Valuations of Enterprises

1. Valuations of Enterprises Dr Clive Vlieland-Boddy

2. Common Reasons for Business Valuations • Mergers and Acquisitions • Many businesses are “overbought” • You need to know at what point to “walk away” • Selling Your Business • Most owners have unrealistic expectations of the value of their business • Divorce/Litigation • Extreme differences of opinion regarding value of the business 2

3. Common Reasons for Business Valuations …..continued • Buy-sell Agreements • Good buy-sell agreements (BSA’s) can help prevent future problems/issues • Gifting of Stock • Report of a certified appraiser required with gift tax return • Estate Tax/Life Insurance Planning • The value of a closely-held business is usually the largest component of an estate • Estate taxes could force the sale of the business 3

4. Understand the Reason/Purpose for Valuation Who is client? (Buyer or Seller?) Desired outcome Who will use/rely on the valuation A misunderstanding here would jeopardize the assignment May not be applicable for a variety of purposes 4

5. Standards of Value • Fair Market Value • Fair Value • Investment Value • Intrinsic Value

6. There are five most commonly used valuation methods Comparable transactions (Market Based) Comparable public companies (Market Based) Discounted cash flow or Earnings Earnings Based Multiples Asset Based Valuation Valuation of Private Companies 2

7. Fair Market Value • “The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell.” • Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.

8. Revenue Ruling 59-60 • Nature of business and its history • Outlook for economy and for the industry • Book value and financial condition • Earning capacity • Dividend paying capacity • Presence of goodwill or intangible value • Sales of stock and size of block to be valued • Market price of similar businesses

9. Steps of the Valuation Process How Why Who What When 9

10. Fair Market Value Considerations The nature of the company’s business and its history since its inception The outlook for the economy in general and the company’s industry in particular The financial condition of the company and the value of its underlying net assets The past earnings and future earning capacity of the company 10

11. Fair Market Value Considerations…….continued Prior transactions involving the company’s stock and the size of the block to be valued The ability of the company to distribute earnings Whether the company has goodwill or other intangible value The price of stock actively traded in a free and open market for comparable companies in the same or similar line of business 11

12. Determine the Appropriate Premise of Value Going concern value, or Liquidation value (piecemeal) Orderly (time to maximize), or Forced (auction) 12

13. Determine the Subject Interest to be Valued 100% Controlling interest Degree of control 13

14. Analyze the Company’s Financial Information Profitability Enterprise’s cash flow Normalizing adjustments Add-back owner’s compensation and perks 14

15. Other Information Site visit, interviews Industry research – market & customers Guideline public companies Comparable transactions 15

16. Other Information…continued Economic outlook Competition Product Life Cycles R & D. Intangibles Like Brands or Know How 16

17. Consider Valuation Approaches & Methods Income approach Market approach Asset approach 17

18. Valuation Techniques • Based upon earnings multiples derived from quoted comparable companies DiscountedCash Flow TransactionMultiplesAnalysis TradingMultiplesAnalysis Valuation • Based upon multiples derived from recent M&A transactions • Based upon earnings multiples derived from quoted comparable companies Net Asset Value • Based upon earnings multiples derived from quoted comparable companies

19. Income Approach Most appropriate for businesses anticipating future earnings Cap of cash flows method, or DCF (discounted cash flow) method Historical results analyzed & adjusted to help estimate future cash flow Investors buy tomorrow’s cash flow Cap rate or multiple 19

20. Income Approach • This approach values an enterprise based on its earnings or cash flow generating abilities. • These benefit streams are converted into estimates of value by discounting or capitalization. • Discounting future returns tends to be more appropriate when these returns are expected to be substantially different from current operations. • Capitalization is appropriate when a normal growth rate in operations is expected.

21. Market Based Approach • Comparability with similar businesses is used to estimate value under this approach. • Methods most often used are either a similar company or the industry method (sometimes called “rules of thumb”). • Price/sales and price/earnings ratios are often applied to financial data adjusted to enhance the comparability of the entities.

22. Market Based Approach Market approach appropriate for all types if comparable and sufficiently similar in purpose and circumstance Apply guideline company multiples (adjusted) to subject’s cash flows, or Comparable deals, or Bona fide offers, or Past transactions in subject’s stock 22

23. Market-based Approach – Guideline Public Company Method Finding sufficiently similar public companies Comparison to subject company Application of valuation multiples (adjusted) Pro- specifically referred to in Rev. Ruling 59-60 Con- difficult to find adequate sample 23

24. Market-based Approach – Merger & Acquisition Method Actual sales of comparable companies Useful for valuations of controlling interests Not as useful for minority interests Difficulty in quantifying minority discount Uncertainty over motivation of parties 24

25. Market-based Approach – Past Transactions Actual arm’s length sales within a reasonable time before or after the valuation date are the best criteria of value Such transactions are rare yet should always be investigated 25

26. Asset Approach Most appropriate for: Asset holding companies Real estate entities Marginally profitable businesses Purchase accounting Should form the base price. 26

27. Asset-based Approach – Liquidation Value Business is worth more dead than alive Floor value for controlling interests May not be applicable for minority interests who do not have the power to cause liquidation 27

28. Asset-based Approach • May be used for appraising businesses with little value beyond that of their tangible assets, such as investment companies or real estate holding companies. • Individual assets and liabilities are adjusted to reflect current values. • Total assets less liabilities equals value of enterprise. • Net asset value, as described, or liquidation value may be appropriate.

