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Business Valuation 101Demystifying Business Valuation for

Small Business Owners Theresa Zeidler-ShonatDirector of Valuation Services

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What is Business Valuation?

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The Short Answer

• Business valuation is a process and a set of procedures used to estimate the economic value of an owner's interest in a business.

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Poll Question

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Let’s Start with Terminology…

•What’s the difference between “Valuation” and “Appraisal?”

Definition: Valuation• Valuation – (noun)

the act or process of determining the value of a business, business ownership interest, security, or intangible asset.

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Definition: Appraisal

• Appraisal - (noun) the act or process of developing an opinion of value; an opinion of value.

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WHEN DO YOU NEED A VALUATION?

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Estate and Gifting

• Death of business owner• Transfer of business ownership to the

next generation through gift of shares

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Divorce

• A party in the divorce holds an equity position in a closely-held company, or owns intellectual property that is considered part of the divisible marital property (“undivided one-half marital property interest”)

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Lending Scenarios

• Some SBA loans require a business valuation if a specific set of conditions exist

• Intangible assets are being used as collateral and the lender wants an idea of their worth

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Business Planning

• Strategic planning - company is considering several options and is wanting to determine the impact of several scenarios

• Succession planning• Exit Planning• Impact of expanding into new

industry or making an acquisition

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Financial Reporting

• Company has just been acquired or made an acquisition: purchase price allocations (ASC 805)– Total purchase consideration is allocated

to the acquired assets.– Includes intangible asset valuations

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Financial Reporting

• Company has goodwill or indefinite-lived intangible assets on their balance sheet from a previous acquisition - impairment testing (ASC 350)

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Financial Reporting

• Company holds a minority interest in another company and is required to mark that investment to market

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Stock-Based Compensation

• 409A valuations. – Private companies are required

by the IRS (Section 409A) to show that their common stock options are issued at fair market value, and therefore must conduct a formal valuation opinion at least once every 12 months to avoid potential tax penalties.

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Stock-Based Compensation

• ASC 718 valuations. – ASC 718 requires that all equity

awards granted to employees, consultants, and board members be accounted for at "fair value" and then expensed over the vesting term of the grant.

– This can become more difficult as additional grants are made and vesting and forfeitures add complexity to the calculations.

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Intangible Asset / Intellectual Property Monetization

• Company is considering monetizing assets - either through use as collateral or licensing the asset to a third party

• Company is contemplating sale of the asset and need help determining a price

• Company is contemplating purchase of an asset and looking to determine if price is fair

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Buy-Sell Agreement Development

• Most buy-sell agreements have a provision for determining the price at which an interest in the company is sold.– Basing this on a valuation, or requiring a

valuation in the buy-sell agreement mitigates risk

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Shareholder Buyouts

• Not all companies have a buy-sell agreement in place.

• Business valuations can provide a good point to begin negotiations, and smooth the process.

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You’ve Decided to do a Business Valuation.

What Happens Next?

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Business Valuation Timeline

I.•Project Scoping and Engagement Letter•This typically takes a few days between initial discussions and the engagement letter

II.• Information and Data Request•This length of this step depends on how quickly client responds with requested information

III.

• Initial Modeling and industry research•This portion should take 4 to 6 days to complete

IV.

•Follow up questions for client•Questions arise during step III. Timing depends on client response time.

V.

•Finish model and finalize report•A few days to a week depending on responses received in Step IV.

VI.

•Submit final report to client• In total process typically takes 3 to 6 weeks.

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Poll Question

So What is “Value?”

• “Value” expresses an economic concept. As such, it is never a fact but always an opinion of the worth of a property (asset)

• “Value” should always be qualified; e.g., “fair market value,” “liquidation value,” or “investment Value

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Definition: Value(USPAP, paraphrased)

• Value is the monetary relationship between properties (assets) and those who buy, sell, or use those properties (assets)

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The “Definitions of Value”

• Fair Market Value• Fair Value• Investment Value• Intrinsic Value• Liquidation Value–Orderly–Forced

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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. Court decisions frequently state in addition that both the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.”

