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Knowledge Base - Valuation
Business Valuations – Types, Purposes & Applied Methods - There are many different types of valuations, each driven by their intended business purpose. Each type of valuation has unique characteristics, dictated by the stated business objectives, the industry, the qualifications of the valuator, and the absence of bias on the part of the valuator. The valuation descriptions that follow are intended to provide the business owner with a fundamental understanding and appreciation of the various types of valuations, purpose of each, formulas used, applied methods and the business objectives driving the valuation. This information is presented principally for your edification. Preparing a high-quality valuation is a process applied by valuation experts to determine the fair market value of an owner’s interest in a business. Business valuations are often used to resolve disputes related to estate and gift taxation, divorce litigation, allocation of business purchase price, and many other business and legal disputes.
Fair Market Value - “Fair market value” is defined as the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts. The fair market value standard incorporates certain assumptions, including the assumptions that the hypothetical purchaser is reasonably prudent and rational but is not motivated by any synergistic or strategic influences; that the business will continue as a "going concern" and not be liquidated; that the hypothetical transaction will be conducted in cash or equivalents; and that the parties are willing and able to consummate the transaction. These assumptions might not, and probably do not, reflect the actual conditions of the market in which the subject business might be sold. However, these conditions are assumed because they yield a uniform ·standard of value, after applying generally-accepted valuation techniques, which allows meaningful comparison between businesses which are similarly situated.
Elements of Business Valuation & Economic Conditions - A business valuation report generally begins with a description of national, regional and local economic conditions existing as of the valuation date, as well as the conditions of the industry in which the subject business operates. The financial statement analysis generally follows a description of the subject company. One of the first techniques that a business valuation professional applies is called “normalization” of the subject company’s financial statements. Normalizing the company's financial statements permits the valuation expert to compare the subject company to other businesses in the same geographic area and industry, and to discover trends affecting the company over time. By comparing a company’s financial statements in different time periods, the valuation expert can view growth or decline in revenues or expenses, increases or decreases in assets or liabilities, or other financial trends within the subject company. Valuation professionals also review the subject company’s financial ratios, such as the current ratio, quick ration, and other liquidity ratios; collection ratios; and other measures of a company’s financial performance. Normalization of Financial Statements - The most common normalization adjustments fall into the following four categories:
  • Comparability Adjustments. The valuator may adjust the subject company’s financial statements to facilitate a comparison between the subject company and other businesses in the same industry or geographic location. These adjustments are intended to eliminate differences between the way that published industry data is presented and the way that the subject company’s data is presented in its financial statements.
  • Non-operating Adjustments. It is reasonable to assume that if a business were sold in a hypothetical sales transaction (which is the underlying premise of the fair market value standard), the seller would retain any assets which were not related to the production of earnings or price those non-operating assets separately. For this reason, non-operating assets (such as excess cash) are usually eliminated from the balance sheet.
  • Non-recurring Adjustments. The subject company’s financial statements may be affected by events that are not expected to recur, such as the purchase or sale of assets, a lawsuit, or an unusually large revenue or expense. These non-recurring items are adjusted so that the financial statements will better reflect the management’s expectations of future performance. Discretionary Adjustments. The owners of private companies may be paid at variance from the market level of compensation that similar executives in the industry might command. In order to determine fair market value, the owner’s compensation, benefits, prerequisites and distributions must be adjusted to industry standards. Similarly, the rent paid by the subject business for the use of property owned by the company’s owners individually may be scrutinized.
  • Income, Asset and Market Approaches - Three different approaches are commonly used in business valuation: the income approach, the asset-based approach, and the market approach. Within each of these approaches, there are various techniques for determining the fair market value of a business. Generally, the income approaches determine value by calculating the net present value of the benefit stream generated by the business; the asset-based approaches determine value by adding the sum of the parts of the business; and the market approaches determine value by comparing the subject company to other companies in the same industry, of the same size, and/or within the same region. In determining which of these approaches to use, the valuation professional must exercise discretion. Each technique has advantages and drawbacks, which must be considered when applying those techniques to a particular subject company. Most trustees and court decisions encourage the evaluator to consider more than one technique, which must be reconciled with each other to arrive at a value conclusion. A measure of common sense and a good grasp of mathematics are helpful.
  • Income Approaches - The income approaches determine fair market value by multiplying the benefit stream generated by the subject company times a discount or capitalization rate. The discount or capitalization rate converts the stream of benefits into present value. There are several different income approaches, including capitalization of earnings or cash flows, discounted future cash flows (“DCF”), and the excess earnings method (which is a hybrid of asset and income approaches). Most of the income approaches consider the subject company’s historical financial data; only the DCF method requires the subject company to provide projected financial data. Most of the income approaches look to the company’s adjusted historical financial data for a single period; only DCF requires data for multiple future periods. The discount or capitalization rate must be matched to the type of benefit stream to which it is applied. The result of a value calculation under the income approach is generally the fair market value of a controlling, marketable interest in the subject company, since the entire benefit stream of the subject company is most often valued, and the capitalization and discount rates are derived from statistics concerning public companies.
Discount or Capitalization Rates - A discount or capitalization rate is used to determine the present value of the expected returns of a business. The discount rate and capitalization rate are closely related to each other, but distinguishable. Generally speaking, the discount rate or capitalization rate may be defined as the yield necessary to attract investors to a particular investment, given the risks associated with that investment. The discount rate is applied only to discounted cash flow (DCF) valuations, which are based on projected business data over multiple periods of time. In DCF valuations, a series of projected cash flows is divided by the discount rate to derive the present value of the discounted cash flows. The sum of the discounted cash flows is added to a terminal value, which represents the present value of business cash flows into perpetuity. The sum of the discounted cash flows and the terminal value is the value of the business. On the other hand, a capitalization rate is applied in methods of business valuation that are based on historical business data for a single period of time. The after-tax net cash flow capitalization rate is equal to the discount rate minus the long-term sustainable growth rate. The after-tax net cash flow of a business is divided by the capitalization rate to derive the present value. Capitalization rates may be modified so that they may be applied to after-tax net income or pre-tax cash flows or income. There are several different methods of determining the appropriate discount rates. The discount rate is comprised of two elements: (1) the risk-free rate, which is the return that an investor would expect from a secure, practically risk-free investment, such as a government bond; plus (2) a risk premium that compensates an investor for the relative level of risk associated with a particular investment in excess of the risk-free rate. Most importantly, the selected discount or capitalization rate must be consistent with stream of benefits to which it is to be applied.

