law practice management & technology prmcle meeting ... · 12/17/2015 · law practice...

Law Practice Management & Technology PRMCLE Meeting

Thursday, December 17, 2015

11:45 AM – Noon Sign In/Lunch 11:55 AM – Noon Welcome/Introductions Joseph F. Emmerth IV, Section Chair

Bryan Sims, Vice Chair Noon – 1:00 PM Program

Accounting for Non-Accountants: Introduction to Business Valuation

James F. Schultz

Jim has 30 years of experience in business valuations, litigation support consulting services, expert witness testimony, real estate, and financial advisory services. Jim's valuation expertise includes estate and gift, sale and/or purchase of interests in closely held entities, cost allocation for acquisition purposes, fair value analysis, S corporation elections and litigation related matters. His valuations cover industries including manufacturing, real estate, wholesale distribution, healthcare, investment partnerships, professional service and retail.

Upcoming DCBA Events:

Mega Meeting- Friday, January 29, 2016 & Saturday, January 30, 2016 Sheraton Lisle Hotel

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The text is presented for informal purposes only and is not intended to constitute advice. www.cca-advisors.com

© 2015 Cendrowski Corporate Advisors LLC. All rights reserved. Proprietary & Confidential. Reproduction or redistribution prohibited.

Accounting for Non-Accountants:Introduction to Business Valuation

Illinois Continuing Legal Education

Cendrowski Corporate AdvisorsIllinois Institute for Continuing Legal Education



What is Valuation?

• Valuation is the process of assigning value to an asset– Examples of assets include businesses, machines, intellectual

property, and people

• Valuators estimate the present value of the total amount of cash an asset can generate for an owner or multiple owners over its life– Present value depends on risk

• A dollar today is worth more than a dollar tomorrow

– Cash may be preserved within the firm or distributed

• Valuations are highly dependent upon the judgment of a valuation professional– Differences in assumptions and estimates can lead to markedly

different valuations

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Outline of Presentation

• This presentation presents an introduction to business valuations, including:– Standards of value and operational premises

– Valuation approaches• Focus on income approach

– Sample Income Approach Process

• It will also highlight items to scrutinize in valuations and present reasons why similarly-qualified valuation professionals can arrive at different conclusions of value for an asset

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Standards for Valuation

• Ethics Standards

• Development Standards

• Reporting standards1. Standards of Value

2. Premises of Value

3. Approaches to Value

• Special Characteristics of Ownership Interests



Ethics

• Independence Issues

• Objectivity and Conflict of Interest

• Professional Competence

• Due Professional Care

• Planning and Supervision

• Sufficient Relevant Data

• Compliance with Standards



Development Standards

• Data gathering – firm and financial history, ownership, clients, operating characteristics, underlying legal documents/agreements

• Organizing data, create exhibits including comparative and common size financial schedules

• Interview/Site visit

• Analyze information for Reporting Phase

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Reporting Standards

• Standards of Value

• Premises of Value

• Approaches to Value1. Asset

2. Income

3. Market


© 2015 Cendrowski Corporate Advisors LLC. All rights reserved. Proprietary & Confidential. Reproduction or redistribution prohibited.8

Summary of Standards of Value & Operational Premises

Standards of value

Fair market value Fair value Investment value Book value Intrinsic value

• Exchange between willing buyer and willing seller• Used to value firms in State of IL, less personal goodwill

• Current owner involuntarily deprived of assets• No discounts for lack of marketability of control• Used for valuation of minority interests in State of MI

• Value to specific investor• May include value of synergies• Used to value firms for divorces in State of MI• Incorporates personal goodwill

• Difference between total assets and total liabilities

• What an investor considers is the “true” or “real” value in spite of the current market environment

Operational Premises

Going concern value Liquidation value

• Value of business that is expected to continue in operation

• Amount realized if a business is terminated and its assets are sold



Asset Approach

• Fair market value analysis of balance sheet, consideration of off balance sheet assets and liabilities– Face value assets and liabilities – market value stated in

actual dollar values

– Tangible assets – land, building, machinery and equipment are reflected in accordance with accounting convention of value (depreciation/amortization), need appraisal/valuation of these assets to establish current fair market value

– Intangible assets – goodwill, copyrights, patents will need special valuation separately.

