THE DIRTY LITTLE SECRETS ABOUT BUSINESS VALUATIONS: What Judges Should Know About Valuations In Their Courtrooms

Transcription

1 THE DIRTY LITTLE SECRETS ABOUT BUSINESS VALUATIONS: What Judges Should Know About Valuations In Their Courtrooms Dan H. Hanke, CPA, ABV Dan H. Hanke, CPA, PC 2161 NW Military Highway, Suite 103 San Antonio, Texas (210)

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4 WHAT WE WILL DISCUSS TODAY Uses of Business Valuations Definitions of Valuation Basic Principles and Techniques Weighing the Experts WHY BUSINESSES ARE APPRAISED Business uses: Mergers & acquisitions Liquidation/reorganization Financing Buy-sell agreements Going public Insurance claims Tax uses of business valuations: Allocation of purchase prices Estate and gift taxes Stock options/compensation

5 Judicial uses of business valuations: Marital dissolution Stockholder disputes Proof of damages in commercial cases Eminent domain actions

6 WHAT IS A BUSINESS WORTH? APPRAISAL PRINCIPLES Principle of Substitution Principle of Future Benefits, also known as Principle of Anticipation STANDARDS OF VALUE Fair Market Value Fair Value [Legal] Fair Value [Accounting] Investment Value Intrinsic Value

7 FAIR MARKET VALUE The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. FAIR MARKET VALUE IS A LEGAL FICTION MUCH LIKE THE REASONABLE PERSON IN TORT LAW FMV does not represent what the business may actually sell for because it does not consider all of the motivations of the parties. But FMV is the prescribed standard for most litigation. FAIR VALUE FOR LEGAL PURPOSES is defined by state statutes is used normally in shareholder redemptions, cramdowns, oppression cases, and similar disputes because the seller usually is not willing and is unable to keep their stock, a concept of fairness to the seller is embedded in the statutory definition

8 FAIR VALUE FOR ACCOUNTING PURPOSES A concept used to measure certain transactions in finance Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. INVESTMENT VALUE The value to a particular investor based on individual investor requirements and expectations INTRINSIC VALUE The value that an investor considers, on the basis of an evaluation or available facts, to be the true or real value that will become the market value when other investors reach the same conclusion.

9 While there are many definitions of value for various purposes, the process of valuing a business involves the same considerations and processes. REVENUE RULING Nature of the business and history of the enterprise since inception The economic outlook in general and the condition and outlook of the specific industry The book value of the stock and the financial condition of the business The earnings capacity of the company REVENUE RULING (continued) The dividend paying capacity Whether or not the enterprise has goodwill or other intangible value Sales of the stock and the size of the block being valued The market price of stocks of corporation engaged in the same or similar line of business having their stocks actively traded in a free and open market

10 We start this process with an analysis of the company s financial condition. Usually five latest years of information Put the data in comparative form Convert the data to percentage statements Perform ratio analysis Compare to the industry statistics FINANCIAL STATEMENT ADJUSTMENTS GAAP adjustments Non-operating/non-recurring adjustments Discretionary adjustments DISCRETIONARY ADJUSTMENTS Owner compensation Owner benefits Entertainment and travel Automobiles Compensation to family members Rent Loans and interest

11 BUSINESS VALUATION APPROACHES Market approach Asset based approach Income method MARKET APPROACH Guideline company method Transactional method Industry method (rule of thumb) MARKET APPROACH CRITERIA FOR SIMILARITY Past growth of sales and earnings Rate of return on invested capital Stability of past earnings Dividends Management Competitive position Industry outlook Nature of activities

12 ADJUSTMENTS TO PUBLIC COMPANY DATA Accounting methods like LIFO/FIFO Non-recurring activities Extraordinary items COMMONLY USED MULTIPLES Price/earnings Price/revenues Price/cash flow Price/EBIT or EBDIT RISKS TO CONSIDER Economic Product risks Business Market risks Operating risks Technology Financial risks Regulatory Asset risks Legal risks

13 Valuations using guideline companies If I have located several guideline companies, I apply the median or selected multiples to the subject company and determine a value or range of values. That value is the value of a marketable minority position. Thus this method excludes a discount for lack of control. What if there are no guideline companies? The market approach turns to a search for transactions in the marketplace. SOURCES FOR ACTUAL SALES IBA Transactional Data Pratt s Stats Done Deals Merger Stats Industry Associations Inquiry and Interview

14 PROBLEMS WITH TRANSACTION DATA Incomplete financial data No way to exclude synergistic buyers Difficulty in getting numbers of sales ASSET BASED METHODOLOGIES (The Cost Approach) Used for: Not used for: Holding companies Service businesses Some manufacturers Operating companies with intangible value Heavy distribution Light distribution Minority interests ASSET BASED APPROACH Commonly: Adjusted Book Value Method Liquidation Value Method Cost to Create Method

15 THE INCOME APPROACH Net income after tax Net income before tax Cash flow Debt free net income Debt free cash flow EBIT, EBDIT or EBDITA Owner s discretionary cash flow INCOME APPROACH SINGLE PERIOD MODEL Capitalization: The process of converting a benefit stream into value by dividing the benefit stream by a rate of return that is adjusted for growth. INCOME APPROACH MULTI-PERIOD MODEL Discounting: The process of converting a future series of benefit streams into value by bringing them to present value at a rate of return that reflects the risks inherent in the benefits stream.

