In the world of pricing, there are simple models (e.g. cost plus a profit markup) and complex models (e.g. dynamic pricing based on real time supply and demand algorithms ). If you have ever purchased an airline ticket online, you’ve seen how a complex model makes prices impossible to decipher. Fortunately, we can offer greater transparency and consistency on business valuation pricing!

Like most professional service pricing models, business valuation pricing is largely a function of the time it takes to do the work. The amount of work involved is driven by the following factors.

Ten Factors that Affect the Cost of a Business Valuation

1. Normalization – Most income statements and balance sheets of owner-operated businesses require normalization (adjustments). There are often discretionary and non-recurring expenses to adjust. Owner compensation needs to be investigated and adjusted. Commingled personal expenses and related-party business expenses must be evaluated. Operating assets need adjusting to market values. Non-standard and tax-driven accounting decisions may need to be “undone.”  How long all this takes depends on the nature, structure and accounting practices of the business. Sometimes it takes us 10 minutes, other times 10 hours!
2. Non-Operating Assets – Some businesses own assets that are not required to run the business. For example, a vacation home or personal vehicles. Or equipment that is no longer used. Or real estate owned by a business that can be removed and rented back. We adjust the balance sheet and cash flows for these items. We may need to separately value these assets or find a specialist to do so.
3. Due Diligence – Some businesses are easy to unravel and understand. Others require a deeper dive. Ultimately, we need to understand the business model, how the company compares to industry peers, and its future outlook and risks. Getting up to speed requires independent research and time with the CEO, CFO, CPA or others.
4. Forecast Complexity – Without access to a long-term financial forecast, we may need to develop one. Is the company at a steady state and if not, what amount of visibility does management have on the future of the business?
5. Industry Niche – Businesses come in all shapes, sizes and flavors. Those that compete in a narrow industry niche that isn’t covered by research firms require us to do custom independent research to evaluate market opportunity and industry outlook.
6. Intended Use and Users – The purpose of a valuation affects standard of value, scope of analysis, due diligence and reporting, which affects the amount of appraiser time required. Our website discusses the various uses of business valuations.
7. Standard of Value – The standards of value for tax, financial reporting, shareholder oppression, marital dissolution and strategic acquisition are all different, and some are easier to work with than others. This one relates back to intended use.
8. Valuation Date – Performing a valuation as of some long-passed historical valuation date requires more due diligence to evaluate market conditions and decide what was known and knowable as of that date. And when a client or their CPA or attorney change the valuation date on us midstream, that adds hours.
9. Interest Valued – Minority interests usually have to be discounted for lack of control and marketability, which requires extra analysis and reporting. Valuing interests in companies with complex capital structures (preferred or convertible shares) also requires extra work.
10. Timeliness and quality of information – This factor is simple but important. When we receive data quickly that is clear, accurate and concise, our work goes faster. When we have to chase people for information or follow up every answer or document with more questions and requests, projects take longer. Having to put down and pick up a project multiple times because we’re waiting for information is also a big time waster.

How We Price Valuations

At Exit Strategies, our goal is always to provide the right level of service (no more, no less) at a fair and competitive price. We start every potential engagement with a discussion on these 14 topics that helps us understand your needs and propose the appropriate valuation service. A valuation that uses the wrong standard of value for example may be cheap, but useless. You’d be surprised how often appraisers get this wrong.

We quote a fee range for most of our business valuation work. In all cases we endeavor to work as fast and affordably as possible. If you have been quoted a fixed fee for a business valuation, be careful. There’s a good chance that appraiser will use the same cookie cutter methods and spend the same amount of time on your valuation no matter what they find along the way, which is probably not in your best interest. Be sure to get what you need.

