Will appear on BV pages – RECENT VALUATION ARTICLES

Secure Your Final Exit

A significant concern for the seller of a business who retains a minority position after a sale, is how to sell the remaining shares if things do not work out as expected. This type of sale is commonly referred to as a majority recapitalization.

There are many ways things can go wrong. But since the seller no longer has control over the company, they face the challenge of how to facilitate a final exit.

Imagine that you are the sole owner of a company that you have managed for many years. You decide to sell your company and hire an M&A advisor. After several talks with potential investors, you agree to sell 70% of your company at a fair value to a strategic or financial investor. Since you are no longer in control, you no longer have the final say in strategic and financial decisions. Now assume that you start to strongly disagree with the new majority owner’s decisions regarding the direction of the business. How can you exit the business in an orderly and amicable manner?

The seller (now minority shareholder) and the new investors must plan for these potential outcomes and resolutions in the shareholder’s agreement, at the time that the initial sale is negotiated.

Here is where your M&A advisor and attorney’s experience comes into play. Standard clauses in stockholder’s agreement do not usually contain buy-sell provisions (i.e. a buy-sell agreement) which are intended to ensure a fair and equitable share transfer without a lot of drama, disagreement or delay. Buy-sell provisions are complex and multi-faceted. Two important aspects are to define appropriate trigger events and methods of determining a share price when triggered. The pricing mechanism can be an independent business valuation, a formula, or a fixed-price.

We strongly advocate for buy-sell agreements that rely on an independent valuation for share pricing to overcome the many pitfalls of other pricing approaches. The valuation expert can perform this work on behalf of the buyer and/or seller. Buy-sell agreements can require one, two, or even three valuation experts to determine a final price.

We also strongly advise owners to hire an experienced M&A advisor and transaction attorney to guide them through the entire sale process and advise on the numerous complex issues and decisions that arise during the course of a transaction.


Exit Strategies values control and minority ownership interests in private businesses for buy-sell, tax, financial reporting, strategic purposes. If you’d like help in this regard or have any questions, you can reach Victor Vazquez, ASA, MRICS at victor@exitstrategiesgroup.com.

Can I retire if I sell my business?

Not every business owner wants to retire, but most do, someday. And in my experience as an M&A advisor, when an owner is ready, they want to move quickly. However, for business owners who have most of their net worth tied up in an enterprise that they personally manage, retirement planning is more complicated.

If you are a business owner, obtaining answers to two simple but powerful questions will bring clarity to your retirement plans.

Question 1: What is the asset value I need to retire?

This question isn’t unique to business owners, but since your business is your most valuable asset, understanding your total net worth is more complicated.

Find out how much your business is worth by having a business valuation expert or M&A advisor do a reasonable amount of analysis on the company to determine the most probable selling price range. It helps to select a valuator who also sells businesses and is not just a theoretician.

You’ll need a CPA or tax attorney to help you understand the taxes on a sale of the business and develop strategies to minimize or defer taxes. Experienced M&A and financial advisors can often introduce tax minimization strategies, but you need a licensed professional to dial this in.

Then you should sit down with a financial advisor to run the numbers on your retirement assets and your desired lifestyle, and estate and philanthropy goals. Investment returns depend on the type of assets you hold and expect to hold in retirement. Income sources may include installment payments, Social Security, deferred compensation payouts, pensions, dividends, annuities, and rental income. Is the income sufficient or will you need to liquidate holdings in retirement? There’s a lot to consider and having the right financial advisor(s) is extremely helpful.

When there is a gap between the current value of your retirement assets and the value you need, owners often look to the business to fill that gap by increasing sales and net margins, and driving out business risk. A seasoned valuator can point to opportunities to improve the value and marketability of the business, and make it more attractive to target acquirors. They can help you understand market conditions, and when the time is right, they can represent you in the sale process and help you obtain the best deal available in the marketplace.

