valuation challenges involving closely held...

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Valuation Challenges Involving Closely Held Businesses

WEDNESDAY, FEBRUARY 20, 2019, 1:00-2:50 pm Eastern

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WEDNESDAY, FEBRUARY 20, 2019

Valuation Challenges Involving Closely Held Businesses

Jon P. Klerowski, CPA, ABV, CFE, Partner

Floyd Advisory, Boston

[email protected]

John F. Maloney, CPA, CFF, CVA, ABAR, Founding and Managing Partner

Wouch Maloney & Co., Horsham, Pa.

[email protected]

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determined through consultation with your tax adviser.

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Valuation Challenges Involving

Closely Held Businesses

Strafford

February 20, 2019

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Agenda

1. Introduction to Business Valuation

➢ Introduction and Background

➢ Valuation Core Concepts

2. Valuation Approaches

➢ Income Approach

➢ Market Approach

➢ Asset (Cost) Approach

3. Challenges Involving Closely-Held Companies

➢ Discounts

➢ Other Challenges / Common Pitfalls

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www.floydadvisory.com

Introduction and Background

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Jon Klerowski, CPA, ABV, CFE

Professional Profile

Mr. Klerowski is a Partner at Floyd Advisory, a consulting firm providing financial and accounting expertise in areas of business strategy, valuation, SEC reporting, and transaction analysis. Mr. Klerowski has significant experience advising executive management, boards of directors, and their counsel on a wide array of accounting, financial reporting and modeling, business valuation and forensic accounting matters.

Education and Certifications

Bachelor’s degree in Finance, Bentley CollegeMaster of Business Administration, Accounting, Suffolk UniversityCertified Public Accountant, CaliforniaCertified Fraud ExaminerAccredited in Business Valuation (ABV) by the AICPA

Professional Associations and Memberships

American Institute of Certified Public Accountants (AICPA)Association of Certified Fraud Examiners

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John F. Maloney, CPA, CFF, CVA, ABAR

Professional Profile

Partner in the independent certified public accounting firm of Wouch, Maloney & Co, LLP, a full-service accounting and business advisory firm with offices in Horsham, PA, Newtown, PA and Bonita Springs, FL.

Over 35 years of public accounting and consulting experience focusing on business valuation, damage measurement, estate planning, marital disputes, income taxation, accounting and auditing, business and strategic planning, business strategy development, shareholder agreements, disputes and resolution, succession, entity planning and structuring, operational budgeting, bankruptcy and performance assessment and improvement. Engagements have involved closely-held business entities and entrepreneurial individuals in the industries of construction, manufacturing, wholesaling, professional services, pharmaceutical, retail, and home building and development. Testified as an expert witness.

Education and CertificationsCertified Valuation Analyst (CVA), January 10, 1997 Accredited in Business Appraisal Review (ABAR), January 24, 2012Certified in Financial Forensics (CFF), February 28, 2009Certified Public Accountant (CPA), March 17, 1988Licensed in Pennsylvania and New JerseyTemple University - Bachelor of Business Administration (1981)

Professional Associations and MembershipsAmerican Institute of Certified Public Accountants (AICPA)Pennsylvania Institute of Certified Public Accountants (PICPA)National Association of Certified Valuation Analysts (NACVA)Construction Financial Management Association (CFMA)Associated Builders and Contractors of Southeastern PA (SEPA ABC)Former Director and Past President, Bucks County Estate Planning Council (BCEPC)Member of PICPA Business Valuation Committee

http://nacva.com/certifications/C_cva.asp

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Overview – Business Valuation Standards

Organizations which offer standards/guidance

▪ Uniform Standards of Professional Appraisal Practice (USPAP) – Issued by The Appraisal Foundation

▪ Statement on Standards for Valuation Services (SSVS 1) – Issued by the AICPA

▪ Professional Standards – Issued by NACVA/IBA

▪ ASA Business Valuation Standards – Issued by ASA

▪ The Internal Revenue Service (IRS)

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Overview – Credentials/Certifications

▪ ABV – Accredited in Business Valuations (AICPA)

▪ CVA – Certified Valuation Analyst (NACVA)

▪ ABAR – Accredited in Business Appraisal Review (NACVA)

▪ ASA – Accredited Senior Appraiser (ASA)

▪ CBA – Certified Business Appraiser (IBA)

▪ CFA – Chartered Financial Analyst (CFAI)

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Types of Valuation Report

▪ Valuation Engagement/Report

– Analyst estimates the value based on the valuation approaches and methods they deem appropriate

– Results expressed as a “Conclusion of Value”

▪ Calculation Report

– Analyst and client agree on the valuation approaches and methods and the value is calculated based on the agreement

– Results expressed as a “Calculated Value”

– Does not include all procedures required for a valuation engagement

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The Valuation Process

▪ Company Background– Business Description – Customers (business sector(s))– Employees– Products– Market (local, regional , national)

▪ Financial Performance– Revenue (historic & projected)– Gross Margins, Operating Margins, EBITDA– Capital Structure

▪ Recent Sale Transactions

▪ Competition

▪ Data & Information > Financial statements, income tax returns, workforce data, trial balances, sales reports, payroll data

▪ Interviews > Owner/Shareholder, CFO, COO, Controller, Ops personnel

▪ Public Information

▪ Industry Overview / Research (Trends, Outlook)

▪ Economic Outlook

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Disputes Involving Business Valuation

Examples include…

▪ Shareholder disputes / shareholder oppression

▪ Business dissolutions: force of a sale / purchase of business interests

▪ Breach of Contract / Commercial Disputes – decrease in business value and/or damages

▪ Intellectual Property rights infringement

▪ Bankruptcy: solvency analyses

▪ Divorce: couple owns an interest in a closely held business

▪ Tax Liability Determination

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Difficulties for Closely-Held Businesses

Definition: Closely-Held Businesses

▪ Small number of owners / shareholders

▪ Not necessarily a “small business” in terms of sales, number of employees etc.

