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Business Valuation Basics

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1 Business Valuation Basics
Presented by: John Hayes, Managing Director Anchor Planning & Valuations, Ltd.

2 About Anchor Planning Specialized firm based in Illinois with a national reputation and client base, designed to deliver clients focused services not available from general CPA or consulting firms Provides business planning and valuation services to primarily small to medium size businesses Recruits the best staff through an extremely selective process which requires maintaining their professional education through industry organizations and turning business valuations from an expense into an asset Valued business transactions ranging from $10,000 to in excess of $100 million Client industries include: Automobiles, Banks, Savings & Loans, Information Services, Insurance, Medical, Dental, Metals and Metal Fabrication, Retail, Healthcare, and third parties such as attorneys and accountants

3 About Your Presenter John W. Hayes, Managing Director
Representative Accomplishments: Undergraduate degree in Finance from DePaul University and MBA from the University of Notre Dame Active in the valuation profession for more than 20 years, professional designations include: CPA/ABV, ASA, CVA, CFE, CrFA Frequent speaker and writer on valuation topics for the AICPA and the Illinois CPA Society Directed and prepared appraisals for the purposes of financial accounting, tax reporting, financing, strategic decision making and litigation support

4 What is Business Valuation?

5 What Is Business Valuation?
The act or process of determining the value of a business enterprise or ownership interest therein General introduction to business valuation

6 When Is A Valuation Needed?
Litigation Bankruptcy Marital Dissolution Damages caused to business Compliance Determination of Estate & Gift taxes Employee Stock Ownership Plans (ESOP) Purchase Price Allocation (PPA) Goodwill Impairment Testing Strategic Purchase/Sale of business or shares Fairness Opinions Discuss reasons a valuation might be needed; why it’s relevant

7 Why Use An Appraiser? Specific knowledge of methods
Experience determining value Certified and complies with accepted industry standards Continuing professional education requirements Litigation support Discuss personal areas of expertise, certifications and experience

8 BV Professional Standards
Uniform Standards of Professional Appraisal Practice (USPAP) National Association of Certified Valuation Analysts (NACVA) Institute of Business Appraisers (IBA) American Institute of Certified Public Accountants (AICPA) American Society of Appraisers (ASA) The Appraisal Foundation Canadian Institute of Chartered Business Valuators (CICBV) Internal Revenue Service (IRS) John, let me know if you’d like to add or delete any of the listed professional standards

9 What is Value?

10 What Is Value? Value = Worth, Utility, Desirability
The purpose of this slide is to introduce the viewer to the basic concept of value, which is the foundation of business valuation. Value = Worth, Utility, Desirability The value of an asset is the benefit you receive from that asset

11 . . . is worth more than a dollar tomorrow
A Dollar Today… . . . is worth more than a dollar tomorrow Due to factors such as: Opportunity Costs Inflation The purpose of this slide is to introduce the income approach and the reason for discounting future cash flows.

12 Definitions Of Value Fair Market Value:
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 (Revenue Ruling 59-60) Family law courts tend to be very inconsistent in the use of definitions of value. Regardless of the definition of value as stated in the opinion, the attorney (and/or the appraiser) needs to read the precedential case law to discover what (if any) is the accepted definition of value in the jurisdiction.

13 Other Definitions Of Value
Fair Value Investment Value Intrinsic Value Fair Value has different definitions for legal and financial reporting purposes. For legal purposes, fair value is heavily determined by prior case law and is typically used in dissenting stockholder and minority oppression cases. Investment Value is the value to a particular investor. Intrinsic Value is the amount that the investor considers to be “true” or “real value” and is based on analysis of all the fundamentals factors inherent in the business.

14 Sources Of Authority For Definition Of Value
Statutory law Legally binding rules and regulations Contractual definitions of value Non-legally binding administrative rules Precedential court decisions Direction from the court Direction from the lawyer Use of IRS authority in non-tax situations Opinions of other lawyers and appraisers

15 Premises Of Value Going concern – value in continued use
Assemblage of assets – value in place, but not in current use or as a going concern Orderly disposition – value in exchange on piecemeal basis given a normal time to sell Forced liquidation – value in exchange on piecemeal basis given less than normal time to sell By premise of value, we mean an assumption as to the status of the business under which a transaction would be expected to take place.

16 Overview of Accepted Approaches, Methods & Procedures

17 Overview Of Accepted Approaches, Methods, And Procedures
Hierarchy of Approaches, Methods, and Procedures Approach is the broadest of the three terms Method refers to general ways to implement approaches Procedures means the specific calculations, data used, and other details involved in a specific method

18 Business Valuation Approaches
Income Approach – valuing the business based on some form of economic income stream Market Approach – valuation by reference to other transactions Asset-Based Approach – valuation on the basis of assets and liabilities This slide is an overview of the approaches to value. These approaches will be discussed more in-depth further into the presentation.

