What Every Business Attorney Should Know about Business Valuations

1. What Every Business AttorneyShould Know aboutBusiness Valuations Edward A. Wilusz, ASA, CFA

2. Overview of Presentation • Overview of Business Valuations • Buy/Sell Agreements • Shareholder Disputes • Estate Planning • What to Expect in Selling a Business • Selecting a Business Valuation Expert

3. Overview of Business Valuation • General Concepts • Value • Levels of Value • Steps in Appraising a Business • Approaches to Value

4. Introduction • Value is the Present Worth of Future Benefits • Supply and Demand • Reasoned Judgment Substantiated by Fact

5. Types of Value • Fair Market Value • Fair Value • Liquidation Value

6. Reasons for Valuations • Accounting Related • Income tax • Estate and Gift tax • Employee Stock Ownership Plans • Employee Incentives (SARs, Options) • Litigation • Buy/Sell Agreements • Sale

7. Levels of Value • Synergistic value • Control • Marketable Minority Interest • Non-Marketable, Minority Interest

8. Discounts • Minority • Lack of Marketability • Key Person • Portfolio discount • Litigation risk • Environmental risk • Trapped-in capital gains • Voting vs. non-voting • Blockage

9. Benefits of Control • Appoint management • Determine management compensation and perqs • Set policy and change course of business • Acquire or liquidate assets • Select people with whom to do business • Declare dividends

10. Benefits of Control (cont’d.) • Make acquisitions • Liquidate, dissolve, sell out • Sell or acquire treasury stock • Register the company’s stock for a public offering • Change the articles of incorp. or bylaws • Block any of the above actions

11. Degrees of Minority Versus Control • Majority interest • 50 percent interest • “Swing vote” minority • Enough votes to elect a director under cumulative voting • High enough percentage to bring a minority dissolution action

12. Quantifying Minority or Lack of Control Discounts • Acquisition premiums for publicly traded stocks • Ex. Company trading at $10 per share is acquired for $15 per share. There was a 50% premium. The implied minority discount is 33.3%. • Acquisition prices can reflect elements of strategic or synergistic value. • In public companies, control shareholders may not have exploited the prerogatives of control at the expense of the minority.

13. Quantifying Minority or Lack of Control Discounts (cont’d.) • Examine difference between market and underlying net asset values for publicly traded holding companies • Examine closed-end investment companies, real estate limited partnerships, etc. • Limited partnership discounts from net asset value

14. Discount for Lack of Marketability • Marketability means the liquidity of an interest • The ability to convert to cash quickly • Lack of marketability means the lack of an established, efficient market. • Even some publicly-traded stocks suffer from illiquidity

15. Other Factors Affecting Discounts for Lack of Marketability • Dividends or distributions • Pool of potential buyers • Information access and reliability

16. Other Factors Affecting Discounts for Lack of Marketability • Amount of control in transferred shares • Restrictions on transferability of stock • Holding period for stock • Company’s redemption policy • Cost associated with public offering

17. Benchmark for Marketability • Restricted stock studies • Pre-IPO studies

18. Restricted Stock Studies • Examine “restricted stock” or “letter stock” of public companies

19. Restricted Stock Studies • Size makes a difference Revenues (in millions)Avg. Discount Under $10 32.9% $10 mil.-$30 30.8% $30 mil.-$50 25.2% $50 mil.-$100 19.4% Over $100 14.9%

20. Restricted Stock Studies StudyAvg. Price Discount SEC average 25.8% SEC non-reporting OTC companies 32.6 Gelman 33.0 Trout 33.5 Moroney 35.6 Maher 35.4 Std. Research Cons. 45.0 Willamette Mgt. Assoc. 31.2 Silber 33.8 FMV Opinions 23.0 Mgt. Planning Inc. 27.7

21. Steps in Appraising a Business • Data Gathering Phase • Analysis and Correlation • Application of Approaches

22. Data Gathering Phase – Company Information • Financial documents • Shareholder agreements • Employment & Management Contracts • Brochures/Descriptive Materials • Projections/Budgets • Details on offers & transactions • Past appraisals & consultants reports