29. Reconcile Various Indications of Value from Approaches Adjust in reconciling Average methods; or Select most appropriate 29

30. Apply Discounts or Premiums Lack of control Lack of marketability Lack of liquidity (controlling) Depends on method used to arrive at value Key person discount Competitiveness of the Industry 30

31. Lack of Control (Minority) Discount • A minority discount is a reduction in the control value of the appraisal subject that is intended to reflect the fact that the owner of a minority interest can not control the daily activities or the policy decisions of an enterprise. • The size of the discount will depend on the amount of control which can be exercised by the minority interest, including the ability to block actions, and various other factors.

32. Benefits of Control Appoint or change management Determine compensation and perquisites Set operational and strategic policy Liquidate, or recapitalize the company Register company’s debt or equity for an IPO 32

33. Lack of Marketability Discount • The concept of “Marketability” deals with the liquidity of an ownership interest, that is, how quickly and easily can it be converted to cash if the owner chooses to sell. • Discounts are usually appropriate for any ownership interest that can not be sold in a timely manner with cash proceeds received in three business days. Some transfers of ownership are restricted by the documents establishing the enterprise.

34. Lack of Marketability of Shares The level of discount to be applied to a specific interest is dependent on many factors. Some of those factors include: Expected appreciation Dividend capacity Probable holding period Prospects for liquidity 34

35. Lack of Marketability …continued Degree of control in the block of stock Restrictions on the transferability Company’s stock redemption policy 35

36. Other Discounts • Undivided fractional interests • Built-in capital gains • Key person discount • Small company discount • Blockage discount • Litigation uncertainties

37. Business Planning Employee retention Retention of key employees Stock options Phantom stock options Direct sale of shares Future acquisitions of shares 37

38. Private Company Financial Metrics - Definitions • EBITDA – Earnings before interest, taxes, depreciation and amortization. Measure of cash produced by the company’s operations. • EBITDA less CAPEX – Reducing EBITDA by the amount of capital expenditures derives a better measure of cash flow to service debt and taxes • Debt to EBITDA – Ratio of interest bearing debt to company’s LTM (last twelve months) EBITDA. This is the ratio that leveraged lenders use to determine the maximum level of debt a company can handle. With companies with less than $10mm of EBITDA, 2.5x – 3.5x is typical; over $10mm, 3.0x – 4.5x. 7

39. Private Company Financial Metrics Definitions Continued • Senior debt – First lien bank debt – refer to case study for pricing • Subordinated or Mezzanine debt – Term debt that is second in priority to senior debt; typically provided by funds and private finance companies. • Equity Value – Market Capitalization for public companies (# of shares times the share price). For a private company equal to Enterprise Value minus debt plus cash (net debt). • Enterprise Value – Equal to interest bearing debt and equity value minus cash on the balance sheet (net debt). This is the value of a company. Also calculated by multiplying LTM EBITDA by a market multiple. 8

40. Model of a Firm Value from Operations Value from investments Value generated Enterprise value Equal if debt is fairly priced FIRM Value to Equity DEBT and other liabilities EQUITY

41. Valuation of goodwill • Based on capital employed and expected profits vs. actual profits • Based on number of years of super profits expected • May be discounted at suitable rate

42. Valuation of IA The value of the IA is from • Economic benefit provided • Specific to business or usage • Has different aspects • Accounting value • Economic value • Technical value • Can you think of examples of these different values?

43. Valuation of IA Depends on objective and can vary widely depending on purpose • For accounting purposes – to show in financial statements • For acquisition/merger/investment • For management to understand value of company for decision making

44. How To Avoid Mistakes

45. Use all appropriate valuation methods – the case will give you enough information to do those that are possible Remember your audience and who hired you – the Board of Directors whose foremost fiduciary responsibility are to the owners of the business. DO NOT get bogged down in the details. Board members will ask a detailed question if they believe you glossed over something important. Put detail in appendix. The cases typically give you more information than you need. You do not need to use everything that is in the case. Make sure you answer the questions the Board is asking. How To Avoid Mistakes 10

46. Focus on Enterprise Value – many contestants only focus on Equity Value and forget about the Debt. Have a handout that is identical to your presentation to the board on the screen. Unless necessary, don’t regurgitate the financial statements in your presentation. LTM earnings is the only relevant number to use for valuation purposes. Make sure the presentation doesn’t switch between landscape and portrait. How To Avoid Mistakes … Continued 11