1. Gregory A. Porcaro CPA/ABV, MST, CFF Otrando Porcaro & Associates, LTD Warwick, RI (401-739-9250) gporcaro@opacpa.com

2.  To unravel the mystery behind business valuation concepts and theories, including the factors that impact the determination of the value of an interest in a closely held business

3.  An independent and objective evaluation of financial and non-financial data that may impact the current and future cash flow (economic benefit) of a closely held business in order to estimate the value of the business as a whole or a fraction there of.

4.  Individuals trained in financial analysis and possibly financial forensics  Accountants/CPAs  Business brokers  Business appraisers  Investment bankers

5.  Independentand objective  Trained in BV theory and practice  Have BV experience  "Expert Witness" experience – may face a "Daubert” Challenge  Industry experience  Have a BV certification  AICPA – Accredited in Business Valuation (ABV)  ASA – Accredited Senior Appraiser (ASA)  IBA – Certified Business Appraiser (CBA)

6.  The Supreme Court determined that it is the obligation of the judge to act as the “gatekeeper” to ensure that all expert testimony is relevant and reliable. This includes business valuation testimony.  Kumho Tire Co. v. Carmichael, 526 U.S. 137 (1999),  Daubert v. Merrell Dow Pharmaceuticals, Inc., 509 U.S. 579, 593 (1993)

7.  Factors to be considered by the judge  Application of a scientific methodology  Techniques subject to peer review  Techniques generally accepted  Techniques can be tested by others  If you fail the challenge your BV report and testimony can be excluded from the litigation  General Electric Co. v. Joiner, 522 U.S. 136 (1997)

8.  Estate & Gift Tax  Business Acquisitions & Dispositions  Divorce  Succession Planning  Reorganizations  Compensation - Stock Options  Financial Reporting

9.  Synergy - Not Representative of FMV  Smaller Businesses - Seller Discretionary Cash Flow  Larger Businesses - Dividend Paying Capacity  Intangible value

10.  Key Questions & Elements  What is being valued?  What is the valuation date?  What standard of value applies?  Consideration for state law  Analysis of financial & non-financial data  Selection of valuation approachs & methods  Prepare of valuation report

11.  This is the first question to answer and it has a major effect on the valuation professional’s course of action.  The professional must determine if he/she is valuing the stock of a corporation or an interest in an LLC and if so is it a controlling interest or a minority interest?  Is the business being valued an operating company or a real estate holding company?

12.  This is a specific point in time, such as  December 31, 2013  The BV engagement may start long after the valuation date, but you may only take into account information that was known or knowable as of the valuation date

13.  RI Supreme Court case: A divorcing couple hire a BV expert who concludes the value of the husbands 25% interest of a business was $2.9M as of the date of the divorce March 2007  In November 2007 husbands sells interest for $5.4M.  Wife sues for adjustment to property settlement agreement

14.  RI Supreme Court determines there was no evidence that anyone knew or should have known about the transaction at the time of the divorce. The value used for the purposes of the divorce was upheld.  Esposito vs. Esposito, 2010-328 (Jan. 2011)

15.  Fair Market Value - the amount at which the property would change hands between a hypothetical willing buyer and a willing seller when the former is not under compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts. (Rev Ruling 59- 60)

16.  Fair Value – A standard of value that has been derived by state law.  Need to review applicable state law  Generally applicable in dissenting or oppressed shareholder/member litigation  Not a “willing buyer and seller” situation  Valuation discounts are not applicable

17.  Investment Value – The standard of value applicable to a specific buyer or pool of buyers.  For example: Takes into account the potential synergistic benefits of being acquired by a competitor

18.  Nature & history of the business  Economic outlook  Financial position of the business  Earnings capacity  Dividend paying capacity  Intangible value – Goodwill  Prior sales of stock  Stock price of similar public companies

19.  Articles of incorporation or organization  By-laws and minute book,  Stockholder or partnership agreements,  Buy-sell agreements,  Employment contracts/non-compete agreements  Loans and leases,  Patents and copyrights,  Information regarding pending litigation.

20.  Financial statement analysis  Typically 5 years of financial statements  Preferably based on GAAP, not tax returns  Method of accounting  Consider normalization adjustments  Review internal trends & ratios  Compare subject company to industry performance data  Evaluate operating budgets & forecasts

21.  The purpose of this process is to adjust the financial statements for items that impact the financial position of the company (BS) and/or its earnings or cash flow (P&L).  To make the financial statements comparable to guideline companies  To eliminate items that will not be transferred or that will not be considered by a willing buyer

22.  In most cases, minority owners do not have the authority to enforce changes in the way the company is capitalized or spends money  Therefore depending on the purpose of the business valuation it may not be necessary to make normalization adjustments

23.  Non – Recurring Income or Expenses  Excessive legal fees due to litigation  Non – Economic or Discretionary Items  Excessive owner perks  Non - Arm's Length Transactions  Rent paid to related party greater than market  Non – Operating Assets & Related Income  Excessive cash or non-operating real estate

24.  Income  Asset  Market

25.  There is a basic underlying valuation principal that the value of a business is equal to the present value of expected future benefits.  The income approach is particularly appropriate to value operating companies with predicable earnings.

