M&A Glossary: Confidential Information Memorandum

A Confidential Information Memorandum (CIM) is a summary of your business used to help pre-screened buyers determine their interest. A CIM contains overview information about your operations, financials, industry trends, and growth prospects.

As your investment bank, we’ll prepare the CIM for you, with your cooperation and review. You approve all material before it’s presented to a buyer. The CIM is only distributed to a select group of vetted, qualified buyers who have signed a nondisclosure agreement.

It is a critical component of the M&A process as it shares your growth story and helps potential buyers see the value in your business.

For advice on exit planning or selling a business, contact Al Statz, CEO of Exit Strategies Group, Inc., at alstatz@exitstrategiesgroup.comExit Strategies Group is a partner in the Cornerstone International Alliance.

M&A Glossary: SDE vs. Normalized EBITDA

M&A Glossary: SDE vs. Normalized EBITDA 

Seller discretionary earnings (SDE) and normalized EBITDA are two common measures used to assess the profitability of a business. While they are both used to determine a business’s value, they differ in the expenses and adjustments made in their calculations.

Seller discretionary earnings (SDE) is a measure of the business’s cash flow that includes the owner’s compensation and benefits, as well as perks and discretionary expenses that are not directly related business operations. Normalized EBITDA, on the other hand, is a measure of the business’s earnings before interest, taxes, depreciation, and amortization, adjusted for unusual or non-recurring items.

The main difference between SDE and normalized EBITDA is in the adjustments made for owner compensation and benefits. This means that SDE provides a more comprehensive view of the cash flow available to the owner, while normalized EBITDA provides a clearer view of the business’s underlying profitability.

SDE is commonly used in Main Street and small business transactions, while buyers in the lower middle market will be looking at normalized EBITDA.

For advice on exit planning or selling a business, contact Al Statz, CEO of Exit Strategies Group, Inc., at alstatz@exitstrategiesgroup.comExit Strategies Group is a partner in the Cornerstone International Alliance.

A Difference of Opinions: Closely-Held vs. Venture-Backed Companies- Part 1 of 2

In my transition from valuing venture-backed technology startups to valuing closely-held businesses with between $2 million to $50 million in revenue when I joined Exit Strategies Group four years ago, I noticed major differences in diligence, tools and approaches used in forming these opinions of value. This blog will focus on the differences in Diligence and Tools.

But before I dig into those differences, let’s define these two types of businesses:

  • Venture-Backed Companies – These companies are usually startups based on an incredible idea that hopes to disrupt existing industries and markets. Some of the Companies I valued in their infancy include Tesla, Okta, Fanatics, and Uninterrupted. Some of these valuations were done before a Subject Company generated its first dollar of revenue and all were flying below the radar at the time of valuation.
  • Closely-Held Companies – These companies include the companies that surround you every day from the local community market to the construction firm building homes in new developments to your local, downtown taproom. For me, they also include a growing number of owner-operated and family-owned craft beverage companies like wineries, craft breweries, distilleries, and cideries.

Now, let’s dig into the differences in how these two types of businesses are valued.

Exit Strategies Group prides itself on the platform and tools that it offers its appraisers and advisors for valuing companies for compliance, strategic, and M&A assessment purposes. In addition to our robust valuation model, we have a “Playbook” that is both a training and reference document that encompasses how we go about valuing and selling businesses. For this blog posting, I will only focus on the first two of these differences, diligence, and tools. Below is a “heat” matrix of how the differences I see in both:


Appraisers have to follow strict diligence guidelines to comply with AICPA, USPAP, and other business valuation standards. Below is a “heat” matrix of the differences in diligence when valuing a family business versus a venture-backed startup.

The four major differences in Diligence are:

  • Access – When valuing venture-backed companies, the appraiser is usually dealing with senior financial management during diligence. Rarely does a founder take on this role for a business. For owner-operated businesses, the conversations before engagement and through to a final report almost always include the founder or owner as the “key person” in charge of the business.
  • Financial History – Venture-backed companies, by definition, lack any financial or operational history so it is almost impossible to analyze any trends over time. Owner-operated businesses usually have long histories that allow for this analysis.
  • Financial Forecast – What a startup lacks in historical financial history they make up for with long-term forecasts that look at the growth of their target market, their share of that market, and ultimate profitability over time. Owner-operators rarely provide long-term forecasts and bemoan the lack of visibility in trying to plan more than a budget year ahead.
  • Normalization – From the beginning, venture-backed companies are meant to be run in a corporate manner where senior managers (and founders) focus on their fiduciary responsibilities to shareholders. However, at times, there is an abuse of the policy of funds spent on “non-operating” or personal expenses. However, owner-operated companies are beholden to no one or have control of the business that allows them to run a business without a requirement for “market pricing” of everything from salaries and expenses. Therefore, it is almost always necessary to review the detail of an owner-operator’s financial statements to adjust for non-operating expenses, assets and liabilities, and above- or below-market salaries for themselves, and family members. The key question to ask in normalization is ”will a willing buyer need this expense or asset to run the business?”


Similar to a carpenter who builds custom furniture compared to a construction worker building houses, valuation experts valuing these two types of businesses use different tools. The matrix below looks at some of these tools in greater detail.