Difficulties Unique to Closely-Held Businesses

▪ No entity separation between ownership and management

▪ Rarely traded or sold in the marketplace – no established market price

▪ Financial data is not standardized

▪ Must stand up to IRS scrutiny

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Valuation Core Concepts

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Standard of Value

▪ “The standard of value usually reflects an assumption as to who will be the buyer and who will be the seller in the hypothetical or actual sales ...”1

Standard of value refers to the type of value being estimated

“Value to whom?” and “under what circumstances?”2

[1] Shannon P. Pratt, Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 5th Ed.

(New York: McGraw Hill, 2008), p 41; [2] Ibid; [3] Ibid

▪ “The standard of value, either directly by statute or (more often) as interpreted in case law, often addresses what valuation methods are appropriate and what factors should or should not be considered.”3

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Commonly Used Standards of Value

• Most widely recognized and accepted definition of value.

• All Federal Tax matters

• Potential synergies not included

Fair Market Value

• Willing Buyer & Seller

• No compulsion to buy/sell

• Reasonable knowledge of facts

• Includes “hypothetical” buyer/seller

Definition Application

• Hypothetical transaction from Seller’s perspective

• “Exit Price”: not a willing selling

• Price that seller would actually get

• Most common in state shareholder lawsuits (minority shareholder oppression)

• Used for financial reporting

Fair Value – State Statutes

Investment Value• Value to the business owner (not

selling)

• Value to a particular buyer

• Strategic M&A and divestitures

• Includes potential synergies to be gained via transaction

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Premise of Value

Going Concern

Going Concern vs. Liquidation?

Value in continued use (as operating entity)

Assemblage of Assets

Forced Liquidation Assets sold individually; fire sale

Assets sold individually over a reasonable amount of time

Value in place as part of a mass assemblage, not in current use

Orderly Liquidation

Less

Val

ue

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Levels of Value

Source: AICPA Introduction to Business Valuation, Chapter 10: PREMIUMS AND DISCOUNTS (VALUATION ADJUSTMENTS), pg. 9

Less

Val

ue

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The Valuation “Formula”

The three major components of the valuation “formula”:

1. Economic Benefit – What is the most appropriate valuation approach/method?

2. Risk – What rate or multiple should be applied to the economic benefit?

3. Adjustments – What adjustments should be made to the entity value?

1) Economic Benefit

( / )

2) Risk

= Entity Value

( / )

3) Adjustments

= Value After

Adjustments

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Example of Valuation Formula

Economic Benefit 500,000$

Risk 20%

2,500,000$

Discount (30%) (750,000)

1,750,000$

Interest Being Valued 25%

Value of Interest 437,500$

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Valuation Approaches

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Valuation Approaches

Primary Drivers of Value

Profitability Growth Risk

Method

Income Approach

Discounted Cash Flow

Capitalization of Earnings

Market Approach

Public Company

M&A Transactions

Asset (Cost) Approach

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Valuation Approaches: Income Approach

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▪ Goal of the income approach:

– To project the future income associated with the investment

– Discount the projected income stream to a present value

– Determine a discount rate appropriate for the expected risk of the projected stream

“The value of a business or an interest in a business depends on future economic benefits that will accrue to that business”1

[1] Pratt, S., The Market Approach to Valuing Businesses, John Wiley & Sons, Inc. (2005)

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Capitalization/Discounted Cash Flows▪ Two most common approaches, same underlying principle:

1. Single Period Capitalization Method

2. Multi-period Discounted Cash Flow (DCF)

▪ Determine annual future cash flow or profit that is expected to be derived from the business• Trends of historical Sales & Costs

• Growth opportunities / Capital expenditures needed for growth

• If historical results are used as a proxy, normalization is necessary

▪ Apply Capitalization Rate or Discount Rate to discount future cash flow to current day dollars (value)

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Single Period Capitalization

▪ Assumes steady stream of cash flow increasing by a fixed % each year

▪ Takes the Free Cash Flow in Year 1 ($1M), and divides it by the Capitalization Rate [Discount Rate (12%) – Long Term Growth Rate (2%)]

▪ Present Value = Benefit Stream (CF) ÷ Capitalization Rate

➢ $10M = $1M ÷ (12% - 2%)

▪ Best suited for companies that are in their long-term stable state

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www.wm-cpa.comIncome Approach – ExampleCapitalized Cash Flow Method

ABC Company, Inc.

