Will appear on BV pages – RECENT VALUATION ARTICLES

Discover Exit Strategies’ New Checklist of COVID-Era Normalization Adjustments

/in , , /by Al Statz

For most of us, 2020 has been one of the most challenging years of our lives. The pandemic has affected business performance both negatively and positively, temporarily and structurally.  It will permanently reshape the global economy in several ways, most of which we are just beginning to understand.

Change and uncertainty makes the job of valuing and appraising businesses and business assets more challenging. At the core of every business valuation analysis is the process of normalizing or recasting the financial statements of the subject company from an historical accounting basis to a proforma economic basis.  If you get this wrong, the value conclusion will be wrong.

Exit Strategies recently developed a checklist of nonoperating and nonrecurring revenue, COGS, expense, assets and liabilities that should be considered for valuations performed during the COVID-19 era. Developed by our team of seasoned valuation analysts and M&A advisors, this checklist provides a framework for private investors, business owners, financial executives and other business valuation professionals to use.

COVID-19 Normalization Checklist

Download the COVID-Era Normalization Adjustments Checklist now.  And check back for updates. This checklist is a work in process as the effects of the pandemic on the economics and financial statements of businesses continue to unfold and evolve.

Best regards,

The Exit Strategies Team

Ten Key Drivers of Company Value

/in , /by Joe Orlando

In our current time of economic recession, social unrest and political partisanship, simple questions rarely have simple answers. For an owner operator of a small- to mid-size business, the question of business value in today’s market is increasingly difficult. It is at these times that the team here at Exit Strategies Group (ESGI) feels the need to simplify the process down to the basic premise of what drives value.

In explaining value, ESGI default to the simple metaphor of value a three-legged stool with key drivers that determine value; cash flow, growth, and risk. A simple but dynamic formula for determining value is the capitalization of a business’ normalized cash flows divided by the difference between the discount rate and a long-term growth rate;

V0 = 𝐶𝐹1/(𝑟−𝑔) where;

  • Benefit stream (𝐶𝐹) to the owners, normalized
  • Growth rate (𝑔) expected, long term
  • Risk (𝑟) involved in receiving the benefits in the amounts and time frames anticipated

This blog post looks at the key drivers that impact value as they relate to these three inputs.

What are the Key Drivers?

An example of what drives value for a hypothetical company is the best way that we can identify and explain these key drivers. Let us start with a company that makes widgets. Not the mythical product from your ECON 101 class in college but the widget’s that are made to infuse nitrogen into a beverage to make it creamy and frothy. Ball Corporation is a public company and one of the largest manufacturer of these widgets in the world. However, let us assume that a hypothetical stand-alone company WDGT Technology makes them instead. What drives the value of the business; more specifically the three key inputs to value outlined above?

For assessing value, ESGI has a master list of 26 key value drivers that dive into very specific detail. We have narrowed down this list to the top 10. These 10 drivers help a valuation expert understand the business model, operating history and growth story surrounding the business. This understanding provides the expert support for key assumptions that drive value using the formula above such as long-term growth rate, discount rate, gross and operating margins, balance sheet and incomes statement adjustments. They also help the expert narrow in on a universe of similar transactions that help narrow down comparable exit multiples that get applied to the company’s operating metrics.

The list below looks at these 10 key drivers, what is included in the analysis of each and our assessment of they impact the valuation of WDGT Technology.

