2001 Monthly Newsletters
December 17, 2001 - Excedrin Headaches # 141 and #142: Valuing Goodwill and Intangible Assets

On June 30, 2001, The Financial Accounting Standards Board ("FASB") issued new rules that change the way companies must report the value of goodwill and certain intangible assets on their financial statements. The new rules do not directly apply for tax accounting purposes.

Statements of Financial Accounting Standards ("SFAS") 141 (governing accounting for mergers and acquisitions) and 142 (governing accounting for intangible assets) will lead to wholesale modifications. SFAS 141 eliminates "pooling of interests" accounting for mergers effective June 30, 2001. Under that method, the financial statements of the acquirer and acquiree were added together as of the merger date regardless of the price paid by the acquirer. Although merger and acquisition activity has declined during the past year, it has not gone away and may increase because of short-term buying opportunities created by falling stock prices.

SFAS 142 eliminates the practice of recording acquired goodwill and certain intangible assets at cost and amortizing them over time, effective for fiscal years beginning after December 15, 2001. Because so much of the value created by entrepreneurial, service and technology businesses in recent years has been intangible (intellectual property and brands being prime examples), this change has major ramifications for all businesses, ranging from large public companies to startups.

Before these Statements were issued, accounting for goodwill and intangible assets presumed that these assets had finite lives and were "wasting assets" that declined in value over time. They could be combined into a single category called "goodwill". The new rules assume that these assets have unique and indefinite useful lives, that their values do not necessarily decline over time, and require that they be tested annually for "impairment" (reduction) in value. In addition, certain intangible assets must be separately identified, valued, and tested for impairment, including some that were acquired before these rulings take effect this year. The SFAS’s provide specific requirements that indicate which types of intangible assets are subject to the new rules. Impairment will be driven by changes in market and business conditions, not by accounting rules, and will probably be infrequent.

The new rules will create a great deal of work for company chief financial officers, their staffs, and their accountants. They will have to identify specific intangible assets separately, allocate (former goodwill) value to them, and test them annually for impairment. What is now permitted to be classified as "goodwill" is the residual after all other intangible assets have been identified and valued.

Further adding to the complexity is the fact that the standard of value for goodwill and intangible assets, although described by financial accounting standards as "fair value", has characteristics of what appraisers call "investment value." Investment value is the value to a specific buyer or seller based on their unique characteristics, not the value to any willing buyer or seller, which would be "fair market value" (as applies to tax-related valuations). As such, the potential impacts of synergy and control benefits apply to the valuation of goodwill and intangible assets. Note that this "fair value" standard is not the same as the standard of the same name that applies to dissenting shareholder litigation. (State laws define that standard).

Accredited and certified business appraisers are trained to help company financial officers and their auditors by providing independent valuations of goodwill and intangible assets. These valuations require high-level appraisal skills. The new rules move away from the so-called "Asset" Approach to valuation (in which the cost of reproducing or replacing assets is the key value indication, which is then reduced by depreciation and amortization), toward values based on the Income Approach (expected future benefits: earnings or cash flow) and the Market Approach (guideline transactions and market comparables). Both of those approaches require case-specific analysis of the risks and returns associated with specific intangible assets. They are precisely those used in most business appraisals.
November 15, 2001 - Back to Basics: Standards of Value

This month’s letter reviews the importance of the standard of value in business appraisals. The three most common standards are:

  • Fair Market Value – the value to ANY buyer and seller, relevant to tax valuations
  • Fair Value – the statutory standard for dissenting shareholder litigation
  • Investment Value – the value to SPECIFIC buyers and/or sellers in real transactions

The purpose of the appraisal (how the client will use it) dictates the standard of value. In some states, fair market and fair value are identical. Others define fair value differently (especially as to whether discounts for lack of control and/or marketability apply). In Idaho and Oregon, fair market value is typically the standard for divorce (this varies greatly by state), but courts have frequently misinterpreted it. Under the fair market value standard, a minority interest is typically valued using discounts for lack of control and lack of marketability—instead of taking a pro-rata share of the total. Whether or not this is appropriate in divorce actions varies from jurisdiction to jurisdiction.