Source: IRS Revenue Ruling 59-60

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Fair Market Value• "The price, expressed in terms of

cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts."

Source: The International Glossary of Business Valuation Terms

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Fair Value (Financial Reporting)

• "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."

Source: ASC 820

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Fair Value

• Can also be defined on a state-by-state basis in divorce matters.

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Investment Value• "The value to a particular investor based on individual

investment requirements and expectations."

Source: The International Glossary of Business Valuation Terms

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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. When the term applies to options, it is the difference between the exercise price or strike price of an option and the market value of the underlying security."Source: The International Glossary of Business Valuation Terms

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Liquidation Value

• The most probable price that a specified interest in real property is likely to bring under extreme compulsion to sell.

Source: Paraphrased from the Appraisal Institute, The Dictionary of Real Estate Appraisal

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What (Exactly) is Being Valued Here?

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The Value Equation

+

++

The Business Enterprise Equation

Value of Business Enterprise

Value of Net Working Capital

Value of Equity

Value of Tangible Assets

Value of Interest-Bearing DebtValue of

Intangible Assets

BEV =Value of

Underlying Assets=

Value of Invested Capital

= =

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Invested Capital

• Invested capital (sometimes called business enterprise value) is the value of the entire business– Think of it like the price you would

receive if you were to sell the whole business today

• Its equal to the value of the equity in the business plus the value of the debt.

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Equity

• The value of the business available to equity holders after debt service.

• Equity can be valued as a 100% interest, or a fractional interest.

Levels of Value

• Business Enterprise Value (Total Invested Capital)

• Equity Value, 100%• Equity Value, Non-controlling• Equity Value, Non-marketable• Equity Value, non-controlling, non-

marketable• Equity Value, non-controlling, non-

marketable, non-voting38

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Intangible Assets

• Intellectual Property (IP)• Marketing Intangibles• Contract-Based Intangibles• Customer-Relationship-Based

Intangibles• Artistic Intangibles

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Does WHEN a Valuation is Done Make a Difference?

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Point in time Measurement• Value Changes over time• “Valuation Date” is important

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Some Valuations have Date Requirements or Deadlines

• Estate tax: date of death• Financial Reporting: fiscal year end

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Let too much time elapse…

… and gathering information can be like an archaeological dig

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How Much Valuation Do I Need?

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Opinion of Value (Appraisal)• a. An Appraisal is the act or process of determining the value of a

business, business ownership interest, security, or intangible asset.

• b. The objective of an appraisal is to express an unambiguous opinion as to the value of a business, business ownership interest, security or intangible asset which opinion is supported by all procedures that the appraiser deems to be relevant to the valuation.

• c. An appraisal has the following qualities:• (1) Its conclusion of value is expressed as either a single

dollar amount or a range• (2) It considers all relevant information as of the appraisal

date available to the appraiser at the time of performance of the valuation

• (3) The appraiser conducts appropriate procedures to collect and analyze all information expected to be relevant to the valuation

• (4) The valuation considers all conceptual approaches deemed to be relevant by the appraiser

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Calculation of Value• Calculation engagement, as defined in the Statement on

Standards for Valuation Services (SSVS) • A valuation analyst performs a calculation engagement

when – (1) the valuation analyst and the client agree on the

valuation approaches and methods the valuation analyst will use and the extent of procedures the valuation analyst will perform in the process of calculating the value of a subject interest (these procedures will be more limited than those of a valuation engagement) and

– (2) the valuation analyst calculates the value in compliance with the agreement. The valuation analyst expresses the results of these procedures as a calculated value. The calculated value is expressed as a range or as a single amount.

• A calculation engagement does not include all of the procedures required for a valuation engagement and were a valuation engagement to be performed, the results may be different.

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Attributes Opinion of Value

Calculation of

Value

Acceptance

Accepted by Courts X

Accepted by IRS X

Basis for Expert Testimony X

Analysis Includes

Income Approacjh X Sometimes

Market Approach X Sometimes

Cost Approach X Sometimes

Economic and Market Conditions X

Past Sales of Interest in Business X

Financial Benchmarks X

Market Research X

Industry Research X

Macro Risk Assessment X

Company-Specific Risk Assessment X

Minority and Marketability Discounts when appropriate

to subject interest

when appropriate to

subject interest

Calculation of Value vs. Opinion of Value

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How Is Value Determined?