Here are the biggest differences:

  • Deal Databases – When valuing venture-backed companies, the appraiser ignores the comparison of the Subject Company with transactions completed in the industry in which it competes. The main reason is that a startup usually lacks specific comparables due to its business model and stage of development; they are at the beginning of its corporate life cycle while these transactions are “tombstones” for companies at the end of theirs. Owner-operated companies mirror the stage of development of these transactions. Therefore, this data is always used when valuing an owner-operated company.
  • Publicly Traded Security Information – I have found that the approach to valuing venture-backed companies always relies on publicly traded market values and a guideline public company approach in valuing the business either at the Valuation Date or in the determination of a terminal value associated with a discounted cash flow (DCF). The simple assumption here is that if a venture-backed company is successful in its business plan and generating income, it will likely be publicly traded or compared to publicly traded companies at the end of a long-term (5-year) cash flow. Small, owner-operated businesses almost always lack that likely outcome. Therefore, while I always used this approach to value venture-backed businesses, I never use it to value small, privately-held companies. The size and characteristics of publicly traded companies are simply not comparable to owner operated businesses.
  • Market Salary Adjustments – Unlike a venture-backed corporation that defaults to market salaries in its hiring process (even for its founders), owner-operated businesses see a wide range of the treatment of salaries in these businesses. I would say that I’ve seen an equal number of owners pay themselves above-market salaries as ones who pay themselves at below-market rates. Some don’t pay themselves at all. In this case, and as detailed above, we need to adjust for this policy to properly burden the Subject Company with market salaries to normalize the income statement for a willing buyer for them to properly value it. This assumption is at the heart of how we define fair market value.

In the coming weeks, we will look at the third of these differences, approach. It’s an important and detailed discussion that needs a separate blog post.

Exit Strategies values control and minority ownership interests of private businesses for tax, financial reporting, and strategic purposes. If you’d like help in this regard or have any related questions, you can reach  Joe Orlando, ASA at 503-925-5510 or jorlando@exitstrategiesgroup.com.

Highlight Your Company’s Intangible Assets When Selling

Intangible assets represent most of the value in almost all of the companies we sell, so it only makes sense that showcasing the intangible assets that make your company unique and successful can significantly impact your final transaction value. Here are some practical tips to help you leverage your intangible assets in a sale process.

Intangible assets are non-physical assets such as contracts, customer lists, proprietary software, databases, designs, recipes, proprietary business processes, well protected trade secrets, works of authorship, key employees, strategic relationships, audit reports, credentials, licenses, and brand recognition. Intellectual property (“IP”), such as patents, trademarks, and copyrights, are all intangible assets. These assets generally produce value for a company, but don’t appear on its balance sheet.

Three steps to inventory your intangible assets:

  1. Conduct an internal audit of your business operations to identify all intangible assets owned by or used in the business and gather appropriate supporting documentation for each asset.
  2. Prepare a detailed description of each item including the nature, scope and history of the asset, how it is used, its original cost, past and future economic benefits, ownership, licenses and any legal restrictions, useful life, potential threats, etc. Include references to supporting documentation.
  3. Group assets into appropriate asset classes (by type and business function) and save the supporting documents in a well-organized virtual data room.

Engaging the services of legal, financial, and valuation experts can help bring to light intangible assets that may not be immediately obvious. An attorney can verify ownership rights and ensure that your assets are properly protected and legally transferable.

When taking a business to market, M&A advisors prepare a marketing document known as a Confidential Information Memorandum or CIM. The CIM will highlight your company’s intangible assets and suggest how buyers can utilize them to create new revenue streams, increase profits, or mitigate potential risks. Of course, buyers will do their own due diligence on your assets, and lots more, before closing the deal, so all assertions in the CIM must be reasonable. Overhyping a company can be a quick turnoff for buyers.

The M&A advisor or investment banker also uses your intangible asset documentation to help them identify potential acquirers that stand the most to gain from obtaining access to those assets.

Intangible assets can exist and not have value to their current owner. When a target business is profitable and growing, it usually isn’t necessary to place values on individual intangible assets for sale purposes. If a business is a pre-revenue startup or marginally profitable, or if certain intangible assets aren’t being used productively in the business, it may be helpful to have an expert determine the economic value of individual assets.

Even owners with long expected hold periods can benefit from identifying and monitoring their company’s intangible assets by using this information in strategic planning and investment decision making. The asset inventory and supporting documents should be reviewed and updated periodically by the executive team as part of its planning process.

In conclusion, having a full inventory of a company’s intangible assets is an advantage when marketing and negotiating the sale of a business. Take the time to identify and document your intangible assets to ensure that you receive the best possible reward for your life’s work.

Continue the Conversation

Al Statz is president and founder of Exit Strategies Group, Inc. For further information on leveraging your intangible assets in a business sale or to discuss a potential M&A need, confidentially, contact Al at 707-781-8580 or alstatz@exitstrategiesgroup.com.

