2005 Monthly Newsletters
December 2005 - Hold ‘em or Fold ‘em?

First, let us wish you a Merry Christmas and a Happy New Year!  

Now, our point. Many business owners are facing a daunting dilemma today, and they don’t know whether to hold ‘em or fold ‘em (that is, to continue to own or sell their businesses):  

Competition, unfavorable economic conditions, and other changes may make it harder for them to maintain profitability and / or grow.
They are besieged with barrages of interest to buy their businesses, but have no idea how to respond.
The decision as to whether to grow or sell is a major life event, and it is easy for many owners to sit on the “inertial fence” -- and do nothing. Although sitting on the fence may seem comfortable, by failing to address the decision, business owners are not managing their businesses as investments...they are treating them just as a source of employment income. This is not a smart way to manage one’s wealth!  

We would be happy to meet with you and your clients or assist you to provide a seminar for selected clients and/or proactive and trusted business advisors who are in a position to help their clients get off the inertial fence and decide, in the immortal words of Kenny Rogers, whether to “hold ‘em or fold ‘em”. The objective of our seminars is to provide either your clients or these advisors – those to whom business owners turn for such vital advice – with a vocabulary and a framework for addressing this major life decision.  

Among the issues we address are:  

What obstacles make fence sitting the easy way out for many owners?
Why not do nothing – what is wrong with the status quo?
When is the right time to decide to hold or fold?
What do you need to do if you decide to hold (grow your business)?
What do you need to do if you decide to fold (sell your business)?
If you would like to set up a seminar for clients or simply for you and your staff, please let us know!

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call. We value both businesses and real estate.  
October 2005 - Using a Third Appraiser to Solve Differences

According to Black’s Law Dictionary, the definition of “appraisal” is 1. The determination of what constitutes a fair price; valuation; estimation of worth. 2. The report of such a determination. In other words, an appraisal is an appraiser’s estimation, or opinion, as to the worth of something. We like to refer to an appraisal as a supportable opinion of value. Unfortunately, some appraisers do not provide much support for their opinion; others do an excellent job supporting their opinion.  

In many Buy-Sell or Shareholder agreements, it is stated that after both parties have obtained a business appraisal from qualified business appraisers and the values differ by more than some agreed upon percentage, then a third business appraiser shall reconcile the difference.  

This is a very workable idea, but it needs to go further. The third business appraiser needs to be a very well qualified individual. The third business appraiser needs to have the same certifications that the authors of the major textbooks in the industry have.  

The third business appraiser should also be given additional authority over the situation as he or she will be required to wear many hats besides just that of technical expert: judge, arbitrator, mediator, teacher, investigator, enforcer, and psychologist. In fact, one might want to consider expanding the third business appraiser’s mission to include getting the dispute resolved equitably and economically, not to just come up with a number.  

This is a big difference, because in order to do it right, the third business appraiser needs the authority  
  • to ensure that the other two appraisers received equal access to information and people,
  • to rectify inequalities in the abilities and work products of the appraisers,
  • to identify issues that are purely for the appraisers to resolve, as opposed to those that might be legal, in the realm of other professional experts, or purely personal,
  • and perhaps the most important, to enforce schedules.  

The third business appraiser should be given copies of the other two experts appraisals for a number of reasons. Some of these are as follow:  

  • It forces the first two business appraisers to actually write a report to support their assumptions and to illustrate their thought processes in such a way that the third business appraiser can follow. (The Uniform Standards of Professional Appraisal Practice state that a report contain enough detail that another expert can follow and replicate the results.)
  • The ability to review the first appraisals eliminates any redundant work and allows the third business appraiser to focus solely on where the first two appraisals differed.
  • If there are any errors in either of the first two reports, the correction of same might bring the first two appraisals back into the agreed upon range and end the conflict almost as soon as it had begun.  

If after everything has been reviewed, there is still a problem, then the third business appraiser will be able to illustrate what points between the differing experts are similar and issue an opinion of value without having to open new ground. In the odd case that the first two appraisers disagreed on everything then it might be a good idea to have the third business appraiser re-appraise the entity from scratch.  

We regularly assist in conflict resolution regarding appraisal differences and have experience in appraisal review. Paul is a review appraiser for those desiring to be certified as a business appraiser by The Institute of Business Appraisers (IBA). He is also the editor of Business Appraisal Practice, the professional journal published quarterly by the IBA. Shawn grades the certification examination for Certified Business Appraiser candidates for the IBA.

Valuations play a part in all strategic transactions. For additional information or advice on a current situation, please do not hesitate to call. 
September 2005 - Buy-Sell Agreement Problems

We have always maintained that every business with more than one owner should have a well written buy-sell agreement that governs the valuation and transfer of ownership interests upon various contingencies (such as death, disability, disagreement, or termination). The agreement must be carefully thought through, legally documented, and reviewed at least annually.  

When there is no agreement, or it is incomplete and / or outdated, situations like the following are encountered:  

Mr. A owns a minority business interest. He is terminated (whether for cause or not is in dispute) as an employee, and wants to be bought out.
He may or may not be a key person; the business impact of his termination is unclear.
The buy-sell agreement, which is 20 years old, has never been updated. It says that value at death will be determined by the company’s accountant based on “book value”. There is no mention of the other contingencies, like termination.
The company is profitable, even after the majority owner takes a very large salary and other benefits.
There is no mention of whether control and / or liquidity characteristics merit discounts, going concern versus liquidation premise of value, or the date of value (e.g. death, most recent fiscal yearend, etc.)
This situation is full of potential problems for the appraiser and those who need to determine the value Mr. A’s interest. The buy-sell agreement is so vague as to be useless to provide direction.  