16 INCOME APPROACH Capitalization of benefits method Discounted future benefits method Excess earnings method SINGLE PERIOD MODEL Adjusted net income Forecasted growth Estimated future income Divided by a capitalization rate Indicated value of operations Add non-operating assets Total Enterprise Value Rounded Value $ 1,000,000 x ,050,000 25% 4,200, ,350 $ 4,557,350 $ 4,600,000 EXCESS EARNINGS METHOD The Internal Revenue Service, in Revenue Ruling , has gone on record to state that: The (excess earnings) approach may be used only if there is not better basis available for estimating the value of intangible assets.

17 EXCESS EARNINGS METHOD INCOME STREAM TANGIBLE ASSETS INTANGIBLE ASSETS EXCESS EARNINGS EXAMPLE Estimated Future Income (normalized) $ 1,000,000 Less Return on Net Operating Tangible Assets ($800,000 x 15%) Excess Earnings Capitalization Rate 120, ,000 40% Intangible Value + Adjusted Book Value 2,200, ,000 Total Entity Value 3,000,000 $ DISCOUNT AND CAPITALIZATION RATES

18 COMPONENTS OF A DISCOUNT RATE Risk-free rate of return General or equity risk premium Specific risk premium HOW DO WE CALCULATE A DISCOUNT RATE? Capital Asset Pricing Model a financial model The build up method Weighted average cost of capital a financial model including debt costs

19 THE BUILD UP METHOD Risk-free rate 3.2% Equity risk premium 6.9% Small company risk premium 5.3% Specific company risk premium 4.0% DISCOUNT RATE 19.4% Less long-term growth rate -3.0% CAPITALIZATION RATE 16.4% WHERE ARE WE? We have analyzed the company Compared it to its industry Looked at trends (macro and micro) Searched for market transactions Determined an earnings stream Determined a rate of return an investor would require WE CAN NOW VALUE THE ENTERPRISE: Market transactions indicate value of My income stream divided by my rate of return indicates Assuming equal weight to each method value is But, are we finished? $4,600,000 $4,200,000 $4,400,000

20 ENTERPRISE VALUE INCLUDES ALL OF THE COMPANY ASSETS: BOTH TANGIBLE AND INTANGIBLE In closely held businesses the owners and the company are closely intertwined. The value of most businesses consist of intangibles, like goodwill, as well as the tangible assets. State laws dictate whether the personal elements of goodwill are subject to the Court s findings of value and division. If not you have a task of dividing personal and corporate goodwill. IS PERSONAL GOODWILL UNIQUE TO PROFESSIONAL PRACTICES? In many jurisdictions the concept of personal goodwill was first recognized in professional practices, particularly medical practices. Reality is that personal goodwill can exist in any business where personal relationships and contacts influence the customer relationship. That personal relationship becomes corporate only through contractual/employment ties that can be legally enforced. Isolating Personal Goodwill The need to isolate personal goodwill is a matter of where you are: 25 states hold clearly that personal goodwill is separate property while enterprise goodwill is marital property 13 states hold that all goodwill is marital property 4 states have ruled that neither personal or employee goodwill are marital property Several states have no clear rules in this area

21 Personal versus corporate goodwill Personal goodwill attaches to the persona and personal efforts of the individual. It is difficult to transfer without the active efforts of the person. This isolation is heavily fact dependent: Age and health Earning power, reputation Sources of new business, individual productivity VALUATION PREMIUMS AND DISCOUNTS Control Premium Minority Discount Discount for Lack of Marketability Key Person Discount Legal/Environmental Risks

22 CONTROL PREMIUM Prerogatives of Control: Elect the Board of Directors Appoint management Set compensation Declare dividends Set business policy Mergers/acquisitions OTHER FACTORS IN CONTROL PREMIUM Voting rights Shareholder agreements State statutes Distribution of ownership Financial condition SOURCES OF CONTROL PREMIUMS Mergerstat Shannon Pratt s Control Premium Study Court decisions

23 DISCOUNT FOR LACK OF CONTROL A minority shareholder can be abused! Factors that should be considered: o o o o How is the company run today? How large is the minority interest? Is there a true controlling shareholder? Shareholder rights/agreements SOURCES FOR LACK OF CONTROL DISCOUNTS Mergerstat studies on control premiums REITS, public partnerships Case law DISCOUNT FOR LACK OF MARKETABILITY These business interests are not readily marketable. This discount reflects cost, time and difficulty in marketing these interests.

24 SOURCES FOR LACK OF MARKETABILITY DISCOUNTS Restricted stock studies IPO studies Costs of floatation or sales costs LOOKING AT THE EXPERTS Are they credentialed? ASA American Society of Appraisers ABV American Institute of CPAs CFA Certified Financial Analyst CBA The Institute of Business Appraisers CVA National Association of Certified Valuation Analysts

25 LOOKING AT THE EXPERTS (continued) Have they followed the Standards? Can they explain their thought process on matters of judgement? - Company-specific risks - Minority disco - Marketability discounts Little changes = big differences How the appraiser views salary and perks impacts net income and has a multiplier impact! A change from a 20% rate of return to a 22% causes a 10% decrease in enterprise value! Discounts for lack of control and marketability are always judgments but should be supported by an analysis of standard business factors

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