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Three Approaches to ValueMarket Approach

Asset Approach

Income Approach

Value Conclusion

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Market Approach

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Market Approach Theory

• The value of the company (or asset) reflects the price at which comparable companies (or assets) are purchased under similar circumstance.

• Requires that comparable transactions be available.

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Market Approach - Methods

• Guideline publicly-traded company method – Based on similar and relevant

comparable entities– Adjustments are often necessary to

make the comparables more similar

• Comparative transaction method– Based on actual transactions of

similar entities

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Public Company Method• Valuation relies on information

from comparable publicly traded companies

• Should have several “comparables”

• Adjustments may be necessary to make them more comparable or to normalize the comps

• Sometimes it just doesn’t make sense to use public companies

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Comparative Transaction Methods

• Transaction database multiples

• Prior “arm’s-length” transactions

• Rules of thumb

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Comparability?

• Public companies tend to be much larger, have greater resources and access to capital– Public company multiples often need to

be adjusted

• Private companies – usually don’t know terms of transaction, which can impact price

Asset Approach

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Asset Approach Theory

• The value of the company is estimated as a function of the current cost to purchase or replace all assets held within the operating entity.

• It is based upon the principal of substitution, which states that no prudent investor would pay more for a company (or asset) than the amount to re-create or buy it.

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Asset Approach

• Useful for:–Asset-intensive businesses–Real estate holding

companies–Entities that hold mostly

securities (or cash)–Some contracting businesses

that bid for work

Asset Approach• Often requires outside

appraisals• Must identify non-operating

assets like excess cash or obsolete inventory

• Company may have intangible assets that contribute to business value that aren’t listed on the books

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Income Approach

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Income Approach Theory

• Predicated upon the value of the future cash flows that an asset will generate over its remaining useful life.

• It involves the projection of the cash flows the company (or asset) is expected to generate.

• These cash flows are then converted into a present value equivalent through discounting.

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Income Approach - Methods

• Discounted cash flow method• Capitalization of earnings method• Other methods exist, but are less

commonly used

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Discounted Cash Flow Method

• Converts a stream of projected earnings or other benefit stream into present value by applying a discount rate

• The earnings from each period are discounted to present value and then a “terminal” value is added to arrive at the total value

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FCFFn (1 + g) (1 + WACC)0.5

PV = FCFF1 + FCFF2 + … + FCFFn + WACC - g

(1 + WACC)0.5 (1 + WACC)1.5 ( 1+ WACC)n - 0.5 (1+WACC)n

Where:PV = Present ValueFCFF = Free Cash Flow to the Firmn = Number of Periods in Discrete Projection Periodg = Long-Term Sustainable Growth Rate in FCFWACC= Weighted Average Cost of Capital

Discounting Formula

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Present Value

Value today Years of saving$1.00 1 year$1.00 2 years$1.00 3 years

Amount received Years till cash flow$1.10 1 year$1.21 2 years$1.33 3 years

$1.00$1.00

What will savings be worth?

Examples of Present Value

$1.21$1.33

$1.10

Saving Today at 10%

Discounting Future Cash Flows at 10%What is this cash flow worth today?

$1.00

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Projected Earnings

• Predict future performance based on analysis of historical performance and current and expected operating and industry conditions– Various tools are available to

assist the valuator in predicting future performance

– Common sense and informed judgment must be the deciding factors

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What Is the Discount Rate?

• The rate of return, or cost of capital, necessary to convert a monetary sum, payable or receivable in the future, into present value

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How Do We Develop a Discount Rate?

