VALUATION of CLOSELY HELD BUSINESSES

Richard A. WarnerPrincipal

Great Lakes Valuations224-764-2280

rawarner@greatlakesval.com

Agenda

Introductory Comments

Business Appraisal Concepts

Approaches to Valuation

Wrap-Up

Selected Business Demographics

Business Size by Employees

Average Annual Revenues

Average Number of Employees

1 to 4 $321,000 2.1

5 to 9 $792,000 6.6

10 to 19 $1,600,000 13.4

20 to 99 $5,701,000 39.2

100 to 499 $27,056,000 192.2

500 to 999 $540,467,000 688.6

Source: 1997 US Census material

Why Do We Need Valuations?

Mergers & Acquisitions

Estate Planning and Wealth Management

Family Law – Marital Dissolution

Shareholder Disputes & Oppression

Succession Planning/Buy-Sell Agreements

ESOPs

Other “Stuff”

Attorney – Appraiser Roles & Relationships

Objectivity & Bias

Appraiser Skills, Knowledge, Certification

Business Valuation Concepts

Standards of Value

• Fair Market Value

• Investment Value

• Fair Value

• Intrinsic Value

Premise of Value

Valuation Date

Present Value

Would you rather have $10,000 now, or $14,025 five years from now?

$10,000

2011

$14,025

2016

Future Value

Present Value

Investment Yield5%7%10%

?

Balance Sheet Basics

=

Current Assets

$41,500,000

Tangible Assets

$41,000,000

Intangible Assets and Goodwill

$126,500,000

+

+

Current Liabilities

$25,000,000

Long Term Debt (including current

portion)

$34,000,000

Equity

$150,000,000

$209,000,000 $209,000,000=

+

+

Box analysis diagram ©Financial Valuation Group International

Income Statement Basics

Revenue: $6,000,000Less Cost of Goods Sold $4,500,000

Equals: Gross Margin $1,500,000

Less Operating ExpensesSelling Expenses $450,000General Expenses $450,000Administrative Expenses $450,000

Equals: Operating Profit $150,000

Plus/minus Other Income/Expenses $0

Earnings Before Taxes $150,000

Income Taxes (40%) $60,000

Net Income After Taxes $90,000

DEFINING the ENGAGEMENT

Who is the client? Who is the appraiser?

What is the specific interest being appraised?

What is the valuation date?

What is the purpose of the appraisal?

What is the standard of value?

What type of report is needed?

Schedules? Fees?

GATHERING COMPANY INFORMATION

Key focus –

•Estimate the stream of future benefits from the business

•Estimate the risk associated with achieving those benefits

•Value = Benefits/Risk

ANALYZING THE INFORMATION

Financial Analysis:• Common-size analysis• Comparative analysis• Trends

Non-financial analysis• Management• Competition• Products & Quality• Customer/supplier concentration

ESTIMATING THE VALUE

Valuation Approaches

• Asset Approaches

• Market Approaches

• Income Approaches

ASSET APPROACH – WHEN TO USE

Appropriate when valuing:• Marginally profitable companies (better

dead than alive?)• Asset-heavy companies• Holding companies and non-profits• Controlling interests

Generally not useful:• When significant intangible value exists• For valuing service companies• For valuing professional practices• When considering minority interests

MARKET APPROACHES - GPTCM

Guideline Publicly Traded Company MethodUsing information from publicly traded, similar companies, determine “multiples” to apply to the subject company’s operating results to obtain a value

Completed Transactions MethodSimilar to GPTCM – based on sales of business interests in the market (M&A)Data Sources

Institute of Business AppraisersBizcomps©Pratt’s Stats©Mergerstat©

CAPITALIZATION OF INCOME

Basic capitalization formula:

PV = E1/c

Where:

E1 = expected economic income at the end of next year

c = capitalization rate

Example:

If E1 = $100,000 and c = 20%

then PV = $500,000

DISCOUNTED CASH FLOW

The value of a business is the present value of the “income” it can reasonably be expected to generate in the future…

Basic DCF formula:

nd

Income

d

Income

d

Income

d

IncomeValue

n

1...

1 1 1 321

321

What about after the forecast period?

tn d

Value Terminal

d

IncomeValue

1 1

tntn

1n

Where “d” is the discount rate…

DISCOUNTED CASH FLOW –

TERMINAL VALUE

One method is to calculate the terminal value using a capitalization of income method…

n

n

k

gkgE

PV

1

1

Where:PV = Terminal ValueEn = “Earnings” during last period of forecastk = discount rate (required rate of return)g = growth rate of En in perpetuityn = number of periods in the projection period

DISCOUNT AND CAPITALIZATION

RATES

• A discount rate is a rate of return used to convert a monetary sum into a present value; also known as

• opportunity cost of capital

• weighted average cost of capital

• required rate of return

• How to determine for a closely held company?

• Build-up models

• CAPM

DISCOUNT AND CAPITALIZATION

RATES – BUILD-UP EXAMPLE

Risk free rate = 5.1%

General equity risk premium = 7.2%

Size Premium = 9.3

Specific risk premium = 4.0%

Discount rate = 25.6%

DISCOUNTED CASH FLOW

EXAMPLE

Valuation - DCF ApproachFair market valueDecember 31, 2010

Discount Rate 15.41%Growth Rate 5%

Year

Forecasted Net Cash Flow to

EquityPresent Value

Factor

Present Value Future Cash

Flows

2011 755,696$ 0.93085 703,438$ 2012 537,746$ 0.80656 433,722$ 2013 643,674$ 0.69886 449,839$ 2014 804,113$ 0.60555 486,928$ 2015 984,646$ 0.52469 516,636$

Terminal Value 9,931,586$ 0.52469 5,211,024$

Value of Equity as of Valuation Date 7,801,587$

CONTROL AND MARKETABILITY

Controlling Interest ValueControlling Interest Value

Marketable Minority Interest ValueMarketable Minority Interest Value(“WSJ Listed Price”)(“WSJ Listed Price”)

Marketable Minority Interest ValueMarketable Minority Interest Value(“WSJ Listed Price”)(“WSJ Listed Price”)

Nonmarketable Minority Nonmarketable Minority Interest ValueInterest Value

Nonmarketable Minority Nonmarketable Minority Interest ValueInterest Value

Control PremiumControl Premium Minority Interest DiscountMinority Interest Discount

Discount for Lack of MarketabilityDiscount for Lack of Marketability

Application of Discounts and Premiums

Value on a control, marketable basis $100.00

Less discount for lack of control (25%) 25.00

Value on a minority, marketable basis $75.00

Less marketability discount (35%) 26.25

Value of minority, non-marketable interest (51.25% discount) $48.75

A CONCLUSION OF VALUE –

WHEW!

Check the math…

Review the facts…

• Review company strengths and weaknesses

• Review economic conditions

• Review comparative financial analysis

Subjectively weight results obtained by different valuation approaches?

Did we value the right property correctly?

QUESTIONS…….