Exit Strategies values businesses for a variety of purposes including divestitures, mergers and acquisitions, buy-sell, business divorce, financial reporting, corporate restructuring and exit planning. If you have questions or need a business valuation, contact Joe Orlando at 503-925-5510 or jorlando@exitstrategiesgroup.com or Jim Leonhard at 208-912-0455 or jhleonhard@exitstrategiesgroup.com

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 are based on market multiples (or their value divided by a specific operating metric like sales or earnings) of public companies that are comparable. Once 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 1970’s. 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 of the put option
• Volatility – The rate at which a security increases or decreases over a period of 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 a 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 $138.90 as of the close of the financial markets on June 14, 2019. This price very close to its 52 week high of $139.22 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 an put option for one year (or with an exercise price of $140 in June 2020) at $12.20.
• Options Purchased: Jane purchases 100 put options for $1,220.00 to lock in the sale of her shares when the option expires in June 2020 for $14,000.00.

What this Means for Jane

Jane just bought an insurance policy that lets her get the $140.00 per share for her stock. The put option ensures the marketability of her shares but it came at a cost of 8.7% of the value of her shares (or $1,220 divided by $14,000). 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 2020 date but at a price of $150.00 is selling at $19.40. 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 protection of believe 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) change. 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 an equity interest for any purpose, call or email Joe Orlando at 503-925-5510 or jorlando@exitstrategiesgroup.com.

If you have acquired or sold a small company, or had one appraised, you’ve probably heard the term “Seller’s Discretionary Earnings”. Or you may be thinking “Earnings are discretionary? My earnings aren’t discretionary at all!” Let’s examine this often-misunderstood term, and how it compares to EBITDA, another common earnings measure.

What is Seller’s Discretionary Earnings?

Seller’s Discretionary Earnings (“SDE”) is a calculation of the total financial benefit that a single full time owner-operator would derive from a business on an annual basis. It is also referred to as Adjusted Cash Flow, Total Owner’s Benefit, Seller’s Discretionary Cash Flow, or Recast Earnings. Here at Exit Strategies, we prefer the term Discretionary Earnings or DE. For this article I’ll use the more common SDE.

SDE is most often used in the valuation and sale of “Main Street” businesses. While there is no precise definition of what a Main Street business is, it often refers to owner-operated companies with less than $5 million of revenue. Larger businesses primarily use EBITDA.

SDE vs EBITDA

SDE = Adjusted EBITDA + Owner Compensation (one full-time owner)
Where EBITDA = net Earnings + Interest + Taxes + Depreciation + Amortization.

So SDE is always a larger number than EBITDA. This is a bit counter-intuitive for people used to working in the middle market. They usually think of EBITDA as the large number that things are subtracted from to calculate net cash flow. And wouldn’t SDE be similar to or smaller than EBITDA? A look back at the formula clears this up.

When applying price multiples for sale or valuation purposes it’s important to accurately differentiate between SDE and EBITDA. A mismatch between the earnings measure used and the multiple applied can result in significantly overvaluing or undervaluing a business.

Normalization Adjustments

Once we calculate EBITDA (or SDE) from a company’s profit and loss statement, we need to work through normalizing adjustments. We often break normalizing adjustments into two categories: discretionary items and non-recurring items.

Discretionary Items

Discretionary expenses are those that the business paid for but are really a personal benefit to the owner. Discretionary expenses exist because owners want the “tax benefit” of expensing these items. But they also want the benefit of adding them back into earnings when it comes time to value and sell the business.

Typical discretionary expenses are owner medical or life insurance, personal travel, personal automobiles, personal meals/entertainment, and social club memberships. To qualify as discretionary, each expense must meet all three of these criteria:

1. Benefit the owner(s)
2. Not benefit the business or its employees
3. Are paid for by the business and expensed on tax returns and P&Ls

Whether an expense is discretionary or not isn’t always obvious:

Definitely Adjust	Don’t Adjust	Gray Areas
Retirement plan contributions	Networking group memberships	Travel (business and pleasure)
Home landscaping	Marketing expenses	Contributions

Discretionary expenses are often the subject of debate between a buyer and seller. Buyers, of course, are risk averse and dubious about all these co-mingled expenses the seller claims are “not really expenses.” Items that fall in the gray area will require extra documentation by the seller and due diligence by the buyer. Certain items that a buyer might accept won’t be accepted by a bank. Generally speaking, sellers will benefit from stopping all commingling of business and personal expenses at least three years before they sell a business.

