BUSINESS VALUATION INSIGHTS

BUSINESS VALUATION INSIGHTS AKRON BAR ASSOCIATION SEPTEMBER 18, 2015 Discussion Topics Business Valuation Overview Evaluating Business Valuation Experts Valuation Approaches Valuation Discounts for Lack of Control and Marketability Valuation Issues in the Courts General Valuation Issues In Closing 1

WHY DO WE VALUE BUSINESSES? There are many different valuation contexts/purposes: TAX REPORTING Valuations to set the tax implications on shares or assets of a Company Gift & Estate Tax Valuing the ownership interest in a company or shares gifted to arrive at the tax implications for clients C-Corp to S-Corp Valuation - Valuing the assets of a company before and after the conversion to arrive at potential tax exposure for the client IRC 409A - Valuation of private company non-qualified deferred compensation Reorganizations Valuation of assets and or legal entities required when corporate structure is changed or country/state that holds the assets needs to be changed. FINANCIAL REPORTING Accounting regulations require estimation of fair value of assets and liabilities, e.g.: In an acquisition, the fair value of acquired assets and liabilities must be reported on the acquiring company s balance sheet (ASC 805) For impairment testing, certain assets must be tested to see if their values have been impaired, i.e., their values are less than what is currently reflected on the balance sheet (ASC 350 & ASC 360) For recording compensation when such compensation is awarded to employees in the form of company stock options (ASC 718) WHY DO WE VALUE BUSINESSES? There are many different valuation contexts/purposes: MERGERS & ACQUISITIONS corporate buyers and sellers need indications of what potential deal prices may be. Fairness Opinions develop a range of values to provide an indication to corporate fiduciaries (e.g., Board of Directors) that a deal is fair from a financial perspective LITIGATION Provide an expert opinion of the value for either the plaintiff or defendant. Marital Dissolution Shareholder Disputes Buy/Sell Agreements MANAGEMENT DECISION-MAKING Valuations for strategic planning purposes (e.g., valuing alternative strategies), exit planning or other consultation type services. OTHER REGULATORY MATTERS Such as ESOPs. INSURABLE VALUES Real estate and machinery and equipment valuations. 2

4 BDO Business Valuation Insights Business Valuation Overview Complexity of the Process The complexity of the business valuation process and the many techniques, approaches and methodologies available to business valuators often leads to user misunderstandings Procedural misunderstandings Interpretive misunderstandings 5 BDO Business Valuation Insights Business Valuation Overview Procedural Misunderstandings Why is the process so extensive? Why are some business valuation reports written in extensive detail and some are not? Are there alternatives to a full valuation? Interpretive Misunderstandings What do the report conclusions mean? How were these conclusions developed? Do the conclusions appear logical and reasonable? 3

6 BDO Business Valuation Insights Business Valuation Overview Questions Specific to the Legal Community Will the valuation consultant t qualify as an expert? Does the valuation consultant have experience in the specific type of valuation/industry? Does the potential economic benefit merit the cost of a business valuation? Will the facts and circumstances afford the business valuator access to all required information? 7 BDO Business Valuation Insights VALUATION ISSUES Engagement of a Valuation Expert Some Basics There are some universal attributes regarding how valuation experts are retained by clients and how valuation opinions can be used that are not always obvious to clients: Valuation opinions are typically performed in accordance with industry and professional standards depending on the context, not every financial analyst is capable of performing quality valuations; professional standards promulgated by the ASA, AICPA, FASB, etc. must be followed. Valuation experts need to be independent although clients can influence the outcome of a valuation opinion, valuation experts need to maintain independence and objectivity, and follow professional standards; a valuation expert s fee arrangement cannot be contingent on the outcome of the valuation; the valuation expert cannot have an interest in the company or assets being valued. Valuation opinions have a shelf-life opinions are issued as of a Valuation Date (value is a function of time); shelf-lives may vary depending on the business or asset being valued, but as an extreme example, you would not expect an opinion to be valid 3 years after the Valuation Date. Valuations are performed for a specific client purpose the use of a valuation opinion prepared for tax purposes may not be appropriate for financial reporting purposes. 4

