Gregory A. Porcaro CPA/ABV, MST, CFF Otrando Porcaro & Associates, LTD Warwick, RI (401-739-9250)...
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Transcript of Gregory A. Porcaro CPA/ABV, MST, CFF Otrando Porcaro & Associates, LTD Warwick, RI (401-739-9250)...
AN INSIDE LOOK AT THE MYSTERY OF BUSINESS VALUATION
Gregory A. Porcaro CPA/ABV, MST, CFFOtrando Porcaro & Associates, LTDWarwick, RI (401-739-9250)[email protected]
OBJECTIVE
To unravel the mystery behind business valuation concepts and theories, including the factors that impact the determination of the value of an interest in a closely held business
WHAT IS A BUSINESS VALUATION
An independent and objective evaluation of financial and non-financial data that may impact the current and future cash flow (economic benefit) of a closely held business in order to estimate the value of the business as a whole or a fraction there of.
WHO IS DOING THIS TYPE OF WORK
Individuals trained in financial analysis and possibly financial forensics
Accountants/CPAs Business brokers Business appraisers Investment bankers
A BV PROFESSIONAL SHOULD BE….
Independent and objective Trained in BV theory and practice Have BV experience
"Expert Witness" experience – may face a "Daubert” Challenge
Industry experience Have a BV certification
AICPA – Accredited in Business Valuation (ABV) ASA – Accredited Senior Appraiser (ASA) IBA – Certified Business Appraiser (CBA)
WHAT IS A “DAUBERT” CHALLENGE
The Supreme Court determined that it is the obligation of the judge to act as the “gatekeeper” to ensure that all expert testimony is relevant and reliable. This includes business valuation testimony. Kumho Tire Co. v. Carmichael, 526 U.S. 137
(1999), Daubert v. Merrell Dow Pharmaceuticals,
Inc., 509 U.S. 579, 593 (1993)
WHAT IS A “DAUBERT” CHALLENGE
Factors to be considered by the judge Application of a scientific methodology Techniques subject to peer review Techniques generally accepted Techniques can be tested by others
If you fail the challenge your BV report and testimony can be excluded from the litigation General Electric Co. v. Joiner, 522 U.S. 136
(1997)
WHY ARE BUSINESS VALUATIONS IMPORTANT?
Estate & Gift Tax Business Acquisitions & Dispositions
Divorce Succession Planning Reorganizations Compensation - Stock Options Financial Reporting
VALUATION DRIVERS
Synergy - Not Representative of FMV
Smaller Businesses - Seller Discretionary Cash Flow
Larger Businesses - Dividend Paying Capacity
Intangible value
THE BUSINESS VALUATION PROCESS
Key Questions & Elements What is being valued? What is the valuation date? What standard of value applies? Consideration for state law Analysis of financial & non-financial data
Selection of valuation approachs & methods
Prepare of valuation report
WHAT IS BEING VALUED?
This is the first question to answer and it has a major effect on the valuation professional’s course of action.
The professional must determine if he/she is valuing the stock of a corporation or an interest in an LLC and if so is it a controlling interest or a minority interest?
Is the business being valued an operating company or a real estate holding company?
WHAT IS THE VALUATION DATE?
This is a specific point in time, such as December 31, 2013
The BV engagement may start long after the valuation date, but you may only take into account information that was known or knowable as of the valuation date
WHAT IS KNOWN OR KNOWABLE?
RI Supreme Court case: A divorcing couple hire a BV expert who concludes the value of the husbands 25% interest of a business was $2.9M as of the date of the divorce March 2007
In November 2007 husbands sells interest for $5.4M.
Wife sues for adjustment to property settlement agreement
WHAT IS KNOWN OR KNOWABLE?
RI Supreme Court determines there was no evidence that anyone knew or should have known about the transaction at the time of the divorce. The value used for the purposes of the divorce was upheld. Esposito vs. Esposito, 2010-328 (Jan. 2011)
WHAT STANDARD OF VALUE APPLIES? Fair Market Value - the amount at
which the property would change hands between a hypothetical willing buyer and a willing seller when the former is not under compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts. (Rev Ruling 59-60)
WHAT STANDARD OF VALUE APPLIES? Fair Value – A standard of value that
has been derived by state law. Need to review applicable state law
Generally applicable in dissenting or oppressed shareholder/member litigation
Not a “willing buyer and seller” situation
Valuation discounts are not applicable
WHAT STANDARD OF VALUE APPLIES? Investment Value – The standard of
value applicable to a specific buyer or pool of buyers.
