Will appear on BV pages – RECENT VALUATION ARTICLES

M&A Advisor Tip: Value = Risk vs. Reward

/in , , /by Al Statz

Buyers value your business based on risk (real or perceived) and future cash flow. Consider potential business risks. What could prevent your company from realizing your forecasted earnings? Think talent, customers, suppliers, competition, cash flow.

Strategize ways to reduce risk in each area, e.g. cross training, outsourcing, succession planning, customer diversification, backup suppliers, etc. The more you do to take away potential pain points, the more attractive your business will be.

For advice on exit planning or selling a business, contact Al Statz, CEO of Exit Strategies Group, Inc., at alstatz@exitstrategiesgroup.com. Exit Strategies Group is a partner in the Cornerstone International Alliance.

Valuing Personal Goodwill

/in , /by Victor Vazquez

What is personal goodwill?

Before starting our discussion about personal goodwill, it is necessary to establish a common ground to understand the concept. First, it is an identifiable intangible asset that will generate future economic benefits to the asset owner. While there is no standard definition. Adam Mason and David Wood searched various textbooks, articles, and leading court cases[1]that define this term. From that exercise, we chose to utilize the following definitions for our discussion;

“Personal goodwill is the value of earnings or cash flow directly attributable to the individual’s characteristics or attributes.”[2]

“Personal goodwill, sometimes referred to as professional goodwill, is a function of the earnings from repeat business that will patronize the individual as opposed to the business, new consumers who will seek out the individual, and new referrals that will be made to the individual”.[3]

Personal goodwill differs from the concept of corporate or enterprise goodwill. Corporate goodwill is the simple calculation of the excess price paid for a company above the value of its tangible and identifiable intangible assets (i.e. brand, customer relationships). In some instances, goodwill can be negative, but that is the topic of another blog.

What is so relevant about personal goodwill?

In summary, it is a tax issue. In the sale of a C Corporation, an owner can have significant tax benefits when a portion of the purchase price is related to personal goodwill instead of corporate goodwill. This identification of goodwill as personal will allow the owner to avoid getting taxed twice for the same value. Let me explain. Assuming that all the goodwill is associated with the company, the sale would likely generate a tax at a corporate level before the after-tax value is allocated to the owners of the company’s stock. Once the owner receives the net proceeds, they would be taxed again at a personal level. Identifying a certain percentage of the goodwill as personal allows the owner to split the tax bill between personal goodwill and corporate goodwill and pay taxes on each only once.

Which characteristics or elements must have personal goodwill?

As with any other intangible asset[4], personal goodwill must have the following characteristics. It can be separated individually from the entity. In other words, if the business owner leaves her or his company, that intangible asset goes with them. For example, the ability of the business owner to generate sales because of its personal relationships. The other element to be recognized as personal goodwill is that the business owner has contractual or legal rights over that intangible asset. In that respect, the owner of the personal goodwill must not transfer it through an employment or a non-compete agreement.

How to estimate the fair value of personal goodwill?

We have found that the most logical and defendable way in which we estimate the value of personal goodwill is the “With and Without Approach.” This methodology consists in estimating the present value of the entity’s future cash flows as it is; that is, the “With” scenario. This “Without” scenario has several key inputs such as the impact the owner has on the company’s future revenues, the cost at which the company must replace the owner, and the time it takes to ramp the business up to its original “With” forecast. The difference in the value of these scenarios is the fair value of personal goodwill. An appraiser needs to provide strong support for some of these “qualitative” inputs, specifically the top-line impact of the owner. That diligence starts with a simple question to the owner as to his or her impact on sales as a % of the total and drills down to the detail of the revenues and the sales responsibility of each customer. An owner may suggest that the business would lose 50% of the revenue if he or she left but an analysis of the sales relationships with each customer may only suggest that impact to be 25%. In defending the “Without” scenario to the IRS, the more defendable number is always the right choice. The owner may disagree but the extra layer of support helps mitigate future audit risk.