23. Data Gathering Phase – Company Interview • Nature & History of Business • Markets & Marketing Efforts • Competition • Management • Operations • Facilities & Equipment • Financial Overview

24. Data Gathering Phase • Industry • Economy • Geographic Area

25. Analysis of Data – Financial Statements • Adjust for Discretionary Items • Accounting Related Adjustments • Eliminate Non-recurring Items • Eliminate Non-operating Items • Comparisons

26. Three Approaches to Value • Income Approach • Market Approach • Asset-Based Approach

27. Market Approach Method • Publicly traded guideline company method • Guideline merger and acquired company method • Past transactions method • Buy-Sell agreement method • Rules of Thumb method

28. Publicly Traded Guideline Company Method • Use for valuing companies of a certain revenue level • Ideal publicly traded guideline companies used for: • Large companies that could go public • Smaller companies as a sanity check

29. Publicly Traded Guideline Company Method • Examine ideal guideline companies for: • Line of business • Growth rates • Levels of revenues and income • Capital structure • Profitability • Identify companies sharing similar investment characteristics

30. Compare Subject Company to Guideline Companies • Quantifiable Comparison • Adjust for accounting differences • Non-Quantifiable Factors

31. Based on Analysis & Comparison Select & Apply Multiples • Price/Earnings (Historical) • Price/Cash Flow • Price/Projected Earnings • Market Value of Invested Capital (“MVIC”)/Earnings Before Interest & Taxes (“EBIT”) • MVIC/Earnings Before Interest & Taxes & Depreciation (“EBITDA”)

32. Selection of Multiples Impacted By: • Quantifiable comparison • Non-quantifiable comparison • Range of publicly traded company multiples

33. Advantages • Reflects arms’ length transactions between buyers and sellers • Efficient market (knowledge of buyers and sellers) • Active market • Availability of financial information

34. Advantages • Availability of descriptive material • Fairly consistent data across companies • Financial analysts’ material: • Analysis of company • Analysis of industry information • Analysis of forecasts

35. Advantages • Simple to understand • Includes value of all operating assets of business

36. Disadvantages • Many times no good guidelines exist • Can be difficult to properly apply • Tendency to use shortcuts • Minority versus majority interest issues

37. Guideline Merger & Acquired Company Method • Valuation of company in entirety • Analysis should be applied similar to guideline publicly traded company method

38. Advantages • For small businesses, can sometimes be a better method than guideline publicly traded analysis

39. Disadvantages • Lack of detailed information on transaction • Limited description of acquired company • Limited financial data • Limited transaction data • Terms of transaction not disclosed • Timeliness of Transaction • Use of this approach with limited information can produce grossly inaccurate conclusion

40. Past Transactions of Subject Company Stock • Can provide best indication of value

41. Relevance of Prior Transactions • Need to examine whether arms’ length transaction involves: • Family members • Distress sale • Other factors

42. Timeliness of Transaction • Depending on market conditions: • A transaction may become “stale” quickly • Older transactions--examine and possibly adjust multiples

43. Knowledgeable Buyer and Seller • Financial sophistication of parties • Did the parties have all the relevant facts?

44. Advantages • Simple • Involves transactions in subject company

45. Disadvantages • Without proper examination, can result in grossly inaccurate conclusion • Sometimes given excessive weight in conclusion

46. Buy-Sell Agreements • Generally use a formula approach • Often based on book value • May only be applicable in certain instances • May involve related parties • Stipulated values are often not updated • Frequency of transactions

47. Buy-Sell Agreements • Can be controlling or irrelevant

48. Rules of Thumb • Supposedly market derived • Quoted as a multiple of some financial measure Examples: • 1.5 times revenue • 3.0 times owner’s cash flow • Generally more applicable in valuing small companies • MUST BE AWARE OF THEM

49. Advantages • For some industries, can be given significant weight • Can be a good sanity check on other valuation methods

50. Disadvantages • Rules may not change over time • Too many factors impact value to be contained in a rule of thumb • Often rules are not clear what assets and liabilities are included