26.  Capitalization of Earnings  Discounted Cash Flow  Determine Income Base  Must be "normalized"  Earnings v Cash Flow Determine Discount Rate  Build up Method vs Capital Asset Pricing Model  Weighted Average Cost of Capital

27.  Capitalization of Earnings – This method should be used when a business's future earnings will not change significantly from current earnings or the growth in future earnings is predictable.  The earnings base is then divided by a capitalization rate to determine the business's value.  Capitalization rate = Discount rate minus the long- term sustainable growth rate

28.  Discounted Cash Flow – This method should be used when a business's future earnings can be reasonably estimated and are expected to be significantly different than historic earnings.  For example, the business may have gained or lost a major customer.  The value of the business is based on the discounted (present value) of the estimated future earning.

29.  Discounted Cash Flow – This method requires the business appraiser to obtain a operating forecast from management.  Must view the forecast with professional skepticism  Compare to prior years forecast to actual results

30.  Determine Income Base - Earnings v Cash Flow –  Important decision impacted by :  The nature of the business  Purpose of valuation  Nature if interest being valued – controlling or minority  I prefer to use cash flow as an Income base

31. Equity BasisInvested Capital – Debt Free Normalized Earnings +N/AInterest Expense (net of tax) +Depreciation/Amortization =Gross Cash Flow -Capital Expenditures + or -Working Capital + or -Loan advances or Payments -Preferred Dividends =Net Cash Flow

32.  Determine a Discount Rate – Must relate to the relative risk associated with an investment in the subject company compared to alternative investments  Build up Method  Capital Asset Pricing Model (CAPM)  Weighted Average Cost of Capital (WACC)

33.  Build up Method - The discount rate is “built-up” starting with risk-free rates of return (T-bonds) and adding on the historical returns for publicly traded large and small cap stocks.  Market risk premiums derived from Morningstar or Duff & Phelps  This method requires the business appraiser to consider applying a company specific risk premium.

34. Risk Free Rate – 20 Yr. US T Bonds2.41% Equity Risk Premium6.70% Industry Risk Premium-2.57% Size Premium3.81% Company Specific Risk (subjective)7.00% Discount Rate17.35% LT Sustainable Growth-3.00% Capitalization Rate14.35% Source: Morningstar/Ibbotson SBBI – 2013 Valuation Yearbook

35.  CAPM – The CAPM method is based on industry specific comparative data and is more difficult to apply to small/mid-size companies.  This method requires the business appraiser to consider applying a company specific risk premium.

36. Risk Free Rate – 20 Yr. US T Bonds2.41% Equity Risk Premium 6.70% Industry Beta (Market Risk)X 1.46%9.78% Size Premium3.81% Company Specific Risk (subjective)5.00% Discount Rate21.00% LT Sustainable Growth-3.00% Capitalization Rate18.00% Source: Morningstar/Ibbotson SBBI – 2013 Valuation Yearbook

37.  A subjective adjustment to the discount rate based on the business appraiser’s assessment of the company as a whole and professional judgment. Factors to consider:  Customer concentration  Depth of management  Supplier dependence  Comparative performance to industry data

38.  WACC – This method calculates the discount rate based on the company’s entire capital structure – debt and equity  The income base must be on a debt free basis  In general, the method is more suitable to larger companies with more complex capital structures

39. Capital Structure Debt to Equity Required ROR & Interest Rate* Discount Rate Equity$900,00075%20%15.00% Debt$300,00025%5.4%1.35% Total$1,100,0016.35% * Interest rate is net of taxes at 40%

40. Restaurant Normalized Cash Flow$150,000 /Capitalization Rate14.35% Value of 100% of Business* $1,045,296 * Before Valuation Discounts

41.  This approach values a company based on its assets and liabilities only.  It is applied generally to a business with little or no earnings or entities that own real estate or investment assets such as publicly traded securities.

42.  Net Asset Value  Suitable for a real estate holding company  Liquidation Value  Suitable for a operating company that is losing money or in recievership  Assets must be appraised

43. Real Estate Holding CompanyAdjusted BasisAdjustmentAppraised Value Land$75,000$125,000$200,000 Building$125,000$500,000$625,000 Mortgage$65,0000 Member Capital*$135,000$625,000$825,000 * Before Valuation Discounts

44.  The market approach is represented by one valuation method. The valuation professional must identify comparable businesses that are publicly traded or have been privately sold and apply key ratios, such as price/earnings (P/E) or price/revenue (P/R) to the Subject Company.  At the public level this is a common method for an investor to make investment decisions. For example, an investor interested in purchasing stock on General Motors would compare the P/E ratio for GM to other major automotive manufacturers such as Ford and Chrysler.

45.  It is commonly used for real estate as well  In the area of closely held business valuations it is difficult to apply for two reasons:  first, obtaining reliable data, and  second, determining if the businesses are comparable.

46.  Guideline Public Company Data - Using comparative company data from publicly traded companies to value small to mid-sized business will not be adequate for many reasons, but size is a major one.  Depth of management,  Market share  Geographic differences generally  Will not be comparable to an interest in a small to mid-sized closely held company.