8 BDO Business Valuation Insights Evaluating Business Valuation Experts Estate of Edgar Berg v. Commissioner (T.C. Memo 1991-279) Court criticized the Estate s expert for not being qualified to perform valuations. Court noted that although a CPA, expert was not in the business appraisal business. Did not have any formal training. Not a member of any professional appraisal association. 9 BDO Business Valuation Insights Evaluating Business Valuation Experts Characteristics to consider: Credibility in the Independence/ courts Objectivity Reliability Responsiveness Restraint from Compliance with advocacy Professional Standards Integrity Communication Skills Consistency with prior testimony, reports & publications 5

10 BDO Business Valuation Insights Evaluating Business Valuation Experts Qualifications Does the Expert have adequate training? Traditional Education MBA PhD Degree in Accounting, Finance, Economics Professional Licenses Qualified Appraiser Section 170(f)(11)(E)(ii) provides that the term qualified appraiser means an individual who (1) has earned an appraisal designation from a recognized professional appraiser organization or has otherwise met minimum education and experience requirements set forth in regulations (2) regularly performs appraisals for which the individual receives compensation, 11 BDO Business Valuation Insights Evaluating Business Valuation Experts ABV (Accredited in Business Valuation)» http://www.aicpa.org/interestareas/forensican dvaluation/downloadabledocuments/ssvs_full_ Version.pdf CVA (Certified Valuation Analyst)» http://www.nacva.com/pdf/nacva_standards.p df CFE (certified Fraud Examiner)» http://www.acfe.com/about/ethics.asp ASA (American Society of Appraisers)» http://www.bvappraisers.org/standards/bvstand ards.pdf CBA (Certified Business Appraiser)» http://www.go-iba.org/standards2.php 6

12 BDO Business Valuation Insights The Business Valuation Process Required Documents: Financial statements Tax returns Resumes of key personnel Share agreements Transactions in the company s shares Projections Significant contractual agreements 13 BDO Business Valuation Insights The Business Valuation Process Economic/Industry Analysis Company Analysis Financial Analysis Company Valuation 7

14 BDO Business Valuation Insights Standards of Value Definitions FAIR MARKET VALUE The price at which property would change hands between a hypothetical willing buyer and a hypothetical willing seller, neither under compulsion to buy or sell and both having reasonable knowledge of relevant facts FAIR VALUE Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date INVESTMENT VALUE The value of an asset to a particular buyer based on their investment requirements ORDERLY LIQUIDATION VALUE Value in exchange, on a piecemeal basis (not part of an assemblage of assets), as part of an orderly disposition. This premise contemplates that all of the assets will be sold individually and that they will enjoy normal market exposure to the appropriate secondary market FORCED LIQUIDATION VALUE Value in exchange, on a piecemeal basis (not part of an assemblage of assets), as part of a forced liquidation. id i This premise contemplates that all of the assets will be sold individually and that they will experience less than normal market exposure to the appropriate secondary market Valuation Methodology 8

16 BDO Business Valuation Insights Valuation Methodology Valuation Approaches Asset Approach Income Approach Market Approach Value Estimate Based on the economic value of assets and liabilities Value Estimate Present value of earnings or cash flow Value Estimate Based on multiples or prices from market transactions involving the sale of comparable interests 17 BDO Business Valuation Insights Valuation Methodology Valuation Approaches Asset Approach Income Approach Market Approach Guideline Public Company Method Based on the market price of the common stock of publicly traded companies Guideline Transaction (Merger & Acquisition) Method Based on the market price of entire companies or a controlling interest in companies in recent merger or acquisition transactions 9