What is the real impact?

It is important to note that there must be a balanced relationship between personal goodwill to total goodwill. According to David Wood[5], personal goodwill should fall within 20%-to-40%. This range is supported by the tax court rulings and guides the appraiser in reconciling the analysis. While there may be a strong case for a higher percentage, it goes without saying that any conclusion above this range may trigger audit concerns unless the appraiser has presented strong support for an outlying opinion. Below is a simple analysis and calculation of the potential tax savings.

[1] Business Valuation Resources, LLC. Personal Goodwill: A Current Survey of Definitions. Adam Manson and David Wood CPA/ABV, CVA.
[2] Wood, David. (2007). Goodwill Attributes: Assessing Utility. The Value Examiner.
[3] Wood, David. (2007). “MUM’s the Word”TM: A formal Method to Allocate Blue Sky Value in Divorce. Business Valuation Update.
[4] Under ASC 805; asset recognition criteria.
[5] Business Valuation in Divorce. Case Law Compendium. Third Edition. Business Valuation Resources, LLC.

Exit Strategies Group, Inc (ESGI)

At ESGI, we are a team of seasoned appraisers to help you with your valuation needs, either to estimate the fair value of personal goodwill or any other. Our business valuations are commonly used in estate, gift, and other tax filings, dispute resolution, expert witness and litigation support, and mergers and acquisitions transactions.

Secure Your Final Exit

/in , /by Victor Vazquez

A significant concern for the seller of a business who retains a minority position after a sale, is how to sell the remaining shares if things do not work out as expected. This type of sale is commonly referred to as a majority recapitalization.

There are many ways things can go wrong. But since the seller no longer has control over the company, they face the challenge of how to facilitate a final exit.

Imagine that you are the sole owner of a company that you have managed for many years. You decide to sell your company and hire an M&A advisor. After several talks with potential investors, you agree to sell 70% of your company at a fair value to a strategic or financial investor. Since you are no longer in control, you no longer have the final say in strategic and financial decisions. Now assume that you start to strongly disagree with the new majority owner’s decisions regarding the direction of the business. How can you exit the business in an orderly and amicable manner?

The seller (now minority shareholder) and the new investors must plan for these potential outcomes and resolutions in the shareholder’s agreement, at the time that the initial sale is negotiated.

Here is where your M&A advisor and attorney’s experience comes into play. Standard clauses in stockholder’s agreement do not usually contain buy-sell provisions (i.e. a buy-sell agreement) which are intended to ensure a fair and equitable share transfer without a lot of drama, disagreement or delay. Buy-sell provisions are complex and multi-faceted. Two important aspects are to define appropriate trigger events and methods of determining a share price when triggered. The pricing mechanism can be an independent business valuation, a formula, or a fixed-price.

We strongly advocate for buy-sell agreements that rely on an independent valuation for share pricing to overcome the many pitfalls of other pricing approaches. The valuation expert can perform this work on behalf of the buyer and/or seller. Buy-sell agreements can require one, two, or even three valuation experts to determine a final price.

We also strongly advise owners to hire an experienced M&A advisor and transaction attorney to guide them through the entire sale process and advise on the numerous complex issues and decisions that arise during the course of a transaction.

Exit Strategies values control and minority ownership interests in private businesses for buy-sell, tax, financial reporting, strategic purposes. If you’d like help in this regard or have any questions, you can reach Victor Vazquez, ASA, MRICS at victor@exitstrategiesgroup.com.

Can I retire if I sell my business?

/in , , /by Al Statz

Not every business owner wants to retire, but most do, someday. And in my experience as an M&A advisor, when an owner is ready, they want to move quickly. However, for business owners who have most of their net worth tied up in an enterprise that they personally manage, retirement planning is more complicated.

If you are a business owner, obtaining answers to these two simple but powerful questions will bring clarity to your retirement plans.