Fair market value is defined by Revenue Ruling 59-60, several others, and a large body of case law. Under it, eight factors (ranging from the nature of the business to the size of the block of stock to be valued) must be considered, along with a healthy portion of "informed judgment, common sense and reasonableness". The most important aspect of fair market value is that it is hypothetical, assuming that there are many willing buyers and sellers of similar interests. Even though Revenue Ruling 59-60 has been around for 40 years, there are still many gray areas in its interpretation.

By contrast, investment value is case-specific, depending entirely upon the characteristics of the individual buyer and seller. The fair market value buyer is assumed to bring only cash to the table (the classic "financial buyer"). The investment value buyer may be "strategic", with a business fit or other value-adding characteristics that allow them to justify a higher (than fair market value) price. In tax-related appraisals, business owners are often surprised by apparently low valuations. They invariably ask, "What’s my business really worth?" They are asking about investment value.

Real transactions occur at investment value; tax-related transactions are at fair market value.

This difference has many implications, the most important of which are:

All businesses have many values at the same time: the right one depends on the purpose of the valuation.

In mergers and acquisitions, fair market value is the MINIMUM a seller should accept, since it is the value ANY willing buyer would pay. The seller should be looking for TOP dollar, which is INVESTMENT VALUE.

This means that elaborate fair market valuations in contemplation of purchase and sale can be a waste of time and money. Buyers and sellers need to develop reasonable bid and ask prices, from which they can then negotiate.

Fair market value also contains many premises. The most common is whether the business is valued as a going concern (one that produces cash flow to its owners) or in liquidation (with its assets sold and liabilities extinguished). Other premises rarely arise in business valuations but are common in real estate, machinery, and personal property appraisals. These are case-specific, and must be addressed by the appraiser in consultation with the client and their other advisors.

October 15, 2001 - How Long Should a Business Appraisal Take?

A common question…and the answer is: it all depends on the complexity of the assignment. Here are some reasonable guidelines for what to expect after the basic parameters of the engagement (date of valuation, standard of value, type of interest to be valued, etc.) have been established:

1. Valuations in contemplation of sale: Full appraisals are seldom necessary in these situations. What is required are basic calculations of a reasonable asking price and the company’s floor value. These calculations can usually be developed after meeting with the client, conducting brief analyses and writing short reports. They usually take less than one week.

2. Family limited partnerships or limited liability companies: When the underlying asset values, entity balance sheet and operating agreement are provided, these usually take about ten days.

3. Estate and gift tax appraisals: These require full appraisals and detailed reports. Reports can usually be completed within 30 days of receipt of the required business and financial information.

4. Litigation (Including Divorces, Shareholder Disputes, Etc.): These require full appraisals and detailed reports, with the same 30 day production time. If possible, additional time is helpful as in many cases, getting the required information may take some time.

Valuations play a part in all strategic transactions. For additional information or advice on a current situation, please don’t hesitate to call.
September 17, 2001 - What is "Cash Flow?"

Many call net income the "bottom line." However, especially for privately held businesses, "cash flow" or more specifically, "net free cash flow to equity" is the real "bottom line." Businesses do not fail because of lack of profits—they fail because they run out of cash! Often, a business may show a profit on paper, but not have a positive cash flow.

Like many other financial terms, "cash flow" has many definitions, but it ultimately measures the tangible economic benefit of ownership (cash available for distribution) rather than profit, which is an accounting and tax concept.

How do we define cash flow? The attached spreadsheet lists the various measures of cash flow and how they are calculated. The simplest measure is sales: how much revenue came in, the proverbial "top line". We then deduct expenses, arriving at earnings after taxes (net income, often called the "bottom line") toward the middle of the table. Along the way we calculate two popular amounts: EBIT (earnings before interest and taxes) and EBITDA (earnings before interest and tax expense and before depreciation and amortization expense). Many think these measure cash flow, but they don’t. They do not reflect balance sheet considerations such as working capital needs, capital investments and debt service. Profitable businesses fail if they run out of cash (because of such things as high working capital needs, large investments in fixed assets or high debt).

As shown in the attached sample statement, cash flow calculations reflect changes in three sets of balance sheet accounts that do not appear on the income statement: working capital, capital expenditures, and debt.

Some comments about the various measures of cash flow (see attached chart for details):

"Gross Cash Flow" is aptly named. It does not reflect balance sheet changes or tell us much.

