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Valuation Challenges Involving Closely Held Businesses
WEDNESDAY, FEBRUARY 20, 2019, 1:00-2:50 pm Eastern
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FOR LIVE PROGRAM ONLY
WEDNESDAY, FEBRUARY 20, 2019
Valuation Challenges Involving Closely Held Businesses
Jon P. Klerowski, CPA, ABV, CFE, Partner
Floyd Advisory, Boston
John F. Maloney, CPA, CFF, CVA, ABAR, Founding and Managing Partner
Wouch Maloney & Co., Horsham, Pa.
Notice
ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY
THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY
OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT
MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR
RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.
You (and your employees, representatives, or agents) may disclose to any and all persons,
without limitation, the tax treatment or tax structure, or both, of any transaction
described in the associated materials we provide to you, including, but not limited to,
any tax opinions, memoranda, or other tax analyses contained in those materials.
The information contained herein is of a general nature and based on authorities that are
subject to change. Applicability of the information to specific situations should be
determined through consultation with your tax adviser.
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Valuation Challenges Involving
Closely Held Businesses
Strafford
February 20, 2019
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Agenda
1. Introduction to Business Valuation
➢ Introduction and Background
➢ Valuation Core Concepts
2. Valuation Approaches
➢ Income Approach
➢ Market Approach
➢ Asset (Cost) Approach
3. Challenges Involving Closely-Held Companies
➢ Discounts
➢ Other Challenges / Common Pitfalls
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www.floydadvisory.com
Introduction and Background
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Jon Klerowski, CPA, ABV, CFE
Professional Profile
Mr. Klerowski is a Partner at Floyd Advisory, a consulting firm providing financial and accounting expertise in areas of business strategy, valuation, SEC reporting, and transaction analysis. Mr. Klerowski has significant experience advising executive management, boards of directors, and their counsel on a wide array of accounting, financial reporting and modeling, business valuation and forensic accounting matters.
Education and Certifications
Bachelor’s degree in Finance, Bentley CollegeMaster of Business Administration, Accounting, Suffolk UniversityCertified Public Accountant, CaliforniaCertified Fraud ExaminerAccredited in Business Valuation (ABV) by the AICPA
Professional Associations and Memberships
American Institute of Certified Public Accountants (AICPA)Association of Certified Fraud Examiners
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John F. Maloney, CPA, CFF, CVA, ABAR
Professional Profile
Partner in the independent certified public accounting firm of Wouch, Maloney & Co, LLP, a full-service accounting and business advisory firm with offices in Horsham, PA, Newtown, PA and Bonita Springs, FL.
Over 35 years of public accounting and consulting experience focusing on business valuation, damage measurement, estate planning, marital disputes, income taxation, accounting and auditing, business and strategic planning, business strategy development, shareholder agreements, disputes and resolution, succession, entity planning and structuring, operational budgeting, bankruptcy and performance assessment and improvement. Engagements have involved closely-held business entities and entrepreneurial individuals in the industries of construction, manufacturing, wholesaling, professional services, pharmaceutical, retail, and home building and development. Testified as an expert witness.
Education and CertificationsCertified Valuation Analyst (CVA), January 10, 1997 Accredited in Business Appraisal Review (ABAR), January 24, 2012Certified in Financial Forensics (CFF), February 28, 2009Certified Public Accountant (CPA), March 17, 1988Licensed in Pennsylvania and New JerseyTemple University - Bachelor of Business Administration (1981)
Professional Associations and MembershipsAmerican Institute of Certified Public Accountants (AICPA)Pennsylvania Institute of Certified Public Accountants (PICPA)National Association of Certified Valuation Analysts (NACVA)Construction Financial Management Association (CFMA)Associated Builders and Contractors of Southeastern PA (SEPA ABC)Former Director and Past President, Bucks County Estate Planning Council (BCEPC)Member of PICPA Business Valuation Committee
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Overview – Business Valuation Standards
Organizations which offer standards/guidance
▪ Uniform Standards of Professional Appraisal Practice (USPAP) – Issued by The Appraisal Foundation
▪ Statement on Standards for Valuation Services (SSVS 1) – Issued by the AICPA
▪ Professional Standards – Issued by NACVA/IBA
▪ ASA Business Valuation Standards – Issued by ASA
▪ The Internal Revenue Service (IRS)
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Overview – Credentials/Certifications
▪ ABV – Accredited in Business Valuations (AICPA)
▪ CVA – Certified Valuation Analyst (NACVA)
▪ ABAR – Accredited in Business Appraisal Review (NACVA)
▪ ASA – Accredited Senior Appraiser (ASA)
▪ CBA – Certified Business Appraiser (IBA)
▪ CFA – Chartered Financial Analyst (CFAI)
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Types of Valuation Report
▪ Valuation Engagement/Report
– Analyst estimates the value based on the valuation approaches and methods they deem appropriate
– Results expressed as a “Conclusion of Value”
▪ Calculation Report
– Analyst and client agree on the valuation approaches and methods and the value is calculated based on the agreement
– Results expressed as a “Calculated Value”
– Does not include all procedures required for a valuation engagement
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The Valuation Process
▪ Company Background– Business Description – Customers (business sector(s))– Employees– Products– Market (local, regional , national)
▪ Financial Performance– Revenue (historic & projected)– Gross Margins, Operating Margins, EBITDA– Capital Structure
▪ Recent Sale Transactions
▪ Competition
▪ Data & Information > Financial statements, income tax returns, workforce data, trial balances, sales reports, payroll data
▪ Interviews > Owner/Shareholder, CFO, COO, Controller, Ops personnel
▪ Public Information
▪ Industry Overview / Research (Trends, Outlook)
▪ Economic Outlook
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Disputes Involving Business Valuation
Examples include…
▪ Shareholder disputes / shareholder oppression
▪ Business dissolutions: force of a sale / purchase of business interests
▪ Breach of Contract / Commercial Disputes – decrease in business value and/or damages
▪ Intellectual Property rights infringement
▪ Bankruptcy: solvency analyses
▪ Divorce: couple owns an interest in a closely held business
▪ Tax Liability Determination
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Difficulties for Closely-Held Businesses
Definition: Closely-Held Businesses
▪ Small number of owners / shareholders
▪ Not necessarily a “small business” in terms of sales, number of employees etc.