Value DriverIncludes …Discussion of Company
1. ManagementExperience, Capabilities, Knowledge Base, Trustworthiness, Perceived Management Style, Effectiveness, Mindset Toward Challenges Risk and Opportunities, Growth Oriented, Overall Stability, Personalities, Owner Involvement, Key Person DependencyCompany is owner operated with strong upper and mid-level management teams.  Succession plan in place with son in key operations position.
2. Customer BaseType and Breakdown, Quantity, How Tied to Company, Buying Trends Over 3-5 years, Stability, Turnover, Number of New Customers, Large or Small, Vulnerable to Economic Fluctuations, Gross Margins For Diff. Profit Centers, Ability to Develop Customer Satisfaction and LoyaltyStrong customer base selling to beer industry but niche product hasn’t caught on with coffee and soft drinks. Number of customers is small with customer concentration (top 3 customers represent 67% of sales).
3. CompetitionHow to Deal With It, Competitive Advantages, Specific Niches Within Industry, Barriers to Entry From Local/National/Global Competitors, Offensive or Defensive Mechanisms in PlaceUnique and proprietary delivery system but others products that produce similar results (burst of nitrogen into beverage). Barriers to entry are high due based on relationships with aluminum can and bottle producers.
4. Financial PerformanceGrowing, Stagnant, Declining, Recurring Revenue, Clean Books or ‘Dirty’, Up to Date, Reliance on Controllers & CPA’s, Ability to Interpret Financial Statements, Partnership with Consultants, Operating Efficiencies, Internal SystemsStrong steady top- and bottom-line growth. Large customers help provide economies of scale to maximize margin on remaining business. Financial statements reviewed. Strong internal finance team. Above average gross and operating margins.
5. Sales, Marketing & DistributionClearly Defined strategy, Any Rainmakers, How Many, Efficient, Ability to Expand Any or All, Technology or Labor Intensive, Protected Areas, Distribution Rights, Supply Chain Partnerships, Synergistic productsStrong salesforce and high-touch customer service, especially with top 3 customers. Strong supply chain partnerships with aluminum and bottle manufacturers that provide a synergistic product (WDGT InsideTM).
6. Industry & Market ConditionsGeneral Tends Within Market or Industry, Market Position, Any Competitive Advantages, Foreseeable Future, General Economics, Industry Economics, Market Conditions, Ongoing Competition StrategiesCraft beverage market is booming at the expense of traditional brands. Competitive advantage is distribution relationships. Ongoing strategies include branding into other craft beverage categories and possible consolidation of the industry under the WDGT umbrella.
7. Asset QualityTANGIBLE: Amount of Deferred Maintenance, (Premise & FFE), Type and Age of Technology/IT, Premise Condition, Age of Inventory, Age and Quality of Rolling Stock  INTANGIBLE: Patents, Trademarks, Copyrights, Proprietary Processes, Community Reputation, Regulator History, Recognizable BrandsSignificant investment in tangible assets including a state-of-the-art production facility in the Midwest and satellite integration hubs at aluminum can and bottle sites. Several trademarked brands and patented product and process. Strong working capital position industry best days receivable and inventory turns.
8. Product / Service Diversity One Product or Multiple, Brand Recognition of Products, Risk Position of Major Product(s), Any Related Products That Could ‘Piggy-back’, General Level of Risk Associated With Product or Service, Investment in R&DIncreased risk in niche product instead of a portfolio of other products. Strong R&D investment to develop next generation product that is smaller, less expensive and easier to integrate into other craft beverages.
9. Growth PlanOffense or Defense in Place to Cope With New Economy and Industry Trends, New Products/Services, Adaptability, Patents, New Industry Knowledge & Concepts, Level of Intellectual PropertyOpportunities to grow business beyond WDGT with its New Product Division tied to R&D. Possible expansion of brand and products through acquisition.
10. Capital Strategy / Resources Ability to Generate Cash and Grow with Earnings, Established Lines of Credit, Solid Financing Strategies, Available for Growth, Satisfactory Levels of Debt, General Capital EfficiencyStrong balance sheet with excess lending capacity to allow company to fund acquisitions with cheap debt. Lower cost of capital helps mitigate acquisition and internal expansion risk.

The above discussion is just one of many steps in a valuation expert’s process for determining value. However, these 10 key inputs drive the appraiser’s due diligence and set the building blocks for the analysis and report that identifies, supports, and opines to value.

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

Gifting Window for 2020 May Be Closing

/in , , /by Joe Orlando

With a Global pandemic and prospects of a sustained recession with double digit unemployment coupled with West Coast wildfires and East Coast hurricanes, I would say that everyone in these United States is looking forward to ringing in the New Year on January 1st. But before the ball drops on a socially distanced crowd in Time Square, you should think about other changes that may occur as we put 2020 in our rear-view mirrors. Specifically the possibility of tax legislation if the party in power shifts in the Executive and Legislative branches of our government.

