Valuing a Business

Accounting and Finance Leadership Forum Valuing a Business

Presented by Harold G. Martin, Jr. CPA/ABV/CFF, ASA, CFE Partner, Valuation and Forensic Services Group

March 28, 2013

Views expressed in these written materials and in the related live presentation do not necessarily reflect the professional opinions or positions that the presenters would take in an actual business appraisal assignment.

Nothing contained in these written materials, or as orally expressed in the related presentation, shall be construed to constitute the rendering or appraisal advice; the rendering of an appraisal opinion; the rendering of an opinion as to the propriety of taking a particular appraisal position; or the rendering of any other professional opinion or service.

Business appraisal services are necessarily fact-sensitive particularly in a litigation context. Therefore, the presenters urge conference participants to apply their expertise to particular appraisal fact patterns that they encounter, or to seek competent professional assistance as warranted in the circumstances.

Speaker Biography – Harold Martin › Harold G. Martin, Jr., CPA/ABV/CFF, ASA, CFE, is the Partner-in-Charge of the Valuation and Forensic Services Group for Keiter, a full-service CPA firm located in Richmond, Virginia. He has over 30 years of experience in financial consulting, public accounting, and financial services. He specializes in valuation and forensic accounting, including financial investigations and litigation consulting and expert witness services. He has appeared as an expert witness in federal and state courts, served as a court-appointed neutral appraiser, served as a federal court-appointed accountant for receiverships, and served as a neutral appraiser or forensic accountant for various types of disputes.

› Harold is also an adjunct faculty member of The College of William and Mary Mason Graduate School of Business where he teaches forensic accounting in the Master of Accounting program.

› Prior to joining Keiter, he was affiliated with Price Waterhouse as a Senior Manager in Management Consulting Services, Coopers & Lybrand as a Director in Financial Advisory Services, and First & Merchants National Bank as a Direct Loan Officer in retail banking.

› He is a former member of the American Institute of Certified Public Accountants Business Valuation Committee, former Chair of the AICPA National Business Valuation Conference Steering Committee, former editor of the AICPA ABV e-Alert, and former editorial adviser and contributing author for the AICPA CPA Expert. In 2012, he was inducted into the AICPA Business Valuation Hall of Fame. He is a two-time recipient of the AICPA Business Valuation Volunteer of the Year Award. He currently serves as an instructor for the AICPA’s National Business Valuation School and ABV Exam Review Course. He is also the former Chair of the Virginia Society of Certified Public Accountants Business Valuation and Litigation Committees, and created and chairs the annual VSCPA Business Valuation, Fraud, and Litigation Services Conference.

› He is a co-author of Financial Valuation: Applications and Models, 3rd ed., and a contributing author to Cost of Capital: Estimation and Applications, 4th ed.

› He received his A.B. degree from The College of William and Mary and his › M.B.A. degree from Virginia Commonwealth University.

Presentation Objectives Presentation Objectives

› Valuation Basics

› The Valuation Process

› Valuation Approaches › Income › Market › Asset

5 Valuation Basics Valuation Basics What is Value?

ABC, INC. › Value means different Balance Sheet things to different people: Total assets $ XX

Liabilities $XX Owner’s equity X › Book value › What a buyer is willing to Total liabilities and equity $ XX pay › Defined by law

Valuation Basics Key Value Concepts

› Value is forward looking

2002 2003 2004 › Past performance is only relevant if it is indicative of what will happen in the future

› Key to maximizing value is to increase the potential for future cash flow given an acceptable level of risk

Valuation Basics Closely-Held Businesses

› Business owned by few stockholders, partners, etc.

› Not publicly traded on a national or local stock exchange or over-the- counter Valuation Basics Definition of Property To Be Valued Entity › State of incorporation or registration › Form of organization (C, S, Partnership, Sole Proprietorship, LLC)

Type of Interest › Securities or assets › Equity or invested capital › Partial interests Valuation Basics Purpose of the Valuation › Financial Reporting › Fair value determination › Business Combinations (FASB ASC 805/SFAS 141R) › Goodwill/Long-lived Asset Impairment (FASB ASC 350/SFAS 142&144) › Preferred and restricted stock › Stock-based compensation (FASB ASC 718/SFAS 123R)

› Taxation › Estate planning › Estate and gift taxes › Charitable contributions › Equity-based compensation plans › C to S Corp Conversion – Built-in Gains Valuation Basics Purpose of the Valuation › Transactions › Corporate restructurings › Purchase/sale of business › Buy/sell agreements › Mergers and acquisitions › Fairness opinions

