BV Integrated Theory

The Integrated Theory of Business ValuationZ. Christopher Mercer, ASA, CFA July 16, 2008

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purposes.

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4www.mercercapital.com

The Integrated Theory© 2008 Mercer Capital

4

Z. Christopher Mercer, ASA, CFA» Z. Christopher Mercer is founder and chief executive officer of Mercer

Capital, a business valuation and investment-banking firm serving national and international clientele. Mr. Mercer is a member of the Editorial Advisory Board of Valuation Strategies, and he is a regular contributor to the Business Valuation Review

» Chris began his valuation career in the late 1970s. He has prepared, overseen, or contributed to more than 1,000 valuations for purposes related to M&A, litigation, and tax, among others. He is a prolific author on valuation-related topics and a frequent speaker on business valuation issues for national professional associations and other business and professional groups.

» Chris is the author of six books including Buy-Sell Agreements: Ticking Time Bombs or Reasonable Resolutions? (Peabody Publishing, LP, 2007), and Business Valuation: An Integrated Theory, Second Edition, which he co-authored with Travis Harms (John Wiley & Sons, Inc., 2008). He has also published scores of articles and given many speeches on topics related to business valuation and investment banking.



5

So Many Questions

» When asking the wrong questions

Difficult to get the right answers

True in life, and in valuation

» Not so complicated if you ask the right questions

» Wrong questions lead to confusion between valuation results and economic inputs (or valuation drivers)

MarketabilityDiscounts

GuidelineMethod

Net AssetValue

ControlPremiums

Adjustments

MinorityInterestDiscount

Levels of

ValueRestricted

StockDiscounts

CF CF

r - gr - g

CAPM

Income Method

The UNINTEGRATED Theory of Business Valuation

V V ==So Many

So Many

Questions

Questions

(BVIT pp. 61-63)

(BVIT pp. 61-63)So Many

So Many

Questions

Questions

(BVIT pp. 61-63)

(BVIT pp. 61-63)



7

An Integrated Theory of Business Valuation

Business Valuation: An Integrated TheoryBy Z. Christopher Mercer, ASA, CFA

and Travis W. Harms, CFA, CPA/ABV

Published by John Wiley & Sons, Inc. (2008)

www.mercercapital.com

Page References on Slides Refer to this Book (BVIT)

So Many Answers

Integrated Theory of

Business Valuation


Business Valuation

© Mercer Capital, 2008

Shareholder Level

Enterprise Levels

Controlling Interest Level

Marketable Minority Level

Nonmarketable Minority Level(Illiquid Minority Interests)

MarketabilityDiscount

MinorityDiscount

ControlPremium

(“As-If-Freely Traded”)

Foundation: Levels of Value

Strategic Control Value

Financial Control Value

Marketable Minority Level

Nonmarketable Minority Level

StrategicPremiums

MarketabilityDiscount

Expanded, Modified

FCP MID

(BVIT, p. 83)



10

Enterprise vs. Shareholder Levels of Value

The value of a business enterprise is the present value

of its expected cash flows (or benefits) discounted to the present at an appropriate discount rate.

“Ultimately, of course, the value of the nonmarketable minority interest is the present value of the benefits it

will produce for its owner.” Pratt/Reilly/Schweihs, Chapter 17



11

The Integrated Theory of Business Valuation

Focus on the cash flows of the enterprise for enterprise values and on the derivative,

shareholder level cash flows for shareholder level (minority interest) values



12

Definition of Value / DCF

No one disagrees with this

CF1 CF2 CFn

(1+r)1 (1+r)2 (1+r)n ++ + ...Value = V0

=

(BVIT, p. 2)



13

Gordon Growth Model

CF1

r - gVo =

Taken for granted

(BVIT, p. 3)



14

General Valuation Model

Value = Earnings x Multiple

(BVIT, p. 3)



15

DCF = Gordon

CF0(1+g) CF0(1+g)2 CF0(1+g)n

CF1

(1+r)1 (1+r)2 (1+r)n r - g++ + ... =V0

=

g = constant

CF = 100% distributed

(BVIT, p. 4)



16

Gordon Dividend Growth Model

D1

r - gd

Po =

D1 = DPO x CF1

(BVIT, p. 10)



17

gv …a Function of Dividends

D1

P0

= Growth in Value + Dividend Yield

r = gv +

Two Sources of Returns

(BVIT, p. 11)



18

Reinvestment Impact on Growth in Value

$0

$10

$20

$30

$40

$50

$60

$70

0 1 2 3 4 5 6 7 8 9 10Years

Value (Gv = r) Value (Gv = Ge) Poly. (Value (Gv = r)) Poly. (Value (Gv = Ge))

Growth at the core growth rate of earnings (10%) yields value of $16.1 million at the end of Year 5 (equivalent t DPO = 100%). Growth at the discount rate of 20% (DPO = 0%) yields Year 5 value of $24.9 million. The difference ($8.8 million) reflects the future value of reinvested cash flows. The relative importance of reinvestment decisions increases with time.

Exp

ecte

d F

utu

re V

alu

e ($

Mill

ion

s)

5 Years

(BVIT, p. 14)



19

Does r relate to Net Income or to Net Cash

Flow?

The measure of net cash flow is determined by

distribution policy (DPO, or its result, the Earnings Retention

Rate)

Earnings D1 Earnings * DPO CF1

r - ge r - gd r - gd r - gcf

=V0 = = =

(BVIT, p. 20)



20

» 4 key decisions

» Define Net Cash Flow

» What is ge?

» What is gCF?

» Net Income or Net Cash Flow

DCF

Single period income capitalization

Question: Net Income or Net Cash Flow?



21

Business Owners Make One of Four Decisions Each Period

» Distribute all cash flows or earnings to the owners; or,

» Retain all cash flows or earnings in the business and reinvest them; or,

» Distribute a portion of cash flows and retain (reinvest) the rest; or,

» Repurchase shares (which, for our purposes, is analogous to a distribution)

Distribution Policy Determines Net Cash Flow

(BVIT, p. 21)



22

What Is Net Cash Flow?

Net Income (after taxes)

+ Noncash Charges (depreciation and amortization and possibly, deferred taxes) - Net Capital Expenditures (new purchases of fixed assets less disposals)+/- Incremental Changes in Working Capital+/- Net Changes in Long-Term Debt (or, perhaps, total debt, depending on capital structure)

= Net (Free) Cash Flow

(BVIT, p. 22)



23

What is ge?