Capitalized Cash Flow Method **equal weighting compare to **graduated weighting

Year

Normalized Net

Income

Add Back Non-

Cash Items

(Depreciation and

Amortization)

Net Adjusted

After Tax Cash

Flow Weight

Weighted Net

Adjusted After

Tax Cash Flow

Net Adjusted

After Tax Cash

Flow Weight

Weighted Net

Adjusted After

Tax Cash Flow

2017 339,900$ 123,739$ 463,639$ 1 463,639$ 463,639$ 5 2,318,195$

2016 683,081 124,926 808,007 1 808,007 808,007 4 3,232,028

2015 707,587 119,830 827,417 1 827,417 827,417 3 2,482,251

2014 286,572 128,222 414,794 1 414,794 414,794 2 829,588

2013 357,095 166,873 523,968 1 523,968 523,968 1 523,968

5 3,037,825$ 15 9,386,030$

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Weighted average (Rounded) normalized net adjusted after tax cash flow 607,565$ 625,735$

Weighted average normalized net adjusted after tax cash flow 607,565$ 625,735$

Capital expenditures necessary to support projected operations (200,000) (200,000)

(+/-) net working capital necessary to support projected operations - -

(+/-) changes in long-term debt to support projected operations - -

Weighted net cash flow to equity 407,565$ 425,735$

Capitalization rate 21.38% 21.38%

Value of the business before non-operating assets 1,906,291 1,991,277

Non-operating Assets 143,329 143,329

Value 2,049,620$ 2,134,606$

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Multi-period Discounted Cash Flow (“DCF”)


▪ Since we cannot estimate cash flows forever, we estimate cash flows until the firm establishes “stable growth” (also an estimate):

▪ Value > Sum of Present Value of Each Year’s Expected Cash Flow

▪ PV = [Cash Flow ÷ (1 + Discount Rate)n)] +

[Terminal Yr Cash Flow ÷ Cap. Rate] ÷ (1 + Discount Rate)n)]

Cash Flow Estimates Year 1 Year 2 Year 3 Year 4 Year 5

“Stable Growth”

“Terminal Period” (future

CF’s grow at fixed & nominal growth

rate)

“VALUE” = Net Present Value of all future funds

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www.wm-cpa.comIncome Approach – ExampleDiscounted Cash Flow Method

ABC Company, Inc.

Discounted Cash Flows Method

Discount rate = 25.02%

Long-term cash flow growth rate = 3.00%

Forecasted net

cash flow to

equity

Present

value factors

(a)

Present value of

future cash flows

Forecasted Year 1 636,135$ 89.4356% 568,931$

Forecasted Year 2 703,046 71.5370% 502,938

Forecasted Year 3 773,695 57.2204% 442,712

Forecasted Year 4 801,433 45.7690% 366,808

Forecasted Year 5 830,004 36.6094% 303,859

Net present value of future cash flows 2,185,248$

Forecasted Year 5 projected net cash flow to equity 830,004

Long-term cash flow growth rate 3.00%

Cash flows with growth 854,904

Capitalization rate 22.02%

Terminal Value (b) (c) 3,882,398 36.6094% 1,421,322$

Present value of projected cash flows to equity 2,185,248$

Present value of terminal value 1,421,322

Value before non-operating assets 3,606,570

Non-operating assets 143,329

Value 3,749,899$

(a) Used mid-period discounting

(b) Assumes business will continue into perpetuity

(c) Terminal Value Calculated using Gordon Growth Model assuming liquidity event occurs the first day of Year 6.

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Income Approach:

Challenges Related to Closely-Held Businesses

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Income Approach Challenges

▪ Certain assumptions and inputs become particularly difficult when valuing closely-held businesses:

• Discount Rate

• Growth Rate

• Estimating future cash flows / Normalization

• Other Common Errors

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www.wm-cpa.comIncome Approach Challenges:

Discount Rate

▪ The discount rate reflects:

o Time value of money

o Risk or uncertainty of future cash flows

➢ The greater the uncertainty of future cash flows, the higher the discount rate

“In economic terms, a present value discount rate is an “opportunity cost,” that is, the expected rate of return (or yield) that an investor would have to give up by investing in the subject investment instead of investing in available alternative

investments that are comparable in terms of risk and other investment characteristics.”1


▪ Higher Risk = Higher Discount Rate = Lower Valuation

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Risk-Free Rate 4.50%

Equity Risk Premium 7.50%

Size Premium 6.00%

Subtotal 18.00%

Plus: Industry Risk Premium 2.00%

Plus: Specific Company Risk 4.00%

Discount Rate 24.00%

Less: LT Growth Rate (2.00%)

Capitalization Rate 22.00%

Long-term Government Bonds

Small Cap. Equity Stock has Greater Risk than Large Cap. Equity Stock

Large Cap. Equity Stock has greater risk than Long-Term Gov. Bonds

Additional Risk Necessary Based on the Type of Industry?

Add’l Risk based on Specific Characteristics of Company? (i.e. Customer Concentration, etc.)

Income Approach Challenges:

Discount Rate Build-Up

Used for DCF model

Applied to single period capitalization formula

Syst

emat

ic R

isk

Un

syst

emat

ic

Mo

re J

ud

gme

nt

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Discount Rate

Company-Specific Risk (CSR)

▪ Based on Judgment

▪ Reliability concerns

▪ Considerations:– Additional Size Premium– Industry Risk (make sure not to double-count)– Depth of Management– Access to Capital– Customer Concentration / Customer Pricing Leverage– Supplier Concentration– Product or Service Diversification– Competition– Availability of Labor– Financial Strength– Profitability and Stability of Earnings/Cash Flow– Local Economic Effects– Key Person

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Growth Rate Considerations

▪ Forecasting the duration of extraordinary growth is subjective

▪ All firms eventually reach a stable state

▪ High Growth -> Excess Returns -> Increased Competition

Extraordinary Growth

▪ Size of the business

▪ Existing growth rate and excess returns

▪ Magnitude and sustainability of competitive advantages

Duration Factors[2]

[2] Damodaran, Aswath. Applied Corporate Finance, 4th Edition. John Wiley & Sons, 2015, Chapter 12.

