1999 Monthly Newsletters
December 6, 1999 - Industry Experts or Business Appraisers?

Clients needing valuations must sometimes decide whether to retain a business appraiser or an industry specialist. Both types of expertise are helpful, however, but one firm or individual usually does not bring both to the table.

Industry experts have many advantages. They talk the client’s language, know the players and understand the issues. They are instantly credible. Appraisers often have no industry knowledge (when they are first called). If they aren’t quick studies, good diagnosticians or are not given time for homework, they can be eliminated from further consideration.

Once the discussion of value begins, however, the tide turns. Today, with the incredible amount of information available from the Internet, trade associations, Wall Street and other sources, competent appraisers can quickly get up to speed on almost any industry. Appraisers know the right questions to ask and where to get answers. They often consult industry experts to obtain crucial insights and are happy to include them as part of the appraisal team (a sound, cost-effective approach).

Once the information playing field is leveled, the advantage shifts decisively to appraisers. They know the rules: legal value standards, proper and improper premises, valuation approaches and methods. They know how to double-check, justify and support opinions. Time and time again, we see industry experts rely on anecdotal evidence, rules of thumb or, worse "their professional opinion". That dog won’t hunt. There is nothing more devastating to an opinion than a fact, and appraisers know how to get the right facts.

The bottom line: industry expertise is a small but important part of a professional appraisal. Although it is highly visible at the outset of an engagement, it is quickly overtaken by the need to follow good appraisal standards, theory and practices. In the end, a competent appraisal will add greater value.

Valuations play a part in all strategic transactions. If we can provide additional information or advice on a current situation, please don’t hesitate to call us.

November 12, 1999 - "How Much Appraising is Enough?"

Business owners and their advisors frequently ask us for full appraisals in situations that clearly call for something less. This happens most often in deal-making situations. Here’s why:

What counts in deals is whether buyers and sellers can negotiate mutually acceptable prices and terms. Deals concern value to specific buyers and sellers, based on their individual situations.

Unless buyers and sellers agree to abide by appraisers’ opinions, of what value are they to either?

It is often impossible for an appraiser to fully capture the issues that drive the deal. How much money will the buyer save by combining the seller’s operations with his or her own? Why is the seller really selling? Both sides are usually holding aces up their sleeves!

Conducting a full appraisal is like a doctor ordering up a full battery of tests when a few key indicators will confirm a diagnosis.

In deal-making situations, a full appraisal is often a waste of money. We have powerful, inexpensive tools – data on other transactions, rules of thumb and justification of purchase tests – in addition to our extensive experience as business brokers that we can apply to quickly validate asking and offer prices. In addition, we believe it is unethical and unfair to clients to perform unnecessary work. We want to maximize their return on their investment in us by doing only what is absolutely necessary to help them.

The higher the probability of a deal, the less our appraisal services are needed, and we tailor our services, fees and schedule accordingly. When we list a business for sale, we help the seller arrive at a price without any up front fees. Instead, we are paid a commission at close of escrow as the sale is completed. When we work with buyers we assist them to view the potential transaction to see if it will meet their needs. When we find a buyer and seller that each have their needs met, the transaction typically takes place.

In low- or no-probability-of-a-deal cases (estate taxation, litigation and divorce), full appraisals are always essential because there will be no arms-length transactions. Typically, whenever there is a possibility of going to court or when you are dealing with the Internal Revenue Service, a full comprehensive appraisal report will be required.

Valuations play a part in all strategic transactions. If we can provide additional information or advice on a current situation, please don’t hesitate to call us.
October 13, 1999 - "Information Known or Reasonably Knowable"

Not a week goes by that I do not receive an inquiry about the relevance and impact of "subsequent events" on a business valuation. It happens so frequently that I have memorized the applicable language from Revenue Ruling 59-60, the foundation document for estate and gift tax valuations. According to Section 3, Paragraph .03 of the Ruling:

"[A valuation] must be based on facts available at the required date of appraisal."

This brief statement has been interpreted in practice to mean that:

1. "Facts available" are those deemed to be known or reasonably knowable as of the valuation date.

2. Subsequent events that indicate value may be relevant. Those that affect value may not be.

The word "subsequent" is vague: how long after the valuation date is "subsequent"? Something that happens a year after the valuation date that was not known/reasonably knowable is probably irrelevant, but something within a few months or less is probably relevant. Like much else in appraising, case facts and circumstances, common sense, reasonability, judgment and the "smell test" are paramount!

