Implied Private Company Pricing Line

1 | © 2013-2015 Bob Dohmeyer, Pete Butler, Rod Burkert - All rights reserved.

AGN International2015 North American Regional Meeting

Atlanta, GA May 17-19, 2015

Implied Private Company Pricing Line/Model:

A New Analytical Tool to Develop Cost of Capital


IPCPL and IPCPM Co-Developers

Bob Dohmeyer

Pete Butler

Rod Burkert


Today’s Presenter – Rod Burkert

Rod is the founder of Burkert Valuation Advisors. His assignments focus on income/gift/estate tax matters and helping savvy business owners make successful transitions.

Rod is the co-founder of Practice Builder Academy, a 12-month mentoring program that teaches BVFLS professionals strategies to build their practices and redesign their lives.

Rod has leveraged social media to build a mobile consulting practice, which allows him to travel full time in an RV throughout the United States and Canada with his wife and two dogs.

Email: [email protected] [email protected] Phone: 215-360-6100Skype: rodburkert


Welcome To This Session!


The Problem

Most business appraisal assignments are for small private companies with revenue less than $20 million … yet current cost of capital estimation methods rely almost entirely on relatively large public company security returns.

But these small private companies differ from large public companies in so many fundamental ways … and issues we know about make current methods for developing discount rates unreliable when they are applied to small enterprises.


A Solution

IPCPL/IPCPM is steeped in market transactions of small private businesses … think of IPCPL as the equity risk premium of private company transaction data.

Developed to eliminate the problematic CoC issues we face (e.g., company specific risk premium, leverage, illiquidity discounts, tax rates for pass-through entities, etc.) and to create a more defensible starting point to derive the WACC of private companies with revenues less than $100 million.


Agenda

IPCPL: K0 = (FCFF1 / P0) + g

Where we are now Flaws of Build-Up Model

Where we are going Description of IPCPL How to use IPCPL Introduction to IPCPM How to use IPCPM Real world examples Q & A

Caveat: Discussion centers on control valuations, but …


Learning Objectives

Review the pitfalls of extrapolating large public company stock market returns to private company cost of capital

1

Discuss the theory underpinning the use of IPCPL

Specify the inputs used to develop IPCPL and IPCPM

Utilize the IPCPL/IPCPM to develop and calibrate a WACC for a small private company

4

2

3


Let’s get started …


PITFALLS OF BUM


Would you use the BUM if it launched today?Dr. Damodaran: The build-up method is a recipe for

disaster.Dr. Paglia: In a galaxy far far away, where unicorns

prance on the back of the Loch Ness monster and privately-held companies have access to public equity markets, appraisers estimate cost of capital … [using returns of publicly traded equity securities]

Pepperdine Survey: 78% of respondents did not feel comfortable with our industry’s current cost of capital methods, using returns on publicly traded equity securities.

Toby Tatum: In the small business M&A world, (i.e., mom-n-pop and main street business brokers) I would say that 99.9% of the brokers value businesses via Rules of Thumb (a market approach) or use the IBA data or BizComps, or in some cases Pratt's Stats.


There is no return data for private companies

Without data, you are just another person with an opinion.

~ W. Edwards Deming, father of the quality revolution

Junk Bonds

Small Company Stocks

Large Company Stocks

Corporate Bonds (AAA)

Certificates of Deposit

Treasury Bonds

Treasury Bills


And the data we have, is it public or private?

The Duff & Phelps Report is designed to assist the analyst in estimating the cost of equity capital for the subject company as if it were publicly traded.

However, discounting expected net cash flows for a closely

held business using an “as if public” cost of capital may not be an accurate estimate of value to the extent that market participants consider other risks associated with investments in closely held businesses.


How do we explain ourselves?

If we look at the details, we know what happens.


First, there is the risk-free rate

Spot rate

Normalized rate

20-year rate (CRSP and D&P)

10-year rate (Damodaran)


Next, the equity risk premium

Ex post approachCRSP’s historical or supply side D&P’s conditional or unconditional Adjust for WWII interest rate bias

Ex ante approach Damodaran forward-looking


And the small stock premium


Don’t get us started on company specific risk

Pratt: “There is no specific model or formula.”