19 Business Valuation Methods
Income Approach Discounting method Capitalizing method Market Approach Guideline public company method Guideline merged and acquired company method Asset-Based Approach Adjusted net asset value method Excess earnings method

20 Financial Statement Basics
Basic Financial Statements Income Statement Balance Sheet Levels of Financial Statement Presentation Audited: Independent auditor expresses opinion Reviewed: Accountant expresses limited assurance Compiled: Management’s representations presented in the form of financial statements

21 Income Approach “Value today always equals future cash flow discounted at the opportunity cost of capital.”1 Discounting Method - a method within the income approach whereby the present value of future expected economic benefits is calculated using a discount rate Discount Rate - an opportunity cost; the rate of return available to investors in the market on investments of comparable risk 1Richard A. Brealey and Stewart C. Myers, Principles of Corporate Finance, 7th ed., p. 75

22 Income Approach $1,000 to be received at the end of each of the three years Discount Rate is 8% Year Year Year 3 PV = $1, $1, $1,000 PV = ( ) ( ) ( )2 PV = $ $ $793.83 PV = $2,577.10

23 Income Approach Note how discounting is the opposite of compounding:
$ x 1.08 = $1,000 $ x 1.08 x 1.08 = $1,000 $ x 1.08 x 1.08 x 1.08 = $1,000

24 Income Approach Capitalization Method - a conversion of a single period of economic benefits into value. Concept of capitalizing: shortcut version of discounting Assumptions: Amount of income capitalized will remain constant each year in perpetuity OR Amount of income being capitalized will either increase or decrease at some constant annually compounded rate into perpetuity

25 Constant Income Capitalization Model
Income Approach Constant Income Capitalization Model (a.k.a. Gordan Growth Model): Assume: Dividend = $5.00 Capitalization rate = % $5.00 Present Value (PV) = = $50.00 The above example (which is unique), the capitalization rate equals the discount rate. This is only true where the amount of expected income is constant in perpetuity.

26 Income Capitalization Growth Model
Income Approach Income Capitalization Growth Model Assume: Prior period income ( i ) = $10.00 Sustainable growth rate ( g ) = % Discount rate ( k ) = % Di $10.00 x $10.30 PV = k - g = = = $103.00 Di = income expected at the end of future year

27 Market Approach Market Approach – a method of determining a value indication of a business asset by using one or more methods that compare the subject to similar businesses that have been sold Reasonable basis for similar businesses: Similar qualitative and quantitative investment characteristics Sufficient amount of available, verifiable data Transacted in arm’s-length deal, opposed to forced or distressed sale

28 Market Approach Valuation Multiple – a fraction in which a value or price serves as the numerator and financial, operating, or physical data serves as the denominator (e.g. Sales Price/EBITDA) Assume: Similar company Sales Price/EBITDA multiple = 3.0 Subject company Last 12 Months EBITDA = $10,000,000 Subject Company Value = 3.0 x $10,000,000 = $30,000,000

29 Market Approach Guideline Public Company Method – share prices of similar, actively- traded publicly owned companies are applied to the subject company through valuation multiples Strengths of method: SEC filing requirements Active trading Daily trading Large amount of analytical information SEC filing requirements leads to a great deal of verifiable and generally reliable information available for each company. Active trading results in a consensus of value by informed investors, on an arm’s-length basis. Daily trading results in observations as of the actual effective valuation date.

30 Market Approach Sources for guideline public company method:
SEC Filings 10-K annual report 10-Q quarterly report 8-K special events filing Yahoo! Finance Daily stock prices

31 Market Approach Guideline merged and acquired company method: Transaction prices of similar, public or privately-owned companies are applied to the subject company through valuation multiples Strengths of method: Large amounts of available data on small businesses and practices Transactions in more industries than guideline public company method Transactions are for controlling interest; no additional control premium needed

32 Market Approach Sources for guideline merged and acquired company method: Sales of Public Companies Mergerstat®/Shannon Pratt’s Control Premium Study™ Public Stats™ Sales of Private Companies Pratt’s Stats™ BIZCOMPS© IBA Market Database All databases available at except IBA Market Database which is available at

33 Asset-Based Approach Asset-Based Approach - a general way of determining a value indication of a business, business ownership interest, or security using one or more methods based on the value of the assets net of liabilities Method most appropriate for the following businesses: Real estate holding companies Investment companies Finance companies Manufacturing companies heavily invested in fixed assets The asset approach is less applicable to minority interests and businesses that have large amounts of intangible value (such as service businesses, software companies, many retail operations, and some distribution businesses).

