discounts and premiums in esop valuation

2013 ESOP Association Technical Conference & Trade Show

Discounts and Premiumsin ESOP Valuation

The ESOP Association 2013 Conference & Trade ShowCaesar’s Palace | Las Vegas, Nevada | November 7 & 8

Chuck Coyne, ASAManaging DirectorEmpire Valuation Consultants

Tim Lee, ASAManaging DirectorMercer Capital

Presenters Courtesy of The ESOP Association Advisory Committee on Valuation


Disclaimersand Notices

Each valuation is subject to unique facts and circumstances.The content of this session is intended to provide generalinformation representing the consensus of valuation practiceand the general body of knowledge in The ESOP valuationcommunity.

Neither the presenters of this session, nor The ESOPAssociation and its Advisory Committee on Valuation warrantor represent that the information in this presentation appliesrigidly to all ESOP valuations.

Terms of art and differences in methodology can vary fromone valuation practitioner to another, particularly in the area ofvaluation discounts and premiums. Attendees of this sessionand users of this presentation material should consult theirfinancial advisors concerning specific questions onmethodologies, treatments, or valuation adjustments as maybe applied in a specific valuation.

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SessionOverview

Fair Market Value defined

Conceptual framework of the “levels of value” and the primaryvaluation discounts and discounts used in ESOP appraisals

Overview of the Premise of Value

Direct vs. Indirect Valuation Methodology

Overviews of

o Control Premiums

o Minority Interest Discounts

o Fundamental Adjustments

o Discount for Lack of Marketability

o Nuances and Treatments that can mask Discounts andPremiums

Q & A

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FairMarketValueDefined

American Society of Appraiserso The price, expressed in terms of cash equivalents, at which property

would change hands between a hypothetical willing and able buyer anda hypothetical willing and able seller, acting at arm’s length in an openand unrestricted market, when neither is under compulsion to buy or selland when both have reasonable knowledge of the relevant facts.

Department of Laboro ERISA section 3(18) (B) defines adequate consideration in the case of

an asset for which there is no generally recognized market (e.g., stockof a closely held corporation) as the fair market value of the asset asdetermined in good faith by the trustee or named fiduciary pursuant tothe terms of the plan and in accordance with the regulationspromulgated by the Secretary of Labor.

o The term "fair market value" is defined in proposed section 2510.3-18(b)(2)(i) as the price at which an asset would change hands betweena willing buyer and a willing seller when the former is not under anycompulsion to buy and the latter is not under any compulsion to sell,and both parties are able, as well as willing, to trade and are well-informed about the asset and the market for that asset.

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FairMarketValueDefined

Department of Labor (continued)

o References to IRS Revenue Ruling 59–60 (valuation guidelines forclosely held entities)

Factors (A) through (G) [valuation fundamentals];

(H) The marketability, or lack thereof, of the securities. Where the planis the purchaser of securities that are subject to "put" rights and suchrights are taken into account in reducing the discount for lack ofmarketability, such assessment shall include consideration of the extentto which such rights are enforceable, as well as the company's ability tomeet its obligations with respect to the "put" rights (taking into accountthe company's financial strength and liquidity);

(I) Whether or not the seller would be able to obtain a control premiumfrom an unrelated third party with regard to the block of securities beingvalued, provided that in cases where a control premium is taken intoaccount:

o (1) Actual control (both in form and in substance) is passed tothe purchaser with the sale, or will be passed to the purchaserwithin a reasonable time pursuant to a binding agreement ineffect at the time of the sale, and

o (2) It is reasonable to assume that the purchaser's control willnot be dissipated within a short period of time subsequent toacquisition.

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Levels ofValueContext of FairMarket Value

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Control

Marketable Minority

NonmarketableMinority

Minority Interest Discount(MID)

Lack of MarketabilityDiscount (DLOM)

Control Premium


Levels ofValueKey TermsDefined

Control. The power to direct the management and policies of a business enterprise.

Control Premium. An amount or a percentage by which the pro rata value of a controllinginterest exceeds the pro rata value of a non-controlling interest in a business enterprise, toreflect the power of control.

Discount for Lack of Control. An amount or percentage deducted from the pro rata share ofvalue of 100 percent of an equity interest in a business to reflect the absence of some or all ofthe powers of control. [a.k.a. minority interest discount]

Discount for Lack of Liquidity. An amount or percentage deducted from the value of anownership interest to reflect the relative inability to quickly convert property to cash.

Discount for Lack of Marketability. An amount or percentage deducted from the value of anownership interest to reflect the relative absence of marketability.

Discount for Lack of Voting Rights. An amount or percentage deducted from the per sharevalue of a minority interest voting share to reflect the absence of voting rights.

Investment Value. The value to a particular investor based on individual investmentrequirements and expectations. [overlapping or interchangeable with strategic value]

Marketable, Minority.* A minority interest in an enterprise that does not suffer from illiquidity –usually relevant to per share interests in publicly-held equities that trade freely on an openmarket

Majority Interest. An ownership interest greater than 50 percent of the voting interest in abusiness enterprise.