Question 1: What is the asset value I need to retire?

This question isn’t unique to business owners, but since your business is your most valuable asset, understanding your total net worth is more complicated.

Find out how much your business is worth by having a business valuation expert or M&A advisor do a reasonable amount of analysis on the company to determine the most probable selling price range. It helps to select a valuator who also sells businesses and is not just a theoretician.

You’ll need a CPA or tax attorney to help you understand the taxes on a sale of the business and develop strategies to minimize or defer taxes. Experienced M&A and financial advisors can often introduce tax minimization strategies, but you need a licensed professional to dial this in.

Then you should sit down with a financial advisor to run the numbers on your retirement assets and your desired lifestyle, and estate and philanthropy goals. Investment returns depend on the type of assets you hold and expect to hold in retirement. Income sources may include installment payments, Social Security, deferred compensation payouts, pensions, dividends, annuities, and rental income. Is the income sufficient or will you need to liquidate holdings in retirement? There’s a lot to consider and having the right financial advisor(s) is extremely helpful.

When there is a gap between the current value of your retirement assets and the value you need, owners often look to the business to fill that gap by increasing sales and net margins, and driving out business risk. A seasoned valuator can point to opportunities to improve the value and marketability of the business, and make it more attractive to target acquirors. They can help you understand market conditions, and when the time is right, they can represent you in the sale process and help you obtain the best deal available in the marketplace.

Do this sooner than you think. Best is 5 years before your target retirement date. The sooner you start to plan, the more knowledgeable you become about your situation, your exit options, and the financial and operating metrics that you must achieve to launch the sale process. If you find you have a valuation gap, it can take time to close. Also, you never know what market conditions are going to be, or what investment returns will be in retirement, so best to have a comfortable asset value safety margin.

Question 2: How well will the business perform without me?

Business valuation, whether performed by an independent expert or a potential acquirer, is a function of expected future cash flows and risk. The lower the risk the higher the value. Changing management introduces risk for the next owner. Whenever an owner’s efforts drive business performance, the future of that business without that owner is riskier.

For some business owners the question of how the business will perform without them is an easy to answer. They’ve worked themselves out of a management or key contributor role and the business can reasonably be expected to perform just fine without them. However, most small and medium sized businesses are significantly dependent on the talents, experience and/or relationships of the owner(s).

The way to overcome this is to grow the business, build a strong management team, groom your successor, and have an org chart that makes good sense to prospective buyers. Absent that, it helps to be willing to stay on for a period after the sale (typically 1 to 3 years), at a normalized salary, until you replace yourself. The first option is usually far better from a valuation perspective.

When choosing a valuator, find one with general management experience and years of M&A dealmaking experience to receive an objective assessment of your management organization and get actionable advice in this area. Remember, the goal is to sell and retire, not just sell and keep working!

You may have to revisit these two questions multiple times before initiating a sale process. And your business valuator, if you find the right one, should become a trusted advisor for you as you go forward.

These are just two of many questions to answer when assessing the value, marketability and sale readiness of a business and deciding if market conditions are right for a successful sale. See Exit Strategies Group’s blog for hundreds of articles on exit planning for business owners.

Al Statz is CEO and founder of Exit Strategies Group, Inc., a lower middle market business valuation and M&A advisory firm with offices in California and Portland OR. For further information or to discuss your retirement goals and circumstances with an M&A advisor and valuation expert, privately and confidentially, contact Al at 707-781-8580 or alstatz@exitstrategiesgroup.com.

How three private equity firms valued the same company

/in , /by Al Statz

As part of our annual State of the Market M&A conference, held virtually this winter, we invited three private equity (PE) firms to review and submit an offer on a hypothetical company. They revealed their offers at the conference, and we held a panel discussion on why they valued the company the way they did.

We keep the invited PE firms confidential. They don’t know who else will be submitting “offers,” so there’s no collusion or comparing notes ahead of time.

