December 2002 - Occasionally You Can Have Your Cake and Eat it Too! ESOPs
Employee Stock Ownership Plans (ESOPs), while not for everybody, have tremendous advantages for the company and shareholders of companies that qualify. Despite the Enron disaster, ESOPs are very viable and can be an excellent retirement vehicle for many small businesses. While there are a number of reasons to establish an ESOP, majority shareholders that desire to retire is the major reason.
Owners of a closely held corporation may receive a larger benefit from selling to an ESOP than to an outside third party! In addition to the financial benefits, they have an opportunity to "reward" employees by setting up a mechanism through employee ownership of the business that both provides for their retirement as well as giving them an opportunity to benefit from their hard work through increasing the value of the company. The selling shareholders, if certain conditions are met, may defer the capital gains tax on the sale of their closely held stock by rolling all or part of the proceeds from the sale into qualified investments. In a leveraged ESOP (a plan that uses a bank loan to fund the stock purchase), both the principal and the interest can typically be deducted as a business expense. The company typically makes contributions up to 25% of payroll to the plan but companies may also take a tax deduction for "reasonable" dividends paid on ESOP shares that are reinvested into the plan to buy more company stock.
The following are the key screening points to see if an ESOP might fit a company:
Other than departing shareholders, are key people in place that are willing and able to run the company?
Are their twenty or more employees?
Is the annual company payroll at least $250,000?
Is the company’s estimated value at least $2 million?
If the answers to these questions are yes, then you should hire a qualified professional to design, develop, and implement the ESOP. The following are the typical steps:
Feasibility Study – the company will be carefully reviewed to determine if an ESOP really makes sense. Is the payroll large enough to satisfy the legal requirements? Can the company afford the contributions that will be required to retire the loan? Is the cost of the plan reasonable?
Business Appraisal – a key element to an ESOP is an independent appraisal made by a qualified appraiser. This is of course our interest in this process!
ESOP Attorney – an attorney must draft the ESOP plan and submit it to the IRS for approval.
Obtain funding for the plan – potential sources for the funds include banks, other financial institutions, ongoing company contributions, and seller notes.
Establish a process to operate the plan – a trustee must be chosen to oversee the plan and employees must be notified and the details of the plan explained to them.
Monitor the plan – there are a number of requirements that must be observed in order to keep the plan in compliance. One of the key components that must be monitored is the repurchase obligation of the plan. When a vested employee departs, the stock held by the employee must be repurchased.
ESOPs while very beneficial, are quite complex. In my opinion, a company desiring to implement an ESOP should retain professionals very familiar with ESOPs to assist with the entire process.
November 18, 2002 - Confusion Regarding Goodwill
Goodwill may be the most misunderstood concept in business valuation. A story may provide insight.
Last week, after a power outage, I bought an oil lamp. I started to polish it (bear with me). Out popped the Goodwill Genie. He offered to answer three questions about goodwill. I asked them.
What is Goodwill?
An accountant would answer this way. Goodwill balances the price paid for an asset with its fair market value. If you pay more than fair market, the excess is goodwill. Until recently, goodwill could be amortized (written down in value) over as many as 40 years. Accounting rules now require that goodwill and intangible assets be valued annually and written down to fair market value if they have depreciated (but not written up if they have appreciated).
Goodwill is one type of intangible asset. Intangible assets have little or no physical presence, and include things like brand names, customer lists, in-process R&D, and computer software expensed as incurred. Many, like the value of a trained workforce in place, are not on the books. When you buy a business, you normally buy both tangible and intangible assets. Each intangible must be identified and valued. When this process is complete, if the price paid for the assets exceeds fair market value, the excess is goodwill, a catchall.
A business appraiser would answer differently. Goodwill reflects the fact that a business earns more than you would expect solely from its tangible assets. Pretend that before I was a genie, I was a lawyer in solo private practice. My tangible assets were modest – cash, receivables, supplies, books, files and equipment. I generated high billings, a nice paycheck and profits for myself, far more than I could have earned had I sold my assets and reinvested them. The value of my practice was greater than that of my tangible assets. The difference was the value of my intangibles: ability, experience, knowledge, license, reputation, network, client list, etc. and goodwill.
How Do You Value Goodwill and Intangible Assets?
There are two ways: the "big pot" and "separation" approaches.
