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Attorney’s Guide to Financials and Business Valuations

May 21, 2013

New Orleans, Louisiana

Presented By: Vanessa Brown Claiborne, CPA/ABV, ASA

A Presentation for

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Table of Contents

I. Introduction to Business ValuationsII. What to Look for When Reviewing a

Business ValuationIII. Using Valuations in Your Case: Why

and How

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I. Introduction to Business Valuations

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Standards

• Business valuation appraisers follow the following standards and guidelines:– American Institute of Certified Public

Accountant’s Statements of Standards for Valuation Services No. 1 (“SSVS”);

– The Appraisal Foundation’s Uniform Standards of Professional Appraisal Practice (“USPAP”);

– The ethics and standards of the American Society of Appraisers; and

– The Internal Revenue Service’s business valuation development and reporting guidelines.

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Revenue Rulings

• Revenue Ruling 59-60– Outlines the approaches, methods, and

factors to be considered in valuing shares of stock in closely-held corporations for federal tax purposes.

• Revenue Ruling 65-192– Extended the concepts in Revenue

Ruling 59-60 to income and other tax purposes as well as to business interests of any type.

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Elements of a Business Valuation Packet

1. Engagement Agreement2. Checklist3. Site Visit

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1. Engagement Agreement

• Rule 201A, Professional Competence, of the AICPA Code of Professional Conduct, states that a member shall “undertake only those professional services that the member or the member’s firm can reasonably expect to be completed with professional competence.”

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1. Engagement Agreement

• In determining to accept an assignment, an evaluator considers, at a minimum, the following:– Subject entity and its industry– Subject interest– Valuation date– Scope of the valuation engagement

• Purpose of the valuation• Assumptions and limiting conditions• Applicable standard of value• Type of valuation report

– Government regulations

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1. Engagement Agreement

• Other factors to be considered– Objectivity and Conflict of Interest– Independence and Valuation– Establishing an Understanding with the

Client– Assumptions and Limiting Conditions– Scope Restrictions and Limitations

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2. Checklist• A basic information checklist includes the following:

– Historical financials of the company– Debt schedule– Schedule of fixed assets– Lease agreements for facilities or equipment– Any existing contracts– List of shareholders with shares outstanding– Budgets or projections– Details on any transactions with a related party– Company documents– Other information including list of locations, customers,

competitors, suppliers, contingent liabilities, and regulations

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3. Site Visit

• When performing a site visit, the appraiser should try to derive an answer to the following:– How does the company perceive itself?

• Strengths, weaknesses, prospects, market, etc.

– How does the company see the industry?• Influential factors, trends, growth, competition, etc.

–Management and management compensation• Personal expenses, market rate compensation, etc.

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The Valuation Process

1. Reasons for a Business Valuation2. Analyzing Qualitative Factors3. Valuation Process

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1. Reasons for a Business Valuation

• Merger/Acquisition/Fairness Opinions• Family Succession Planning/Estate and

Gift Taxes• Employee Share Ownership Plans (ESOP)• Buy-Sell Agreements• Executive Compensation (Options/SARS)• Stock Repurchase or Recapitalization• Fair Value Accounting• Income Tax

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2. Analyzing Qualitative Factors

• Relevant economic data (Global, National, Local)• Industry factors• Competition• Regulation• Product or service lines• Supplier relationships• Market position• Management and employees• Adequacy of physical facility• Operating efficiencies and inefficiencies

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Relevant Economic Data

• National Economic Data

• Regional and Local Economic Data

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Industry Factors

• Markets• Channels of Distribution• Technology• Sources of Industry Information

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Competition

• Existing Competition

• Potential Competition

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Regulation

• Present Regulation

• Potential Changes in Regulatory Environment

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Product or Service Lines

• Existing Lines• Opportunities for Related Lines• Patents, Copyrights, Trademarks• Relative Profitability of Lines• Service or Warranty Obligations

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Supplier Relationships

• Continuity• Degree of Exclusivity• Contractual Relationships

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Market Position

• Reputation• Geographic Scope• Method of Marketing and Distribution• Pricing Policies• Customer Base• Customer Relationships• Market Continuity, Growth

Opportunities and Weaknesses

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Management and Employees

• Size and Composition of Work Force• Key Employees• Other Employees• Compensation• Personnel Policies, Satisfaction,

Conflict, and Turnover

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Adequacy of Physical Facility

• Condition• Heat, Light, Plumbing, and Other

Systems• Size• Continuity of Occupancy

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Operating Efficiencies and Inefficiencies

• Physical Plant

• Accounting and Other Controls

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3. Valuation Process

• Gather company data• Site visit• Research economic and industry

information• Analyze company financial

statements• Tests of valuation• Discounts, premiums, and value

conclusion

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Working with the Accountant/Appraiser

