AN INSIDE LOOK AT THE MYSTERY OF BUSINESS VALUATION

Gregory A. Porcaro CPA/ABV, MST, CFFOtrando Porcaro & Associates, LTDWarwick, RI (401-739-9250)gporcaro@opacpa.com

OBJECTIVE

To unravel the mystery behind business valuation concepts and theories, including the factors that impact the determination of the value of an interest in a closely held business

WHAT IS A BUSINESS VALUATION

An independent and objective evaluation of financial and non-financial data that may impact the current and future cash flow (economic benefit) of a closely held business in order to estimate the value of the business as a whole or a fraction there of.

WHO IS DOING THIS TYPE OF WORK

Individuals trained in financial analysis and possibly financial forensics

Accountants/CPAs Business brokers Business appraisers Investment bankers

A BV PROFESSIONAL SHOULD BE….

Independent and objective Trained in BV theory and practice Have BV experience

"Expert Witness" experience – may face a "Daubert” Challenge

Industry experience Have a BV certification

AICPA – Accredited in Business Valuation (ABV) ASA – Accredited Senior Appraiser (ASA) IBA – Certified Business Appraiser (CBA)

WHAT IS A “DAUBERT” CHALLENGE

The Supreme Court determined that it is the obligation of the judge to act as the “gatekeeper” to ensure that all expert testimony is relevant and reliable. This includes business valuation testimony. Kumho Tire Co. v. Carmichael, 526 U.S. 137

(1999), Daubert v. Merrell Dow Pharmaceuticals,

Inc., 509 U.S. 579, 593 (1993)

WHAT IS A “DAUBERT” CHALLENGE

Factors to be considered by the judge Application of a scientific methodology Techniques subject to peer review Techniques generally accepted Techniques can be tested by others

If you fail the challenge your BV report and testimony can be excluded from the litigation General Electric Co. v. Joiner, 522 U.S. 136

(1997)

WHY ARE BUSINESS VALUATIONS IMPORTANT?

Estate & Gift Tax Business Acquisitions & Dispositions

Divorce Succession Planning Reorganizations Compensation - Stock Options Financial Reporting

VALUATION DRIVERS

Synergy - Not Representative of FMV

Smaller Businesses - Seller Discretionary Cash Flow

Larger Businesses - Dividend Paying Capacity

Intangible value

THE BUSINESS VALUATION PROCESS

Key Questions & Elements What is being valued? What is the valuation date? What standard of value applies? Consideration for state law Analysis of financial & non-financial data

Selection of valuation approachs & methods

Prepare of valuation report

WHAT IS BEING VALUED?

This is the first question to answer and it has a major effect on the valuation professional’s course of action.

The professional must determine if he/she is valuing the stock of a corporation or an interest in an LLC and if so is it a controlling interest or a minority interest?

Is the business being valued an operating company or a real estate holding company?

WHAT IS THE VALUATION DATE?

This is a specific point in time, such as December 31, 2013

The BV engagement may start long after the valuation date, but you may only take into account information that was known or knowable as of the valuation date

WHAT IS KNOWN OR KNOWABLE?

RI Supreme Court case: A divorcing couple hire a BV expert who concludes the value of the husbands 25% interest of a business was $2.9M as of the date of the divorce March 2007

In November 2007 husbands sells interest for $5.4M.

Wife sues for adjustment to property settlement agreement

WHAT IS KNOWN OR KNOWABLE?

RI Supreme Court determines there was no evidence that anyone knew or should have known about the transaction at the time of the divorce. The value used for the purposes of the divorce was upheld. Esposito vs. Esposito, 2010-328 (Jan. 2011)

WHAT STANDARD OF VALUE APPLIES? Fair Market Value - the amount at

which the property would change hands between a hypothetical willing buyer and a willing seller when the former is not under compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts. (Rev Ruling 59-60)

WHAT STANDARD OF VALUE APPLIES? Fair Value – A standard of value that

has been derived by state law. Need to review applicable state law

Generally applicable in dissenting or oppressed shareholder/member litigation

Not a “willing buyer and seller” situation

Valuation discounts are not applicable

WHAT STANDARD OF VALUE APPLIES? Investment Value – The standard of

value applicable to a specific buyer or pool of buyers.

For example: Takes into account the potential synergistic benefits of being acquired by a competitor

ANALYSIS OF FINANCIAL & NON-FINANCIAL DATA

Nature & history of the business Economic outlook Financial position of the business Earnings capacity Dividend paying capacity Intangible value – Goodwill Prior sales of stock Stock price of similar public companies

ANALYSIS OF FINANCIAL & NON-FINANCIAL DATA

Articles of incorporation or organization By-laws and minute book, Stockholder or partnership agreements,

Buy-sell agreements, Employment contracts/non-compete

agreements Loans and leases, Patents and copyrights, Information regarding pending litigation.