The big pot approach is simple. Value the whole business using the Market (comparable transactions) or Income Approach (present value of cash flows). Then value tangibles – cash, receivables, inventory, and fixed assets (those often require a specialist), net of liabilities. The difference between business and net tangible value is the value of the big pot, which includes all intangibles and goodwill.
The big pot approach is usually sufficient if the pot’s value is small, zero, or negative, or if there is no need to separate the tangibles from the intangibles. This occurs in most tax-related appraisals, where a business interest is sold or gifted to a related party or charity, in most divorce appraisals (except that some jurisdictions treat goodwill attached to an individual differently from that attached to a business) and in most dissenting shareholder matters. In each case, only the value of the business is needed, not an analysis of its tangible and intangible components.
In mergers and acquisitions (because of the new accounting rules), specific intangibles and goodwill must be valued using the separation approach. Its methodology is like that for conventional business appraisals, but the techniques and data sources differ.
What Is The Biggest Misunderstanding About Goodwill?
Harking back to the big pot, when a business is valued using the Market or Income Approaches, the value includes goodwill and intangibles. Many business owners think these should be sources of additional value, but they are not. Goodwill and intangibles cause the business to be worth more than its net tangible value, like my imaginary law practice. Those approaches implicitly include the intangibles.
While I am on the subject, the goodwill of an entire business cannot be negative. If a business is worth less than its net tangible assets, logic would seem to suggest that its big pot has a negative value. True, but what really happens is that if the causes of negative goodwill cannot be eliminated, the business should liquidate. The owners would realize the value of the net tangibles, and the negative goodwill would go away.
There are two caveats about my last statement:
It does not apply to a minority interest. Its owner cannot force liquidation except in limited circumstances: he or she is stuck with the lower value.
Negative goodwill does not include identifiable contingent assets or liabilities like lawsuits. These have separate, identifiable (albeit with great uncertainty) values.
October 14, 2002 - Bills Get Paid With Cash, NOT ‘Earnings’
I am constantly amazed at how many small business owners have no idea of the cash position of their company and the amount of cash flow it generates. Many business owners have very poor records—just enough to scrape them together at the end of the year and take to their tax preparer in a shoe box.
Years ago, I ran into a former controller of a regional airline that had taken his $250,000 ‘golden parachute’ funds and purchased two Arby’s Roast Beef fast food restaurants that he had seen advertised in the Wall Street Journal. He had owned and ‘operated’ them for a couple of years before calling me. Before visiting with him, I visited the restaurants and timed the drive-thru (a quick way to determine the quality of a fast food restaurant’s management). His units were running average times of over ten minutes—incredibly slow. Customers were leaving the line, driving over the curb and across a section of lawn to get away. Needless to say, I was convinced that this restaurant owner was in serious trouble. When I met with this owner, he told me, "when I cross the threshold of my restaurants, I become physically ill." No kidding, this is a direct quote! When I asked him for a copy of his books and records, he gave me a bunch of storage boxes. He had never set up any accounting records and was running his business with only a checkbook. When he had cash, he paid bills. That was it. Now, this is an extreme case, but it is not that unusual in concept.
It is pretty hard to manage a business without any idea of what is happening. Financial statements including reports such as accounts receivable and accounts payable agings are not just nice things to have—they are required. In addition to having access to these reports, a business owner must learn how to use them. I have seen some businesses with wonderful, detailed reports that are filed each month in a very nice binder that have never been looked at by an owner or manager. Obviously, unless the financial reports are used, they are of little value.
We recently finished a consulting engagement for a small tire shop owned by two brothers. They bought the business directly from a long-term owner about 18 months ago. We found that they were selling a large amount of product and services to customers on account. Everything was essentially done on a handshake. They had no signed agreements other than a signature on an invoice. Unfortunately, a number of their customers were not honoring the ‘handshake agreement.’ This small business is suffering cash flow problems because a large amount of their assets are tied up in accounts receivable of questionable value. They have been making sales on account and carrying the accounts themselves when customers could not qualify for one of the financing programs they offer through lenders or did not have a credit card. We had to explain to them that since their business operates with only a five percent profit margin, it takes $2,000 in additional sales to cover every hundred dollars lost on a bad account! Put this way, they understood their problem. It was very expensive for them to make sales on account, especially to customers that had bad credit! A business does not pay bills with earnings, it pays them with cash! Businesses typically fail when they run out of cash. It is possible to show earnings and not have positive cash flow. This tire store showed a profit on paper but did not have the cash from many of the sales on account. They are making needed changes.
