Vol. 25, No. 8, August 2019

BUSINESS UPDATE TIMELY NEWS, ANALYSIS, AND RESOURCES FOR DEFENSIBLE VALUATIONS

Business Valuation Terms Need Restructuring Based on Value Drivers

By James A. Lisi, The Mentor Group appears that we are working backwards—trying Inc. and Santa Barbara Valuations Inc. to fit existing standards into these primary types— (Santa Barbara, California, USA) instead of the other way around. In The Business Valuation Bench Book,1 William J Morrison and As a relatively young profession, we are just be- Jay E. Fishman tell judges: ginning a transition beyond our original busi- ness valuation pioneers. These leaders shaped The process begins with the consideration a plethora of theories and court precedents into of the overarching Value Premise, which rep- a vocation. But, with the time span and diversity resents the general concepts of property of early contributions, the profession suffers from under which the standard of value falls. The a muddling of concepts and terms. It is time for a two fundamental Value Premises are value- recalibration of valuation terms that grows out of to-the-holder and value-in-exchange. Under the previously laid foundation. value-to-the-holder, the owner realizes the benefits of ownership by the cash flow The current environment exists because theory received by owning the business. Under development was fostered by academic mod- value-in-exchange, the owner realizes the eling, statistical study, and court cases over benefits of ownership by selling the busi- four decades, not rigorous variables analysis ness. (italics added) that defines a system and its baselines from the bottom up. In addition to confusing ex- Judges are told that valuation begins with de- pressions, we have somewhat faulty assump- termining whether worth is based upon an Ex- tions and an incomplete set of variables. These change or Holder/Owner perspective. If true, it aspects need to be detailed within a compre- necessarily follows that the first determination in hensive structure. Revising terminology and a valuation assignment is to make the same as- adding new parameters to better define an sessment. For our starting point, let’s classify the engagement will improve alignment of results existing Standards of Value under the overarch- between analysts and benefit all business valu- ing nature of value. A standard’s nature is identi- ation stakeholders. fied by the conditions presented in its definition. Exchange Nature refers to an open-market trans- Standards of Value action, while Owner Nature refers to participants such as creditors, investors, and owners who are The topmost element of defining value is Stan- not buying or selling their interest. dard of Value. Here the issues of open-market value and intrinsic value need separation and delineation. In current valuation teaching, we 1 William J, Morrison and Jay E. Fishman, The Business Valuation Bench Book, 2017, Business are presented two primary types of value from Valuation Resources; bvresources.com/products/ which our standards are established. However, it the-business-valuation-bench-book. Reprinted with permissions from Business Valuation Resources, LLC

bvresources.com Business Valuation Terms Need Restructuring Based On Value Drivers