In our opinion, business appraisers should not take unilateral responsibility for determining:  

The standard of value (investment, fair market, fair).
The level of value (whether discounts and premiums apply).
The valuation date.
When these parameters are at issue, we emphatically place the responsibility for defining them on the parties and their attorneys, whose expertise, original intent, and desires are controlling. If they cannot agree, then we offer the these options:  

Give us arbitral power to decide them. (This rarely happens.)
Let us opine a range of value opinions covering all relevant combinations of standard, level, and date of value. Then the parties may negotiate or litigate.
Put our engagement on hold until these issues are resolved.
On the other hand, we believe that appraisers can appropriately make determinations of:  

Whether valuation formulas contained in buy-sell agreements are consistent with fair market value and the valuation (not the legal) provisions of Chapter 14, Section 2703 of the IRS Code. We do this (if parameters have been agreed upon) by appraising values with and without the buy-sell agreement and comparing them.
The appropriate premise of value, or whether it is too close to call (as occasionally occurs when a business may be worth more dead than alive), in which we might provide alternative values for each premise, or weight them).
Appraisers can make similarly valuable contributions when buy-sell agreements are being drafted and negotiated. We have found the easiest procedure to start with being retained by the entire shareholder group (or the business or its board of directors) so that we are neutral. We then review the draft agreement to see whether the valuation parameters are clear for each contingency and raise questions if they are not. We specifically question terms that are vague, such as “book value,” does it mean:  

GAAP or tax?
As reported or as adjusted?
If adjusted, what is adjusted (fixed and other reported assets, what about intangibles that might not be on the books?)
Formula clauses in buy-sell agreements or specified dollar amounts often lead to problems down the road. Rarely are formula clauses tested to see if they are reasonable and will be valid in a few years. Agreements that call for an annual dollar amount to be agreed upon by the shareholders sound great, but rarely are updated and the initial “price” should be supported so that it is really representative of the value each party would either sell or buy at.  

The moral of our story is simple: buy-sell agreements when carefully and correctly drafted are a benefit, however, when done without much thought or incorrectly, they can compound problems for a business and its shareholders. It is often worth it to value the company when establishing a buy-sell agreement. When this is done, everybody knows what to expect and how things will work down the road. 

Valuations play a part in all strategic transactions. For additional information or advice on a current situation, please do not hesitate to call. 
August 2005 - Subsequent Events: The Appraisal Date Matters!

Picking the effective date of an appraisal is often a very important decision. Sometimes, it is fixed by some event, however, other times it is a decision that needs to be made by the client in conjunction with the attorney or accountant. Getting the date wrong can cause some real problems. Appraisals are made as of a specific date – a change in the date can make a big difference in value. The classic example is the value of a travel agency on September 10, 2001! It changed dramatically the next day, however, had the appraisal been required as of September 10, 2001, the events of the next day could not have been considered.  

IRS Revenue Ruling 59-60  

In Section 3, Paragraph 3, this ruling states that:  

“Valuation of securities is, in essence, a prophesy as to the future and
 must be based on facts available at the required date of appraisal.”

The key points are:
  • Facts – not suppositions, but valid information
  • Available – known or reasonably knowable  

Appraisals must be based on information known or reasonably knowable as of the valuation date.
Information that becomes available after the valuation date can be divided into two types:

Information that indicates but does not affect value.
Information that affects value.
 An example of the first type would be a subsequent sale of the business, assuming that there had been no material change in its environment, business, or financial position in the intervening period. Such information could reasonably be interpreted to indicate but not affect value, and could be relevant to a previous valuation date. Several court cases have affirmed this general principle, which makes sense as well.

Examples of the second type abound. In some instances, this information was not known or reasonably knowable as of the valuation date and was thus not relevant to the appraisal. For completeness, however, the appraiser should indicate his or her awareness of it and state why it was given no weight.  

Although RR 59-60 3.03 applies strictly to tax appraisals, its relevance to compliance (e.g. financial reporting and ESOP) and litigation engagements is also obvious. In litigation, however (particularly divorce), there is sometimes controversy about the valuation date. If this is not clarified promptly in advance of beginning work, this can create major headaches for all concerned.  

An Example:  

A business owner died on June 5, 2004. We are valuing a business for estate tax purposes. It is now August of 2005. The valuation date will be June 5, 2004 and the report date will be sometime in September 2005.

The company prepares quarterly financials and cannot furnish a June 5 (or May 31) statement. Should we use March 31 or June 30 results? 
We would look at both the March and June statements and see if there were material differences. If not, the choice is moot. We would personally lean toward the June statement because it was closer to date of death, even though it is technically after it. If there were major changes between the statements, we might interpolate an estimated date-of-death statement with management’s help. Alternatively, we could work the problem as of both dates and determine the significance of the difference.  

On October 1, 2004 well after the owner died, the executor received a totally unsolicited offer to buy the business, which had not been put on the market. How should this be addressed in the appraisal?
We would disclose this in our report and not assign it any weight as it was not known or reasonably knowable as of the valuation date. We might use it as a weak test of reasonability. (If the buyer was strategic, this might not be a fair market value indication.)  

As of the date of death, the company had just become aware of a major new potential customer, but had not done any research, prepared proposals, or contacted any of the customer’s representatives. How should this be reflected in the appraisal?
Same as (2); we have no facts with which to quantify the impact or probability of getting the new customer. We are appraisers, not fortune tellers (unfortunately we were not issued a crystal ball with our appraisal designations).  