For example: Takes into account the potential synergistic benefits of being acquired by a competitor
ANALYSIS OF FINANCIAL & NON-FINANCIAL DATA
Nature & history of the business Economic outlook Financial position of the business Earnings capacity Dividend paying capacity Intangible value – Goodwill Prior sales of stock Stock price of similar public companies
ANALYSIS OF FINANCIAL & NON-FINANCIAL DATA
Articles of incorporation or organization By-laws and minute book, Stockholder or partnership agreements,
Buy-sell agreements, Employment contracts/non-compete
agreements Loans and leases, Patents and copyrights, Information regarding pending litigation.
WHERE DOES THE PROCESS BEGIN?
Financial statement analysis Typically 5 years of financial statements Preferably based on GAAP, not tax returns
Method of accounting Consider normalization adjustments Review internal trends & ratios Compare subject company to industry
performance data Evaluate operating budgets & forecasts
WHY DO YOU ”NORMALIZE” FINANCIAL STATEMENTS?
The purpose of this process is to adjust the financial statements for items that impact the financial position of the company (BS) and/or its earnings or cash flow (P&L).
To make the financial statements comparable to guideline companies
To eliminate items that will not be transferred or that will not be considered by a willing buyer
WHAT IF YOU ARE VALUING A MINORITY INTEREST?
In most cases, minority owners do not have the authority to enforce changes in the way the company is capitalized or spends money
Therefore depending on the purpose of the business valuation it may not be necessary to make normalization adjustments
TYPICAL NORMALIZATION ADJUSTMENTS
Non – Recurring Income or Expenses Excessive legal fees due to litigation
Non – Economic or Discretionary Items Excessive owner perks
Non - Arm's Length Transactions Rent paid to related party greater than
market Non – Operating Assets & Related Income
Excessive cash or non-operating real estate
VALUATION APPROACHES
Income Asset Market
VALUATION APPROACH - INCOME
There is a basic underlying valuation principal that the value of a business is equal to the present value of expected future benefits.
The income approach is particularly appropriate to value operating companies with predicable earnings.
VALUATION METHODS - INCOME
Capitalization of Earnings Discounted Cash Flow
Determine Income Base Must be "normalized" Earnings v Cash Flow
Determine Discount Rate Build up Method vs Capital Asset Pricing Model Weighted Average Cost of Capital
VALUATION METHODS - INCOME
Capitalization of Earnings – This method should be used when a business's future earnings will not change significantly from current earnings or the growth in future earnings is predictable. The earnings base is then divided by a
capitalization rate to determine the business's value.
Capitalization rate = Discount rate minus the long-term sustainable growth rate
VALUATION METHODS - INCOME
Discounted Cash Flow – This method should be used when a business's future earnings can be reasonably estimated and are expected to be significantly different than historic earnings. For example, the business may have gained
or lost a major customer. The value of the business is based on the
discounted (present value) of the estimated future earning.
VALUATION METHODS - INCOME
Discounted Cash Flow – This method requires the business appraiser to obtain a operating forecast from management. Must view the forecast with professional
skepticism Compare to prior years forecast to actual
results
VALUATION METHODS - INCOME
Determine Income Base - Earnings v Cash Flow – Important decision impacted by:
The nature of the business Purpose of valuation Nature if interest being valued –
controlling or minority I prefer to use cash flow as an Income
base
VALUATION METHODS - INCOME
Equity Basis Invested Capital – Debt Free
Normalized Earnings Normalized Earnings
+ N/A Interest Expense (net of tax)
+ Depreciation/Amortization Depreciation/Amortization
= Gross Cash Flow Gross Cash Flow
- Capital Expenditures Capital Expenditures
+ or -
Working Capital Working Capital
+ or -
Loan advances or Payments Loan advances or Payments
- Preferred Dividends Preferred Dividends
= Net Cash Flow Net Cash Flow
VALUATION METHODS - INCOME
Determine a Discount Rate – Must relate to the relative risk associated with an investment in the subject company compared to alternative investments Build up Method Capital Asset Pricing Model (CAPM) Weighted Average Cost of Capital (WACC)
VALUATION METHODS - INCOME
Build up Method - The discount rate is “built-up” starting with risk-free rates of return (T-bonds) and adding on the historical returns for publicly traded large and small cap stocks. Market risk premiums derived from
Morningstar or Duff & Phelps This method requires the business
appraiser to consider applying a company specific risk premium.
BUILD UP METHOD EXAMPLE - RESTAURANT
Risk Free Rate – 20 Yr. US T Bonds 2.41%
Equity Risk Premium 6.70%
Industry Risk Premium -2.57%
Size Premium 3.81%
Company Specific Risk (subjective) 7.00%
Discount Rate 17.35%
LT Sustainable Growth -3.00%
Capitalization Rate 14.35%
Source: Morningstar/Ibbotson SBBI – 2013 Valuation Yearbook
VALUATION METHODS - INCOME
CAPM – The CAPM method is based on industry specific comparative data and is more difficult to apply to small/mid-size companies.
