Business Valuation Basics Presented by John Hayes Managing

Business Valuation Basics Presented by: John Hayes, Managing Director Anchor Planning & Valuations, Ltd.

About Anchor Planning § Specialized firm based in Illinois with a national reputation and client base, designed to deliver clients focused services not available from general CPA or consulting firms § Provides business planning and valuation services to primarily small to medium size businesses § Recruits the best staff through an extremely selective process which requires maintaining their professional education through industry organizations and turning business valuations from an expense into an asset § Valued business transactions ranging from $10, 000 to in excess of $100 million § Client industries include: Automobiles, Banks, Savings & Loans, Information Services, Insurance, Medical, Dental, Metals and Metal Fabrication, Retail, Healthcare, and third parties such as attorneys and accountants

About Your Presenter John W. Hayes, Managing Director Representative Accomplishments: § Undergraduate degree in Finance from De. Paul University and MBA from the University of Notre Dame § Active in the valuation profession for more than 20 years, professional designations include: CPA/ABV, ASA, CVA, CFE, Cr. FA § Frequent speaker and writer on valuation topics for the AICPA and the Illinois CPA Society § Directed and prepared appraisals for the purposes of financial accounting, tax reporting, financing, strategic decision making and litigation support

What is Business Valuation?

What Is Business Valuation? Business Valuation: § The act or process of determining the value of a business enterprise or ownership interest therein

When Is A Valuation Needed? Litigation § Bankruptcy § Marital Dissolution § Damages caused to business Compliance § Determination of Estate & Gift taxes § Employee Stock Ownership Plans (ESOP) § Purchase Price Allocation (PPA) § Goodwill Impairment Testing Strategic § Purchase/Sale of business or shares § Fairness Opinions

Why Use An Appraiser? § Specific knowledge of methods § Experience determining value § Certified and complies with accepted industry standards § Continuing professional education requirements § Litigation support

BV Professional Standards § Uniform Standards of Professional Appraisal Practice (USPAP) § National Association of Certified Valuation Analysts (NACVA) § Institute of Business Appraisers (IBA) § American Institute of Certified Public Accountants (AICPA) § American Society of Appraisers (ASA) § The Appraisal Foundation § Canadian Institute of Chartered Business Valuators (CICBV) § Internal Revenue Service (IRS)

What is Value?

What Is Value? Value = Worth, Utility, Desirability The value of an asset is the benefit you receive from that asset

A Dollar Today…. . . is worth more than a dollar tomorrow Due to factors such as: § Opportunity Costs § Inflation

Definitions Of Value Fair Market Value: The price at which the property would change hands between a willing buyer and a willing seller, when the former is not under any compulsion to buy and the latter is not under any compulsion to sell; both parties having reasonable knowledge of relevant facts (Revenue Ruling 59 -60)

Other Definitions Of Value § Fair Value § Investment Value § Intrinsic Value

Sources Of Authority For Definition Of Value § Statutory law § Legally binding rules and regulations § Contractual definitions of value § Non-legally binding administrative rules § Precedential court decisions § Direction from the court § Direction from the lawyer § Use of IRS authority in non-tax situations § Opinions of other lawyers and appraisers

Premises Of Value § Going concern – value in continued use § Assemblage of assets – value in place, but not in current use or as a going concern § Orderly disposition – value in exchange on piecemeal basis given a normal time to sell § Forced liquidation – value in exchange on piecemeal basis given less than normal time to sell

Overview of Accepted Approaches, Methods & Procedures

Overview Of Accepted Approaches, Methods, And Procedures Hierarchy of Approaches, Methods, and Procedures § Approach is the broadest of the three terms § Method refers to general ways to implement approaches § Procedures means the specific calculations, data used, and other details involved in a specific method

Business Valuation Approaches § Income Approach – valuing the business based on some form of economic income stream § Market Approach – valuation by reference to other transactions § Asset-Based Approach – valuation on the basis of assets and liabilities

Business Valuation Methods Income Approach § Discounting method § Capitalizing method Market Approach § Guideline public company method § Guideline merged and acquired company method Asset-Based Approach § Adjusted net asset value method § Excess earnings method

Financial Statement Basics § Basic Financial Statements § Income Statement § Balance Sheet § Levels of Financial Statement Presentation § Audited: Independent auditor expresses opinion § Reviewed: Accountant expresses limited assurance § Compiled: Management’s representations presented in the form of financial statements

Income Approach “Value today always equals future cash flow discounted at the opportunity cost of capital. ” 1 § Discounting Method - a method within the income approach whereby the present value of future expected economic benefits is calculated using a discount rate § 1 Richard Discount Rate - an opportunity cost; the rate of return available to investors in the market on investments of comparable risk A. Brealey and Stewart C. Myers, Principles of Corporate Finance, 7 th ed. , 2003. p. 75

