1. Business Valuation Valuation Methodologies Discounts and Premiums 7.12.2015 Navjivan and Ashram Road CPE Study Circles of WIRC of ICAI

2. 2 Business Valuation: Common Uses of Business Valuation  Tax –Estate/Gift –Buy/Sell Agreements  Bankruptcy and Litigation –Liquidation or Reorganization –Patent Infringement –Partner Disputes –Economic Damages  Financial Reporting –Purchase Price Allocation, Impairment Testing and Stock Options and Grants, etc.  Strategic Planning/Transaction –Value Enhancement –Business Plan/Capital Raising/merger –Strategic Direction, Spin-Offs, Carve Outs, etc. –Acquisitions, Due Diligence –Employee Stock Ownership Plan (ESOP) –Income tax u/s 56 and 68 –Solvency and Fairness Opinions –Damage Assessment –Dissenting Shareholder Actions –Marital Dissolutions/Family settlement

3. 3 Business Valuation: Valuation Process 1.1 Proposal and Engagement Letter 1.3 Establish Valuation Date 1.2 Establish Standard of Value and Define Purpose Ongoing Internal Review and Discussion with Other Professionals and Client Income, Market, Net Asset Approaches Signed Engagement Letter with Retainer 1.4 Data Gathering 2.1 Company and Industry Analysis 2.3 Adjustments and Recasts 2.2 Analyze Historical Financial Statements 2.4 Financial Statements Analysis (Ratios, etc.) 3.1 Implement Selected Valuation Methodologies 3.3 Final Internal Review and QC Process 3.2 Narrative Write-up of the Report 3.4 Finalize

4. 4 Business Valuation: Standard of Value  Purpose – Establish Purpose of the Engagement »Estate/Gift, Buy/Sell Agreements, etc. »Standards of Value (i.e. Fair Market Value, Stress Asset Value, etc.) »Interest Being Valued (i.e. Enterprise, Equity, Marketable, Non- Marketable, Control, Minority, etc.)  Valuation Date – Agree on a Appropriate Valuation Date »Utilize Data Subsequent to the Valuation Date »Sometimes can Consider Data After the Valuation Date if it was Foreseeable as of the Valuation Date

5. 5 Business Valuation: Standards of Value  Common Standards of Value –Fair Market Value (Tax): Fair market value applies to virtually all tax matters. »“The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.” –Liquidation Value: Orderly; forced. –Stress Value : Can vary but it is generally need based Fair market value with some exceptions. – Fair Value (Litigation): Fair value may be the applicable standard of value in a number of different situations, including shareholder dissent and oppression matters, corporate dissolution and divorce.

6. 6 Business Valuation: Gathering Data  Gathering Company Data –Articles of Incorporation; Operating Agreement –History and Background –Products and Services –Shareholders and Key Personnel Compensations and Responsibilities –Organization/Corporate Structure –Operations –Customers/Clients, Target Markets and Suppliers –Legal, Tax and Other Considerations –Five Year Historical and Latest Interim Financial Statements –Projections (If applicable)

7. 7 Business Valuation: Analyzing Data  Researching Economic and Industry Information – Country specific Economy – Global Economy – Target Industry  Financial Statements Analysis – Adjustments and Recasts »Extraordinary Items, Shareholders’ Perquisites (Personal Expenses), Fair Market Value Compensation and Rent, etc. – Ratio and Trend Analysis »Growth Rates, Liquidity, Leverage, Profitability, Efficiency, etc.

8. Valuation Methodologies Income Approach Market Approach Net Asset Approach

9. 9 Business Valuation: Valuation Approaches  Income Approach –The Income Approach is a valuation technique that provides an estimation of the value of an asset based on the present value of expected cash flows. –The various forms: »Capitalization of Earnings/Cash Flow Analysis (Gordon Growth Model) » Discounted Cash Flow Analysis (DCF) » Dividend Discount Model (DDM)

10. 10 Business Valuation: Income Approach  Capitalization of Earnings Approach –Single Period Discounted Cash Flow Analysis –Simplest for Companies with Stable Growth – Next Year Free Cash Flow to Firm (FCFF) – Next Year Free Cash Flow to Equity (FCFE) – Apply Appropriate Discount Rate

11. 11 Business Valuation: Income Approach  Common Levels of Value – Enterprise Value: Free Cash Flow to Firm (FCFF) »This is the total cash flow a 100% owner would receive assuming no debt »Net Income + Depreciation +/- Non-Cash Items + Interest Expense*(1- Tax) +/- Change in Working Capital – CAPEX »Weighted Average Cost of Capital (WACC) – Equity Value: Free Cash Flow to Equity (FCFE) »This is the cash flow a shareholder would expect to receive after interest and net borrowings »Net Income + Depreciation +/- Non-Cash Items +/- Change in Working Capital – CAPEX +/- Net Borrowings »Cost of Equity (higher than WACC for the levered company)