» ge is the constant, long-term growth of net

earnings available to a business that

distributes all reported earnings each year



24

Key Assumptions of ge?

» Capital expenditures are assumed equal to depreciation. To the extent that current capital expenditures are more productive than the machinery or equipment that they replace, some growth can occur.

» Inflationary price increases are achieved to the extent they are achievable over time.

» Productivity enhancements are also captured to the extent available over time.

» Incremental working capital requirements are assumed to be negligible, with incremental assets being financed by incremental liabilities.

(BVIT, p. 21)



25

Expected Net Income vs. Expected Net Cash Flow

$0.00

$2.00

$4.00

$6.00

$8.00

$10.00

$12.00

$14.00

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

Years

Exp

ecte

d N

I or

NC

F (

$ M

illio

ns)

Net Income Net Cash Flow

Investors expect to achieve a rate of return on reinvested earnings equal to the discount rate. Any lower return would call for current distribution. In the graph below, Earnings begin in Year 1 at $1.0 million. Continuing our example:

Net Income is forecasted based on (r = 20%) and (ge = 10%) and Stategy 1: (DPO = 100%) . With no earnings retentnion, investor achieves current return (10%) plus long-term, core growth in earnings (10%), or a return equal to the discount rate.

Net Cash Flow is forecasted based on the same discount rate, but Strategy 2: (DPO = 25%). Therefore (g* = gcf = 12.5%). The investor receives a current return of 7.5%, but is compensated with higher future growth (12.5%), thereby achieving a return equal to the discount rate.

Investors are assumed indifferent between the two strategies, since both yield a return of 20%. However, the second strategy generates lower current yield, but more robust capital apreciation as the compounding effects of reinvestments accumulate.

Net Income

Less CF Today

Net CF

More CF Tomorrow

(BVIT, p. 23)



26

G Growth

R Risk & Reward

A Alternative Investments

P Present Value

E Expectations

S Sanity, Rationality, and Consistency

Organizing Principles of Business Valuation

(BVIT, Ch. 2)



27

Polling Question One

Please rate your experience in the field of business valuation.

» A. None

» B. Nominal

» C. Modest

» D. Seasoned

» E. Well-Oiled



28

The Enterprise Levels of Value



29


The value of a business enterprise is the:

» Present value of the

» Expected, and potentially

» Growing, future cash flows of the business.

These cash flows are discounted in a

» Sane, rational, and consistent manner, weighing the relevant

» Risks and rewards in the context of available

» Alternative investments.

CF1 CF2 CFn

(1+r)1 (1+r)2 (1+r)n++ +

...

Value = V0

=



30

The Integrated Theory Enlightens» Valuation Premiums and Discounts

» Meaning and Interpretation of Ge

» Net income or net cash flow

Which to capitalize/discount when?

Does R relate to net income or net cash flow?

» Normalizing adjustments and the prerogatives of control

» Nature of control premiums

» Deriving Marketability Discounts

» Valuing S Corporations



31

Focus of Questions: Value Trilogy

» Value/result is a function of expected Cash Flow Risk Growth

» Focus of questions should be on value drivers ofCash Flow, Risk and Growth

CF1

r- geV0

=



32

Vmm

CFe(mm)

Rmm- Gmm

MarketableMinority

ConceptualConceptual Key Key Value Value MathMath Relationships Relationships ImplicationsImplications

GV = Rmm – Div Yld

Cash flow of the enterprise represents normalized cash flow, adjusting for non-recurring items and discretionary expenses

above market levels. Otherwise, the resulting valuation indication would not be marketable minority. Such

adjustments are not control adjustments in the context of the Integrated Theory.

Enterprise Levels: Marketable Minority (BVIT, p. 67)


© Mercer Capital 2007 www.mercercapital.com


Conceptual Math Relationships Value Implications

CFe(c,s) ≥ CFe(c,f)

Gs ≥ 0 Ve(c,s) ≥ Ve(c,f)

Rs ≤ Rmm

CFe(c,f) ≥ CFe(mm)

Gf ≥ 0 Ve(c,f) ≥ Vmm

Rf = Rmm (+/- a little)

Gv = Rmm - Div YldMarketable

Minority Value

CFe(mm)

Rmm - Gmm

Vmm is the

benchmark for the other levels


CFe(c,s)

Rs - [Gmm + Gs]


CFe(c,f)

Rf - [Gmm + Gf]

(BVIT, p. 85)



34

Prerogatives of Control» Right to declare dividends

» Right to select officers

» Right to choose business strategies

» Right to … (it is a long list)

» Where do these “prerogatives” come from? Corporate Charter

Articles of Incorporation

By-Laws

Other Agreements

» What are they?

Intangible assets of the enterprise

(BVIT, p. 78)



35

Enterprise ValuationInsights into Key Questions» Value CF of private company in relationship to

public securities markets

What is cash flow?

Normalized cash flow using appropriate normalizing adjustments

» Determine r for private company in relationship to public securities markets

How and whether to adjust r?

Fundamental adjustments



36

Normalizing Adjustments

» Two kinds of normalizing adjustments

Type 1Type 1Eliminate one-time gains or losses, other unusual items, non-recurring business elements, adjust for expenses of non-operating assets, and the like

Type 2Type 2Normalize officer/owner compensation to levels of comparable companies and adjust for other discretionary expenses that likely would not exist in a well-run publico

Must make, even in minority interest appraisals!

(BVIT, p. 110)



37

Fundamental Adjustments

CFCFmmmm

RRmmmm - - GGmmmm

VmmVmm====

CFCFprivate, private,

normalizednormalized

RRprivateprivate - - GGprivateprivate

VVprivateprivateVVprivateprivate====

We look at We look at public public

companies .companies .....