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▪ The transition from extraordinary growth to a stable state growth rate overnight, does not seem practical

▪ A different form of Discounted Cash Flow model (the H-model) attempts to address this pitfall, by assuming a linear decline in the growth rate over time, smoothing out the projections

▪ However, a linear decline in growth might fail to capture volatility in earnings

Transition Period (from High to Stable growth)

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▪ Stable state growth should be high enough to keep pace with inflation, but not high enough to outpace long term GDP growth

▪ Nominal vs. Real Growth

▪ Economic Benchmarks Include:

▪ Inflation (historic)

▪ Real GDP (historic)

▪ Nominal GDP (historic)

▪ Includes inflation and real growth

▪ Note: The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.96 percent (January 11, 2019; www.clevelandfed.org)

Stable State Growth Rate

http://www.clevelandfed.org/

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Cash Flow - Normalizing Adjustments

▪ Often, historical financial results are used to estimate future earnings

▪ Historical financial statements must be “normalized” to remove non-recurring expenses or revenue

▪ Common normalizing adjustments

1. Adjust for non-recurring revenue or expenses

➢ Start-up costs

➢ Unusually large one-time sales contract

➢ Lawsuits, arbitrations, insurance claim recoveries and one-time disputes

2. Amounts not reported at market value

➢ Related-party transactions (not “arm’s length”)

➢ Discretionary expenses

➢ Owner salaries and bonuses not at fair market value

3. Other Adjustments

➢ Income Tax

➢ Non-operating and off-balance sheet assets

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Cash Flow - Normalizing Adjustments

Actual Adjusted Reason

Revenue 1,000,000$ 1,000,000$

Cost of Goods Sold 350,000 350,000

Gross Margin 650,000 650,000

Operating Expenses

Rent 5,000 8,000 Actual Not Arms Length

Travel 5,000 - Personal Expense

Auto 8,000 - Discretionary Comp.

Travel 5,000 2,000 Personal Expense

SG & A 120,000 120,000

Owner's Compensation 100,000 50,000 Reasonable Comp.

Subtotal 243,000 180,000

Income before Taxes 407,000 470,000

Less: Income Taxes 59,750 69,000

Net Income 347,250 401,000

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Income Approach: Common Errors

Sensitivity of Assumptions:

▪ Assume Owners Comp. = $75K instead of $50K

▪ Assume Cap Rate = 2% higher due to Company Specific Risks

▪ Assume Net Income = Cash Flow

Small changes in valuation assumptions can have material impact on value…

Value 1 Value 2 Variance

Annual Net Income 401,000$ 376,000$ (25,000)$

Cap Rate 22% 24% 2%

Value (before discounts) 1,822,727$ 1,566,667$ (256,061)$ (14%)

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▪ Use beginning rather than ending cash flow under the single period capitalization method

▪ Inconsistency between discount rate and future cash flows

▪ Failing to properly adjust for non-operating / off-balance sheet assets

▪ Failing to reconcile capital expenditures and depreciation

▪ Using an incorrect standard of value

▪ Working Capital Deficiency

▪ As the business grows, additional permanent working capital is required which may reduce future cash flows

James R. Hitchner, Financial Valuation Applications and Models, 3rd ed., Wiley, 2015, p. 141.Andersen, Jim. “Valuing the Closely Held Business: Spot These Common Errors Before Going Into Court.” Aug. 2014.

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Lack of Professional Skepticism Regarding Forecasts

▪ Senior Management or “FP&A” group typically prepares forecasts

▪ Valuation professional must vet forecasts

▪ Understand forecasts

▪ Document how management developed forecast

▪ Evaluate reasonableness

▪ Factors and considerations:

▪ Compare against historical trends

▪ Budget-to-Actual analyses

▪ Comparison to industry/analyst expectations

▪ Perform math and logic check

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Income Taxes: C Corp vs. S Corp

▪ Delaware Open MRI Radiology Associates, PA v. Howard B. Kessler (Decision April 26, 2006)

▪ The Court determined it was appropriate to tax-affect the earnings of the S corp at a rate that would reflect the tax structure differences of a traditional C corp and S corp. The Court applied the top corporate and personal tax rates, and assumed that profits were distributed to the shareholders.

Traditional C

Corp

Traditional S

Corp

S Corp

Valuation

Corporate Level

Income Before Tax 100$ 100$ 100$

Corporate Tax Rate* 40.00% 0% 29.40% *

Net Income 60$ 100$ 70.6$

Shareholder Level

Income Available for Distribution 60$ 100$ 70.6$

Personal Income Tax Rate** 0% 39.60% 0%

Dividend Tax Rate 15.00% 0% 15.00%

Total, Post-Tax Distributions 51$ 60$ 60$

*The Court used income before taxes of $100, total post-tax distributions of $60 and a

dividend rate of 15% to calculate the 29.4% implied corporate tax rate.

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Valuation Approaches: Market Approach

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Market Approach

▪ Based on the economic principle of substitution:

▪ Measures value by comparing the subject company to market data (similar to real estate “comps”)

▪ Uses concept of valuation “multiples”

o Multiple = value ÷ financial measure

o Ex: Revenue multiple of 10x = $100 value ÷ $10 of revenue

“One would not pay more than one would have to pay for an equally desirable alternative investment”1


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▪ Identify “comparable” companies, considering: o Capital structure and size of balance sheet (economies of scale)o Industry and company factors (maturity, competition, etc.)