Business Valuation 101 for Testing Laboratories

Testing laboratories operating in the agriculture, food production, environmental, manufacturing and construction industries provide essential and recurring services to their customers. As such they can be attractive to investors looking for steady growth, recession-resistant acquisition opportunities. If you own a testing laboratory and are thinking about an exit, you’ll likely want to know its value. Business valuation can help lab owners to plan for their future and to understand how to improve their company’s financial health.

Valuation is the process of analyzing value drivers such as market conditions, business model, customer base, competitive landscape, and financial performance. In this article, we discuss the basics of business valuation and explore some key drivers for testing laboratories that can help you to understand the value of your laboratory business.

Different Valuation Approaches

There are three fundamental approaches to determine value: Asset, Income and Market. Most valuations triangulate the analysis results using each approach.

  1. Asset – based on the fair market value (adjusted from book value) of a company’s underlying assets and liabilities and the identification of intangible assets.

  2. Income – based on present value of the expected future benefit stream (cash flow) adjusted for risk.

  3. Market – based on a principle of substitution where value is based on a multiple of an operating metric (earnings) derived from the publicly available value of companies with similar characteristics.

The fundamentals that drive value in testing laboratories are the same as for any small business, strong cash flow, consistent growth and known and controllable risks. Cash flow is measured by EBITDA, which is net operational income less interest expense, state and federal taxes, depreciation and amortization. EBITDA can be used to analyze and compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions. The more consistently profitable a business is, the more valuable it will be. A well-executed valuation does not just consider historical performance but will analyze future growth prospects and risks for the business.

Value Drivers for Testing Laboratories

Within the testing industry, we’ve identified some drivers that commonly result in strong business performance and enhance value:

  • Provide in-demand services: Demand for testing is typically driven by third party government agencies, vendors or customers requiring verifiable evidence of reliability, safety or regulatory compliance. It is important to keep testing procedures relevant to changing demands and compliant with regulations. Laboratories that understand the sources of industry demand and position their services accordingly will be more valuable.
  • Recommendation/accreditation from authoritative source: Quality and consistency of service is vital to testing laboratories. Obtaining laboratory and quality systems accreditation like ISO will help to improve service delivery and demonstrate to the marketplace that the laboratory can provide a high level of service.
  • Contracts: Maintaining long-term vendor and customer relationships creates a more stable business and a pedestal to plan for the future. One approach to encourage these relationships is to establish vendor contracts that provide consistent pricing and terms and customer contracts that provide recurring revenue. Businesses with these contracts in place are more valuable.
  • Access to highly skilled workforce: Companies need to employ highly qualified and highly skilled scientists and support staff who are knowledgeable not just in test protocols, but how test results are utilized by the industries that they are servicing. Businesses with a committed and capable management team are better positioned to perform after a business owner exits.
  • Prompt, consistent delivery to market: The ability to deliver results in a timely manner is important due to the results-oriented nature of this industry. To remain competitive, laboratories need to be located close to clients for quick delivery of test results and utilize processes, equipment and technology that produces efficient and accurate test results.

Exit Strategies Group helps business owners to value and exit their testing laboratories. If you’d like to have a confidential, no commitment discussion on your exit plans or have related questions, please contact Adam Wiskind, Senior M&A Advisor at (707) 781-8744 or awiskind@exitstrategiesgroup.com.

Spring Break 2022

We all remember the question; what did you do on your spring break? Whether it was the title of a paper you needed to write for 11th grade English class or the topic of discussion at the pub in late April of your senior year of college, it’s a great question whose answer can be as boring as it is exciting. So what did I do on my spring break this year? I’ll tell you…

Delayed Service

In the summer of 2019, my son, entering his sophomore year of high school, asked if I would be interested in chaperoning a service trip to Panama for Courts for Kids. With the mission of “transforming lives through building courts and cultural exchange”, Courts for Kids is a not-for-profit that pairs service-oriented high school students, families, and adults with needy communities all over the world. These communities need to go through a rigorous application process to secure a court. Like Los Pilares, these rural villages commit their entire population to the process and construction from housing visitors, securing materials and equipment, and helping with the construction. Most of the costs are covered by fees charged to the volunteers that they can raise through donations and fundraisers. The total cost (including flights and all other expenses) per participant for my trip was $2,375 for each of us, half of which we raised through donations from family and friends, and a 50’s themed dinner and silent auction that 6 students organized at our favorite diner in downtown Camas, WA. By January of 2020, we were ready to go. I worked with a local business to get t-shirts made for the trip that the students could mark up and sell for another fundraiser. Fortunately, we didn’t put the date of the trip on the t-shirt. With a departure date in late March, we found ourselves gripped by the news about some pesky virus raging across the globe. Once the WHO labeled it a pandemic, we were on hold. Maybe we could go? Maybe it would be delayed a week or so? We all know how wrong that optimistic approach was.