34 Asset-Based Approach Adjusted Net Asset Value Method Steps:
Obtain or develop an accrual basis balance sheet Determine which assets and liabilities on the balance sheet require valuation Identify any off-balance sheet assets or liabilities Value the items identified in steps 2 and 3 Construct a market value-based balance sheet using the adjusted values

35 Asset-Based Approach Excess Earnings Method Steps:
Estimate (A) a normalized level of operating earnings, (B) the operating tangible asset value, and (C) a reasonable rate of return Multiply the reasonable rate of return by the value of tangible assets to arrive at the reasonable dollar return on tangible assets Determine excess earnings by subtracting the return on tangible assets from normalized earnings The Excess Earnings Method was originally used in 1920 to measure the value of goodwill that breweries and distilleries lost because of prohibition. “The (excess earnings) approach may be used only if there is not better basis available for estimating the value of intangible assets.” (Revenue Ruling )

36 Asset-Based Approach Excess Earnings Method Steps (continued):
Determine the capitalization rate appropriate for the excess earnings Determine the value of intangible assets by dividing the capitalization rate into the excess earnings Add the value of tangible assets to the value of intangible assets Common errors associated with the excess earnings method: Undefined earnings stream, unsupported normalized earnings stream, failure to allow for owner’s compensation, unsupported net tangible asset value, unsupported or unrealistic required rate of return on tangible assets, unsupported or unrealistic capitalization rate for excess earnings, using rates that are not currently supportable rates, claiming that the IRS recommends use of the excess earnings method.

37 A Word On Approaches and Methods
Approaches and Methods Not Totally Discrete There is some overlap among approaches and methods. How much overlap there is depends on the procedures used in each method. Business appraisers generally prefer to avoid overlaps to the extent possible in order to form independent indications of value by each approach.

38 Discounts and Premiums
Often the largest money issue is not the base value, but the applicability and/or magnitude of discounts and/or premiums to be applied to the base value Adjustments may need to be made to arrive at the fair market value of the interest being appraised. These adjustments may arise due to differing characteristics between the subject company and the comparable companies or to the inherent nature of the quantity of shares being appraised.

39 Benefits Of Control An Investor Likes Control Because:
Effect an acquisition/merger Pursue own business interests Influence management selection and policies Determine capital structure Manage operations Discretion over new stockholders or partners Acquire or liquidate assets

40 Minority Versus Control
Degrees of minority versus control ownership: 100 percent control Slightly less than 100 percent control Less than a supermajority where a supermajority is required for certain corporate actions 50 percent interest “Swing vote” minority block High enough percentage to bring a minority oppression dissolution action

41 Entity Level Discounts
Entity Level Discounts affect all shareholders: Significant risk factors Key person, size, lack of geographic diversification Portfolio discount Trapped-in capital gains discount Environmental or litigation risk

42 Shareholder Level Discounts
Shareholder level discounts have different impacts on different shareholders: Minority versus control Lack of marketability Voting versus nonvoting shares Blockage discount

43 Discounts For Lack Of Marketability [DLOM]
The concept of marketability: “The ability to convert the business ownership interest (at whatever ownership level) to cash quickly, with the minimum transaction and administrative costs in so doing and with a high degree of certainty of realizing the expected amount of net proceeds.”2 2. Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 4th ed., p. 393.

44 DLOM Degrees of marketability or lack thereof:
Registered with the SEC and with an active trading market Registered with the SEC and fully reporting, but with a somewhat thin trading market Private company with frequent private transactions Private company with few or no transactions Private company with ownership interest absolutely prohibited from transfer

45 Levels Of Value In Terms Of Characteristics Of Ownership
Source: PPC’s Guide to Business Valuations, Exhibit 8.8 in 16th Edition

46 The “Mandelbaum” Factors
In Mandelbaum v. Commissioner3 (1995), a federal Tax Court case, Judge Laro details the factors to consider in determining discounts: Financial Statement Analysis Company’s Dividend Policy Nature of the Company (History, Position in Industry, Economic Outlook) Company’s Management Amount of Control in Transferred Shares Restrictions on Transferability of Stock Holding Period for Stock Company’s Redemption Policy Costs Associated with Making a Public Offering 3. Mandelbaum v. Commissioner, 1995 Tax Ct. Memo LEXIS 256 (1995) (Laro, J.)