I often must advise small business owners to go to their accountant and request and pay for him or her to prepare financial statements—at least compilation statements with notes annually. The cash flow statement is particularly important. We also advise clients to set up a good accounting system—if they cannot do it in house, they need to talk to their accountant and get some help. Many do not want to pay for good accounting—a huge mistake. A business owner needs good accounting records in order to manage the financial side of the business. Business owners need to develop a good relationship with their accountant and have their accountant teach them what to look for in their financial reports.
Having a good accountant and using him or her to help a business obtain and use regular financial reports is a necessity in the long term success of most businesses. We often assist accountants with valuation and consulting issues. However, we cannot do much without good financial records.
September 16, 2002 - "Sure, we lose $5 on the sale of each item, but we’ll make it up on the volume!"
There are lots of ways to lose money in business—some are more obvious than others. I did not make up the quote listed above—honest, I worked with a business owner that actually said and tried this.
Less obvious losses can come from reducing prices in order to increase sales. Cutting prices generally results in increased sales. However, it is possible to reduce margins to the point where the business, after increased operating expenses associated with the increased sales, loses money on the increased sales. Not a good idea!
Another way to increase sales is to relax accounts receivable terms and credit policies. If a company sells to anyone who is willing to buy on account, the collection period for accounts receivable is going to increase thereby reducing the company’s cash flow and bad debts resulting from non-collectable accounts will likely increase. The cost of these increased sales can be enormous.
Most of us can readily make the connection between increasing sales or decreasing expenses and larger profits. However, the productive use of business assets is another area that can cause a business grief. Many small businesses do not consider the amount of funds they tie up in inventory, accounts receivable and equipment and other items used in the business. You are probably familiar with several common inventory methods such as "first in, first out" and "last in, first out." Are you familiar with the commonly used small business inventory method called "FISH." This stands for "first in, still here!" Many small businesses do not consider the ramifications of their terms given for sales on account—nor do they manage this sometimes very large business asset very efficiently. Funds spent on equipment, furniture, fixtures, and other assets used in a business are often made haphazardly with very little, if any, planning.
How a business owner funds his or her business can dramatically affect the success of the business. We have seen many owners with lots of money tied up in slow paying and uncollectable accounts receivable and inventory of questionable value forced to borrow on expensive personal credit cards to obtain cash needed to make payroll and other expenses. Others have decided to expand their business without carefully considering the cash requirements of the expansion and knowing that needed cash will be available when needed. This can be very dangerous and often results in a formerly very successful small business failing.
Owning and operating a small business is a difficult and high risk endeavor. Small business owners must do it all—they are in charge of daily operations, personnel, marketing and sales, research and development, accounting, and so forth. Surprisingly, most small business owners do not have a clearly defined plan and developed strategies to help them achieve this plan. Instead, most small business owners operate on a "crisis to crisis" method—they do not deal with a problem or potential problem until they are forced to do so.
Small businesses, if managed properly, can provide an excellent current income to the owner and also provide a source of considerable funds for retirement. In order for this to occur, business owners must establish, follow, and regularly update a plan for success. Most successful small businesses succeed because they meet a specific need in the marketplace not covered by large companies. This "niche" is the reason they exist and prosper. Occasionally, the business must modify and adjust its way of doing business and sometimes the very nature of its business in order to survive. Small businesses are supposed to be able to be highly flexible—to be able to change quickly and to be able to immediately recognize and meet changing customer needs. This does not always happen. However, if the business owner is truly "involved" in the business, changes that need to be made can be recognized and made in a timely manner.
There are many "value and risk drivers" for each business. These drivers are typically categorized as profitability value drivers, asset turnover value drivers, and risk drivers. The drivers that affect each business must be recognized and strategies developed to maximize cash flow, reduce risk, and thus enhance the overall business value.
August 12, 2002 - One Point Does NOT Define a Line – One Method Does NOT Constitute an Appraisal
A few months ago, a case I was working on went before a judge to try and work out an agreement. In the meeting, I was startled to hear the judge say only one appraisal method—the Excess Earnings Method—should be used. Since then I have thought about this comment and how best to respond to the idea of using only one "favorite" method to value a privately held business. Using only one method is very similar to trying to define a specific line by using only one point—as we all learned in our math classes at school, an infinite number of lines can be drawn through only one point.
