Valuing Businesses and Property after Matrimonial Breakdown

1. NQLA Conference 25 May 2011 Valuing Businesses and Property after Matrimonial Breakdown

3. What is Valuation? • Purpose of Valuation • Is a Valuation necessary? • The Valuation process • Types of methodologies • How business Valuer conducts process • Issues to take into consideration for matrimonial breakdown • Issues for Valuers • The application of retrospectivity (Kizbeau case) • Summary for Lawyers • Appendix 1 – 41 factors affecting a Business Valuation

4. What is valuation? • “Valuation can be described as estimating a fair price for the parties to exchange an asset having regard to the risk and the expected return of the asset” • Concept of risk and return – key to valuation

5. Purpose of a valuation • Why are valuations conducted: “to arrive at a value as a reference point for a transaction”

6. Purpose of a valuation • A valuation must have regard for: • Expected returns • Risk free rate • Comparable returns of similar assets or classes of assets • Risks of the returns • Other variables

7. Market value “the price that would be negotiated between an knowledgeable and willing but not anxious buyer and a knowledgeable and willing but not anxious seller acting at arm’s length within a reasonable time frame.” (Lonergan, 2003)

8. Alternatives to Market value definition • Intrinsic value • Fair market value • Realisable value • Going concern value (primarily for businesses) • Present value or net present value • Investment • Deprival value

9. Intrinsic Value • Intrinsic Value of a business is defined as being the value “inherent” therein, “belonging to”, or “arising from” its “true or fundamental nature”. Thus, the Intrinsic Value of a business equates to its value, to the owner, in its present form, independent on the amount for which it can be sold.

10. Intrinsic Value and Market Value • “Intrinsic Value” and “Market Value” cannot be one and the same, because the value of a business, “in its current operating state”, includes assets and liabilities that are not transferred to a purchaser, in a sale thereof. • It may be described as “true value” inherent in the object of the valuation. This may not be a reflection of current market price or realisable value, but is rather an assessment of value computed on true worth, irrespective of any other considerations. Intrinsic values change less frequently, as a rule, than market values.

11. Intrinsic Value Assets • Assets included in the “Intrinsic Value” of a business, not transferred to a buyer of the business, i.e., excluded from its “Market Value”, include: •  Cash at Bank • Trade Debtors • Utilities Deposits

12. Intrinsic Value Liabilities • Liabilities accounted for in establishing the “Intrinsic Value” of a business, not transferred to a buyer of the business i.e., excluded from its “Market Value”, include: • Trade Creditors • Employee PAYG Tax Deducted • Employer Superannuation Contributions

13. Intrinsic Value and Market Value • Nevertheless, for “a knowledgeable and willing, but not anxious buyer and a knowledgeable and willing, but not anxious seller, acting at arms length, within a reasonable time frame”, “Market Value” would normally equate to “Intrinsic Value”,adjusted for the above exclusions.

14. Price v value • “Price is what you pay, value is what you get” (Kilpatrick 2006) • Price: - is the amount realised in a transaction - Price is objective • Value: - is an estimate at what price should be - Value is subjective • In a going concern business no two Valuers are going to agree exactly on a value

15. Conceptual framework • Valuation is built around the concepts of risk and return • Put simply, the value of an asset (Business) is the present value of the future cash flows of that asset • This applies to businesses and property

16. What is being valued? • Business • Shares • To value the shares you need to value the business

17. Is a Valuation necessary? • Is it profitable after deduction of owners wages and other adjustments • Has it been incurring losses • Is it solvent • Is it a going concern • Is it only worth in situ plant and equipment value • Does one of the parties have specific expertise • Is there any goodwill • Is business saleable • Small business – is the profit no more than the business owners wage “Buying a job” • Maybe pertinent to just value plant and equipment

18. The valuation process • Understanding the business, its risks and industry • Selecting the relevant methodology • Determining the variables • Determine the result • Review the result