47 Evidence Quantifying DLOM
Restricted Stock Studies Pre-IPO Studies “(The IRS’s expert) should have considered the…data reflected in those pre- IPO studies because they, together with the restricted stock studies, would have provided a more accurate base range and starting point for determining the appropriate lack-of marketability discount…”4 - Tax Court 4. Davis v. Commissioner 110 T.C. 530, 110 T.C. No. 35, June 30, 1998

48 Sources For Quantifying Discounts And Premiums
Control Premium/Minority Discount Mergerstat®/Shannon Pratt’s Control Premium Study™ Lack of Marketability Discount FMV Restricted Stock Study™ Valuation Advisors’ Lack of Marketability Discount Study™ All databases available at

49 Reconciliation Of Value
Weighting of valuation method results Final value estimate Review of appraisal process Did the analyst appraise the right thing? Did the analyst appraise the right thing in the right way? Explicit weighting – assigning a percentage weight to each method. Implicit weighting – discussing qualitatively the relative aspects of methods without assigning a mathematical weight to each Final value estimate – can be a point estimate or range of value

50 Courtroom Tips for the Expert
Watch Out for these Questions: Would you buy this company for what you've valued it? Have you actually ever sold a business? Because if not, you really don't have a clue what real buyers and sellers consider, do you? You have arrived at a specific dollar value in your report—but value is a range, isn't it? If so, what is an “acceptable” range, plus or minus? Within what range does your value fall? Q: Would you buy this company for what you've valued it? A: “When attorneys ask this question,” Hawkins notes, “they usually act as if…they've caught the business appraiser like a deer in the headlights.” But you can step out of the glare by explaining that the values stated in your report arise from the company's unique circumstances, taking into account the actual market conditions of what others are paying for similar companies. Moreover, you never recommend what a buyer ought to pay; that decision must reflect the buyer's personal view of the market, tolerance for risk, etc. Q: Have you actually ever sold a business? Because if not, you really don't have a clue what real buyers and sellers consider, do you? A: Of course, the answer must be unique to every business appraiser and his/her experience. Hawkins has a background in financing mergers and acquisitions, and his current practice is “intimately involved with” many buy-sell scenarios. “Sadly, though, the level of expertise among business appraisers varies greatly,” he observes. The most vulnerable will be those who live “solely in the world of theory but have little common sense about how buyers and sellers in the real world would size up a situation.” Q: You have arrived at a specific dollar value in your report—but value is a range, isn't it? If so, what is an “acceptable” range, plus or minus? Within what range does your value fall? A: “This is almost always a trick question designed to get the appraiser to admit that the value could therefore be X or Y,” instead of the stated value.

51 Courtroom Tips for the Expert
Does your report contain any math errors? Because if it does—then it would be unreliable, correct? Do you consider Shannon Pratt to be an authority in the field of business valuation? Q: Does your report contain any math errors? Because if it does—then it would be unreliable, correct? A: It's an unfortunate truism that valuation reports are rarely error-free, even though they've been through several stages of quality control. (Keep this in mind when reviewing the opposing party's report for possible weaknesses.) “Never, ever accept anything at face value,” Hawkins says. Or citing the words of an ex-President: “Trust, but verify.” Q: Do you consider Shannon Pratt to be an authority in the field of business valuation? A: Of course you do—as you do many of the best-known leaders in the valuation industry. The red flag here: Watch out for the questions that follow, as the attorney will usually ask you to read a passage from said leader, which—on its face—would seem to contradict your own assumptions, calculations, or conclusions. These passages are usually selective, taken out of context, and/or offer only one opinion on a subject about which reasonable experts could disagree, including the one cited. Finally, just because a book says “that is how you should do it” doesn't mean “that is how you do it” today. It's appropriate to demonstrate where a business appraiser has in fact made a mistake or is truly out of sync with the industry.

52 Thank You John W. Hayes Anchor Planning & Valuations, Ltd
Thank You John W. Hayes Anchor Planning & Valuations, Ltd Jorie Blvd., Suite 380 Oak Brook, IL Phone: (630) Fax: (630)

53 Additional Resources Flexibility is at your fingertips with this additional resources slide library. Add slides on specific topics for special audiences, or store slides you do not want to use for a particular presentation. The customizing possibilities are endless!