Valuing a closely held, privately owned small business is a complex assignment. Small, closely held businesses are generally operated with the primary aim being the minimization of income taxes. Often, "discretionary expenses" are paid by the business reducing the net income to an amount not representative of the business’s real economic income. The appraiser must identify and adjust to account for these items.
The appraiser must also identify and quantify risks and develop appropriate rates of return to be applied in order to value the business. In this process, a number of subjective decisions must be made. For this reason, well-qualified and experienced appraisers always try to use a variety of appraisal methods and then reconcile the results in order to develop a final estimate of value. Using more than one appraisal method, when possible, helps an appraiser develop a supportable value in the same way that the use of two or more points helps define a line. Occasionally, only one method is possible—for example, when appraising a family limited partnership, often only an asset-based method can be used.
In order to better explain my point, I have included an example of the Excess Earnings Method and have shown the differences in the result when components are modified.
Excess Earnings Method Chart
In this example, the value of the company is shown to be $1,230,000 based on using an 8% rate of return on tangible assets and a 25% rate of return on intangible assets. Note that the Forecasted Net Cash Flow was used. In the Excess Earnings Method, net cash flow is generally used but other income streams could also be used. For example, I have seen appraisers use pretax income, net income after tax, and seller’s discretionary cash flow to name just a few. Also in this method, the income stream should be forward looking; usually a forecasted income stream but sometimes historical figures are used and occasionally, an average of historical figures is used. In our example, the following would be the value of the company if these other income streams had been used:
Simply changing the income stream used varies the estimate of value from a low of $1,070,000 to a high of $2,150,000—each of these could be correct!
Instead of changing the income stream, different rates of return on the tangible and intangible assets could also be justified and used. For example, a ten percent rate of return on the tangible assets and a 35% return on the intangible assets might be justified. Or, if the risk of achieving the forecasted income stream is fairly high, a fifteen percent rate of return on the tangible assets and a 50% rate of return on the intangible assets might be justified. If these other rates of return were used in the first example illustrated, the value of the business would be as follows:
This example shows the difficulties that arise when only one method is used. The difficulties are compounded when a method that has as many subjective variables as the Excess Earnings Method is the only method used.
There is no substitute for a carefully thought out and well documented business appraisal report prepared by a credentialed and experienced business appraiser. A business appraisal report should used a variety of methods, when possible, provide a well reasoned reconciliation of the values determined by the various methods employed, and support the final value with some checks for reasonableness, again where possible.
July 15, 2002 - Rebutting Unreasonable Appraisals
"Nothing is more devastating to an opinion than a fact."
Up the Organization
We are often asked to critique the work of other appraisers without starting from scratch. This usually comes up in transactional and litigation support contexts. In both situations, we are provided with valuations done by others, with the question being: "is their value conclusion reasonable?"
How can this be done effectively? There are three ways to approach this assignment:
- Show that the conclusion is unreasonable.
- Show that the premises are incorrect.
- Show that methodology is incorrect or is incorrectly applied.
Show That the Conclusion Is Unreasonable
This is the first step, because you immediately answer the question posed in the first paragraph. The two best ways to accomplish this are:
To perform a justification of purchase analysis: does the business provide cash flow to the buyer, and what is the implied rate of return on investment? To do this, a full financial forecast for the entity in question is prepared (with emphasis on cash flow to equity). The entity is assumed to be acquired at the concluded value with normal financing terms. The "cash on cash" internal rate of return on equity can then calculated and compared to the cost of equity capital (or the net present value of the acquisition cost and benefits at the indicated cost of equity capital can be computed). If there is sufficient cash flow and rate of return to the buyer, the purchase price is justified and the value conclusion is reasonable.
Use appropriate transaction data (public or private comparables) or rate of return data to test the reasonability of multiples, discount and capitalization rates. This is a basic business appraisal skill. If you can show that price multiples of comparable public or private companies are different from that opined by the other appraiser, you have significantly weakened their case.
Show That Premises Are Incorrect
Many mistakes are made at the outset of an engagement. The trick is to catch them in the rear-view mirror. Some of the most common errors involve:
Standard of value: how often have you seen fair market value appraisals done in contemplation of sales (when investment value was more appropriate), or an incorrect standard of value applied in a divorce case?