Difficulties Unique to Closely-Held Businesses
▪ No entity separation between ownership and management
▪ Rarely traded or sold in the marketplace – no established market price
▪ Financial data is not standardized
▪ Must stand up to IRS scrutiny
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Valuation Core Concepts
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Standard of Value
▪ “The standard of value usually reflects an assumption as to who will be the buyer and who will be the seller in the hypothetical or actual sales ...”1
Standard of value refers to the type of value being estimated
“Value to whom?” and “under what circumstances?”2
[1] Shannon P. Pratt, Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 5th Ed.
(New York: McGraw Hill, 2008), p 41; [2] Ibid; [3] Ibid
▪ “The standard of value, either directly by statute or (more often) as interpreted in case law, often addresses what valuation methods are appropriate and what factors should or should not be considered.”3
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Commonly Used Standards of Value
• Most widely recognized and accepted definition of value.
• All Federal Tax matters
• Potential synergies not included
Fair Market Value
• Willing Buyer & Seller
• No compulsion to buy/sell
• Reasonable knowledge of facts
• Includes “hypothetical” buyer/seller
Definition Application
• Hypothetical transaction from Seller’s perspective
• “Exit Price”: not a willing selling
• Price that seller would actually get
• Most common in state shareholder lawsuits (minority shareholder oppression)
• Used for financial reporting
Fair Value – State Statutes
Investment Value• Value to the business owner (not
selling)
• Value to a particular buyer
• Strategic M&A and divestitures
• Includes potential synergies to be gained via transaction
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Premise of Value
Going Concern
Going Concern vs. Liquidation?
Value in continued use (as operating entity)
Assemblage of Assets
Forced Liquidation Assets sold individually; fire sale
Assets sold individually over a reasonable amount of time
Value in place as part of a mass assemblage, not in current use
Orderly Liquidation
Less
Val
ue
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Levels of Value
Source: AICPA Introduction to Business Valuation, Chapter 10: PREMIUMS AND DISCOUNTS (VALUATION ADJUSTMENTS), pg. 9
Less
Val
ue
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The Valuation “Formula”
The three major components of the valuation “formula”:
1. Economic Benefit – What is the most appropriate valuation approach/method?
2. Risk – What rate or multiple should be applied to the economic benefit?
3. Adjustments – What adjustments should be made to the entity value?
1) Economic Benefit
( / )
2) Risk
= Entity Value
( / )
3) Adjustments
= Value After
Adjustments
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Example of Valuation Formula
Economic Benefit 500,000$
Risk 20%
2,500,000$
Discount (30%) (750,000)
1,750,000$
Interest Being Valued 25%
Value of Interest 437,500$
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Valuation Approaches
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Valuation Approaches
Primary Drivers of Value
Profitability Growth Risk
Method
Income Approach
Discounted Cash Flow
Capitalization of Earnings
Market Approach
Public Company
M&A Transactions
Asset (Cost) Approach
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Valuation Approaches: Income Approach
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Valuation Approaches: Income Approach
▪ Goal of the income approach:
– To project the future income associated with the investment
– Discount the projected income stream to a present value
– Determine a discount rate appropriate for the expected risk of the projected stream
“The value of a business or an interest in a business depends on future economic benefits that will accrue to that business”1
[1] Pratt, S., The Market Approach to Valuing Businesses, John Wiley & Sons, Inc. (2005)
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Valuation Approaches: Income Approach
Capitalization/Discounted Cash Flows▪ Two most common approaches, same underlying principle:
1. Single Period Capitalization Method
2. Multi-period Discounted Cash Flow (DCF)
▪ Determine annual future cash flow or profit that is expected to be derived from the business• Trends of historical Sales & Costs
• Growth opportunities / Capital expenditures needed for growth
• If historical results are used as a proxy, normalization is necessary
▪ Apply Capitalization Rate or Discount Rate to discount future cash flow to current day dollars (value)
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Valuation Approaches: Income Approach
Single Period Capitalization
▪ Assumes steady stream of cash flow increasing by a fixed % each year
▪ Takes the Free Cash Flow in Year 1 ($1M), and divides it by the Capitalization Rate [Discount Rate (12%) – Long Term Growth Rate (2%)]
▪ Present Value = Benefit Stream (CF) ÷ Capitalization Rate
➢ $10M = $1M ÷ (12% - 2%)
▪ Best suited for companies that are in their long-term stable state
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www.wm-cpa.comIncome Approach – ExampleCapitalized Cash Flow Method
ABC Company, Inc.