• The attorney is responsible for the following:– Definition of standard of value– Determination of applicability of legal

agreements of valued interests– Decision on who the client will be– Reading the valuation report and asking

questions

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Standards of Value

1. Fair Market Value2. Fair Value3. Investment Value4. Intrinsic Value

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1. Fair Market Value

• The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts (ASA BVS definition)

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2. Fair Value

• Has two different contexts:– Fair value for legal purposes• Usually defined by various authorities an

statutes

– Fair value for financial reporting purposes• The price that would be received to sell an

asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (FASB ASC 820, formerly SFAS 157)

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3. Investment Value

• Specific value to a particular investor based on individual investment requirements– This extremely small and limited market

is typically characterized by a premium because of the unique synergies the perceived particular buyer would realize as a result of acquiring the asset

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4. Intrinsic Value

• Amount an investor considers to be “real” worth of an item based on evaluation of available facts; may be above or below fair market value

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Methods and Approaches

• There are several valuation approaches in valuing a company:1. Market approach2. Income approach3. Asset approach

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1. Market Approach

• Previous sales of or offers for the Company’s stock

• Sales of similar companies• Sales of stock of publicly traded

companies• Rules of thumb

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2. Income Approach

• Discounted cash flow method• Leveraged buyout model• Capitalization of earnings method• Excess earnings method

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3. Asset Approach

• Liquidation model• Net asset value

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Deciphering Valuation Discounts

• Levels of Value• Synergistic Premium• Control Premium/Minority Discount• Lack of Marketability Discount• Layered Discounts or Discounts on

Top of Discounts

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Levels of Value

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Synergistic Premium

• Reflects the value to a specific buyer• Synergistic buyer can pay more due

to perceived earnings benefit from a merger

• Not appropriate consideration in determining “Fair Market Value”

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Control Premium/Minority Discount

• Appointment or removal of management or determination of their compensation

• Setting policy or changing the course of business• Acquisition or liquidation of assets• Acquisitions of other companies• Liquidation, dissolution, sale, or recapitalization of the

company• Registering the company’s stock for an IPO• Forcing the sale of the stock of the Company• Determination of the amount and timing of any

dividends to shareholders• Amendments to the Articles of Incorporation

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Lack of Marketability Discount

• Securities of privately owned companies are not readily tradable on an established exchange and may require a discount for their lack of marketability.

• Control blocks of stocks are generally more readily marketable than minority blocks.

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Layered Discounts or Discounts on Top of Discounts

• When going to the next entity level, does asset allocation change or can it be changed by the manager of that entity? – Probably not.

• When going to the next entity level, does the manager have the ability to affect performance/timing of sales? – Probably not.

• Does the manager have the ability and intention to pay distributions? – Perhaps

•  What if the entity owns other assets in addition to its investment in the entity? – Discounts may apply to that portion of the assets.

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Layered Discounts or Discounts on Top of Discounts

• Lack of Marketability exists at all ownership levels.

• Lack of liquidity is taken into account at the asset holding entity.

• Is it greater at the Tier 1, 2, etc. level?– Possibly, if there are distributions or

likelihood of asset liquidation.

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Example

TIER 2

NAV= $39,336

TIER 1

NAV= $198,333

ASSETHOLDING

ENTITY

DONOR

10% Ownership

33.3% Ownership

33.3% Ownership

$1,333

$13,333

$40,000

NOI/DISTRIBUTION

$120,000

$1 million Net Asset Value

$595,000 Less 40.5% Disc. AHE to Tier 1

$354,000 Less 40.5% Disc. Tier 1 to Tier 2

$210,000 Less 40.5% Disc. Tier 2 to Donor

TOTAL DISCOUNT : 78.96%

$2,340Gift

$198,333(80,325) 40.5% Total Discount$118,008 x 33.3% ownership

15% LOC, 30% LOM$1,000,000 Real Estate(150,000)$850,000(255,000)$595,000 x 33.3% ownershipTotal Discount: 40.5%

$39,336(15,931) 40.5% Total Discount$23,405 x 10% ownership

Distribution Yield= 50%

$1,333 $2,340

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II. What to Look for When Reviewing a Business

Valuation

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Types of Engagements

• Valuation Engagement– Detailed Report– Summary Report

• Calculation Engagement– Calculation Report

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Calculation Engagement

• According to SSVS, a valuation analyst performs a calculation engagement when – (1) the valuation analyst and the client agree on the

valuation approaches and methods the valuation analyst will use and the extent of procedures the valuation analyst will perform in the process of calculating the value of a subject interest (these procedures will be more limited than those of a valuation engagement)

– (2) the valuation analyst calculates the value in compliance with the agreement. The valuation analyst expresses the results of these procedures as a calculated value. The calculated value is expressed as a range or as a single amount.