Proposed Changes

With no political bias intended, it makes sense for everyone to consider what changes to individual and corporate tax policy a Democratic president and a possible Democratic majority in the both chambers of Congress may enact. Bay Area business and real estate attorney Hubert Lenczowski, reminds us that “under a 1984 court case, Congress can enact retroactive tax legislation in an emergency”, thus limiting a individual or corporation the ability to act prior to the effective date.[1] In a Tax Planning Alert letter penned in late August, 2020, he notes that the following proposals have been identified by Vice President Joe Biden as his legislative agenda for tax policy:

  1. Extend the 12.4% social security tax on earnings over $400,000;
  2. Restore the 39.6% tax rate on ordinary income over $400,000;
  3. Cap the tax benefit of itemized deductions to 28% or less;
  4. Tax capital gains as ordinary income for those with income over $1,000,000;
  5. Eliminate the deferral of gain on like-kind exchanges of real estate;
  6. Apply estate taxes to estates exceeding $3,500,000;
  7. Apply gift taxes to transfers exceeding $1,000,000;
  8. Repeal the step-up on basis at death; and
  9. Increase the corporate tax rate to 28%.

Governor Newsom has already fired the first shot for California introducing AB1253 “which, if enacted, would increase the California income tax rate retroactive to January 1, 2020 by another 1% on income over $1,180,000; 3% on income over $2,363,000, and 3.5% on income over $5,900,000.”[2]

A “Use it or Lose it” Opportunity

Before any change to Federal and State tax legislation takes place, we believe that it is time to reconsider the following advantages currently available to those looking to gift ownership in businesses and assets before the clock strikes midnight on January 1st;

  • Lifetime Transfers – The current $11,580,000 exemption on lifetime transfers and bequests that allows married couples to make tax- free lifetime gifts up to double that amount, or $23,160,000. Even without a change in the current Republican government, current law stipulates that this exemption is temporary and will reduced to approximately $6,500,000 per person in 2026.[3]
  • Depressed Values – While the stock indices are at record levels, most operating businesses have been feeling incredible pain from COVID-19 shutdowns leading to record unemployment and negative GDP growth. The sunshine hiding behind these storm clouds is the opportunity to gift business ownership and other illiquid at significant haircuts to values seen only six months ago.
  • IRS Announcements – The “IRS has announced that transfers that take place during our current favorable transfer tax structure will not cause more estate or gift tax in future years as a result of the limits being reduced by tax legislation. In effect, right now we have a ‘use it or lose it’ opportunity to transfer a significant amount of assets under very favorable conditions.”

Tax strategies take time to develop and execute. It makes sense now to talk to your estate planning specialists to determine if these opportunities will work for you and your family. Putting in place a coordinated gifting plan now has the potential to save you and your estate millions of dollars in taxes and transfer more ownership to the next generation under the current temporary exemptions without any gift tax. While you are at it, it’s probably a good time to lock down your health care directive and power of attorney so that it mirrors your current wishes. Regardless of the above tax considerations that you can control, this pandemic has reminded us of risks beyond our control. It’s a tough conversation to have with family but it is one that they will see as a blessing when tough health and financial decisions need to be made.

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.

[1] www.lenczowskilaw.com

[2] Ibid.

[3] Ibid.

Winery Valuation 101

/in /by Joe Orlando

Joe OrlandoIt was either Churchill or Napoleon who said that “in victory you deserve champagne, in defeat you need it.” In a post-COVID world, consumers certainly haven’t admitted defeat but they’ve taken to wine to deal with the “next” normal. Case in point; wine sales (along with beer, hard seltzer and distilled spirits) are up…big. Whether you are a producer making an Estate Pinot Noir from grapes on your Russian River vineyard or a consumer searching for a reasonably priced bottle of Pinot Noir for Taco Tuesday, here are a few thoughts to ponder on what drives the value of a winery.

Different Valuation Approaches

In the world of business valuation, there are three fundamental approaches to determine value; Asset, Income and Market. While most of our valuations triangulate around the results of our analysis using each approach, some approaches map better to different types of wineries. Before we look at the differences, here is some background on each valuation approach;

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

Different Types of Wineries

These three approaches have multiple methods of calculation but that discussion is for another day. In this discussion we want to highlight some simple differences that lend themselves to each approach.

  • Asset Heavy Winery – An asset heavy winery owns significant assets in the form of vineyards, production and storage facilities, and equipment. It is commonly self-contained location that grows most, if not all, of the grapes used to make the wine. Production is usually on-site and they hold and age significant inventory in bottles and barrels in on-site storage facilities. If they are profitable, they hold significant value in assets not on the balance sheet in the form of brand, wine club list and AVA (American Viticultural Area or grape growing region) designation.
  • Asset Light Winery – Sometimes referred to as a négociant or virtual winery these businesses focus on brand with little to no production facilities. They leverage the assets of other wineries and dedicated production facilities (crush pads) to buy grapes, juice or unfinished wine to produce their own branded wines.

