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Business Valuation and ExitPlanning
Aaron J. Pryor, CFA, ASA
Phases of a Business Valuation Assignment
Define the valuation assignment
What exactly is the subject of the valuation
What is the purpose
Valuation date
Engagement letter
Gather/analyze the pertinent facts
Request for information form sent
Preliminary analysis
Site visit and management interviews
Phases of a Business Valuation Assignment
Apply valuation approaches and methods Determine relevant valuation methods
Earnings and risk assessment
Determine the final estimate of value Reconciliation of results from relevant methods
Sanity check / Test of reasonableness
Draft Valuation Report Management review and comment
Finalize Valuation Report
Define the Valuation Assignment
Assets vs. invested capital vs. equity
Control -- minority
Degree of control depends on ownership structure;existence of other shareholders
Premium or discount is based on comparison
Marketable -- Non-marketable
Closely-held vs. as if freely traded
Degree of illiquidity varies
Discount is based on comparison
Standards of Value
Fair market value
Fair value (statutory)
Fair value (GAAP)
Investment (strategic) value
Intrinsic (fundamental) value
Premises of value
Going concern (most common)
Assemblage of assets
Orderly disposition (liquidation)
Forced liquidation
Revenue Ruling 59-60 - Eight Factors
The nature of the business and the history of theenterprise from its inception.
The economic outlook in general and thecondition and outlook of the specific industry inparticular.
The book value of the stock and the financialcondition of the business.
The earning capacity of the company
Revenue Ruling 59-60 - Eight Factors
The dividend-paying capacity.
Whether or not the enterprise has goodwill orother intangible value.
Sales of the stock and the size of the block ofstock to be valued.
The market price of stocks of corporationsengaged in the same or similar line of businesshaving their stocks actively traded in a free andopen market, either on an exchange or over-the-counter.
Gather/Analyze the Facts Conduct independent research Economic conditions and outlook Industry conditions and outlook Guideline companies Comparable transactions Discount and capitalization rate
Review company information Analyze financial information/ratio analysis
• Adjust for GAAP adjustments, non-operating, non-recurring, excessive discretionary, and related-partyitems
Review company operating data
Plant tour and management interviews
Approaches and Methods
Asset Approach Asset Accumulation
Excess Earnings
Market Approach Guideline Companies
Comparable Transactions
Income Approach Capitalization of Earnings
Discounted Future Earnings
Asset-Based Approach: AssetAccumulation Method
Can be complex and rigorous
Adjust underlying assets and liabilities to marketvalues
Consideration of built-in capital gain taxes if Ccorp
May require assistance of other appraisers (realestate, machinery and equipment, and personalproperty)
Result is controlling-interest basis
Apply DLOM and DLOC, if appropriate
Market Approach: Guideline CompaniesMethod
Value multiples: Equity
• Price / Revenue
• Price / Earnings
• Price / Gross Cash Flow
Invested Capital• Market Value of Invested Capital (MVIC)/ Revenue
• MVIC/Earnings before Interest Taxes Depreciation andAmortization (EBITDA)
• MVIC/Book Value of Invested Capital
Market Approach: ComparableTransactions
• Sources :
– IBA
– Done Deals
– Bizcomps
– Pratt’s Stats
– Mergerstat Review
– Securities DataCorporation
- Acquisition/DivestitureWeekly Report
- Merger & AcquisitionSource Book
- Mergers & AcquisitionsMagazine
- The Merger Yearbook
Market Approach: ComparableTransactions
Important to understand what was exchanged inthe transaction as different sources measuredifferent items
Result is controlling-interest basis
DLOM is controversial
Earnings Approach: Discounted FutureEarnings
Based on the present value of expected futureearnings
Use when historical earnings are not reflectiveof expected future earnings and reliableforecasts of future operations can be prepared
Assumes all operational assets and liabilities in“normal” amounts are acquired by the purchaser
Earnings Approach: Discounted FutureEarnings
Discount Rate =
Risk-free rate (20 yr. Treasury Bond)
+ Equity risk premium
+\- Industry risk adjustment
+\- Size adjustment
+\- Company specific risk adjustment
Weighted Average Cost of Capital =
(Ke X Wd) + (Kd(1-t) X Wd)
Earnings Approach: Capitalization ofEarnings
Based on present value of expected futureearnings
Use when historical earnings are reflective ofexpected future earnings
Capitalization rateDiscount rate – long-term sustainable growth rate
Result may be either a controlling-interest orminority interest depending on earningsmeasure used and adjustments made
Apply DLOM and DLOC, if appropriate
Valuation Discounts and Premiums
Reflect additional risks not already considered inthe valuation process
Meaningless unless base to which it applies isclearly defined
Measured as a percent of some base amount
Minority-control issue is addressed first, thenmarketability
Multiplicative not additive
Valuation Discounts and Premiums
Most common: Discount for lack of control (DLOC)
Discount for lack of marketability (DLOM)
Others: Voting vs. non-voting
Blockage/market absorption
Key person
“Portfolio” or conglomerate
Environmental/litigation
Built-in capital gains tax
Discount for Lack of Control
Deals with shareholder rights
Various degrees of control
Reflects the inability of the minority stockholderto exercise the common prerogatives of control
Sources: Mergerstat Review
HLHZ Control Premium Studies
Discounts for Lack of Marketability
Deals with ability to liquidate an interestquickly, at low cost, and for a relatively certainprice
Various degrees of marketability
Factors: Potential pool of buyers
Restrictions on transfer
Prospects of IPO or sale
Dividend paying history/intentions
Information access/reliability
Discounts for Lack of Marketability
Comparison to of empirical studies Two types:
• Restricted stock
• Initial public offering
Quantification of Marketability Discount Model Controversial
Based on following factors:• Length of expected holding period (EHP)
• Growth in underlying assets during EHP
• Return of capital and income returns during EHP
• Required rate of return during EHP
Reconciliation and Synthesis of ValuationConclusion
Judgment, not mechanical
Industry norms important
Prospective earnings important
Discuss strengths and weaknesses of eachmethod
Private Capital Markets
What is an ESOP?