47.  Private Company Transaction Data Base - The Institute of Business Appraisers and other data base services such as "Bizcomps" provide comparable sales data for closely held business by SIC Code.  This information is very useful and at least can provide a benchmark to compare the value determined using the income approach.

48. Price to Revenue Earnings Selected Multiples:0.102.20 Based upon the data obtained below, I selected multiples for both the price to sales and price to earnings multiples. Commercial Construction Contractor - NAICS # 236220 - SIC # 1541 & 1542 All Transactions Sales (,000)DE (,000)Price (,000)Price / SalesPrice / DE Low$117$15$430.030.43 High$10,484$1,807$18,1002.2130.17 Mean$2,182$360$1,5080.486.05 Median$989$104$2780.352.28 Standard Deviation$2,556$527$3,4820.439.13 Coefficient of Variation 0.921.51 Harmonic Mean 0.231.87 Count2920302920

49. Commercial Contraction Contractor - NAICS # 236220 - SIC # 1541 & 1542 Price to RevenueEarnings Revenue/Seller Discretionary Earnings (See Exhibit C) $ 7,154,806 $ 262,936 Multiple Selected 0.10 2.20 Operating Value 715,481 578,460 Add/(Less): Current Assets 1,287,496 Total Liabilities (1,161,179) Indicated Value $ 841,798 $ 704,777 Rounded* $ 842,000 $ 700,000 * Before Valuation Discounts

50.  A valuation engagement is not complete if the professional has not considered the possible application of a premium or discount. There are basically three types of valuation adjustments;  A control premium,  A minority interest discount,  A lack of marketability discount.  All valuation adjustments must be supported by analysis

51.  Control Premium – This refers to the inherent additional value attributed to the power to control the business. For example, a stockholder that owns a controlling interest (greater than 50%) can elect officers, establish compensation, sell assets, etc.  A business appraiser must review an entity’s organizational documents to be sure that a 51% interest represents control. In some cases a super-majority (i.e. 70%) or unanimous consent may be required for certain events to take place.

52.  Minority Interest Discount -. A minority interest discount is basically the opposite of a control premium.  Depending on how ownership interests in an entity are held an individual with a 2% interest can be entitled to a swing vote premium.  For example, if a corporation is owned by three people, two own a 49% interest each and one owns a 2% interest, then the 2% stockholder can impact the outcome of a particular issue if the other two stockholders do not agree

53.  Quantifying a control premium or minority interest discount is not a simple task and varies on a case by case basis. According to Mergerstat Review (2013), the average control premium was 44% (median average 33%) and average minority interest discount was 24%.

54.  Lack of Marketability Discount (LOMD) – This applies to an interest in a closely held company because they are inherently less liquid than publicly traded companies.  This discount can be applied in addition to a control premium or minority interest discount.

55.  Lack of Marketability Discount – There are several ways to document and support a LOMD. In August 2011 the IRS released a detailed practice aid for revenue agents to assist them is dealing with the issue in the field. It addresses the various methods for calculating a LOMD.  See www.irs.gov/pub/irs-utl/dlom.pdf

56. Restaurant Normalized Cash Flow$150,000 /Capitalization Rate14.35% Value of 100% of Business $1,045,296 Fair Value of a 33% Interest$344,948 Minority Interest discount @ 20%-$68,990 Sub-Total$275,958 LOMD @ 20%-$55,192 FMV of a 33% Interest$220.767

57.  The valuation report should be clearly written and free from errors and inconsistencies, In general, the following areas will be addressed in some detail:  Introductory statement identifying what is being valued  The standard of value applied  The valuation date  Company background and history  National, regional, and local economic and industry data

58.  The valuation report should be clearly written and free from errors and inconsistencies, In general, the following areas will be addressed in some detail:  Company financial statements and comparative industry analysis  Description of valuation approaches and method considered  Valuation calculations and conclusions  Qualification statement (resume)  Assumptions and limiting conditions

59.  Effect of "Gross" decision (a gift tax case) - Tax effecting earnings of pass-through entities is not acceptable without substantive analysis.  Gross case, 272 F.3d 333, 88 AFTR 2d 2001-6858 (6th Cir. 2001)  IMPACT – can increase value of the company by 40%

60.  The Delaware Chancery Court took and different approach and calculated an effective tax rate attributed to the S corporation structure after taking into account the tax implication of a pass through entity  Delaware Open MRI Radiology Associates, P.A. vs. Kessler, et al,898 A.2d 290 (Del. Ch. 2006)

61.  The Supreme Judicial Court of Massachusetts applied the same methodology as the Delaware court in a divorce case.  Bernier v. Bernier,449 Mass. 774 (2007), 82 Mass. Appeals. Ct 81(2012).

62.  PPC’s Guide to Business Valuation – 24 th Edition – J. Fishman, S. Pratt, J. Griffith & J. Hitchner  Understanding Business Valuation – 2 nd Edition – G.Trugman  Morningstar/Ibbotson SBBI – 2013 Valuation Yearbook

63. Thank you