… … to value to value private private

companiescompanies

(BVIT, Ch. 5)



38


RRprivate private RRmmmm==

» Often, private company is riskier than public guidelines

» Have concept of Small Company Stock Risk Premium (SSR) or, more broadly, the size premium, and the Specific Company Risk (SCR) in ACAPM

<<>>

(BVIT, Ch. 5)



39


GGprivate private GGmmmm==

» Often, the realistic expectations for growth of subject are less than expected growth rate imbedded in public company pricing

» Must be careful to compare expectations, which in public arena sometimes bear little resemblance to the recent past

<<>>

(BVIT, Ch. 5)



40

Fundamental Adjustments - Example

FundamentalFundamental PublicPublic PrivatePrivateAdjustments Adjustments AA B B

RiskRisk 0%0% 2%2% Greater riskGreater risk

Expected Expected Growth Growth 10%10% 6%6% Slower growthSlower growth

Base RBase R 18%18% 18%18% Same base RSame base R

Adjusted RAdjusted R 20%20%(R - G)(R - G) 8%8% 14%14% Higher Cap FactorHigher Cap Factor

MultipleMultiple 12.5x12.5x 7.1x7.1x Lower multipleLower multiple

43% FundamentalDiscount

(BVIT, p. 136)



41

Polling Question Two

Which Mercer Capital books are currently in your library

» A. Business Valuation: An Integrated Theory

» B. Quantifying Marketability Discounts

» C. Buy-Sell Agreements: Ticking Time Bombs or Reasonable Resolutions?

» D. More than one of the above

» E. None of the above



42

The Shareholder Levels of Value



43

The Shareholder Level of Value

The value of a shareholder interest in a business enterprise is the:

» Present value of the

» Expected, and potentially

» Growing, future cash flows attributable to the subject interest.

These cash flows are discounted in a

» Sane, rational, and consistent manner, weighing the relevant

» Risks and rewards in the context of available

» Alternative investments.

CFsh1 CFsh2 CFshn

(1+Rhp)1 (1+Rhp)2 (1+Rhp)n+ + +

...

Value = Vsh

=

(BVIT, p. 190)



44

The Shareholder Level of Value


Gv = Rmm - Div Yld

CFsh ≤ CFe(mm)

Gv ≤ Rmm - Div Yld Vsh ≤ Vmm

Rhp ≥ Rmm

MarketableMinority Value

CFe(mm)

Rmm - Gmm

Vmm is the


NonmarketableMinority Value

CFsh

Rhp - Gv

(BVIT, p. 92)



45

The Theory & the Math

Enterprise LevelsValue is a function of the Expected Cash Flows to equity of the

Enterprise (as capitalized by the public markets or controlling buyers)

Shareholder LevelValue is a function of the Cash Flows expected by Shareholders from

their Interests in the Enterprise (which are derived from the cash flows of the Enterprise, but may not be the same)

Nonmarketable Minority Value



Marketable Minority Value

(BVIT, p. 88)



46

The Theory & the Math




Rs ≤ Rmm




Gv = Rmm - Div Yld

CFsh ≤ CFe(mm)


Rhp ≥ Rmm

Vmm is the



CFe(mm)

Rmm - Gmm


CFsh

Rhp - Gv


CFe(c,s)

Rs - [Gmm + Gs]


CFe(c,f)

Rf - [Gmm + Gf]

(BVIT, p. 98)



47

What is a Marketability Discount Applicable to a Controlling Interest?




Rs ≤ Rmm




Gv = Rmm - Div Yld

CFsh ≤ CFe(mm)


Rhp ≥ Rmm

Vmm is the



CFe(mm)

Rmm - Gmm


CFsh

Rhp - Gv


CFe(c,s)

Rs - [Gmm + Gs]


CFe(c,f)

Rf - [Gmm + Gf]

(BVIT, p. 94-98)



48

What is a Marketability Discount Applicable to a Controlling Interest?

» Common “Reasons”

Uncertain time horizon to complete the offering or sale

Cost to prepare for and execute the offering or sale

Risks concerning eventual sale price

Noncash and deferred transaction proceeds

Inability to hypothecate

(BVIT, p. 94-98)



49

What is a Marketability Discount Applicable to a Controlling Interest?» What gives rise to the value of a business?

Present value of expected cash flows discounted to the present at an appropriate discount rate

» Who controls the cash flows during the period of marketing a business?

The controlling shareholder(s)

» What is the economic basis for a so-called “marketability discount for controlling interests”?

There is none

Consider the value drivers of expected cash flow, risk and growth

(BVIT, p. 94-98)



50

The Integrated Theory Enlightens» Valuation Premiums and Discounts (another session)






» Nature of control premiums (another session)





51

Polling Question Three

Have you used the QMDM as a primary or secondary valuation method?

» A. Yes

» B. No



52

1. Deriving Marketability Discounts

The Integrated Theory in Practice



53

Theory in Practice» The Integrated Theory supports use of the income approach to directly

value the subject nonmarketable minority interest (in the context of the existing enterprise valuation)

» The asset approach seldom makes sense in valuing minority interests (except as a step along the way, e.g., to arrive at net asset value)

» Attempts at using the market approach will fail because of lack of sufficiently comparable and timely transactional data for minority interest transactions

“Benchmarking” is a very weak form of the market method

FMV Restricted Stock Study is a weak form of the market method

Pre-IPO studies are also a weak form of the market method

» The discounted cash flow model is the best tool to analyze the following question: What motivates hypothetical willing buyers and sellers of minority interests? In other words, what does available market evidence mean?

(BVIT, p. 170-172) (also, p. 185-188)



54

Critical Insight

» In the Integrated Theory, the marketability discount is appropriately viewed as descriptive of the relationship between the marketable minority and nonmarketable minority values, not determinative of that relationship

» The marketability discount is a valuation result, not a valuation driver



55

Understanding the QMDM» The QMDM is a shareholder-level discounted cash

flow model consistent with the Integrated Theory

It is inextricably linked to the enterprise valuation, since the shareholder cash flows are derived from (alternatively, are a subset of) the enterprise cash flows

The value of any business is a function of its expected cash flows, risks, and expected growth

The value of an interest in a business is a function of its expected cash flows (derived from the enterprise cash flows), risks (in addition to those of the enterprise), and expected growth (in the value of the enterprise)

(BVIT, p. 172)



56

Challenges

» What are the three most important elements of an income approach

To value businesses

To value non-marketable minority interests in businesses

» Assumptions

» Assumptions

» Assumptions



57

Polling Question Four

What is your opinion regarding the use of normalizing adjustments for owner compensation in minority interest appraisals

» A. They are appropriate/necessary

» B. They are inappropriate

» C. It depends on the facts and circumstances



58

DCF vs. QMDM

QMDM DCF

1. Gv

2. D%

3. GD%

4. Holding Period Forecast Period

5. RHP R

The DCF Forecast

Interim CF + Growth

Selection of TV

(BVIT, p. 173-174)



59

“Criticisms” of the QMDM

» Must make assumptions

» Sensitive to assumptions

» Must make assumptions re: expected holding period

» Appraiser must select a marketability discount within a range

» Must estimate holding period premium to develop discount rate

» Complicated

Legitimate?