Minority Interest. An ownership interest less than 50 percent of the voting interest in abusiness enterprise. [referred to as nonmarketable minority for a closely held company]

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Levels ofValueContext of theOverall Market

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Strategic Control

Financial Control


Minority InterestDiscount

Lack of MarketabilityDiscount

Strategic ControlPremium

Marketable MinorityFinancial Control

Premium


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“Run Different”Synergies in Business

Combinations

“Run Better”Organic Optimization

Levels ofValueFinancial vs.Strategic

Strategic Control

Financial Control




Marketable Minority


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Levels ofValueStandard of Value

Strategic Control

Financial Control




Marketable Minority

InvestmentValue!?

FairMarketValue


Levels ofValueCommon Flaw InControl PremiumApplication

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Commonly citedreference for controlpremiums generallycombines thesepremiums, resulting inpotential over-valuationfor closely held ESOPcompanies

Strategic Control

Financial Control




Strategic ControlPremium

Marketable MinorityFinancial Control

Premium


Historical Implied MinorityNumber of Control Premiums Interest Discounts

Year Transactions Averages Medians Averages Medians1998 512 40.7% 30.1% 28.9% 23.1%1999 723 43.3% 34.6% 30.2% 25.7%2000 574 49.2% 41.1% 33.0% 29.1%2001 439 57.2% 40.5% 36.4% 28.8%2002 326 59.7% 34.4% 37.4% 25.6%2003 371 62.3% 31.6% 38.4% 24.0%2004 322 30.7% 23.4% 23.5% 19.0%2005 392 34.5% 24.1% 25.7% 19.4%2006 454 31.5% 23.1% 24.0% 18.8%2007 491 31.5% 24.7% 24.0% 19.8%2008 294 56.5% 36.5% 36.1% 26.7%2009 239 58.7% 39.8% 37.0% 28.5%2010 348 51.5% 34.6% 34.0% 25.7%2011 321 54.1% 37.8% 35.1% 27.4%2012 323 46.2% 37.1% 31.6% 27.1%

Data for 2002-2012 per 2013 Mergerstat Review p. 25Premium calculations are based on the seller's closing market price five business daysbefore the initial announcement. Calculations exclude negative premiums.

Levels ofValuePotential Error inthe CommonApplication ofControl Premiumsand MinorityDiscounts

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DLOMsMethods Galore

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Marketability Discount ModelsDiscussed in the Discount for Lack of Marketability Job Aid for IRS Valuation Professionals

Income Approach Market Approach

Benchmark MethodsRestricted Stock Studies XPre-IPO Studies XRestricted Stock Equivalent Studies XCost of Flotation XMandlebaumFactors X

Securities-Based MethodsLong-Term Equity Anticipation Securities XLongstaff Model XChaffeModel XBid-Ask Spread Model X

Analytical MethodsKaren Hopper Wruck XHertzel and Smith XBajaj, Denis, Ferris, and Sarin XAshokAbbott X

Other MethodsQMDM XNICE XNERA (Tabak) XPartnership Profiles XPublic vs. Private Acquisition Multiples X


DLOMsLegacy Data

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Number of Reporting StandardStudy Observations Dates Medians Means Deviation Low HighSEC Institutional Investor Study 398 1966-1969 24% 26% na -15% 80%Gelman Study 89 1968-1970 33% 33% na <15% >40%Moroney Study 146 1968-1972 34% 35% 18% -30% 90%Maher Study 34 1969-1973 33% 35% 18% 3% 76%Trout Study 60 1968-1972 na 34% na na naStryker/Pittock Study 28 1978-1982 45% na na 7% 91%Willametter Management Associates 33 1981-1984 31% na na na naSilber Study 69 1981-1988 na 34% 24% -13% 84%Hall/Polacek Study (FMV Opinions) 100+ 1979-1992 na 23% na na naManagement Planning Study 49 1980-1990 29% 28% 14% 0% 58%Johnson (BVR) Study 72 1991-1995 na 20% na -10% 60%Columbia Financial Advisors (pre-1997) 23 1996-1997 14% 21% na 1% 68%Columbia Financial Advisors (post-1997) 15 1997-1998 9% 13% na 0% 30%FMV Opinions Database 475 1980-2005 19% 22% 19% na naLiquiStat Database 41 2005-2006 32% 31% 16.5% 8% 62%

Summary Results of Restricted Stock Studies

Range


Levels ofValueNumericalExample with“Typical”Discounts andPremiums

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$12,500,000

$10,000,000

$8,100,000

Minority InterestDiscount (10%)

Lack of Marketability Discount(ESOPs @ 5-20%: Typical

non-ESOP range @ 25-45%)

Strategic ControlPremium (25%)

$9,000,000Financial ControlPremium (11.1%)


Levels ofValueNumericalExample with“Typical”Discounts andPremiums

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$12,500,000

$10,000,000

$8,100,000

Minority InterestDiscount (10%)

Lack of Marketability Discount(ESOPs @ 5-20%: Typical

non-ESOP range @ 25-45%)

Strategic ControlPremium (25%)

$9,000,000Financial ControlPremium (11.1%)


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Strategic Control

Financial Control


Marketable Minority

Levels ofValueIn Context ofPremise of ValueAsset Value > Income Value(I.E. Liquidation > GoingConcern)

Assuming a “normal” ESOPDLOM of 10%, is the value

$9.0mm or $6.75mm?