› Employee Stock Ownership Plans (ESOP)

› Incentive Stock Option Plans

Valuation Basics Purpose of the Valuation

› Litigation › Damages – Lost profits v. Diminution of Value › Shareholder/Partner Disputes › Breach of Contract › Business Interruption › Divorce › Intellectual Property Infringement › Post-Acquisition Disputes › Securities › Tortious Interference › Wrongful Termination

Valuation Basics Purpose of the Valuation

› Valuation purpose may affect: › Standard of value › Premise of value › Valuation approaches › Types of adjustments to financial statements › The same company may have different values for different purposes

Valuation Basics Standard of Value

Fair Market Value Investment Intrinsic Value Fair Value Value Price at which “Real Worth” as Value of shares property would Specific value to a opposed to before corporate change hands if: particular investor current market action to which based on price influenced dissenter objects › Willing buyer and individual by: › defined by willing seller investment › Value of firm’s state statute › No compulsion to requirements assets buy or sell (also known as › Expected future › Both parties strategic value) earnings possess › Prospects for knowledge of growth facts

Real Value 1 + 1 = 3 Trade Price Valuation Basics Premise of Value

› Defines the status of the business at a point in time

2000 2001 2002 › Types › Going concern

› Liquidation › Orderly › Forced

Valuation Basics Alternative Valuation Approaches

Income Approach Market Approach Asset-Based Approach

ABC, INC. ABC, INC. Balance Sheet Income Statement 1994 Total assets $ XX Sales $ X Expenses (X) Liabilities $XX Owner’s equity (X) Income $ X Total liabilities and equity $ XX Valuation Basics Ownership Characteristics Type of interest influences applicability of discounts/premiums

Minority v. Control › Minority – Interest < 50% of voting interests › Majority – Interest > 50% of voting interests › Control – Power to direct management and policies of enterprise

Marketable v. Non-marketable › Ability to quickly convert property to cash at a minimal cost Valuation Basics Ownership Characteristics

Control v. Minority Investor is willing to Investor is unwilling pay premium for control to pay as much interest because of because of perception of less perception of higher risk if he can control risk due to a lack of company’s actions rights

Valuation Basics Levels of Value

Synergistic value (or Investment Value) Higher Value Control Stand Alone Value (or Financial Control Value)

As if Freely Traded Value Minority Interest Value

Lower Value Non-Marketable Minority Interest Value

Source: Financial Valuation, 2nd ed. Hitchner Valuation Basics Factors that Influence a Valuation – External › Financial markets › Availability of capital › Interest rates › Economic trends › Demographics › Industry conditions and trends › Market share › Competitive environment › Government regulation Valuation Basics Factors that Influence a Valuation – Internal › Rate of growth and volatility › Seasonality and cyclical nature of sales › Size in terms of sales or assets › Depth of management › Geographic market presence › Customer concentration › Types and diversification of product or services › Intangibles such as name and reputation, customer base and assembled work force The Valuation Process The Valuation Process Step 1: Select the Appraiser

› Select a qualified business appraiser

› Considering that you have invested a lifetime in building your business and its value may be your most significant asset, hire an appraiser with the requisite expertise and experience The Valuation Process Select the Appraiser - Professional Valuation Organizations

American Institute of Certified Public Accountants

American Society of Appraisers

Institute of Business Appraisers

National Association of Certified Valuation Analyst

CFA Institute The Valuation Process Select the Appraiser - Ten Questions to Ask 1. What is your general appraisal and educational background? 2. What specific experience do you have with the kind of property I wish to have appraised? 3. Are you a member of a professional appraisal society? Does that society teach, test and accredit? 4. Do you hold a special designation issued by an appraisal society? 5. Is that designation based on successfully completing written examinations? 6. How long ago did you take the examination? 7. What continuing education have you undertaken to keep up-to-date in the field? 8. Has the appraisal society you belong to adopted a mandatory reaccreditation program to ensure that your education and knowledge are current? 9. What do you charge for your services, and how do you base your fee? 10. Are you required by your appraisal society to adhere to the Uniform Standards of Professional Appraisal Practice (USPAP)? The Valuation Process Step 2: Collect Information › Visit company location to conduct a site visit › Collect financial and operational information for the purpose of assessing the company’s performance. › Adjust company’s financial information to derive financial statements that represent the company’s “true” economic performance The Valuation Process Step 3: Select a Valuation Approach › Assess and select alternative approaches given the facts and circumstances › Alternative approaches include the income, market, and asset approaches › Selection of an approach is dependent upon: › Nature of the business › Consistency of its cash flows › Projected financial performance › Availability of required data. The Valuation Process Step 4: Determine Premiums, Discounts, and Final Value

› Determine any required premiums or discounts: › Lack of control/minority interest › Lack of marketability

› Reconcile values derived using the alternative valuation approaches

› Calculate the value (or range of value) of the applicable ownership interest(s). The Valuation Process Step 5: Communicate Results › Communicate results: › Oral report › Written report

› Alternative types of written reports: › Summary report › Comprehensive report Valuation Approaches Valuation Approaches Which Valuation Approach is Appropriate?