Our most common inquiries concern:

1. A company about to be (or actually) sold shortly after the valuation date.

The best plan is to determine whether it was known or reasonably knowable that the sale was about to take place. At one extreme, if the owners were not considering a sale, had done no preparatory work (talking to advisors, retaining intermediaries) and an offer came from nowhere, a strong case could be made that the sale was not known or knowable (condition 1 above). But the sale price would be indicative of value (condition 2). If the buyer was strategic (having a fit with the seller), then the price could have reflected synergistic benefits that are not part of fair market value (which considers any willing buyer, not a buyer with specific attributes) and the price might be higher than fair market value. Would I strongly argue this point? Probably not.

2. A company about to go public.

Although the same issues arise, there is a long road between the desire to go public and an IPO. Stock market hiccups freeze the IPO market instantly. IPO's are risky propositions, and I heavily discount them.

3. A material change in the business and/or its financial position.

What if a company lost a major customer? Developed a new product? Here the appraiser must closely question clients to determine facts and circumstances. Was there any evidence as of the valuation date that the customer relationship was at risk? Had the new product been field-tested? Were there any firm prospects?

4. Valuations prompted by estate planning for elderly and/or ill people.

The IRS has had a field day challenging transactions occurring just before death. There are strict rules about actions taken in contemplation of death. Aggressive moves are sure to be challenged. Let the "dier" beware!

Valuations play a part in all strategic transactions. If I can provide additional information or advice on a current situation, please don't hesitate to call me.
September 15, 1999 - Justification of Purchase: A Key Appraisal Tool

A valuation without a reasonability test is open to criticism, rebuttal, and rejection because the appraiser cannot answer the killer question: "Why is your value justified?" Look for this test in all business appraisals. Those without them often prove to be unreliable.

The best test is the Justification of Purchase (JOP). It is based on the premise that a value is reasonable if the business, bought for that amount, will:

Pay the manager (or owner-manager) reasonable compensation.

Service existing and purchase-related debt adequately.

Generate cash flow (above management compensation).

Earn a sufficient return on investment (ROI). (For a small store or franchise, the owner’s sole motivation is often to keep a job. He or she may not consider ROI. Stated another way, they accept a low return or dangerously assume they will earn a high one when selling out. ROI usually applies to medium- and large-size firms.)

The JOP also assesses financeability, shows creditworthiness (lenders always do this kind of analysis) and indicates a rate of return. This is why the JOP is a powerful tool that helps our clients inexpensively and quickly:

In deals, buy-sells, divorces and other real transactions, it addresses not only value but also terms.

It is an ideal way to rebut unreasonable values in litigation.

It is substantiates a fairness opinion.

It determines whether a business qualifies for the $1.3 million family business estate tax exclusion.

The JOP lets us work valuations backward. Given a value (price and terms), we determine an implied rate of return, cash flow or holding period. When clients’ budgets or time frames are tight, the JOP, along with a short report and appropriate disclaimers, does the job very well.
COST SAVING ESTATE PLANNING SUGGESTION

Federal gift tax rules require that valuations be made within 60 days of the gift date. Clients can have a valuation as of December 1, make gifts by yearend and early the next year, using the same valuation. They then wait two years and repeat the process. This way one appraisal is used for two years’ gifts, and the cost is halved!

Valuations play a part in all strategic transactions. If we can provide additional information or advice on a current situation, please don’t hesitate to call us.
August 15, 1999 - Rates and Multiples: Define Them!

Many valuation discussions founder on misunderstood definitions. Multiples of earnings and rates of return are proposed, argued and negotiated, and may turn out to be inappropriate. This month’s letter reviews three of the most common areas of misunderstanding:

The difference between publicly traded and private company valuation multiples.

The relationship between capitalization multiples and rates of return.

The importance of using the appropriate capitalization multiple or rate.

Public vs. Private Multiples

Publicly traded companies are usually priced relative to net income (earnings) per share, which is defined as profit net of interest and tax expense. Today, typical net income multiples range from the low teens to 40 or more (and higher, for high-flying Internet and technology stocks). Private companies, on the other hand, are priced relative to operating income ("EBIT", which is earnings before interest and tax expense, or variants thereof), and multiples of from 3 to 7 are common. The difference in multiples arises from two factors:

Operating income (which excludes interest and tax expense) is larger than net income, so, all other things being equal, the multiple is smaller.

