Business Valuation fo r Lawyers: Effective Use of Business Valuations in Legal Matters

1. Business Valuation for Lawyers: Effective Use of Business Valuations in Legal Matters PRESENTED BY: Michael S. Jones Jones, McCoy & Lincoln, P.A. – Senior Partner G. Matt Barberich, Jr., CPA/ABV/CFF/CGMA, CIA, CFE, ASA, MBA GlassRatner - Managing Director

2. Overview • When Does a Lawyer Need to Obtain a Business Valuation? • What is a Business Valuation? • Business Valuation Methods What They Mean • How to Present Business Valuation Evidence in Court – An Appraiser’s Perspective • Attacking Opposing Valuation Evidence – An Appraiser’s Perspective

3. When Does a Lawyer Need to Obtain a Business Valuation?

4. When Does A Lawyer Need To Obtain A Business Valuation? • Lawyers may need to obtain a business valuation in the following: • Income tax compliance (Charitable Contributions, Built-In Gains taxes, etc.) • Estate and Gift tax planning and/or compliance • Mergers and Acquisitions • Litigation and/or Ownership Disputes • Marital Dissolution • Stock Options • Dissenters’ Rights Casts • Employee Stock Ownership Plans

5. When Does A Lawyer Need To Obtain A Business Valuation? • Lawyers may need to obtain a business valuation in the following: • Financial Reporting • Purchase Price Allocations • Goodwill Impairment • Buy / Sell Agreements • Reorganizations and Bankruptcies • Business and/or Succession Planning • Probate

6. What is a Business Valuation?

7. What is a Business Valuation? The act or process of determining the value of a business enterprise or ownership interest therein.

8. General Elements of a Business Valuation • General Elements of a Business Valuation: • Purpose of the Business Valuation • Valuation Date • Premise of Value • Standard of Value • Subject Ownership Interest • Business Valuation Approaches • Business Valuation Methods • Discounts and/or Premiums • Valuation Reconciliation and Conclusion

9. Purpose of a Business Valuation • The Purpose of the Business Valuation usually determines the following: • The Valuation Date • The Premise of Value • The Operational Premise of Value • The Standard of Value

10. Valuation Date • Valuation Date Definition: • The specific point in time as of which the valuator’s opinion of value applies (also referred to as “Effective Date” or “Appraisal Date” or “as of” date). • Why is the Valuation Date Important? • Circumstances can cause values to vary materially from one date to another. • The valuation date directly influences data available for the valuation. • Business Valuations are always forward-looking. What is known or knowable as of the valuation date?

11. Valuation Date Importance

12. Premise of Value • There are two (2) common Premises of Values: • Value in Exchange: The value of the business or business interest changing hands, in a real or hypothetical sale. • Value to the Holder: The value of a property that is not being sold but, instead, is being maintained in its present form by its present owner.

13. Operational Premise of Value • There are two (2) common Operational Premises of Values: • Going Concern Value: The value of a commercial enterprise’s assets or of the enterprise itself as an active business with future earning power as opposed to the liquidation value of the business or its assets; and • Liquidation Value: The value of a business or of an asset when it is sold in liquidation, as opposed to being sold in the ordinary course of business. • In judicial valuations, it is often assumed that a company will continue functioning as it had been during and after the valuation.

14. Operational Premise of Value • There are three (3) levels of Liquidation Value: • Value as an Orderly Disposition: A value in exchange on a piecemeal basis; a value in exchange that contemplates the price at which the assets of a business will be sold with normal exposure to their appropriate secondary markets; • Value as a Forced Liquidation: A value in exchange that contemplates the price at which assets will be sold on a piecemeal basis, but instead of normal exposure to the market, these assets will have less-than-normal exposure; and • Value as an Assemblage of Assets: A value in exchange, consisting of the value of the assets in place, but not in their current use in the production of income and not as a going-concern business enterprise.

15. Standards of Value • There are four (4) common Standards of Value: • Fair Market Value: The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts. • Fair Value: • Financial Reporting: The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date; and • Litigation: Defined by jurisdictional statute. Common Standard of Value for dissenting shareholder and/or minority oppression lawsuits.

16. Standards of Value • There are four (4) common Standards of Value: • Investment Value: The value to a particular investor based on individual investment requirements and expectations; and • Intrinsic Value: The value that an investor considers, on the basis of an evaluation or available facts, to be the “true” or “real” value that will become the market value when other investors reach the same conclusion.

17. Defining Fair Market Value • Fair Market Value is the most common Standard of Value: • International BV Glossary: The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts. • IRS Regulations: The price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. • Black’s Law Dictionary: The price that a seller is willing to accept and a buyer is willing to pay on the open market and in an arm’s-length transaction; the point at which supply and demand intersect.