54 Additional Resources Association web sites:
American Institute of CPAs (AICPA), American Society of Appraisers (ASA), Institute of Business Appraisers (IBA), International Business Brokers Association (IBBA), National Association of Certified Valuation Analysts (NACVA),

55 Uses of Business Valuation Reports
Related to Buying / Selling Sale of a Business Mergers & Acquisitions Divestiture Initial Public Offerings Allocation of Acquisition Price Buy/Sell Agreements Franchise Valuation or Evaluation Split-ups/Spin-offs

56 Other Than Buying/Selling
Adequacy of Life Insurance Gifting Programs Estate and Gift Taxes Charitable Contributions Eminent Domain

57 Other Than Buying/Selling
Employee Stock Ownership Plans (ESOP’s) Fairness Opinions Lease versus Buy Mediation & Arbitration Succession Planning

58 Litigation Support Dissenting shareholder actions Divorce
Economic Loss Analysis Disruption of Business Partner Disputes Wrongful Death

59 Types of Clients Business Owners Attorneys Judges Creditors
Financial Institutions and Planners Insurance Companies Real Estate Appraisers Other Business Valuators

60 Who Can Be A Qualified Valuator?
Economists Investment Bankers Business Brokers Financial Analysts Certified Public Accountants (CPA’s)

61 Valuators As Expert Witnesses

62 Professional Designations
American Society of Appraisers (ASA) Accredited Senior Appraiser Institute of Business Appraisers (CBA) Certified Business Appraiser National Association of Valuation Analysts (CVA) Certified Valuation Analyst

63 Professional Designations
American Institute of Certified Public Accountants (ABV) Accredited in Business Valuation Canadian Institute of Chartered Business Valuators (CBV) Chartered Business Valuator Association for Investment Management and Research (CFA) Chartered Financial Analysts Oriented primarily to public companies, includes material on private company valuation, and several hundred CFA’s specialize

64 USPAP Professional Standards
Uniform Standards of Appraisal Practice (USPAP) Established in 1987 by The Appraisal Foundation Consists of eight (8) appraisal organization and ten (10) non-appraisal organizations interested primarily in real estate appraisals The most widely cited and recognized set of professional standards for appraisals is the Uniform Standards of Professional Appraisal Practice (USPAP), published by The Appraisal Foundation The Foundation is located at 1029 Vermont Ave., NW, Suite 900, Washington, D.C., 20005, ph: (202) USPAP is updated each year in November, to be effective the following January 1 It covers appraisal for all disciplines, including real estate, personal property, and appraisal of businesses, business interests, and intangible asset Two (2) of USPAP’S ten (10) standards apply to business valuations and were added due to the number of members performing business appraisals

65 Professional Standards
Standards published be each of the above organizations are somewhat more detailed than USPAP However, none of them are in conflict with USPAP All of these organizations’ standards are available at no charge

66 Professional Standards Summary
All Organizations Require: Ethics Competency Consideration of all recognized valuation approaches Clear and accurate reports

67 Selection of a Valuation Professional
Education Training & Continuing Education in Business Valuation Technical training, accreditation and certification ASA, CBA, CVA, ABV, CBV and CFA Experience Certified Public Accountant Specific Industry Experience - Skills and expertise in tax treatments, IRS regulations, financial analysis, and business valuation experience

68 “Top Ten” List for Attorneys
Define the project Understand the standard of value Involve the appraiser early on Distinguish between a business appraisal and a real estate appraisal Establish a reasonable time frame

69 “Top Ten” List for Attorneys
Insist on an appraiser with experience and credentials Know the primary business valuation methods The appraisal is the first line of defense Litigation support issues Expect the best

70 Definitions Fair Market Value
The price at which an asset would change hands between a willing buyer and a willing seller Enterprise and Invested Capital The sum of debt and equity capital Equity This is the value to all shareholders

71 Definitions Majority vs. Minority
Control premium – the premium, over the minority price, that a buyer would pay to gain control Discount for lack of control – the amount by which the majority value is reduced to obtain a minority value Marketability Discount This reduction in value accounts for the stocks lack of a liquid market

72 Definitions Standards of Value Fair Market Value
IRS Ruling “…the amount 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.” Fair Value Defined by individual states and is based upon the case law precedents involving dissenting stockholder actions

73 Definitions Investment Value
Value of a business asset to a particular buyer as compared to a population of willing buyers The purpose and function of the business valuation is to determine the proper standard of value used in a valuation

74 Definitions Premise of Value
Going Concern – The value of a business enterprise that is expected to continue to operate into the future The intangible elements of Going Concern Value result from factors such as having a trained work force, an operational plant, and the necessary licenses, systems and procedures in place

75 Definitions Liquidation Value – the net amount that can be realized if the business is terminated and the assets are sold piecemeal Liquidation can be either “orderly” or “forced” Orderly: Liquidation value at which the asset or assets are sold over a reasonable period of time to maximize proceeds received Forced: Liquidation value at which the asset or assets are sold as quickly as possible, such as at an auction

76 About Your Presenter

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