BUSINESS VALUATION UPDATE Exchange Nature standards. There are two stan- dards for open-market transactions: Publisher: Sarah Andersen Executive Legal Editor: Sylvia Golden, Esq. Managing Editor: Monique Nijhout-Rowe Chief Revenue Officer: Lisa McInturff 1. Fair market value (FMV) (U.S. Treasury) is the Senior Copy Editor: David Solomon President: Lucretia Lyons price at which the property would change Desktop Editor: Warren Simons CEO: David Foster hands between a willing buyer and a willing Executive Editor: Andrew Dzamba seller, neither being under any compulsion EDITORIAL ADVISORY BOARD to buy or to sell and both having reasonable knowledge of relevant facts; and R. JAMES ALERDING, CPA/ABV, ASA JARED KAPLAN, ESQ. ALERDING CONSULTING LLC DELAWARE PLACE ADVISORY SERVICES, LLC INDIANAPOLIS, IN CHICAGO, IL 2. Fair value (GAAP FAS 157) is the price in an CHRISTINE BAKER, CPA/ABV/CFF HAROLD G. MARTIN JR. ADVANCED ARCHITECTURAL PRODUCTS LLC CPA/ABV/CFF, ASA, CFE orderly transaction between market partici- ALLEGAN, MI KEITER GLEN ALLEN, VA pants to sell the asset or transfer the liability NEIL J. BEATON, CPA/ABV, CFA, ASA ALVAREZ & MARSAL VALUATION SERVICES GILBERT E. MATTHEWS, CFA in the market in the principal or most advan- SEATTLE, WA SUTTER SECURITIES INC. SAN FRANCISCO, CA tageous market for the asset or liability. JOHN A. BOGDANSKI, ESQ. LEWIS & CLARK LAW SCHOOL Z. CHRISTOPHER MERCER, ASA, CFA PORTLAND, OR MERCER CAPITAL Owner Nature standards. Prior to GAAP use MEMPHIS, TN ROD BURKERT, CPA/ABV, CVA of the term, fair value was the identifier used BURKERT VALUATION ADVISORS LLC JOHN W. PORTER, ESQ. MADISON, SD BAKER & BOTTS to express intrinsic worth. The foundation for HOUSTON, TX DR. MICHAEL A. CRAIN, CPA/ABV, CFA, CFE much of the state law surrounding the definition FLORIDA ATLANTIC UNIVERSITY RONALD L. SEIGNEUR, BOCA RATON, FL MBA, ASA, CPA/ABV, CVA of fair value is the Model Business Corporation SEIGNEUR GUSTAFSON MARK O. DIETRICH, CPA/ABV LAKEWOOD, CO Act (MBCA). The MBCA was issued by The Com- FRAMINGHAM, MA ANDREW STRICKLAND, FCA mittee on Corporate Laws of the American Bar JOHN-HENRY EVERSGERD, ASA, CFA, MBA SCRUTTON BLAND FTI CONSULTING UNITED KINGDOM Association Section of Business Law in 1950 and SYDNEY, AUSTRALIA EDWINA TAM, ASA, CBV has been revised several times. In 1999, MBCA NANCY J. FANNON, ASA, CPA, MCBA DELOITTE MARCUM LLP HONG KONG defined fair value as: PORTLAND, ME JEFFREY S. TARBELL, ASA, CFA HOULIHAN LOKEY JAY E. FISHMAN, FASA, FRICS The value of the corporation’s shares de- FINANCIAL RESEARCH ASSOCIATES SAN FRANCISCO, CA BALA CYNWYD, PA GARY R. TRUGMAN, termined immediately before the effectua- LANCE S. HALL, ASA ASA, CPA/ABV, MCBA, MVS tion of the corporate action to which the STOUT RISIUS ROSS TRUGMAN VALUATION ASSOCIATES IRVINE, CA PLANTATION, FL shareholder objects using customary and THEODORE D. ISRAEL, CPA/ABV/CFF, CVA KEVIN R. YEANOPLOS, current valuation concepts and techniques ISRAEL FREY GROUP LLP CPA/ABV/CFF, ASA SAN RAFAEL, CA BRUEGGEMAN & JOHNSON generally employed for similar YEANOPLOS PC TUCSON, AZ in the context of the transaction requiring appraisal without discounting for lack of Business Valuation Update™ (ISSN 2472-3657, print; ISSN 2472-3665, online) is published monthly by Business Valuation Resources, LLC, 111 SW Columbia Street, marketability or minority status except, if Suite 750, Portland, OR 97201-5814. Periodicals Postage Paid at Portland, OR, and at additional mailing offices. Postmaster: Send address changes to Business Valuation appropriate, for amendments to the articles Update (BVU), Business Valuation Resources, LLC, 111 SW Columbia Street, Suite 750, Portland, OR 97201-5814. pursuant to section 13.02(a)(5). The annual subscription price for the BVU is $459. Low-cost site licenses are available for those who wish to distribute the BVU to their colleagues at the same firm. Contact our sales department for details. Please contact us via email at In addition, the Delaware Supreme Court’s land- [email protected], phone at 503-479-8200, fax at 503-291-7955 or visit our website at bvresources.com. Editorial and subscription requests may be mark decision in Cavalier Oil Corp v. Harnett made via email, mail, fax or phone. cited three reasons for why the application of Please note that, by submitting material to BVU, you grant permission for BVR to republish your material in this newsletter and in all media of expression now known discounts at the shareholder level was contrary or later developed. to the fair value mandate: Although the information in this newsletter has been obtained from sources that BVR believes to be reliable, we do not guarantee its accuracy, and such information may be condensed or incomplete. This newsletter is intended for information purposes only, and it is not intended as financial, investment, legal, or consulting advice. 1. Fair value does not assume a hypothetical Copyright 2019, Business Valuation Resources, LLC (BVR). All rights reserved. No part of this newsletter may be reproduced without express written consent from BVR. sale of the minority’s interest but assumes Please direct reprint requests to [email protected].