18. Subject Ownership Interest • The types of interest that can be valued include: • A 100% controlling interest • A majority interest that possess control • A majority interest that does not possess control • A 50% interest • A dominant minority interest • A non-dominant minority interest • Stockholder agreements often define the rights afforded to the subject ownership interest.

19. Subject Ownership Interest • The primary ownership interest characteristics that need to be addressed in almost every business valuation are the following: • Controlling or Non-Controlling Valuation Basis: The degree of control, or lack of it, may fall anywhere across a broad spectrum; and • Degree of Marketability:The benchmark usually used to represent full marketability is an actively traded stock of a public company. The premise as to the extent to which the entity or business interest being valued is or is not marketable is usually considered in relation to this benchmark.

20. Rev. Rul. 59-60 • Rev. Rul. 59-60 states the following: A sound valuation will be based upon all the relevant facts, but the elements of common sense, informed judgment, and reasonableness must enter into the process of weighing those facts and determining their aggregate significance.

21. Rev. Rul. 59-60 • Rev. Rul. 59-60 states, although not all-inclusive, the following factors are fundamental and require careful analysis in each fair market value appraisal: • The nature of the business and the history of the enterprise from its inception; • The economic outlook in general and the condition and outlook of the specific industry in particular; • The book value of the stock and the financial condition of the business; • The earning capacity of the company; • The dividend-paying capacity; • Whether or not the enterprise has goodwill or other intangible value; • Sales of the stock and the size of the block of stock to be valued; and • The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter.

22. Business Valuation Principles • There are three (3) business valuation principles: • The Principle of Alternatives: Each party has alternatives to consummating the transaction; • The Principle of Substitution: Neither party will pay more for something than he or she would pay for an equally desirable substitute; and • The Principle of Anticipated Future Benefits: Economic value reflects anticipated future benefits.

23. Business Valuation Approaches • There are three (3) Business Valuation approaches: • The Asset Approach: A general way of determining a value indication of a business, business ownership interest, security, or intangible asset using one or more methods based on the value of the assets net of liabilities; • The Income Approach: A general way of determining a value indication of a business, business ownership interest, security, or intangible asset using one or more methods that convert anticipated economic benefits into a present single value; and • The Market Approach: A general way of determining a value indication of a business, business ownership interest, security, or intangible asset by using one or more methods that compare the subject to similar businesses, business ownership interests, securities, or intangible assets that have been sold.

24. Business Valuation Methods • There are several Business Valuation Methods under each Business Valuation Approach: • Asset Approach: • Net Asset Value Method • Liquidation Value Method • Excess Earnings Method (Hybrid method with the Income Approach) • Income Approach: • Discounted Earnings Method • Capitalized Earnings Method • Excess Earnings Method (Hybrid method with the Asset Approach) • Market Approach: • Guideline Public Company Method • Guideline Merged & Acquired Company Method • Direct Market Data Method • Prior Sales Method

25. Discounts and/or Premiums • Common Business Valuation Discounts and/or Premiums: • Control Premium • Discount for Lack of Control • Discount for Lack of Marketability • Other Business Valuation Discounts and/or Premiums: • Key Person Discounts • Discounts for Trapped-In Capital Gains Taxes • Portfolio Discounts • Discounts for Contingent Liabilities • Discounts and/or Premiums for Nonvoting versus Voting Stock • Blockage Discounts

26. Valuation Reconciliation and Conclusion

27. Valuation Reconciliation and Conclusion Net Asset Value Income Approach Methods Market Approach Methods Intangible Value (Goodwill)

28. Business Valuation Standards

29. Business Valuation Standards • There are several sources of Business Valuation Standards: • The Appraisal Foundation: • Uniform Standards of Professional Appraisal Practice • The American Institute of Certified Public Accountants: • VS Section 100 • The American Society of Appraisers: • ASA Business Valuation Standards • National Association of Certified Valuation Analysts and Institute of Business Appraisers: • Professional Standards • Compliance is voluntary or based on appraisers membership in these organizations.

30. Business Valuation Methods and What They Mean

31. Asset Approach Methods

32. Asset Approach Valuation Methods • There are several Business Valuation Methods under the Asset Approach: • Asset Approach: • Net Asset Value Method • Liquidation Value Method • Excess Earnings Method (Hybrid method with the Income Approach)

33. Asset Approach Valuation Methods • The fundamental business valuation principle is: The current value of assets minus the current value of liabilities equals the current value of business owners’ equity.