"Operating Cash Flow" is helpful because it includes changes in working capital (receivables, payables and inventories). Many profitable businesses get into "cash flow" difficulties when their receivables and inventories become excessive, tying up cash. Operating cash flow is a good measure of viability.

"Net Free Cash Flow to Equity" is the cash available to the owner(s) after capital expenditures are funded, loans are repaid and new loans taken down. This measures the amount of money available for dividends (ignoring loan covenants). This is the "real bottom line!"

"Net Free Cash Flow to Invested Capital" or sometimes called "Debt Free Cash Flow" calculates the cash that would have been available to the owner(s) if the business had no interest-bearing debt. This is important in acquisitions in which only assets will be sold and the buyer will choose a (different) financing structure.

There are several things to remember about all of this:

Each measure of cash flow reflects benefits accruing to different combinations of owners, creditors, suppliers, etc.

Each cash flow measure has different risk characteristics. Sales, the grossest measure of cash flow, indicates nothing about profitability. Sales thus have a profit risk (as well as many others), and for that reason, businesses are valued at lower multiples of sales than profits. Another way of saying this is that profits are worth more than sales, and thus are valued at higher multiples.

There is no general relationship between the magnitudes of profit and cash flow, as shown in the spreadsheet example. Each business has its own characteristics.

Because of this, it is crucial that the valuation multiple (or capitalization rate) be consistent with the measure of cash flow chosen. A valuation multiple based on cash flow does not apply to net income, and vice versa. Discount rates developed using Ibbotson Associates data (used by virtually all business appraisers) is applicable to net free cash flow to equity. This is an area in which inexperienced business appraisers often make major errors, with disastrous results. For example, it would be a major mistake to use a discount rate that should be applied to net free cash flow to equity and apply it to pretax income. Yet this is a common error made by many inexperienced business appraisers resulting in an unrealistically high value.
August 13, 2001 - Stock vs. Asset Sales

Just as there is often confusion as to what a specific valuation multiple applies to, there is equal potential for confusion as to whether assets, assets net of liabilities, or equity are to be valued. For tax and liability reasons, buyers usually prefer asset sales. Sellers, on the other hand, usually think about selling the equity in their businesses. How many times have you seen deals break down over the asset versus stock sale issue? Companies with significant depreciated fixed assets almost always have this conflict. The Buyer wants to buy assets and allocate a large part of the purchase price to them. The Seller wants to avoid recapturing the depreciation and thus paying a lot of income taxes—a stock sale accomplishes this desire for the Seller but leaves the Buyer with mostly depreciated assets and an eventual tax.

When "value" is discussed, it might not be clear what is included: is it all of the assets, some of the assets, or either of those less some or all of the liabilities or is it stock? It is critical that clients, advisors and appraisers are all on the same page. The easiest way to do this is to make sure that the parties agree on whether it is an asset or stock sale, and what assets and liabilities are included. The income tax considerations of the transaction play a large part in the decision of how to structure the "deal." In order to structure the "deal" properly, the attorney(s), accountant(s) and the business appraiser must work closely together.

In tax-related appraisals, it is almost always the equity of a business that is being valued. Equity by definition includes all assets minus all liabilities. There is usually not as much potential for confusion here, except that some appraisal methods assume an asset sale, in which case the resulting value has to be adjusted by excluding the assets and liabilities which are not to be transferred, to determine equity value.

As a general rule, the way to compare asset and stock sale values is through this formula:

Assets Transferred To Buyer
 - Liabilities Transferred to Buyer
= Net Assets Transferred (= Consideration Paid By Buyer and Received By Seller)
 + Assets Retained by Seller
 - Liabilities Retained by Seller
= Seller’s Equity

Typical assets retained in an asset sale and in some stock sales are cash, receivables (under a certain age), "bad" inventory and non-operating assets such as company cars. Typical liabilities retained are payables and accrued expenses. Every deal is unique with respect to other obligations such as bank debt and leases. There are usually a number of possible ways to structure a "deal"—some with better consequences for the parties than others.

Summing up, if all parties are clear about what is to be valued and transacted, and the appraisal report carefully reconciles and explains all asset- and equity-related values, the potential for confusion can be minimized. Less confusion means happier parties!