Capitalized Cash Flow Method **equal weighting compare to **graduated weighting
Year
Normalized Net
Income
Add Back Non-
Cash Items
(Depreciation and
Amortization)
Net Adjusted
After Tax Cash
Flow Weight
Weighted Net
Adjusted After
Tax Cash Flow
Net Adjusted
After Tax Cash
Flow Weight
Weighted Net
Adjusted After
Tax Cash Flow
2017 339,900$ 123,739$ 463,639$ 1 463,639$ 463,639$ 5 2,318,195$
2016 683,081 124,926 808,007 1 808,007 808,007 4 3,232,028
2015 707,587 119,830 827,417 1 827,417 827,417 3 2,482,251
2014 286,572 128,222 414,794 1 414,794 414,794 2 829,588
2013 357,095 166,873 523,968 1 523,968 523,968 1 523,968
5 3,037,825$ 15 9,386,030$
5 15
Weighted average (Rounded) normalized net adjusted after tax cash flow 607,565$ 625,735$
Weighted average normalized net adjusted after tax cash flow 607,565$ 625,735$
Capital expenditures necessary to support projected operations (200,000) (200,000)
(+/-) net working capital necessary to support projected operations - -
(+/-) changes in long-term debt to support projected operations - -
Weighted net cash flow to equity 407,565$ 425,735$
Capitalization rate 21.38% 21.38%
Value of the business before non-operating assets 1,906,291 1,991,277
Non-operating Assets 143,329 143,329
Value 2,049,620$ 2,134,606$
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Multi-period Discounted Cash Flow (“DCF”)
Valuation Approaches: Income Approach
▪ Since we cannot estimate cash flows forever, we estimate cash flows until the firm establishes “stable growth” (also an estimate):
▪ Value > Sum of Present Value of Each Year’s Expected Cash Flow
▪ PV = [Cash Flow ÷ (1 + Discount Rate)n)] +
[Terminal Yr Cash Flow ÷ Cap. Rate] ÷ (1 + Discount Rate)n)]
Cash Flow Estimates Year 1 Year 2 Year 3 Year 4 Year 5
“Stable Growth”
“Terminal Period” (future
CF’s grow at fixed & nominal growth
rate)
“VALUE” = Net Present Value of all future funds
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www.wm-cpa.comIncome Approach – ExampleDiscounted Cash Flow Method
ABC Company, Inc.
Discounted Cash Flows Method
Discount rate = 25.02%
Long-term cash flow growth rate = 3.00%
Forecasted net
cash flow to
equity
Present
value factors
(a)
Present value of
future cash flows
Forecasted Year 1 636,135$ 89.4356% 568,931$
Forecasted Year 2 703,046 71.5370% 502,938
Forecasted Year 3 773,695 57.2204% 442,712
Forecasted Year 4 801,433 45.7690% 366,808
Forecasted Year 5 830,004 36.6094% 303,859
Net present value of future cash flows 2,185,248$
Forecasted Year 5 projected net cash flow to equity 830,004
Long-term cash flow growth rate 3.00%
Cash flows with growth 854,904
Capitalization rate 22.02%
Terminal Value (b) (c) 3,882,398 36.6094% 1,421,322$
Present value of projected cash flows to equity 2,185,248$
Present value of terminal value 1,421,322
Value before non-operating assets 3,606,570
Non-operating assets 143,329
Value 3,749,899$
(a) Used mid-period discounting
(b) Assumes business will continue into perpetuity
(c) Terminal Value Calculated using Gordon Growth Model assuming liquidity event occurs the first day of Year 6.
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Income Approach:
Challenges Related to Closely-Held Businesses
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Income Approach Challenges
▪ Certain assumptions and inputs become particularly difficult when valuing closely-held businesses:
• Discount Rate
• Growth Rate
• Estimating future cash flows / Normalization
• Other Common Errors
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www.wm-cpa.comIncome Approach Challenges:
Discount Rate
▪ The discount rate reflects:
o Time value of money
o Risk or uncertainty of future cash flows
➢ The greater the uncertainty of future cash flows, the higher the discount rate
“In economic terms, a present value discount rate is an “opportunity cost,” that is, the expected rate of return (or yield) that an investor would have to give up by investing in the subject investment instead of investing in available alternative
investments that are comparable in terms of risk and other investment characteristics.”1
[1] Pratt, S., The Market Approach to Valuing Businesses, John Wiley & Sons, Inc. (2005)
▪ Higher Risk = Higher Discount Rate = Lower Valuation
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Risk-Free Rate 4.50%
Equity Risk Premium 7.50%
Size Premium 6.00%
Subtotal 18.00%
Plus: Industry Risk Premium 2.00%
Plus: Specific Company Risk 4.00%
Discount Rate 24.00%
Less: LT Growth Rate (2.00%)
Capitalization Rate 22.00%
Long-term Government Bonds
Small Cap. Equity Stock has Greater Risk than Large Cap. Equity Stock
Large Cap. Equity Stock has greater risk than Long-Term Gov. Bonds
Additional Risk Necessary Based on the Type of Industry?
Add’l Risk based on Specific Characteristics of Company? (i.e. Customer Concentration, etc.)
Income Approach Challenges:
Discount Rate Build-Up
Used for DCF model
Applied to single period capitalization formula
Syst
emat
ic R
isk
Un
syst
emat
ic
Mo
re J
ud
gme
nt
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www.wm-cpa.comIncome Approach Challenges:
Discount Rate
Company-Specific Risk (CSR)
▪ Based on Judgment
▪ Reliability concerns
▪ Considerations:– Additional Size Premium– Industry Risk (make sure not to double-count)– Depth of Management– Access to Capital– Customer Concentration / Customer Pricing Leverage– Supplier Concentration– Product or Service Diversification– Competition– Availability of Labor– Financial Strength– Profitability and Stability of Earnings/Cash Flow– Local Economic Effects– Key Person
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www.wm-cpa.comIncome Approach Challenges:
Growth Rate Considerations
▪ Forecasting the duration of extraordinary growth is subjective
▪ All firms eventually reach a stable state
▪ High Growth -> Excess Returns -> Increased Competition
Extraordinary Growth
▪ Size of the business
▪ Existing growth rate and excess returns
▪ Magnitude and sustainability of competitive advantages
Duration Factors[2]
[2] Damodaran, Aswath. Applied Corporate Finance, 4th Edition. John Wiley & Sons, 2015, Chapter 12.