▪ Adjust the data of the subject company to be consistent w/ public companies > normalization adjustments (discussed previously)

▪ The 10.6x Net Income multiple is then applied to subject company N.I.▪ If Subject Net Income = $10K, derived value = $106K

Market Approach:

Guideline Public Company Method


Public Company Equity Value Net Income Multiple

Comparable Company 1 $800,000 $60,000 13.3x



Average 10.6x

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▪ Identify comparable mergers and acquisitions (M&A) of guideline companies to create valuation multiples

▪ Theory: prices paid for similar company M&A transactions provide approximation of value

▪ The 5x EBITDA multiple is then applied to subject company EBITDA

▪ If Subject EBITDA = $3M, derived Value = $15M

Market Approach:

Guideline M&A Method

Guideline M&A (Transactions) Method

Sale Price EBITDA Multiple

Comparable Transaction 1 $25 M $4.5 M 5.6x

Comparable Transaction 2 $35 M $9 M 3.9x

Comparable Transaction 3 $15 M $2.5 M 6.0x

Average 5.0x

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www.wm-cpa.comMarket Approach – ExampleGuideline (M&A) Transaction Method (GTM)

ABC Company, Inc.

Guideline Transaction Method

1. Selected Guideline Companies and Relevant Measures of Value

SIC Sale Date

Transaction

Type MVIC Revenue EBITDA*

MVIC /

Revenue

MIC /

EBITDA*

3441 9/30/2014 Asset 5,485,000 16,355,790 2,495,697 0.34 2.20

3441 9/12/2014 Asset 2,280,000 4,852,419 N/A 0.47 N/A

3441 9/24/2013 Asset 1,021,496 2,434,706 248,867 0.42 4.10

3441 11/4/2011 Asset 400,000 532,125 146,048 0.75 2.74

3441 8/3/2011 Asset 385,000 470,812 153,936 0.82 2.50

3444 4/1/2012 Asset 970,000 3,007,145 565,914 0.32 1.71

3444 4/24/2013 Asset 1,100,000 2,300,000 193,400 0.48 5.69

3444 5/26/2010 Asset 760,000 2,232,480 262,275 0.34 2.90

3444 3/26/2013 Asset 475,000 2,210,112 36,497 0.21 13.01

3444 3/31/2014 Asset 1,800,000 1,947,786 179,058 0.92 10.05

3444 1/27/2014 Asset 725,000 1,363,060 N/A 0.53 N/A

3444 3/18/2013 Asset 2,000,000 1,250,700 492,500 1.60 4.06

3444 4/5/2013 Asset 560,000 837,341 72,752 0.67 7.70

3444 11/26/2012 Asset 275,000 801,966 99,113 0.34 2.77

3446 8/23/2011 Asset 89,000 655,000 N/A 0.14 N/A

3446 12/1/2011 Asset 350,000 508,470 N/A 0.69 N/A

3448 8/23/2010 Asset 3,431,341 6,291,996 755,901 0.55 4.54

3449 11/1/2010 Asset 1,556,492 2,386,283 179,679 0.65 8.66

3449 11/11/2011 Asset 1,592,293 1,361,251 367,990 1.17 4.33

3449 8/1/2011 Asset 160,000 507,840 57,444 0.32 2.79

* - Earnings Before Interest, Taxes, Depreciation & Amortization

Statistics MVIC Revenue EBITDA* MVIC / Revenue MIC / EBITDA*

Count 20 20 16 20 16

Minimum 89,000 470,812 36,497 0.14 1.71

Maximum 5,485,000 16,355,790 2,495,697 1.60 13.01

Mean 1,270,781 2,615,364 394,192 0.59 4.98

Harmonic Mean 478,237 1,135,599 139,889 0.43 3.63

10th percentile 263,500 508,407 65,098 0.31 2.35

25th percentile 396,250 765,225 134,314 0.34 2.76

Median 865,000 1,655,423 186,540 0.51 4.08

75th percentile 1,644,220 2,398,389 399,118 0.71 6.19

90 percentile 2,395,134 4,996,377 660,908 0.95 9.36

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www.wm-cpa.comMarket Approach – ExampleGTM (cont’d)

2. Application of Variable to Subject Company

MVIC / Revenue Analysis:

Normalized Revenue 25,194,329$

Selected MVIC / Revenue Multiple 0.51 Median

Indicated Value of Invested Capital 12,723,136

MVIC / EBITDA Analysis:

Normalized EBITDA 672,978$

Selected MVIC / EBITDA Multiple 4.08 Median

Indicated Value of Invested Capital 2,745,750

Selected Metrics: Value Weight

MVIC / Revenue 12,723,136 0% 0

MVIC / EBITDA 2,745,750 100% 2,745,750

Value of business before adjustments 2,745,750

3. Adjustments to Value

Cash and trade receivables of Subject Company** 2,831,210

Less: interest bearing debt** (2,081,948)

Non-operating assets 143,329

Value 3,638,341$

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www.wm-cpa.comMarket Approach – ExampleGuideline Public Company Method

ABC Company, Inc.