Hitchner: “This is one of the most subjective areas of business valuation.”


Or the courts …

To judges, the company specific risk premium often seems like the device experts employ to bring their final results into line with their clients’ objectives, when other valuation inputs fail to do the trick. Delaware Open MRI Radiology Associates, PA v. Howard B.

Kessler

This court has also explained that we have been understandably suspicious of expert valuations offered at trial that incorporate subjective measures of company-specific risk premia, as subjective measures may easily be employed as a means to smuggle improper risk assumptions into the discount rate so as to affect dramatically the expert’s ultimate opinion on value. Gesoff v. IIC Industries


Then, an adjustment for control illiquidity In conventional valuation, there is little scope for showing

the effect of illiquidity. The cash flows are expected cash flows, the discount rate is usually reflective of the risk in the cash flows and the present value we obtain is the value for a liquid business.

With publicly traded firms, we then use this value, making the implicit assumption that illiquidity is not a large enough problem to factor into valuation. In private company valuations, analysts have been less willing (with good reason) to make this assumption.

The standard practice in many private company valuations is to apply an illiquidity discount to this value. But how large should this discount be and how can we best estimate it? This is a very difficult question to answer empirically because the discount in private company valuations itself cannot be observed.


Last, models to adjust for pass-thru taxes Mercer Treharne Van Vleet Grabowski Fannon (until she withdrew it) Delaware MRI

And now Nancy again, along with Keith Sellers – let’s not tax affect the earnings, let’s adjust the cost of equity


Example of BUM unreliability

RF4.0%

RF2.8%

ERP5.0%

Small Stock5.0%

AVG CSR2.0%

ERP6.0%

Small Stock6.0%

Avg CSR4.0%

Illiquidity2.0%

Both assume $500,000 FCFF1 / (ke – 3%)and same “everything else”

But

Appraiser A: 19.0% and $2.6 millionAppraiser B: 9.8% and $5.1 million

Unreliability self-evident from webinar polls of BUM supporters

PTE -2.0%

PTE 0%

Illiquidity0.0%

Sum =22.0%

Sum =12.8%


IMPLIED PRIVATE COMPANY PRICING LINE


IPCPL: Begin with the end in mind

$0 $10 $20 $30 $40 $50 $60 $70 $80 $90 $10012.4%12.9%13.4%13.9%14.4%14.9%15.4%15.9%16.4%16.9%17.4%

Revenue $Millions

After Tax (35%) Ko

$0 $10 $20 $30 $40 $50 $60 $70 $80 $90 $1004.3

4.8

5.3

5.8

6.3

Revenue $Millions

Operating Income Mul-

tiple


The inspiration

All other asset classes have return evidence.

Only rough tethering device for BUM/WACC is the market approach and implied transaction multiples:Lower discount rates yield values > actual

transaction evidence Higher discount rates yield values < actual

transaction evidence

Pratt & Hitchner use implied market multiple in their DCF terminal value calculations as a reasonability check.

So IPCPL looks at implied IRRs of private transactions.


Do completed transaction prices = FMV?

People make no adjustment in the market approach for this issue.

We assume distressed sales are offset by eager buyers. And that biz transition losses are offset by synergies.

So in the aggregate, Yes.

Remember, we are solving for IRR - the back solve is axiomatically Price.


Frame of reference: K0 = (FCFF1 / P0) + g Gordon Growth Model rearranged to solve

for K0

K0 is WACC; not Ke

Discount rate; not cap rate

Control DCF (see me for minority) = FMV

Probability neutral (not risk adjusted) cash flows

Small, privately held company


Frame of reference (continued)

IPCPL regresses 840 small private company transactions and directly estimates the aggregate IRR. This ex-ante approach is fundamentally

same as Damodaran’s ERP estimation approach.