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www.wm-cpa.comIncome Approach Challenges:
Growth Rate Considerations
▪ The transition from extraordinary growth to a stable state growth rate overnight, does not seem practical
▪ A different form of Discounted Cash Flow model (the H-model) attempts to address this pitfall, by assuming a linear decline in the growth rate over time, smoothing out the projections
▪ However, a linear decline in growth might fail to capture volatility in earnings
Transition Period (from High to Stable growth)
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www.wm-cpa.comIncome Approach Challenges:
Growth Rate Considerations
▪ Stable state growth should be high enough to keep pace with inflation, but not high enough to outpace long term GDP growth
▪ Nominal vs. Real Growth
▪ Economic Benchmarks Include:
▪ Inflation (historic)
▪ Real GDP (historic)
▪ Nominal GDP (historic)
▪ Includes inflation and real growth
▪ Note: The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.96 percent (January 11, 2019; www.clevelandfed.org)
Stable State Growth Rate
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www.wm-cpa.comIncome Approach Challenges:
Cash Flow - Normalizing Adjustments
▪ Often, historical financial results are used to estimate future earnings
▪ Historical financial statements must be “normalized” to remove non-recurring expenses or revenue
▪ Common normalizing adjustments
1. Adjust for non-recurring revenue or expenses
➢ Start-up costs
➢ Unusually large one-time sales contract
➢ Lawsuits, arbitrations, insurance claim recoveries and one-time disputes
2. Amounts not reported at market value
➢ Related-party transactions (not “arm’s length”)
➢ Discretionary expenses
➢ Owner salaries and bonuses not at fair market value
3. Other Adjustments
➢ Income Tax
➢ Non-operating and off-balance sheet assets
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www.wm-cpa.comIncome Approach Challenges:
Cash Flow - Normalizing Adjustments
Actual Adjusted Reason
Revenue 1,000,000$ 1,000,000$
Cost of Goods Sold 350,000 350,000
Gross Margin 650,000 650,000
Operating Expenses
Rent 5,000 8,000 Actual Not Arms Length
Travel 5,000 - Personal Expense
Auto 8,000 - Discretionary Comp.
Travel 5,000 2,000 Personal Expense
SG & A 120,000 120,000
Owner's Compensation 100,000 50,000 Reasonable Comp.
Subtotal 243,000 180,000
Income before Taxes 407,000 470,000
Less: Income Taxes 59,750 69,000
Net Income 347,250 401,000
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Income Approach: Common Errors
Sensitivity of Assumptions:
▪ Assume Owners Comp. = $75K instead of $50K
▪ Assume Cap Rate = 2% higher due to Company Specific Risks
▪ Assume Net Income = Cash Flow
Small changes in valuation assumptions can have material impact on value…
Value 1 Value 2 Variance
Annual Net Income 401,000$ 376,000$ (25,000)$
Cap Rate 22% 24% 2%
Value (before discounts) 1,822,727$ 1,566,667$ (256,061)$ (14%)
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Income Approach: Common Errors
▪ Use beginning rather than ending cash flow under the single period capitalization method
▪ Inconsistency between discount rate and future cash flows
▪ Failing to properly adjust for non-operating / off-balance sheet assets
▪ Failing to reconcile capital expenditures and depreciation
▪ Using an incorrect standard of value
▪ Working Capital Deficiency
▪ As the business grows, additional permanent working capital is required which may reduce future cash flows
James R. Hitchner, Financial Valuation Applications and Models, 3rd ed., Wiley, 2015, p. 141.Andersen, Jim. “Valuing the Closely Held Business: Spot These Common Errors Before Going Into Court.” Aug. 2014.
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Income Approach: Common Errors
Lack of Professional Skepticism Regarding Forecasts
▪ Senior Management or “FP&A” group typically prepares forecasts
▪ Valuation professional must vet forecasts
▪ Understand forecasts
▪ Document how management developed forecast
▪ Evaluate reasonableness
▪ Factors and considerations:
▪ Compare against historical trends
▪ Budget-to-Actual analyses
▪ Comparison to industry/analyst expectations
▪ Perform math and logic check
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Income Approach: Common Errors
Income Taxes: C Corp vs. S Corp
▪ Delaware Open MRI Radiology Associates, PA v. Howard B. Kessler (Decision April 26, 2006)
▪ The Court determined it was appropriate to tax-affect the earnings of the S corp at a rate that would reflect the tax structure differences of a traditional C corp and S corp. The Court applied the top corporate and personal tax rates, and assumed that profits were distributed to the shareholders.
Traditional C
Corp
Traditional S
Corp
S Corp
Valuation
Corporate Level
Income Before Tax 100$ 100$ 100$
Corporate Tax Rate* 40.00% 0% 29.40% *
Net Income 60$ 100$ 70.6$
Shareholder Level
Income Available for Distribution 60$ 100$ 70.6$
Personal Income Tax Rate** 0% 39.60% 0%
Dividend Tax Rate 15.00% 0% 15.00%
Total, Post-Tax Distributions 51$ 60$ 60$
*The Court used income before taxes of $100, total post-tax distributions of $60 and a
dividend rate of 15% to calculate the 29.4% implied corporate tax rate.
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Valuation Approaches: Market Approach
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Market Approach
▪ Based on the economic principle of substitution:
▪ Measures value by comparing the subject company to market data (similar to real estate “comps”)
▪ Uses concept of valuation “multiples”
o Multiple = value ÷ financial measure
o Ex: Revenue multiple of 10x = $100 value ÷ $10 of revenue
“One would not pay more than one would have to pay for an equally desirable alternative investment”1
[1] Pratt, S., The Market Approach to Valuing Businesses, John Wiley & Sons, Inc. (2005)
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▪ Identify “comparable” companies, considering: o Capital structure and size of balance sheet (economies of scale)o Industry and company factors (maturity, competition, etc.)