Same as (3), but the company had presented a proposal and knew what the revenue, profit and cash flow impact of its acceptance (or rejection) would be. What should be done in the report?
We would try to estimate the chances of getting (or losing) the business and prepare a probability-weighted analysis. We would not talk to the customer, since they would obviously not make this disclosure to a potential supplier in the normal course of business.  

Same as (3) and (4), but the proposal was accepted (and a contract was signed).
This should be included with 100% weight in the appraisal.  

In summary, if an appraiser is aware of subsequent information, it should be disclosed in the report and a description made of why it was or was not relevant.

Valuations play a part in all strategic transactions. For additional information or advice on a current situation, please do not hesitate to call. 
July 2005 - (Out of) Control Premiums and Discounts

One of the biggest valuation adjustments in many business appraisals is the control premium or discount for lack of control. A premium (increase in value) is often applied to a majority interest, and a discount (reduction in value) to a minority interest, due to their different legal rights and the economic benefits derived therefrom.

The most frequently cited benchmark for these premiums and discounts is the Pratt / Mergerstat Control Premium Study, which is based on acquisitions of publicly traded companies. Frequently, these occur at values higher than the previous trading price of the shares of the acquired company. The percentage by which the acquisition price exceeds the previous trading price is the control premium, and the studies consistently find an average premium of about 35%. This implies a discount for lack of control of 25%, because the percentage decrease from 135% (the acquisition price) to 100% (the previous trading price) is approximately 25%.

There are many problems associated with this data:

These are based on public companies, which have every incentive to maximize reported earnings. Private company owners have the opposite goal: to minimize them for tax purposes. Like almost everything else in appraisal, the Pratt study is an imperfect proxy.
Averages do not capture case-specific facts and circumstances, which must by law be assessed (see Mandelbaum v. Commissioner).
Many acquisitions are “strategic”, meaning that the acquirer had a business fit with the seller that justified a higher acquisition price. These considerations are not normally part of fair market value. The magnitude of an adjustment that should be made to compensate for strategic purchases is unknown and really undeterminable.
Some of the averages included only transactions where premiums were paid, not those for which there were no or negative premiums.
Most of the companies acquired were operating businesses, which may not be very comparable to passive holding entities such as Family Limited Partnerships (FLPs) and Limited Liability Companies (LLCs). 
FLPs and LLCs generally provide their control owners with fewer prerogatives; legal powers which they can exercise to earn disproportionate benefits, such as above-market salaries. As an example, consider a family limited partnership that owns marketable securities managed by an outside investment counselor with full discretion. The general partner has very few control prerogatives other than deciding overall asset allocation and which manager to hire. By contrast, control owners of operating businesses have many more prerogatives, such as deciding what products or services to offer and how they are priced and sourced.
One must be very careful in considering “control prerogatives” in a tax-related (fair market value) appraisal. Many of them (such as deciding what products or services to offer) could fundamentally change the nature, risks and returns of the business. This is not something that the fair market value buyer (who is a passive financial investor) will normally consider, because they do not have sufficient knowledge (or a strategic business fit) to do so.
As a result of these concerns, we tend to handle discounts for lack of control for holding entities (like FLPs and LLCs), by benchmarking it using a blend of the data from Mergerstat Review (adjusted in so far as possible to account for synergies) and closed-end investment funds (which are like mutual funds, except that there is a fixed number of shares outstanding, and they are publicly traded, rather than issued or redeemed by the fund). We then analyze and determine the required adjustment to the baseline using a variety of applicable factors so that the conclusion is supportable. We also compare the results to data obtained from Partnership Profiles, a data source generated from a variety publicly traded limited partnerships in order to support our conclusion.

For control interests in operating businesses, some appraisers consider the ratio of adjusted to unadjusted cash flow or profits. Unadjusted results are as reported (except that non-recurring or extraordinary items are excluded). Adjusted results include the traditional “add-backs” for excess owner compensation, perquisites, and the proverbial condominium in Sun Valley . If unadjusted cash flow is $100,000 and adjusted cash flow is $150,000 ($50,000 of add-backs); this implies a control premium of 50% and a discount for lack of control of 33%. We consider this approach in each transaction, but generally whenever possible use appraisal methods where a control premium or discount for lack of control is not necessary.

When valuing minority interests in operating businesses, there are two approaches that can be used. First, the appraiser can value the company on a control basis and apply applicable discounts or, the second approach, an income stream available to minority interests can be used and the need for a discount for lack of control avoided. By definition, a minority shareholder, in the absence of special agreements, cannot control or influence the “add-backs” (unless they are excessive, oppressing the minority shareholder). Therefore, it is confusing and somewhat misleading to first make the add-backs (which increase the ultimate value) and then discount for lack of control (which decreases the value) – the first approach. In theory, these two adjustments should exactly offset each other; they are circular and irrelevant. One can simply value the minority interest on the basis of unadjusted (except for non-recurring and extraordinary items) cash flow or earnings, and take no discount for lack of control, as it is implicit in the unadjusted results – the second and preferred approach.

Valuations play a part in all strategic transactions. For additional information or advice on a current situation, please do not hesitate to call.
June 2005 - See the Big Picture

We learned an important lesson from a recent engagement that will help us be better advisors (general problem solvers), not just appraisers (specific problem solvers).

Case Study

Mom, son, and daughter each owned one-third of Mom’s home. Mom died, and the daughter wanted to buy the other interests, gaining 100% ownership. Daughter insisted that the other interests should bear discounts for lack of control and marketability, but the executor and the son were having none of that, saying that daughter could immediately sell the house. They were stuck.  