Not perfect, but we believe more reliable.

Exposure: Business Valuation Review, BV Update, numerous webinars and conferences.

Tests: Pepperdine WACC, Hitchner, new BVR paper.


You no longer have to worry aboutBy using prices paid (FMV) for small privately

held companies, the issues of extrapolating public security returns are moot: Rf

ERP SSP CSRP Illiquidity PTE taxes Optimal capital structure and

unlevering/relevering beta How much cash to add back


IPCPL point 1: selection criteria

Pratt’s Stats Revenue size of $3.5 – $15 million From all available dates Owner compensation data provided No medical/dental practices US entity Private acquirer

Currently gives us 840 transactions


IPCPL reliability – law of large numbers

0 25 50 75 100 125 150 175 200 225 250 275 300 325 350 375 400 425 450 475 5000.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

18.0%

Completed Transaction Data Reliability AnalysisAt 95% Confidence Interval

# of Completed Transactions

Pote

nti

al Err

or,

+ o

r -

% o

f Tru

e M

ean M

ult

iple

Typical completed transaction sample size


Our growth estimate

Estimating expected growth for 1 company is difficult

Estimating the median growth for 800+ companies is easy

BLS data, Pratt’s Stats data show 1% real growth

1% change in growth = 0.5% change to K0


Growth: private buyer v. public buyer


Summary of other adjustments

Seller finance adjustment

Market compensation adjustment

Present day adjustment

Tax adjustment

Income lag adjustment


And voilá! (we got point 1)


IPCPL point 2: micro cap ETF – ticker IWC


Point 1 to Point 2: Connecting the dots

$ 6 million revenue Pratt’s Stats to $150 million revenue microcap ETF

Adjusted for cost of going and staying public

No Arbitrage Rule Double Lehman formula


IPCPL: We have arrived!

$0 $10 $20 $30 $40 $50 $60 $70 $80 $90 $10012.4%12.9%13.4%13.9%14.4%14.9%15.4%15.9%16.4%16.9%17.4%

Revenue $Millions

After Tax (35%) Ko

$0 $10 $20 $30 $40 $50 $60 $70 $80 $90 $1004.3

4.8

5.3

5.8

6.3

Revenue $Millions

Operating Income Mul-

tiple


Practical example IPCPL output

Privately held manufacturer

$4 million revenues (note: less $ than point 1)

Go to website www.biz-app-

solutions.com > Cost of Capital > IPCPL


Comparison with other private CoC models Point 1 = approximately 5x EBITDA

Pepperdine’s Private Markets Capital Project

Toby Tatum’s PEPM

So can you use IPCPL in a litigation setting?Hold on there cowboy!


IMPLIED PRIVATE COMPANY PRICING MODEL


Uh-oh! My subject company is not “average” What if our privately-held $4M manufacturer

is not an “average” privately held company? Depart from IPCPL:

- Systematic risk (Beta)- Unsystematic risk (Total Beta)- Illiquidity- Ability to obtain financing

Go back to biz-app-solutions.com Cost of Capital > IPCPL > New BUM WACC

Calibrator


IPCPM: 4 factors you can adjust (all else equal)

1. Systematic Risk: How correlated is the subject company or cash flow with the economy?

2. Unsystematic Risk: How uncertain is the subject company’s cash flow?

3. Illiquidity – Complexity, uniqueness, geography: How shallow is the potential buyer pool?

4. Debt Finance Capacity: How acceptable are the subject company’s assets as collateral?


Adjust for systematic risk

How correlated is the business and future cash flow to the economy?

Expensive dinner house = 7 (high risk) Fast food burger joint = 3

Private jet manufacturer = 9 (high risk) Defense contactor = 2

Compared to other small, privately held companies of the same size … on a scale of 0 - 10 … with 5 being typical/average:


Adjust for unsystematic risk

How uncertain are the subject company’s future cash flows?

One or two customers = 10 (high risk) Diversified customer base and no one customer is more than 5% of sales = 1



Adjust for illiquidity

How shallow is the pool of (hypothetical) willing buyers?