Because they’re doing this as a public exercise, there’s a built-in disincentive to bid too low or too high. Value the business too low, and they’ll scare off future acquisition targets. Go too high, and future targets will demand a similar multiple. It’s a great educational experience to see “what is market” and to dig into deal trends, value drivers, and detractors.

This year, we based the deal on a real company that actually sold in 2018, fudging enough details to hide the company’s true identity. We provided a full memorandum and financial info and set parameters so everyone is reviewing the same info and providing the same detail in their Letter of Intent.

In the end, the winning bid came in about 10-20% higher than the company actually sold for. The lowest bids came in around 80% of value.

Why could one PE firm bid higher? As it turns out, they had previous experience in the space. The acquisition target did big capital product sales. In other words, large, mostly one-time sales without much recurring revenue. What this PE firm saw, though, was an opportunity to build new sales through parts, maintenance, and add-on systems.

They’d done something similar before and believed they could do it again. The target had a 100+ year history in the market and had some international sales, and they saw a great foundation to grow on.

Why did the other PE firms bid lower? They didn’t have experience with a similar operation. The nature of one-time sales turned them off. And though the target acquisition had made some international sales, they were to a country that has experienced political disruption—making the foreign market angle less attractive to these buyers.

Lessons learned:

Buyers have money to spend. These three PE firms alone have $500 million in dry powder or equity they need to put to work. With dry capital plus their current investments, they have a combined capital base of $1 billion.

That’s just three firms, and there’s an estimated 4,000 of them in the U.S. A lot of people are putting money into private equity right now because they’re generating stronger returns than traditional investments.

Management team matters. These firms said the quality of a company’s management team was typically their top consideration when evaluating a target. They want to see strong, proven management teams who will stay to guide the company after a sale.

Exit strong. Their second big requirement is to see a company on an upward, or at least stable, trend. They don’t want to see sales and profits dropping or yo-yoing with no rhyme or reason. They put the most weight on the trailing 12 months of performance, meaning an owner’s last year in business can be the most important year in their lifecycle.

Diversify. Another key value driver was customer and supplier concentration. These PE firms said they’re okay as long as the top customer is around 25% or less of sales. Once the top customer starts getting to be 30% or more, they’ll either walk away because the deal has too much risk or they’ll restructure the offer to include earnouts and other performance-based payments.

Second exit is a team decision. PE firms invest in businesses with the intent to sell. Some firms have “patient capital” and can wait 7 to 15 years for that exit. Others manage investments in 5-to-7-year windows. But the firms we spoke to said timing that sale is often driven more by company management than the PE firm itself.

They depend on their management teams to tell them when they think the timing is right, and that becomes a group discussion. It’s generally not a top-down mandate, and that’s an encouraging thing for the remaining shareholders to hear.

Overall, the message was that the number of good quality deals on the market has declined, and PE firms have money they need to spend. That’s a supply and demand equation in the business owner’s favor. Businesses relatively unaffected (or those positively affected) by COVID-19 are going to get some good, hard looks and are likely to pull in strong multiples right now.

Al Statz is President and founder of Exit Strategies Group, a leading California-based M&A advisory firm with decades of experience selling manufacturing, distribution and service companies in the lower middle market. For further information, or to discuss a potential sale or acquisition, confidentially, contact Al Statz at 707-781-8580.

Understanding Discount Rates The Company Specific Risk Premium – Part 4 of 5

/in /by Joe Orlando

Up until now, our discussion of the discount rate as “one of the most important inputs surrounding the valuation of the business” has focused on overall market data that arrives at the basis of risk associated with the cost of equity for a privately held company. We’ve begun with a risk-free rate and added risk for equity and size. Now, we need to look at the subject company to determine if we should any additional risk for factors not accounted for in the first three inputs. For example, does the business have a strong management team? Is risk impacted by the industry in which it competes? Is there risk in the supply chain in securing the products needed to produce the company’s products? All of this risk is accounted for in the Company-Specific Risk Premium (or CSRP).