A request was made for an appraisal to determine the discount for the one-third interests, a simple assignment. This assignment was declined for the following two reasons:  

No matter what the opinion, someone would reject it on principle, as there was no agreement that discounts were relevant. The request was only for an opinion of a discount, not to arbitrate or mediate, so an appraisal would waste time and money.
Much more important, the clients were not asking the right question! They were focused only on discounts. They were not seeing the big picture of the economics of selling (buying) versus holding their interests. They had not considered the costs of operating and maintaining the home (utilities, property taxes, etc.), nor had they considered capital gains taxes or possible appreciation in value. When this was pointed out, a different assignment was made and completed.
As it turned out, the house was expensive to maintain, the daughter was willing to absorb those costs, and the estate and son were happy to be relieved of them. THIS, not lack of control or marketability, became the basis upon which they negotiated a discounted purchase price for the interests. (It also turned out that the high costs led to a much greater discount than would be indicated by Lack of Control or Lack of Marketability. The estate was able to claim, justify, and receive that discount on its tax return, based on the analysis and the fact that the interests were actually sold at that price.)  

Conclusion
The moral of the story is this: appraisal skills allow us to objectively and independently consider all relevant economic aspects of a situation as some problems require a different solution than the norm. We all need to refuse to let client pressure, standard operating procedure, or our technical focus cloud our vision of the big picture. 

Valuations play a part in all strategic transactions. For additional information or advice on a current situation, please do not hesitate to call. 
May 2005 - Defining the Appraisal Assignment

Proper business appraisals are always team efforts. The team includes the client, their professional advisors, and the business appraiser. Good teamwork requires not only that each member executes his or her individual assignment, but also that they agree and cooperate on the many aspects of the assignment that involve other members. This will result in a highly desirable end product: a strong, well-documented, defensible, and reasonable value opinion. This month’s newsletter categorizes these aspects from the viewpoint of the business appraiser, and suggests who should be responsible for each.

The analogy of building a house is very helpful. Using it, there are four levels of construction:

Bedrock
Foundation
Walls
Roof
Bedrock Issues

These are primarily under the control and direction of the client. Some of the most important and common ones are:

In estate-tax free appraisals, what standard of value is to be applied? Should the presence of strategic buyers (who can justify higher than fair market “financial buyer” prices) be considered?
In buy-outs where there is no controlling legal authority (thanks, Al Gore!) should minority interests be valued net of discounts for lack of control and / or lack of marketability?
In tax-related appraisals, how aggressive is the client willing to be in light of potential adverse audit scrutiny?
What is the budget and time schedule for the appraisal, and how detailed in scope and reporting is the appraisal report to be?
Will the client be able to make full and accurate disclosure of all of the information necessary to complete the appraisal? (In divorces, the non-propertied spouse may have problems getting access to necessary information.)
Foundation Issues

These are primarily decided with the assistance of legal and tax counsel or the accountant, and have influence on the standard bedrock premises (e.g. going concern versus liquidation), date, and level of value (that is, whether discounts for lack of control and / or marketability are applicable):

What is the impact of applicable statutory and case law as well as government regulations (e.g. ERISA for ESOPs) on the assignment?
What is the effect of relevant contracts (such as buy-sell or close corporation agreements, or dispute resolution mechanisms involving arbitration, mediation or multiple appraisers)?
In litigation, if there are restrictions on the data available to the appraiser or questions about its integrity, how are those to be handled?
Wall Issues

These are primarily decided by the appraiser, and include:

Development of historical actual and adjusted financial statements, as well as forecasts
Whether or not fixed asset appraisals (of real estate and / or equipment) will be necessary
How specific case facts and circumstances are to be interpreted and considered
Which valuation approaches (e.g. Income, Asset or Market), methods (such as comparable transactions) and market data are relevant, and their relative importance
The magnitudes of key appraisal assumptions such as the discount or capitalization rate or the discounts for lack of control and / or marketability
If there are huge contingencies (such as the outcome of lawsuits) which could dramatically affect value, how should they be considered, appraised and reported?
Roof Issues

Considering all of the above, it is the appraiser’s final job to justify the reasonability of his or her value conclusion with a clearly written report and tests of reasonability.

Conclusion

A good appraisal rests on a strong foundation down to the bedrock, has sturdy walls and a roof to protect it, all of which contribute to a well-built home that provides a great quality of life.
April 2005 - Business vs. Real Estate: Cap Rate Problems

Problems occur in both business and real estate appraisals when an appraiser uses a capitalization rate applicable to one for the other. I made this mistake as a brand new business broker many years ago. I was used to seeing a capitalization rate of ten percent or so for income producing real estate properties, i.e. commercial buildings, apartment buildings, etc., and used that rate to estimate a listing price for my very first business opportunity listing. Needless to say, the business did not sell. I soon learned that there is a big difference between the way income producing real estate properties and small operating businesses are viewed even if they are combined.
The following are three different cap rate options available to appraisers along with the values they generate based on the example included later in this article:
1. A typical real estate capitalization rate is used to value a business enterprise including real estate as an operating asset.

$1,667,000 Enterprise Value

This results in an over valuation of the business enterprise. As shown in the example below, there is a significant difference in a typical business pre-tax income capitalization rate and a typical real estate capitalization rate applicable to pre-tax net operating income.

2. A business capitalization rate is used to value the same business enterprise including real estate as an operating asset.

$333,000 Enterprise Value

This results in an under valuation of the business enterprise. The typical business capitalization rate, on a pre-tax equivalent basis, is significantly higher than the typical real estate capitalization rate.