After a lockdown, a few open windows to travel (that shut as quickly as they opened), and subsequent COVID variants that eliminated any opportunity to make the trip in the spring of 2020 or 2021, plans were cemented (pun intended) and we boarded a plane in Portland, OR on our way to Panama City through Houston on April 1st. For those of you who got my out-of-office response, I was off the grid for 10 days. The opportunity to travel with your child for 10 days without electronics was a gift in itself. Paper made a reappearance in his life; playing cards at the airport, reading books on the plane, and writing in his journal. As a chaperone, I was able to have my phone but as the map shows you, we were about 4 hours west of Panama City and out of range of most cell coverage. After a full day of travel, a night in a youth hostel, and a long bus ride sitting next to chatty teenage girls the next day, we were greeted with the warmest welcome from the Los Pilares community (see the picture above and the t-shirts we made for the trip).

My son, now a junior in high school, was now at an age where kids shy away from parental participation in anything. And as a connoisseur of dad jokes, I got more than a few eye rolls from the group of 20 high school students. Still, as you can tell from the photos, we had a great and meaningful trip.

The pictures below tell the story. We bunked in a classroom at the schoolhouse in the town center. The nets were definitely required. The food was rich in starches (rice, yuca, plantains, corn) and paired with locally grown coffee and bottled water. Meat and fish are luxuries for the community but they were generously included in our menu. The community bought a pig and used every bit of it to feed our group of volunteers and members of the construction and planning team. We ate local fruit (papaya, banana, and nance fruit) and feasted on classic Panamanian dishes such as Arroz Con Pollo (or rice with chicken being made in one of the pictures below). We learned how to make tamales and Bollo De Maiz (a boiled cornmeal dumpling) after learning how to grind corn into masa. On our first night there, we were graced with a traditional dance performed by two local children in native dress.


Oh, and we built a sports court with the help of incredible individual effort matched with superior teamwork.

BEFORE                                                                                                                 AFTER


So What Did I Learn?

I like to consider myself a “student of business” and look to learn about economic situations and business models wherever I go. I’m that guy in the Progressive Commercial (the one in the visor at 0.12 of the video). So here are my takeaways from an incredible trip.

  1. It rains in Panama in April. A lot.
  2. “Farm to table” isn’t a tagline on a restaurant menu but the default way of life here.
  3. Most families in Los Pilares live on about $10 a week.
  4. Panama uses the US Dollar as currencies but prices are so reasonable that you use coins much more than you do in the US.
  5. A rural community has its own self-contained ecosystem where everyone knows and embraces their role.
  6. That ecosystem is built on generations of families that seek a simple life and are reluctant to travel or live in the bustle of a big city
  7. Life’s riches lie in the love of family, community, tradition, and faith, not money.
  8. I will remember the people I met in Panama as some of the richest, nicest, and most authentic people I’ve ever met.


Exit Strategies values control and minority ownership interests of private businesses for tax, financial reporting, and strategic purposes. If you’d like help in this regard or have any related questions, you can reach  Joe Orlando, ASA at 503-925-5510 or jorlando@exitstrategiesgroup.com.



Six Benefits of Monitoring Company Value

Even if your business is not for sale, monitoring its market value can be incredibly helpful. This article describes six ways that understanding value over the life of a closely held business benefits shareholders, directors and managers.

1. Value Report Card

Like financial statements, an annual independent business valuation is a type of report card on company health. CEO’s can use this report card to educate, align and focus executive teams on maximizing enterprise value. Owners and boards of directors can use it to hold management accountable for value creation.

2. Equity Transaction Enabler

Having a business appraised periodically enables equity transactions. I am talking about buy-sell transactions between shareholders, redeeming stock of retiring owners, and buy-ins by managers, key employees, family, or investors, to name a few.  Most experienced business attorneys will tell you that not agreeing on valuation is the #1 impediment to successfully completing these transactions.  An independent business valuation is usually the fastest route to an agreement on value.

3. Shareholder Agreement Test

A business valuation can be used to test the composition of your shareholder buy-sell agreement from a valuation perspective. In our experience, there are as many faulty buy-sell agreements out there as there are good ones. By faulty I mean that the valuation terms are incorrect or ambiguous, or produce unfair share values, which ultimately leads to surprises, divisiveness, and disputes among shareholders. Also, all buy-sell agreements, regardless of how well-written, lose relevance over time and should be tested periodically. A valuation expert can identify potential problems and recommend solutions.

4. Versatile Planning Tool

A comprehensive valuation report can provide a solid foundation for strategic planning and a roadmap to increasing value. Shareholders can use periodic valuations for their own retirement planning, estate planning, buying life insurance, and maintaining appropriate liquidity for future buyouts. Without an accurate valuation, these planning activities involve a lot more guesswork.

5. Executive Education

The very act of going through a valuation process is educational for owners and leadership teams. They will see what information goes into the valuation and learn what factors are driving or detracting from business value. Experiencing the valuation process also prepares them for what will happen if the buy-sell agreement is triggered or if the company becomes involved in an acquisition.

6. Compliance

You may be aware that ESOP companies are required by law to obtain an annual independent valuation of their shares.  Companies that have stock option plans are required to have regular valuations for IRC 409A and financial reporting purposes. Companies that have executive teams whose compensation is tied to company value through the use of stock appreciation rights or phantom stock plans need valuations as well.

Getting This One Done!