Do this sooner than you think. Best is 5 years before your target retirement date. The sooner you start to plan, the more knowledgeable you become about your situation, your exit options, and the financial and operating metrics that you must achieve to launch the sale process. If you find you have a valuation gap, it can take time to close. Also, you never know what market conditions are going to be, or what investment returns will be in retirement, so best to have a comfortable asset value safety margin.

Question 2: How well will the business perform without me?

Business valuation, whether performed by an independent expert or a potential acquirer, is a function of expected future cash flows and risk. The lower the risk the higher the value. Changing management introduces risk for the next owner. Whenever an owner’s efforts drive business performance, the future of that business without that owner is riskier.

For some business owners the question of how the business will perform without them is an easy to answer. They’ve worked themselves out of a management or key contributor role and the business can reasonably be expected to perform just fine without them. However, most small and medium sized businesses are significantly dependent on the talents, experience and/or relationships of the owner(s).

The way to overcome this is to grow the business, build a strong management team, groom your successor, and have an org chart that makes good sense to prospective buyers. Absent that, it helps to be willing to stay on for a period after the sale (typically 1 to 3 years), at a normalized salary, until you replace yourself. The first option is usually far better from a valuation perspective.

When choosing a valuator, find one with general management experience and years of M&A dealmaking experience to receive an objective assessment of your management organization and get actionable advice in this area. Remember, the goal is to sell and retire, not just sell and keep working!

You may have to revisit these two questions multiple times before initiating a sale process. And your business valuator, if you find the right one, should become a trusted advisor for you as you go forward.

These are just two of many questions to answer when assessing the value, marketability and sale readiness of a business and deciding if market conditions are right for a successful sale. See Exit Strategies Group’s blog for hundreds of articles on exit planning for business owners.


Al Statz is CEO and founder of Exit Strategies Group, Inc., a lower middle market business valuation and M&A advisory firm with offices in California and Portland OR. For further information or to discuss your retirement goals and circumstances with an M&A advisor and valuation expert, privately and confidentially, contact Al at 707-781-8580 or alstatz@exitstrategiesgroup.com.

How three private equity firms valued the same company

As part of our annual State of the Market M&A conference, held virtually this winter, we invited three private equity (PE) firms to review and submit an offer on a hypothetical company. They revealed their offers at the conference, and we held a panel discussion on why they valued the company the way they did.

We keep the invited PE firms confidential. They don’t know who else will be submitting “offers,” so there’s no collusion or comparing notes ahead of time.

Because they’re doing this as a public exercise, there’s a built-in disincentive to bid too low or too high. Value the business too low, and they’ll scare off future acquisition targets. Go too high, and future targets will demand a similar multiple. It’s a great educational experience to see “what is market” and to dig into deal trends, value drivers, and detractors.

This year, we based the deal on a real company that actually sold in 2018, fudging enough details to hide the company’s true identity. We provided a full memorandum and financial info and set parameters so everyone is reviewing the same info and providing the same detail in their Letter of Intent.

In the end, the winning bid came in about 10-20% higher than the company actually sold for. The lowest bids came in around 80% of value.

Why could one PE firm bid higher? As it turns out, they had previous experience in the space. The acquisition target did big capital product sales. In other words, large, mostly one-time sales without much recurring revenue. What this PE firm saw, though, was an opportunity to build new sales through parts, maintenance, and add-on systems.

They’d done something similar before and believed they could do it again. The target had a 100+ year history in the market and had some international sales, and they saw a great foundation to grow on.

Why did the other PE firms bid lower? They didn’t have experience with a similar operation. The nature of one-time sales turned them off. And though the target acquisition had made some international sales, they were to a country that has experienced political disruption—making the foreign market angle less attractive to these buyers.

Lessons learned:

Buyers have money to spend. These three PE firms alone have $500 million in dry powder or equity they need to put to work. With dry capital plus their current investments, they have a combined capital base of $1 billion.