3. The real estate owned by the business is valued as real estate, a market lease rate is included in the business expenses, the business is valued using a business capitalization rate, and the enterprise value is obtained by combining the real estate and business values.

$707,000 Enterprise Value

This is the correct way to value the enterprise. It uses the appropriate business capitalization rate for the business entity portion of the income stream and the appropriate real estate capitalization rate for the real estate portion of the income stream.

First, the rates shown below are assumed for the example:

Business Appraisers typically use what is called a “build-up” method to estimate a discount rate. It involves adding a risk free rate, the rate for the stock market risk overall, the rate for small cap stocks, and an estimate of the specific company risk premium.



Discount Rate from Build-Up Method

20%

Long-Term Sustainable Growth Rate

3%

Capitalization Rate

17%

Real Estate Capitalization Rate Extracted

from the Market

9%

Second, the income forecast for ABC Company is presented:

ABC Company Forecast


Revenue

  1,000,000

Cost of Goods Sold

  400,000

Gross Profit

  600,000

Operating Expenses

Salaries Etc.

This forecast does NOT include any rent expense for the operating real estate asset owned by the company.

  100,000
Other Expenses

  350,000

Total Expenses

  450,000

Pre-Tax Net Income

  150,000

Income Tax

  60,000

Net Income

  90,000

Add: Depreciation

  75,000

Less: Capital Expenditures

  (50,000)

Changes in Working Capital

  (35,000)

Changes in Long-Term Debt

  (25,000)

Net Cash Flow to Equity

  55,000

Included in the company’s assets is the real estate owned by the company that is considered an operating asset. For simplicity, it is assumed that there is no loan against the real estate.
Third, the value of the enterprise using the real estate capitalization rate, option one above, is illustrated:
This estimate of value uses a real estate cap rate applied to a business pretax net income stream – it over values the enterprise.

Enterprise Value Using Capitalization Rate Applicable to Real Estate

Pre-Tax Net Income

150,000

  =

  1,666,667

Real Estate Capitalization Rate

9%

Value of the Enterprise (Rounded)

  1,667,000

Fourth, option two above, the value of the enterprise using the business capitalization rate on both a net cash flow and an equivalent rate using a pre-tax income stream is shown:

Enterprise Value Using Capitalization Rate Applicable to Net Cash Flow

This is the value of the business enterprise using a typical business cap rate and the appropriate income stream, however, the real estate value is ignored as it is considered an operating asset. This under values the enterprise.

Forecast Net Cash Flow to Equity

  55,000

Times: Long-Term Sustainable Growth Rate

  1.03

Net Cash Flow Applicable to the Future

  56,650

Net Cash Flow Applicable to the Future

  56,650

  =

  333,235

Capitalization Rate to Net Cash Flow

17%

Value of the Enterprise (Rounded)

  333,000

Enterprise Value Using Capitalization Rate Applicable to Pre-Tax Income

It does not matter what earnings stream is used. What does matter is applying the correct cap rate to the appropriate income stream. This example shows how a 46.4% pre-tax net income cap rate is equivalent to a 17% net cash flow cap rate.


Pre-Tax Net Income

  150,000

Times: Long-Term Sustainable Growth Rate

  1.03


Pre-Tax Net Income Applicable to the Future

  154,50

Pre-Tax Net Income

  154,500

  =

  333,235

Capitalization Rate

46.4%

Value of the Enterprise (Rounded)

  333,000

​It should be noted that business appraisals grow the forecasted income stream by one year using the sustainable long-term growth rate in order to be representative of what is expected long-term including an eventual sale of the business. The capitalization rate used in the business appraisal is the discount rate, often developed using the build-up method, less the long-term sustainable growth rate.
Real estate appraisers are trained to observe capitalization rates in the market and to extract the capitalization rate for the subject property from the market. In order to do this, they typically examine sales of very similar properties comparing the net operating income to the sales price for indications of the appropriate rate. Real estate appraisers are careful to use only properties for which the net operating income was calculated the same way. For example, it would be inappropriate to use the net operating income for a property that deducted as an expense reserve allowances for a new roof, replacement of appliances, and other such capital expenditures to value a property using an income stream without a replacement allowance. Other differences in comparable properties must also be adjusted for using market data before capitalization rates can be extracted and used to value a subject property. Because the real estate capitalization rates are extracted directly from the market, they do not need to be grown by a year nor modified for long-term growth as are the business capitalization rates. Included in the real estate capitalization rate is the market’s perception of all future cash flows from the property including its eventual sale.
Fifth, the appropriate method of valuing a mixed enterprise is illustrated:  

ABC Company Forecast

Revenue

  1,000,000

Cost of Goods Sold

  400,000

Gross Profit

  600,000

Operating Expenses



Salaries Etc.

  100,000

Real Estate As If Leased

  50,000

Other Expenses

  350,000

Total Expenses

  500,000

Pre-Tax Net Income

  100,000

Income Tax

  40,000

Net Income

  60,000

Add: Depreciation

  75,000

Less: Capital Expenditures

  (50,000)

Changes in Working Capital

  (35,000)

Changes in Long-Term Debt

  (25,000)

Net Cash Flow to Equity

  25,000


The following illustrates the same company with an operating expense adjustment to deduct the market value rental rate for the real estate owned by the business in determining the value of the business. The real estate appraiser determines both the value of the real estate and the appropriate market rental rate using a capitalization rate applicable to the real estate portion of the income stream. The enterprise value is determined by combining the value of the real estate and the business.
Value of the Real Estate Owned by the Company


Retail
50,000

  =

  555,556

Capitalization Rate

9%


This shows the calculation of the business value using the appropriate cap rate applicable to net cash flow and an income stream after an allowance for market rent for the real estate. The value of the real estate is added to the value of the business to get the correct value of the total enterprise.