19. 1. Understand the company’s business • PORTER MODEL – introduced in 1980’s • Understanding the business, its risks and industry, including: - Barriers to entry - Quality of management - Company’s competitive position Porters 5 forces - Industry and outlook - Competition

20. 2. Select relevant methodology • Standalone value / value to acquirer • Methodologies: - DCF - Capitalisation multiples • Which methodology to use • Depends on information available and circumstances

21. Quite a number of issues are considered before determining the methodology for valuation

22. Terms of premises occupancy can determine the appropriate method for valuing a business • E.g. If business is expected to have a limited life span business should be valued by DCF method only

23. Types of methodologies

24. Capitalisation multiples Capitalisation Multiples: • Surrogates for DCF • Less reliable • Capture growth and risk in multiple • Requires comparable companies • Issues with each method: - EBITDA (Earnings before interest tax depreciation and amortisation) - EBITA (Earnings before interest tax amortisation) - EBIT (Earnings before interest tax) - PE

25. Discounted cash flow • DCF is theoretically the best methodology • However it is not always practical • Therefore it is mainly used for: - Lumpy cash flows - Start ups - Resource projects - Finite timeframes

26. Capitalisation multiples - Advantages • Easy to understand and extensively used in practice • Inputs (published financials, short-term forecast, comparable multiples) are widely available • Ability to benchmark against industry • Works well for stable established business

27. Capitalisation multiples - Drawbacks • Seen as less rigorous/simplistic • Inconsistency in accounting practices; depreciation, amortisation, tax outstanding • Small sample size and sample reliability • Range of multiples are often wide and outliers exists • Uneven cash flows – start-ups, and turnarounds

28. 3. Determining the variables • DCF - Discount rate / WACC (weighted average cost of capital) - Cash flow variables e.g. foreign exchange • Capitalisation multiples - Earnings to be multiplied - Earnings multiple based on comparable companies • Other detailed research

29. 4. Determining the result • What is the result of the DCF of multiple valuation? • Sensitivities around key assumptions

30. 5. Review the result • Cross check to other methodologies, i.e. what multiples does the DCF valuation provide? • Check for reasonableness • Stand back and look at result - Does it make sense? - Should the company be worth more or less? - Do the assumptions need revision?

31. Selection of appropriate maintainable profits figure • “The selection of an appropriate maintainable profits figure is a matter of judgment depending on the circumstances. For example, a company may be in a position of short term decline, as a result of industry pressures, or internal management problems. • In such a situation, it is important to adopt a longer term view so as to discount any short term irregularities in the company’s profitability.” (Lonergan)

32. Intrinsic value established by capitalisation of future maintainable earnings (FME) method • Quite common for small business operators not to prepare estimates of future net cash flows • Reasons for this include: a) do not believe they can be reliably predicted b) simply do not have any idea about their future net cash flow c) not willing to incur the cost of professional assistance to prepare them • Method preferred by small business operators • CAP FME method, an Earnings before Interest AFTER TAX Capitalisation Rate is applied to expected FME

33. Criticisms of future maintainable earnings methodology • “Too many FMP based valuations are flawed in that they automatically employ historical profits as a proxy for FMP without undertaking sufficient critical examination of past performance and likely future events. An understanding of the future of a business is essential for an accurate valuation, yet is omitted when historical profits are used in isolation.” Lonergan • Noted American valuation text author, Shannnon P. Pratt, also endorses that view: “There is a mind set that can be described as the ‘mechanistic mentality’, for lack of a better expression. It mechanically relies on past data, without considering whether adjustments should be made, or whether it is reasonable to expect future results to conform to past results.