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Income Approach

• Discounted cash flow method – look forward method

• Capitalization of cash flow method – look back method with estimated consistent long term growth– Discount/Capitalization factor determined by a build up

method (BUM) or use of market multiples applied to the related economic benefit stream

• Seller’s Discretionary Cash Flow – based on recent operating cash flow, used for small businesses



Market Approach

• Transaction based analysis of market multiples of actual sales or operating multiples of comparable (guideline) companies– Market multiples are derived from various levels of

economic benefit streams (income) compared to sales price or stock values

• GRM – Gross Revenue Multiplier

• EBITDA – Earnings Before Interest, Taxes, Depreciation and Amortization

• EBIT – Earnings Before Interest and Taxes

• Net Income/Earnings

• Price/Earnings ratios

• Beds – specialty for nursing homes

• Keys – specialty for hospitality industry (hotels, motels)


© 2015 Cendrowski Corporate Advisors LLC. All rights reserved. Proprietary & Confidential. Reproduction or redistribution prohibited. 12

Select standard of value

• Business valuation process summary:

Select valuation approach

Income Market Asset

Estimate free cash flows

Estimatediscount rate

Analyze precedent transactions

Analyze comparable company trading

multiples

Estimate asset value

Compute valuation

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Sample Income Approach Analysis



Principles of Business Valuation

• Value is equal to the sum of expected future benefits discounted back to a present value.

• The market for capital determines the appropriate discount rate.

• Value of stock can be more or less than a proportionate share of the underlying net asset value.

• Lack of control and lack of marketability are distinct concepts.

• Minority interests may be worth less than a pro-rata portion of the overall business value.

• Business interests that lack marketability are generally worth less than business interests that are readily marketable.



Income Approach

• Best used for a profitable business

• No distinguishing of assets

• Assumes all operating assets are used to produce economic income

• Adjust for value of non-operating assets and liabilities

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Understanding Economic Income

• What is economic income?– Economic income represents an inflow into a business in

exchange for goods, services, or capital• Selected components of economic income:

– Revenues– Costs

• Raw material• Production• Sales, general, and administrative

– Capital expenditures• Expenditures for betterment of assets

• Other components may include:– Depreciation/amortization– Working capital




• Common Adjustments to arrive at “normalized” or arm’s-length income– Non-Arms Length Transactions

• Management Fees• Rents• Benefits to Outsiders

– Personal Expenses– Normalized Compensation– Non-Business Expenses (But Another Business’s

Expenses)– Beware of Expense Account Headings – What is

Included?




• Economic income is often projected for a specific period (the “projection period”) after which growth is assumed to stabilize– Growth rate during period of stability = “terminal

growth rate”

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• How can forecasts of economic income be manipulated?– Individuals who own a businesses may provide overly

aggressive/conservative forecasts to valuators• R.A.I.D.S. = Recently Acquired Income Deficiency Syndrome

– They may change accounting policies in order to report increased/decreased income

• Legal professionals should ask for a list of recent accounting policy changes and the impact of these changes on a business’ income when analyzing valuations

– One area of manipulation is the valuation of a business’ inventory




• In order to better identify overly aggressive/conservative projections, a business’ historical performance should be examined when analyzing future projections– Previously realized values for economic income should be

analyzed against projected values

• Example: Do the 2011 estimates seem reasonable at first glance?




• To confirm realistic economic income values, use ratio comparisons to ratios reflected in industry complied financial databases (benchmarks)

• Ratio Comparison– Industry Publications

– RMA

– Profit Sense

– IRS Ratios

– Integra

– First Research

– Bizminer

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Analyzing Projections

• Business projections can sometimes be verified by examining projections for competitors– Example: Are the following projections for the

subject business reasonable?




• Overall “red flags” in economic income projections include:– Aggressive (conservative) revenue growth assumptions

– Aggressive (conservative) cost assumptions

– Underinvestment (overinvestment) in capital expenditures• Expenditures for betterment of assets

• Commensurately affects asset depreciation/amortization

– Greater capital expenditures = greater future depreciation

– Underinvestment (overinvestment) in working capital• Represents operating liquidity

• Especially critical for growing firms

– Aggressive (conservative) estimates of terminal growth rates• Growth rates employed in terminal value calculations should generally fall

between the historical rate of inflation and the historical GDP growth rate of the country in which the subject business operates (between 3% and 7% for US businesses)



Estimating the Discount Rate

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Discount Rate

• Discount rate is dependent upon a business’:– Market value of debt– Cost of debt– Marginal tax rate– Market value of equity– Cost of equity

• Frequent source of disparity

• Higher discount rate = lower valuation• How does the value of a business vary by its

discount rate?



Discount Rate

• Example: Assume a business is expected to generate $10 million of economic income each year into perpetuity. What is its value?