Forecast Net Cash Flow to Equity

  25,000

Times: Long-Term Sustainable Growth Rate

  1.03

Net Cash Flow Applicable to the Future

  25,750

Net Cash Flow to Equity

  25,750

  =

  151,471

Capitalization Rate

17%
Add: Value of Real Estate

  555,556

Value of the Enterprise (Rounded)

  707,000

Value Using Capitalization Rate Applicable to Pre-Tax Income

Pre-Tax Net Income

  100,000

Times: Long-Term Sustainable Growth Rate

  1.03

Pre-Tax Net Income Applicable to the Future

  103,000

Pre-Tax Net Income

  103,000

  =

  151,471

Capitalization Rate

68.0%

 Add: Value of Real Estate

  555,556

Value of the Enterprise (Rounded)

  707,000


The large difference in the capitalization rate applicable to pre-tax net income, 68% in the example above, compared to the rate applicable to the real estate, 9% in this example, illustrates the typical difference in risks associated with many business enterprises and real estate income properties.
Real estate properties incur vacancies, tenants that may not pay, etc., however, there is typically a good chance that the property can be resold for a substantial sum whether or not it meets the forecasted income expectation. In other words, it is likely that an investor in income producing real estate can obtain at least a large portion of the amount originally invested if not that plus a return on the investment. Of course, investors sometimes lose properties to foreclosure or other problems because of a variety of circumstances, but, ignoring problems associated with how the investment is funded, the risk of the original investment being returned to the investor is often much lower with income producing real estate than with an operating small business. 
Business appraisers simply do not have the needed data to extract capitalization rates directly from the market. Some appraisers use the inverse of market multiples such as Price to Earnings as indications of capitalization rates, however, rarely does sufficient information about the comparables exist so that the degree of difference between the comparables and the subject can be determined. Due to the lack of very similar sales about which sufficient data is available, business appraisers must use some other method to mirror the market with respect to risk of the forecasted income stream. A build-up method is commonly used.
Whichever method is used to develop a capitalization rate, it should be understood that the rate when applied to the chosen income stream should be representative of all future cash flows associated with the investment. In real estate, what is called the reversion (the realization of proceeds from an eventual sale) is accounted for in the capitalization rate including any anticipated appreciation in value. The theoretical concept is similar for the business appraisal capitalization rate – when applied to the chosen income stream, it too reflects the value of all future cash flows associated with the investment. However, it must include the often higher risk associated with the return on investment or even that the actual investment may not be returned at all. Business investments are typically much more risky than real estate investments—the cap rates should reflect this difference. 
When valuing enterprises that contain both a real estate and a business component, special care must be taken to correctly identify each component and use appropriate risk rates applied to the correct level of income stream.

Valuations play a part in all strategic transactions. For additional information or advice on a current situation, please do not hesitate to call. 
Sincerely,

Paul R. Hyde, EA, MCBA, ASA Shawn M. Hyde, CBA
Enrolled Agent Certified Business Appraiser
Master Certified Business Appraiser
Accredited Senior Appraiser
​March 2005 - Appraisal Diagnosis

One of Paul’s greatest pleasures and privileges is teaching business valuation classes in conjunction with national professional societies. The students are invariably highly motivated, enthusiastic, intelligent, and they always ask good stimulating questions.

One of the questions heard most often is, “How can I make sure I define the appraisal assignment properly?” Clients and their advisors often present valuation cases to appraisers accompanied by a wealth of information. Some of that material is critical, some is irrelevant, and some is missing. It is easy, even for experienced professionals, to miss nuances. This can have enormous, negative consequences.

The business appraisal literature, although abundant, gives relatively short shrift to this challenge. “Defining the assignment” is usually discussed at the front of the book, presented in abstract and general terms, and accompanied by a statement of its importance, but there is little practical guidance on how to do it well.

A sound, comprehensive definition of the assignment by the client and their advisors will uncover all of the fundamental issues and clearly indicate the appraisal approaches and methods that will most likely be relevant. All concerned will benefit accordingly. Doing this well does not take a great deal of time, but requires excellent listening and diagnostic skills.

A medical analogy is apt. Your internist asks you “Where does it hurt?” Depending on your answer, and the doctor’s experience and ability, the follow-up questions and possible further tests, are then apparent.

Here are the questions the appraiser should ask of the client (or the referring professional):

1. What do you own?

This might seem easy and superficial, but there may be major valuation implications depending on the type of entity (“S”, “C” or other form of incorporation; general or limited partnership; proprietorship; limited liability company) and ownership form (all of the various types of equity or capital; debt; and whether the interest is divided or undivided).

2. How much of it do you own?

Answers can range from enterprise scale (100%) to control (over 50%), 50-50, swing, and minority, with important nuances as to type of ownership (e.g. tenancy in common).

3. Are there ownership constraints?

This is the toughest issue, because of the wide range of possible limitations. Some may require legal interpretation (shareholder agreements regarding the conduct of business, compensation, share valuation, and transfers). Others involve contractual relationships with third parties (such as building leases or bank loans), related parties, or affiliated entities. Still others involve legal claims (e.g. pending lawsuits), contingencies (such as environmental problems) and hypothetical assumptions. The important point is that these constraints may encumber the ownership interest in some manner that affects its value.