34. Rules of thumb market value methods • Criticism is rules of thumb do not provide a real value of a business in terms of the earnings derived from the net assets employed

35. How does Business Valuer conduct process? • Obtain last 3 - 5 years financials (tax returns preferable) • Review profit and loss for last 3 - 5 years • Establish whether future cash flow forecasts have been undertaken and if so review same • Ascertain if owners wages have been paid and commercial rent charged • Determine if any other applicable adjustments • Take into account inflation • Calculate adjusted net profit

36. Review assets and liabilities • Review Balance Sheet • Land and buildings – consult Property Valuer (not to be included in net tangible assets calculation) • Plant & equipment/vehicles – obtain specialist valuer of plant and equipment/vehicles • Stock – determine obsolete stock • Debtors – ascertain collectability

37. Review assets and liabilities • Work in progress – ascertain position • Directors loan accounts • Review other assets: and adjust for non business assets - below market value • Review liabilities: - normally bank borrowings, (not to be included in net tangible assets calculation) trade creditors, ATO payable

38. Have any assets been omitted? • Most obvious – Goodwill • May be patents or trademarks (intellectual property)

39. Goodwill definition • The High Court of Australia provides a definition of Goodwill, from a legal perspective: “For legal purposes, goodwill is the attractive force that brings in custom and adds to the value of the business. It may be site, personality, service, price or habit that obtains custom.”

40. Valuing Goodwill or other tangible assets component of the value of a business • Whether business valued by DCF, CAP FME or combination DCF and terminal value method, value of goodwill or other intangible assets therein calculated by total value of business Minus • The value of the tangible assets

41. How does Business Valuer conduct process? • Alternatively described as price earnings ratio method i.e. A Price Earnings Ratio (PER) is applied to expected FME to establish the value of the business so that: e.g. A PER of 5 is equivalent to a Capitalisation rate of 20% most small business PER 2-5 (i.e. Multiples of 2-5) • Applies multiplier

42. How does Business Valuer conduct process? • All Business Valuations, whether by the: Discounted Future Net Cash Flows Method,Capitalisation of Future Maintainable Profits Method,or the Combination Discounted Future Net Cash Flowsand Terminal Value Methodshould be based on After Tax Figures!

43. Calculation of Goodwill • E.g. Calculated FME to be $200,000 after adjustments using a multiplier of say 4 (25%) $800,000 if tangible assets $700,000 liabilities $300,000 Net tangible assets $400,000 Goodwill $400,000

44. Continuing businesses with no Goodwill • Value of business may be less than the value of net tangible assets • Therefore no goodwill and value is tangible assets less value of liabilities

45. Businesses discontinuing or closing down • Value represented by value realised on disposal

46. Issues to take into consideration for Matrimonial Breakdown • Saleability of business • Age of respective parties (is retirement looming) • Succession planning • Parties particular skill set • Whether business will be continuing

47. Issues for Valuers • Can only use figures they have been provided with • Does not undertake an audit of the business • Difficulties re cash economy (cannot have your cake and eat it) • Important for valuer to clearly articulate their assumptions • Necessary to comply with Valuation Standard Apes 225 – Valuation Services

48. Issues for Valuers - continued • Expert witness if appointed by court their overriding duty is to assist court • Expert witness is not an advocate for a party • Combine service trusts and other entities

49. The application of retrospectivity for valuing the interests of an exiting equity holder • Pertinent to divorce settlements where the interest of one of the parties is to be transferred to the other party who will continue to conduct the business • Not a hypothetical sale of a business to a hypothetical seller • Interest not available for sale on open market • Interest – intrinsic value method

50. Rather, Profits derived, subsequent to the exiting date, which may not be ascertainable, until some time later, may be adopted as the Future Maintainable Profits of the Business, by applying the principle expounded in Kizbeau’s case: • “Although the value is assessed, as at the date of the acquisition, subsequent events may be looked at, in so far as they illuminate the value of the thing, as at that date.” Kizbeau Pty Ltd v W G B Pty Ltd McLean [1995] HCA 4; (1995) 69 ALJR 787; (1995) 131 ALR 363; (1995) 184 CLR 281 (11 October 1995) [100%](From High Court of Australia; 11 October 1995; 50 KB)