An experienced business appraiser can usually recommend the appropriate scope of analysis and reporting for your intended use and circumstances after a brief phone call with you. In many cases, a full scope business valuation (appraisal) is necessary or strongly recommended. In other cases, a limited scope calculation of value may be sufficient. At issue are accuracy, the knowledge of intended users, credibility, compliance requirements and cost.

Working with the same valuation analyst (appraiser) over time has additional benefits.  Your team gets to know and trust the valuation expert. The expert’s knowledge of the company and its industry grows, and they become better able to offer insights into improving business operations, financial results, enterprise value, sale readiness and marketability. Also, valuation updates are generally faster, less expensive and more consistent.

Al Statz is the founder and president of Exit Strategies Group. For further information on this topic or to discuss a potential business sale, merger or acquisition, confidentially, Al can be reached at 707-781-8580 or alstatz@exitstrategiesgroup.com.

The Importance of Valuation in Business Sales

With decades of expert valuation and real-world business transaction experience, Exit Strategies routinely values companies and positions them for successful sales. At a minimum, buyers should be willing to pay the fair market value of a business.

The initial and perhaps most important step in selling a business is a thorough, objective, and accurate business valuation. Too many sellers and brokers shortcut the valuation phase, not understanding that it is an essential step to accurately predicting selling price and cash proceeds. Both overvaluing and undervaluing a business leads to bad decisions and produces poor results.

The business valuation process involves gathering relevant facts, properly normalizing financial statements, identifying intangible assets, analyzing business value drivers and risks, and developing credible financial projections — all from an investor perspective. And of course, it involves correctly applying accepted valuation methods, without bias.

Many industry rules of thumb are available to estimate value, however, they are often outdated and ambiguous, and are frequently misapplied. Experienced intermediaries know that rules of thumb should not be relied on as a valuation method and are just one of many data points. It takes extra time and expertise to produce a credible and reliable valuation result, which is why many business brokers don’t do it.

There are three main valuation approaches and multiple accepted methods for valuing businesses within each of these approaches. The methods that our team of M&A advisors and valuation analysts use and ultimately rely upon will always depend on the facts and circumstances of each target business.

Once fair market value is understood, Exit Strategies knows what it takes to leverage the synergistic benefits of target strategic buyers to derive a premium price from the market.

Exit Strategies Group (ESG) is a California-based provider of strategic merger and acquisition advice and execution, and business valuation services. Founded in 2002, with offices in San Francisco and Portland, ESG represents private companies on the sell-side and works with private equity, public and private companies and family offices on the buy-side. For more information visit www.exitstrategiesgroup.com

Tracking your Business Perks

Perks is an abbreviation of perquisite, which means a benefit, incidental payment, or advantage over and above regular income, salary, or wages.

Business owners take any number of perks from their business, from the standards like auto expenses, memberships, and insurance plans to extras like entertainment, vacations, or an additional family member on the books.

Perks are a way for owners to be further compensated for their hard work. However, they can complicate valuing a business. When you go to sell your business, make sure you do one of two things: 1) reduce perks to drop money to the bottom line, or 2) maintain an excellent paper trail so you can clearly delineate which expenses are needed for operations and which are done for you as a tax write off.

Be aware that doing a job for “cash” – or perks that can’t be tracked and proven – can diminish the value of your business. When preparing your business for sale, your advisors will “normalize” your financials to account for these extras. When perks are adequately documented, we can usually get the majority of that value accepted.

While valuing a business is not a straight calculation, buyers will use SDE (seller’s discretionary earnings) or normalized EBITDA (earnings before interest, taxes, depreciation, and amortization) as a tool when arriving at their offer.

For example, a small Main Street business with an SDE of $200,000 USD will typically sell at a 2.0 multiple: $200,000 x 2.0 = $400,000 in value. A lower middle market business with EBITDA of $1.2 million might sell at a 5.0 multiple, or $6 million.

These are very general guidelines that can be influenced by any number of business factors or market conditions, but it helps to show the importance of driving cash to the bottom line in the last couple of years before you sell. Your discretionary cash is multiplied in a sale, so talk to your advisors about the tax benefits / value tradeoff of certain perks.

Think about how perks impact your total compensation and retirement needs, too. For example, if you’re pulling $200,000 as salary, you might think you can comfortably live off that amount in retirement income. But under closer examination, your perks may actually provide an income closer to $275,000. It’s important to know how much you’re truly taking out of the business.

Consider family perks as well. For example, maybe your child works for the company as part-time social media support but receives a salary equivalent to a full-time marketing manager. Adjustments will need to be made there, too.

Perks are a common way for owners to pull additional value from their business. However, when it’s time to sell, your advisors need to be able to account for these perks in detail.

For advice on exit planning or selling a business, contact Al Statz, CEO of Exit Strategies Group, Inc., at alstatz@exitstrategiesgroup.comExit Strategies Group is a partner in the Cornerstone International Alliance.

Understanding Discount Rates – Parts 1 through 5

The Risk Free Rate – Part 1 of 5

One of the most important inputs surrounding the valuation of the business is the discount rate that is used in the analysis. This discount rate is the expected rate of return on the subject interest which in most cases is the equity in the value of an operating business. Most often in our practice, this equity is attached to a private business that is owner operated. Over the next few weeks, I will dig into the five key inputs that go into a discount rate.