Valuation Decisions

Based on the simple review of a Company’s balance sheet, a winery will fall into one of the above two categories, each of which correlate to the use of one of the three valuation approaches.

Below is a matrix of how these approaches relate to each winery type:

Takeaways

This understanding of methodologies and winery types is a strong starting point for a discussion of value either over a glass of wine at a socially distanced dinner party or at the annual board meeting to answer the question; “so what are we worth?” Regardless of the venue, this “101” should make for a great conversation starter. If you are one of the two winery types and want us to help you answer the question of the value of your business, give us a call and let’s talk through your situation and possible next steps.

Exit Strategies values control and minority ownership interests of private businesses for tax, financial reporting, strategic purposes and has valued dozens of wineries over the past few years. 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.

Exit Strategies Adds Machinery & Equipment Appraisal Services

/in , /by Joe Orlando

Exit Strategies Group, Inc. (ESGI) is pleased to announce that we are expanding our valuation services offering to include Machinery and Equipment Appraisals, also referred to as asset appraisals.

Asset appraisals can be an adjunct to a business valuation, or provided as a stand-alone service. Adam Wiskind, CBI, CMEA will be leading this practice out of our San Francisco Bay Area (Sonoma County) office.

Our appraisers are Certified Machinery & Equipment Appraisers (CMEA) through the NEBB Institute.  NEBB is a leading equipment and machinery appraisal association in the U.S., with a network of over 400 members, representing a vast pool of machinery and equipment data, appraisal experience, and collaboration.

Exit Strategies is considered a “qualified source” of business valuations and asset appraisals, as defined by the Small Business Administration and Internal Revenue Service. Our valuations and appraisals are USPAP-compliant and they hold up to review by financial institutions, courts, government agencies, buyers, sellers and financial auditors.

To learn more about our Machinery and Equipment Appraisal services or receive a complimentary consultation about a potential need, please contact Adam Wiskind at awiskind@exitstrategiesgroup.com or 707-781-8744.

Valuing a Business in the Time of COVID-19

/in , /by Joe Orlando

Joe OrlandoBusiness owners and investors alike are asking themselves the same questions in the current COVID-19 environment.  Are there opportunities in downturns? If so, when do you know when buy and sell? What are my illiquid assets worth?

A former boss and one of the best bond traders I’ve ever met frequently used a popular trader’s phrase that predicting when a market will bottom and turn is “like trying to catch a falling knife.” A recent article revisited this phrase in the context of today’s market and the human decision-making process. As the article suggests, the big takeaway from Nobel Prize-winning psychologist Daniel Kahneman’s book Think, Fast and Slow is that “in critical situations that rapidly unfold…we tend to rely on our intuitions.” However, Kahneman suggests that when we are losing money fast, “we’d be better off…by slowing down and taking the time to analyze not only the market situation unfolding but our response to it.”

Responding to Market Data

In publicly traded markets, there is no short supply of data to analyze in determining a proper response. Volatile markets generate gigabits of trading data that money managers, traders and research analysts can tap into to assess markets and responses in the form of buy/hold/sell recommendations. But what about small private companies? With data limited to their own operating metrics and year over year change, how can an owner operator analyze the market situation and how to respond to it. Following Kahneman’s advice we suggest you slow down and analyze before acting.

A Private Company Response

The most prevalent approach to value is capitalizing current or discounting forecasted cash flows. This approach is based on three key inputs;

  1. Cash Flows – or the benefit stream to a business owner.
  2. Growth – or the rate at which these cash flows are expected to grow or decline.
  3. Risk – or the impact outside forces have on receiving these benefits over time.

These three inputs have different relationships. All other inputs being equal, the increase in cash flows increases value. The same is true for growth. Risk has an inverse relationship to value as the increase in risk lowers value. So as an owner operator or business manager, a quick assessment of the impact of this market on value depends on the flow of these three inputs. If you are lucky enough to benefit from the demand of essential products in this market, both cash flows and growth (at least in the short-term) are likely up. Some if not most of that increase in value is offset by an increase in risk as the world ponders a strange question of when to “reopen” its economies.

The Next Layer of the Onion

A quick assessment by the seasoned owner or manager is the difference between growth and stagnation, deep losses versus breakeven and, ultimately, success and failure. These quick assessments are needed every day as these three key inputs constantly update. As valuation experts, Exit Strategies Group also believes that there is “value” in a formal valuation of a business at a specific date. The value of this formal approach increases in chaotic times and a deep dive of a business by an independent, third-party appraiser at a relative low in a company’s valuation history has many benefits. The most important of these benefits is an answer to the question, “what is my business worth today in is COVID-19 market.”