2 Business Valuation Update August 2019 Business Valuation Resources Business Valuation Terms Need Restructuring Based On Value Drivers

that the minority will maintain his or her in- implement this agenda. Historically, the term for vestment in the business; owner-based intrinsic value has been “fair value.” Now, under GAAP, it represents “exchange 2. Applying discounts at the shareholder value.” While this differentiation may have little level injects speculation into the appraisal meaning for public-company accounting, it is process; and a key aspect to the value of small and medium business, especially in shareholder and partner 3. Discounts penalize dissenting shareholders matters. To properly define an intrinsic value for enforcing their rights while providing engagement, we need to formulate a reliable majority shareholders a windfall by cashing standard that uses terminology different from out the minority at a discounted price. “fair value” and to consider other contributing assumptions. Other terms relating to Owner Nature are: It is important to note that intrinsic value is con- • Fair value (American Law Institute). The value cerned with shares of a business, which may rep- of an eligible holder’s proportionate interest resent an owner exit or a new investment. Thus, in the corporation, without any discount for intrinsic value includes the impact of elements minority status. from the liabilities side of the balance sheet, which is differentiated from cash purchases of • Fair value (—Business Trans- whole entities that exclude those elements. To action). This is the price that is fair between this end, terminology and two specific parties considering the respec- the catch-all term Investment Value are adapted tive advantages or disadvantages that each to arrive at: will gain from the transaction. Investment Value is the value of an asset • Divorce value. This special case of fair value to the owner, or prospective owner, for in- is the value of an asset to both spouses, dividual investment or operational objec- considered to be investors, that considers tives, and considers the impact of issues intrinsic ownership issues related to the that change intangible value in comparison business. The basis of value is upon that to open-market value, such as the impact which the original interest was transacted, at of cash-on-hand, leverage, entity type and or subsequent to the date of the marriage. distributions. The basis of value for a partial interest in the asset is upon that which the • Intrinsic value. This is the true worth of an original interest was transacted. asset to investors based upon facts, cir- cumstances, and expectations, ignoring The proposed Investment Value standard first open-market transactions because these addresses the entity level. Then, by noting the transactions omit new, unknown, or unrec- original investment basis, issues of eligibility ognized information. Business writers and and discounts for partial interests are settled investment management industries often based upon the holder’s entry terms. One issue use this meaning in relation to the prices of is for the profession to take a leadership position a public . on this topic and define a name different than “fair value” for intrinsic valuation engagements. So how is that for confusing? The accounting Another issue is to settle the basis for partial in- profession moves to “fair value accounting”— terests that satisfies the MBCA and other prec- the pricing of assets and liabilities at current edents. A third point, which is examined next, market value—and applied the term “fair value” to is to clearly separate Value Premise from Value Reprinted with permissions from Business Valuation Resources, LLC bvresources.com August 2019 Business Valuation Update 3 Business Valuation Terms Need Restructuring Based On Value Drivers

Standard so that business combinations are ad- Premise defines intangible value context, which dressed within variables structure. Value Premise has six possibilities: must cover situations such as stand-alone busi- ness, acquisition for consolidation or acquisition 1. No Intangible Value: Entity has negative for synergies, which today is ambiguously incor- cash flow, has failed or will fail, and only has porated into the Investment Value term. value in its component parts.