Again, a highlight of how we build up both the cost of equity and the weighted cost of capital is pictured below. As noted, the highlight deals with our discussion of the CSRP which is built out below and to the right of this summary;

Build-Up Approach – Company-Specific Risk Premium
As noted above and highlighted in the matrix that identifies and quantifies this risk, all of these factors relate to the business, how it competes as well in the environment in which the company and its industry compete. To dig into the list above, let’s assume that the subject company is a small chain of liquor stores located in a mid-sized but growing metropolitan area; Sonoma County, CA where Exit Strategies is headquartered.

Below is an enlarged copy of the matrix outlined above. As you can see, it is a list of risk categories that are not related to the overall market (type of security and size) but instead associated with the company’s business model, how it navigates the unique challenges of executing on it, and how it competes with other in its industry. A discussion of the specific rationale for adding (and subtracting) risk to the subject business; a liquor store in Sonoma County.

Fair Market Value is defined as “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, both parties having reasonable knowledge of relevant facts.” In determining this value using an income approach and discount rate, the above list is what a valuation expert would expect a willing buyer to see as an incremental risk to buying the business.

However, a willing buyer (or even a willing seller two years before selling the business) can look at this list as a “to-do” to increase value by “de-risking” the business associated with these specific risks.


What Does This All Mean?

All other key inputs (cash flows and long-term growth) de-risking the business for these company-specific risks will increase the value of the business. Less risk correlates to higher values. However, there may be a tradeoff in de-risking and value with an increased cost structure (insurance, technology tools, increased staff). In this case, the real challenge for management is leveraging these incremental costs by increasing revenue and profits.

Stay tuned for our last installment where we look at the cost of debt and how the ability to secure debt over equity lowers your discount rate and has a positive impact on value.

Exit Strategies values control and minority ownership interests of private businesses for tax, financial reporting, strategic purposes. If you’d like help in this regard or have any related questions, you can reach  Joe Orlando, ASA at 503-925-5510 or jorlando@exitstrategiesgroup.com.

Understanding Discount Rates The Size Premium – Part 3 of 5

/in /by Joe Orlando

So far, in our educational discussion of the discount rate as “one of the most important inputs surrounding the valuation of the business”, we introduced the first two inputs of the build-up approach. Added together, these two inputs equal the expected market return of equity. However, because the equity risk premium looks at the overall market returns, our build up approach needs to now focus on the Company we are valuing. The last two inputs to the cost of equity focus on the size of the Company and its “specific” risks that are not accounted for in the other four inputs

Again, a highlight of how we build up both the cost of equity and the weighted cost of capital is pictured below. As noted, the highlight deals with the size premium;

Build-Up Approach – Size Premium

The size premium is based on the simple premise that “size matters” when it comes to market returns but not the way you think. While this theory may seem simple, its proof is based on the analysis of stock returns from as far back as 1928. More complex theories, including those of Nobel Prize winning professors from the University of Chicago’s Booth School of Business suggest that the smaller a Company’s market capitalization (or share price times number of shares outstanding), the higher the stock’s compound average growth rate (“CAGR”) over time.[1] A graphical depiction of these returns are below where decile 10 represents the smallest and decile 1, the largest market caps.

[1] https://seekingalpha.com/article/1921171-examining-the-size-premium

The detail above show the mean annual return for each decile between 1928 and 2020 and are represented both with and without an adjustment for each decile’s beta (or its volatility of stock prices compared to the overall market = 1.00). Because we mostly work with Companies below $189.8 million in market capitalization, our standard default size premium is Decile 10 or 5.47%.

Another way to understand why smaller companies generate greater returns than bigger companies is the fact that the return is an increase by percentage rather than real dollar value. For example, a $200 million company that grows 10% grows its value by $20 million. If a $2.0 billion where to grow its value by $20 million, its return would only be 1.0%. Both companies grew the same amount (call it the numerator in this simple ratio below) but the denominator (the size of each company) is different.