Reconciliation of Income and Cash Flow Measures Chart
July 16, 2001 - Buy-Sell Agreements: the Good, the Bad and the Ugly

All private companies with multiple owners MUST have buy-sell (or other) agreements governing the valuation and disposition of interests. Like death and taxes, the departure of an owner is inevitable due to death, disability, termination or resignation. Attorneys MUST carefully draft these agreements. Since circumstances change, clients MUST carefully review them at least ANNUALLY. I am constantly urging business owners to do this in every business seminar I teach and in consulting engagements. I hope it brings attorneys lots of buy-sell business!

This said, however, I am deeply troubled by the surprisingly large number of such businesses with outdated, poorly drafted and technically (from an appraiser’s point of view) defective agreements governing the valuation and disposition of interests. Business appraisers can strongly back up sound legal advice with inexpensive, high value-added reviews of these agreements.

Here are some of the things an appraiser can instantly spot. Most agreements use terms that can easily be misconstrued ("fair market value" or "market value"). Most do not distinguish between levels of value. (They fail to stipulate whether discounts for lack of control and/or lack of marketability apply). Those incorporating formulas (the classic "something times earnings" or, potentially much worse, "book value") are virtually certain to be outdated and incompletely defined. (What is included in earnings?). A few incorporate appraisal clauses, but almost none specify that an appraiser be certified (certified by whom?) and provide clear valuation guidance. Finally, I have seen very few agreements mention alternative dispute resolution options such as arbitration and mediation (again by whom?).

It is important to note that a buy-sell agreement review is much less in scope than a full appraisal (which is a determination of value). The buy-sell specifies how value is to be determined. A full and detailed appraisal (an unambiguous determination of value) is certainly not required, since no transaction is imminent. Instead, limited calculations of value (a rough estimate at best of value) may be used to validate the buy-sell agreement and illustrate their implications to business owners. In some instances, not a single number need be crunched. The cost of such a review is quite modest in comparison to that of a full appraisal. The essential benefit of an appraiser’s review will be clearer, better understood agreements and tested intentions, language, mechanisms and consequences. Thus will "ticking time bombs" be detected and defused.

June 18, 2001 - Selecting A Business Appraiser

Most professionals such as doctors, attorneys, engineers, dentists, etc. have clearly defined career paths that must be followed to enter their profession. Typically, a specific college program must be completed followed by some examination for licensing or other certification.

Unfortunately, the business valuation profession does not have a clearly defined entry path. No specific college major exists for business valuation, nor are there any governmental licensing requirement to prove minimum competency. Because of this lack of a specific career path and licensing requirements, many individuals with different backgrounds claim expertise and perform business appraisals, often with poor results.

Business appraisers typically come from one of the following groups: certified public accountants (CPAs), business brokers, college professors, and stockbrokers. Without special training and business valuation credentials, none of the individuals from these groups are competent to do business appraisals. Very few individuals actually performing business appraisals have earned a professional designation from a recognized professional organization certifying business appraisers.

For years many assumed CPAs were competent to value businesses. In 1997 the American Institute of Certified Public Accountants (AICPA) established a special credential for business valuation called Accredited in Business Valuation (ABV) to demonstrate competence in business appraisal. This seems to indicate that the vast majority of CPAs nationwide have little or no training or expertise in business valuation. Another problem for CPAs is potential conflicts of interest. In 1991, another organization called the National Association of Certified Valuation Analysts (NACVA), exclusively for CPAs, was also formed to give CPAs some training and a credential in business valuation called Certified Valuation Analyst (CVA). However, only approximately one percent of CPAs across the nation currently hold either of these two credentials in business valuation.

Business brokers sell businesses but most have no training in business valuation. Often business brokers use generic rules of thumb to list and sell businesses. Also, many business brokers lack the financial expertise necessary to properly analyze a company’s financial statements.

College professors typically have expertise in financial theory and may be able to analyze financial statements but they often try to apply sophisticated financial techniques designed for very large companies to small privately held companies. They also often lack the "real world" experience necessary to properly value most privately held companies.

Stockbrokers and stock analysts usually have the ability to analyze financial statements and understand public markets. However, they typically have no experience dealing with privately held companies.