4. What type of and how much economic benefit does or will it provide, and what drives it?

At its core, this addresses the issue of highest and best use: whether the enterprise is an operating business seeking earnings or a holding entity seeking appreciation. It leads directly to the premise of value (going concern versus liquidation, and other variations) and translates into a financial forecast, supported by economic, industry, and company analyses. Based on market data of various types (dictated by the appraisal methodology), the benefit stream is then assigned a discount or capitalization rate or valuation multiple.

5. What risk factors influence value?

This relates to earnings predictability, the factors that drive it, and the significance of each one.

6. How liquid is it?

Since appraisals are stated in cash-equivalent terms, the lack of a ready market reduces value.

7. What are your intentions and desires?

Although legal and appraisal standards are inviolate, intentions come into play in many gray areas. An example would be a sale of a business to family members in an estate-tax free context. Here the standard of value need not be fair market value. A frequent issue is whether or not discounts for lack of control and marketability apply when there is no buy-sell or similar agreement, and a minority shareholder’s interest is to be redeemed.

In reviewing this list, questions 4, 5 and 6 are the basis of the business appraisal literature, professional education and certification programs. The first three and the last are the hardest, because they require non-appraisal expertise and skill to answer.

Valuations play a part in all strategic transactions. For additional information or advice on a current situation, please do not hesitate to call. We value both businesses and real estate.

Sincerely,

Paul R. Hyde, EA, MCBA, ASA Shawn M. Hyde, CBA
Enrolled Agent Certified Business Appraiser
Master Certified Business Appraiser
Accredited Senior Appraiser

February 2005  - Undivided Interest Appraisal Problems

What is an undivided interest in real estate worth? The answer is the most common response you will hear from an appraiser: “It depends …”  

The biggest problem in valuing an undivided interest in real estate is that undivided interests rarely sell so there is very little direct market data available. An undivided interest in real estate has many of the same characteristics of a closely held business security – in order to value it, typically both a real estate appraisal and a business appraisal are necessary. The real estate appraisal is needed to estimate the value of the entire property and the business appraisal is needed to estimate the value of the interest in the property actually owned as undivided interests when they do sell, typically sell at a discount from the pro rata value of the property.

The business appraiser estimating the value of the undivided interest requires information not included in many real estate appraisals. The real estate appraisal that will be used by the business appraiser to estimate the value of an undivided interest needs to:

· Include the business appraiser and other professionals that will use the report as intended users of the real estate appraisal.  

· Be prepared as of the effective date needed for the undivided interest value. Problems often occur when a client tries to use an earlier appraisal prepared for a different intended use, such as for a loan.  

· Not have any unusual assumptions, hypothetical conditions, and or limiting conditions.  

· Include sufficient market area data and analysis – of particular importance to the business appraisal is growth rates and trends and the anticipated time frame for events such as changes in supply and demand relationships, zoning, nearby development, rental trends, etc.  

· Address in sufficient detail the highest and best use issues, zoning issues, etc. that may affect the ability to partition the property. Included in this area are things like an estimate of when it will likely be feasible to develop the property based on market trends, are the current owners likely to redevelop the property, does the property only need a face lift, is a major remodel necessary, is there room for additional improvements, can the property be divided and if so, does the highest and best use change, etc.  

· Include the typical or anticipated holding period for the specific type of property. The holding period of the investment is of critical importance to the business appraisal – things like remaining economic life, the estimated time of expected major improvements, etc. that affect the likely holding period need to be addressed.  

· In the income approach, the business appraiser will need more detail than is found in most real estate appraisals – often a more thorough analysis of leases including the likelihood of renewal and at what rates, vacancy rates in the future depending on what is happening in the area, the adequacy of replacement reserves, and expected change of management resulting in a change of costs. Also, if a capitalization rate is used, the business appraiser needs to know the growth rate portion (separated from total). A multi-period discounted cash flow or yield capitalization approach is preferable for business valuation as the expected holding period is defined and explained.  

· In the sales comparison approach, the business appraiser will need to know more about the estimated exposure and marketing time than is usually included in most real estate appraisals. They will also need to know as much as possible about the magnitude of any required adjustments to the comparables used in the real estate appraisal.

It must be remembered that the real estate appraisal assumes the transfer of the entire property will occur – the business appraisal assumes that only a transfer of the noncontrolling (minority) interest will take place. For undivided interests, the most important single factor facing a buyer is the length of time they can expect to hold the interest before the pro rata value of the overall property can be realized.

One of the most important features of an undivided interest is the ability of any holder of whatever size interest to sue for partition or to force a sale. Since all undivided interest holders must agree – any one can block an action – an undivided interest has more control than a limited partnership interest, but it does not have absolute control. The expected holding period of the interest is critical to estimating its value. Things that must be considered by the business appraiser include the:  

· Historical cash flow and distributions and the likelihood of their continuation or the expected timing of future cash flow distributions. 

· How will management decisions be made, both now and in the future? Who will be the cotenant’s “partners” in the future? What happens if cotenants disagree?  

· If a partition action is undertaken, how long will the lawsuit likely take and what is it likely to cost? Is the expected expense worth it? What is the likelihood of one of the other cotenants mounting a strong opposition?  

Valuations play a part in all strategic transactions. For additional information or advice on a current situation, please do not hesitate to call. We value both businesses and real estate.
January 2005 - Appraisals: Is the Cheapest Really the Best

I remember as a young boy dreaming to grow up and be an astronaut going to the moon and beyond. As I grew up and realized that I was not going to be able to live my dream, I became rather disappointed until one day, when out of the blue, someone put my dream into perspective for me. He said, “Son, on the surface, the life of an astronaut appears to be wonderful and full of glory. However, you must remember that an astronaut’s job comes down to one thing, and that is to be strapped inside a highly explosive device comprised of many different components, all manufactured by the lowest bidder.” For some reason after that discussion, I never wanted to be an astronaut again. 