Level of value (control/minority, marketable/non-marketable): countless errors are made when appraisals use methods that produce conflicting levels of value, or levels inconsistent with the purpose and use of the appraisal.
Valuation date: for tax appraisals, this is the date of death (or alternate valuation date) or gift. For transactions, the appraisal is usually current. In litigation, particularly divorce, this is often a matter of confusion as the parties, their counsels and triers of fact may not have agreed upon this. It is incumbent upon the appraiser to raise the issue of the valuation date until it is resolved.
Going concern versus liquidation: this premise of value is critical, particularly for unprofitable or low-profit businesses, or those with excess assets, particularly when a controlling interest is valued.
Level and type of benefits capitalized or discounted: Appraisal courses and publications are full of warnings about the need to make sure that the level (control or minority) and type (e.g. sales, net income or cash flow of various types) of benefits capitalized are appropriate for the engagement and consistent with the capitalization and discount rates used.
Control-related adjustments: are these appropriate (again, given the nature of the assignment and type of interest to be valued) and have they been adequately substantiated?
Unsustainable growth rate: appraisers often neglect the fact that the growth rate assumption is perpetual, and that it cannot exceed combined real economic growth and inflation, which most would concede cannot be much greater than 5 to 7%.
Market averages without case-specific adjustments: examples of errors of this type occur in substantiating discounts for lack of control and lack of marketability; failure to cite case-specifics violates the precedent set by Mandelbaum.
Equity discount rate and risk premium: errors range from misuse of market data (in many ways) and omitting case specific factors to the use of totally case-specific methodologies that do not tie in any manner to market data.
Supportability: it is a violation of professional appraisal standards to proclaim an assumption, a methodology, or a conclusion without sufficient proof that it is reasonable.
Interpretation of law: simply put, the job of the appraiser is to advance economic arguments based on case and market facts and logic. Appraisers are not attorneys, and must seek the guidance of counsel in interpreting statutory and case law.
Show that Methodology Is Incorrectly Applied
These are just a few self-evident examples:
Logical errors (e.g. capitalizing pretax benefits at an after-tax rate)
Using large public companies as comparables to value very small private businesses
This letter has presented the major ways to approach the critique of an unreasonable appraisal conclusion. This is a useful framework for organizing rebuttal reports and testimony by focusing on the most important issue (the conclusion) first, then the assumptions, and lastly the methodology.
June 17, 2002 - Have You Valued a Dallas Diamond Dealer for Divorce?
One of the biggest, but wholly understandable, misconceptions that attorneys and clients have about business appraisers is that we must have prior experience with the type of business, geographic region, and nature of the circumstances involving the business to be appraised. These concerns often arise when we are being cross-examined, as well as when we are speaking with prospective clients. Both parties are naturally concerned about our expertise and familiarity with a given business, industry, region or valuation context.
The point is that although an appraiser may not have previously appraised a business with identical circumstances, his or her experience with similar businesses and situations is eminently applicable. Qualified appraisers have four essential skill sets:
Economic and industry research
Qualitative and quantitative company analysis
Accounting, tax, legal and regulatory knowledge
Technical valuation ability
An industry consultant, accountant or broker with no appraisal training is not qualified to handle issues of the fourth type, such as the standard and level of value, the valuation date, and appropriateness of alternative valuation approaches and methods. These are critical to a sound appraisal.
A qualified appraiser is required by professional standards to obtain the knowledge and skills of the first three types in order to undertake an assignment. Credentialed, peer-reviewed appraisers have demonstrated competency in these vital areas. They know what questions to ask and of whom in order to obtain necessary information.
Therefore, if you need to have a Diamond Dealer, based in Dallas, Texas valued for a Divorce, leave no stone unturned to retain a Certified Business Appraiser (CBA) or an Accredited Senior Appraiser (ASA) Anywhere, ASAP!
Valuations play a part in all strategic transactions. For additional information or advice on a current situation, please do not hesitate to call.
BREAKING NEWS: THE GROSS DECISION – WHAT AN APT NAME!
The Tax Court recently reached a flawed, illogical verdict in the case of Gross v. Commissioner and two related verdicts (Heck and Adams). At issue was whether the different tax treatments of "S" and "C" corporate earnings should affect the value of the entity. "S" earnings are not taxed at the corporate level; "C" earnings are. The Court erroneously concluded that "S" corporations are therefore worth much more than "C" corporations, all other things being equal. This makes no sense for two real-world reasons: (1) Most "C" corporations pay out most of their profits as owner compensation, which is deductible to the company and taxed only once, at the shareholder level, just like "S" corporation profits; and (2) most "C" corporations do not pay dividends, which are taxed at both the corporate and shareholder levels.