In order to meet the need of demonstrating competence in business valuation, several professional organizations have evolved that certify business appraisers. Additionally, often a business appraisal is done because of some type of litigation. Historically, it was fairly easy to qualify an individual with a business background as an "expert witness." In 1993, this began to change. Now, trial judges are deemed to be "gatekeepers." Meaning that the trial judge has the ability to exclude experts if they do not meet appropriate standards. It is now more important than ever to ensure that an expert witness has the credentials and experience to survive a challenge. Otherwise, their testimony might be excluded in court, or even worse, admitted but given little or no weight.

The four well recognized organizations in the United States that certify business appraisers are: 1) The Institute of Business Appraisers, Inc.; 2) the American Society of Appraisers; 3) the National Association of Certified Valuation Analysts; and 4) the American Institute of Certified Public Accountants. The table shown below compares and contrasts the requirements to obtain credentials from each of these professional organizations. Before you select a business appraiser, carefully review his or her credentials and experience. Generally, those who have obtained the more difficult credentials, such as the Certified Business Appraiser (CBA) from The Institute of Business Appraisers, Inc. or the Accredited Senior Appraiser (ASA) in business valuation from the American Society of Appraisers will do high quality work and be well regarded in court. I hold both the Certified Business Appraiser designation and have recently received the Accredited Senior Appraiser in Business Valuation designation, the first in Idaho. I also hold the Business Valuator Accredited in Litigation (BVAL) designation awarded by The Institute of Business Appraisers—a designation geared specifically for training as an expert witness.
In summary, the Certified Business Appraiser (CBA) and the Accredited Senior Appraiser (ASA) in business valuation designations are the two most highly regarded in the business appraisal profession due to the rigorous peer review report requirements. 
May 14, 2001 - Stock Options for Private Companies? Whoa!

The bull market and dot.com craze (may they rest in peace) generated tremendous interest in stock options as a means of attracting, retaining and rewarding key employees. Although they worked temporarily in Silicon Valley, I am not convinced that stock options make sense for the typical private company.

Stock options are premised on the expectation that the company will have significant growth in value. Few businesses will achieve this. Look what happened to so many of the dot.com businesses: their stock prices fell dramatically, and their stock options became worthless, creating huge employee dissatisfaction.

A company issuing stock options usually hopes to go public, at which time the options can be exercised and the stock sold on the open market. What happens if the company decides not to or cannot go public? How will the option owners be able to dispose of the stock they acquire? Will the company be able to buy it back? Where will it get the resources to do so? By borrowing? Can it afford to do that? Absent these considerations, options are of questionable value!

There are many other mechanisms available to provide equity-like compensation to employees, the simplest being cash bonuses related to performance or profit sharing plans. Unlike stock options, which relate to total company value, performance bonuses can be job-specific (e.g. exceeding quota for a salesperson, reducing costs for a plant manager), which can significantly leverage their motivational power. I recommend this approach for most privately held companies!

Stock option plans are legally and financially complex, and have important accounting and tax ramifications, which can cost private companies significant amounts of time to understand and dollars to develop and administer.

Without public offerings or arms-length sales, the values of a company’s stock and options must be determined by appraisal. Although the stock valuation might be relatively straightforward, the valuation of stock options is extremely complicated in theory and practice. In doing appraisals of stock options for privately held companies many issues related to the definition of the level of value, potentially spurious comparisons with public companies, and other interesting issues often arise.
April 16, 2001 - Understanding Discounts for Lack of Control

When a minority interest is to be valued, one of the crucial adjustments is the discount for lack of control (sometimes referred to as the "minority discount"). This discount must be carefully selected and supported by the business appraiser. No table or chart exists from which this discount can be selected. The difficulty in selecting and supporting this discount provides another example why qualified, experienced business appraisers are needed—a canned computer software "business valuation program" will never work. Every business is unique—therefore, each business valuation case must be considered individually. There are three ways of measuring and substantiating the magnitude of a discount for lack of control:

The most frequent method is to consult studies of the "control premiums" paid by large public companies to acquire others. The control premium is the amount by which the acquisition price exceeded the price at which the acquired company was trading. (The previous stock price was a minority price, because it reflected transactions in minority interests.) These premiums have consistently averaged 35 to 40% over the last few years. A control premium of 40% implies a discount for lack of control of 29%. (If the control price is $140 and the minority price was $100, there is a 40% premium from $100 to $140 and a 29% discount from $140 to $100.) A widely known problem with this data is that many of the acquisitions were by strategic buyers who had business fits with the acquired companies. Strategic benefits such as synergy should not be reflected in fair market value (the value to ANY willing buyer) appraisals. The control premium studies thus tend to overstate the true premium (and discount). An experienced and well qualified business appraiser understands the limitations of the data and must make appropriate adjustments to determine the magnitude of the discount that applies in a given situation.