12. 12 Business Valuation: Income Approach  Discounted Cash Flow Analysis – More General and Flexible Than Capitalized Earnings Method

13. 13 Business Valuation: Weighted Average Cost of Capital  Weighted Average Cost of Capital (WACC) – WACC = Weight of Equity (Cost of Equity) + Weight of Debt (Cost of Debt * (1-Tax)) + Weight of Preferred Security (Cost of Preferred Security) – Provides Overall Cost of Capital to Whole Company – Assumes Constant Debt to Capital Over Time

14. 14 Business Valuation: Weighted Average Cost of Capital  Cost of Equity: Capital Asset Pricing Model (CAPM) – Simple CAPM »For larger publicly-traded companies »R e = R f + B(R m – R f ) » Risk Free Rate (R f ) Risk free rate as of the valuation date (Lont term Govt bonds) »Equity risk premium – By Analysis »Beta is a systematic risk measure

15. 15 Business Valuation: Weighted Cost of Capital  Cost of Equity and Leverage – Companies with More Debt Relative to Equity are Riskier and Have Higher Costs of Equity »Beta (B) Beta is a measure of the sensitivity of the movement in returns on a particular stock to movements in returns on some measure of the market (say Nifty) Published and calculated betas typically reflect the capital structure of each respective company at market values Unlevered beta is the beta a company would have if it had no debt Lever the beta for the subject company based on one more assumed capital structure.

16. 16 Business Valuation: Weighted Cost of Capital  Cost of Debt –Cost of Debt Based on Subject Company’s Credit Rating and Borrowing Rate (i.e. Prime rate + 1%, BBB, BB, B-, Prime Rate, etc.) at Valuation Date – After Tax Cost of Debt »Cost of Debt x (1 – Target Company’s Tax Rate)

17. 17 Business Valuation: Other Notes About Income Approach  Other Notes on Income Approach – Generally on a Control, Marketable Basis – Levels of Value » Synergy Level Cash Flow » Control Level Cash Flow » Minority Level Cash Flow – Publicly-Traded Company Derived Discount Rate » Minority and Marketable Level Discount Rate » Many Consider it to be Appropriate for Control Level

18. 18 Business Valuation: Market Approach  Publicly-Traded (Guideline) Comparable Company Analysis –The Guideline Publicly Traded Company Method indicates the value of the subject company by comparing it to publicly-traded companies in similar lines of business –Valuation Multiples Vary Based on Industry and States of Growth –Problem is that there are rarely perfect matches –Equity Multiples »Fair Market Value of Equity (Stock Price x Outstanding Number of Shares) »Common Equity Level Multiples Price / Earnings (P/E) Price / Tangible Book Value (P/B)

19. 19 Business Valuation: Market Approach  Publicly-Traded (Guideline) Comparable Company Analysis – Enterprise Multiples »Enterprise Value = (Stock Price x Outstanding Number of Shares) + Total Debt/Preferred Securities – Cash and Short- Term Investments »Common Enterprise Level Multiples EV / Revenue EV / EBITDA EV / EBIT

20. 20 Business Valuation: Market Approach  Publicly-Traded (Guideline) Comparable Company Analysis –Other Multiples »EV / R&D Expenses; # of Phase I, Phase II and Phase III products in pipeline – Early Stage Biotechnology »EV / # of Licenses and Rights – Shell Company, etc »Appropriate Multiple Depends on Company Characteristics

21. 21 Business Valuation: Market Approach  Market Transaction (M&A) Approach –In the Guideline Merged and Acquired Company Method, the value of the business is indicated based on multiples paid for entire companies or controlling interests. –Public Market Transaction Approach »Public Buyer or Seller Transactions »Control Value – Private Market Transaction Approach »Private to Private Transactions »Control Value – Common Transaction Database

22. 22 Business Valuation: Market Approach  Market Approach Adjustments – Most Companies Differ from the Subject Company – Need to Adjust for Differences between Market Comparables and Subject Company – Common Adjustments are Based on: »Size »Growth Rate »Profitability »Leverage »Other Company Specific Factors »Discounts and Premiums

23. 23 Business Valuation: Reconciling Items  Reconciling Items and Adjustments –Appropriate Weighting Value Conclusions from Different Approaches –Non-Operating Assets/Liabilities and Excess Working Capital/Cash –Pass-Through Entity Tax Adjustments »Adjustment for Discounted Cash Flow Analysis and Publicly-Traded Guideline Comparable Company Analysis »Depends on Hypothetical Buyer –Interest-Bearing Debt and Contingent Liabilities –Discounts and Premiums »Apply to Equity Level »Lack of Marketability and Minority Discounts, Key Person Discount and Control Premium, etc.