Based on these observations, there is no practical difference between "S" and "C" cash flows to shareholders because they are both taxed only once. Yes, there are differences in corporate and individual tax rates, but these are not only relatively minor but also case-specific, and not significant in the huge majority of cases.
More will be heard about Gross: I would wager that at minimum there will be 144 (!) or more challenges, which will ultimately prevail, just as occurred with embedded capital gains taxes and attribution rules for family-owned entities.
May 13, 2002 - The Geeks Shall Inherit the Earth
Having sold and valued private businesses for just over twenty years, one of the most interesting developments I have seen is the increasing sophistication of appraisal techniques. There are many contributing factors:
Cheaper and more powerful personal computers
Entry of experienced, older and well-educated younger people into the profession
4. More and higher quality education provided by business appraisal societies
Ever-changing tax and case law
Sophistication has manifested itself in three areas:
Better information: data are being "sliced and diced" more carefully
Innovative theories are becoming more widely accepted
Competent appraisers are capitalizing on both of these trends
Nevertheless, there are some pitfalls to all of this:
In some areas, our profession is getting ahead of our clients, their advisors, the courts, and tax authorities. We have to remember the edict of an important 1984 court case (Weinberg v. Commissioner): that appraisal techniques must be "generally accepted in the financial community."
The proliferation of data and the ease with which it can be statistically analyzed make it easy to create spurious correlations between unrelated factors (such as Super Bowl winners and stock prices). Statistical correlation does not guarantee that one factor causes another.
Appraisers cannot quantify the unknowable. There are some things, such as future commodity or stock prices, which are just unknown.
Computer "Valuation" programs exist but a "canned" software program cannot take the place of an appraiser’s experience and expertise. Qualified and certified business appraisers use spread sheets but not canned software programs to appraise businesses. Each business is unique—therefore, each business appraisal must be "custom" work.
"Garbage in, garbage out": bad assumptions plus good techniques equals wrong conclusion.
The appraiser always has to be able to explain and defend his or her assumptions, methodology and conclusion. Why are all of these reasonable? The use of canned software packages results in many assumptions and other decisions that should be made by the appraiser—instead being made by a programmer.
April 17, 2002 - Profit Is Not an Option
"The value of shares of stock of a company with uncertain prospects is highly speculative. The appraiser must exercise his [or her] judgment as to the degree of risk related to all of the other factors affecting value. Valuation of securities is, in essence, a prophecy as to the future."
Internal Revenue Service- Revenue Ruling 59-60, Section 3
This is a superb description of what business appraisers are supposed to do. As a colleague once put it, we are "risk assessors." Risk and return are inseparable. Where the possibility of profit is high, the risk of failure is also high. (Stated simply, there is no free lunch.)
Every generation relearns this. Remember the investment crazes of the last 30 years:
Conglomerate companies in the early 1970s,
Then crude oil in the mid 1970s,
Then collectibles and hard assets in the late 1970’s (remember shortages?),
Then leveraged buyouts in the 1980s, and
Then dotcoms, tech stocks and stock options in the 1990s
Each craze lasted about five years. In the beginning (a biblical reference), innovative investors spotted opportunities. The speculative herd poured in money, driving up prices. After a bit, the bubble burst and stock prices collapsed. Business appraisers must look beyond these temporary phenomena. We ignore them if they are not "fundamentals" or "value drivers".
I valued stock options for private companies during the last craze. Public Stock Options have two value components: current and future. Current value is easy: if the stock today sells for more than the exercise price, current value is the difference. For example, if the stock sells today for $20 and the option price is $12, the profit per share or value of the option is $8. (Exercise the option, pay the price ($12), and sell the stock at $20: pocket the profit--the option value--of $8.) Future value for public shares is based on the Black-Scholes formula, which quantifies the probability of and amount that the stock price will exceed the exercise price when the option expires. A major assumption is volatility: how much will the stock price go up and down?