Unique Valuation Opportunities and Needs

We believe that in addition to answering this question, a formal business valuation (either a full or limited scope analysis and report) exposes unforeseen or unnoticed risks and conversely “nuggets of value” in the form of intangible assets that fuel the business and its growth. But this deliverable of an opinion of value of 100% or 1.0%  has additional and unique uses amid this COVID-19 crisis;

  1. Gifting – Down markets give owner operators and investors a unique opportunity to pass value to the next generation or your favorite charity at a low price that limits the use of a lifetime gift tax exemption and maximizes the benefits of estate planning.
  2. Option Plans – The IRS in its IRC 409A statute requires that a valuation of equity securities used to price options be updated every year or when there is a “material change” in the business. Usually, for venture backed companies, this material change within the one year window is a new financing round. However, in times of market downturns, there is a unique opportunity to price new options or reprice existing options at a lower price. For companies that rely on this stock-based compensation to woo new hires, this opportunity allows these companies to reset the price and restart the clock for another year.
  3. Exit Strategies – In our conversations with owner operators in this market that had plans to sell the business before COVID-19, we have sensed both frustration and acceptance of the fact that either retirement just got pushed off a few more years or the quality of that immediate retirement has taken a hit with an expected decline in the selling price. A current valuation will help you decide whether to proceed with a sale or stay the course. For those who want to maximize exit value in the next 2-5 years, now is the time to identify key risks to mitigate and “nuggets of value” to invest in.
  4. Bankruptcy – A recent blog on our site talks about valuing a business in bankruptcy. An assessment of the value of your business may suggest that it is time to take advantage of Bankruptcy Code of the US and reorganize your company and renegotiate with your creditors to develop a plan to come out of this down time with a stronger balance sheet and capital structure, even at the cost of diluting ownership. Less of something is worth more than all of nothing.

When Should I Start the Valuation Process?

Again, perfect market timing is a myth and trying to predict when your business’ value will bottom and turn is “like trying to catch a falling knife.” Any valuation requires significant due diligence on the part of owners and managers so the time to start is when you have the time to dedicate to this process. If you or your team are currently slow based on the demand of your products and services, now may be the best time to dedicate that down time to this process. If you are going gangbusters supplying essential products and services, your time now is better spent running your business. If the above benefits don’t coincide with your current situation but may soon, then later (or in the next 6-12 months) is a better time to engage.

Regardless of your timing, give us a call and let’s talk through your situation and what may make the most sense for you in this market.

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.

Valuing a Business in Bankruptcy

/in , , /by Exit Strategies

According to data collected by the U.S. Bankruptcy Courts, business bankruptcies declined from 60,750 (or 4% of total filings) in 2009, just after the 2008 financial meltdown to approximately 22,750 in 2019 (or approximately 3%).[1]  With overwhelming challenges ahead as a result of the Coronavirus Pandemic, the question is not if these filings will go up over the next 12 months but by how much.

Before I dig into valuing a business in bankruptcy, let’s review the relevant “chapters” of the U.S. Bankruptcy Code. These “filings” are as follows;

  • Chapter 7 – a liquidation proceeding where assets are sold by a trustee to repay unsecured creditors and, in the case of a business filing, the Company ceases operation[2];
  • Chapter 11 – a reorganization where a Company (as well as individuals) negotiate a plan with its creditors to pay a portion of the amount outstanding while remaining in business.[3]

What is Value in a Bankruptcy?

The U.S. Bankruptcy Code defines “insolvent” as

“…financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at a fair valuation…”[4].

It is at this time, when a business is insolvent, that an appraiser comes in to determine the value of the Company’s assets. However, there is no definition of value in the U.S. Bankruptcy Code, only the guidance that;

“Such value shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property, and in conjunction with any hearing on such disposition or use or on a plan affecting such creditor’s interest.”[5]. 

The value of the Company depends on the type of filing and the recovery plan if the company is to survive as a going concern. In a Chapter 7 filing, the asset value is based on a liquidation approach (orderly or forced) based on the expected timing set forth by a bankruptcy trustee. In a Chapter 11 filing, the value is based on a going concern approach, also dependent on the proposed timing, but tied to a financial and operational plan for reorganization that impacts the capital structure of the business.