▪ Adjust the data of the subject company to be consistent w/ public companies > normalization adjustments (discussed previously)
▪ The 10.6x Net Income multiple is then applied to subject company N.I.▪ If Subject Net Income = $10K, derived value = $106K
Market Approach:
Guideline Public Company Method
Guideline Public Company Method
Public Company Equity Value Net Income Multiple
Comparable Company 1 $800,000 $60,000 13.3x
Comparable Company 2 $650,000 $90,000 7.2x
Comparable Company 3 $380,000 $34,000 11.2x
Average 10.6x
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▪ Identify comparable mergers and acquisitions (M&A) of guideline companies to create valuation multiples
▪ Theory: prices paid for similar company M&A transactions provide approximation of value
▪ The 5x EBITDA multiple is then applied to subject company EBITDA
▪ If Subject EBITDA = $3M, derived Value = $15M
Market Approach:
Guideline M&A Method
Guideline M&A (Transactions) Method
Sale Price EBITDA Multiple
Comparable Transaction 1 $25 M $4.5 M 5.6x
Comparable Transaction 2 $35 M $9 M 3.9x
Comparable Transaction 3 $15 M $2.5 M 6.0x
Average 5.0x
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www.wm-cpa.comMarket Approach – ExampleGuideline (M&A) Transaction Method (GTM)
ABC Company, Inc.
Guideline Transaction Method
1. Selected Guideline Companies and Relevant Measures of Value
SIC Sale Date
Transaction
Type MVIC Revenue EBITDA*
MVIC /
Revenue
MIC /
EBITDA*
3441 9/30/2014 Asset 5,485,000 16,355,790 2,495,697 0.34 2.20
3441 9/12/2014 Asset 2,280,000 4,852,419 N/A 0.47 N/A
3441 9/24/2013 Asset 1,021,496 2,434,706 248,867 0.42 4.10
3441 11/4/2011 Asset 400,000 532,125 146,048 0.75 2.74
3441 8/3/2011 Asset 385,000 470,812 153,936 0.82 2.50
3444 4/1/2012 Asset 970,000 3,007,145 565,914 0.32 1.71
3444 4/24/2013 Asset 1,100,000 2,300,000 193,400 0.48 5.69
3444 5/26/2010 Asset 760,000 2,232,480 262,275 0.34 2.90
3444 3/26/2013 Asset 475,000 2,210,112 36,497 0.21 13.01
3444 3/31/2014 Asset 1,800,000 1,947,786 179,058 0.92 10.05
3444 1/27/2014 Asset 725,000 1,363,060 N/A 0.53 N/A
3444 3/18/2013 Asset 2,000,000 1,250,700 492,500 1.60 4.06
3444 4/5/2013 Asset 560,000 837,341 72,752 0.67 7.70
3444 11/26/2012 Asset 275,000 801,966 99,113 0.34 2.77
3446 8/23/2011 Asset 89,000 655,000 N/A 0.14 N/A
3446 12/1/2011 Asset 350,000 508,470 N/A 0.69 N/A
3448 8/23/2010 Asset 3,431,341 6,291,996 755,901 0.55 4.54
3449 11/1/2010 Asset 1,556,492 2,386,283 179,679 0.65 8.66
3449 11/11/2011 Asset 1,592,293 1,361,251 367,990 1.17 4.33
3449 8/1/2011 Asset 160,000 507,840 57,444 0.32 2.79
* - Earnings Before Interest, Taxes, Depreciation & Amortization
Statistics MVIC Revenue EBITDA* MVIC / Revenue MIC / EBITDA*
Count 20 20 16 20 16
Minimum 89,000 470,812 36,497 0.14 1.71
Maximum 5,485,000 16,355,790 2,495,697 1.60 13.01
Mean 1,270,781 2,615,364 394,192 0.59 4.98
Harmonic Mean 478,237 1,135,599 139,889 0.43 3.63
10th percentile 263,500 508,407 65,098 0.31 2.35
25th percentile 396,250 765,225 134,314 0.34 2.76
Median 865,000 1,655,423 186,540 0.51 4.08
75th percentile 1,644,220 2,398,389 399,118 0.71 6.19
90 percentile 2,395,134 4,996,377 660,908 0.95 9.36
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www.wm-cpa.comMarket Approach – ExampleGTM (cont’d)
2. Application of Variable to Subject Company
MVIC / Revenue Analysis:
Normalized Revenue 25,194,329$
Selected MVIC / Revenue Multiple 0.51 Median
Indicated Value of Invested Capital 12,723,136
MVIC / EBITDA Analysis:
Normalized EBITDA 672,978$
Selected MVIC / EBITDA Multiple 4.08 Median
Indicated Value of Invested Capital 2,745,750
Selected Metrics: Value Weight
MVIC / Revenue 12,723,136 0% 0
MVIC / EBITDA 2,745,750 100% 2,745,750
Value of business before adjustments 2,745,750
3. Adjustments to Value
Cash and trade receivables of Subject Company** 2,831,210
Less: interest bearing debt** (2,081,948)
Non-operating assets 143,329
Value 3,638,341$
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www.wm-cpa.comMarket Approach – ExampleGuideline Public Company Method
ABC Company, Inc.