A second method is to consider the discounts at which closed-end public investment companies trade relative to the values of their underlying assets. These discounts range from 5 to 15% on the low end and 40 to 60% on the high end. The discounts reflect the fact that a buyer of closed-end company shares cannot influence the investment or dividend decisions of the company. Some business appraisers feel that this data provides a more realistic measure of the true discount for lack of control unaffected by strategic buyers. Again, it depends on the specifics of the situation.

3. A third often overlooked method is to consider the relationship of actual and "adjusted" company earnings, where the adjustments are made to normalize for ownership compensation, non-arms-length and other discretionary expenses. If our company earns pretax income of $100 but the control owner has excess compensation and benefits of $50, then the earnings available to us as minority shareholders are $100, but the adjusted "control" earnings are $150. (Someone could buy our company, pay a third party $50 less than the current control owner earns, and receive the $50 as extra profit). This implies a control premium of ($150/$100 – 100%) = 50%. This method can be used in some situations, but is inappropriate in others. Using case-specific facts such as the presence of very high (or no) ownership discretionary expenses can materially influence the reasonability of the control premium and discount for lack of control.

This brief discussion of different methods to arrive at the magnitude of a discount for lack of control illustrates that the area of discounts and premiums in the business appraisal arena is one of the most complex.
March 12, 2001 - Valuation as of When?

Seemingly small details of business appraisals often have major significance. A classic, simple example is the date as of which the business is to be valued.

 Revenue Ruling 59-60 and its foundation statute require that valuations be completed as of the date of death or gift (with an alternate date in the case of death). These are straightforward choices, except when there are subsequent developments. Assume it is early January of 2001. If we are valuing a business as of December 31, 2000, how do we handle:

December 31, 2000 closing stock market prices?

Fourth quarter 2000 economic data (released three months later)?

December 31, 2000 financial statements (not available until much later)?

November 30, 2000 financial statements (the latest available as of the time we are doing the appraisal)?

An unsolicited purchase offer made in January 2001 (with no prior contact)?

A major new contract in February 2001 that was negotiated during the preceding year?

Same as 6, except negotiations started in January 2001?

Revenue Ruling 59-60, Section 3, Paragraph .03 provides clear guidance on subsequent developments: only information known or reasonably knowable as of the valuation date is relevant. This means that:

Item 1, the December 31, 2000 closing stock market prices, is relevant: known as of the valuation date (at the end of the day).

Item 2, fourth quarter 2000 economic data, is NOT relevant: not knowable as of December 2000. A reasonable estimate could be used.

 Item 3, the December 31, 2000 financial statements, causes confusion. Most companies do not close their books until well after December 31. Many make big year end adjustments to inventory and bonuses. As a practical matter, most appraisers use the December 31, 2000 statements, if available in time to meet the report deadline. The argument in favor of using the statements is that the data is available as of that date but it is simply not yet compiled in the final format.

Item 4, the November 30, 2000 financial statements, is relevant, and the appraiser should inquire as to whether there were material changes in the business or its financial position between November 30 and December 31. If there were, they must be disclosed and their value impacts assessed. If not, that fact should be clearly stated.

The last three items require a further distinction developed by case law and standard appraisal practice: whether the subsequent event is indicative of or affects value. The former is relevant, but not the latter. "Indicative of value" means that it reflects value, but does not change it. A good example of an event indicative of value would be a subsequent arms-length stock sale to a private buyer. A subsequent public sale (a situation that comes up often) is VERY case-specific, and depends heavily on then-current market conditions and risks.

 Based on the above:

Item 5, an unsolicited purchase offer in January 2001, indicates value, but does not affect it, so it is relevant.