Valuing a Business in Chapter 11 as a Going Concern

Under a Chapter 11 reorganization, the approval of a reorganization plan depends on whether the parties can negotiate a favorable outcome for the Company (or debtor) and the unsecured creditors. When this path to resolution fails, the U.S. Bankruptcy Court needs to rule on this insolvency and whether the reorganization plan proposed suggests that the value of the business is less than its liabilities. While this plan may include the sale of assets, subsidiaries or other court-mandated transactions, it always assumes that the Company will continue as a going concern that requires a valuation.

For example, in a recent court case, a valuation expert for the debtor concluded that the value of the business burdened with $317 million of debt was between $180 million and $220 million (midpoint of $200 million) while the expert for the unsecured creditors’ expert pegged the value between $335 million to $445 million (midpoint of $390 million). In effect, the unsecured creditors concluded that the business was solvent and that they are responsible for 100% of the liabilities of the business. The Court determined that both experts were highly qualified and used the same valuation methods and weightings. The differences came down to their selection of comparable companies. The final decision agreed with the debtor’s expert and the plan was approved and the terms “crammed down” to the unsecured creditors who had to take a haircut on the amount owed to them.[6]

Other key components or potential issues faced by an expert in valuing a business in bankruptcy include;

  • Forecast – The appraiser needs to determine the strength of the forecast in a proposed reorganization plan and whether a management-prepared projection shows bias towards a low case scenario.
  • Diligence – In court cases, either side will hire appraisers to determine the value of the Company as a result of the reorganization plan. This adversarial situation reinforces the importance of the appraisers’ diligence and strong support for key assumptions and inputs.
  • Comparables – As noted above, the question of comparability is key in the defense of the value determined using a market approach. Comparing a small niche software company to Google lacks, among other things, strength based on size, business model and portfolio of revenue streams. There is also a question as to how actively traded companies compare to a bankrupt company with inactive or no recent trading history.
  • New Debt – Determination of the interest rates available to the debtor and changes in the capital structure are key in determining the Company’s risk profile before and after the reorganization plan. Also important is the assumption of potential balloon payments and the need for asset sales or refinancing when these payments are due.
  • Hindsight – The court will accept a “known or knowable rule” but discourages the use of hindsight which may lead to bias.
  • Taxes – A consideration of the debtor’s tax situation including the possible utilization of NOLs and a change in ownership after the reorganization.

A Small Business in Bankruptcy

The above example underscores a frequent adage of appraisers that a big company is much easier to value than a smaller one. Whether it’s the lack of detailed financial information or the presence of operating agreements that may trigger a specific approach to and allocation of enterprise value, small businesses are almost always an extension of the individual owner operator and therefore always unique. In particular, professional service businesses in bankruptcy (such as an electrical contractor or a barber shop) may lack the ability to realize value, especially in Chapter 7 filings, for intangible assets that will remain with the business owner. Additionally, a market approach requires the use of different datasets that compare control transactions as opposed to publicly traded companies. Otherwise, the same issues above apply but with limited financial and management resources, a full detailed plan and forecast may not be part of an appraiser’s available information.

Unfortunately, the current health and economic crisis will likely cause an uptick in business bankruptcies and situations where appraisers need to determine value in unique and distressed situations.

Exit Strategies values control and minority ownership interests of private businesses for tax, financial reporting, ownership transfer, strategic and bankruptcy purposes. If you’d like help in this regard or have any related questions, contact Al at alstatz@exitstrategiesgroup.com.

[1] https://www.uscourts.gov/report-name/bankruptcy-filings

[2] https://www.usbankruptcycode.org/chapter-7-liquidation/

[3] https://www.usbankruptcycode.org/chapter-11-reorganization/

[4] https://www.usbankruptcycode.org/chapter-1/section-101-definitions/

[5] https://www.usbankruptcycode.org/chapter-5-creditors-the-debtor-and-the-estate/subchapter-i-creditors-and-claims/section-506-determination-of-secured-status/

[6] https://www.bvresources.com/articles/bvwire/bankruptcy-court-highlights-comparables-selection-in-assessing-experts-valuations

Company Size Matters in Business Valuation

/in /by Joe Orlando

Joe OrlandoAccording to well-known business valuation authority Dr. Shannon Pratt in his book The Market Approach to Valuing Businesses, “smaller companies in most industries tend to sell at lower multiples of most financial variables than larger companies in the same industry. This conclusion, reached from analysis of market data, is consistent with income approach (cost of capital) research, which shows that smaller companies have higher costs of capital (higher discount rates) than larger companies. Higher discount rates in the income approach should mean lower multiples in the market approach, and this relationship does, indeed, hold true.”