This method requires the business appraiser to consider applying a company specific risk premium.
CAPM METHOD EXAMPLE – ELECT. EQUIPMENT
Risk Free Rate – 20 Yr. US T Bonds
2.41%
Equity Risk Premium 6.70%
Industry Beta (Market Risk) X 1.46% 9.78%
Size Premium 3.81%
Company Specific Risk (subjective) 5.00%
Discount Rate 21.00%
LT Sustainable Growth -3.00%
Capitalization Rate 18.00%
Source: Morningstar/Ibbotson SBBI – 2013 Valuation Yearbook
WHAT IS COMPANY SPECIFIC RISK?
A subjective adjustment to the discount rate based on the business appraiser’s assessment of the company as a whole and professional judgment. Factors to consider: Customer concentration Depth of management Supplier dependence Comparative performance to industry data
VALUATION METHODS - INCOME
WACC – This method calculates the discount rate based on the company’s entire capital structure – debt and equity The income base must be on a debt free
basis In general, the method is more suitable to
larger companies with more complex capital structures
WACC METHOD EXAMPLE - RESTUARANT
Capital Structure
Debt to
Equity
Required ROR &
Interest Rate*
Discount Rate
Equity $900,000 75% 20% 15.00%
Debt $300,000 25% 5.4% 1.35%
Total $1,100,00
16.35%
* Interest rate is net of taxes at 40%
CAPITALIZATION OF EARNINGS EXAMPLE
Restaurant
Normalized Cash Flow $150,000
/Capitalization Rate 14.35%
Value of 100% of Business* $1,045,296
* Before Valuation Discounts
VALUATION APPROACH - ASSET
This approach values a company based on its assets and liabilities only.
It is applied generally to a business with little or no earnings or entities that own real estate or investment assets such as publicly traded securities.
VALUATION METHODS - ASSET
Net Asset Value Suitable for a real estate holding company
Liquidation Value Suitable for a operating company that is
losing money or in recievership
Assets must be appraised
NET ASSET VALUE METHOD EXAMPLE
Real Estate Holding Company
Adjusted Basis
Adjustment Appraised Value
Land $75,000 $125,000 $200,000
Building $125,000 $500,000 $625,000
Mortgage $65,000 0 $65,000
Member Capital* $135,000 $625,000 $825,000
* Before Valuation Discounts
VALUATION APPROACH - MARKET
The market approach is represented by one valuation method. The valuation professional must identify comparable businesses that are publicly traded or have been privately sold and apply key ratios, such as price/earnings (P/E) or price/revenue (P/R) to the Subject Company.
At the public level this is a common method for an investor to make investment decisions. For example, an investor interested in purchasing stock on General Motors would compare the P/E ratio for GM to other major automotive manufacturers such as Ford and Chrysler.
VALUATION APPROACH - MARKET
It is commonly used for real estate as well
In the area of closely held business valuations it is difficult to apply for two reasons: first, obtaining reliable data, and second, determining if the businesses are
comparable.
VALUATION METHODS - MARKET
Guideline Public Company Data - Using comparative company data from publicly traded companies to value small to mid-sized business will not be adequate for many reasons, but size is a major one. Depth of management, Market share Geographic differences generally
Will not be comparable to an interest in a small to mid-sized closely held company.
VALUATION METHODS - MARKET
Private Company Transaction Data Base - The Institute of Business Appraisers and other data base services such as "Bizcomps" provide comparable sales data for closely held business by SIC Code.
This information is very useful and at least can provide a benchmark to compare the value determined using the income approach.
PRIVATE COMPANY TRANSACTION EXAMPLE
Price to Price to
Revenue Earnings
Selected Multiples: 0.10 2.20
Based upon the data obtained below, I selected multiples for both the price to sales and price to earnings multiples.
