. Monte Carlo simulations can help bridge that gap. In this report, a group of valuation experts explain how to apply Monte Carlo techniques to a broad spectrum of valuation issues. In the first edition, David Dufendach and Jason Andrews covered the basics of what is included in Monte Carlo, how to consider applying the analysis, and how to use the information developed from the simulation. This second edition adds more detailed and complex examples of Monte Carlo appli-cations, with Dufendach joined in discussion and analysis by Randy Heng, Oksana Westerbeke, and Jared Hannon.

The Monte Carlo analysis arose out of computer simulations created to address equilibrium prop-erties for specific experiments. Prior to the advent of computers, the outcome of an experiment could be predicted in only one way: by making use of a theory that provided an approximate description of the system under consideration. An approximate theory was used because very few model systems could compute exact equilibrium properties. As a result, most properties of real materials were predicted on the basis of approximate theories. However, approximate theories required one to execute an experiment and then compare the results with the thesis. This was suboptimal because such experimentation and feedback took so much time. With the advent of computer simulation, researchers were able to obtain essentially exact results for a given model system without having to rely on approximate theories. It is from this original work that Monte Carlo has found its way into the world of valuation.

Numerous versions of simulation software are out there. The contributors to this report have used Oracle’s Crystal Ball, and thus their references are specifically to that software, but others may be used.

With this report, Dufendach and his fellow experts have taken Monte Carlo simulations out of the laboratory and into the workplace. Monte Carlo simulations are explained and applied to real-life valuation problems so that any valuation professional will be able to understand the underlying concepts and begin the journey to full appreciation of this technique. Modeling examples and useful applications are explained, and minefields or potential problems are exposed.

The four appendixes provide a valuable trove of additional information on incorporating Monte Carlo analysis into a business valuation practice. Appendix 1, an article by the BVR staff, explores the diffidence that many business valuation experts feel in approaching Monte Carlo and offers tips from those who have taken the plunge. Similarly, Appendix 2 deals with the reluctance of valuators to defend this still-unfamiliar method in court and illustrates its successful use by oth-ers. In Appendix 3, David Dufendach ties Monte Carlo together with the accounting rules that are

Monte Carlo Simulations: Advanced Techniques

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specific to valuation under generally accepted accounting principles. Steve Hoye of Oracle discusses in Appendix 4 how Crystal Ball, a software application widely used for Monte Carlo analysis, is currently being used both in Monte Carlo and other applications.

This report is essential for practitioners wishing to elevate their valuation analyses of complex assignments requiring more than what traditional valuation procedures can provide. I highly recommend it for that purpose.

Neil J. Beaton, CPA/ABV, CFA, ASA

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About the Contributors

Jason Andrews is a director at Alvarez & Marsal Valuation Services LLC. He specializes in economic research, financial modeling, and analysis for the valuation of public and privately held businesses and business segments, financial instruments, and related matters for financial statement reporting, tax reporting, corporate planning, litigation support, and other purposes.

Neil J. Beaton, CPA/ABV, CFA, ASA, is a managing director with Alvarez & Marsal Valuation Services LLC. He specializes in the valuation of public and privately held businesses and intangible assets for the purposes of litigation support.

David Dufendach, CPA/ABV, ASA, is a managing director at Alvarez & Marsal Valuation Services LLC in Seattle. He focuses primarily on complex valuation needs, including development stage entities, earnouts, options and other derivatives, intangible assets, and intellectual property for financial reporting, tax, and other purposes.

Jared Hannon is a manager at Grant Thornton LLP in Boston specializing in the valuation of busi-nesses, privately held equity securities, and complex financial instruments.

Randy Heng is a director in the San Francisco valuation services practice for Grant Thornton, with experience in valuations for financial accounting, tax, and reorganization purposes for both U.S. and international companies.

Oksana Westerbeke is a principal in Grant Thornton’s Financial and Valuation Services practice in the New England Cluster, specializing in the valuation of debt and embedded derivatives, contingent assets and liabilities, warrants with anti-dilution provisions and other contingencies, privately held securities, performance and market condition options, and other complex securities.

Business Valuation Resources . 1000 SW Broadway, Ste. 1200 . Portland, OR 97205 . (503) 291-7963 . bvresources.com

Monte Carlo Simulations: Advanced Techniques, Second Edition

In the ongoing search for simple, easy to explain valuation methods, many appraisers have given wide berth to Monte Carlo simulations, fearing their perceived complexity and unsure of their proper implementation. In doing so, valuable insights and metrics may have been missed, potentially at the peril of the appraiser.

Essential for practitioners who wish to elevate their valuation analyses for complex assignments, Monte Carlo Simulations: Advanced Techniques is a new report that takes simulations out of the laboratory and into practical application. Experts explain Monte Carlo simulations and how they can be applied to real-life valuation problems and readers will learn how and when to use Monte Carlo simulations, as well as be able to identify pitfalls and prepare for potential problems.

A BVR Special Report

MONTE CARLO Simulations Advanced Techniques

BVRWhat It’s Worth

Second Edition

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