Will appear on BV pages – RECENT VALUATION ARTICLES

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.

Finally!

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.

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]

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

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.

We will present all five of these parts in their entirety so that you can understand every aspect of a discount rate.

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.

M&A Advisor Tip: Perks & business value

Business owners take a 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 preparing your business for sale, your advisors will “normalize” your financials to account for these extras.

Be aware of providing products or services for cash – or perks that can’t be adequately tracked and proven in your books – can diminish the value of your business. When planning to sell, talk to your advisor about the tax benefits / value tradeoff of certain perks and consider where it would be better to drive cash to the bottom line.


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.

Market Pulse Survey – Quarter 3, 2021

Presented by IBBA & M&A Source


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 Advisor Tip: Value = Risk vs. Reward

Buyers value your business based on risk (real or perceived) and future cash flow. Consider potential business risks. What could prevent your company from realizing your forecasted earnings? Think talent, customers, suppliers, competition, cash flow.

Strategize ways to reduce risk in each area, e.g. cross training, outsourcing, succession planning, customer diversification, backup suppliers, etc. The more you do to take away potential pain points, the more attractive your business will be.


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.

Valuing Personal Goodwill

What is personal goodwill?

Before starting our discussion about personal goodwill, it is necessary to establish a common ground to understand the concept. First, it is an identifiable intangible asset that will generate future economic benefits to the asset owner. While there is no standard definition. Adam Mason and David Wood searched various textbooks, articles, and leading court cases[1]that define this term. From that exercise, we chose to utilize the following definitions for our discussion;

“Personal goodwill is the value of earnings or cash flow directly attributable to the individual’s characteristics or attributes.”[2]

“Personal goodwill, sometimes referred to as professional goodwill, is a function of the earnings from repeat business that will patronize the individual as opposed to the business, new consumers who will seek out the individual, and new referrals that will be made to the individual”.[3]

Personal goodwill differs from the concept of corporate or enterprise goodwill. Corporate goodwill is the simple calculation of the excess price paid for a company above the value of its tangible and identifiable intangible assets (i.e. brand, customer relationships). In some instances, goodwill can be negative, but that is the topic of another blog.

What is so relevant about personal goodwill?

In summary, it is a tax issue. In the sale of a C Corporation, an owner can have significant tax benefits when a portion of the purchase price is related to personal goodwill instead of corporate goodwill. This identification of goodwill as personal will allow the owner to avoid getting taxed twice for the same value. Let me explain. Assuming that all the goodwill is associated with the company, the sale would likely generate a tax at a corporate level before the after-tax value is allocated to the owners of the company’s stock. Once the owner receives the net proceeds, they would be taxed again at a personal level. Identifying a certain percentage of the goodwill as personal allows the owner to split the tax bill between personal goodwill and corporate goodwill and pay taxes on each only once.

Which characteristics or elements must have personal goodwill?

As with any other intangible asset[4], personal goodwill must have the following characteristics. It can be separated individually from the entity. In other words, if the business owner leaves her or his company, that intangible asset goes with them. For example, the ability of the business owner to generate sales because of its personal relationships. The other element to be recognized as personal goodwill is that the business owner has contractual or legal rights over that intangible asset. In that respect, the owner of the personal goodwill must not transfer it through an employment or a non-compete agreement.

How to estimate the fair value of personal goodwill?

We have found that the most logical and defendable way in which we estimate the value of personal goodwill is the “With and Without Approach.” This methodology consists in estimating the present value of the entity’s future cash flows as it is; that is, the “With” scenario. This “Without” scenario has several key inputs such as the impact the owner has on the company’s future revenues, the cost at which the company must replace the owner, and the time it takes to ramp the business up to its original “With” forecast. The difference in the value of these scenarios is the fair value of personal goodwill. An appraiser needs to provide strong support for some of these “qualitative” inputs, specifically the top-line impact of the owner. That diligence starts with a simple question to the owner as to his or her impact on sales as a % of the total and drills down to the detail of the revenues and the sales responsibility of each customer. An owner may suggest that the business would lose 50% of the revenue if he or she left but an analysis of the sales relationships with each customer may only suggest that impact to be 25%. In defending the “Without” scenario to the IRS, the more defendable number is always the right choice. The owner may disagree but the extra layer of support helps mitigate future audit risk.

What is the real impact?

It is important to note that there must be a balanced relationship between personal goodwill to total goodwill. According to David Wood[5], personal goodwill should fall within 20%-to-40%. This range is supported by the tax court rulings and guides the appraiser in reconciling the analysis. While there may be a strong case for a higher percentage, it goes without saying that any conclusion above this range may trigger audit concerns unless the appraiser has presented strong support for an outlying opinion. Below is a simple analysis and calculation of the potential tax savings.


[1] Business Valuation Resources, LLC. Personal Goodwill: A Current Survey of Definitions. Adam Manson and David Wood CPA/ABV, CVA.
[2] Wood, David. (2007). Goodwill Attributes: Assessing Utility. The Value Examiner.
[3] Wood, David. (2007). “MUM’s the Word”TM: A formal Method to Allocate Blue Sky Value in Divorce. Business Valuation Update.
[4] Under ASC 805; asset recognition criteria.
[5] Business Valuation in Divorce. Case Law Compendium. Third Edition. Business Valuation Resources, LLC.

Exit Strategies Group, Inc (ESGI)

At ESGI, we are a team of seasoned appraisers to help you with your valuation needs, either to estimate the fair value of personal goodwill or any other. Our business valuations are commonly used in estate, gift, and other tax filings, dispute resolution, expert witness and litigation support, and mergers and acquisitions transactions.