18 BDO Business Valuation Insights ABC COMPANY Guideline Transaction Method - Pratt's Stats Valuation as of December 31, 2014 Price/Net Sales Multiple Price/Earnings Multiple 0.36 7.32 Base 8,200,000 300,000 Unadjusted Value 2,952,000 2,196,000 Less: LT Liabilites (300,000) 000) (300,000) 000) Add: Real Estate Value 800,000 800,000 Company Value on a Controlling Marketable Basis $ 3,452,000 $ 2,696,000 19 BDO Business Valuation Insights Valuation Methodology Valuation Approaches Asset Approach Income Approach Market Approach Companies not reporting earnings/breakeven Adjusted net asset value Receivables Fixed assets Intangible assets 10

20 BDO Business Valuation Insights ABC Company Adjusted Net Asset Value Unadjusted Adjusted June 30, June 30, 2014 Debit Credit 2014 Current Assets Cash $ 21,326 $ 21,326 Total Current Assets 21,326 21,326 Property and Equipment, (1) Land 1,377,656 10,330,000 1,377,656 10,330,000 Buildings 3,546,402 3,546,402 - Office equipment 8,527 8,527 4,932,585 10,338,527 less: accumulated depreciation (1,217,399) 1,217,399 - Property and Equipment, net 3,715,186 10,338,527 Total Assets $ 3,736,512 $ 10,359,853 21 BDO Business Valuation Insights Valuation Methodology Valuation Approaches Asset Approach Income Approach Market Approach Discounted cash flow method History not indicative of future Future operations can be reasonably estimated Capitalized cash flow method History is indicative of future Normalizing adjustments 11

22 BDO Business Valuation Insights ABC COMPANY Valuation as of December 31, 2011 Discounted Cash Flow Analysis Years Ending December 31, 2015 2016 2017 2018 2019 2020 Discounted Cash Flow Calculation Net Cash Flow to Equity $ 479,170 467,165 798,304 1,149,918 1,552,715 2,005,409 PV factor for discount rate of 24.21% 0.8973 0.7224 0.5816 0.4682 0.3770 0.3035 Discounted value $ 429,943 $ 337,470 $ 464,277 $ 538,417 $ 585,312 $ 608,614 Sum of discounted values $ 2,964,033 Terminal Value 2,889,578 Unadjusted Company Value on a Controlling Marketable Basis $ 5,853,611 Pass - Through Entity Tax Benefit 85,282 Adjusted Company Value on a Controlling Marketable Basis $ 5,938,893 Discount for Lack of Control 10% (593,889) Company Value Before Discount for Lack of Marketability $ 5,345,004 Discount for lack of marketability 25% (1,336,251) Company Value on a Minority Non-Marketable Ownership $ 4,008,753 23 BDO Business Valuation Insights Valuation Methodology Build up of Discount Rate Risk free rate of return 2.57% Equity risk premium 6.62% Small stock premium 6.10% Industry risk premium 2.92% Adjustments for other risk factors 6.00% DISCOUNT RATE 24.21% 12

24 BDO Business Valuation Insights Valuation Methodology Company and industry specific risk factors Depth of management Customer concentration Stability of industry & competition Diversification of services/products Supplier concentration Business maturity Financial stability Outlook 25 BDO Business Valuation Insights Valuation Methodology Normalization Adjustments Purpose : To eliminate nonrecurring items and to present the financial information on a basis comparable to that of other companies. Typical Examples: Nonrecurring legal or insurance settlements Nonrecurring professional fees Nonrecurring gains or losses Excessive owner/physician compensation and personal/non-business expenses 13

26 BDO Business Valuation Insights ABC Company Normalized Income Statement For the Seven Months Ended Years Ended December 31, July 31, 2011 2012 2013 2014 Earnings Before Taxes $ 283,210 $ 426,604 $ 422,756 $ 235,036 Add: Officer Compensation - Historical 400,000 400,000 400,000 230,000 Charitable contributions - - - 200 Loss on sale of assets 116,054-35,298 - Fees - Management 56,025 56,160 55,815 28,755 Miscellaneous expenses 6,117 558 315 40 Less: Officer Compensation - FMV 300,000 325,000 350,000 200,000 Gain on sale of assets - (25,441) - (887) Normalized Pre-Tax Income 1,161,406 1,182,881 1,264,184 693,144 27 BDO Business Valuation Insights Reconciliation Of Approaches Typically, multiple approaches are used by valuation practitioners to triangulate on an indication of fair value. Different approaches do not always provide the same result when applied to the same assets Whether one approach is preferred or relied upon more heavily than another depends on: Valuation context; Quality and availability of data; and, Reliability of specific assumptions. For valuation practitioners, it is particularly important to rely on (or at least consider) multiple methods in potentially contentious situations or in situations that will be subject to scrutiny. When multiple approaches result in very different valuation conclusions, it is more likely the case that certain assumptions in one or more of the approaches are faulty or unfounded 14