No

No

No

No

No

No



60

Expected Returns from Restricted Stock Discounts

1. What does RSD tell us? Nothing

2. What do lots of RSD’s tell us? Nothing

Pmm

Prs

$1.00

$0.70

RSD = 30%



61


Pmm

Prs

$1.00

$0.70

4. Implies RHP > R

5. $1.00 = $0.70 + $0.30 and $0.70 = $1.00 - $0.30

0 1 2 3 4

3. Transactions occurred at discounts

2. Rule 144 required 2 year minimum holding period

1. Value isExpected to grow



620 1 2 3 4

Pmm

Prs

RSD = 30%

$1.00

$1.10

$1.21

$1.32

$1.46

gv = 10%

$0.70(PV) 31.5%

2 Years RHP(2)

20.2% 4 Years RHP(4)

23.5% 3 Years RHP(4)

Expected Future Values




63

Restricted Stock Discounts (and Marketability Discounts) are NOT Economic Drivers

» RSV = MMV * (1 - RSD)

» MMV = CFmm / r - ge

» RSV = CFsh / Rhp - gv

» CFsh = CFmm * 1 - RSD

Rhp - gv R - ge

Restricted Stock Discounts equate differing views of value, i.e., value from the perspective of the public markets and value to holders of illiquid interests

RSD’s reflect observed differences in economic thinking and not the economics behind that thinking



64

Enterprise Assumptions

» Earnings = $0.10

» R = 16.0%

» Ge = 6.0%

» V = $0.10

= $1.00

» Use Gordon Model to summarize an enterprise DCF valuation

16.0% - 6.0%



65

Shareholder Level DCF (QMDM) Inputs1. Expected Holding Period 10 years2a. Expected Distribution / Dividend Yield 10.0%2b. Expected Growth in Distributions / Dividends 6.0%2c. Timing (Mid-Year or End of Year) End3a. Growth in Value over Holding Period 6.0% $1.7913b. Premium/Discount to Projected Enterprise Value 0.0% $1.6894. Required Holding Period Return 16.0% $1.594

$1.504$1.419

$1.338$1.262

$1.191$1.124

Enterprise Value $1.060Normalized to $1.00 $1.000

(MM Value)

Interim Dividends / Distributions (Interim Cash Flows)$0.100 $0.106 $0.112 $0.119 $0.126 $0.134 $0.142 $0.150 $0.159 $0.169

0 1 2 3 4 5 6 7 8 9 10

Discount Periods (Interim Cash Flows) 1.00 2.00 3.00 4.00 5.00 6.00 7.00 8.00 9.00 10.00PV Factors (Interim Cash Flows) 0.8621 0.7432 0.6407 0.5523 0.4761 0.4104 0.3538 0.3050 0.2630 0.2267PV Factor (Terminal Value) 0.2267 Nonmarketable Minority Value Present Value of Interim Cash Flows and Terminal Value

PVICF $0.594 59.4% $0.086 $0.079 $0.072 $0.066 $0.060 $0.055 $0.050 $0.046 $0.042 $0.038PVTV $0.406 40.6% $0.406

NMM Value $1.000 100.0%

Derivation of Marketability DiscountMarketable Minority Value (Enterprise Value) $1.000Less: Nonmarketable Value (Shareholder Value) $1.000Marketability Discount ($) $0.000Marketability Discount (%) 0.0%

Shareholder = Enterprise

Base Case

(BVIT, p. 179)



66


$1.407$1.340

$1.276$1.216

$1.158$1.103


(MM Value)


0 1 2 3 4 5 6 7 8 9 10


PVICF $0.573 60.8% $0.086 $0.078 $0.071 $0.064 $0.058 $0.052 $0.047 $0.043 $0.039 $0.035PVTV $0.369 39.2% $0.369

NMM Value $0.943 100.0%


Suboptimal Reinvestment Only

(BVIT, p. 181)



67


$1.407$1.340

$1.276$1.216

$1.158$1.103


(MM Value)


0 1 2 3 4 5 6 7 8 9 10


PVICF $0.573 60.8% $0.086 $0.078 $0.071 $0.064 $0.058 $0.052 $0.047 $0.043 $0.039 $0.035PVTV $0.369 39.2% $0.369

NMM Value $0.943 100.0%


Incremental Risk Only20.3%

6.0%

6.0%

20%

(BVIT, p. 183)



68


$1.407$1.340

$1.276$1.216

$1.158$1.103


(MM Value)


0 1 2 3 4 5 6 7 8 9 10


PVICF $0.491 65.1% $0.083 $0.073 $0.064 $0.056 $0.049 $0.043 $0.037 $0.033 $0.029 $0.025PVTV $0.263 34.9% $0.263

NMM Value $0.754 100.0%


Suboptimal Reinvestment and Incremental Risk

(BVIT, p. 177)



69

( 1 ) ( 2 ) ( 3 ) ( 4 )

Years 10 10 10 10

2a. Expected Distribution / Dividend Yield Yield 10.0% 10.0% 10.0% 10.0%

2b. Expected Growth in Distribution / Div. Yield Growth 6.0% 5.0% 6.0% 6.0%

2c. Timing (Mid-Year or End of Year) Timing E E E E

3a. Growth in Value over Holding Period Gv 6.0% 5.0% 6.0% 6.0%

3b. Premium or Discount to Marketable Value Prem/Disc. 0.0% 0.0% 0.0% 0.0%

Low 16.0% 16.0% 20.0% 20.0%

Marketability Discount 0.0% 5.7% 20.3% 24.6%

( 1 ) Enterprise Value (Figure 7-6)

( 2 ) Suboptimal Reinvestment Only (Figure 7-7)

( 3 ) Incremental Risk Only (Figure 7-8)

( 4 ) Suboptimal Reinvestment and Incremental Risk (Figure 7-5)

1. Expected Holding Period

4. Required Holding Period Returns

Components of Marketability Discount

5.0%

5.0%

Yield

(BVIT, p. 184)



70

USPAP SR 9-4(d)

» d) An appraiser must, when necessary for credible assignment results, analyze the effect on value, if any, of the extent to which the interest appraised contains elements of ownership control and is marketable and/or liquid.