That’s just three firms, and there’s an estimated 4,000 of them in the U.S. A lot of people are putting money into private equity right now because they’re generating stronger returns than traditional investments.

Management team matters. These firms said the quality of a company’s management team was typically their top consideration when evaluating a target. They want to see strong, proven management teams who will stay to guide the company after a sale.

Exit strong. Their second big requirement is to see a company on an upward, or at least stable, trend. They don’t want to see sales and profits dropping or yo-yoing with no rhyme or reason. They put the most weight on the trailing 12 months of performance, meaning an owner’s last year in business can be the most important year in their lifecycle.

Diversify. Another key value driver was customer and supplier concentration. These PE firms said they’re okay as long as the top customer is around 25% or less of sales. Once the top customer starts getting to be 30% or more, they’ll either walk away because the deal has too much risk or they’ll restructure the offer to include earnouts and other performance-based payments.

Second exit is a team decision. PE firms invest in businesses with the intent to sell. Some firms have “patient capital” and can wait 7 to 15 years for that exit. Others manage investments in 5-to-7-year windows. But the firms we spoke to said timing that sale is often driven more by company management than the PE firm itself.

They depend on their management teams to tell them when they think the timing is right, and that becomes a group discussion. It’s generally not a top-down mandate, and that’s an encouraging thing for the remaining shareholders to hear.

Overall, the message was that the number of good quality deals on the market has declined, and PE firms have money they need to spend. That’s a supply and demand equation in the business owner’s favor. Businesses relatively unaffected (or those positively affected) by COVID-19 are going to get some good, hard looks and are likely to pull in strong multiples right now.

Al Statz is President and founder of Exit Strategies Group, a leading California-based M&A advisory firm with decades of experience selling manufacturing, distribution and service companies in the lower middle market. For further information, or to discuss a potential sale or acquisition, confidentially, contact Al Statz at 707-781-8580.

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 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.

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.[1] A graphical depiction of these returns are below where decile 10 represents the smallest and decile 1, the largest market caps.

[1] 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.

How a Discount for Lack of Marketability (DLOM) is Determined

In a prior chapter of my professional career, I focused on equity security valuations for tax and financial reporting purposes. I led a team of valuation experts who determined the strike price of options granted to employees of up-and-coming technology companies on their way to IPO. For most, that strike price represents the basis (or cost) of an employee’s future wealth (and tax bill). In simple terms, the valuation of these shares in private companies is based on market multiples (or their value divided by a specific operating metric like sales or earnings) of comparable public companies. Once the value is allocated to common shares, the per-share price is a marketable value because it is based on the stock prices of marketable securities (the publicly traded companies we used to compare). Because private company shares are not as marketable (liquid) as public company shares, we need to adjust for this relative lack of marketability. But how?

Enter the Black-Scholes Model

One answer lies in the economic studies of the early 1970s. In 1973, Fisher Black, Myron Scholes, and Robert Merton published “The Pricing of Options and Corporate Liabilities” in the Journal of Political Economy introducing a simple model with five key inputs. While the formula truly has some high-level calculus, I will try to simplify the output and how it is used.

Here are some definitions you will need to understand before we start:

  • Current Price – The current per-share value of the stock.
  • Dividend Yield – The annual return to an investor in the form of dividends as a % of the stock price.
  • Strike Price – The predetermined price.
  • Maturity – The amount of time in years until the option expires.
  • Risk-free Rate – The rate of a return for a risk-free investment, in this case, a US Government debt instrument at the same maturity term as the put option
  • Volatility – The rate at which a security increases or decreases over time.
  • Call Option – The option or right to buy (or call) a security at a predetermined price by a predetermined date.
  • Put Option – The option or right to sell (or put) a security at a predetermined price by a predetermined date.

How a Put Option Works

Before I dive into how a Discount for Lack of Marketability (DLOM) is determined, I want to examine a real-life example of what marketability is worth. For my example, I’m only going to look at buying a put option. The purchase of a put option assumes that the buyer is a long-term holder looking to protect his/her position in security. I chose a put option because it can be easily compared to an insurance policy.