29 BDO Business Valuation Insights Valuation Methodology Rule of Thumb/Industry Formulas The result of years of observation of market transactions by accountants, business brokers, bankers, appraisers, and trade associations, among others Pros Ease of use Cons Not reliable Do not consider operational or time period differences 30 BDO Business Valuation Insights Valuation Reports Valuation v. Calculation Valuation Fully analyze the subject interest Consider and apply appropriate valuation approaches and methods Prepare and maintain appropriate documentation Results in a conclusion of value Calculation The client and the analyst agree on the valuation approaches and methods used and the extent of procedures performed (usually more limited than a valuation) Results in a calculated value Significantly limited usefulness generally cannot be submitted to a court 15

32 BDO Business Valuation Insights Common Errors Common errors in business valuation include the failure to: Define purpose of Apply discounts report properly Include the date of Examine/discuss valuation different methods & reconcile values List assumptions and Use proper limiting conditions Discuss company background, industry, economy, other (R.R. 59-60) capitalization/ discount rate for earnings stream selected Conduct site visit Other 34 BDO Business Valuation Insights VALUATION DISCOUNTS Understanding Value Basis There are four value bases that investors need to consider: Marketable, Controlling Marketable, Minority Interest Non-Marketable, Controlling Non-Marketable, Minority Interest Valuations are typically established at a specific value basis and then adjusted through the use of discounts and premias to arrive at the desired value basis Lack of Marketability Discount (DLOM) Non-Marketable, Controlling Basis Marketable, Controlling Basis Minority Interest Discount (DLOC) Marketable, Minority Interest Basis DLOM Non-Marketable, Minority Interest Basis C ontrol P remium 16

35 BDO Business Valuation Insights Valuation Discounts DISCOUNT FOR LACK OF CONTROL - Key consideration is the legal and operating rights embodied in the ownership that affect the owners ability to control the entity - Block size and distribution ib ti of shares among other owners - Voting rights - Compensation and Dividend policies - Selection of officers and directors DISCOUNT FOR LACK OF MARKETABILITY - Based on several factors, including: - Prospects for public offering - Restrictions on transfers - Size of holdings - Holding period - Dividend history - Put rights - Liquidity of underlying assets 36 BDO Business Valuation Insights Valuation Discounts DISCOUNT FOR LACK OF CONTROL Can be estimated in several ways Closed end funds Acquisition premiums = 1-(1/1+CP) 1-(1/1+20%) = 16.67% DLOC Mergerstat Review Capital IQ database Selection of a DLOC or control premium is based upon the valuation methodology Voting v Non-Voting VALUING PRIVATE COMPANIES Page 36 17

37 BDO Business Valuation Insights Discount for Lack of Control Lack of control discounts are considered before the discount for lack of marketability Any interest greater than 50% is generally considered a controlling interest. Succession of Betty Felix Helis v. U.S.A., 88 AFTR2d Par. 2001-5085 (Fed. Cl. July 3, 2001) Court of Federal Claims disagreed with IRS expert and found that a 50% ownership interest did not represent a controlling interest. Estate of Melton (77 AFTR2d Par. 96-612) 612) Magistrate stated that A shareholder with 50 percent of the stock can block action by other shareholders but does not have sufficient interest to control corporate affairs. 38 BDO Business Valuation Insights Valuation Discounts DISCOUNT FOR LACK OF MARKETABILITY Can be estimated t in several ways Restricted stock studies Pre IPO studies Protective Puts Empirical method In certain instances you can use Partnership Profiles data VALUING PRIVATE COMPANIES Page 38 18