Comment: An appraiser must analyze factors such as holding period, interim benefits, and the difficulty and cost of marketing the subject interest. Equity interests in a business enterprise are not necessarily worth the pro rata share of the business enterprise interest value as a whole. Also, the value of the business enterprise is not necessarily a direct mathematical extension of the value of the fractional interests. The degree of control, marketability and/or liquidity or lack thereof depends on a broad variety of facts and circumstances that must be analyzed when applicable.

(BVIT, p. 247)



71

USPAP Requirements

» Analyze the effect on value, if any, on subject interest of ownership control and liquidity/marketabilty, including consideration (analysis) of:

1. Holding period. The expected (or estimated) duration of the investment – at which time liquidity is achieved

2. Interim benefits. Dividends or distributions expected to be received during the expected holding period

3. Difficulty and cost of marketing. The risks of the expected holding period or costs of information acquisition and monitoring that would cause the next buyer to reduce price relative to marketable minority value

4. Other relevant facts and circumstances

(BVIT, p. 247)



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QMDM and USPAP

Shareholder Level DCF (QMDM) Inputs) Addresses Factors ofUSPAP SR 9-4(d)?

2a. Expected Distribution / Dividend Yield Interim Benefits? Yes2b. Expected Growth in Distribution / Div. Yield (including amount, 2c. Timing (Mid-Year or End of Year) growth and t)iming3a. Growth in Value over Holding Period Holding Period? Yes3b. Premium or Discount to Marketable Value (what happens to value

over Holding Period)Cost and Difficulty of

Marketing? Yes

Holding Period? Yes1. Range of Expected Holding Periods (Years)

4. Range of Required Holding Period Returns



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Polling Question Five

Based on your experience, do you believe that S corporations are worth more than C corporations at the level of enterprise?

» A. S Corps are worth more than C Corps

» B. S Corps are worth the same as C Corps

» C. S Corps are worth less than C Corps

» D. No opinion



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2. Valuing Tax Pass-Through Entities

The Integrated Theory in Practice



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S Corporation Synthesis









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(-) f (Low distribution, Risk)

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Value Differentials Between a C Corporation and an Otherwise Identical S Corporation









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Who Gets the S Corp Benefit?

» The appropriate valuation treatment of S corporations hinges upon an appropriate understanding of where the indisputable benefit of the S election resides

» While the legal obligation to pay taxes on the corporate earnings falls to the individual shareholders, the economic obligation remains with the corporation



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Legal vs. Economic Obligation

0% Economic Payout 50% Economic Payout 100% Economic PayoutC Corp S Corp C Corp S Corp C Corp S Corp

Taxable Corporate Income $100 $100 $100 $100 $100 $100Corporate Tax on Corporate Earnings 40.0% (40) 0 (40) 0 (40) 0Shareholder Tax on Corporate Earnings 40.0% 0 (40) 0 (40) 0 (40)Net Income Available for Economic Distributions $60 $60 $60 $60 $60 $60

Economic Payout Ratio 0% 0% 50% 50% 100% 100%Economic Distribution to Shareholders (Pre-tax) $0.0 $0.0 $30.0 $30.0 $60.0 $60.0Shareholder Tax on Economic Distribution (%) 15% 0% 15% 0% 15% 0%Shareholder Tax on Economic Distribution ($) 0.0 0.0 4.5 0.0 9.0 0.0

Economic Distribution to Shareholders (After-tax) $0.0 $0.0 $25.5 $30.0 $51.0 $60.0 Shareholder Level Benefit of S Corporation Election 0.0 4.5 9.0

Retained Corporate Earnings $60.0 $60.0 $30.0 $30.0 $0.0 $0.0 Enterprise Level Benefit of S Corporation Election 0.0 0.0 0.0

(BVIT, p. 256)



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Who Gets the S Corp Benefit?

» Because the economic obligation for corporate income taxes remains with the S corporation, the S Corp benefit ought to be reflected at the shareholder level of value rather than the enterprise level of value

» Notably, the Delaware Chancery Court identified this distinction in Kessler



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What are the S Corp Benefits?

» At the enterprise level:

Increased Cash Flow? No

Reduced Risk? No

Increased Growth Prospects? No

» At the enterprise level, S corporations are worth no more or less than otherwise identical C corporations based on the functional drivers of value



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What are the S Corp Benefits?» At the shareholder level:

Reduction in expected holding period? Probably not

Increase in interim cash flows? Perhaps, depending on distribution policy

Increase in projected terminal value? No, although net proceeds from sale of interest may be higher due to build-up of tax basis from undistributed earnings

Reduction in discount rate? Probably not, depending on risk that

S election will be broken and/or distributions will be insufficient to pay taxes

» At the shareholder level, the value of an S corporation interest may be worth more or less than an otherwise identical C corporation interest, depending on the distribution policy and unique risks



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Enterprise = Shareholder

DCF Assumptions Corresponding QMDM Assumptions Model InputsLow 10

High 10

Expected Distribution / Dividend Yield Yield 10.0%

Expected Growth in Distribution / Dividend Growth 6.0%

Timing (Mid-Year or End of Year) Timing E

Growth in Value over Holding Period Gv 6.0%

Premium or Discount to Marketable Value Prem/Disc. 0.0%

Low 16.0%

High 16.0%

Base Value (Marketable Minority Interest) $1.00

Forecast Period Range of Expected Holding Periods (Years)

Range of Required Holding Period ReturnsDiscount Rate

Projected Interim Cash Flows (during forecast period)

Projected Terminal Value (at end of forecast period)



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Enterprise = Shareholder (MD=0)Assumed Holding Periods in Years