Discount Rate Theory

The rate of return used to discount projected future income to present value must be a reasonable estimate of the return needed to attract the capital of a willing buyer in the marketplace given the level of risk inherent Company. The determination of this rate puts the appraiser in the role of surrogate analyst for a hypothetical, informed, typically motivated, arms-length financial buyer. The appropriate discount rate should be the expected rate of return available on alternative investment opportunities with comparable risk.
In determining the cost of equity, we use the build-up method which starts with a risk-free rate and adds risk components appropriate to the Company to arrive at a total discount rate. Risk premiums cover the incremental risk of equity investments in large-company stocks (vs. debt), the difference in risk between large and small public companies, and the risk of the specific investment (subject company) vs. the market overall. A highlight of how we build up both the cost of equity and the weighted cost of capital is pictured below. As noted, the highlighted input below refers to the risk free rate and the starting point of our build-up approach.

Basic Definitions

Before we dig in to comparisons let us define some common terms that we will use in our discussion [1];

  1.  Risk-Free Rate of Return – The theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time.
  2. Treasury Yield – The return on investment, expressed as a percentage, on the U.S. government’s debt obligations. Looked at another way, the Treasury yield is the effective interest rate that the U.S. government pays to borrow money for different lengths of time.
  3. Mortgage Rate – The rate of interest charged on a mortgage. Mortgage rates are determined by the lender and can be either fixed, staying the same for the term of the mortgage, or variable, fluctuating with a benchmark interest rate.
  4. Correlation – Variables are correlated if the change in one is followed by a change in the other. Positive correlation describes the relationship between two variables which change together, while an inverse correlation describes the relationship between two variables which change in opposing directions. Inverse correlation is sometimes known as a negative correlation, which describes the same type of relationship between variables.
  5. Spread – The difference between two interest rates. For example, in the highlighted box on the chart below, there has been an uptick in the 10-year treasury yield but little to no change or a continued decline on the other rates. The difference between the black chart and the others at any particular date is the spread between those two rates.

As you can see from the graph below, there is a positive correlation between the three daily rates with almost mirror like lines showing the yields of the 15-year fixed rate mortgage, 30-year fixed rate mortgage and the US 10-year treasury yield rates over the last 21 years.

[1] Definitions care of www.nvestopedia.com

What Does This All Mean?

In the 2020 Berkshire Hathaway Annual Shareholders Meeting in early May 2020, in the midst of a global pandemic, Warren Buffett was asked if there is a risk that the US government would default on its debt, he answered “no”.[2] “If you print bonds in your own currency, what happens to the currency will be the question,” said Buffett. “But you don’t default. The U.S. has been smart to issue its debt in its own currency.” [3]So if there is a concern of default, the US government has the option to simply print more of its own currency to pay back the debt. This mitigation of this default risk is the main reason why the yield on a US treasury note or bond is considered “risk-free” or with zero risk.

So how does the above chart deal with risk-free rate? Simple. The line at the bottom of the graph is what we use as the risk-free rate and the starting point of our build-up approach above. In synch with the definitions above, we have assumed that the rate of US government’s debt obligations have zero risk and our build up approach to the discount rate is a function of adding risk to this “risk-free” rate.

In coming weeks we will deal with the other key inputs of our build-up approach.

Exit Strategies values control and minority ownership interests of private businesses for tax, financial reporting, strategic purposes. If you’d like help in this regard or have any related questions, you can reach Joe Orlando, ASA at 503-925-5510 or jorlando@exitstrategiesgroup.com.

The Equity Risk Premium – Part 2 of 5

Our prior post and educational discussion of the discount rate as “one of the most important inputs surrounding the valuation of the business” introduced the first input of the build-up approach, the risk-free rate. The second key input is the equity risk premium. In our reports, we define this input as “The ERP represents the extra yields demanded and earned (and risk assumed) over time by equity investments in large public companies over U.S. Treasuries. This premium is sometimes referred to as the market risk premium. It is a measure of systematic risk of equity securities.”

Build-Up Approach – Equity Risk Premium (“ERP”)

Again, in determining the cost of equity, we use the build-up method which starts with a risk-free rate and adds risk components appropriate to the Company to arrive at a total discount rate. A highlight of how we build up both the cost of equity and the weighted cost of capital is pictured below. As noted, the highlighted;

Basic Definitions

As shown we are using an ERP of 5.90% which is calculated as follows; “using the S&P 500 average annual return of 11.81% derived from CRSP data for the 1928 – 2020 period and a 5.91% 20-year T-Bond average annual return for the same timeframe.” Said another way, the ERP is difference between a long-term rate of return of a portfolio of equity securities (SP = S&P 500 over the last 72 tears) and a similar long-term risk free rate (RFR = T-Bond average annual return). [4]

ERP = SP – RFR = 11.81% – 5.91% = 5.90%

Investopedia sums up this concept with the following key take-aways;

1)     The equity-risk premium predicts how much a stock will outperform risk-free investments over the long term.
2)     Calculating the risk premium can be done by taking the estimated expected returns on stocks and subtracting them from the estimated expected return on risk-free bonds.
3)     Estimating future stock returns is difficult, but can be done through an earnings-based or dividend-based approach.[5]

Below is a graphical depiction of the S&P 500 Index from 1928 through 2021 that includes dividends and supports the 11.81% return.[6]

What Does This All Mean?