Volatility is easily measurable for public stocks with trading price histories. For private companies, however, there are no price histories. Many analysts assumed that private companies had volatilities comparable to those of public companies. Their fundamental error was the HUGE implicit assumption that the private companies would go public. That was beyond speculation and into the realm of the fantastic, as shown by the popping of the initial public offering (IPO) market bubble. Very few private companies actually go public!
I took the conservative position that, since these stocks were not public, there was no volatility and therefore no future option value. I valued them solely at present value. Harking back to the opening quotation, in my judgment, the key "factor affecting value" was that the companies were private and I could not "prophesy" their going public. If however, a company is actually in the process of an initial public offering (IPO), then the real possibility that it may have a future public market must be considered.
Valuation is indeed a prophecy. Nevertheless, it must be based on considered judgment, not foolish assertions.
March 18, 2002 - Runs, Hits and Enrons
"If you don’t know how to keep score, don’t play the game, especially for money."
--- Advice from Unknown Author
One of the benefits of aging is that you see history repeat itself. So it is with the recent media focus on the accounting practices of some well-known companies. When I was starting my over twenty years ago, there were issues with corporate accounting for pension liabilities, mergers and acquisitions, and sale-leaseback transactions. Then, as now, there were stock market disasters and subsequent accounting rules changes. Today’s crises, however, appear to be leading toward fundamental institutional reforms (such as independent oversight of auditors and the separation of auditing and consulting functions) which were not on the table twenty years ago.
- From my standpoint as an appraiser of primarily privately owned businesses, there is a fundamental difference between the motivations of public and private company owners. Public companies are under huge pressure to demonstrate continuous earnings growth. Private companies, by contrast, have a strong disincentive to show earnings (unless their owners are contemplating selling out), because earnings entail income tax liabilities. That said, there are interesting similarities and contrasts between public and private companies in some of the common areas in which earnings can be "managed":
- Revenue recognition: public companies needing to boost earnings will often aggressively "book" sales that might not be final. Sunbeam, for example, forced excessive inventory onto its distributors, regardless of their needs, and recorded those transactions as sales, when in fact much of the excess was not going to sell for a long time, if at all. Most private companies, in order to reduce taxable income, are very conservative in recognizing sales. They will not book them until orders are placed, products are shipped, or payments are received.
- Compensation: many public companies paid their employees with stock options, which, if valued according to the rules, result in no compensation expense charge to the company. By contrast, private company owners pay themselves as much as they can in cash to reduce taxable income. For taxable private companies, dividends are taxed twice (they are not deductible expenses, and they are taxable to the recipients) and are thus inefficient compensation vehicles.
- Write-offs: when businesses go bad or asset values are impaired, both private and public companies are prone to devalue them. Public companies report these expenses "below the line", separate from the results of operations. They hope that investors will ignore these one-time expenses as not being indicative of normal results. They also issue "pro forma" earnings reports, which can be massaged to cover up a multitude of sins. For private companies, write-offs reduce earnings and taxes, but, since the results are not public, only their owners (and bankers) see them.
- Off-balance sheet entities: these were Enron’s downfall. The idea was to set up separate entities that owed large amounts of debt on assets that were leased to Enron. The debt did not appear on Enron’s balance sheet, so it appeared to be borrowing less. But Enron pledged its own stock to guarantee the asset values; when those asset values fell, Enron had to pledge more stock to make good, and, given its declining stock price, a vicious cycle ensued. There will be BIG changes in how such transactions are accounted for and disclosed in the very near future. Private companies also use off-balance sheet entities, but they are usually set up to take advantage of differing tax rates between individuals and companies. Most of the time, banks require that owners of such entities personally guarantee debts incurred by them, so there is no way to hide indebtedness.
Inventories: many public companies, for sound business and financial reasons (not accounting purposes) try to minimize their holdings through "just-in-time" systems. Lower inventories lead to lower borrowings, more liquidity, and improved cash flow, all of which are laudable. Private company owners, on the other hand, are often aggressive in devaluing inventories in order to reduce taxable income, an entirely different motivation. These inventories have a tendency to be revalued upward when the owners contemplate sales of their businesses.
These are just a few ways in which scorekeeping can affect the results and values of public and private companies. I think the above advice was "right on the money!"
February 11, 2002 - Master Limited Partnerships
Increasingly, people are forming Master Limited Partnerships (MLPs), limited liability companies or similar pass-through entities to consolidate holdings of other limited partnerships (LPs) or similar interests. For simplicity, this letter discusses only MLPs holding LP interests, but the same comments apply regardless of the types of pass-through entities involved.