Build-Up Method
- The Build-Up Method is a widely-recognized method of determining the after-tax net cash flow discount rate, which in turn yields the capitalization rate. The figures used in the Build-Up Method are derived from various sources. This method is called a “build-up” method because it is the sum of risks associated with various classes of assets. It is based on the principle that investors would require a greater return on classes of assets that are more risky. The first element of a Build-Up capitalization rate is the risk-free rate, which is the rate of return for long-term government bonds. Investors who buy large-cap equity stocks, which are inherently more risky than long-term government bonds, require a greater return, so the next element of the Build-Up method is the equity risk premium. In determining a company’s value, the long-horizon equity risk premium is used because the Company’s life is assumed to be infinite. The sum of the risk-free rate and the equity risk premium yields the long-term average market rate of return on large public company stocks. Similarly, investors who invest in small cap stocks, which are riskier than blue-chip stocks, require a greater return, called the “size premium.” Size premium data is generally available from two sources: Ibbotson & Associates' Stocks, Bonds, Bills & Inflation and Duff & Phelps' Risk Premium Report. By adding the first three elements of a Build-Up discount rate, we can determine the rate of return that investors would require on their investments in small public company stocks. These three elements of the Build-Up discount rate are known collectively as the “systematic risks.” In addition to systematic risks, the discount rate must include “unsystematic risks,” which fall into two categories. One of those categories is the “industry risk premium.” Ibbotson’s yearbooks contain empirical data to quantify the risks associated with various industries, grouped by SIC industry code. The other category of unsystematic risk is referred to as “specific company risk.” No published data is available to quantify specific company risks. Instead, specific company risks are determined by the valuation professional, based upon the specific characteristics of the business and the professional’s reasonable discretion applied to appropriate criteria. It is important to understand why this capitalization rate for small, privately-held companies is significantly higher than the return that an investor might expect to receive from other common types of investments, such as money market accounts, mutual funds, or even real estate. Those investments involve substantially lower levels of risk than an investment in a closely-held company. Depository accounts are insured by the federal government (up to certain limits); mutual funds are comprised of publicly-traded stocks, for which risk can be substantially minimized through portfolio diversification; and real estate almost invariably appreciates in value of long time horizons. Closely-held companies, on the other hand, frequently fail for a variety of reasons too numerous to name. Examples of the risk can be witnessed in the storefronts on every Main Street in America. There are no federal guarantees. The risk of investing in a private company cannot be reduced through diversification, and most businesses do not own the type of hard assets that can ensure capital appreciation over time. This is why investors demand a much higher return on their investment in closely-held businesses; such investments are inherently much more risky.