Guideline Public Company Method
Public Co #1 Public Co #2 Public Co #3 Public Co #4 Public Co #5 Mean Median
Subject
Company
Revenue 144,875,000 1,731,244,000 97,790,000 1,319,757,000 466,064,000 97,790,000 466,064,000 751,946,000 466,064,000 7,228,694
Total Assets 79,959,000 1,602,475,000 125,315,000 2,915,984,000 690,581,000 125,315,000 690,581,000 1,082,862,800 690,581,000 2,601,686
Liquidity Ratios
Current Ratio 2.33 2.46 1.10 0.85 0.86 0.86 1.10 1.52 1.10 1.95
Quick Ratio 2.33 2.31 1.08 0.85 0.82 2.33 1.08 1.48 1.08 1.57
Profitability Ratios
Gross Margin (%) 44.30% 30.07% 21.08% 43.21% 31.88% 31.88% 21.08% 34.11% 31.88% 11.79%
EBIT/Sales (%) 7.37% 10.66% 6.43% 2.01% 3.86% 3.86% 6.43% 6.07% 6.43% 1.00%
Net Income/Sales (%) 2.94% 7.54% 2.67% 10.24% 8.25% 8.25% 2.67% 6.33% 7.54% 4.74%
Leverage
Assets/Equity 1.78 2.05 1.62 2.13 7.35 1.62 7.35 2.99 2.05 1.96
Total Liab/Total Assets (%) 43.89% 51.27% 37.35% 52.81% 86.39% 37.35% 86.39% 54.34% 51.27% 48.86%
Price per share 15.97 55.44 1.37 33.62 5.80
Outstanding Shares 4,240,000 52,940,000 55,170,000 113,030,000 26,890,000
Market Value of Equity 67,712,800 2,934,993,600 75,582,900 3,800,068,600 155,962,000
LT Debt 767,000 270,846,000 6,637,000 909,978 461,418,000
Cash 14,230,000 302,210,000 136,000 9,873,000 1,893,000
Net Debt (Cash) (13,463,000) (31,364,000) 6,501,000 (8,963,022) 459,525,000
MVIC 54,249,800 2,903,629,600 82,083,900 3,791,105,578 615,487,000
MVIC/EBIT 5.08 15.74 13.06 14.27 34.21
Range 5.08 34.21
Mean* 14.36
Median* 14.27
Selected Multiple** 14.27
Company EBIT 500,000
Multiple 14.27
Value without Debt 7,136,602
Less: Debt 1,271,295
Value of business 5,865,307
Range
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Market Approach - Challenges
Challenges with closely-held companies:
▪ True comparables are difficult to identify
▪ Owner misconceptions re comparability
▪ Need to identify somewhat comparable companies/transactions considering:
– Size
– Industry
– Geography (local business vs international player)
– High-tech / Innovative
– Stage of development (very difficult to find data on early-stage companies)
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Valuation Approaches: Asset (Cost)
Approach
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Asset (Cost) Approach
▪ Value = Value of Assets – Value of Liabilities
- Based on the premise that the economic value of a business can be associated with the productive assets of a business
▪ Not used often:
1) might fail to account for the income potential of a business (“big picture”)
2) The resulting value is cost to re-create the business today
▪ Asset Approach can be used as a ‘reality check’ (i.e. if value of assets is more than value of future earnings, something is wrong)
▪ This approach can be used in valuing holding companies, capital-intensive firms or cases of liquidation
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Asset (Cost) Approach
•Adjusted Net Assets Method
•Liquidation Value Method
•Book Value Method
•Excess Earnings Method – Asset/Income Hybrid Approach
Common Asset Approach Methods
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www.wm-cpa.comAsset Approach - ExampleAdjusted Net Asset Method
ABC Company, Inc.
Adjusted Net Assets Method
Unadjusted Adjusted Value Unadjusted Adjusted Value
2017 Adjustments 2017 2017 Adjustments 2017
Current Assets Current Liabilities
Cash & Cash Equivalents 1,070,805$ 4] (600,000)$ 470,805$ N/P - Bank 695,305$ -$ 695,305$
Accounts Receivable 2,360,405 - 2,360,405 Current Portion of Long-Term Debt 490,350 - 490,350
Inventory 2,149,034 1] (125,000) 2,024,034 Accounts Payable 675,664 - 675,664
Prepaid and Other Current Assets 421,573 - 421,573 Accrued Expenses 540,908 - 540,908
Total Current Assets 6,001,817 (725,000) 5,276,817 Total Current Liabilities 2,402,227 - 2,402,227
Fixed Assets Long Term Liabilities
Total Fixed Assets 5,176,290 2] (3,676,290) 1,500,000 Long-Term Debt 896,293 - 896,293
Less: Accumulated Depreciation 4,668,618 2] (4,668,618) - Other Liabilities 353,000 - 353,000
Total Fixed Assets - Net 507,672 992,328 1,500,000 Total Long Term Liabilities 1,249,293 - 1,249,293
Other Assets 143,329 3] (143,329) - Shareholders Equity
Common Stock 2,000 - 2,000
Total 6,652,818$ 123,999$ 6,776,817$ Additional Paid-In Capital 111,049 - 111,049
Retained Earnings 5,883,442 5,883,442
Treasury Stock (2,987,187) 5] 123,999 (2,863,188)
1] Adjust inventory to the inventory value using FIFO. Total Equity 3,009,304 123,999 3,133,303
2] Adjust fixed assets to fair market value.
3] Remove non-operation assets Total 6,660,824$ 123,999$ 6,784,823$
4] Remove excess cash.