Income Approach § $1, 000 to be received at the end of each of the three years § Discount Rate is 8% Year 1 Year 2 Year 3 PV = $1, 000 PV = (1 +. 08)1 (1 +. 08)2 PV = $925. 93 PV = $2, 577. 10 + $857. 34 + $793. 83

Income Approach Note how discounting is the opposite of compounding: $925. 93 x 1. 08 = $1, 000 $859. 34 x 1. 08 = $1, 000 $793. 83 x 1. 08 = $1, 000

Income Approach § Capitalization Method - a conversion of a single period of economic benefits into value. § Concept of capitalizing: shortcut version of discounting Assumptions: § Amount of income capitalized will remain constant each year in perpetuity OR § Amount of income being capitalized will either increase or decrease at some constant annually compounded rate into perpetuity

Income Approach Constant Income Capitalization Model (a. k. a. Gordan Growth Model): Assume: Dividend = $5. 00 Capitalization rate = 10% $5. 00 Present Value (PV) = . 10 = $50. 00

Income Approach Income Capitalization Growth Model Assume: Prior period income ( i ) = $10. 00 Sustainable growth rate ( g ) = 3% Discount rate ( k ) = 13% Di $10. 00 x 1. 03 PV = k - g = $10. 30 . 13 -. 03 = . 10 = $103. 00 Di = income expected at the end of future year

Market Approach § Market Approach – a method of determining a value indication of a business asset by using one or more methods that compare the subject to similar businesses that have been sold Reasonable basis for similar businesses: § Similar qualitative and quantitative investment characteristics § Sufficient amount of available, verifiable data § Transacted in arm’s-length deal, opposed to forced or distressed sale

$Market Approach § Valuation Multiple – a fraction in which a value or price$

Market Approach § Valuation Multiple – a fraction in which a value or price serves as the numerator and financial, operating, or physical data serves as the denominator (e. g. Sales Price/EBITDA) Assume: § Similar company Sales Price/EBITDA multiple = 3. 0 § Subject company Last 12 Months EBITDA = $10, 000 § Subject Company Value = 3. 0 x $10, 000 = $30, 000

Market Approach § Guideline Public Company Method – share prices of similar, activelytraded publicly owned companies are applied to the subject company through valuation multiples Strengths of method: § SEC filing requirements § Active trading § Daily trading § Large amount of analytical information

Market Approach Sources for guideline public company method: § SEC Filings § 10 -K annual report § 10 -Q quarterly report § 8 -K special events filing § Yahoo! Finance § Daily stock prices

Market Approach § Guideline merged and acquired company method: Transaction prices of similar, public or privately-owned companies are applied to the subject company through valuation multiples Strengths of method: § Large amounts of available data on small businesses and practices § Transactions in more industries than guideline public company method § Transactions are for controlling interest; no additional control premium needed

Market Approach Sources for guideline merged and acquired company method: § Sales of Public Companies § Mergerstat®/Shannon Pratt’s Control Premium Study™ § Public Stats™ § Sales of Private Companies § Pratt’s Stats™ § BIZCOMPS© § IBA Market Database All databases available at www. BVMarket. Data. com, except IBA Market Database which is available at www. go-iba. com

Asset-Based Approach § Asset-Based Approach - a general way of determining a value indication of a business, business ownership interest, or security using one or more methods based on the value of the assets net of liabilities Method most appropriate for the following businesses: § Real estate holding companies § Investment companies § Finance companies § Manufacturing companies heavily invested in fixed assets

Asset-Based Approach Adjusted Net Asset Value Method Steps: § Obtain or develop an accrual basis balance sheet § Determine which assets and liabilities on the balance sheet require valuation § Identify any off-balance sheet assets or liabilities § Value the items identified in steps 2 and 3 § Construct a market value-based balance sheet using the adjusted values

Asset-Based Approach Excess Earnings Method Steps: § Estimate (A) a normalized level of operating earnings, (B) the operating tangible asset value, and (C) a reasonable rate of return § Multiply the reasonable rate of return by the value of tangible assets to arrive at the reasonable dollar return on tangible assets § Determine excess earnings by subtracting the return on tangible assets from normalized earnings

Asset-Based Approach Excess Earnings Method Steps (continued): § Determine the capitalization rate appropriate for the excess earnings § Determine the value of intangible assets by dividing the capitalization rate into the excess earnings § Add the value of tangible assets to the value of intangible assets

A Word On Approaches and Methods Not Totally Discrete § There is some overlap among approaches and methods. How much overlap there is depends on the procedures used in each method. § Business appraisers generally prefer to avoid overlaps to the extent possible in order to form independent indications of value by each approach.