Item 6, a major new contract in February 2001 that was negotiated during the preceding year, affects value, but could have been reasonably anticipated as of the valuation dates, and so is relevant. The competent appraiser will have inquired about matters like this, disclosed them in his or her report and come to a judgment about the probability and magnitude of their value impact. This is one of many areas where reasonable people can have legitimately different conclusions.

Item 7, a major contract that negotiations began in January, if literally true, would not be relevant because it was not knowable as of the valuation date.

These examples illustrate the major impact of the valuation date on the appraisal and conclusion and why it must be thought through very carefully in each assignment.

February 12, 2001 - An ESOP Fable

Once upon a time, there was an old lion that owned a nice business. Unfortunately, he did not have any cubs to take his place since he had no mane squeeze (ooh). Since the old lion knew that even he, the king of the jungle, would not live forever, he hired some hares to help plan his estate. The hares were quick (of course) to tell the old lion to sell his company to an Employee Stock Ownership Plan (ESOP). Some of the hares were rabbit (ooh) about it. The lion roared with approval, because he liked the idea of liquidity and the tax benefits. He also wanted his employees (mice) to share in his company’s success.

For many years, everyone lived happily ever after. Nothing much changed. The lion counted his cash and kept paying himself a kingly salary to run the company. He also took a lion’s share (ooh) of the extra benefits. He spent a lot of time on his hobby, a Lionel train set. The company grew steadily, and every year its value (determined by an independent appraiser, a wise owl) rose.

But then one year, bad things happened. A drought caused the jungle’s economy to dry up. A young lion with a better product started to compete, taking a chunk out of the old lion’s hide. At the end of that year, the owl’s valuation of the Company was lower.

Things then got worse. One of the employee mice, operating on the theory that the squeaky (!) wheel gets the grease, complained that his shares had depreciated. (He actually said, "Who Moved My Cheese?," but that’s another story.) This got the attention of a famous big game hunter, the Department of Labor. The hunter stalked into the old lion’s office (which was decorated like a den) and accused him of taking too much compensation, treating the mice unfairly and, even worse, of selling his company to them for too high a price. A huge battle ensued, and the old lion ended up having to give back some of his sale proceeds to the mice. In addition, he had to pay the hares expensive fees to defend him. All in all, the lion suffered a marked loss of pride (ooh).

The moral of the story: ESOPs are attractive because of their benefits to company owners, but when the company’s value falls, the cost can be great…and I ain’t lion!
January 15, 2001 - How Much Does Debt Really Cost?

As we enter a period of falling interest rates, some business owners may find debt financing to be increasingly attractive, especially if stock prices continue to fall. We often think that debt costs only the stated interest rate. If we borrow $1,000 at 10%, we have to pay $100 in interest every year, and that’s that, right?

No! Debt is much more expensive, for many reasons:

We have to pay back the principal, too! Many people forget to include this in their calculations. Banks lend other people’s money, and have to be able to get it back if depositors withdraw it! Many borrowers and lenders forgot this in the late 1980’s, to their detriment.

Debt entails loan covenants that restrict borrowers’ prerogatives in areas such as compensation, capital expenditures, dividends and distributions. The interest rate does not reflect these costly limitations on control and ownership benefits. Don’t forget that lenders make the rules! It is a case of whoever has the gold, makes the rules!

A personal guarantee or other collateral is almost always required: THAT can be hugely expensive if things go badly! Losing a business can be tough. Losing a business along with a house, etc., etc. can be really tough!

Reporting requirements (audits, monthly statements) can be a costly, time-consuming burden.

Other compliance requirements (such as credit life insurance or asset appraisals) are expensive.

If the repayment schedule is inflexible and cash flow is barely sufficient or inadequate to cover current obligations, the risk of insolvency (in which case the loan is called, or placed in "workout", in which even more onerous controls are enforced) is material. This will drive down the value of the business.

Today, most debt has floating interest rates pegged to the prime rate (e.g. prime plus 2%). If interest rates rise, the cost of debt will rise accordingly.

Venture capital debt almost always includes "equity kickers" such as stock options and warrants that can dramatically increase the cost of the financing package. Typical "mezzanine" financing has an overall cost of 25% (including both debt and equity components), even though the debt component might have a stated interest rate of 10% to 15%.

Don’t be fooled by the interest rate alone: the hidden costs of debt are far greater!
Business Valuation Credentials Chart
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