1 2 3 4 5 6 7 8 9 10 15 20 25 30 16.0% Implied Marketability Discounts13.0% - - - - - - - - - - - - - - 14.0% - - - - - - - - - - - - - - 15.0% - - - - - - - - - - - - - - 16.0% - - - - - - - - - - - - - - 16.0% - - - - - - - - - - - - - - 16.0% - - - - - - - - - - - - - - 17.0% 1% 2% 2% 3% 4% 4% 5% 5% 5% 6% 7% 8% 8% 9%18.0% 2% 3% 5% 6% 7% 8% 9% 10% 10% 11% 13% 15% 16% 16%19.0% 3% 5% 7% 9% 10% 12% 13% 14% 15% 16% 19% 21% 22% 22%

PV=100%

RETURNS EXPECTED TO BE REALIZED OVER VARIOUS HOLDING PERIODS GIVEN MARKETABILITY DISCOUNT SELECTED1.00% Selected Discount Increment

Subsequent Holding Period in Years

1 2 3 4 5 6 7 8 9 10 15 20 25 30

-4.0% 12% 14% 14% 15% 15% 15% 15% 15% 15% 15% 15% 16% 16% 16%-3.0% 13% 14% 15% 15% 15% 15% 15% 15% 15% 16% 16% 16% 16% 16%-2.0% 14% 15% 15% 15% 15% 16% 16% 16% 16% 16% 16% 16% 16% 16%-1.0% 15% 15% 16% 16% 16% 16% 16% 16% 16% 16% 16% 16% 16% 16%0.0% 16% 16% 16% 16% 16% 16% 16% 16% 16% 16.0% 16% 16% 16% 16%1.0% 17% 17% 16% 16% 16% 16% 16% 16% 16% 16% 16% 16% 16% 16%2.0% 18% 17% 17% 17% 17% 16% 16% 16% 16% 16% 16% 16% 16% 16%3.0% 20% 18% 17% 17% 17% 17% 17% 17% 17% 17% 16% 16% 16% 16%4.0% 21% 19% 18% 17% 17% 17% 17% 17% 17% 17% 17% 16% 16% 16%

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C Corporation Suboptimal Reinvestment and Extra Risk


High 10


Expected Growth in Distribution / Dividend Growth 5.0% < 6.0%Timing (Mid-Year or End of Year) Timing E

Growth in Value over Holding Period Gv 5.0%

Premium or Discount to Marketable Value Prem/Disc. 0.0%

Low 20.0% > 16%%High 20.0%








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C Corporation Suboptimal Reinvestment and Extra Risk

Assumed Holding Periods in Years

1 2 3 4 5 6 7 8 9 10 15 20 25 30 20.0% Implied Marketability Discounts17.0% 2% 3% 5% 6% 7% 8% 9% 10% 10% 11% 13% 15% 16% 16%18.0% 3% 5% 7% 9% 10% 12% 13% 14% 15% 16% 19% 21% 22% 22%19.0% 3% 6% 9% 11% 13% 15% 17% 18% 19% 20% 24% 26% 27% 28%20.0% 4% 8% 11% 14% 16% 18% 20% 22% 23% 24.6% 29% 31% 32% 33%20.0% 4% 8% 11% 14% 16% 18% 20% 22% 23% 24.6% 29% 31% 32% 33%20.0% 4% 8% 11% 14% 16% 18% 20% 22% 23% 24.6% 29% 31% 32% 33%21.0% 5% 9% 13% 16% 19% 21% 24% 25% 27% 28% 33% 35% 36% 37%22.0% 6% 11% 15% 19% 22% 24% 27% 29% 31% 32% 37% 39% 40% 41%23.0% 7% 12% 17% 21% 24% 27% 30% 32% 34% 35% 40% 43% 44% 44%

PV=100%

RETURNS EXPECTED TO BE REALIZED OVER VARIOUS HOLDING PERIODS GIVEN MARKETABILITY DISCOUNT SELECTED1.00% Selected Discount Increment

Subsequent Holding Period in Years

1 2 3 4 5 6 7 8 9 10 15 20 25 30

20.6% 45% 30% 25% 23% 22% 21% 20% 20% 19% 19% 18% 18% 18% 18%21.6% 47% 31% 26% 23% 22% 21% 20% 20% 20% 19% 18% 18% 18% 18%22.6% 49% 32% 26% 24% 22% 21% 21% 20% 20% 20% 19% 18% 18% 18%23.6% 51% 32% 27% 24% 23% 22% 21% 20% 20% 20% 19% 18% 18% 18%24.6% 53% 33% 28% 25% 23% 22% 21% 21% 20% 20.0% 19% 19% 18% 18%25.6% 55% 34% 28% 25% 24% 22% 22% 21% 21% 20% 19% 19% 19% 19%26.6% 57% 35% 29% 26% 24% 23% 22% 21% 21% 21% 20% 19% 19% 19%27.6% 59% 36% 29% 26% 24% 23% 22% 22% 21% 21% 20% 19% 19% 19%28.6% 61% 37% 30% 27% 25% 24% 23% 22% 21% 21% 20% 19% 19% 19%

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S Corporation Suboptimal Reinvestment and Extra Risk

S Corporation Suboptimal Reinvestment and Extra RiskDCF Assumptions Corresponding QMDM Assumptions Model Inputs

Low 5

High 10

Expected Distribution / Dividend Yield Yield 11.76% 10% / (1 - 15%)Expected Growth in Distribution / Dividend Growth 5.0% (Suboptimal by 1%)Timing (Mid-Year or End of Year) Timing E

Growth in Value over Holding Period Gv 5.0% (Suboptimal by 1%)Premium or Discount to Marketable Value Prem/Disc. 0.0%

Low 19.0% > 16%%High 21.0%


Tax Pass-Thru Assumptions Distribute 100% of Earnings to ShareholdersPre-Tax Earnings Growth Rate 6.0% Personal Capital Gains Rate 15.0%

Assumed Corporate Federal Tax Rate 40.0%

Distribution Payout % of Earnings 100.0% Required Holding Period Return 20.0%

(normally the average of the range above)

Ongoing/Expd Net Income P/S $0.10 Marketable Minority Value Per Share (or Unit) $1.00







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Distribute 100% of Earnings to Shareholders