Private companies are less liquid than freely traded public shares, so their multiples are lower.

Private companies are traditionally priced relative to operating income because the buyer has the ability to change the amount of debt (and thus interest expense) and may face a different tax rate.

Multiples and Rates

Valuation multiples are inversely related to capitalization rates. Mathematically,

1 / Capitalization Rate = Capitalization Multiple

A company with a capitalization rate of 20% would have a price multiple of (1 / 20% =) 5.0. The capitalization rate is in turn related to the "discount rate", which is the rate of return expected for the given company, by the formula:

Capitalization Rate = Discount Rate – Growth Rate

This applies only when growth is expected to be constant (in percentage terms), a common situation.

Using the Appropriate Multiple or Rate

Generally speaking, an appraiser can capitalize (that is, apply a capitalization rate or multiple to) any level of business activity desired. It is perfectly legitimate to price based on income before taxes, cash flow or sales as long as the capitalization rate is consistent with what is being capitalized. As discussed above, public companies are typically priced relative to net income and private companies are priced relative to operating income.

If we have a company with $100 in sales, $25 in operating income, $20 in income before taxes, $15 in net income and $30 in cash flow, an appraiser could decide to capitalize any one of these. Their decision will be based on which one(s) have the most empirical support from market data and appraisal methodology. The point: all of the rates and multiples must lead to the same value. In this example, assume we capitalized the $25 in operating income at a multiple of 4 (a capitalization rate of 25%), resulting in a value of (4 X $25 =) $100. For this company, the equivalent multiple of net income would be 5 since 6.7 X $15 = $100. The comparable multiples of sales, income before taxes and cash flow would be 1, 5 and 3.3; all of them, when multiplied out, yield the same value. Many appraisers err by applying an inappropriate capitalization rate. The most common mistake is to apply a capitalization rate based on after-tax returns (such as net income or cash flow) to a pre-tax return (like income before taxes or operating income).

Valuations play a part in all strategic transactions. If we can provide additional information or advice on a current situation, please don’t hesitate to call us.
July 14, 1999 - Double Counting!

During the past few months, several client engagements have involved what I call "the double-counting fallacy" or "having it both ways." This letter will define and resolve the problem.

Businesses are either valued on their assets or their earnings. A good example of a business for which an asset-based valuation is appropriate is an investment company. The value of its underlying assets—such as publicly traded securities—can easily be determined at any time. The company is worth the market value of its assets less its liabilities. On the other hand, a service business, for which most of the assets (people) are not measured on the financial statements, is normally valued at a multiple of its earnings. Its financial assets are often inconsequential in comparison to the value of the business as a whole.

Sometimes business owners inadvertently double-count the value of their assets—and try to have it both ways. We see this a lot in our business brokerage activities! A statement like "my business is worth five times earnings plus the value of the inventory, receivables, etc." is fallacious, because it is valuing assets essential to the operations of the business twice. The assets are worth the greater of EITHER what they will EARN or what they can be SOLD for, not both. This is the principle of value in highest use often cited in real estate appraisals. Stated another way, if you sell your business for five times earnings, you sell all of the operating assets that produce those earnings—the "inventory, receivables, etc." You cannot produce earnings without them. If you sell the business at a value based on earnings, you sell its operating assets at the value determined by those earnings.

Please note the italicized phrase in the preceding paragraph. Assets deemed non-essential to operations—excess cash and investments, obsolete inventory, unrelated investments, owner’s personal toys, etc.—should be appraised separately from the business itself and then added to compute the overall value. In mergers or acquisitions, sellers often keep these assets and sell only essential operating assets.

A less obvious instance of the fallacy often arises in divorce valuations. On the one hand, alimony and support payments may be based on the actual earnings of the spouse owning the business. If this is the case, then the business should be valued WITH THAT LEVEL OF COMPENSATION in place. To do otherwise is to assume one level of income for support purposes and another for valuation purposes, which could either double—or under-count compensation. If the appraisal assumes a lower level of compensation, then the ultimate value of the business will be overstated (assuming it is valued on the basis of earnings). If the appraisal assumes higher compensation, the business will be undervalued. It is easy for this to fall through the cracks, as the appraiser may focus only on the business value while another professional analyzes support payments. They need to be on the same page, because, as the saying goes, "you can’t have it both ways."
June 17, 1999 - How long is a business appraisal good for?