5] Reconciling adjustment. Net Operating Assets 3,133,303
(+) Non-Operating Assets:
Cash 600,000
Other Assets 143,329
Adjusted Net Tangible Assets 3,876,632$
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Asset Approach - Challenges
Challenges (for all types of companies):
▪ Framework is considered conceptually weakest of 3 approaches
▪ Results may not reflect true market value
▪ Intangible assets – would need to be valued using another approach
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Challenges Involving Closely-Held
Companies: Valuation Discounts
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Adjustments to Valuation
Two Notable Adjustments to Valuation
▪ Marketability (Discount for Lack of Marketability or “DLOM”)
▪ Control (Discount for Lack of Control (“DLOC”) and Control Premium)
Source: AICPA Introduction to Business Valuation, Chapter 10: PREMIUMS AND DISCOUNTS (VALUATION ADJUSTMENTS), pg. 9
Less
Val
ue
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Discount for Lack of Marketability
Attempts to equalize an interest in a closely-held stock with an interest in a publicly traded-stock
Interest in a closely-held business is illiquid due to lack of ready market of buyers
Discounts can range from 10% - 35%. Factors driving discount size include:
• Historical and expected dividend payments
• Expected investment holding period
• Subject company risk
Due to the time, costs and effort to sell
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www.wm-cpa.comDiscount for Lack of Marketability:
Empirical Evidence
▪ In contrast to minority discounts, a larger body of empirical evidence exists for marketability discounts
▪ Empirical methods employed to quantify the discount:
1. Discounts on the sale of restricted shares of public companies
2. Discounts on the sale of closely held company shares, pre-IPO compared to post-IPO prices
3. Option pricing theory
4. Tax Court Cases
▪ What are restricted securities?
▪ Stock issued prior to an IPO
▪ Stock issued in private placements by the issuer
▪ Securities acquired privately from affiliates
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www.wm-cpa.comDiscount for Lack of Marketability:
Empirical Evidence
• Robert W. Baird & Company Studies (1981-2000)
• Used prospectus data
• Most recent private transaction within 5 months of IPO
• Willamette Management Associates Studies (1975-2002)
• Used SEC registration statements primarily on Form S-1 & S-18
• All private transactions within 3 years of IPO
• Compared Price to Earnings Multiples at IPO vs. private transactions
• Valuation Advisors Studies
• Studies using the Valuation Advisors’ Discount for Lack of Marketability Database breaking down the number of transactions by timing of private transaction vs. IPO.
Notable Studies on Private Transactions Prior to IPOs
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Discount for Lack of Marketability
▪ Additional Factors Influencing Marketability
– IRS Job Aid (2009) – 33 factors
1 The cost of similar corporation’s public and private stock 18 Percent of shares held by institutions
2 Distribution ability and history 19 Percent of independent directors
3 Dividend yield 20 Listing on a major exchange
4 Attractiveness of subject business 21 Active vs. passive investors
5 Attractiveness of subject industry 22 Registration costs
6 Prospects for a sale or public offering of the subject company 23 Availability of hedging opportunities
7 Number of identifiable buyers 24 Market capitalization rank
8 Attributes of controlling shareholder 25 Business risk
9 Availability of access to information or reliability of that information 26 Restrictive transfer provisions
10 Management 27 Length of the restriction period
11 Earnings levels 28 Length of expected holding period
12 Revenue levels 29 Offering size as a percentage of total shares outstanding
13 Book to market value ratios 30 Registered vs. unregistered
14 Information requirements 31 General economic conditions
15 Ownership concentration effects 32 Prevailing stock market conditions
16 Financial condition 33 Volatility of stock
17 Percent of shares held by insiders
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Discount for Lack of Control
• Unable to Control Operations / Salaries
• Unable to Approve Distributions
• Unable to Purchase/Sell Assets
Accounts for lack of control when valuing an interest < 50% ownership
• Empirical evidence to quantify minority discount is less available than for marketability discount
• For very small companies, discount may be greater, as some investors see little value in a non-controlling interest in a small company
Discounts typically range from 10% to 25%
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www.wm-cpa.comDiscount for Lack of Control:
Empirical Evidence Issue
Control Premium
▪While no source of empirical evidence exists for closely-held DLOC, there are alternatives.
▪DLOC can be implied using control premiums paid in public buyouts or
▪ Limited Partnership Transactions– Traded in a secondary market by a small number of brokerage
houses tracked by Direct Investments Spectrum
▪DLOC is derived from Control Premium:
DLOC = 1 – (1/(1 + Control Premium))
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www.wm-cpa.comDiscount for Lack of Control:
Spectrum of Control
• Blocking power
• Swing votes
• Takeover or “coattail” protection
• Cumulative voting rights
• State dissolution statutes
Minority interests can retain some elements of control which may reduce the discount for lack of control
The range for minority discounts reflects a spectrum of control exists amongst ownership interests
Other factors may limit the control of the majority interest, resulting in a smaller discount
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www.wm-cpa.comDiscount for Lack of Control:
Spectrum of Control
• Potential Dilution
• Cumulative Voting Rights
• Contractual Restrictions
• Financial Condition of the Business
• Presence of Significant Regulation
• Buy Sell & Other Shareholder Agreements
• Fiduciary Duties
• Private Company with Public Securities
Other factors influencing the spectrum of control
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Not Additive
Discount Calculation Example
Cash Flow 401,000$
Capitalization Rate 22%
Value (before Discounts) 1,822,727
Less: Minority Discount (15%) (273,409)
Subtotal 1,549,318
Less: Marketability Discount (25%) (387,330)
Fair Market Enterprise Value 1,161,989$
* Note that discounts are not additive (total discount is ~36%, not 40%)
Multiplicative rather than additive – discounts are taken in sequence:
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Additional Challenges Involving
Closely-Held Companies
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Tax Cuts and Jobs Act (TCJA)
▪ Reduction in tax rates (C Corp = 21%) (The 21% C Corp rate does not sunset)
▪ Repeal of Corporate Alternative Minimum Tax
▪ QBI Deduction (20% of QTBI; 50% of wages)
– Specified Service Trade or Business (SSTB) (Health, Law, Accounting, Financial Services, Athletics, Consulting)
▪ Accelerated Depreciation (up to $1M on $2.5M limit)
▪ Interest Deduction (>$25M) limited to 30% of EBITDA (2018-2021) / EBIT (thereafter)
▪ Net Operating Losses (NOLs) (80% carryforward limit; no carryback available)
▪ Alimony / Divorce Settlement
▪ Estates: Lifetime Exemption increased (2019: $11.4M/individual; $22.8M/couple)
– Sunset to $5M/individual; $10M couple at end of 2025
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TCJA Impact on Valuation
▪ Consideration: Could tax laws change due to change of political control?