Value Premises 2. Asset Group Value: Entity has minimal cash flow and can theoretically operate indefi- Rationalizing Value Standard leads to a revision of nitely, but cash flow value is less than the Value Premise. Value Premise has been muddled value of the assets in place. Only a marginal together with issues involving Standard and return on assets is present. Market and subject to implied assumptions. For example, the term “Liquidation Value” appears 3. Stand-Alone Intangible Value: Entity has to be a Standard, having the word “value” in its cash flow value greater than the value of its body, but it does not define conditions neces- assets and theoretically can operate indefi- sary to be a standard such as buyer, seller, and nitely. market. It is widely seen as meaning “being sold in pieces” and has conditions of being “orderly” 4. Potential Intangible Value: Entity has nega- or “forced,” but is it open-market value or some- tive cash flow but with nonoperating re- thing else? Value Premise is better represented sources, or a guarantor, which allow it to by targeted terms such as “in pieces” and “going persist, pursue profitability, and theoreti- concern” than expansive terms such as “Liqui- cally operate indefinitely if it is successful. dation Value” that can be confused with other issues. 5. External Intangible Value: Entity combined with another company creates new intan- Although present jargon may not be ideal, Value gible value adding to its stand-alone value Premise is clearly related to a subject’s state and theoretically operates indefinitely. of intangible value. Our current terms, “going concern” and “liquidation,” however, do not 6. Breakup Intangible Value: A unit of an entity fully explain the array of circumstances that is divested from its parent and has intan- analysts must consider. To function suitably, gible value that may be different than the Value Premise will avoid crossing over with Stan- intangible value when operating within the dard and solely examine possibilities. parent business. A benefit of this construction is that either an Exchange Standard or Owner Standard can be In practice, these Premises show up as clusters of paired with the following Value Premises, which valuation multiples in transaction data. So clas- is important in preparing fairness opinions re- sification by Value Premise would also lend itself garding a specific combination of businesses to categorizing transaction data and determining and communicating the viewpoint of the value market value under a particular context, which opinion. would be extremely valuable. Exhibit 1 displays drivers by EBITDA multiplier; the categories are Premise of (Goodwill) Value. The driver for Value loosely arranged by increasing cash flow and Premise is the source(s) of goodwill. Goodwill MVIC. may be absent, internally generated, or arise from external elements. With the buyer-seller- Data collect in the clusters shown in Exhibit 1 for market relationship set by other assumptions, multiple reasons. Startups have small cash flow Reprinted with permissions from Business Valuation Resources, LLC

4 Business Valuation Update August 2019 Business Valuation Resources Business Valuation Terms Need Restructuring Based On Value Drivers

Exhibit 1. Value Drivers

EBITDA MULTIPLE BY ECONOMIC DRIVER 100 90 80 70 60 50 40 30 20 10 0 Distressed Sale & Buy a JobInvestment Consolidation & Strategic Growth Startup Return Diversification

Central Tendency: LowHigh Most Common

Increasing Capitalization

resulting in high EBITDA multipliers versus poten- • Value in Consolidation (value from cost tial earnings. Distressed businesses have small savings combination); cash flows in relation to assets. A Main Street business provides above-market owner com- • Value in Synergy (value from new growth pensation and independence, so “Buy-a-Job” combination); and multipliers can reflect low entry cost and lifelong job . Other high multiplier deals are for • Breakup Value (value after separating from product line extensions or to take a competitor holding entity). out of the market, both of which improve indus- try dynamics in favor of the acquirer. Strategic Market Premise. In addition to Value Premise interests typically have the highest value as the reflecting Goodwill composition, the most im- combination of two particular companies is pro- portant remaining condition to standardize is jected to expand and lever the number of avail- a Market Premise for Exchange conclusions. able future opportunities, offering a high reward. Historically, distinction on market has been assumed between Standard and Value Premise. Knowledgeable buyers and sellers may take any An open market conveys full value. The idea of of these positions, which makes the need for a this premise has to do with whether a proposed value premise to cover all these situations neces- sale has access to a full complement of poten- sary. Borrowing terminology from the equipment tial buyers or whether the available number of appraisal field, the proposed Value Premises are: buyers is diminished.