What Does This All Mean?

The discount rate is a simple build-up of risk and size differences are the easiest to understand. It makes no sense to compare Microsoft to a small cloud-based software company unless you adjust for this size. Consider the additional risk added to the discount rate for a small software company as the additional return an investor would need to receive for investing in a riskier, early stage stock.

Stay tuned for Part 4 of 5, the Company Specific Risk Premium where we adjust returns for the specific characteristics of the Company we are valuing.

Exit Strategies values control and minority ownership interests of private businesses for tax, financial reporting, strategic purposes. If you’d like help in this regard or have any related questions, you can reach  Joe Orlando, ASA at 503-925-5510 or jorlando@exitstrategiesgroup.com.

How a Discount for Lack of Marketability (DLOM) is Determined

/in /by Joe Orlando

In a prior chapter of my professional career, I focused on equity security valuations for tax and financial reporting purposes. I led a team of valuation experts who determined the strike price of options granted to employees of up-and-coming technology companies on their way to IPO. For most, that strike price represents the basis (or cost) of an employee’s future wealth (and tax bill). In simple terms, the valuation of these shares in private companies is based on market multiples (or their value divided by a specific operating metric like sales or earnings) of comparable public companies. Once the value is allocated to common shares, the per-share price is a marketable value because it is based on the stock prices of marketable securities (the publicly traded companies we used to compare). Because private company shares are not as marketable (liquid) as public company shares, we need to adjust for this relative lack of marketability. But how?

Enter the Black-Scholes Model

One answer lies in the economic studies of the early 1970s. In 1973, Fisher Black, Myron Scholes, and Robert Merton published “The Pricing of Options and Corporate Liabilities” in the Journal of Political Economy introducing a simple model with five key inputs. While the formula truly has some high-level calculus, I will try to simplify the output and how it is used.

Here are some definitions you will need to understand before we start:

  • Current Price – The current per-share value of the stock.
  • Dividend Yield – The annual return to an investor in the form of dividends as a % of the stock price.
  • Strike Price – The predetermined price.
  • Maturity – The amount of time in years until the option expires.
  • Risk-free Rate – The rate of a return for a risk-free investment, in this case, a US Government debt instrument at the same maturity term as the put option
  • Volatility – The rate at which a security increases or decreases over time.
  • Call Option – The option or right to buy (or call) a security at a predetermined price by a predetermined date.
  • Put Option – The option or right to sell (or put) a security at a predetermined price by a predetermined date.

How a Put Option Works

Before I dive into how a Discount for Lack of Marketability (DLOM) is determined, I want to examine a real-life example of what marketability is worth. For my example, I’m only going to look at buying a put option. The purchase of a put option assumes that the buyer is a long-term holder looking to protect his/her position in security. I chose a put option because it can be easily compared to an insurance policy.

Facts:

  • Stock Owned: Jane owns 100 shares of Microsoft currently priced at $257.24 as of the close of the financial markets on June 10, 2021. This price very close to its 52 weeks high of $263.19 per share.
  • Goal: Jane wants to lock in the current price (or close to it) for the next year and is willing to pay for the security of knowing that she can lock in that price.
  • Publicly Traded Options: Jane can buy a put option for one year (or with an exercise price of $255.00 in June 2022) at $26.56.
  • Options Purchased: Jane purchases 100 put options for $2,656 to lock in the sale of her shares when the option expires in June 2022 for $25,500.

What this Means for Jane

Jane just bought an insurance policy that lets her get the $255.00 per share for her stock. The put option ensures the marketability of her shares but it came at a cost of 10.4% of the value of her shares (or $2,656 divided by $25,500). While she can’t exercise the option until it expires (the terms of a standard put option) she can sell the options if they increase in value before it expires.