Discount Rate

• The Discount Rate (or Capitalization Rate) is the Yield necessary to attract investors to a particular investment given the risks associated with that investment.

• Comprised of two elements – risk-free rate and risk premia

• Common methods of determining discount rates– Build-up method– Capital asset pricing model (CAPM)– Weighted average cost of capital (WACC)

• Capitalization rate is equal to discount rate less long-term growth rate

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Discount Rate

• Cost of equity estimates are generally a source of disparity in valuations

• Sample “build up method” calculation for cost of equity, a component of the discount rate:Risk-free rate (4-6%)+ Market risk premium (4.5-7.5%)+ Size risk premium (0-15%)+ Industry risk premium+ Company-specific risk premia (wide range of estimates >=0%)= Cost of equity

• Sources of disparity in cost of equity estimates often center on valuators’ estimates of the size risk premium and company-specific risk premia



Discount Rate

Size Risk Premium• Based on premise that smaller firms presumably

require an investor to bear greater risks– More susceptible to macroeconomic, industry, and firm-

specific factors

• Can be a source of great disparity in valuations, especially those of smaller businesses (market capitalizations under $200 million)– Size premiums for companies under $200 million can

reasonably range between 4% and 15%– It is up to the valuation analyst’s discretion to select an

appropriate size premium



Discount Rate

Company-Specific Risk Premia• Valuation professionals may add additional

company-specific risk premia pertaining to issues such as:– Industry– Company-specific issues

• Management depth• Customer concentration• Level of competition• Employee turnover• Location• Internal controls

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Discount Rate

Company-Specific Risk Premia• These additional risk premia may significantly increase

a firm’s cost of equity– Adding a premium of >5% for any of these issues might be

merited, but should be analyzed

• There are no specific rules pertaining to other risk premia, they are used at the discretion of the valuation professional

• The impact of company-specific risk premia should decrease with firm size– Valuations of larger firms should not include significant

amounts of additional risk premia



Discount Rate

• Legal professionals should ensure valuators’ estimates of risk premia come from the same source– The main source of data is Duff & Phelps, but there

are three different sets of data to choose from

– Valuation professionals may select from many sources of data, but, once selected, all estimates should come from the same source

– Use of differing sources should be viewed as a “red flag”



Discount Rate

Common errors in computing value are –• Misuse of capitalization rate – applying rate to projected

income

• Misuse of discount rate – applying to historic income

• Net income used with a cash flow capitalization rate

• Applying an after-tax rate to pre-tax income and vice versa

• Overstating the long-term growth rate

• Inappropriate projection model

• Ignoring non-operating assets and liabilities

• Ignoring real world sale analysis to arrive at equity value

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Owner and Entity Level Discounts



Owner-level Discounts

Owner-level discounts• Valuation professionals may adjust a valuation for

numerous investment-specific issues, including:– Lack of marketability– Lack of control

• These adjustments are made after a preliminary estimate of value has been derived– There are no specific rules for these estimates– They are employed at the discretion of the valuation

professional




Owner-level discounts• Lack of marketability:

– Marketability is the ability to sell an interest and obtain cash quickly without a loss of value

– A lack of marketability discount is often applied to privately-held business interests as they are less liquid than publicly-traded interests

• Lack of control:– A controlling stake in a business often affords an owner the

ability to make strategic, operational, and process changes that he might not otherwise be able to affect

– A lack of control discount is often applied when valuing minority equity interests in businesses

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Owner-level discounts

• Significant disparities can exist between valuators’ estimates of owner-level discounts

• However, high levels of discounts should be examined when used in conjunction with high discount rates



Entity-level Discounts

Entity level discounts are the function of the operating status/aspects of the business entity being valued

— Key person discount—Trapped in capital gains—Portfolio discount



Summary of Key Areas of Disparity and Red Flags

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Summary of Disparities

• Disparities in valuations can exist between estimates of:– Personal goodwill

• Not included in State of Illinois-based divorce valuations– Economic income– Discount rate

• Size premium• Company-specific premium

– Owner-level discounts• Lack of marketability• Lack of control

• A side-by-side comparison of these estimates can assist a legal professional in determining the reasonableness of valuators’ assumptions



Questions?

Contact us:

Chicago Bloomfield Hills

180 North LaSalle Street 4111 Andover RoadSuite 2620 West, Third FloorChicago, IL 60601 Bloomfield Hills, MI 48302

866-717-1607 / www.cca-advisors.com42

law practice management & technology prmcle meeting ... · 12/17/2015 · law practice...

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