• Piece Value (now called liquidation); The term “open market” represents the concept of an asset transfer without duress. In principle, • Value in Place (now called going concern); an open market is an exchange accessible to all Reprinted with permissions from Business Valuation Resources, LLC bvresources.com August 2019 Business Valuation Update 5 Business Valuation Terms Need Restructuring Based On Value Drivers

economic participants, where only the forces Only the three market conditions—Open-Market, of supply and demand determine price. In a re- Restricted Market, and No Access to Market— stricted market, constraints of time, geography, appear necessary as an analyst can specify any or other factors reduce the number of available type of restriction in his or her description of the buyers. valuation problem.

Time constraint deserves special attention to Discount Terminology avoid confusion with liquidity. The open-mar- ket exposure time for an asset is the time re- As with the series of standards and premises quired for a sale to be completed in a subject’s above where each condition is an element that primary market.2 An illiquid asset such as a whole adds together to form a complete analysis, the company does not have ready buyers and re- discount for lack of marketability (DLOM) has quires lengthy market exposure and due dili- multiple elements. The interrelationship of all gence investigation before a sale. As long as these elements is not necessarily recognized by time is allowed to complete the selling process, those in practice, and confusion over terminol- full value will be conveyed and meet an open- ogy exists. market test. DLOM analysis suffers in application because the On the other hand, time constraints limit market term “marketability” in DLOM is misconstrued exposure and reduce the number of available with the term “liquidity” due to its founding in buyers. This impedes the seller’s options to relation to studies of public markets and subse- ignore undesirable offers and wait for better quent comparison to the lack of a public market. ones. Typically, a deadline to sell an illiquid asset Lack of a public market is not the same as having and the resulting lack of competition reduces no market, which the academic originators price. Other limitations may be that the asset only implied. Private markets exist; they are simply appeals to a very small geographic area or that, illiquid. Because of this early mischaracteriza- by agreement with other shareholders, a partial tion, some equate marketability and liquidity. interest may only be sold to family members; or, But the term “marketability” in relation to private if the value of the asset is too low, it will not be assets represents a broad connotation related to acceptable to a licensed broker and cannot reach a measure of overall appeal. The nature of liquid- the market. Market Premises proposed are: ity, meanwhile, is directed at the time an owner must wait to convert an asset to cash. To clarify • Open-Market (now called Orderly); the strata, the term “DLOM” is claimed to be the multiaspect, overall examination of attractive- • Restricted Market (now called Forced): ness—of marketability—and subfactors categorize analysis into three components: liquidity, control, ❍❍ Time restriction; and salability. ❍❍ Geography restriction; and

❍❍ Contract restriction. Liquidity. A liquid interest enjoys the benefit of having its company information widely published to a broad pool of qualified, able, and interested • No Access to Market. buyers and is able to quickly convert a sale to cash (two days in public markets). An illiquid inter- est is unknown, does not have ready buyers, and 2 Two days for stock shares in public markets, three requires lengthy market exposure before sale. months if secondary markets are available to a private stock, six to 18 months for whole companies, public or Generally, controlling interests of both private private. and public companies are illiquid, brought to Reprinted with permissions from Business Valuation Resources, LLC