1 2 3 4 5 6 7 8 9 10 15 20 25 30 20.0% Implied Marketability Discounts16.0% - - - - - - - - - - - - - - 17.0% 0% 0% 1% 1% 1% 1% 1% 1% 1% 1% 2% 2% 2% 2%18.0% 1% 2% 3% 4% 4% 5% 5% 6% 6% 7% 8% 9% 9% 9%19.0% 2% 4% 5% 6% 7% 8% 9% 10% 11% 11.4% 14% 15% 15% 16% Assuming Same20.0% 3% 5% 7% 9% 11% 12% 13% 14% 15% 15.9% 19% 20% 21% 21% Risk as C Corp21.0% 4% 7% 9% 11% 13% 15% 17% 18% 19% 20.1% 23% 25% 26% 26% Have Lower MD22.0% 4% 8% 11% 14% 16% 18% 20% 22% 23% 24% 28% 29% 30% 30% 15.9% vs. 24.6%23.0% 5% 9% 13% 16% 19% 21% 23% 25% 26% 28% 31% 33% 34% 34% If increase Rhp by 2.2%,24.0% 6% 11% 15% 19% 22% 24% 26% 28% 30% 31% 35% 37% 37% 38% MD is same as for C Corp

PV=100%

Potential Adjustment to the Marketability Discount Resulting from Basis Build-Up Over Expected Holding Periods

1 2 3 4 5 6 7 8 9 10 15 20 25 30

Pre-Tax Income $0.167 $0.177 $0.187 $0.199 $0.210 $0.223 $0.236 $0.251 $0.266 $0.282 $0.38 $0.50 $0.67 $0.90

Net Distribution (0.167) (0.177) (0.187) (0.199) (0.210) (0.223) (0.236) (0.251) (0.266) (0.282) (0.38) (0.50) (0.67) (0.90)

Retained Earnings $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.00 $0.00 $0.00 $0.00Cum. Basis Build-Up $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.00 $0.00 $0.00 $0.00

Cum. Tax Savings $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.00 $0.00 $0.00 $0.00

PV Factors 0.8333 0.6944 0.5787 0.4823 0.4019 0.3349 0.2791 0.2326 0.1938 0.1615 0.0649 0.0261 0.0105 0.0042

PV of Tax Shelter $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.000 $0.00 $0.00 $0.00 $0.00Potential MD Adj. 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

No Basis Build-up

Average Shelter for the Expected Holding Period Relative to $1.00 of Marketable Minority ValueAverage Potential Adjustment to Marketability Discount To be considered in final determination of discount

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C Corporation – No Dividend


High 10


Expected Growth in Distribution / Dividend Growth 0.0% (Adj. for Payout %)Timing (Mid-Year or End of Year) Timing E


Low 19.0% > 16%High 21.0%








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C Corporation – No Dividend


1 2 3 4 5 6 7 8 9 10 15 20 25 30 20.0% Implied Marketability Discounts16.0% 1% 2% 3% 3% 4% 5% 6% 7% 7% 8% 12% 16% 19% 23%17.0% 2% 3% 5% 7% 8% 10% 11% 13% 14% 16% 23% 29% 35% 40%18.0% 3% 5% 7% 10% 12% 14% 16% 19% 21% 23% 32% 40% 47% 54%19.0% 3% 7% 10% 13% 16% 19% 21% 24% 26% 29.0% 40% 50% 57% 64%20.0% 4% 8% 12% 16% 19% 23% 26% 29% 32% 34.7% 47% 57% 65% 72%21.0% 5% 10% 14% 18% 22% 26% 30% 33% 37% 39.9% 53% 64% 72% 78%22.0% 6% 11% 16% 21% 26% 30% 34% 38% 41% 45% 59% 69% 77% 83%23.0% 7% 13% 18% 24% 29% 33% 38% 42% 45% 49% 64% 74% 81% 87%24.0% 7% 14% 20% 26% 31% 36% 41% 45% 49% 53% 68% 78% 85% 90%

PV=100%

1 2 3 4 5 6 7 8 9 10 15 20 25 30 Pre-Tax Income $0.167 $0.177 $0.187 $0.199 $0.210 $0.223 $0.236 $0.251 $0.266 $0.282 $0.38 $0.50 $0.67 $0.90Net Distribution 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00 0.00 0.00 0.00Retained Earnings $0.167 $0.177 $0.187 $0.199 $0.210 $0.223 $0.236 $0.251 $0.266 $0.282 $0.38 $0.50 $0.67 $0.90Cum. Basis Build-Up $0.167 $0.343 $0.531 $0.729 $0.940 $1.163 $1.399 $1.650 $1.915 $2.197 $3.88 $6.13 $9.14 $13.18Cum. Tax Savings $0.025 $0.052 $0.080 $0.109 $0.141 $0.174 $0.210 $0.247 $0.287 $0.330 $0.58 $0.92 $1.37 $1.98PV Factors 0.8333 0.6944 0.5787 0.4823 0.4019 0.3349 0.2791 0.2326 0.1938 0.1615 0.0649 0.0261 0.0105 0.0042PV of Tax Shelter $0.021 $0.036 $0.046 $0.053 $0.057 $0.058 $0.059 $0.058 $0.056 $0.053 $0.04 $0.02 $0.01 $0.01Potential MD Adj. -2.1% -3.6% -4.6% -5.3% -5.7% -5.8% -5.9% -5.8% -5.6% -5.3% -3.8% -2.4% -1.4% -0.8%

Average Shelter for the Expected Holding Period $0.057Average Potential Adjustment to Marketability Discount -5.7% Consider in final determination of discount

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S Corporation – No Economic Dividend


High 10

Expected Distribution / Dividend Yield Yield 0.00% 10% / (1 - 15%)Expected Growth in Distribution / Dividend Growth 0.0% (Adj. for Payout %)Timing (Mid-Year or End of Year) Timing E


Low 20.0% +1% Risk High 22.0%


Tax Pass-Thru Assumptions

Pre-Tax Earnings Growth Rate 6.0% Personal Capital Gains Rate 15.0%

Assumed Corporate Federal Tax Rate 40.0%

Distribution % of Pre-Tax 40.0% Required Holding Period Return 21.0%

(normally the average of the range above)

Ongoing/Expd Net Income P/S $0.10 Marketable Minority Value Per Share (or Unit) $1.00







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S Corporation – No Economic Dividend