The discount rate is a simple build-up of risk. When valuing the equity of a privately held company, the starting point for this calculation is always a risk-free rate which represents a risk free debt security with little to no risk of default. Because the scope of work is the value of equity of a private equity security, we need to build up this rate with the risk associated with equity.

Stay tuned for Part 3 of 5, the Size Premium where the difference in risk between and small companies.

Exit Strategies values control and minority ownership interests of private businesses for tax, financial reporting, strategic purposes. If you’d like help in this regard or have any related questions, you can reach Joe Orlando, ASA at 503-925-5510 or jorlando@exitstrategiesgroup.com.

Understanding Discount Rates
The Size Premium – Part 3 of 5

So far, in our educational discussion of the discount rate as “one of the most important inputs surrounding the valuation of the business”, we introduced the first two inputs of the build-up approach. Added together, these two inputs equal the expected market return of equity. However, because the equity risk premium looks at the overall market returns, our build up approach needs to now focus on the Company we are valuing. The last two inputs to the cost of equity focus on the size of the Company and its “specific” risks that are not accounted for in the other four inputs

Again, a highlight of how we build up both the cost of equity and the weighted cost of capital is pictured below. As noted, the highlight deals with the size premium;

Build-Up Approach – Size Premium

The size premium is based on the simple premise that “size matters” when it comes to market returns but not the way you think. While this theory may seem simple, its proof is based on the analysis of stock returns from as far back as 1928. More complex theories, including those of Nobel Prize winning professors from the University of Chicago’s Booth School of Business suggest that the smaller a Company’s market capitalization (or share price times number of shares outstanding), the higher the stock’s compound average growth rate (“CAGR”) over time.[7] A graphical depiction of these returns are below where decile 10 represents the smallest and decile 1, the largest market caps.

[7] https://seekingalpha.com/article/1921171-examining-the-size-premium

The detail above show the mean annual return for each decile between 1928 and 2020 and are represented both with and without an adjustment for each decile’s beta (or its volatility of stock prices compared to the overall market = 1.00). Because we mostly work with Companies below $189.8 million in market capitalization, our standard default size premium is Decile 10 or 5.47%.

Another way to understand why smaller companies generate greater returns than bigger companies is the fact that the return is an increase by percentage rather than real dollar value. For example, a $200 million company that grows 10% grows its value by $20 million. If a $2.0 billion where to grow its value by $20 million, its return would only be 1.0%. Both companies grew the same amount (call it the numerator in this simple ratio below) but the denominator (the size of each company) is different.

What Does This All Mean?

The discount rate is a simple build-up of risk and size differences are the easiest to understand. It makes no sense to compare Microsoft to a small cloud-based software company unless you adjust for this size. Consider the additional risk added to the discount rate for a small software company as the additional return an investor would need to receive for investing in a riskier, early stage stock.

Stay tuned for Part 4 of 5, the Company Specific Risk Premium where we adjust returns for the specific characteristics of the Company we are valuing.

Exit Strategies values control and minority ownership interests of private businesses for tax, financial reporting, strategic purposes. If you’d like help in this regard or have any related questions, you can reach  Joe Orlando, ASA at 503-925-5510 or jorlando@exitstrategiesgroup.com.

Understanding Discount Rates The Company Specific Risk Premium – Part 4 of 5

Up until now, our discussion of the discount rate as “one of the most important inputs surrounding the valuation of the business” has focused on overall market data that arrives at the basis of risk associated with the cost of equity for a privately held company. We’ve begun with a risk-free rate and added risk for equity and size. Now, we need to look at the subject company to determine if we should add any additional risk for factors not accounted for in the first three inputs. For example, does the business have a strong management team? Is risk impacted by the industry in which it competes? Is there risk in the supply chain in securing the products needed to produce the company’s products? All of this risk is accounted for in the Company-Specific Risk Premium (or CSRP).

Again, a highlight of how we build up both the cost of equity and the weighted cost of capital is pictured below. As noted, the highlight deals with our discussion of the CSRP which is built out below and to the right of this summary;

Build-Up Approach – Company-Specific Risk Premium
As noted above and highlighted in the matrix that identifies and quantifies this risk, all of these factors relate to the business, how it competes as well in the environment in which the company and its industry compete. To dig into the list above, let’s assume that the subject company is a small chain of liquor stores located in a mid-sized but growing metropolitan area; Sonoma County, CA where Exit Strategies is headquartered.

Below is an enlarged copy of the matrix outlined above. As you can see, it is a list of risk categories that are not related to the overall market (type of security and size) but instead associated with the company’s business model, how it navigates the unique challenges of executing on it, and how it competes with other in its industry. A discussion of the specific rationale for adding (and subtracting) risk to the subject business; a liquor store in Sonoma County.

Fair Market Value is defined as “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.” In determining this value using an income approach and discount rate, the above list is what a valuation expert would expect a willing buyer to see as an incremental risk to buying the business.