That option will increase in value as the price of Microsoft drops because it is worth more to someone to sell shares at a higher price in the future. An example of this concept is the fact that the put option for the same June 2022 date but at a price of $245.00 is selling at $31.93. In simple terms, the price is driven by the supply (people willing to bet that when the option expires in a year the price of Microsoft will be much higher than it is today) and demand (investors like Jane that simply want the protection of believing that the price will be less in a year than it is today).

How this Relates to a DLOM in Valuing Private Company Shares

Let’s replace Jane with Jack and let’s assume that Jack’s investment is 100 shares in Software Widget, Inc., a private company with no publicly traded market for its shares.

Say Jack hires Exit Strategies to value his 100 shares. We value the shares based on market multiples of publicly traded (or “marketable”) companies comparable to Software Widget, Inc. and arrive at a price per share of $50.00 a share. But Jack’s shares aren’t marketable. He can’t call his broker to sell them and certainly can’t buy a put option to protect the value of his shares. Like Jane, he expects the shares to be marketable in a year but unlike Jane, he can’t buy a real insurance policy to lock in that price. Simply put he lacks marketability for the next year but what does this mean to the value we place on his shares?

The answer lies in the put option that we discussed above but instead of looking for the price of one on Google Finance, we need to go back to the formula Black and Scholes determined to build up and calculate a hypothetical one. Using the inputs below highlighted in gray, the hypothetical option asks a simple question; what would it cost to buy a hypothetical put option to lock in the price of a security at $1.00 for one year? In the case of the inputs below, the answer is $0.15 or 15.0% of the value of the security. Because it would cost $0.15 per share to lock in the price of $1.00 over a year, the lack of this marketability is the cost of not having this protection (or to Jane’s example, an insurance policy).

 

 

So back to Jack. His shares are worth $50.00 per share on a marketable basis but we need to value them on the non-marketable basis of a private company. Therefore, we apply a 15% discount to arrive at our concluded price of $42.50 as detailed below:

 

 

 

This is just one way to determine a DLOM

In determining discounts for lack of marketability, Exit Strategies also considers studies that map actual discounts of restricted stock. The uniqueness of the put option model approach above lies in the inputs and how the discounts change when one of the three key inputs (dividend yield, maturity, and volatility) changes. For example, if we change the term above to 5 years, the discount goes to 28%. That increase makes sense because an “insurance policy” to lock in a price would cost more for 5 years than it would for one.

If you have questions about discounts for lack of marketability or if you would like us to value your private business or equity interest for any purpose, email Joe Orlando at jorlando@exitstrategiesgroup.com.

Fair Market Value – what does it mean? Business Valuation Standards of Value Terminology

/in /by Louis Cionci

Fair Market Value is one of several standards of value terminology used in business valuations. The Fair Market Value (FMV) term is used by the IRS in estate and gift taxes, can be found in many buy-sell agreements, and is frequently the standard of value used in a business valuation report. Anyone who reads a business valuation report by an accredited professional will likely see the Standard of Value stated in the opening pages and in conjunction with the business value conclusion.

One of the most broadly accepted definition of Fair Market Value comes from IRS Revenue Ruling 59-60 which states Fair Market Value as:

…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, both parties having reasonable knowledge of relevant facts.

For gift and estate tax purposes, the same Fair Market Value definition can be found in the Internal Revenue Code Section 20.2031-1 and Section 25.2512-1 respectively.

…the price at which (such) 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.

When the term Fair Market Value is used in a buy-sell agreement, it should be noted that, the term FMV includes any discounts which may be applicable to the subject interest being valued, unless clearly stated otherwise in the agreement. For example, a less than 50% interest may be subject to discounts related to control and/or marketability. If the buy-sell agreement states Fair Market Value, the buy-sell agreement should also specifically state whether any discounts to value are intended.

In addition to Fair Market Value, other common Standard of Value terms are listed below.