Now, it seems to me that many appraisals fall into this same category as my dream to be an astronaut. Most of our clients understandably want to spend the least amount of money possible in pursuit of their goals. I believe that part of our job as professionals is to assist our clients to make smart decisions that will help them to safely reach the moon or to make a gift of a minority interest in a limited partnership. In order to do this we should attempt to educate them on what exactly is involved in the preparation (manufacture) of these critical components that comprise their transportation to the successful transfer of ownership of the family business to the next generation. 

Any appraisal, is the person performing the appraisal’s “opinion of value” of the subject of the appraisal. In any opinion, there can be a lot of subjective decisions and underlying assumptions that can greatly affect either the quality of the report, the indication of value, or both. Depending on who is doing the appraising, there might be some potential conflict of interest issues that could blow up in the clients face. No one likes only making it halfway to where they want to go. Instead of searching for the cheapest opinion of value available, there are some ways to save money and still get a good solid number that will take you all the way to the moon.  

There are many situations that arise where a full, comprehensive appraisal report is not required. For example, last month we were visiting with an attorney who often works with family owned businesses that want to transfer ownership to the next generation. In a scenario such as this, many sections of a full, comprehensive appraisal report are not needed, such as the explanation of how the economy and the industry affect the value of the subject company, as the involved parties already know how all that works. Clearly a family would not want to pay for an appraiser to write down what they already know, which leaves the attorney to figure out how to value the company’s goodwill. We understand these situations, and often will recommend that a limited, summary report be issued. These are less expensive, can be done more quickly, and deliver the required numbers that other professionals are sometimes required to estimate instead of insisting that the client pay for a full appraisal.  

There are many other such situations where paying for a full, comprehensive appraisal report is actually unnecessary. Many times lenders are happy with a summary report that illustrates how the appraiser got to the indicated value, but without a lot of the extra detail. Other uses where a summary report is useful are for possible partner buyouts, determining the value for a potential sale, and to assist with the determination of applicable values required for Buy-Sell agreements. The type of appraisal report required depends very much on the use for which it is being done. 

There are some assignments that always require a comprehensive appraisal, such as any tax related issue, or when the report will be used as an exhibit in court, or whenever it is expected that an interested party might be unhappy with the end result. In these situations, the appraisal report may not the best place to try to save some money. In any situation, should you or your client have questions or would just like to learn some more about the appraisal process, we are happy to stop by your offices free of charge and with no obligation. 

Valuations play a part in all strategic transactions. For additional information or advice on a current situation, please do not hesitate to call. We value both businesses and real estate.
Sincerely,


Paul R. Hyde, EA, MCBA, ASA Shawn M. Hyde, CBA
Enrolled Agent Certified Business Appraiser
Master Certified Business Appraiser
Accredited Senior Appraiser in Business Valuation




November 2005 - Developing a Realistic Forecast vs. Dream Sheets

While our topic of discussion is forecasting, we will not be discussing precipitation, expected temperatures, or wind conditions! According to Revenue Ruling 59-60, long considered the appraiser’s “Bible”, value is based on future expected earnings. Estimating future expected earnings, i.e. developing a forecast for the entity, can be challenging!  

A forecast of earnings or cash flow for either a business entity or income producing real estate should represent what an informed willing and able buyer and an informed willing and able seller would expect. Many people are concerned that a forecast incorporates unknowns or, after the fact, that the forecast did not exactly predict actual results. They miss the key issue. Forecasts are not a prediction or guarantee of future results; they cannot be and are not expected to be. Instead, they are expected to represent reasonable expectations of the future earnings as of a specific point in time; as of the effective date of the appraisal.  

Forecasts are prepared by different parties, sometimes with different objectives. For example, when a company is put up for sale, often the forecast it prepares for potential buyers presents a rosy picture of the expected future. However, should the owner of the company be involved in a divorce, the forecast for the company often appears quite gloomy. The appraiser’s job is to evaluate a company forecast or prepare his or her own forecast that is a fair representative of future expected profits.  

Occasionally we see a “forecast” prepared for a company that uses an average of historical earnings, often a weighted average in which the more recent years are weighted more heavily than prior years. The statement is usually made that this represents a “conservative” estimate of future earnings. However, when considered carefully, unless we are expecting a future with no inflation at all, any average of historical earnings will result in a guaranteed undervaluation of the entity!  

Analysis of historical results is important. Historical results provide indications and trends that can and should be incorporated in the development of a forecast. A forecast that differs widely from historical results generally is considered very optimistic and is often called a “dream sheet” as it typically has no basis in reality and represents what the business owner hopes might happen. This type of forecast, also occasionally referred to as a hockey stick forecast as it takes off towards the moon in similar fashion to the shape of a hockey stick, is not very useful. A forecast should carefully explain how each component has been developed so that the reader can understand and feel relatively comfortable that the forecast reasonably outlines the expectation of future results.  

When developing a forecast, there are many items that must be considered. Among them are:  

§ The entities past stability

§ Its growth rate

§ The diversity of its operations

§ The current and prospective economic and industry conditions

§ Existing and prospective competition

§ Management

§ Financial condition and outlook

§ Events in the past that are unlikely to recur in the future  

When evaluating a forecast, the most important consideration is: Does it pass the “smell” test? If it just does not make sense or seem reasonable, then it may not represent what an informed willing and able buyer and an informed willing and able seller would expect.  

Valuations play a part in all strategic transactions. For additional information or advice on a current situation, please do not hesitate to call.
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