Capital Asset Pricing Model (“CAP-M”) - The Capital Asset Pricing model is another method of determining the appropriate discount rate in business valuations. The CAP-M method originated from the Nobel Prize winning studies of Harry Markowitz, James Tobin and William Sharpe. Like the Ibbotson Build-Up method, the CAP-M method derives the discount rate by adding a risk premium to the risk-free rate. In this instance, however, the risk premium is derived by multiplying the equity risk premium times “beta,” which is a measure of stock price volatility. Beta is published by various sources (including Ibbotson Associates, which was used in this valuation) for particular industries and companies. Beta is associated with the systematic risks of an investment. One of the criticisms of the CAP-M method is that beta is derived from the volatility of prices of publicly-traded companies, which are likely to differ from private companies in their capital structures, diversification of products and markets, access to credit markets, size, management depth, and many other respects. Where private companies can be shown to be sufficiently similar to public companies, however, the CAP-M model may be appropriate.

Weighted Average Cost of Capital (“WACC”) - The weighted average cost of capital is the third major approach to determining a discount rate. The WACC method determines the subject company’s actual cost of capital by calculating the weighted average of the company’s cost of debt and cost of equity. The WACC capitalization rate must be applied to the subject company’s net cash flow to invested equity. One of the problems with this method is that the evaluator may elect to calculate WACC according to the subject company’s existing capital structure, the average industry capital structure, or the optimal capital structure. Such discretion detracts from the objectivity of this approach, in the minds of some critics. Once the capitalization or discount rate is determined, it must be applied to an appropriate benefit stream
s: pretax cash flow, after-tax cash flow, pretax net income, after tax net income, excess earnings, projected cash flow, etc. The result of this formula is the indicated value before discounts. Before moving on to calculate discounts, however, the valuation professional must consider the indicated value under the asset and market approaches.

Asset Based Approaches - The value of asset based analysis of a business is equal to the sum of its parts. That is the theory underlying the asset based approaches to business valuation. In contrast to the income based approaches, which require the valuation professional to make subjective judgments about capitalization or discount rates, the adjusted net book value method is relatively objective. Pursuant to accounting convention, most assets are reported on the books of the subject company at their acquisition value, net of depreciation where applicable. These values must be adjusted to fair market value wherever possible. The value of a company’s intangible assets, such as goodwill, is generally impossible to determine apart from the company’s overall enterprise value. For this reason, the asset based approach is not the most probative method of determining the value of going business concerns. In these cases, the asset based approach yields a result that is probably lesser than the fair market value of the business. In considering an asset-based approach, the valuation professional must consider whether the shareholder whose interest is being value would have any authority to access the value of the assets directly. Shareholders own shares in a corporation, but not its assets, which are owned by the corporation. A controlling shareholder may have the authority to direct the corporation to sell all or part of the assets it owns and to distribute the proceeds to the shareholder(s). The non-controlling shareholder, however, lacks this authority and cannot access the value of the assets. As a result, the value of a corporation's assets is rarely the most relevant indicator of value to a shareholder who cannot avail himself of that value. Adjusted net book value may be the most relevant standard of value where liquidation is imminent or ongoing; where a Company's earnings or cash flow are nominal, negative or worth less than its assets; or where net book value is standard in the industry in which the company operates. None of these situations applies to the Company which is the subject of this valuation report. However, the adjusted net book value may be used as a “sanity check” when compared to other methods of valuation, such as the income and market approaches.

Market Approaches - The market approach to business valuation is rooted in the economic principle of substitution: that buyers would not pay more for an item than the price at which they can obtain an equally desirable substitute. It is similar in many respects to the “comparable sales” method that is commonly used in real estate appraisal. The market price of the stocks of publicly traded companies engaged in the same or a similar line of business, whose shares are actively traded in a free and open market, can be a valid indicator of value when the transactions in which stocks are traded are sufficiently similar to permit meaningful comparison. The difficulty lies in identifying public companies that are sufficiently comparable to the subject company for this purpose.