Non-Recurring Items

The other major category is extraordinary/one time income or expenses. Adjusting for extraordinary one time income and expense makes sense because they are not expenses that are indicative of the core business operations. Common examples are restructuring costs, costs related to acts of nature, asset sales, litigation expense and emergency repair costs.  One-time expenses are also scrutinized and debated. Did that bad debt really only happen once? Or is it likely to occur again in the future?

Why is this important?

In M&A transactions buyers are concerned about risks: What aren’t you telling them? How could this investment go bad? We often say that getting to a closing is about removing roadblocks in the deal – and often the biggest among them is reducing the buyer’s level of perceived risk. With that in mind it’s important to think about the line items that go into SDE well before you go to market and do your best to reduce any areas that might fall into the “questionable” zone. The cleaner your financials are the more likely you are to sell on the best price and terms.

For more information on the use of earnings and cash flow measures used in business valuation, or to discuss a current business valuation need, contact Joe Orlando at jorlando@exitstrategiesgroup.com.

Jointly retaining a single trusted business valuation expert in disputes over value is becoming increasingly common as owners seek ways to streamline the valuation process, protect their companies and control costs. Naming one appraiser in buy-sell agreements is also becoming more popular. In this slightly long-winded rant, I will discuss the pros and cons of using one appraiser that all parties know and trust, and explain why you should give serious consideration to this option.

Where My Thought Process Started

Exit Strategies has provided valuation services for many California companies going through involuntary dissolution processes.  Involuntary dissolution proceedings, per California Corporations Code § 1800 and § 2000, give minority shareholders who feel they have been victimized by those in control to force a liquidation or sale of the company, unless the corporation or its majority owners agree to buy them out at fair value.  CCC § 2000 stipulates that, “The court shall appoint three disinterested appraisers to appraise the fair value of the shares …”. Often, the judge in these cases requires that the appraisers work together to develop a conclusion of value.

What’s interesting to me is that in every CCC § 2000 case where I worked collaboratively with other competent appraisers from start to finish, we were able to reach agreement on a conclusion of value.  I’ve talked to several other BV experts who have similar experiences on such panels.

So, why do appraisers, working separately, reach different values?

I see three main reasons why Qualified (experienced and professionally accredited) valuation experts selected by opposing parties and working in isolation from each other are more likely to conclude different values for the same business:

1. They have different facts. They ask different questions about the company, often of different people with different agendas, Then, using different information they arrive at different conclusions. Makes sense, right? Conversely, when appraisers receive the exact same inputs on a company, they are far more likely to produce similar values. If you hire multiple appraisers, be sure that they all get the exact same information.
2. They head off in different directions.  Subtle differences in scope of work can have a substantial effect on reported values.  Appraisers using different standards or levels of value are guaranteed to report different values.  It’s also common to see different valuation dates used.  Or, one appraiser reports a value of equity and another reports an undefined asset sale value. Often, the clients don’t even know this is happening.  And the appraisers don’t know because they are working in isolation. Such differences in direction are best identified and resolved in advance.
3. Bias. Even though appraisers are supposed to be impartial, some succumb to pressure to deliver a result that favors the party that selected them or satisfies the attorney that hired or referred them. Exit Strategies’ professionals assiduously avoid letting bias creep into our valuations. (M&A advisory is a different story. There we absolutely advocate for our client.)

Now, CCC § 2000 cases are fairly infrequent, and usually the parties decide how many appraisers to hire. At this point you may be thinking, “wait a minute, doesn’t each shareholder need to have their own appraiser?” Let me turn that question around…

If a panel of appraisers working together generally see eye-to-eye, why have more than one?

The main argument for having multiple appraisers (besides putting more appraisers to work!) is that it can guard against an outlier opinion or one appraiser making an honest mistake. If you are careful in selecting the appraiser, however, you can mitigate these risks.