Commercial Construction Contractor - NAICS # 236220 - SIC # 1541 & 1542
All Transactions
Sales (,000) DE (,000) Price (,000) Price / Sales Price / DE
Low $117 $15 $43 0.03 0.43
High $10,484 $1,807 $18,100 2.21 30.17
Mean $2,182 $360 $1,508 0.48 6.05
Median $989 $104 $278 0.35 2.28
Standard Deviation $2,556 $527 $3,482 0.43 9.13
Coefficient of Variation 0.92 1.51
Harmonic Mean 0.23 1.87
Count 29 20 30 29 20
PRIVATE COMPANY TRANSACTION EXAMPLE
Commercial Contraction Contractor - NAICS # 236220 - SIC # 1541 & 1542
Price to Price toRevenue Earnings
Revenue/Seller Discretionary Earnings (See Exhibit C) $ 7,154,806
$ 262,936
Multiple Selected 0.10
2.20
Operating Value 715,481 578,460
Add/(Less):
Current Assets 1,287,496
1,287,496
Total Liabilities (1,161,179)
(1,161,179)
Indicated Value $ 841,798
$ 704,777
Rounded* $ 842,000
$ 700,000
* Before Valuation Discounts
VALUATION PREMIUMS OR DISCOUNTS
A valuation engagement is not complete if the professional has not considered the possible application of a premium or discount. There are basically three types of valuation adjustments; A control premium, A minority interest discount, A lack of marketability discount.
All valuation adjustments must be supported by analysis
VALUATION PREMIUMS OR DISCOUNTS
Control Premium – This refers to the inherent additional value attributed to the power to control the business. For example, a stockholder that owns a controlling interest (greater than 50%) can elect officers, establish compensation, sell assets, etc.
A business appraiser must review an entity’s organizational documents to be sure that a 51% interest represents control. In some cases a super-majority (i.e. 70%) or unanimous consent may be required for certain events to take place.
VALUATION PREMIUMS OR DISCOUNTS
Minority Interest Discount -. A minority interest discount is basically the opposite of a control premium.
Depending on how ownership interests in an entity are held an individual with a 2% interest can be entitled to a swing vote premium.
For example, if a corporation is owned by three people, two own a 49% interest each and one owns a 2% interest, then the 2% stockholder can impact the outcome of a particular issue if the other two stockholders do not agree
VALUATION PREMIUMS OR DISCOUNTS
Quantifying a control premium or minority interest discount is not a simple task and varies on a case by case basis. According to Mergerstat Review (2013), the average control premium was 44% (median average 33%) and average minority interest discount was 24%.
VALUATION PREMIUMS OR DISCOUNTS
Lack of Marketability Discount (LOMD) – This applies to an interest in a closely held company because they are inherently less liquid than publicly traded companies.
This discount can be applied in addition to a control premium or minority interest discount.
VALUATION PREMIUMS OR DISCOUNTS
Lack of Marketability Discount – There are several ways to document and support a LOMD. In August 2011 the IRS released a detailed practice aid for revenue agents to assist them is dealing with the issue in the field. It addresses the various methods for calculating a LOMD.
See www.irs.gov/pub/irs-utl/dlom.pdf
CAPITALIZATION OF EARNINGS EXAMPLE
Restaurant
Normalized Cash Flow $150,000
/Capitalization Rate 14.35%
Value of 100% of Business $1,045,296
Fair Value of a 33% Interest $344,948
Minority Interest discount @ 20%
-$68,990
Sub-Total $275,958
LOMD @ 20% -$55,192
FMV of a 33% Interest $220.767
VALUATION REPORT
The valuation report should be clearly written and free from errors and inconsistencies, In general, the following areas will be addressed in some detail:
Introductory statement identifying what is being valued
The standard of value applied The valuation date Company background and history National, regional, and local economic and
industry data
VALUATION REPORT
The valuation report should be clearly written and free from errors and inconsistencies, In general, the following areas will be addressed in some detail:
Company financial statements and comparative industry analysis
Description of valuation approaches and method considered
Valuation calculations and conclusions Qualification statement (resume) Assumptions and limiting conditions
SPECIAL CONSIDERATIONS
Effect of "Gross" decision (a gift tax case) - Tax effecting earnings of pass-through entities is not acceptable without substantive analysis. Gross case, 272 F.3d 333, 88 AFTR 2d 2001-6858
(6th Cir. 2001)
IMPACT – can increase value of the company by 40%
SPECIAL CONSIDERATIONS
The Delaware Chancery Court took and different approach and calculated an effective tax rate attributed to the S corporation structure after taking into account the tax implication of a pass through entity Delaware Open MRI Radiology Associates,
P.A. vs. Kessler, et al,898 A.2d 290 (Del. Ch. 2006)
SPECIAL CONSIDERATIONS
The Supreme Judicial Court of Massachusetts applied the same methodology as the Delaware court in a divorce case. Bernier v. Bernier,449 Mass. 774 (2007), 82
Mass. Appeals. Ct 81(2012).
REFERENCE SOURCES
PPC’s Guide to Business Valuation – 24th Edition – J. Fishman, S. Pratt, J. Griffith & J. Hitchner
Understanding Business Valuation – 2nd Edition – G.Trugman
Morningstar/Ibbotson SBBI – 2013 Valuation Yearbook
QUESTIONS?
Thank you