However, a willing buyer (or even a willing seller two years before selling the business) can look at this list as a “to-do” to increase value by “de-risking” the business associated with these specific risks.

What Does This All Mean?

All other key inputs (cash flows and long-term growth) de-risking the business for these company-specific risks will increase the value of the business. Less risk correlates to higher values. However, there may be a tradeoff in de-risking and value with an increased cost structure (insurance, technology tools, increased staff). In this case, the real challenge for management is leveraging these incremental costs by increasing revenue and profits.

Stay tuned for our last installment where we look at the cost of debt and how the ability to secure debt over equity lowers your discount rate and has a positive impact on value.

Understanding Discount Rates

The Cost of Debt and the Debt to Capital Ratio – Part 5 of 5

The first four parts of this five-part blog have dealt solely with the components of the buildup approach and the determination of a cost of equity. However, when determining a discount rate, it is important not to forget the ability to access debt. Each of the preceding parts of this discussion focuses on the cost of equity. This last part introduces the cost of debt and the debt to equity ratio in determining the weighted cost of capital (or “WACC”).

Build-Up Approach – Cost of Debt

In short, invested capital is equal to a Company’s capitalization or the total value of equity and debt. In our simple example above in determining the discount rate as the WACC, we are assuming debt is equal to bank debt only. While this assumption simplifies the determination of a discount rate, it also represents what would be needed in bank debt to settle the outstanding debt and obligations highlighted in the definition above.

The cost of debt is the interest rate (or the cost of borrowing debt) a Company pays on its debts. Similar to the build-up of the cost of equity, we start with a base rate of interest for a risk-free investment. While the cost of equity highlights this base rate as the cost of a US Treasury Note or Bond, the base cost of debt is identified by the prime lending rate (or “Prime Rate”). “The Prime Rate is the interest rate that commercial banks charge their most creditworthy corporate clients.”[8]

Similar to borrowing money to buy a house, the rate at which an individual or Company can borrow money depends on the collateral or the value of the asset used to secure a loan. Therefore, the rate at which a Company borrows money is based on the value of the assets that a bank can access if the Company defaults on the loan. How banks determine this collateral is a topic for another post. But banks are very similar to investors. The greater the risk, the greater return they require. As noted above, the “lever” to account for the risk is the premium a Company pays above the base Prime Rate. In our case, we have assumed a 2.0% (or 200 basis points where 100 basis points = 1%) as an example. Companies with more tangible assets should be able to get a lower rate. Companies with less tangible assets (think a start-up software company) will likely need to pay a greater premium. Of note, once this rate is determined, it is appropriate to use the after-tax cost of debt because a Company can utilize interest as an operating expense that lowers its tax liability.

Calculating WACC

So now that we have identified the approach to determining the cost of equity and the cost of debt and concluded that a discount rate is equal to the weighted average cost of capital or WACC, we come to the end of our discussion with one last important input to finally determine the WACC. This input is equal to the assumed amount of debt we apply to the capital structure (where the amount of equity is equal to 100% – the % amount of debt). Again, with a mortgage for a house, a lender usually requires at least 20% equity so the debt (or mortgage amount) is equal to 80%. For a business, these weightings have two key drivers, and the decision on which one to use is based on the scope of the valuation or analysis.

The two key drivers for a valuation are the % of the debt of the subject Company or the % of the debt that a market participant (or an investor in the industry) would likely have the ability to borrow. For the valuation of minority ownership (say a single share or 1.0% of a Company), the valuation is of a minority ownership interest. Because a minority owner has no control over how the Company spends (or borrows) money, we use the Company’s current % of debt to capital. For the valuation of a controlling ownership interest (greater than 50%), we assume that the potential buyer has the control to negotiate a deal with a bank based (like a mortgage) on how much equity is required to contribute to investment.

Once this % is determined, the calculation of the discount rate is a simple weighting exercise outlined below;

What Does This All Mean?

The Cost of Debt and the amount of debt used in the calculation of WACC is both the last and for some companies the most important component of the discount rate. Debt helps mitigate overall risk by lowering the cost of an investment. It is a key component of corporate strategies that look to invest in projects with “cheap money” by leveraging their assets to grow their business. As such, it allows them to capture a more significant return on that investment.

[1] Definitions care of www.nvestopedia.com

[2] https://finance.yahoo.com/news/warren-buffett-explains-the-simple-reason-why-the-us-will-never-default-on-its-debt-185105213.html

[3] Ibid.

[4] https://www.bvresources.com/products/cost-of-capital-professional

[5] https://www.investopedia.com/investing/calculating-equity-risk-premium/

[6] https://www.macrotrends.net/2324/sp-500-historical-chart-data

[7] https://seekingalpha.com/article/1921171-examining-the-size-premium

[8] https://www.investopedia.com/terms/p/primerate.asp

Exit Strategies values control and minority ownership interests of private businesses for tax, financial reporting, strategic purposes. If you’d like help in this regard or have any related questions, you can reach  Joe Orlando, ASA at 503-925-5510 or jorlando@exitstrategiesgroup.com.