▪ Overall, are companies more valuable under new law?– Look at the 2017 stock market– + in value: historically high tax rates; heavy investment in
capital equip– - in value: historically low tax rates; highly leveraged
▪ Tax Rates (lower for C Corp and PTE’s)▪ Increased cash flows?
– What will owners do with increase? Wages? Capital Expenditures? R&D?
– Look at DCF. How accurate?
▪ Reasonable Comp (changes due to QBI deduction?)
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TCJA Impact on Valuation
▪ Cost of Debt? Greater due to deductibility limits for highly leveraged company– How will this impact private equity firms use of debt?
▪ NOL deduction limitation▪ Guideline Transactions
– How will lower tax rates impact M&A activity?
▪ Alimony▪ Estate Planning: To Gift or Not to Gift?
– Gift minority interests? – No Clawback. That’s good
▪ IRC Section 2704 (valuation discounts), no longer an issue
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Planning Opportunities for Clients
▪ Update Buy-Sell Agreements
– Include valuation language
– Identify standard of value
– Identify discounts that apply
▪ Gifting Ownership Interests
▪ Succession Planning
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Goodwill
▪ Personal/Professional
– An individual’s goodwill, something he/she contributes to the company while employed
– This value travels with the individual, absent a contractual restriction
– Underlying Consideration: How much revenue and opportunity may disappear assuming the loss of a valuable individual or individuals in an ongoing entity
▪ Enterprise/Practice
– Asset of the business or practice
– Transfer of personal goodwill to an enterprise often achieved via noncompete agreements
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Key Person Discount
• Management & Leadership Skill
• Relationships with Customers, Employees & Suppliers
• Intellectual Property and Innovation
• Economic Resources and Ability to Obtain Financing
Key Person Defining Characteristics
“An amount or percentage deducted from the value of an ownership interest to reflect the reduction in value resulting from the actual of potential loss of a key person in a business enterprise.”3
[3] International Glossary of Business Valuation Terms
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Key Person Discount
• Income Approach
• Incorporate in discount rate under company specific risk
• Estimate effect of loss of key person on future cash flow projections
• Market Approach
• Adjust pricing multiples under guideline company method
• Cost Approach
• Apply the key person discount after determining total equity value for the company
Applying the Key Person Discount4
[4] Harter, Michael A. “Thought Leadership in Family Law Financial and Valuation Issues.” Willamette Management Associates: Insights, Spring 2017 Issue, www.willamette.com/insights.html.
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www.wm-cpa.comConstruction Company:
Valuation Issues
▪ Backlog
– A better indication of future earnings than current earnings
▪ Financial Capacity
– Strict financial covenants
▪ Industry
– Low bid (very competitive)
– Dependent on overall economy
▪ Litigation Risk
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How to Increase Business Value
▪ Focus on Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA)
– Represents the operating efficiency of a business without effect of financing
▪ Minimize Risk
– Diversify customers and vendors
▪ Prepare for the future
– Prepare forecasts and a clear road map
– Recruit strong management team and shift duties from owner
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Reliability of Information
▪ In any business valuation, financial data should be reviewed to assure the quality and reliability of information
▪ Methods to detect earnings manipulation and other anomalies:
– Review year-over-year changes in:
▪ Sales, margins etc.
▪ Financial Ratios
▪ Inventory
– Analyze revenue recognition and cash conversion cycle
▪ Channel Stuffing
▪ Bill & Hold Sales
▪ Fictitious Sales
– Compare to Industry Peers whenever possible
▪ Higher Revenue growth than peers
▪ Analyze Margins
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Considerations for a Defensible Valuation
Avoid Common Errors:
▪ Failure to conform to the appropriate standard and premise of value
▪ Failure to visit business or interview key management personnel
▪ Leaps of faith in assumptions
▪ Inadequate comparative market data
▪ Value conclusion inconsistent with relative performance vs. peers/industry
▪ Advocacy vs. Objective Expert
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Considerations for a Defensible Valuation
Questions to ask prior to finalizing your valuation report:
▪ Are you able to reconcile the results of the various approaches (income, market, asset)?
– If they produce materially different results, need to explain why
▪ Are all major assumptions adequately explained and supported?
– Be prepared to explain areas that rely heavily on “professional judgment” due to lack of evidence
– Can the assumptions be supported in multiple ways?
▪ Does the analyst understand sensitivity of key assumptions and inputs?
– Most sensitive variables typically involve growth, profitability, & risk
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Considerations for a Defensible Valuation
Is the end value “reasonable” when considering all facts and circumstances?
Be prepared to discuss all treatises and resource materials relied upon
Be prepared to discuss previous publications, testimony, etc.
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Questions or Comments
Jon Klerowski, CPA, ABV, CFE
Partner, Floyd Advisory LLC
(617) 586-1076
John F. Maloney, CPA, CFF, CVA, ABAR
Partner, Wouch, Maloney & Co, LLP