Facts:

  • Stock Owned: Jane owns 100 shares of Microsoft currently priced at $257.24 as of the close of the financial markets on June 10, 2021. This price very close to its 52 weeks high of $263.19 per share.
  • Goal: Jane wants to lock in the current price (or close to it) for the next year and is willing to pay for the security of knowing that she can lock in that price.
  • Publicly Traded Options: Jane can buy a put option for one year (or with an exercise price of $255.00 in June 2022) at $26.56.
  • Options Purchased: Jane purchases 100 put options for $2,656 to lock in the sale of her shares when the option expires in June 2022 for $25,500.

What this Means for Jane

Jane just bought an insurance policy that lets her get the $255.00 per share for her stock. The put option ensures the marketability of her shares but it came at a cost of 10.4% of the value of her shares (or $2,656 divided by $25,500). While she can’t exercise the option until it expires (the terms of a standard put option) she can sell the options if they increase in value before it expires.

That option will increase in value as the price of Microsoft drops because it is worth more to someone to sell shares at a higher price in the future. An example of this concept is the fact that the put option for the same June 2022 date but at a price of $245.00 is selling at $31.93. In simple terms, the price is driven by the supply (people willing to bet that when the option expires in a year the price of Microsoft will be much higher than it is today) and demand (investors like Jane that simply want the protection of believing that the price will be less in a year than it is today).

How this Relates to a DLOM in Valuing Private Company Shares

Let’s replace Jane with Jack and let’s assume that Jack’s investment is 100 shares in Software Widget, Inc., a private company with no publicly traded market for its shares.

Say Jack hires Exit Strategies to value his 100 shares. We value the shares based on market multiples of publicly traded (or “marketable”) companies comparable to Software Widget, Inc. and arrive at a price per share of $50.00 a share. But Jack’s shares aren’t marketable. He can’t call his broker to sell them and certainly can’t buy a put option to protect the value of his shares. Like Jane, he expects the shares to be marketable in a year but unlike Jane, he can’t buy a real insurance policy to lock in that price. Simply put he lacks marketability for the next year but what does this mean to the value we place on his shares?

The answer lies in the put option that we discussed above but instead of looking for the price of one on Google Finance, we need to go back to the formula Black and Scholes determined to build up and calculate a hypothetical one. Using the inputs below highlighted in gray, the hypothetical option asks a simple question; what would it cost to buy a hypothetical put option to lock in the price of a security at $1.00 for one year? In the case of the inputs below, the answer is $0.15 or 15.0% of the value of the security. Because it would cost $0.15 per share to lock in the price of $1.00 over a year, the lack of this marketability is the cost of not having this protection (or to Jane’s example, an insurance policy).

 

 

So back to Jack. His shares are worth $50.00 per share on a marketable basis but we need to value them on the non-marketable basis of a private company. Therefore, we apply a 15% discount to arrive at our concluded price of $42.50 as detailed below:

 

 

 

This is just one way to determine a DLOM

In determining discounts for lack of marketability, Exit Strategies also considers studies that map actual discounts of restricted stock. The uniqueness of the put option model approach above lies in the inputs and how the discounts change when one of the three key inputs (dividend yield, maturity, and volatility) changes. For example, if we change the term above to 5 years, the discount goes to 28%. That increase makes sense because an “insurance policy” to lock in a price would cost more for 5 years than it would for one.

If you have questions about discounts for lack of marketability or if you would like us to value your private business or equity interest for any purpose, email Joe Orlando at jorlando@exitstrategiesgroup.com.

Fair Market Value – what does it mean? Business Valuation Standards of Value Terminology

Fair Market Value is one of several standards of value terminology used in business valuations. The Fair Market Value (FMV) term is used by the IRS in estate and gift taxes, can be found in many buy-sell agreements, and is frequently the standard of value used in a business valuation report. Anyone who reads a business valuation report by an accredited professional will likely see the Standard of Value stated in the opening pages and in conjunction with the business value conclusion.