34. Net Asset Value Method • The Net Asset Value Method involves separate identification and individual revaluation of the Company’s: • Financial asset accounts (Cash, Accounts Receivable, etc.) • Tangible Personal Property (Machinery & Equipment, Vehicles, etc.) • Real Estate (Land, Buildings, etc.) • Intangible Real Property (Leasehold Interests, Air and Water Rights, etc.) • Intangible Personal Property (Patents, Customer Relationships, Goodwill, etc.) • Current Liabilities (Accounts Payable, Accrued Liabilities, etc.) • Long-Term Liabilities (Notes Payable, etc.) • Contingent Liabilities (Pending Litigation, Possible Environmental Liabilities, etc.) • Special Obligations (Unfunded Pensions, ESOP Repurchase Liabilities, etc.)

35. Liquidation Value Method • The Liquidation Value Method involves the same components as the Net Asset Value Method, except the asset and liability liquidation values are used. • Consideration as to the appropriate exposure time determines the appropriate liquidation values. • Liquidation expenses (and/or selling expenses) are generally considered as an unrecorded liability, or a direct reduction of the asset’s liquidation value.

36. Liquidation Value Method • Consideration of the Liquidation Value Method is sometimes required when valuing a controlling interest. USPAP Standard Rule 9-3 states: In developing an appraisal of an equity interest in a business enterprise with the ability to cause liquidation, an appraiser must investigate the possibility that the business enterprise may have a higher value by liquidation of all or part of the enterprise than by continued operation as is. If liquidation of all or part of the enterprise is the indicated premise of value, an appraisal of any real property or personal property to be liquidated may be appropriate.

37. Income Approach Methods

38. Business Valuation Methods • There are several Business Valuation Methods under the Income Approach: • Income Approach: • Discounted Earnings Method • Capitalized Earnings Method • Excess Earnings Method (Hybrid method with the Asset Approach)

39. Income Approach Valuation Methods The fundamental premise of valuation is comprised of three (3) factors: • The Magnitude of Future Cash Flows; • The Timeliness of Future Cash Flows; and • The Riskiness of Future Cash Flows.

40. Income Approach Valuation Methods Return on Invested Capital Cash Flow Value Revenue Growth Cost of Capital

41. Discounted Earnings Method • Projects earnings into one or more discrete future periods. • Terminal Period (last forecast period) assumes either the sale of the business (exit multiple) or continued growth into perpetuity (capitalization rate). • Future earnings are discounted to Present Value by the appropriate discount rate.

42. The Present Value Formula Where: NCF = Net Cash Flow (or Earnings) k = Discount Rate n = Number of periods into the future when the returns are expected to be realized.

43. Definitions of Cash Flows • Net Equity Cash Flow: • Net Income (After Income Taxes) • Minus: Dividends on Preferred Equity Capital • Plus: Non-Cash Charges (e.g., Depreciation, etc.) • Minus: Capital Expenditures • Plus/Minus: Changes in Net Working Capital • Plus: Proceeds from Issuance of Preferred Equity or Debt • Minus: Repayments of Preferred Equity or Debt • Equals: Net Equity Cash Flow

44. Cash Flow Adjustments • There are three (3) main categories of cash flow adjustments: • Normalization Adjustments: Adjustments for comparability, develop future expectations, and eliminate nonrecurring items. • Controlling Adjustments: Excess or deficient compensation, elimination of non-market related party transactions (e.g., above/below market rent to related party). • Income Taxes: Most non-publicly held companies are pass-through entities. After-tax cash flow is conceptually appropriate and required for comparability with cost of capital information.

45. Cost of Capital (Discount Rate) The cost of capital is the expected rate of return that market participants require in order to attract funds to a particular investment.

46. Cost of Capital (Discount Rate) • The Cost of Capital is: • A function of the investment, not the investor. • Forward-looking. It is always an estimate. It is never observed. • Based on the market value of an investment (asset). • Usually stated in nominal terms. Expected returns should include inflation expectations.

47. Cost of Capital (Discount Rate) • There are two (2) main methods of estimating the cost of capital for a closely-held company: • The Build-Up Method • The Modified Capital Asset Pricing Model

48. The Build-Up Method • The Build-Up Method is an additive model, in which additional risk premium(s) are added to a risk-free rate to estimate the cost of capital for a closely-held company. Where: Dr = Discount Rate Rf = Risk-Free Rate RPm = Equity Risk Premium RPs = Size Premium RPc = Company Specific Risk Premium

49. The Build-Up Method Example

50. The Modified Capital Asset Pricing Model • The Modified Capital Asset Pricing Model is used to estimate the cost of capital for a closely-held company. Where: Dr = Discount Rate = Beta Estimate Rf = Risk-Free Rate RPm = Equity Risk Premium RPs = Size Premium RPc = Company Specific Risk Premium