Pratt adds, “Middle Market companies with $2 to $3 million of earnings before interest, taxes, depreciation and amortization (EBITDA) are easier to sell and command higher pricing multiples on average than companies with $1 to 1.5 million in EBITDA. …Larger companies are less risky, and therefore, are priced in the market reflecting lower discount rates and higher market multiples. … The smaller the company, the higher the average cost of capital and the lower the average market valuation multiple.”[1]

Pratt goes on to give examples to support his positions. While I agree with his opinions, I also believe that the presence and strength of intangible assets (such as brand, customer and supplier relationships, intellectual property) has a strong correlation to this size effect.

The Size Effect

This size effect continues across the entire spectrum of business size categories. Companies with less than $20 million revenue typically sell for lower price-to-earnings multiples than companies with $20 to $50 million revenue, and companies over $50 million revenue typically trade for still higher multiples. This relationship between price multiples and company size holds true for smaller businesses as well. Therefore, one must be sensitive to the range of revenue and earnings of comparable transactions relative to the subject company.

See our previous article, “Does Size Matters in Business Valuation?”

For further information on this subject or to discuss a business valuation need, contact Joe Orlando, ASA, at 503-925-5510 or jorlando@exitstrategiesgroup.com.

[1] Shannon P. Pratt, The Market Approach to Valuing Businesses, (New York: John Wiley & Sons, Inc., 2000), pages 242-251.

Secrets to Business Valuation – a Lesson from Curly

/in , /by Al Statz

Remember that scene from the 1991 movie City Slickers where Curly (Jack Palance) shares the secret to life with Mitch (Billy Crystal) shortly before he dies? Curly holds up his index finger and says to Mitch that the secret to life is to figure out his one thing and then stay with it. Channeling Curly today, I will share with you the three things that determine the value of any operating company, with rare exception.

As M&A advisors and valuation experts, we frequently see similar companies of the same size sell for vastly different sums. Let’s look at a simple illustration. Say Company A and Company B both distribute industrial products in similar markets, both do $30 million in revenue and both go to market at the same time. At the end of a rigorous sale process, Company A sells for $25 million and Company B sells for $15 million.

What caused the difference in the price buyers were willing to pay? It usually boils down to three factors: cash flow, growth and risk.

Cash Flow

At the end of the day what matters most to investors is future cash flow. Net cash flow is influenced by net profits, as well as working capital levels and capital investment needs. Owners can use free cash flow to either pay themselves, pay debt providers or reinvest in the business. Looking at our example, even though Companies A and B have the same revenue, Company A operates more efficiently and generates significantly more cash flow for its investors.

Growth

The second factor is growth — top line and bottom line growth. The more cash flows are expected to grow over time, the more cash flow investors will have at their disposal, and the higher they will value a company. Company A has likely proven – based on its historical financial results and investment record – that they are capable of growing at a faster pace than Company B.

Risk

The third thing affecting valuation is the level and types of risk associated with receiving those expected cash flows. Investors decide how certain they are that a company will continue to perform the way it has or achieve its growth projections. The more certain they are, the more they’ll pay, and vice versa. In our example, Company A may have less cash flow volatility, a stronger leadership team, or more market or product diversification, which would reduce perceived risk and increase certainty of performance.

Valuation theory and actual prices paid support the view that similar companies can have very different values. Acquirers and investors, when deciding how much to pay for a company, quickly look past gross revenue and EBITDA to net cash flows, growth and risk. The sooner a company owner understands and embraces this, the happier they’ll be when they decide to sell.

Exit Strategies values private companies for business owners before they make important decisions about sales, mergers acquisitions, recapitalizations, buy-sell agreements, equity incentive plans, and more. If you are business owner and would like to learn more or discuss a potential M&A transaction or valuation need, confidentially, give Al Statz a call at 707-781-8580.

 

How Discounts for Lack of Control are Determined

/in /by Joe Orlando

Joe OrlandoI recently penned a summary on valuation discounts for lack of marketability. As a follow-up, this post is about the other common valuation discount, the discount for lack of control (DLOC), which is often used when valuing minority interests in operating businesses.