• A calculation engagement does not include all of the procedures required for a valuation engagement

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Elements of a Business Valuation Report

1. The Report2. Basic Elements of the Report3. Business Valuation Math4. Traits to Expect in a Business Appraiser5. Premise of Value6. Standards of Value7. Factors Specific to U.S. Gift and GST

Returns

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1. The Report

• Cover of the Report• Math• Signatories• Standards • Assumptions

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2. Basic Elements of the Report

• Subject entity• Valuation date• Standard of value• Appraisers• Clear indication of value

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3. Business Valuation Math

• A business valuation goes beyond the math

• It’s the assessment of a business’s hard and intrinsic assets to determine its moneymaking power in the hands of the same owner or a new owner years from now

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4. Traits to Expect in a Business Appraiser

• Independence/objectivity• Confidentiality• Technical competence• Experience• Industry awareness

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5. Premise of Value

• Going Concern– Value in continued use or as a going concern business

enterprise

• Value as an Assemblage of Assets– Value in place, as part of a mass assemblage of assets, but

not in current use in the production of income & not a going-concern business enterprise

• Value as an Orderly Disposition– Value in exchange, on a piecemeal basis; assumes assets will

enjoy normal exposure to their appropriate secondary market

• Value as a Forced Liquidation– Value in exchange, on a piecemeal basis; assumes assets will

experience less than normal exposure to their appropriate secondary market

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6. Standards of Value

• Discussed earlier

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7. Factors Specific to U.S. Gift and GST Returns

• A gift tax return must meet adequate disclosure requirements in order for the statute of limitations to start

• Two ways to meet disclosure requirements are:– Description Safe Harbor– Appraisal Safe Harbor

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Description Safe Harbor

• To satisfy this requirement, the following information is required:– The financial data used in valuing the interest– Any restrictions taken into consideration – Detailed descriptions of any discounts– For transfers valued using the asset value method:

• The undiscounted FMV of 100%• The pro-rata portion of the entity subject to the transfer• The FMV of the transferred property

– For transfers of an entity that directly or indirectly holds interest in another entity, a detailed description of the method used to determine FMV.

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Appraisal Safe Harbor

• To meet the requirements, the taxpayer must– Engage a Qualified Appraiser– Submit a Qualified Appraisal

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III. Using Valuations in Your Case: Why and How

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Examples

• Property Settlement• Squeeze-out of Minority Shareholder• Tax Litigation• Shareholder or Partner Litigation

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EBITDA

Earnings before interest expense, taxes, depreciation and amortization

Net income+interest expense on long term debt+ income taxes+depreciation and amortizationEBITDA

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Total Enterprise Value

• (“TEV”) = equity + long term debt

• Pricing multiple = (Equity + LT debt)/EBITDA

• Equity = pricing multiple x EBITDA – LT debt.

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Downstream: Wholesaler

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Upstream: Exploration and Production

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Oil Services: Offshore Service Vessels

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Understanding Discount and Capitalization Rates

• “Discounting” versus “Capitalizing”• Components of a Discount Rate• Relationship between Discount Rates and

Capitalization Rates

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“Discounting” versus “Capitalizing”

• Discounting is a procedure that converts an expected future return, or a series of expected future returns, to a present value using a discount rate.

• Capitalizing is a procedure that converts a single flow of returns to an indication of value.

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Components of a Discount Rate

• The discount rate is the expected total rate of return required to attract capital to the particular investments.

• Components– Risk-Free Rate of Return– Premium for Risk– Premium for Illiquidity

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Different Rates for Different Buyers

• The cost of equity, either debt or equity, is different from one buyer to another.

• For an individual buying a sole proprietorship from another individual, each would have about the same cost of capital.

• For a public company, the cost of capital would be somewhat less than the typical small entrepreneur.

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Making a Sanity Check

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Examples

1. Wholesaler2. Exploration & Production Company3. Equipment rental

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1. Downstream

Wholesaler

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Income Approach

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Market Approach

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Rules of Thumb

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Summary Conclusion

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2. Upstream

Exploration and Production

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Income Approach

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Market Approach

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Asset Approach

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Summary Conclusion

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3. Oil Services

Offshore Service Vessels

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Income Approach

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Market Approach

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Asset Approach

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Summary Conclusion

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Vanessa Brown Claiborne, CPA/ABV, ASAvbrown@chaffe-associates.com

Chaffe & Associates, Inc.201 St. Charles Ave.

Suite 1410New Orleans, LA 70170

www.chaffe-associates.com