1. Business Valuation
Valuation Methodologies
Discounts and Premiums

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
Strategic Direction, Spin-Offs, Carve Outs, etc.
Acquisitions, Due Diligence
Employee Stock Ownership Plan (ESOP)
Internal Revenue Codes (IRC) 743, IRC 409A, etc.
Solvency and Fairness Opinions
Damage Assessment
Dissenting Shareholder Actions
Marital Dissolutions

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

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, Fair 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. Business Valuation: Standards of Value
Common Standards of Value
Fair Market Value (Tax): Fair market value applies to virtually all federal and state tax matters, including estate, gift, inheritance, income and ad valorem taxes as well as many other valuation situations.
“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.” – IRS Revenue Ruling 59-60
Liquidation Value: Orderly; forced.
Fair Value (Financial Reporting): Can vary but it is generally similar to Fair market value with some exceptions.
The amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale.” - FASB 157
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. 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
Other Financial Information (A/R, A/P, Fixed Asset Ledger, etc. - if needed)
Adjustments
Projections (If applicable)

7. Business Valuation: Analyzing Data
Researching Economic and Industry Information
U.S. Economy
Local Economy
Target Industry
Financial Statements Analysis
Adjustments and Recasts (Control Value)
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. 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. 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. 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
NI + 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. Business Valuation: Income Approach
Discounted Cash Flow Analysis
More General and Flexible Than Capitalized Earnings Method

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. Business Valuation: Weighted Average Cost of Capital
Cost of Equity: Capital Asset Pricing Model (CAPM)
Simple CAPM
For larger publicly-traded companies
Re = Rf + B(Rm – Rf)
Risk Free Rate (Rf)
Risk free rate as of the valuation date (20-year U.S. Treasury)
Equity risk premium (Source: Ibbotson/Morningstar)
Size adjustments often are appropriate (Source: Ibbotson/Morningstar and Duff & Phelps Risk Premium Reports)
Beta is a systematic risk measure

15. Business Valuation: Weighted Cost of Capital
Cost of Equity: Build-up
For smaller closely-held companies
Inputs are same as CAPM except for the application of industry risk premium instead of Beta coefficient
Industry risk premium based on Morningstar (Ibbotson) Yearbook
Generally similar to CAPM after adjustments for size and specific risks

16. 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 (i.e. S&P 500, etc.)
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
The result will be a market-derived beta specifically adjusted for the degree of financial leverage of the subject company
Wd = Weight of Debt
We = Weight of Equity
Wc = Weight of Capital

17. 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)
Debt to Capital Ratio
Control Value: Target/Optimal or Industry Average Debt to Capital Ratio
Lack of Control/Minority Value: Company Specific Debt to Capital Ratio

18. 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

19. 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)

20. 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

21. 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

22. 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
Common Transaction Database
MergerStat, Pratts’ Stat, Biz Comps, Capital IQ

23. 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

24. 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 (C-Corp.? S-Corp.?, etc.)
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.

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

26. 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

27. 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 U.S. Tax Court normally allows discounts for lack of marketability for non-controlling interests in closely held companies, but the size of the discounts varies greatly from one case to another
Need to carefully study the recent case law in the relevant jurisdiction
The quality of the expert evidence and testimony presented in the Tax Court makes a big difference in the outcome
The Tax Court expects good empirical evidence, relevant to the subject at hand; simple averages are insufficient

28. Business Valuation: Lack of Marketability Discounts
The highest discount that the Tax Court has allowed purely for lack of marketability is 45%, and most discounts have been considerably less
The ESOP discounts for lack of marketability are generally low because most ESOP stock has a “put” right to sell the stock back to the sponsoring company, thus enhancing its liquidity and value.
Dissenting shareholder and shareholder oppression cases are quite mixed on the matter of discount for lack of marketability
There is little case law on discount for lack of marketability in divorce cases, and what exists is also quite mixed
If the standard of value is clearly stated as fair market value, then a discount for lack of marketability is appropriate

29. Business Valuation: Lack of Marketability Discounts
Lack of Marketability/Illiquidity Discount for Minority Interest
Restricted Stock Studies
Restricted stocks are, by definition, stocks of public companies that are restricted from public trading under SEC Rule 144
Although they cannot be sold on the open market, they can be bought by qualified institutional investors. 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
Price differences are attributed to liquidity
Many feel the discounts are a reliable guide to discounts for LOM
Empirical Studies: McConaughy, SEC Institutional Investor, Gelman, Trout, Moroney, Maher, Standard Research Consultants, Siber, FMV Opinion, Management Planning, Johnson, Columbia Financial Advisors Studies