One of the most broadly accepted definition of Fair Market Value comes from IRS Revenue Ruling 59-60 which states Fair Market Value 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.

For gift and estate tax purposes, the same Fair Market Value definition can be found in the Internal Revenue Code Section 20.2031-1 and Section 25.2512-1 respectively.

…the price at which (such) property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.

When the term Fair Market Value is used in a buy-sell agreement, it should be noted that, the term FMV includes any discounts which may be applicable to the subject interest being valued, unless clearly stated otherwise in the agreement. For example, a less than 50% interest may be subject to discounts related to control and/or marketability. If the buy-sell agreement states Fair Market Value, the buy-sell agreement should also specifically state whether any discounts to value are intended.

In addition to Fair Market Value, other common Standard of Value terms are listed below.

Standard of ValueWhere defined:
Fair Market ValueIRS Revenue Ruling 59-60; Treasury Regulations
Fair Value (dissenting SH, minority oppression cases)Minority oppression statutes, CCC §2000.  Study case law to determine how interpreted.
Fair Value (financial reporting)FASB, SEC.
Investment ValueInternational Glossary of BV Terms.  When the buyer is known (not hypothetical).

For more information on business valuations or exit planning, Email Louis Cionci at LCionci@exitstrategiesgroup.com or call him at 707-781-8582.

Understanding Discount Rates 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 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.

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”. “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.” 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.

SBA Covers 3 Months of Payments on New Loans

As part of the Economic Aid Act that passed in December, the Small Business Administration will make borrowers’ payments for three months on new SBA 7(a) and 504 real estate and micro-loan programs.

These incentives were available last summer under a stimulus program that expired in September 2020. Now the program has been revived and enhanced.

The SBA will make the first three months of payments (principal and interest) on new loans approved between Feb. 1 and Sept. 30, 2021. To be clear, these payments will be covered, not deferred or pushed back to the end of the loan period. Payments are capped at $9,000 per borrower per month.

The Section 7(a) loan can be used to buy a business or used for working capital, equipment, or inventory. Qualified borrowers can access up to $5 million.

The SBA’s 504 microloan program can be used for assets that grow your business, including land, facilities, facility improvements, and long-term equipment investments. These loans have similar limits and requirements as the Section 7(a) loans.

Would-be borrowers will have to get approval through an SBA lender. But the good news here is that the new law has increased the federal guarantee for the loans from 75% under last year’s program to 90% this year for most loans. That lowers the risk for lenders and makes it easier for them to extend financing.

Borrowers with existing loans will receive an additional three months of payments and interest, starting February 2021. (These borrowers previously received automatic payment assistance from the SBA.) Plus, borrowers in the hardest-hit industries, such as restaurants, salons, entertainment, arts, and recreation, can receive an additional five months of payments.

The law appears to be written with the intent that the SBA will cover loan origination fees which are 2.5 to 3.5% of the loan amount. That’s something we hoped was coming last summer, but ultimately didn’t come to fruition.

On a loan of $5 million, SBA fees could be about $138,125 or more. That’s free money for buyers who move now and get their loan issued soon. While the program is set to end on September 30, 2021, it could be closed earlier if all funds have been exhausted.

While the law has been approved, the SBA and Treasury Department were still fleshing-out the final rules at the time of writing. The SBA maintains a list of authorized lenders on its website. We recommend reviewing a lender’s SBA loan closure rate to ensure you’re working with an experienced, responsive lender.

If you are acquiring a business, your M&A advisor or investment banker should be able to recommend active SBA lenders with a track record of success.

For advice on financing a business acquisition, contact Al Statz in Exit Strategies Group’s Sonoma County California office at 707-781-8580 or alstatz@exitstrategiesgroup.com.


Exit Strategies Group is a partner of Cornerstone International Alliance.