A properly done appraisal—an assessment of a business’s intrinsic value based on characteristics such as earnings and assets—is valid as long as its underlying assumptions remain valid. Some of these assumptions change rapidly, some more slowly: external factors such as world events, economic trends and competition as well as internal factors such as management, markets and finances.

Some valuations, like those for Employee Stock Ownership Plans, are legally obsolete after a year and must then be updated. Others are contractually outdated; prudent buy-sell agreements should stipulate annual reviews. Estate tax returns, litigation appraisals, merger and acquisition reviews and transaction fairness opinions are normally one-time engagements.

Most valuations are open-ended because their underlying purposes are long-term. A typical example occurs when families sell or transfer minority business interests each year as part of their estate and business succession planning.

Valuations depend on many factors, all of which can change. I have appended the table of contents of a typical Hyde Business Valuations appraisal report and highlighted the sections most susceptible to change. These include critical assumptions (such as management continuity), the industry outlook, historical financial performance, assumptions about and projections of future results, prices of guideline (comparable) companies, the price/earnings multiple and the company’s normal earnings.

Consistent with my "once a client, always a client" philosophy, I follow up to make sure the ultimate goal of every valuation is achieved and to recommend an update, if needed. This is determined by a brief discussion of business developments and by review of the most recent financial statement. This generates similar data to what public companies disclose in their annual reports. Typically, chances are 4 in 5 that a valuation will be good for at least a year.

Valuations play a part in all strategic transactions. If I can provide additional information or if you would like to meet to discuss current developments or a specific situation, I would be happy to talk to you.
Valuing Stock Options

Stock options are increasingly popular vehicles for employee incentives, executive compensation and estate planning. Here’s how we value them.

Most options are "calls" giving owners the right to purchase a fixed number of shares at set "exercise" or "strike" prices for a period of time (the "option period"). Assume you own a call on one share at $100. If the stock sells for $110, you exercise (buy the share) and sell it for a $10 profit (less the cost of the option). This option is "in the money" by $10. If the stock trades at $80, the same transaction loses $20. This option is "out of the money" by $20. You would not exercise the option. If the option ultimately expires without the stock price moving high enough to be worthwhile exercising it, you would lose the amount paid for the option.

Options are attractive for estate planning. The best assets to transfer out of an estate are those with little current value and high appreciation potential. Options, particularly those out of the money, work well as long as they are not subject to restrictions such as delayed vesting (ownership) or exercise periods. Limitations like these may reduce or eliminate their eligibility for transfer for estate and gift tax purposes. Securities and Exchange Commission rulings permit employees of public companies to transfer unrestricted options to family members at minimal estate/gift tax cost.

Appraisal theory and the Financial Accounting Standards Board dictate valuations of publicly traded options. They prescribe the Black-Scholes valuation model. It relies on six key factors:

The volatility of the underlying stock: as it rises, the option value rises because there is a greater chance of being in the money before the option expires.

The option period: the longer it is, the higher the option value for the same reason.

The risk-free interest rate (on Treasury debt of the same maturity as the option period): as it rises, the option value rises because the owner earns interest until the option is exercised.

The difference between the stock and exercise prices: as an option becomes more in the money (or less out of the money), its value rises for the first reason cited above.

The stock dividend yield: as it increases, the option value falls because option owners do not receive dividends (stock owners do).

There are technical problems with Black-Scholes (it assumes options are excercisable only at the end of the option period), but it is generally accepted in the financial community for publicly traded options.

The accounting treatment of options is also complicated. It depends on the terms associated with the option and market prices. Knowledgeable accounting advice is mandatory.

There are major differences between options on public and private company stocks. Privately owned stocks and options are illiquid. Their values are highly uncertain. Black-Scholes does not work for them because their volatility and value are unknown. Small changes in these key factors, whose values must be developed and substantiated, lead to big changes in Black-Scholes values, a major drawback in defending valuation conclusions.

Other private option valuation models exist that are better but are less well known, despite having been empirically tested. We have had success with the Shelton model. It values options based on Black-Scholes variables except for volatility and interest rates. It also considers lack of marketability.

If we can be of assistance, please give us a call.

Sincerely,

 

 Paul R. Hyde, C. B. A.
Certified Business Appraiser, The Institute of Business Appraisers, Inc.
Candidate Member, Business Valuation, American Society of Appraisers
Enrolled to Practice Before the Internal Revenue Service, Enrolled Agent
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