• Weighted Average Cost of Capital (WACC)– Capital Asset Pricing Model (CAPM)

• Published industry standards

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Weighted Average Cost of Capital

WACC = (Ke x We) + (Kd x Wd)

Where: Ke = Cost of Equity

Kd = Cost of Debt

We = Weight of Equity

Wd = Weight of Debt

WACC Formula

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Cost of Equity

Cost of Equity = Rf + β(RPm) + RPs + RPu

Where: Rf =

β =

RPm =

RPs =

RPu =

(1) Modified Capital Asset Pricing Model

Risk premium for specific company ("unsystematic risk)

Risk premium for small size

Cost of Equity Formula (1)

Rate of Return for a risk-free security as of the valuation date

Subject company's beta coefficient

Equity risk premium for the market

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Cost of Equity

Cost of Equity = RPm + Rf + RPs + IP + RPu

Where: RPm =

Rf =

RPs =

IP =

RPu =

(1) Modified Capital Asset Pricing Model - Build-Up Method

Risk premium for specific company ("unsystematic risk")

Cost of Equity Formula (1)

Equity risk premium for the market

Rate of Return for a risk-free security as of the valuation date

Risk premium for small size

Industry Risk Premium

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Example of a Build-Up Method to Developing the WACC

Risk-Free Rate (20-year Treasury-Bill) 2.5%Equity Risk Premium 7.0%Size Premium 3.5%Company and Industry Specific Risk Premium 5.0%

Total Equity Discount Rate 18.0%

Less: Long-Term Growth 5.0%

Equity Capitalization Rate 13.0%

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Capitalization of Earnings Method

• Like other income approach methods, this is based on the principle that the value of the business can be estimated by the future benefits received from ownership of the business.

• Future benefits of ownership are assumed to be reliably predicted by past performance,

• Only appropriate for companies in stable growth phases

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Capitalization of Earnings Method

PV = NCF1

k-g

Where:PV =NCF1 =

k =g =

Present valueNet Cash Flow expected in period 1, the period immediately following the valuation dateWeighted Average Cost of CapitalExpected long-term growth rate in net cash flow

Capitalization of Earnings Formula

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Discounted Earnings Method vs. Capitalization Method

• DCF is applied when– Future performance is not expected to

be consistent and/or stable

• Capitalization is applied when– Company performance is expected to be

stable or grow at a stable rate

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What Impacts Value?

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Factors that Affect Business

Value

External

Business owner can't really

change these

Internal

Business owner can change these

and impact business value

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External Factors That Impact Company Value

Increase Value

• Expanding markets• A dominant market

position• Barriers to entry• Expanding industry• Expanding economy• Shift in consumer

preference to company product

Decrease Value• Shrinking market• Challenged market

share• Lack of barriers to

entry• Contracting industry• Contracting Economy• Shift in consumer

preference away from company product

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Market Timing

SIC Code Industry Pre-Recession (1) Recession (2) Post-Recession (3)

5812 Eating Places 0.49 0.38 0.35

7231 Beauty Shops 0.49 0.40 0.36

7349 Building Cleaning and Maintenance Services 0.68 0.65 0.65

7389 Business Services, Not Elsewhere Classified 1.01 0.99 0.93

7538 General Automotive Repair 0.48 0.42 0.39

7991 Physical Fitness Facilities 0.66 0.76 0.64

8299 Schools and Education Services, NEC 1.07 0.66 0.94

Notes: (1) Pre-recession is defined as 1/1/03 through 11/31/07

(2) Recession is defined as 12/1/07 through 8/31/09

(3) Post-recession is defined as 9/1/09 through 12/1/14

Transactions Multiples Throughout the Business Cycle

MVIC to Sales

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Internal Factors That Impact Company Value

Increase Value• Organized up-to-date

financials• Strong gross margins• Projections of strong

cash flow• Sufficient working

capital to support operations

• Systems and structures• Cross trained employee

base

Decrease Value

• Declining Sales• Inconsistent yearly

financial performance• Unreported cash, or

off-balance sheet loans

• Lack of key employees• No formalized

business and marketing plan

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DISCOUNTS FOR LACK OF CONTROL AND

MARKETABILITY

Levels of Value

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Investment or Synergistic Value

Control Value (Freely-Traded)

Minority Value (Freely-Traded)