30. 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 difficult to apply to private companies
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).
Restrictions have been relaxed and discounts have dropped
Statistical studies can explain at best 1/3 of the discount

31. Business Valuation: Lack of Marketability Discounts
Pre-IPO Stock Studies
A pre-IPO transaction is a transaction involving a private company stock prior to an Initial Public Offering (IPO)
The pre-IPO studies compare the price of the private stock transaction with the public offering price. The percentage below the public offering price at which the private transaction occurred is a proxy for the discount for lack of marketability
The application of pre-IPO studies heavily debated and criticized because comparisons are apples to oranges
The dates of the transaction differ at a time when the company is changing rapidly (in the year before the IPO)
Discounts are very large
Discounts/premium should be based on specific to the subject case and not past court cases

32. Business Valuation: Lack of Marketability Discounts
Other Studies
Modified put option model (i.e. Finnerty and Chaffee)
Modified cost of capital – total beta (McConaughy and Covrig)
“Private Company Discount” by Koeplin, Sarin & Shapiro, Journal of Applied Corporate Finance Winter 2000.
Find approximately a 30% discount. Perhaps the best study, but limited sample size makes it difficult to apply to a specific case.

33. 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

34. 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 States
Typically, private companies sell in 6 months which is shorter than the restriction period of restricted stocks

35. Business Valuation: Control Premium and Minority Discount
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
Some suggest that valuations of controlling interests be adjusted upward if they are based on publicly-traded stock prices which are minority interests
Hubris and synergy may explain premia
Not needed if cash flows are estimated at the control level

36. Business Valuation: Control Premium and Minority Discount
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

37. Business Valuation: Control Premium and Minority Discount
Control Premium Database
Control Premia Based on Market Transactions
Identify one month to six months control premium prior to announcement date for public and private transactions from Mergerstat, Capital IQ, etc.
Control premia should exclude potential synergies associated with selected transactions, but this is extremely difficult
Appropriately adjust for other qualitative factors based on control prerogatives

38. Business Valuation: Control Premium and Minority Discount
Lack of Control/Minority Discount
Some feel that the control premium and the minority discounts should have the relationship as shown below:
This is overly simplistic. Ignores hubris and synergy and other factors that impact take-over premia
Must deal with negative “premia” in databases

39. Business Valuation: Control Premium and Minority Discount
Lack of Control/Minority Discount
Supermajority Requirement – About a quarter of the states require something more than 50% plus 1 share vote to approve certain major corporate actions, such as selling out or merging. Thus, a discount for a lack of supermajority may be appropriate
Swing Vote Potential – Depending on distribution of the stock, a minority, swing block could have the potential to gain a premium price over a pure minority value
Interest of 50% - Discount from lack of control value should be less for the interest with some control prerogatives and a little greater for the interest without the control prerogatives
Many experts feel that publicly-traded stocks generally sell at a control value

40. Business Valuation: Other Discounts
Key Person Discount
Measure potential negative impact to the projected cash flows in the absence of Key Personnel
Trapped-in Capital Gains
A company holding an appreciated asset would have to pay a capital gains tax on the sale of the asset. If ownership of the company were to change, the liability for the tax on the sale of the appreciated asset would not disappear
Use with Caution, it depends on expected time of liquidity event (usually applied when liquidity event is imminent
Consult a tax expert to analyze the situations
Block Discount
A large interest may be less liquid than a smaller one

41. Business Valuation: 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)

42. 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

43. Business Valuation: Discounts and Premiums
Common Errors in Applying Discounts and Premiums
Using synergistic acquisition premia to quantify premiums for control
Assuming that the discounted cash flow valuation method always produces a minority value
Assuming that the guideline public company method always produces a minority value
Valuing underlying assets instead of the stock or partnership interests
Using minority interest marketability discount data to quantify marketability discounts for controlling interests
Using only pre-initial public offering studies and not restricted stock studies as benchmark for discounts for lack of marketability
Indiscriminate use of average discounts or premiums applying (or omitting) a premium or discount inappropriately for the legal context
Applying discounts or premiums to the entire capital structure
Quantifying discounts or premiums based on past court cases
Using a tangible (real property, fixed assets, etc.) appraiser to quantity discounts and premiums