Guideline Public Company Method - The Guideline Public Company method entails a comparison of the subject company to publicly-traded companies. The comparison is generally based on published data regarding the public companies’ stock price and earnings, sales, or revenues, which is expressed as a fraction known as a “multiple.” If the guideline public companies are sufficiently similar to each other and the subject company to permit a meaningful comparison, then their multiples should be nearly equal. The public companies identified for comparison purposes should be similar to the subject company in terms of industry, product lines, market, growth, and risk. In another variation of this method, the evaluator may determine market multiples by reviewing published data regarding actual transactions involving either minority or controlling interests in either publicly traded or closely held companies. In judging whether a reasonable basis for comparison exists, the evaluator must consider: (1) the similarity of qualitative and quantitative investment and investor characteristics; (2) the extent to which reliable data is known about the transactions in which interests in the guideline companies were bought and sold; and (3) whether or not the price paid for the guideline companies was in an arms-length transaction, or a forced or distressed sale. To identify guideline companies that might be comparable to the company that is the subject of this valuation report, we reviewed data provided by the Center for Economic and Industry Research, a service affiliated with the National Association of Certified Valuation Analysts. The data was compiled by BIZCOMPS and Multex, two widely-used providers of data.

Discounts and Premiums - The valuation approaches yield the fair market value of the company as a whole. In valuing a minority, non-controlling interest in a business, however, the valuation professional must consider the applicability of discounts that affect such interests. Discussions of discounts and premiums frequently begin with a review of the “levels of value.” There are three common levels of value: controlling interest, marketable minority, and non-marketable minority. The intermediate level, marketable minority interest, is lesser than the controlling interest level and higher than the non-marketable minority interest level. The marketable minority interest level represents the perceived value of equity interests that are freely traded without any restrictions. These interests are generally traded on the New York Stock Exchange, AMEX, NASDAQ, and other exchanges where there is a ready market for equity securities. These values represent a minority interest in the subject companies – small blocks of stock that represent less than 50% of the company’s equity, and usually much less than 50%. Controlling interest level is the value that an investor would be willing to pay to acquire more than 50% of a company’s stock, thereby gaining the attendant prerogatives of control. Some of the prerogatives of control include: electing directors, hiring and firing the company’s management and determining their compensation; declaring dividends and distributions, determining the company’s strategy and line of business, and acquiring, selling or liquidating the business. This level of value generally contains a control premium over the intermediate level of value, which typically ranges from 25% to 50%. An additional premium may be paid by strategic investors who are motivated by synergistic motives. Non-marketable, minority level is the lowest level on the chart, representing the level at which non-controlling equity interests in private companies are generally valued or traded. This level of value is discounted because no ready market exists in which to purchase or sell interests. Private companies are less “liquid” than publicly-traded companies, and transactions in private companies take longer and are more uncertain. Between the intermediate and lowest levels of the chart, there are restricted shares of publicly-traded companies. Despite a growing inclination of the IRS and Tax Courts to challenge valuation discounts, Shannon Pratt suggested in a scholarly presentation recently that valuation discounts are actually increasing as the differences between public and private companies are widening. Publicly-traded stocks have grown more liquid in the past decade due to rapid electronic trading, reduced commissions, and governmental deregulation. These developments have not improved the liquidity of interests in private companies, however. Valuation discounts are multiplicative, so they must be considered in order. Control premiums and their inverse, minority interest discounts, are considered before marketability discounts are applied.

Discount for Lack of Control - The first discount that must be considered is the discount for lack of control, which in this instance is also a minority interest discount. Minority interest discounts are the inverse of control premiums, to which the following mathematical relationship exists: MID = 1 – [ 1 / (1 + CP)] The most common source of data regarding control premiums is the Control Premium Study, published annually by Mergerstat since 1972. Mergerstat compiles data regarding publicly announced mergers, acquisitions and divestitures involving 10% or more of the equity interests in public companies, where the purchase price is $1 million or more and at least one of the parties to the transaction is a U.S. entity. Mergerstat defines the “control premium” as the percentage difference between the acquisition price and the share price of the freely-traded public shares five days prior to the announcement of the M&A transaction. While it is without valid criticism, Mergerstat control premium data (and the minority interest discount derived there from) is widely accepted within the valuation profession.