Non-Marketable, Minority Interest Value

$14

$12

$10

$7

Marketable, control value

Marketable, control value

Marketable, non-control value

Non-marketable, non-control value

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Discounts & Premiums

• Discount for lack of control• Premium for control• Discount for lack of marketability• Key person discount• Depend on the interest to be valued

and the techniques used to establish the value conclusion

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Value of Control

• Control attributes– Hire and fire– Distribute earnings/declare dividends– Buy and sell assets– Enter into contracts– Liquidate the business– Set strategic objectives and goals– Set compensation and performance

standards

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Lack of Control

• Lack of control in a closely held company implies you are at the mercy of the controlling owner(s)

• Substantial discounts may be necessary to attract an investor to purchase a minority interest in a closely held company

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Determination of Discount/Premium

• Control premium studies

• Mergerstat Control Premium Studies

– Measures how much over the market price is paid to gain control of a company– Looks at the price of the stock before

and after the announcement of an acquisition or merger

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Marketability

• Ability to convert ownership interest to cash

• Time required to do so affects the level of marketability

• Other factors that affect marketability– Distributions of earnings– Active market or industry roll-up– Key person– Number and profile of owners– Restrictions on transfer of stock

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Discount for Lack of Marketability

• From Pre-IPO studies– Comparing the price of a company’s

stock before and after the announcement of “going public”

• From Restricted Stock Studies– Compare Letter Stock restricted from

trading for a certain time period to its publicly traded counterpart

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Marketable, control value 5,000,000$

Discount for lack of control 20% 1,000,000$

Marketable, minority value 4,000,000$

Discount for lack of marketability 30% 1,200,000$

Non-Marketable, minority value 2,800,000$

Example of Lack of Control and Lack of Marketablility Discounts

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WHAT ARE THE ADJUSTMENTS TO MY FINANCIAL DATA AND WHY HAVE YOU

DONE THEM?

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Adjustments to Financial Statements

• One objective of financial statement analysis is to provide a financial picture that can be reliably used to estimate future performance.

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Adjustments to Financial Statements

• Historical financial statements may need to be adjusted for certain items that distort the picture of the true operating performance of the business.

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Reasons for Financial Adjustments

• To develop a starting point from which to predict future earnings

• To present historical financial information on a normalized basis

• To adjust for accounting practices that are a departure from industry or GAAP standards

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Reasons for Financial Adjustments

• To facilitate comparison of a given company to itself, to other companies within the same industry, or to an accepted industry standard.

• To compare the debt and/or capital structure of the company to that of its competition or peers

• To compare compensation with industry norms

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What is Adjusted?

• Unusual items• Nonrecurring items• Extraordinary items (both unusual and

nonrecurring)• Non-operating items• Items affected by changes in accounting

principle• Items that are not in conformance with

GAAP• Degree of ownership interest, including

whether interest has control

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Unusual Items

• Events or transactions that posses a high degree of abnormality

• Unrelated to, or only incidentally related to, the ordinary and typical activities of the entity

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Nonrecurring Items

• Events or transactions that are not reasonably expected to recur in the foreseeable future

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Extraordinary items

• Events or transactions that are distinguished by their unusual nature and infrequency of occurrence

• Item must be both unusual and nonrecurring to be classified as extraordinary

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Extraordinary items

• Events or transactions that are distinguished by their unusual nature and infrequency of occurrence

• Item must be both unusual and nonrecurring to be classified as extraordinary

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Unusual, Nonrecurring, and Extraordinary items

• Strikes and other types of work stoppages

• Litigation expense or recoveries

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Unusual, Nonrecurring, and Extraordinary items

• Uninsured losses due to unforeseen disasters like fire or flood

• One-time realization of revenues or expenses due to nonrecurring contracts

• Gain or loss on the sales of a business unit or business assets

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Unusual, Nonrecurring, and Extraordinary items

• Discontinuation of operations• Insurance proceeds received on the

life of a key person or from property or casualty claim

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Non-Operating Items

• Excess cash• Marketable securities (in excess of

reasonable needs of the business)• Real estate (if not used in business

operations)• Private planes, entertainment, or

sports facilities• Antiques, private collections, etc.