Few competitors, unique/specialized knowledge = 8 (high illiquidity, high risk)Many competitors, no unique or specialized knowledge = 2 Low population density = 7 High population density = 3



Adjust for ability to obtain financing

How bankable are the subject company’s collaterizable assets?

Low inventory, AR, and FFE = 3 (low bankability, high risk) High inventory, AR, and FFE = 7 (high bankability, low risk)



Calibrator example – no adjustment


Calibrator example – BUM too low


Calibrator example – BUM too high


RESOURCES


Most of what you need to know

BV Update, last page, cost of capital center

BVR email notification when IPCPM updated

Monthly update: www.bvmarketdata/IPCPL

Monthly update: www.biz-app-solutions.com


WRAPPING UP


Closing thoughts


Closing thoughts

The chief characteristic which distinguishes the scientific method from other methods of acquiring knowledge is that scientists seek to let reality speak for itself, supporting a theory when a theory's predictions are confirmed and challenging a theory when its predictions prove false …

~ Wikipedia: definition of Scientific Method


Closing thoughts

… among competing hypotheses that predict equally well, the one with the fewest assumptions should be selected. Other, more complicated solutions may ultimately prove to provide better predictions, but – in the absence of differences in predictive ability – the fewer assumptions that are made, the better.

~ William of Ockham English Franciscan friar and scholastic philosopher and theologian


Closing thoughts

An important scientific innovation rarely makes its way rapidly winning over and converting its opponents; it rarely happens that Saul becomes Paul. What does happen is that its opponents gradually die out and the growing generation is familiarized with the idea from the beginning.

~ Max Planck, German physicist, quantum theory founder



Today’s Presenter – Bob Dohmeyer

Bob is the founder of Dohmeyer Valuation Corp., a business valuation and M&A consulting firm. Bob provides professional valuation advice and appraisals primarily for bankruptcy and family law matters. He also specializes in complex valuation issues and provides consulting work for other appraisers in that regard.

Bob has lectured and published several papers on various valuation topics and is on the review boards of the Journal of Business Valuation & Economic Loss Analysis and the Business Valuation Review.

Prior to forming his company, Bob was employed by a Fortune 100 conglomerate where he was responsible for estimating the firm’s cost of capital, analyzing and evaluating merger and acquisition candidates and hedging/trading crude oil.

Bob received a Bachelor’s degree in Finance from California State University, Fullerton and is an ASA.

Email: [email protected]: 214-499-5954


Today’s Presenter – Pete Butler

Peter Butler, CFA, ASA, Principal at Valtrend, has more than 20 years of financial/business valuation experience. He invented and co-developed the Butler Pinkerton Calculator. He is also a co-developer of the Implied Private Company Pricing Line (the “IPCPL”) and the Implied Private Company Pricing Model (the “IPCPM”)

Peter has published articles in all of the major U.S. business valuation journals, as well as in a Romanian journal. He has been invited to speak at regional, national and international valuation conferences.

He holds a BS in mechanical engineering from Annapolis and an MBA from San Diego State. Peter served as a four-term president of the CFA Society of Idaho and taught corporate finance as an Adjunct Faculty Professor at George Fox University.

Email: [email protected]: 208-371-7267


Seller finance adjustment

Actual Cash Price something less than reported with seller financing69.1% of transactions had owner financing,

resulting in a 6.4% premium69.1% x 6.4% premium = 4.4% discount to MVIC


Market compensation adjustment

Separate labor and business value


Present day adjustment


Pre-tax net cash flow adjustment


Income lag adjustment

Current Implied ERP = 5.40% Sample Period Implied ERP Avg. =

4.36% Difference = 1.04%

Divide by 1.04%/1.5 Increase Ko by

0.70%


Other IPCPM example

Live demonstration of Calibrator in Use Expensive Steakhouse Funeral Service and Crematories Requests from the audience (time permitting)


Expensive Steakhouse


Funeral Home