Cost is an obvious disadvantage to having multiple appraisers. Not only do the parties have to pay for 2 or 3 valuations, but appraisers generally charge more when they know they’ll be working in an antagonistic and uncooperative environment or when they know their report is likely to be challenged in litigation. The reason; more hours of work.

One very important disadvantage of hiring multiple appraisers is the deleterious effect it can have on shareholder relationships and the company itself. The perception of having an appraiser in their corner promotes divisiveness between owners. They become suspicious of the other expert(s). And doubling or tripling the number of information requests, interviews and follow up questions increases management’s workload, distracts them from running the business, and prolongs the valuation process. As the rift between owners grows and the company drifts, value erodes for all shareholders.

This seems to be a good point to summarize the advantages of a using single, jointly-retained business valuator — lower cost, less work and distraction for management, better shareholder cooperation, reduced likelihood that information will be withheld or biased, less danger of advocacy, and scope of work clarity. Next, let’s discuss how you go about selecting and working with a joint BV expert.

Three Keys to Success Using a Jointly Retained Business Valuation Expert

1. Find, select and get to know the expert. Ask around for recommendations. Require professional valuation credentials, several years of relevant valuation experience and real-world business transaction expertise (not just financial theory). Be sure they are unbiased and have no conflict of interest.  Jointly interview appraisers until you find one that you are all comfortable with.
2. Correctly define the engagement, i.e. standard of value, subject interest, level of value, scope of analysis, type of report, valuation date, etc. Many buy-sell agreements and jurisdictions do not have well-defined valuation criteria. A trusted and Qualified BV expert can point out the various interpretations and work with the parties and their legal advisors to reach a consensus. Or the parties can have the appraiser produce multiple values using different interpretations, often for little extra cost.
3. Require open communication. Set ground rules to involve all shareholders, and advisors (attorney, CPA, etc.), in all communications with the valuation expert throughout the process. Shareholders should have access to all information requests and documents provided, be copied on emails, be invited to fill-out and review questionnaire responses, be invited to all live interviews, presentations and meetings, and be given the opportunity to review and give feedback on a draft valuation report.

Getting to Trust an Appraiser

Successful jointly-retained experts have high integrity and strong interpersonal skills. Get a sense of who they are by looking at their website and LinkedIn profile. Are they transparent and forthcoming with information? Can they write? Are they involved in their community and do they give back to their profession? Someone from a pure litigation support firm with little or no digital footprint probably isn’t right for this job.

In our experience, when we are jointly-retained, the parties are naturally more open and honest about company strengths/weaknesses, risks and future prospects. Separate experts rarely get the full access 360-degree view that a single expert with the support of all parties gets. In turn, they do better work and greater trust is built.

There is perhaps no better way to decide if you can trust someone than to work on a project together. If you know you’ll need an appraiser to set a share price for an imminent buy-sell transaction, don’t wait for a trigger event. Select an appraiser now and go through the valuation process together while there is less at stake. You and your stakeholders will get to know the appraiser and the quality of their work. Further, the appraiser’s knowledge of the company and its industry will grow and they can even recommend strategies to enhance the value of your company, which benefits all shareholders and more than pays for the extra valuation work.

What Business Owners Can Do

The next time you need an accurate unbiased business valuation or are preparing shareholder agreements, think about using a single qualified valuation expert that all parties know and trust.  Feel free to call us to discuss your needs and circumstances, or ask your attorney to contact us, in total confidence. We will let you know if we think this is a good option for you.

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Valuations play a part in all strategic transactions, tax, and many litigation matters.  Al Statz is President and founder of Exit Strategies Group, Inc. which has four California offices and has been selling and appraising businesses since 2002. Al is an accredited business appraiser (ASA and CBA) and a Merger & Acquisition Master Intermediary (M&AMI).  For additional information or advice on a current situation, please do not hesitate to call Al at 707-781-8580 or Email.