MLP valuations create two significant complexities:
There are two levels of discounts for lack of control and lack of marketability. One applies to the underlying LP interests. The second applies to the MLP interest.
Why are two levels of discount appropriate? Because there is a big difference between owning an asset outright, owning a limited interest in a partnership owning the asset, and owning a limited interest in an MLP owning a limited interest in a partnership owning the asset. In the second instance, there are two entities between the asset and the MLP owner, and therefore two constraints on control and two obstacles to liquidity. The following analogy makes the point. What would you rather own, and how much would you pay for:
$1 million in cash;
- A safe for which you do not have the combination which holds $1 million; or
- A safe for which you do not have the combination, which holds another safe for which you do not have the combination that holds $1 million?
I don’t know about you, but I would pay less for (2) than for (1), and less for (3) than (2)!
It is often impossible to obtain proper valuation information for MLP interests, specifically the values of the assets (and liabilities) of the underlying LP interests. In most cases, one only has available K-1’s for the LPs, which disclose only taxable income, book capital and distributions. The LP interest owners cannot usually persuade or force the partnerships to provide asset/liability fair market values. Even if they could, the cost of doing so could be prohibitive, as would the cost of appraising the discounts for lack of control and lack of marketability applicable to each LP as well as the MLP.
A colleague of mine recently appraised an interest in an MLP that owned 200 LP interests. At $3,500 per valuation, it would have cost 201 X $3,500 = $703,500 just to value the 200 LP discounts and the MLP discount. (I would have "discounted" my fee…however, appraising each of 200 limited partnerships would be very expensive!) At an arbitrary $5,000 per LP, it would have cost an additional $1 million to value the underlying LP assets. Since the annual cash flow from the MLP interest was $45,000, it does not require rocket science to see that a proper appraisal would be cost-prohibitive.
A reasonable and cost-effective solution reflects the reality that LP owners cannot force the LPs to liquidate. As such, they cannot access the underlying asset value, and it is therefore irrelevant unless there is evidence of the intention of the general partner(s) to liquidate. In the case mentioned above, of the 200 LPs, three fell into this category. Asset appraisals for each were obtained and they were valued accordingly. The only economic benefit to ownership of the other 197 LPs was cash flow, and each interest was valued on that basis. As a further reasonable and appropriate simplification, the LPs were grouped into three categories (income-producing real estate, illiquid venture capital investments and marketable securities) for which cash flow multiples were developed. Using this methodology, the scope of work was reduced to valuing the three liquidating partnerships and the three categories of non-liquidating LPs, which led to obvious major economies in fees, not to mention the time required to complete the assignment.
January 21, 2002 - Irrelevant Appraisal Issues
In many valuations, issues that might appear at first to be significant turn out not to matter at all.
Let’s say that we are valuing a minority interest (sometimes called a non-controlling interest) in a service business. The company is established, profitable, and financially strong. There are two owners: a control (majority) owner and a minority owner. The control owner receives a salary greater than fair market value (but not so high as to oppress the minority owner).
The experienced appraiser will recognize three irrelevant issues in this case:
- Valuing the company’s tangible and intangible assets.
- Adjusting earnings for excess control owner compensation.
- The discount for lack of control.
Why are these irrelevant?
The minority shareholder cannot force liquidation. He or she cannot access the value of the assets. Liquidation would be illogical, since the business is profitable and strong. This makes the asset-based valuation irrelevant.
Even if it was completed, the asset-based valuation would entail significant extra expense to appraise the tangible assets (such as equipment) and the intangible assets (using methods that require difficult, sensitive assumptions). This would simply waste time, effort and money.
To adjust earnings for excess compensation (which increases the value to "control level") and then reduce them back to minority level by a discount for lack of control is circular. The appraiser will end up where he or she started, with a value based on minority-level earnings. These two adjustments must offset each other.
Although it is not wrong to complete these analyses, they unnecessarily lengthen and complicate appraisal reports, fail to reinforce the ultimate value conclusion, confuse readers, and cost extra. Instead of going through the extra steps, an experienced appraiser will simply explain why the extra steps are not necessary thus saving the client both time and money. However, in some situations, all possible alternatives may need to be addressed by the appraiser. Each case is different—another reason for using an experienced appraiser .
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