In the business valuation context, control refers to the ability to manage or control a business. A controlling shareholder enjoys many benefits that are not enjoyed by minority interest holders. Minority interests are therefore usually worth less, often a lot less, on a per share basis.

Control Premiums

Conversely, a controlling interest in a company is more valuable than a non-controlling interest because the interest holder can control policy, strategic and operational aspects of the company. An investor will generally pay more per share for the rights and liberties afforded a controlling interest than for a non-controlling interest.

When a control premium is warranted, the size of the premium is often based on the controlling interest holder’s ability to:

  • Appoint or change members of the board of directors
  • Appoint management
  • Set management compensation and perquisites
  • Set operational and strategic policy and change the course of the business
  • Acquire, lease or liquidate business assets
  • Negotiate and consummate mergers, acquisitions and divestitures
  • Sell, liquidate, dissolve or recapitalize the company
  • Sell or acquire treasury shares
  • Register the company’s debt/equity for an initial or secondary public offering
  • Declare and pay cash dividends to shareholders
  • Change the articles of incorporation or bylaws of the company
  • Establish, revise or execute buy-sell agreements
  • Select joint venture partners or enter into such agreements
  • Decide product/service offerings, pricing, and markets to serve and not serve
  • Select suppliers, vendors and contractors to do business with
  • Enter into license or technology sharing agreements regarding intellectual property
  • Block any (or all) of the above actions

Evidence of Control Premiums in the Marketplace

A variety of studies have examined the premiums paid when public companies are bought out. One such source is the Mergerstat Control Premium Study. Mergerstat calculates buyout price premiums paid over market prices five business days prior to public announcement of the buyout.

We compiled the following table from Mergerstat Control Premium Study data:

It is impossible to know exactly how much of the premiums paid were due to gaining control versus the existence of synergistic benefits between the acquirer and the acquired. Some business appraisers argue that a significant portion of the premium relates to synergies (or other non-control factors), while others accept these studies at face value.

Lack of Control Discounts

When a valuation method result is on a controlling basis and we are valuing a non-controlling interest, a Discount for Lack of Control is usually applied. DLOC’s cannot be observed directly in the marketplace. Instead they are calculated from control premiums:

DLOC = 1 – (1 / (1 + Control Premium))

Business appraisers often select a baseline DLOC from studies of empirical data, then adjust up or down to fit the specific control attributes of the interest being valued. Key items to consider when evaluating a minority interest for a DLOC include the non-controlling interest holder’s inability to take the actions listed above, as well as other power attributes of the subject interest and economic attributes of the company.

How the IRS and Courts See Control Discounts

The IRS, valuation professionals and the courts recognize the appropriateness of DLOC’s. In a 1982 estate tax decision (Estate of Woodbury G. Andrews, 79 T.C. 938) the court distinguished this discount from a discount for lack of marketability, stating in part, “The minority shareholder discount is designed to reflect the decreased value of shares that do not convey control of a closely-held corporation.” The tax court continued in Harwood v. Commissioner, 82 T.C. 239, 267 (1984), “The minority discount is recognized because the holder of a minority interest lacks control over corporate policy, cannot direct the payment of dividends, and cannot compel a liquidation of corporate assets.”

In establishing a DLOC, IRS Revenue Ruling 93-12 should also be considered if the interest being transferred results in a control block of shares among family members in the subject entity. In brief, this ruling states that a minority discount will not be disallowed solely because a transferred interest, when aggregated with interest held by family members, would form a controlling interest.

Exceptions to the Rules

Users of business valuations should be aware that some valuation methods produce a non-controlling level of value, and no adjustment is needed when the subject being valued is a non-controlling interest (sometimes referred to as a minority interest, although they are not always the same). For the business valuation expert, it is critical to identify the level of control implied in a valuation method result before applying a DLOC. In some cases, a valuation method generates the same level of value needed for the valuation assignment, and no discount is required. In other cases, the levels don’t match.

It should also be noted that a minority interest usually does not have the benefit of control; however there are situations where a minority interest has control, such as an organization that has shareholders with limited voting rights. A minority owner without special rights cannot control the paying of dividends or selling of assets, or otherwise direct or manage a company’s activities.

Exit Strategies Group values control and minority (non-controlling) interests of private businesses for tax, financial reporting, strategic, buy-sell, ESOP and other purposes. If you’d like help in this regard or have any related questions, contact Joe Orlando, ASA, at 503-925-5510 or jorlando@exitstrategiesgroup.com.