1 2 3 4 5 6 7 8 9 10 15 20 25 30 21.0% Implied Marketability Discounts17.0% 2% 3% 5% 7% 8% 10% 11% 13% 14% 16% 23% 29% 35% 40%18.0% 3% 5% 7% 10% 12% 14% 16% 19% 21% 23% 32% 40% 47% 54%19.0% 3% 7% 10% 13% 16% 19% 21% 24% 26% 29% 40% 50% 57% 64% Versus 34.7%20.0% 4% 8% 12% 16% 19% 23% 26% 29% 32% 34.7% 47% 57% 65% 72% MD = 39.9%21.0% 5% 10% 14% 18% 22% 26% 30% 33% 37% 39.9% 53% 64% 72% 78% (Suboptimal by 1%)before considering

22.0% 6% 11% 16% 21% 26% 30% 34% 38% 41% 44.6% 59% 69% 77% 83% value impact of23.0% 7% 13% 18% 24% 29% 33% 38% 42% 45% 49% 64% 74% 81% 87% basis build-up24.0% 7% 14% 20% 26% 31% 36% 41% 45% 49% 53% 68% 78% 85% 90%25.0% 8% 15% 22% 28% 34% 39% 44% 49% 53% 57% 71% 81% 88% 92%

PV=100%

Potential Adjustment to the Marketability Discount Resulting from Basis Build-Up Over Expected Holding Periods

1 2 3 4 5 6 7 8 9 10 15 20 25 30 Pre-Tax Income $0.167 $0.177 $0.187 $0.199 $0.210 $0.223 $0.236 $0.251 $0.266 $0.282 $0.38 $0.50 $0.67 $0.90 Net Distribution (0.067) (0.071) (0.075) (0.079) (0.084) (0.089) (0.095) (0.100) (0.106) (0.113) (0.15) (0.20) (0.27) (0.36) S Corp 39.9%Retained Earnings $0.100 $0.106 $0.112 $0.119 $0.126 $0.134 $0.142 $0.150 $0.159 $0.169 $0.23 $0.30 $0.40 $0.54 C Corp -34.7%Cum. Basis Build-Up $0.100 $0.206 $0.318 $0.437 $0.564 $0.698 $0.839 $0.990 $1.149 $1.318 $2.33 $3.68 $5.49 $7.91 Delta for S 5.2%Cum. Tax Savings $0.015 $0.031 $0.048 $0.066 $0.085 $0.105 $0.126 $0.148 $0.172 $0.198 $0.35 $0.55 $0.82 $1.19 Basis Benefit -3.2%PV Factors 0.8264 0.6830 0.5645 0.4665 0.3855 0.3186 0.2633 0.2176 0.1799 0.1486 0.0573 0.0221 0.0085 0.0033 Adjusted Delta 2.0%PV of Tax Shelter $0.012 $0.021 $0.027 $0.031 $0.033 $0.033 $0.033 $0.032 $0.031 $0.029 $0.02 $0.01 $0.01 $0.00 Your CallPotential MD Adj. -1.2% -2.1% -2.7% -3.1% -3.3% -3.3% -3.3% -3.2% -3.1% -2.9% -2.0% -1.2% -0.7% -0.4%

Average Shelter for the Expected Holding Period $0.032 Relative to $1.00 of Marketable Minority ValueAverage Potential Adjustment to Marketability Discount -3.2% Consider in final determination of discount

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S Corporation vs. C Corporation

Value Trilogy C Corp S Corp1 C Corp S Corp1 Potential Differences for an S Corp Shareholder Relative to Otherwise Identical C Corp Shareholder

Cash Flow

1. Enterprise Earnings/ Distributions CF1 CF1 CFm,c CFm,s 1. To the extent that distributions are less than 100% of earnings, both will be less than CF1

2. To the extent that there are economic distributions, there is a premium yield applicable to S corp distributions

a. This premium is determined by the current level of income taxes on dividends/distributions (P = 1 / (1 - Dividend Tax%)) b. This premium lasts only as long as the expected holding period of the investment in an S corporation minority interest c. The "value" of this premium to an informed investor is the present value of the premium discounted to the present over the expected holding period at the appropriate required return (Rhp)

==> To the extent of any premium yield from economic distributions beyond taxes, the effective cash flow for S corporation shareholders will exceed that of C corporation shareholders and value will be biased upward

2. Basis Build-Up none CFm,s(b) 1. To extent that an S corporation retains earnings, its shareholders accrete incremental basis in their stock ownership positions

a. This basis can be used to offset capital gains upon sale at the end of expected holding period b. This basis accretion is an additional cash flow for S corporation shareholders not enjoyed by C corporation shareholders c. The"value" of this basis accretion to an informed investor is the present value of the sheltered capital gains tax savings realized at the terminal sale, discounted back to the present at the appropriate requried return (Rhp)

d. Note that if an S corporation retains all economic earnings (after personal taxes) there will be no value to basis build-up2. There are no other cash flow benefits experienced by S corp shareholders relative to otherwise identical C corp shareholders

==> To the extent of any basis build-up for S corporation shareholders, value will be biased upward (higher for low distributing S corporations, and lower for high distribution firms)

Expected Growth G G G G 1. Assuming equivalency between corporate and personal income taxes applicable to C and S corporations respectively, of Cash Flows there will be no differences between expected growth in earnings for the two

==> There is no differential in expected growth for an S or C, and therefore no impact on value Risk R R Rhp,c Rhp,s 1. The primary incremental risk associated with an S corporation holding is that the entity cannot or does not make distributions

for shareholders to pay their pass-through taxes. a. This risk is often mitigated by shareholder agreements, but cannot necessarily be eliminated completely==> To the extent that risks of owning an S corporation relative to an otherwise identical C corporation are greater, value will be biased downward. Otherwise, there will be no impact on value.

All identical at the ==> The net difference in value between an S corporation interest and an otherwise identical C corporation interest will result in enterprise level the interplay of the assumptions regarding differences in expected cash flow and risk, both considered over the expected

Assumes equivalency between corporate and personal income taxes holding period or investment horizon for the investments.

ShareholdersEnterprise

Enterprise

Earnings

Dividends/

Distributions



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S Corporation Synthesis









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(BVIT, p. 254)



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The Integrated Theory Enlightens» Valuation Premiums and Discounts






» Nature of control premiums





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Ask the Right Questions and…


Business Valuation


Business Valuation



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MERCER CAPTIAL5860 Ridgeway Center Parkway, Suite 400 • Memphis, TN 38120

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Z. Christopher Mercer, ASA, [email protected]

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Questions?



96

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