pluses & minuses of business valuation

PLUSES & MINUSES OF BUSINESS VALUATION

James Lisi, MBA, BSIE, CPIM

James Lisi, American ValueMetrics

Overview

What Are We Valuing? Value Drivers Methods Fair Market Value Analyst’s Job Defense for Litigation Current Issues


What Are We Valuing?

An economic engine that converts an investment into a stream of profit

Changes over Time - with economy, management plans and markets

Where Future Performance is at Risk


What Are We Valuing?

A Complex Enterprise with multiple subsystems Production, quality, purchasing, sales,

marketing, finance, accounting, banking, sales tax collection, employees, government relations, public relations, facilities, insurance, transportation, logistics, income taxes…


Value Drivers

We develop an economic model to capture the investment to profit conversion process

Value is driven by: Cash flow - the wealth creation Rate of Return - the measure of investment

risk

Value Drivers

Cash Flow is EBITDA + Other Non-Cash Adjustments

EBITDA – Earnings Before Interest, Taxes, Depreciation & Amortization

Note: Net Income is not cash flow. It can be easily manipulated by non-cash events

Value Drivers

Rate of Return - Capitalization Rate or Discount Rate As a business takes its investment capital

and converts to profit, the capital is depleted and must be replenished

The cap rate indirectly represents the time it takes to recover an investment and turn a profit.

It is a measure of Investment Risk

Value Drivers

Cash Flow and Capitalization Rates work like bonds in the market – when rates go up, value goes down, and rates go down, values go up.

Positive Free Cash Flow Needed (Separate Test) After Tax Net Income less Capital Expenditures Growth Stages require capital investment

throughout


Valuation Methods Rules of Thumb

OK for Main Street Business under $500K in revenue

Implicit Assumptions Single line of business No different from other similar businesses Limited Growth Potential

Valuation Methods (Going Concern) Income Approach

Cash flow and capitalization rate from historical performance are used to derive a value

Market Approach Cash flow and a capitalization rate from market

comps performance are used to derive value Liquidation Approach (Value Minimum)

Analysis to wind down operations and liquidate assets is prepared to derive value

Valuation Methods

Discounted Cash Flow Approach A projection of future cash flows is

discounted back to present to derive a value

Defining the discount rate is a critical analysis

Replacement Approach Analysis to build operations up from scratch

is prepared to determine value

Start-ups Since we value based on future cash flows, Value

for a Start-up is shown in its Business Plan and how far along in development the company has come

Since there is little or no historical record of performance, the investment is risky

How risky? - The success rate of an entrepreneur’s first startup is 18%, the second 20% and the third 30%


Expect a Range of Values

Multiple Business Variables and Characteristics

Depends on the Investor/Buyer’s Use and Rationality

Depends on the Seller’s Needs and Rationality


Analysis The numbers are not an end in

themselves. Rather they are a means to understanding what is really happening with a company.

From the valuation approaches it’s clear that the key elements in increasing company value are: Decreasing investment risk Increasing cash flow


Business, Market & Player Dynamics

Value

Value


Expect a Range of Values

Range of values is from the investor/seller’s value to the buyer’s value

Price will be in the Middle


Strong Seller

Buyer Seller

Fair Marke

t Value

Sale Price

Buyer’s Value Seller’s Value


Fair Market Value (FMV) So we can see that there is a large variation in what

value a buyer and seller may agree on

Business valuation becomes a complex process of projecting a business model, market and unique factors

Expected to yield imprecise and uncertain results

To actually complete a valuation, we have to limit the circumstances. This has resulted in the definition of the concept of Fair Market Value (FMV)


Fair Market Value (FMV)US Tax Court Fair market value is the price at which a 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.

Wikipedia: Fair market value is an estimate of the value of an

asset, based on what a knowledgeable, willing, and unpressured buyer would probably pay to a knowledgeable, willing, and unpressured seller in the market.


Valuation Purpose Statutory

Minimum defensible value Market

Willing buyer & seller under current business plan Investment

Capital added to accelerate current business plan Strategic

Control Synergy analyses on new business plan Typically a buyer’s analysis


Strategic Buyer Competitor or Vertical Partner in Supply Chain

Willing to Pay More for: Reduced Competition and Higher Prices Strategic Customers To Acquire Technology or Talent To Unlock Underutilized Assets To Reduce Costs, Improve Buying Power

Provides Higher Cash Flow, Risk Reduction


Strategic Buyer Waze is being bought by Google

Mapping technology using cell phone data

Four years old $67 million invested 47 employees

What’s it worth?


Strategic Buyer

Google is paying $1.3 Billion.

Nineteen times capital invested

Who knew?