Lesson of this example is that an appraiser can [inadvertently] shift thelevel of value and change the premise of value via how the valuemethods are correlated (averaged). Perhaps DLOMs and/or repurchaseobligation analysis can true-up this situation.

Fair Market ValueValue Value

Approach Indication

Asset / Cost $10,000,000

Income / GPCM $7,500,000


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Discounts& PremiumsValuation Deviceor Consequentialto ValuationAdjustments andTreatments

• Are discounts and premiums devices in their own right orare they derivatives of other valuation treatments andadjustments?

• Does your valuation reflect a control premium, minoritydiscount, or DLOM as a device without reconciling it tofinancial facts and circumstances?

• Where is my control premium?!

• Simple Example:


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FundamentalAdjustmentsAdjustments toPublic MarketValuationMeasures

Questions for discussion:Does public market pricing result in control values for closely held businesses?How are fundamental discounts and premiums determined?


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Questions for discussion:Is all transaction data derived and employed equally?What are some common double counting issues in change of control valuations?

FundamentalAdjustmentsAdjustments toMarketTransaction andChange-of-Control Data


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Value = Multiplier x Performance Measure

Using the basic valuation equation, we can see that valuationdiscounts and premiums are the resulting product of theadjustments and treatments in the valuation process.

Discounts& PremiumsThe Messy WorkUnderlyingValuationDiscounts andPremiums


ValuationAdjustments &Assumptions

What is a concisemethod of categorizingfinancial statementadjustments?

When and where arefinancial statementadjustments applied?

How do financialstatement adjustmentsdiffer frommethodologicalassumptions?

Income/Market Approach

o Valuation of the adjusted enterpriseversus reported financials

o ESOP valuation is a construct of thespecific valuation adjustments applied(what is the trend in adjustedperformance?)

o Two primary categories (not universalterminology to appraisers)

Normalizing Adjustments Control Adjustments (Financial)

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What is a concisemethod ofcategorizing financialstatementadjustments?


How do financialstatementadjustments differfrom methodologicalassumptions?

Income/Market Approacho Normalizing Adjustments

Attempt to proxy expectations of a public companyand/or private peer performance and composition

Non-recurring events neutralized (legal, gains on sale,etc.)

Segregation of Operating (core) from Non-operating(non-core) income and expense attributes (reconcile tobalance sheet adjustments under the Cost Approach)

Related party considerations (rent expense, captivesupply chain or customers)

Pro forma adjustments (added or divested products,locations, etc.)

N.B. Finite adjustments are applied at a point in time; Significantadjustments can arise in the form of multi-period averaging orother forms of treatment that blur the lines between financialstatement adjustments and valuation assumptions

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Income/Market Approacho Control Adjustments (Financial)

Address operating efficiencies and performanceoptimization (how can the business be runbetter?)

Compensation, rents, interest rates, capitalstructure, etc.

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Income/Market Approach

o Special ESOP Valuation Adjustments andTreatments

Normalization of retirement expense(effectively replacing the ESOP with a lowercost retirement plan)

ESOP benefit = present value of future taxbenefits on ESOP contributions (on theexpense beyond the assumed adjustedretirement expense)

Repurchase obligation (that’s an entirelydifferent discussion!)

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Income & Market Approaches

o Control Premiums in Disguise

Leveraging-up of capital structure (lower theWACC)

Compensation and discretionary expenseadd-backs

Growth Assumptions

Ever-present risk of double counting viaadjustments and treatments and thenadding a separate control premium

Value correlations from disparate methods(averaging)

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Is ESOPvaluationrequired toreflectperpetuation ofthe plan or asettling up of theliability createdthus far?

Possible Considerations

o Control versus Minority Plan Ownership

Primary underlying difference between pure businessvalue and ESOP perpetuation value in most valuations isthe consideration of ESOP repurchase obligation

Minority: Perhaps obligated to consider only planperpetuation; Trustee lacks prerogatives of control

Control: No explicit treatment due to latent option to sellthe company as a method of settling ESOP obligationsand maximizing share value

Control: No explicit treatment due to latent option toredeem shares rather than recycle (implied plantermination over time?)

Control: Perhaps both value perspectives are usefulo Tendency is to reflect plan perpetuation

o Hypothetical nature of fair market value confined to internalmarket for shares and excludes the outside world (is DOLguidance subject to alternative interpretation?)

o Issue with perpetuation only? Trustee does not know the truevalue of the pure business asset

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Questions?

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Discounts& Premiumsin ESOPValuation


Discounts and Premiumsin ESOP Valuation

ESOP Association 2013 Conference & Trade ShowCaesar’s Palace | Las Vegas, Nevada | November 7 & 8

Chuck Coyne, ASAManaging DirectorEmpire Valuation Consultants

Tim Lee, ASAManaging DirectorMercer Capital

Presenters Courtesy of The ESOP Association Advisory Committee on Valuation

discounts and premiums in esop valuation

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