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Changes in Accounting Principal• A change in the method of pricing

inventory (e.g., LIFO to FIFO)• A change in the method of

depreciating previously-recorded assets (e.g., straight-line to MACRS)

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Changes in Accounting Principal• A change in the method of

accounting for long-term construction-type contracts

• A change to or from the full-cost method of accounting in extractive industries

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Nonconformance with GAAP

• Financial statements prepared on a tax or cash accounting basis

• Unrecorded revenue in cash business

• Inadequate bad debt reserve

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Nonconformance with GAAP

• Understated amounts of inventory, failure to write off obsolete or slow moving inventory, etc.

• Unrecorded liabilities such as capital lease obligations, workforce-related costs (wages, sick/vacation pay), deferred income taxes

• Capitalization/expense policies for fixed assets and prepaid expenses

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What Are Adjustments Based On?

• Industry ratios• Market wage data• Company historical data

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GOODWILL?

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What is Goodwill?Two commonly used definitions of goodwill

- The bundle of all intangible assets of a company- The residual intangible value remaining after all identifiable intangible assets have been valued.

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What Is Goodwill?

• Entity goodwill is the goodwill that attaches to the business enterprise.

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What Is Goodwill?

• Personal Goodwill is the goodwill that attaches to the persona and personal efforts of the individual.– Generally considered

to be difficult to transfer, if it is transferable at all

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When Does Goodwill Matter?

• Divorce Valuations• Financial Reporting

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Where Does Personal Goodwill Arise?

• Traditionally, the issue of personal goodwill arose almost exclusively in the context of a professional practice owner.

• The line gets “fuzzy” in the commercial business arena

• Personal goodwill in a commercial business might be more “key person risk” than actual personal goodwill

• Look for special relationships with customers or suppliers

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Separating Personal from Entity

• No generally accepted methodologies to divide goodwill into personal and entity components– Methods to calculate personal goodwill can

depend on case or jurisdiction– Multi-Attribute Utility Model–With and Without Analysis– Excess Earnings

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Factors the Impact Personal Goodwill

• Age and health of professional• Earning power• Reputation• Comparative success• Practice duration• Marketability• Types of Clients and Services

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Factors that Impact Personal Goodwill

• Location and Demographics• Fees• Source of New Clients• Production• Workforce• Competition• Non-Compete Agreements

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DIVORCE-SPECIFIC VALUATION CHALLENGES

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Valuation isn’t Taught in Law School

• Judges don’t necessarily understand valuation theory– Contradictory Case Law proves this out– Valuation report needs to make valuation

theory and the intuition behind it crystal clear

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Short Window in which to Obtain

Info• Need to anticipate all future info needs as part of discovery process

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Short Window in which to Obtain Info• Valuation Process Often Goes Like

This:1. Request info2. Go through info and determine if additional info is

required3. Request follow on info4. Repeat step two/three as needed5. Valuation and report writing6. Last round of questions to cover issues that came up

in the valuation process/dot the i’s and cross the t’s.7. Finalize and issue report

• Steps 3, 4, and 6 can be challenging

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Short Window in which to Obtain Info• If you miss key info, you are out of

luck

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Problematic Information Flow

• Spouse may be unwilling to share info, or actively attempting misdirection

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Incentive to Hide Value• Perceived advantage to

making business look less valuable• Postpone signing

contracts that guarantee business income

• Defer follow-on rounds of financing

• “Business Shift” Syndrome

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“BS”• A sudden shift in

business performance around the time of the divorce filing.

• Business owner trying to make business appear less valuable.

• Could also be the result of macroeconomic or industry conditions. Careful assessment is necessary

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In summary…

• Valuation is a process that leads to an opinion of value.

• There are many scenarios in which a valuation is needed or helpful.

• There are three approaches to value, but many valuation methods.

• You can value invested capital, equity, or individual assets.

• Certain situations have special considerations to be aware of.

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Questions?

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Theresa Zeidler-Shonat

Director of Valuation Services

Smith & Gesteland, LLP

608.828.3154

theresa.zeidler-shonat@sgcpa.com