Qualified, defined contribution employee benefitplan designed to invest primarily in the stock of thesponsoring company.
Governed by the Internal Revenue Code (enforced bythe Internal Revenue Service) and EmployeeRetirement Income Security Act (ERISA) - Enforced bythe Department of Labor.
As with other qualified retirement plans, ESOPs mustmeet general rules concerning eligibility toparticipate, vesting, and non-discrimination.
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What is an ESOP?
However, unlike other qualified retirement plans,ESOPs may borrow funds to purchase stock of thesponsoring company.
An ESOP allows the employees of the sponsoringcompany to acquire a “beneficial interest” in thesponsoring company’s stock.
Because of certain tax benefits associated with anESOP, it is commonly used to finance acquisitions ofbusinesses in a tax-advantaged manner.
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How Does an ESOP Work?
To set up an ESOP, the sponsoring company creates atrust for its employees.
The sponsoring company funds the trust in one ofthe following ways:
Contribute shares of the company stock;
Contribute cash to enable the ESOP to acquire shares ofcompany stock; or
Provide a loan guarantee that enables the ESOP to borrowmoney to buy the shares. The Company then makes ESOPcontributions to the ESOP to enable the ESOP to make theloan payments.
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How Does an ESOP Work?
The Plan trustee buys and/or holds the shares of thecompany’s stock in the trust’s name for the benefitof the employees.
The shares of the company’s stock are allocated toindividual participants’ accounts, subject to vestingrequirements.
When the participants retire or otherwise leave thecompany, they receive either shares of thecompany’s stock or cash equal to the value of thestock.
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How Does an ESOP Work?
The shares of company stock issued to departingparticipants have a put option attached to them thatrequires the trust (or the company) to repurchasethe shares at their fair market value.
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Benefits of an ESOP - Stockholders Diversifies personal wealth.
Creates liquidity for the stock (including non-ESOPshares) by providing a ready market at fair market value.
The owner(s) may sell to the ESOP partially, or in stagesover a period of years so they can gradually ease out ofthe company -particularly important for sellers withmanagement responsibilities.
Maintains “control”.
In a C corporation, the selling owner(s) may defertaxation on the gains by using the Section 1042 "rollover“if the sales proceeds are reinvested in QualifiedReplacement Property (QRP).
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Section 1042 Rollovers
Capital gain taxes on sale of stock to ESOP can bedeferred or excluded: Owner sells stock issued by a domestic closely held C
corporation to the ESOP.
ESOP must own at least 30% of stock after sale.
Seller must reinvest proceeds in QRP, which are securitiesof domestic operating companies.
Seller, seller’s family, and 25% owners cannot receiveallocations of 1042 stock in the ESOP (for 10 years as toseller and family members).
Tax deferral can be permanent if QRP transferred by gift,death of seller, or corporate reorganization.
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Benefits of an ESOP – Company Increased cash flow through tax savings. Corporate continuity and perpetuation. In a C corporation, the company can fund the transaction
with pretax dollars by paying the principal on the ESOPloan with tax-deductible contributions to ESOP ordividends paid on ESOP stock.
In an S corporation, distributions that would otherwisebe used for stockholders to pay taxes on S corporationincome may be used to fund a portion of the ESOP sharepurchase.
Research indicates that ESOP-owned companies mayperform better than non-ESOP-owned companies.
To create an additional employee benefit and spreadcorporate ownership among all employees.
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S Corporation ESOPs
The ESOP is a tax-exempt stockholder of thesponsoring company.
If 100% of the sponsoring company’s stock is held bythe ESOP, the S corporation pays no United Statesincome taxes on its income.
Company can retain tax savings. If retained, value ofsponsoring company’s stock increases rapidly.
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Benefits of an ESOP - Employees
Share in growth of equity in the company.
Motivation – can help to build unity and team spirit.
To build a stronger corporate culture:
Research has shown that ESOPs enhance corporateperformance and job satisfaction by creating a corporate“ownership” culture.
Especially effective when combined with participativeopen-book style of management.
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Who is a Candidate for a Leveraged ESOP?
Company Characteristics:
C corporation (IRC § 1042 rollover)
Increasing earnings / cash flow expectations
Company expects to pay income taxes
Fair market value of $2 million +
20+ employees and stable employment base
Strong management team in place
Sufficient level of underlying assets and eligiblecompensation to support ESOP debt
Participative management style
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Who is a Candidate for a Leveraged ESOP?
Selling Stockholder Characteristics:
Owns at least 30% of all outstanding shares of the stock ofthe company
Has low basis in stock
Investment in company’s stock represents significantportion of personal net worth
Willing to transfer a beneficial ownership interest in aportion of the company’s stock to the company’semployees
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Illustration of 100% S Corp ESOP Transaction
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