24. Discounts and Premiums Control Premium Lack of Control/Minority Discounts Lack of Marketability/Illiquidity Discounts Others Discounts

25. 25 Business Valuation: Lack of Marketability Discounts  Let the Fireworks Begin!! –Often subject to wide disparity among practitioners –Determination based on analogy –Data sources problematic –Reasonable range

26. 26 Business Valuation: Lack of Marketability Discounts  Lack of Marketability Discounts (LOM) –Marketability (liquidity) is valuable. Other things equal, investors will pay more for the more liquid (marketable) asset –The discount for lack of marketability is the largest money issue in many, if not most, disputed valuations of minority interests in closely-held, private companies –The size of the discounts varies greatly from one case to another –Need to carefully study the recent transaction in the relevant sector –Dissenting shareholder and shareholder oppression cases are quite mixed on the matter of discount for lack of marketability

27. 27 Business Valuation: Lack of Marketability Discounts  Lack of Marketability/Illiquidity Discount for Minority Interest – Restricted Stock Studies of foreign regime may be equated with shares of private limited companies »Although they cannot be sold on the OTS, they can be bought thru private discussion. Thus, the “restricted stock studies” compare the price of restricted shares of a public company with the freely-traded public market price on the same date with DILOM. »Price differences are attributed to liquidity »Empirical Studies: McConaughy, SEC Institutional Investor, Gelman, Trout, Moroney, Maher, Standard Research Consultants, Siber, FMV Opinion, Management Planning, Johnson, Columbia Financial Advisors Studies

28. 28 Business Valuation: Lack of Marketability Discounts  Restricted Stock Studies – General Findings »Show that restricted shares are worth less than unrestricted shares – generally ranging from 10 to 30%. Discounts as high as 55% have been observed »Discounts are larger for smaller companies and companies with more volatile stocks and more debt »These data are most appropriate for valuing restricted stocks and are apply to private companies with difficulties »The value of the studies is that the comparisons are apples to apples (i.e. liquid stock value vs. illiquid stock value of the same company at the same time). »Statistical studies can explain at best 1/3 of the discount

29. 29 Business Valuation: Lack of Marketability Discounts  Factors Affecting Discounts for Lack of Marketability – Company’s Financial Performance and Growth – Size of Distributions – Prospects for Liquidity (Expected Liquidity Event) – Restrictions on Transferability – Company’s Redemption Policy – Costs Associated with a Public Offering – Pool of Potential Buyers – Nature of the Company, Its History, Other Risk Factors – Amount of Control in Transferred Shares – Company’s Management

30. 30 Business Valuation: Lack of Marketability Discounts  Lack of Marketability/Illiquidity Discounts for Controlling Interests – Still a controversial concept – A company with control can be marketable, but illiquid – More marketable and liquid than the minority interest; Higher lack of marketability discount for smaller blocks (for closely held companies) – Super majority requirement for certain resolutions and compliance

31. 31 Business Valuation: Control Premium and Minority Discount  Control Premium –Other things equal, an interest with control is worth more than one that lacks control –An amount by which the pro rata value of a controlling interest exceeds the pro rata value of a noncontrolling interest in a business enterprise that reflects the power of control often associated with takeovers of public companies

32. 32 Business Valuation: Control Premium and Minority Discount  Control Premium –Common Prerogatives of Control »Elect directors and appoint management »Determine management compensation and perquisites »Set policy and change the course of business »Acquire or liquidate assets »Select people with whom to do business and award contracts »Make acquisitions »Liquidate, dissolve, sell, leverage or recapitalize the company »Sell or acquire treasury shares »Register the company’s stock for a public offering »Declare and pay dividends »Change the articles of incorporation or bylaws or operating agreement

33. 33 Business Valuation: Other Discounts  Other Discounts – Key Person Discount »Measure potential negative impact to the projected cash flows in the absence of Key Personnel

34. 34 Business Valuation: Other Discounts  Other Discounts –Voting vs. Non-Voting »If a company has both voting and nonvoting classes of stock, there may be a price difference between the two, usually in favor of the voting stock »Based on level of influence by the voting shareholders, restrictive agreements, state laws and policies and the total number of block of shares between voting and non-voting »Empirical studies indicates premium for voting shares Lease, McConnell and Mikkelson Study – 5.4% Robinson, Rumsey and White Study – 3.5% ~ 4.5% O’Shea and Siwicki Study – 3.5% Houlihan Lokey Howard & Zukin Study – 3.2% (average), 2.7% (median)

35. 35 Business Valuation: Discounts and Premiums  Common Errors in Applying Discounts and Premiums –Greed produces inconsistencies with economic reality –Low value desired »Conservative projections »High discount rate »Large DLOM, etc. –Higher value desired »Aggressive projections »Low discount rate »Small DLOM, etc. –Conservative projections should be accompanied by a lower discount rate –Aggressive projections should be accompanied by a higher discount rate