Discounts and Premiums Often the largest money issue is not the base value, but the applicability and/or magnitude of discounts and/or premiums to be applied to the base value

Benefits Of Control An Investor Likes Control Because: § Effect an acquisition/merger § Pursue own business interests § Influence management selection and policies § Determine capital structure § Manage operations § Discretion over new stockholders or partners § Acquire or liquidate assets

Minority Versus Control Degrees of minority versus control ownership: § 100 percent control § Slightly less than 100 percent control § Less than a supermajority where a supermajority is required for certain corporate actions § 50 percent interest § “Swing vote” minority block § High enough percentage to bring a minority oppression dissolution action

Entity Level Discounts affect all shareholders: § Significant risk factors § Key person, size, lack of geographic diversification § Portfolio discount § Trapped-in capital gains discount § Environmental or litigation risk

Shareholder Level Discounts Shareholder level discounts have different impacts on different shareholders: § Minority versus control § Lack of marketability § Voting versus nonvoting shares § Blockage discount

Discounts For Lack Of Marketability [DLOM] The concept of marketability: “The ability to convert the business ownership interest (at whatever ownership level) to cash quickly, with the minimum transaction and administrative costs in so doing and with a high degree of certainty of realizing the expected amount of net proceeds. ” 2 2. Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 4 th ed. , p. 393.

DLOM Degrees of marketability or lack thereof: § Registered with the SEC and with an active trading market § Registered with the SEC and fully reporting, but with a somewhat thin trading market § Private company with frequent private transactions § Private company with few or no transactions § Private company with ownership interest absolutely prohibited from transfer

Levels Of Value In Terms Of Characteristics Of Ownership Source: PPC’s Guide to Business Valuations, Exhibit 8. 8 in 16 th Edition

The “Mandelbaum” Factors § In Mandelbaum v. Commissioner 3 (1995), a federal Tax Court case, Judge Laro details the factors to consider in determining discounts: § Financial Statement Analysis § Company’s Dividend Policy § Nature of the Company (History, Position in Industry, Economic Outlook) § Company’s Management § Amount of Control in Transferred Shares § Restrictions on Transferability of Stock § Holding Period for Stock § Company’s Redemption Policy § Costs Associated with Making a Public Offering 3. Mandelbaum v. Commissioner, 1995 Tax Ct. Memo LEXIS 256 (1995) (Laro, J. )

Evidence Quantifying DLOM § Restricted Stock Studies § Pre-IPO Studies § “(The IRS’s expert) should have considered the…data reflected in those pre. IPO studies because they, together with the restricted stock studies, would have provided a more accurate base range and starting point for determining the appropriate lack-of marketability discount…” 4 - Tax Court 4. Davis v. Commissioner 110 T. C. 530, 110 T. C. No. 35, June 30, 1998

Sources For Quantifying Discounts And Premiums Control Premium/Minority Discount § Mergerstat®/Shannon Pratt’s Control Premium Study™ Lack of Marketability Discount § FMV Restricted Stock Study™ § Valuation Advisors’ Lack of Marketability Discount Study™ All databases available at www. bvresources. com

Reconciliation Of Value § Weighting of valuation method results § Final value estimate § Review of appraisal process § Did the analyst appraise the right thing? § Did the analyst appraise the right thing in the right way?

Courtroom Tips for the Expert Watch Out for these Questions: § Would you buy this company for what you've valued it? § Have you actually ever sold a business? Because if not, you really don't have a clue what real buyers and sellers consider, do you? § You have arrived at a specific dollar value in your report—but value is a range, isn't it? If so, what is an “acceptable” range, plus or minus? Within what range does your value fall?

Courtroom Tips for the Expert § Does your report contain any math errors? Because if it does—then it would be unreliable, correct? § Do you consider Shannon Pratt to be an authority in the field of business valuation?

Thank You John W. Hayes Anchor Planning & Valuations, Ltd. 1010 Jorie Blvd. , Suite 380 Oak Brook, IL 60523 Phone: (630) 573 -7654 Fax: (630) 573 -9930 anchorjwh@cs. com

Additional Resources Flexibility is at your fingertips with this additional resources slide library. Add slides on specific topics for special audiences, or store slides you do not want to use for a particular presentation. The customizing possibilities are endless!