WHERE DOES THE PROCESS BEGIN?

Financial statement analysis Typically 5 years of financial statements Preferably based on GAAP, not tax returns

Method of accounting Consider normalization adjustments Review internal trends & ratios Compare subject company to industry

performance data Evaluate operating budgets & forecasts

WHY DO YOU ”NORMALIZE” FINANCIAL STATEMENTS?

The purpose of this process is to adjust the financial statements for items that impact the financial position of the company (BS) and/or its earnings or cash flow (P&L).

To make the financial statements comparable to guideline companies

To eliminate items that will not be transferred or that will not be considered by a willing buyer

WHAT IF YOU ARE VALUING A MINORITY INTEREST?

In most cases, minority owners do not have the authority to enforce changes in the way the company is capitalized or spends money

Therefore depending on the purpose of the business valuation it may not be necessary to make normalization adjustments

TYPICAL NORMALIZATION ADJUSTMENTS

Non – Recurring Income or Expenses Excessive legal fees due to litigation

Non – Economic or Discretionary Items Excessive owner perks

Non - Arm's Length Transactions Rent paid to related party greater than

market Non – Operating Assets & Related Income

Excessive cash or non-operating real estate

VALUATION APPROACHES

Income Asset Market

VALUATION APPROACH - INCOME

There is a basic underlying valuation principal that the value of a business is equal to the present value of expected future benefits.

The income approach is particularly appropriate to value operating companies with predicable earnings.

VALUATION METHODS - INCOME

Capitalization of Earnings Discounted Cash Flow

Determine Income Base Must be "normalized" Earnings v Cash Flow

Determine Discount Rate Build up Method vs Capital Asset Pricing Model Weighted Average Cost of Capital

VALUATION METHODS - INCOME

Capitalization of Earnings – This method should be used when a business's future earnings will not change significantly from current earnings or the growth in future earnings is predictable. The earnings base is then divided by a

capitalization rate to determine the business's value.

Capitalization rate = Discount rate minus the long-term sustainable growth rate

VALUATION METHODS - INCOME

Discounted Cash Flow – This method should be used when a business's future earnings can be reasonably estimated and are expected to be significantly different than historic earnings. For example, the business may have gained

or lost a major customer. The value of the business is based on the

discounted (present value) of the estimated future earning.

VALUATION METHODS - INCOME

Discounted Cash Flow – This method requires the business appraiser to obtain a operating forecast from management. Must view the forecast with professional

skepticism Compare to prior years forecast to actual

results

VALUATION METHODS - INCOME

Determine Income Base - Earnings v Cash Flow – Important decision impacted by:

The nature of the business Purpose of valuation Nature if interest being valued –

controlling or minority I prefer to use cash flow as an Income

base

VALUATION METHODS - INCOME

Equity Basis Invested Capital – Debt Free

Normalized Earnings Normalized Earnings

+ N/A Interest Expense (net of tax)

+ Depreciation/Amortization Depreciation/Amortization

= Gross Cash Flow Gross Cash Flow

- Capital Expenditures Capital Expenditures

+ or -

Working Capital Working Capital

+ or -

Loan advances or Payments Loan advances or Payments

- Preferred Dividends Preferred Dividends

= Net Cash Flow Net Cash Flow

VALUATION METHODS - INCOME

Determine a Discount Rate – Must relate to the relative risk associated with an investment in the subject company compared to alternative investments Build up Method Capital Asset Pricing Model (CAPM) Weighted Average Cost of Capital (WACC)

VALUATION METHODS - INCOME

Build up Method - The discount rate is “built-up” starting with risk-free rates of return (T-bonds) and adding on the historical returns for publicly traded large and small cap stocks. Market risk premiums derived from

Morningstar or Duff & Phelps This method requires the business

appraiser to consider applying a company specific risk premium.

BUILD UP METHOD EXAMPLE - RESTAURANT

Risk Free Rate – 20 Yr. US T Bonds 2.41%

Equity Risk Premium 6.70%

Industry Risk Premium -2.57%

Size Premium 3.81%

Company Specific Risk (subjective) 7.00%

Discount Rate 17.35%

LT Sustainable Growth -3.00%

Capitalization Rate 14.35%

Source: Morningstar/Ibbotson SBBI – 2013 Valuation Yearbook

VALUATION METHODS - INCOME

CAPM – The CAPM method is based on industry specific comparative data and is more difficult to apply to small/mid-size companies.