Irrational Seller Retiring company founder of a 30 year old

manufacturing firm Used to making decisions on his own Knows what the company is worth using

Industry Rules of Thumb from years in the industry association

Asking $7 million - 3 times earnings plus inventory

Does he get it?


Irrational Seller You bet.

The seller didn’t account for the fact that over 30 years the company had grown into a higher earnings multiple for valuation.

Based on market comparables for that size of operating income and projected earnings, the seller left $3 million on the table.

Lesson: At a certain value and risk, it’s profitable to use good advisors

Angel Investor

Will not be able to get cash out for a long period of time

Expecting a 70% Failure Rate Invests in ten companies to assure a

positive investment return Seeks a 10X return on each investment -

a 3X payback of invested capital


Analyst’s Job Determine Cash Flow from Financial Statements Determine Capitalization Rate Evaluate Projections of Future Cash Flows Select & Construct Appropriate Market

Comparisons Prepare each Valuation Approach Reconcile the Approaches to a Value Determine Discounts for Secondary Analyses

Control Marketability


Accreditation

Recognized as a separate appraisal discipline in 1978

50,000 professionals value at least occasionally

10,000 accredited valuation analysts 2,000 full time firms 300 Master Analysts in Financial Forensics


Standards Uniform Standards of Professional

Appraisal Practice (USPAP) is the U.S. standard for real property, personal property, intangibles, and business valuation appraisal analysis and reports.

USPAP is not required for business and equipment valuation.

Federally regulated institutions require USPAP. So federally guaranteed loans, such as SBA loans, must have a supporting USPAP compliant appraisal.


Standards

USPAP Key Differentiators Requires Market Comparisons Must be a Self-Contained or Full Report


Defense for Litigation What makes a valuation opinion valuable is

the degree to which it is defensible

Courts generally say “Show your Reasoning” in order to accept a valuation conclusion.

One way to improve defensibility is to ensure that competing approaches are considered in the valuation process and assessed for their relevance.


Litigation Issues Daubert Challenges

Opposition tries to knock out the rival appraiser before trial by attacking their credibility

Formulaic approaches often thrown out completely

Proven Appraisers withstand a Daubert challenge


Current Issues Private Equity

Use of financial derivatives – such as stock options –

that require valuation as done by public markets

Government Attention Recognizing taxable events Regulating toward independent valuation

Fair Value Accounting To prevent crises due to over/undervalued

assets


Private Equity Shift Classic Private Equity was:

Family Business Regional Markets Stable Growth Manageable Capital Needs No Intellectual Property

Valuation Triggers Sale Estate Plan or Gift Dispute or Divorce


Private Equity Shift Growth companies moving from public

financing to private markets Ongoing needs for Capital and

Management Talent Valuation Triggers:

Outside investors with preferred stock Management with Stock options Acquisition Activity Intangible Assets Impairment


Private Equity Shift Valuing this new private equity venture calls for

a knowledge of the drivers of business value a quantification of business risk adapting business valuation techniques used for

illiquid markets to private stock, financial derivatives and incentive compensation

We have a number of academics valuing business based on theory and formula, particularly option modeling – it fails because it bases private stock valuation on public market data


Government Attention

Advocating for arms-length valuation by third party valuators

Provides safe harbor for third party valuation in IRC 409a for private stock option valuation


Fair Value Accounting

Also called Mark-to-Market accounting

An ideal “exit value” for assets or liabilities through orderly transactions at a particular time

Reflects conditions at the balance sheet date Bubble Markets Depressed / Illiquid Markets



Pros: More accurately communicates current

value Self correcting over time Best platform for communicating current

enterprise value to investors



Cons: Recognizing non-cash gains & losses makes

owners’ equity volatile and could create systematic investment risk

Added cost for recurring valuation of assets Tax basis and Reporting basis may require

separate accounting


Take-Aways DECREASE RISK, INCREASE VALUE. That's because risk and value

move in opposite directions. We see it every day in the bond markets.

Fair Market Value (FMV) is a judgment, a calculated opinion. Price is negotiated and may be higher or lower than FMV.

Prepare like you are going to court – and you rarely do. Anticipate competing approaches and address them in the analysis.

We see a much broader size and range of financial activity in private markets today that has been placed through public markets in the past.

Use caution with analyses founded solely on financial theories, those without some basis in markets.

Contact Info

James (Jim) LisiAmerican ValueMetrics

[email protected]

www.americanvaluemetrics.comJames Lisi, American ValueMetrics

pluses & minuses of business valuation

Documents

value market approachcash

investment capital

capital investment

conversion process value

positive free cash flow

income taxes james lisi

capitalization rates

future performance