Standard of Value Where defined:
Fair Market Value IRS Revenue Ruling 59-60; Treasury Regulations
Fair Value (dissenting SH, minority oppression cases) Minority oppression statutes, CCC §2000.  Study case law to determine how interpreted.
Fair Value (financial reporting) FASB, SEC.
Investment Value International Glossary of BV Terms.  When the buyer is known (not hypothetical).

For more information on business valuations or exit planning, Email Louis Cionci at LCionci@exitstrategiesgroup.com or call him at 707-781-8582.

Valuation of Intangible Assets

/in /by Victor Vazquez

As a follow-up to our posts “Profit from Intangible Assets in a Business Sale” and “Understanding the Value of Intangible Assets”, this post offers answers to the question, “How do you value intangible assets?”

In one of these posts, we looked at a simple example for valuing the Bayer tradename associated with its sale of aspirin using a simple capitalized earnings approach to a likely royalty stream. While the valuation of intangible assets is the subject of a dedicated course of study and professional certification, I will try to simplify these methodologies and offer other approaches to give you a general idea on how these assets are valued.

Approaches

The same approaches to estimate the value of a business are applied to intangible assets. These are: i) the income approach; ii) the market approach; and ii) the cost approach. Selection of an approach depends on the situation and the characteristics of the intangible asset. The most common approach when valuing intangible assets is the income approach, while the less common applied is the market approach.

The income approach is a general way of determining a value indication of a business, business ownership interest, security, or intangible asset by using one or more methods through which anticipated benefits are converted into value. A method within the income approach is the discounted cash flows (DCF) method, based on the present value of the forecasted cash flows during the expected life of the asset.

The market approach determines 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.

The cost approach estimates a value indication of an individual asset by quantifying the amount of money required to replace the future service capability of that asset. [1]

[1] American Society of Appraisers – ASA Business Valuation Standards.

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There is one technique that it is especially useful within the income approach. It is called the “with” and “without” method, since the objective is to extract the value of the intangible asset that it is in the company by determining the value of the business with and without the intangible asset. The difference between the two values is the value of the intangible assets.

Let me illustrate this technique with a simple example. Assume that you own a business and the buyer wants you to sign a non-compete agreement that says that you can’t compete within the industry (or geographic area) for three years. You agree. Therefore the value of the business is the value “with” the non-compete. The “without” scenario has you not sign the agreement with the expectation of competing day one after the deal closes. This competition will impact the buyer in many ways from a decline in revenues, the possibility of losing other staff, and the need to go out and replace you with someone else, likely through a recruiter. All of these costs add up and the buyer, in the “without” scenario suggests that the impact to the value of the business is $500,000 in lost profits and increased costs over the three year period they hoped to have you not competing. Therefore, the value of the non-compete intangible asset is the difference in value between the “with” and “without” scenarios. That is exactly how it works when dealing with an intangible asset.

Other applications of this technique are applied to estimate the value of employment agreements, franchise agreements, and key knowhow (formulas and other intellectual property) and processes and technologies developed internally.

In many ways, this approach highlights the overall theory of intangible asset value as a subset of the enterprise value. This concept is true in identifying specific income streams associated with certain intangible assets like technology and customer relationships. In thinking of your business as a portfolio of these tangible and intangible assets, some have low risk (real estate or fixed assets) while others have significant risk (technology, drug development; i.e intangible assets).

Other methodologies using the income approach include the Relief from Royalty (see our Bayer tradename example in our prior post), and the Excess Earnings (see above in terms of carving off income streams to an asset). Understanding these methodologies and the fact that every intangible asset has a “charge” that you need to apply to the other intangible assets, including the estimation of a discount rate that considers additional risk are fundamental when valuing intangibles. These concepts may be the subject of another blog.

Exit Strategies values intangible assets as well as control and minority ownership interests of private businesses for tax, financial reporting, strategic purposes. If you’d like help in this regard or have any related questions, you can reach Victor Vazquez, ASA, MRICS at victor@exitstrategiesgroup.com.