This method requires the business appraiser to consider applying a company specific risk premium.

CAPM METHOD EXAMPLE – ELECT. EQUIPMENT

Risk Free Rate – 20 Yr. US T Bonds

2.41%

Equity Risk Premium 6.70%

Industry Beta (Market Risk) X 1.46% 9.78%

Size Premium 3.81%

Company Specific Risk (subjective) 5.00%

Discount Rate 21.00%

LT Sustainable Growth -3.00%

Capitalization Rate 18.00%

Source: Morningstar/Ibbotson SBBI – 2013 Valuation Yearbook

WHAT IS COMPANY SPECIFIC RISK?

A subjective adjustment to the discount rate based on the business appraiser’s assessment of the company as a whole and professional judgment. Factors to consider: Customer concentration Depth of management Supplier dependence Comparative performance to industry data

VALUATION METHODS - INCOME

WACC – This method calculates the discount rate based on the company’s entire capital structure – debt and equity The income base must be on a debt free

basis In general, the method is more suitable to

larger companies with more complex capital structures

WACC METHOD EXAMPLE - RESTUARANT

Capital Structure

Debt to

Equity

Required ROR &

Interest Rate*

Discount Rate

Equity $900,000 75% 20% 15.00%

Debt $300,000 25% 5.4% 1.35%

Total $1,100,00

16.35%

* Interest rate is net of taxes at 40%

CAPITALIZATION OF EARNINGS EXAMPLE

Restaurant

Normalized Cash Flow $150,000

/Capitalization Rate 14.35%

Value of 100% of Business* $1,045,296

* Before Valuation Discounts

VALUATION APPROACH - ASSET

This approach values a company based on its assets and liabilities only.

It is applied generally to a business with little or no earnings or entities that own real estate or investment assets such as publicly traded securities.

VALUATION METHODS - ASSET

Net Asset Value Suitable for a real estate holding company

Liquidation Value Suitable for a operating company that is

losing money or in recievership

Assets must be appraised

NET ASSET VALUE METHOD EXAMPLE

Real Estate Holding Company

Adjusted Basis

Adjustment Appraised Value

Land $75,000 $125,000 $200,000

Building $125,000 $500,000 $625,000

Mortgage $65,000 0 $65,000

Member Capital* $135,000 $625,000 $825,000

* Before Valuation Discounts

VALUATION APPROACH - MARKET

The market approach is represented by one valuation method. The valuation professional must identify comparable businesses that are publicly traded or have been privately sold and apply key ratios, such as price/earnings (P/E) or price/revenue (P/R) to the Subject Company.

At the public level this is a common method for an investor to make investment decisions. For example, an investor interested in purchasing stock on General Motors would compare the P/E ratio for GM to other major automotive manufacturers such as Ford and Chrysler.

VALUATION APPROACH - MARKET

It is commonly used for real estate as well

In the area of closely held business valuations it is difficult to apply for two reasons: first, obtaining reliable data, and second, determining if the businesses are

comparable.

VALUATION METHODS - MARKET

Guideline Public Company Data - Using comparative company data from publicly traded companies to value small to mid-sized business will not be adequate for many reasons, but size is a major one. Depth of management, Market share Geographic differences generally

Will not be comparable to an interest in a small to mid-sized closely held company.

VALUATION METHODS - MARKET

Private Company Transaction Data Base - The Institute of Business Appraisers and other data base services such as "Bizcomps" provide comparable sales data for closely held business by SIC Code.

This information is very useful and at least can provide a benchmark to compare the value determined using the income approach.

PRIVATE COMPANY TRANSACTION EXAMPLE

Price to Price to

Revenue Earnings

Selected Multiples: 0.10 2.20

Based upon the data obtained below, I selected multiples for both the price to sales and price to earnings multiples.

Commercial Construction Contractor - NAICS # 236220 - SIC # 1541 & 1542

All Transactions

  Sales (,000) DE (,000) Price (,000) Price / Sales Price / DE

Low $117 $15 $43 0.03 0.43

High $10,484 $1,807 $18,100 2.21 30.17

Mean $2,182 $360 $1,508 0.48 6.05

Median $989 $104 $278 0.35 2.28

Standard Deviation $2,556 $527 $3,482 0.43 9.13

Coefficient of Variation       0.92 1.51

Harmonic Mean       0.23 1.87

Count 29 20 30 29 20

PRIVATE COMPANY TRANSACTION EXAMPLE

Commercial Contraction Contractor - NAICS # 236220 - SIC # 1541 & 1542

Price to Price toRevenue Earnings

Revenue/Seller Discretionary Earnings (See Exhibit C) $ 7,154,806

$ 262,936

Multiple Selected 0.10

2.20

Operating Value 715,481 578,460

Add/(Less):