› IRS Rev. Rul 59-60 – ABC, INC. › Earnings may be the most important

Income Statement criterion of value in cases whereas asset 1994 value will receive primary consideration Sales $ X in others Expenses (X) › In general, give primary consideration to Income $ X earnings when valuing stocks of companies which sell products or services to the public › Conversely, in the investment or holding type of company, the appraiser give the greatest weight to the assets underlying the security to be valued. Income Approach Income Approach Overview

› Theory is that the present value of an ABC, INC. investment is equal to the sum of the values of all the future benefits the investment is Income Statement expected to produce for its owner. 1994 Sales $ X › These benefits are then discounted to a Expenses (X) present value at a discount rate that reflects

Income $ X the time value of money and the degree of risk of the investment

Income Approach Two Alternative Methods

1. Capitalized Economic Income ABC, INC. Method The income stream is projected for one period where the subject company’s growth rate is Income Statement assumed to stabilize, and then the 1994 income is divided by a capitalization Sales $ X rate to determine value. Expenses (X)

Income $ X 2. Discounted Economic Income Method The income stream is projected for multiple periods until the growth rate is assumed to stabilize, the present value of the income for each year is calculated using a discount rate, and then the present values are summed to determine value.

Income Approach Selection of Alternative Income Methodology

Alternative Assumptions Regarding Growth Scenario 2: Growth in Income is Volatile 20 in Short Term (Years 1 to 5) and Stabilizes in Long Term (Year 6 to 15 Perpetuity)

10 Scenario 1: Growth in Income is Stable in Year 1 to Perpetuity

Net Cash Flow 5

0 0 1 2 3 4 5 6 Years Market Approach Market Approach Overview

› Price multiples are applied against a financial variable for the subject company (e.g., Price to Earnings) to calculate the value of the subject company’s invested capital or equity.

Market Approach Two Alternative Methods 1. Guideline Publicly Traded Company Method - The valuation multiple is based on the prices for publicly-traded stocks.

2. Merger and Acquisition (or Transaction Method) - The valuation multiple is based upon the sales of an entire company.

Market Approach Guideline Public Company Method

› Guideline company methods are usually most applicable for closely held companies that have comparable public company counterparts.

Market Approach Merger & Acquisition Method › In using the M&A method, the subject company’s value is calculated based on the prices at which:

1. Entire comparable public or privately-held companies have been sold

2. Significant ownership interests have changed hands

Asset Approach Asset Approach Overview

ABC, INC. › In applying an asset-based approach, a Balance Sheet company's assets and liabilities are adjusted to appraised values and the Total assets $ XX difference is used to calculate the value of the equity. Liabilities $XX Owner’s equity (X) › The asset approach should generally be Total liabilities considered if the subject company is being and equity $ XX valued at the enterprise level and the following criteria are met:

› The business is an investment or real estate holding company › The business is appraised on a basis other than as a going concern

Asset Approach Overview

ABC, INC. › The two most commonly used asset Balance Sheet methodologies include:

Total assets $ XX 1. Net Asset Value Method - Assumes that Liabilities $XX the company's value will be realized by Owner’s equity (X) the hypothetical sale of its assets as part of a going concern. Total liabilities and equity $ XX 2. Liquidation Value Method - Assumes that the company’s value is equal to the present value of the net proceeds resulting from the liquidation of the company’s assets and payment of its liabilities.

Concluding Remarks Additional Reading › Financial Valuation: Applications and Models, 3rd ed., Jim Hitchner, ed. › Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 5th ed., Shannon Pratt › Understanding Business Valuation, 4th ed., Gary Trugman

Questions? › Contact:

Harold G. Martin, Jr., CPA/ABV/CFF, ASA, CFE Partner, Valuation and Forensic Services Keiter 4401 Dominion Boulevard, 2nd Floor | Glen Allen, VA 23060 Direct: 804.273.6240 | E-mail: [email protected] |

Subscribe to our Valuation E-newsletter by emailing your contact information to [email protected] or register through our website.