Public Co #1 Public Co #2 Public Co #3 Public Co #4 Public Co #5 Mean Median

Subject

Company

Revenue 144,875,000 1,731,244,000 97,790,000 1,319,757,000 466,064,000 97,790,000 466,064,000 751,946,000 466,064,000 7,228,694

Total Assets 79,959,000 1,602,475,000 125,315,000 2,915,984,000 690,581,000 125,315,000 690,581,000 1,082,862,800 690,581,000 2,601,686

Liquidity Ratios

Current Ratio 2.33 2.46 1.10 0.85 0.86 0.86 1.10 1.52 1.10 1.95

Quick Ratio 2.33 2.31 1.08 0.85 0.82 2.33 1.08 1.48 1.08 1.57

Profitability Ratios

Gross Margin (%) 44.30% 30.07% 21.08% 43.21% 31.88% 31.88% 21.08% 34.11% 31.88% 11.79%

EBIT/Sales (%) 7.37% 10.66% 6.43% 2.01% 3.86% 3.86% 6.43% 6.07% 6.43% 1.00%

Net Income/Sales (%) 2.94% 7.54% 2.67% 10.24% 8.25% 8.25% 2.67% 6.33% 7.54% 4.74%

Leverage

Assets/Equity 1.78 2.05 1.62 2.13 7.35 1.62 7.35 2.99 2.05 1.96

Total Liab/Total Assets (%) 43.89% 51.27% 37.35% 52.81% 86.39% 37.35% 86.39% 54.34% 51.27% 48.86%

Price per share 15.97 55.44 1.37 33.62 5.80

Outstanding Shares 4,240,000 52,940,000 55,170,000 113,030,000 26,890,000

Market Value of Equity 67,712,800 2,934,993,600 75,582,900 3,800,068,600 155,962,000

LT Debt 767,000 270,846,000 6,637,000 909,978 461,418,000

Cash 14,230,000 302,210,000 136,000 9,873,000 1,893,000

Net Debt (Cash) (13,463,000) (31,364,000) 6,501,000 (8,963,022) 459,525,000

MVIC 54,249,800 2,903,629,600 82,083,900 3,791,105,578 615,487,000

MVIC/EBIT 5.08 15.74 13.06 14.27 34.21

Range 5.08 34.21

Mean* 14.36

Median* 14.27

Selected Multiple** 14.27

Company EBIT 500,000

Multiple 14.27

Value without Debt 7,136,602

Less: Debt 1,271,295

Value of business 5,865,307

Range

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Market Approach - Challenges

Challenges with closely-held companies:

▪ True comparables are difficult to identify

▪ Owner misconceptions re comparability

▪ Need to identify somewhat comparable companies/transactions considering:

– Size

– Industry

– Geography (local business vs international player)

– High-tech / Innovative

– Stage of development (very difficult to find data on early-stage companies)

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Valuation Approaches: Asset (Cost)

Approach

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▪ Value = Value of Assets – Value of Liabilities

- Based on the premise that the economic value of a business can be associated with the productive assets of a business

▪ Not used often:

1) might fail to account for the income potential of a business (“big picture”)

2) The resulting value is cost to re-create the business today

▪ Asset Approach can be used as a ‘reality check’ (i.e. if value of assets is more than value of future earnings, something is wrong)

▪ This approach can be used in valuing holding companies, capital-intensive firms or cases of liquidation

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•Adjusted Net Assets Method

•Liquidation Value Method

•Book Value Method

•Excess Earnings Method – Asset/Income Hybrid Approach

Common Asset Approach Methods

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www.wm-cpa.comAsset Approach - ExampleAdjusted Net Asset Method

ABC Company, Inc.

Adjusted Net Assets Method

Unadjusted Adjusted Value Unadjusted Adjusted Value

2017 Adjustments 2017 2017 Adjustments 2017

Current Assets Current Liabilities

Cash & Cash Equivalents 1,070,805$ 4] (600,000)$ 470,805$ N/P - Bank 695,305$ -$ 695,305$

Accounts Receivable 2,360,405 - 2,360,405 Current Portion of Long-Term Debt 490,350 - 490,350

Inventory 2,149,034 1] (125,000) 2,024,034 Accounts Payable 675,664 - 675,664

Prepaid and Other Current Assets 421,573 - 421,573 Accrued Expenses 540,908 - 540,908

Total Current Assets 6,001,817 (725,000) 5,276,817 Total Current Liabilities 2,402,227 - 2,402,227

Fixed Assets Long Term Liabilities

Total Fixed Assets 5,176,290 2] (3,676,290) 1,500,000 Long-Term Debt 896,293 - 896,293

Less: Accumulated Depreciation 4,668,618 2] (4,668,618) - Other Liabilities 353,000 - 353,000

Total Fixed Assets - Net 507,672 992,328 1,500,000 Total Long Term Liabilities 1,249,293 - 1,249,293

Other Assets 143,329 3] (143,329) - Shareholders Equity

Common Stock 2,000 - 2,000

Total 6,652,818$ 123,999$ 6,776,817$ Additional Paid-In Capital 111,049 - 111,049

Retained Earnings 5,883,442 5,883,442

Treasury Stock (2,987,187) 5] 123,999 (2,863,188)

1] Adjust inventory to the inventory value using FIFO. Total Equity 3,009,304 123,999 3,133,303

2] Adjust fixed assets to fair market value.

3] Remove non-operation assets Total 6,660,824$ 123,999$ 6,784,823$

4] Remove excess cash.