39 BDO Business Valuation Insights Discount for Lack of Marketability Mandelbaum v. Commissioner, T.C. Memo 1995-255 Financial statement analysis. Dividend policy. Nature of the company, its history, its position in the industry, and its economic outlook. The company s management. Amount of control in the transferred shares. Restrictions on transferability of the stock. Holding period for the stock. Company s redemption policy. Costs associated with a public offering. 40 BDO Business Valuation Insights Discount for Lack of Marketability Illiquidity vs. Lack of Marketability Illiquidity idit - Owner of an entire business Lack of Marketability Owner of a noncontrolling interest Most agree that any DLOM for a controlling interest should be less than the discount for a minority interest. 19

41 BDO Business Valuation Insights Discounts for Multi-Tiered Entities ABC, LLC ABC Alpha Holdings Inc. Owns 18% Owns 65% ABC Gamma Holdings, Inc. ABC Operating Co., Inc. Owns 100% 42 BDO Business Valuation Insights Discounts for Multi-Tiered Entities Various tiers in a multi-tiered entity often contain a mix of ownership rights and restrictions that must be considered at each level. IRS scrutiny IRS may reject a valuation based on the magnitude of applied discounts Discounts should be applied using a reasonable method that is consistent with the facts and circumstances of the case. 20

43 BDO Business Valuation Insights Discounts for Multi-Tiered Entities Some of the factors that impact valuation discounts associated with interests in tiered entities include: (1) The extent of interrelationship between the entities Entities that rely on each other to function from either an operational or lending perspective may be less marketable and more risky to a hypothetical willing buyer. (2) Diversification The greater the diversification of the assets, the lower the discounts. (3) Holding period Investors require additional returns to account for illiquidity. Assets with longer marketing or holding periods will generally require larger discounts. (4) Contractual restrictions The extent to which restrictive agreements limit the degree of influence on distributions, allocations of profit and loss, transferability and other factors impact the magnitude of the discounts. 44 BDO Business Valuation Insights Discounts for Multi-Tiered Entities 5) Financial Condition Tiered structures that include highly leveraged entities with lower or less stable cash flows, generally would have higher discounts than profitable entities with greater stability of earnings and the ability to distribute those earnings. (6) Ownership Assessing the relative degree of control at each tier is important. When control of the entities is separate and unrelated, additional discounts may be warranted. If the general partner is the same for each entity, the discounts for the upper tiers should be significantly reduced but may not be zero. The general partner of the upper tier entity may be expected to, but may not govern the related entities in a similar manner. As such, there may be some marginal risks that warrant additional adjustment. 21

49 BDO Business Valuation Insights Valuation Issues in the Courts Selected Court Cases and Issues S-Corp Tax Affecting (Gross/Wall/Heck/Adams/Dallas) When valuing an S-Corp is it appropriate to apply taxes? Courts have generally held that no tax should be imputed in the analysis. Recognize that S-Corps are more risky and have higher return requirements Courts have not been convinced that taxes paid at shareholder level affects value (Taxable v non-taxable bonds) Fact and circumstances have not been the best in each of these cases. Delaware Open MRI V. Kessler (CA-275-N, Del. Ch. Lexis 84 (2006) Judge agreed that there is a difference in value between an S-Corp and C-Corp but that it is not as great and other court cases have demonstrated Built-In Capital Gains Tax (Est. of Richmond v. Commissioner) Particularly for asset holding companies that have appreciated assets and the resulting unrealized capital gain liability. Some courts have allowed a full dollar-for-dollar deduction and some have not. Richmond case assumes that a gradual turnover of the portfolio would allow for the CG tax to be paid over a 20 to 30 year period and that it should be discounted to account for the time to liquidation. 50 BDO Business Valuation Insights PROPOSED CHANGES TO 2704 Legislation has been proposed that would create an additional category of restrictions (disregarded restrictions) that would be ignored in valuing an interest in a family-controlled entity transferred to a member of the family if, after the transfer, the restriction will lapse or may be removed by the transferor and/or the transferor s family. Disregarded restrictions would include limitations on a holder s right to liquidate that holder s interest that are more restrictive than a standard to be identified in regulations. A disregarded restriction also would include any limitation on a transferee s ability to be admitted as a full partner or to hold an equity interest in the entity. 22