Discount for Lack of Marketability - Another factor to be considered in valuing closely held companies is the marketability of an interest in such businesses. Marketability is defined as the ability to convert the business interest into cash quickly, with minimum transaction and administrative costs, and with a high degree of certainty as to the amount of net proceeds. There is usually a cost and a time lag associated with locating interested and capable buyers of interests in privately-held companies, because there is no established market of readily-available buyers and sellers. All other factors being equal, an interest in a publicly traded company is worth more because it is readily marketable. Conversely, an interest in a private-held company is worth less because no established market exists. The IRS Valuation Guide for Income, Estate and Gift Taxes, Valuation Training for Appeals Officers acknowledges the relationship between value and marketability, stating: “Investors prefer an asset which is easy to sell, that is, liquid.” The discount for lack of control is separate and distinguishable from the discount for lack of marketability. It is the valuation professional’s task to quantify the lack of marketability of an interest in a privately-held company. Because, in this case, the subject interest is not a controlling interest in the company, and the owner of that interest cannot compel liquidation to convert the subject interest to cash quickly, and no established market exists on which that interest could be sold, the discount for lack of marketability is appropriate. Several empirical studies have been published that attempt to quantify the discount for lack of marketability. These studies include the restricted stock studies and the pre-IPO studies. The aggregate of these studies indicate average discounts of 35% and 50%, respectively.

Restricted Stock Studies - Restricted stocks are equity securities of public companies that are similar in all respects to the freely traded stocks of those companies except that they carry a restriction that prevents them from being traded on the open market for a certain period of time, which is usually one year (two years prior to 1990). This restriction from active trading, which amounts to a lack of marketability, is the only distinction between the restricted stock and its freely-traded counterpart. Restricted stock can be traded in private transactions and usually do so at a discount. The restricted stock studies attempt to verify the difference in price at which the restricted shares trade versus the price at which the same unrestricted securities trade in the open market as of the same date. The underlying data by which these studies arrived at their conclusions has not been made public. Consequently, it is not possible when valuing a particular company to compare the characteristics of that company to the study data. Still, the existence of a marketability discount has been recognized by valuation professionals and the Courts, and the restricted stock studies are frequently cited as empirical evidence. Notably, the lowest average discount reported by these studies was 26% and the highest average discount was 45%.

Option Pricing - In addition to the restricted stock studies, U.S. publicly traded companies are able to sell stock to offshore investors (SEC Regulation S, enacted in 1990) without registering the shares with the Securities and Exchange Commission. The offshore buyers may resell these shares in the United States, still without having to register the shares, after holding them for just 40 days. Typically, these shares are sold for 20% to 30% below the publicly traded share price. Some of these transactions have been reported with discounts of more than 30%, resulting from the lack of marketability. These discounts are similar to the marketability discounts inferred from the restricted and pre-IPO studies, despite the holding period being just 40 days. Studies based on the prices paid for options have also confirmed similar discounts. If one holds restricted stock and purchases an option to sell that stock at the market price (a Put), the holder has, in effect, purchased marketability for the shares. The price of the Put is equal to the marketability discount. The range of marketability discount derived by this study was 32% to 49%.

Pre-IPO Studies - Another approach to measure the marketability discount is to compare the prices of stock offered in initial public offering (IPO’s) to transactions in the same company’s stocks prior to the IPO. Companies that are going public are required to disclose all transactions in their stocks for a period of three years prior to the IPO. The pre-IPO studies are the leading alternative to the restricted stocks in quantifying the marketability discount. The pre-IPO studies are sometimes criticized because the sample size is relatively small, the pre-IPO transactions may not be at arm’s length, and the financial structure and product lines of the studied companies may have changed during the three year pre-IPO window.

Applying the Studies - The studies confirm what the marketplace knows intuitively: Investors covet liquidity and loathe obstacles that impair liquidity. Prudent investors buy illiquid investments only when there is a sufficient discount in the price to increase the rate of return to a level which brings risk-reward back into balance. The referenced studies establish a reasonable range of valuation discounts from the mid-30%'s to the low 50%'s. The more recent studies appeared to yield a more conservative range of discounts than older studies, which may have suffered from smaller sample sizes. Other methods of quantifying the lack of marketability discount, such as the Quantifying Marketability Discounts Model (QMDM) have not been considered and are beyond the scope of this report.
"John Nelson's business and intangible Valuation in conjunction with his expert witness testimony was crucial to the bankruptcy court approving the sale of my client’s company. Without his thoughtful Valuation and testimony the sale certainly would not have been approved."
-Edwin G. Rice
Attorney, with Glenn, Rassmussen, Fogarty & Hooker, P.A. and legal counsel to the Assignee of the Bankruptcy Court 



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