5] Reconciling adjustment. Net Operating Assets 3,133,303

(+) Non-Operating Assets:

Cash 600,000

Other Assets 143,329

Adjusted Net Tangible Assets 3,876,632$

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Asset Approach - Challenges

Challenges (for all types of companies):

▪ Framework is considered conceptually weakest of 3 approaches

▪ Results may not reflect true market value

▪ Intangible assets – would need to be valued using another approach

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Challenges Involving Closely-Held

Companies: Valuation Discounts

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Adjustments to Valuation

Two Notable Adjustments to Valuation

▪ Marketability (Discount for Lack of Marketability or “DLOM”)

▪ Control (Discount for Lack of Control (“DLOC”) and Control Premium)

Source: AICPA Introduction to Business Valuation, Chapter 10: PREMIUMS AND DISCOUNTS (VALUATION ADJUSTMENTS), pg. 9

Less

Val

ue

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Discount for Lack of Marketability

Attempts to equalize an interest in a closely-held stock with an interest in a publicly traded-stock

Interest in a closely-held business is illiquid due to lack of ready market of buyers

Discounts can range from 10% - 35%. Factors driving discount size include:

• Historical and expected dividend payments

• Expected investment holding period

• Subject company risk

Due to the time, costs and effort to sell

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www.wm-cpa.comDiscount for Lack of Marketability:

Empirical Evidence

▪ In contrast to minority discounts, a larger body of empirical evidence exists for marketability discounts

▪ Empirical methods employed to quantify the discount:

1. Discounts on the sale of restricted shares of public companies

2. Discounts on the sale of closely held company shares, pre-IPO compared to post-IPO prices

3. Option pricing theory

4. Tax Court Cases

▪ What are restricted securities?

▪ Stock issued prior to an IPO

▪ Stock issued in private placements by the issuer

▪ Securities acquired privately from affiliates

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www.wm-cpa.comDiscount for Lack of Marketability:

Empirical Evidence

• Robert W. Baird & Company Studies (1981-2000)

• Used prospectus data

• Most recent private transaction within 5 months of IPO

• Willamette Management Associates Studies (1975-2002)

• Used SEC registration statements primarily on Form S-1 & S-18

• All private transactions within 3 years of IPO

• Compared Price to Earnings Multiples at IPO vs. private transactions

• Valuation Advisors Studies

• Studies using the Valuation Advisors’ Discount for Lack of Marketability Database breaking down the number of transactions by timing of private transaction vs. IPO.

Notable Studies on Private Transactions Prior to IPOs

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Discount for Lack of Marketability

▪ Additional Factors Influencing Marketability

– IRS Job Aid (2009) – 33 factors

1 The cost of similar corporation’s public and private stock 18 Percent of shares held by institutions

2 Distribution ability and history 19 Percent of independent directors

3 Dividend yield 20 Listing on a major exchange

4 Attractiveness of subject business 21 Active vs. passive investors

5 Attractiveness of subject industry 22 Registration costs

6 Prospects for a sale or public offering of the subject company 23 Availability of hedging opportunities

7 Number of identifiable buyers 24 Market capitalization rank

8 Attributes of controlling shareholder 25 Business risk

9 Availability of access to information or reliability of that information 26 Restrictive transfer provisions

10 Management 27 Length of the restriction period

11 Earnings levels 28 Length of expected holding period

12 Revenue levels 29 Offering size as a percentage of total shares outstanding

13 Book to market value ratios 30 Registered vs. unregistered

14 Information requirements 31 General economic conditions

15 Ownership concentration effects 32 Prevailing stock market conditions

16 Financial condition 33 Volatility of stock

17 Percent of shares held by insiders

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Discount for Lack of Control

• Unable to Control Operations / Salaries

• Unable to Approve Distributions

• Unable to Purchase/Sell Assets

Accounts for lack of control when valuing an interest < 50% ownership

• Empirical evidence to quantify minority discount is less available than for marketability discount

• For very small companies, discount may be greater, as some investors see little value in a non-controlling interest in a small company

Discounts typically range from 10% to 25%

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www.wm-cpa.comDiscount for Lack of Control:

Empirical Evidence Issue

Control Premium

▪While no source of empirical evidence exists for closely-held DLOC, there are alternatives.

▪DLOC can be implied using control premiums paid in public buyouts or

▪ Limited Partnership Transactions– Traded in a secondary market by a small number of brokerage

houses tracked by Direct Investments Spectrum

▪DLOC is derived from Control Premium:

DLOC = 1 – (1/(1 + Control Premium))

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Spectrum of Control

• Blocking power

• Swing votes

• Takeover or “coattail” protection

• Cumulative voting rights

• State dissolution statutes

Minority interests can retain some elements of control which may reduce the discount for lack of control

The range for minority discounts reflects a spectrum of control exists amongst ownership interests

Other factors may limit the control of the majority interest, resulting in a smaller discount

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Spectrum of Control

• Potential Dilution

• Cumulative Voting Rights

• Contractual Restrictions

• Financial Condition of the Business

• Presence of Significant Regulation

• Buy Sell & Other Shareholder Agreements

• Fiduciary Duties

• Private Company with Public Securities

Other factors influencing the spectrum of control

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www.wm-cpa.comValuation Discounts:

Not Additive

Discount Calculation Example

Cash Flow 401,000$

Capitalization Rate 22%

Value (before Discounts) 1,822,727

Less: Minority Discount (15%) (273,409)

Subtotal 1,549,318

Less: Marketability Discount (25%) (387,330)

Fair Market Enterprise Value 1,161,989$

* Note that discounts are not additive (total discount is ~36%, not 40%)

Multiplicative rather than additive – discounts are taken in sequence:

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Additional Challenges Involving

Closely-Held Companies

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Tax Cuts and Jobs Act (TCJA)

▪ Reduction in tax rates (C Corp = 21%) (The 21% C Corp rate does not sunset)

▪ Repeal of Corporate Alternative Minimum Tax

▪ QBI Deduction (20% of QTBI; 50% of wages)

– Specified Service Trade or Business (SSTB) (Health, Law, Accounting, Financial Services, Athletics, Consulting)

▪ Accelerated Depreciation (up to $1M on $2.5M limit)

▪ Interest Deduction (>$25M) limited to 30% of EBITDA (2018-2021) / EBIT (thereafter)

▪ Net Operating Losses (NOLs) (80% carryforward limit; no carryback available)

▪ Alimony / Divorce Settlement

▪ Estates: Lifetime Exemption increased (2019: $11.4M/individual; $22.8M/couple)

– Sunset to $5M/individual; $10M couple at end of 2025

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TCJA Impact on Valuation

▪ Consideration: Could tax laws change due to change of political control?