Current Assets 1,287,496

1,287,496

Total Liabilities (1,161,179)

(1,161,179)

Indicated Value $ 841,798

$ 704,777

Rounded* $ 842,000

$ 700,000

* Before Valuation Discounts

VALUATION PREMIUMS OR DISCOUNTS

A valuation engagement is not complete if the professional has not considered the possible application of a premium or discount. There are basically three types of valuation adjustments; A control premium, A minority interest discount, A lack of marketability discount.

All valuation adjustments must be supported by analysis

VALUATION PREMIUMS OR DISCOUNTS

Control Premium – This refers to the inherent additional value attributed to the power to control the business. For example, a stockholder that owns a controlling interest (greater than 50%) can elect officers, establish compensation, sell assets, etc.

A business appraiser must review an entity’s organizational documents to be sure that a 51% interest represents control. In some cases a super-majority (i.e. 70%) or unanimous consent may be required for certain events to take place.

VALUATION PREMIUMS OR DISCOUNTS

Minority Interest Discount -. A minority interest discount is basically the opposite of a control premium.

Depending on how ownership interests in an entity are held an individual with a 2% interest can be entitled to a swing vote premium.

For example, if a corporation is owned by three people, two own a 49% interest each and one owns a 2% interest, then the 2% stockholder can impact the outcome of a particular issue if the other two stockholders do not agree

VALUATION PREMIUMS OR DISCOUNTS

Quantifying a control premium or minority interest discount is not a simple task and varies on a case by case basis. According to Mergerstat Review (2013), the average control premium was 44% (median average 33%) and average minority interest discount was 24%.

VALUATION PREMIUMS OR DISCOUNTS

Lack of Marketability Discount (LOMD) – This applies to an interest in a closely held company because they are inherently less liquid than publicly traded companies.

This discount can be applied in addition to a control premium or minority interest discount.

VALUATION PREMIUMS OR DISCOUNTS

Lack of Marketability Discount – There are several ways to document and support a LOMD. In August 2011 the IRS released a detailed practice aid for revenue agents to assist them is dealing with the issue in the field. It addresses the various methods for calculating a LOMD.

See www.irs.gov/pub/irs-utl/dlom.pdf

CAPITALIZATION OF EARNINGS EXAMPLE

Restaurant

Normalized Cash Flow $150,000

/Capitalization Rate 14.35%

Value of 100% of Business $1,045,296

Fair Value of a 33% Interest $344,948

Minority Interest discount @ 20%

-$68,990

Sub-Total $275,958

LOMD @ 20% -$55,192

FMV of a 33% Interest $220.767

VALUATION REPORT

The valuation report should be clearly written and free from errors and inconsistencies, In general, the following areas will be addressed in some detail:

Introductory statement identifying what is being valued

The standard of value applied The valuation date Company background and history National, regional, and local economic and

industry data

VALUATION REPORT

The valuation report should be clearly written and free from errors and inconsistencies, In general, the following areas will be addressed in some detail:

Company financial statements and comparative industry analysis

Description of valuation approaches and method considered

Valuation calculations and conclusions Qualification statement (resume) Assumptions and limiting conditions

SPECIAL CONSIDERATIONS

Effect of "Gross" decision (a gift tax case) - Tax effecting earnings of pass-through entities is not acceptable without substantive analysis. Gross case, 272 F.3d 333, 88 AFTR 2d 2001-6858

(6th Cir. 2001)

IMPACT – can increase value of the company by 40%

SPECIAL CONSIDERATIONS

The Delaware Chancery Court took and different approach and calculated an effective tax rate attributed to the S corporation structure after taking into account the tax implication of a pass through entity Delaware Open MRI Radiology Associates,

P.A. vs. Kessler, et al,898 A.2d 290 (Del. Ch. 2006)

SPECIAL CONSIDERATIONS

The Supreme Judicial Court of Massachusetts applied the same methodology as the Delaware court in a divorce case. Bernier v. Bernier,449 Mass. 774 (2007), 82

Mass. Appeals. Ct 81(2012).

REFERENCE SOURCES

PPC’s Guide to Business Valuation – 24th Edition – J. Fishman, S. Pratt, J. Griffith & J. Hitchner

Understanding Business Valuation – 2nd Edition – G.Trugman

Morningstar/Ibbotson SBBI – 2013 Valuation Yearbook

QUESTIONS?

Thank you