Additional Resources Association web sites: § American Institute of CPAs (AICPA), www. aicpa. org § American Society of Appraisers (ASA), www. appraisers. org § Institute of Business Appraisers (IBA), www. go-iba. org § International Business Brokers Association (IBBA), www. ibba. org § National Association of Certified Valuation Analysts (NACVA), www. nacva. com

Uses of Business Valuation Reports Related to Buying / Selling § Sale of a Business § Mergers & Acquisitions § Divestiture § Initial Public Offerings § Allocation of Acquisition Price § Buy/Sell Agreements § Franchise Valuation or Evaluation § Split-ups/Spin-offs

Other Than Buying/Selling § Adequacy of Life Insurance § Gifting Programs § Estate and Gift Taxes § Charitable Contributions § Eminent Domain

Other Than Buying/Selling § Employee Stock Ownership Plans (ESOP’s) § Fairness Opinions § Lease versus Buy § Mediation & Arbitration § Succession Planning

Litigation Support § Dissenting shareholder actions § Divorce § Economic Loss Analysis § Disruption of Business § Partner Disputes § Wrongful Death

Types of Clients § Business Owners § Attorneys § Judges § Creditors § Financial Institutions and Planners § Insurance Companies § Real Estate Appraisers § Other Business Valuators

Who Can Be A Qualified Valuator? § Economists § Investment Bankers § Business Brokers § Financial Analysts § Certified Public Accountants (CPA’s)

Valuators As Expert Witnesses

Professional Designations § American Society of Appraisers (ASA) § Accredited Senior Appraiser § Institute of Business Appraisers (CBA) § Certified Business Appraiser § National Association of Valuation Analysts (CVA) § Certified Valuation Analyst

Professional Designations American Institute of Certified Public Accountants (ABV) § Accredited in Business Valuation Canadian Institute of Chartered Business Valuators (CBV) § Chartered Business Valuator Association for Investment Management and Research (CFA) § Chartered Financial Analysts § Oriented primarily to public companies, includes material on private company valuation, and several hundred CFA’s specialize

USPAP Professional Standards Uniform Standards of Appraisal Practice (USPAP) § Established in 1987 by The Appraisal Foundation § Consists of eight (8) appraisal organization and ten (10) non-appraisal organizations interested primarily in real estate appraisals § The most widely cited and recognized set of professional standards for appraisals is the Uniform Standards of Professional Appraisal Practice (USPAP), published by The Appraisal Foundation § The Foundation is located at 1029 Vermont Ave. , NW, Suite 900, Washington, D. C. , 20005, ph: (202) 347 -7722 § USPAP is updated each year in November, to be effective the following January 1 § It covers appraisal for all disciplines, including real estate, personal property, and appraisal of businesses, business interests, and intangible asset § Two (2) of USPAP’S ten (10) standards apply to business valuations and were added due to the number of members performing business appraisals

Professional Standards § Standards published be each of the above organizations are somewhat more detailed than USPAP § However, none of them are in conflict with USPAP § All of these organizations’ standards are available at no charge

Professional Standards Summary All Organizations Require: § Ethics § Competency § Consideration of all recognized valuation approaches § Clear and accurate reports

Selection of a Valuation Professional § Education § Training & Continuing Education in Business Valuation § Technical training, accreditation and certification § ASA, CBA, CVA, ABV, CBV and CFA § Experience § Certified Public Accountant § Specific Industry Experience - Skills and expertise in tax treatments, IRS regulations, financial analysis, and business valuation experience

“Top Ten” List for Attorneys 1. Define the project 2. Understand the standard of value 3. Involve the appraiser early on 4. Distinguish between a business appraisal and a real estate appraisal 5. Establish a reasonable time frame

“Top Ten” List for Attorneys 6. Insist on an appraiser with experience and credentials 7. Know the primary business valuation methods 8. The appraisal is the first line of defense 9. Litigation support issues 10. Expect the best

Definitions § Fair Market Value § The price at which an asset would change hands between a willing buyer and a willing seller § Enterprise and Invested Capital § The sum of debt and equity capital § Equity § This is the value to all shareholders

Definitions § Majority vs. Minority § Control premium – the premium, over the minority price, that a buyer would pay to gain control § Discount for lack of control – the amount by which the majority value is reduced to obtain a minority value § Marketability Discount § This reduction in value accounts for the stocks lack of a liquid market

Definitions § Standards of Value § Fair Market Value § IRS Ruling 59 -60 “…the amount at which the property would change hands between a willing buyer and a willing seller, when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. ” § Fair Value § Defined by individual states and is based upon the case law precedents involving dissenting stockholder actions

Definitions § Investment Value § Value of a business asset to a particular buyer as compared to a population of willing buyers § The purpose and function of the business valuation is to determine the proper standard of value used in a valuation

Definitions § Premise of Value § Going Concern – The value of a business enterprise that is expected to continue to operate into the future § The intangible elements of Going Concern Value result from factors such as having a trained work force, an operational plant, and the necessary licenses, systems and procedures in place

Definitions § Liquidation Value – the net amount that can be realized if the business is terminated and the assets are sold piecemeal § Liquidation can be either “orderly” or “forced” Orderly: § Liquidation value at which the asset or assets are sold over a reasonable period of time to maximize proceeds received Forced: § Liquidation value at which the asset or assets are sold as quickly as possible, such as at an auction

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