▪ Overall, are companies more valuable under new law?– Look at the 2017 stock market– + in value: historically high tax rates; heavy investment in

capital equip– - in value: historically low tax rates; highly leveraged

▪ Tax Rates (lower for C Corp and PTE’s)▪ Increased cash flows?

– What will owners do with increase? Wages? Capital Expenditures? R&D?

– Look at DCF. How accurate?

▪ Reasonable Comp (changes due to QBI deduction?)

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TCJA Impact on Valuation

▪ Cost of Debt? Greater due to deductibility limits for highly leveraged company– How will this impact private equity firms use of debt?

▪ NOL deduction limitation▪ Guideline Transactions

– How will lower tax rates impact M&A activity?

▪ Alimony▪ Estate Planning: To Gift or Not to Gift?

– Gift minority interests? – No Clawback. That’s good

▪ IRC Section 2704 (valuation discounts), no longer an issue

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Planning Opportunities for Clients

▪ Update Buy-Sell Agreements

– Include valuation language

– Identify standard of value

– Identify discounts that apply

▪ Gifting Ownership Interests

▪ Succession Planning

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Goodwill

▪ Personal/Professional

– An individual’s goodwill, something he/she contributes to the company while employed

– This value travels with the individual, absent a contractual restriction

– Underlying Consideration: How much revenue and opportunity may disappear assuming the loss of a valuable individual or individuals in an ongoing entity

▪ Enterprise/Practice

– Asset of the business or practice

– Transfer of personal goodwill to an enterprise often achieved via noncompete agreements

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Key Person Discount

• Management & Leadership Skill

• Relationships with Customers, Employees & Suppliers

• Intellectual Property and Innovation

• Economic Resources and Ability to Obtain Financing

Key Person Defining Characteristics

“An amount or percentage deducted from the value of an ownership interest to reflect the reduction in value resulting from the actual of potential loss of a key person in a business enterprise.”3

[3] International Glossary of Business Valuation Terms

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Key Person Discount

• Income Approach

• Incorporate in discount rate under company specific risk

• Estimate effect of loss of key person on future cash flow projections

• Market Approach

• Adjust pricing multiples under guideline company method

• Cost Approach

• Apply the key person discount after determining total equity value for the company

Applying the Key Person Discount4

[4] Harter, Michael A. “Thought Leadership in Family Law Financial and Valuation Issues.” Willamette Management Associates: Insights, Spring 2017 Issue, www.willamette.com/insights.html.

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www.wm-cpa.comConstruction Company:

Valuation Issues

▪ Backlog

– A better indication of future earnings than current earnings

▪ Financial Capacity

– Strict financial covenants

▪ Industry

– Low bid (very competitive)

– Dependent on overall economy

▪ Litigation Risk

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How to Increase Business Value

▪ Focus on Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA)

– Represents the operating efficiency of a business without effect of financing

▪ Minimize Risk

– Diversify customers and vendors

▪ Prepare for the future

– Prepare forecasts and a clear road map

– Recruit strong management team and shift duties from owner

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Reliability of Information

▪ In any business valuation, financial data should be reviewed to assure the quality and reliability of information

▪ Methods to detect earnings manipulation and other anomalies:

– Review year-over-year changes in:

▪ Sales, margins etc.

▪ Financial Ratios

▪ Inventory

– Analyze revenue recognition and cash conversion cycle

▪ Channel Stuffing

▪ Bill & Hold Sales

▪ Fictitious Sales

– Compare to Industry Peers whenever possible

▪ Higher Revenue growth than peers

▪ Analyze Margins

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Considerations for a Defensible Valuation

Avoid Common Errors:

▪ Failure to conform to the appropriate standard and premise of value

▪ Failure to visit business or interview key management personnel

▪ Leaps of faith in assumptions

▪ Inadequate comparative market data

▪ Value conclusion inconsistent with relative performance vs. peers/industry

▪ Advocacy vs. Objective Expert

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Questions to ask prior to finalizing your valuation report:

▪ Are you able to reconcile the results of the various approaches (income, market, asset)?

– If they produce materially different results, need to explain why

▪ Are all major assumptions adequately explained and supported?

– Be prepared to explain areas that rely heavily on “professional judgment” due to lack of evidence

– Can the assumptions be supported in multiple ways?

▪ Does the analyst understand sensitivity of key assumptions and inputs?

– Most sensitive variables typically involve growth, profitability, & risk

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Is the end value “reasonable” when considering all facts and circumstances?

Be prepared to discuss all treatises and resource materials relied upon

Be prepared to discuss previous publications, testimony, etc.

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Questions or Comments

Jon Klerowski, CPA, ABV, CFE

Partner, Floyd Advisory LLC

(617) 586-1076

[email protected]

John F. Maloney, CPA, CFF, CVA, ABAR

Partner, Wouch, Maloney & Co, LLP

[email protected]

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