51 BDO Business Valuation Insights PROPOSED CHANGES TO 2704 On May 10, 2015, Cathy Hughes, from the Treasury's Office of Tax Policy, spoke at the ABA Tax Section Meeting. She discussed various proposed regulations and anticipated regulations and projects. Specifically, she indicated that proposed section 2704 regulations might be released by mid- September. For many years taxpayers have been claiming valuation discounts on family owned and managed entities to reflect lack of control and lack of marketability. Concerned with the extent of the discounts allowed by courts, and the ability to create, fund and transfer assets to entities in order to claim discounts, the IRS may be about to take action. There is a growing concern that new regulations might be released by mid-september that may significantly curtail discounts. In Closing 23

55 BDO Business Valuation Insights IN CLOSING Valuation is deceptively challenging Two qualified experts with similar expertise and using the same information can come to materially different conclusions regarding the value of a business or asset Valuation conclusions rely on many assumptions and parameters, many of which are subjective in nature which can be the source of large variations in value the challenge for valuation experts is to establish assumptions that are supported by market data, company-specific information, guideline public company information, industry information, and qualified statements/assertions of company management. The old adage, Valuation is more an art than a science is true! Small variations in assumptions, each innocuous individually, can have a material impact on the final valuation conclusion Valuations may rely on many different pieces of information, some of which may be inconsistent with each other valuation experts need to carefully mine through the information, documenting what was relied upon and why. 56 BDO Business Valuation Insights IN CLOSING However, there is hope! Most businesses and assets can be valued with more than one approach, providing a way to triangulate on value. Over time, much more research and resources are available to valuation experts to obtain objective company, industry, and market information to use in a valuation analysis. The valuation industry is much more established today with experts at many firms solely focusing on valuation matters and with those firms having appropriate p technical standards in place VALUING PRIVATE COMPANIES Page 56 24

57 BDO Business Valuation Insights Questions? Tami M. Bolder, CPA/ABV, ASA, MBA, DBA Valuation & Business Analytics BDO Consulting 32125 Solon Road Cleveland, Ohio 44139 Direct: 440-394-6161 Tel: (440) 248-8787 Fax: (440) 248-0841 E-mail: tbolder@bdo.com About BDO Consulting BDO Consulting, a division of BDO USA, LLP, provides litigation, investigation, business restructuring, valuation, and risk advisory services to clients in the United States and internationally. Our highly experienced and well-credentialed professionals leverage the global industry and accounting knowledge of the BDO international network, providing rapid, strategic advice to assist our clients. www.bdoconsulting.com About BDO USA, LLP BDO is the brand name for BDO USA, LLP, a U.S. professional services firm providing assurance, tax, financial advisory and consulting services to a wide range of publicly traded and privately held companies. For more than 100 years, BDO has provided quality service through the active involvement of experienced and committed professionals. The firm serves clients through more than 49 offices and more than 400 independent alliance firm locations nationwide. As an independent Member Firm of BDO International Limited, BDO serves multinational clients through a global network of 1,204 offices in 138 countries. BDO USA, LLP, a Delaware limited liability partnership, is the U.S. member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms. BDO is the brand name for the BDO network and for each of the BDO Member Firms. www.bdo.com. To ensure compliance with Treasury Department regulations, we wish to inform you that any tax advice that may be contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or applicable state or local tax or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein. Material discussed in this publication is meant to provide general information and should not be acted on without professional advice tailored to your individual needs. 2013 BDO USA, LLP. All rights reserved. www.bdo.com BDO USA, LLP, a Delaware limited liability partnership, is the U.S. member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms. BDO is the brand name for the BDO network and for each of the BDO Member Firms. 25