6 Business Valuation Update August 2019 Business Valuation Resources Business Valuation Terms Need Restructuring Based On Value Drivers

market through professionals. Noncontrolling in- of a company. A shareholder agreement or other terests in private companies may have no liquid- externalities may also convey, diminish, or block ity at all because professional marketing services entity control. Noncontrolling interests cannot are unavailable to sell them. Only a tiny market enact changes in a company alone. segment of noncontrolling interests is truly liquid: those in large, diversified companies traded on Salability. Salability is the capability of an asset to public stock exchanges. be exchanged for cash or cash equivalents and/ or an asset’s relative suitability for trade versus In theory, when liquidity is immediate, full value is similar assets that are selling. For similar assets realized because the principal investment and its having the same liquidity and control, salability appreciation are returned to the owner without is related to adjustments for dividend, holding risk. Conversely, when liquidity is zero, value is cost, exit costs, and market conditions. based solely upon dividends because the owner cannot realize the initial investment and appre- So one point is to eliminate confusion of the ciation. The effect of market type and liquidity is terms “marketability” and “liquidity” by using shown in Exhibit 2. the correct terms within valuation literature. Many analysts only apply the liquidity factor for DLOM Control. Controlling interest is when an due to confusion with the term “marketability.” A holder controls a high enough percentage of second point is that clearly establishing DLOM ownership to enact changes at the highest level to be a multifaceted analysis of relevant discount

Exhibit 2. Market and Liquidity Effect

VALUE IMPAIRMENT

LIQUIDITY / MAXIMUM INTEREST TYPE CHANNEL VALUE INVESTMENT BANK PUBLIC CONTROL INTEREST P U B L TWO DAY PUBLICLY TRADED SHARES I C P R I EXIT PLAN V A T BROKER CLOSELY HELD COMPANIES E

NO MARKETING CLOSELY HELD NO EXIT NO DIVIDEND CLOSELY HELD MINORITY INTEREST ZERO VALUE

Reprinted with permissions from Business Valuation Resources, LLC bvresources.com August 2019 Business Valuation Update 7 Business Valuation Terms Need Restructuring Based On Value Drivers

drivers is pertinent because each of these ele- • The term “marketability” should be re- ments has a different impact on value. placed in all literature when used in re- lation to liquidity by the word “liquidity,” Conclusions and the term “Discount for Lack of Market- ability” should be established as a multi- Revising valuation terminology based upon value element analysis of appeal based upon drivers is important to all stakeholders—analysts, the components of liquidity, control, and clients, attorneys, judges, and other participants. salability. The structure proposed explains the necessary conditions for determining value and rational- The next step should be that the standards izes confusing and overlapping terms. The main boards of the valuation professional organiza- changes are: tions (VPOs) take this proposal under consid- eration. As a CVA, I am a member of NACVA; • Value standards should be rationalized therefore, I recommend that the NACVA Stan- under two Natures that reflect Value-in-Ex- dards Board study adoption of the protocol as a change and Value-to-the-Holder principles. recommended practice, then incorporate into it While we have FMV and GAAP Fair Value the development standards under NACVA Pro- for the former, we do not have an adequate fessional Standards, teaching materials, USPAP, definition for intrinsic matters that satisfies and the Glossary of Valuation Terms, should it Value-to-the-Holder conditions. The pro- prove acceptable. posed term for the intrinsic value standard is a revised version of Investment Value, which James A. Lisi, CVA, is managing director for is already commonly used, but not effec- Central Coast California at The Mentor Group tively defined for use as a standard. Inc., and owner of Santa Barbara Valuations Inc. He has an MBA from the University of Califor- • In the standardization effort, the terms nia, Irvine, 20 years of operating experience at “Going Concern,” “Liquidation Value,” Fortune 100, private equity and his own personal- “Orderly Liquidation,” and “Forced Liqui- ly held businesses, and over 15 years of valuation dation” should be replaced by an expanded experience spanning growth company invest- Value Premise and adding Market Premise. ment, 409a, cryptocurrency, ESOP, real property Value Premise describes the nature of in- partnerships, discounting, and litigation matters. tangible value. Market Premise identifies He can be reached at [email protected] or any restrictions of the expected number of [email protected] or by telephone at 805- buyers available at the valuation date. 797-1710.

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8 Business Valuation Update August 2019 Business Valuation Resources