Prior to these cases, appraisers generally treated valuation of such discounts as a relatively minor adjunct to the valuation of the basic (majority) position. Many either used “industry standards” for marketability discounts of, say, 35% without support, or they attempted to support these values with statistics from studies of restricted stock of public companies (which can be sold, usually at a discount, from their unrestricted brethren, and by IPO studies of stock values before and after the Initial Public Offering. The courts have virtually all rejected such valuations in the case of closely held securities, and laid down some principles which, if adhered to in appraisals, should significantly limit the chances of litigation. And, if litigated it should dramatically enhance the chances of winning.

Valuation Principles

All appraisals are a defensible opinion of value, prepared by an expert, for an ownership interest. Such an ownership interest is often referred to as a “bundle of rights.” Normally ownership in fee contains the most valuable bundle of rights, and lesser forms such as ownership of a security interest, lease, license, or other such instrument will reduce the bundle of rights – and hence the value. Further, restrictions on marketability or control of such minority interests results in a reduction of value.

If the asset to be valued is a minority interest, and/or if it is subject to restricted marketability, and/or lack of control, appropriate discounts to value must be applied. Over the years, many appraisers have adopted policies that separated the lack of control discount from the lack of liquidity or marketability discount. However, this appears to be a difference without a distinction. All discounts from value appear to be, in the end, evidence of impairments in marketability. The fact that such discounts, even if treated as separate discounts, are multiplicands which are multiplied by each other to derive a final discount figure illustrates this point.

Though the appropriateness of applying such discounts in these situations has been universally accepted by the IRS and the courts, recent court decisions have shown a fair amount of disagreement over the means of quantifying the appropriate discounts. (IRS Revenue Ruling 77-287 deals with marketability discounts for “restricted securities,” but it is silent on “exempted securities,” which make up the vast majority of privately held securities.  Both are defined and described in the Securities Act of 1933.) The cases indicate a complete analysis is required.

To quantify the “marketability discount,” because of a lack of available specific data, some appraisers have been relying on two sources of data from public company transactions;  Initial Public Offering Studies, and Restricted Stock Studies to defend their discount opinion. The “standard” discount often derived from these studies is typically between 30% to 40%. Three cases against the Commissioner in 2003 found that such studies, based upon data from public companies, were not sufficient basis to value  closely held private (exempt and unregistered) ownership. Upon a deeper look the reasons are fairly obvious:

* Initial Public Offering Studies (IPO) show the difference in the price of a stock before the offering and after, and an appraiser may attempt to infer that this is direct evidence to support a marketability discount for an exempt security. This is erroneous for the following reasons:

* Stock values of privately held companies typically are based upon investment value – that is, an investor will be interested in both the current return, and the amortization factor (risk abatement factor) which indicates how long it will take to recover the initial investment. This is necessary because of the high degree of illiquidity of non-public securities.

* The IPO price, on the other hand, reflects a speculative value – that is, the investor is looking mainly towards price appreciation. By its nature once publicly traded, the stock should have high liquidity, so recovery of the investment is not an investment concern. Thus, this study is relevant only to companies anticipating an IPO. Unfortunately, these companies represent less than 1% of the companies extant in the U.S.

* Restricted Stock Studies deal with stocks of public companies that have been temporarily restricted from sale for two years (later for one year) in the public markets (usually by virtue of securities regulations under Rule 144). Nonetheless, there is no prohibition in selling these securities in private transactions where they usually sell at an average of 30% or so less than publicly traded stock. But these are applicable only to publicly traded stocks that have only a temporary restriction from public markets, and not on the general ”permanent” illiquidity problem faced by small privately held companies which would make them far less marketable.

* Control discounts, (or more appropriately control-based marketability discounts) for small privately held companies are magnified in comparison with publicly held companies for a simple reason – in privately held companies the only practicable way to recover the investment is liquidation (sale) of the company. Without control, an investor does not have the right to exercise this option. Thus minority interests in closely held companies are very difficult to sell. In practice, in the past appraisers have often attempted to base discounts for lack of control on control premium studies of public companies. The two are not the same at all.

The case of Mandelbaum v. Commissioner, T.C.M 1995-255 determined that use of irrelevant data is unacceptable, and sets forth some basic factors which might comprise the discount, but specified that this list was not exclusive, and other factors may (and should) apply as the situation dictates. It basically states that a complete analysis must be done which is relevant to the subject. The factors listed to be evaluated included but were not limited to:

• Private vs. public sales of stock
• Financial statement analysis
• Dividend policy
• Nature of the company, history, position in the industry and economic outlook
• Management
• Amount of control in transferred shares
• Restrictions on transferability of stock
• Company’s redemption policy
• Costs associated with making a public offering

IRS Revenue Ruling 77-287 deals with marketability discounts for “restricted securities”, but it is silent on “exempted securities,” which make up the vast majority of privately held securities. Both are defined and described in the Securities Act of 1933.

Post by: Gerald W. Barney MS, CSBA, CMEA

American ValueMetrics Corp.
www. Americanvaluemetrics.com
info@americanvaluemetrics.com

They are:

• Assets in place and ready to use as a going-concern (capital, labor and management)
• Excess economic income over that justifiably allocated to other assets
• Expectation of a valuable future event, such as gains on a sale

An appraiser must assess all of the attributes of a business to determine if items one and three on the list above pertain.

We have written in past articles that a company’s cash flow is the key to its value – greater cash flow begets not only greater value, but it fetches a higher “premium”, or multiple of revenue or cash flow, as the size of the cash flow increases. But, what if the cash flow is negative? All is not necessarily lost; there may be value to be found even when times are difficult.

These days, with the massive challenges all businesses face in our economy, cash flows for most companies have suffered. If you are looking for opportunities to sell your business, or merge with or acquire another business, you may look beyond the cash flow to find its real value.

Tangible Assets are the first place to find value. Your equipment, furnishings, vehicles, etc. all have some value depending on their age and condition. The tangible assets typically will sell for their market value without much of a premium (although in some cases they have greater value if sold as a functioning set, rather than sold off as individual items). Intangible assets that may be transferred (called discrete intangibles), such as franchise fees and licenses, also carry value.

Next, look for other intangible value; that is, value beyond the tangible and discrete intangible assets of the company based on what they add to company performance.

Here are some common places to look:

Location and Facilities of the business: Excellent location and leases with favorable terms that can be transferred may add intangible value.

Customer List: For businesses with a great deal of repeat business from its clients, the database of clients certainly has value.

Proprietary Processes: Businesses whose success is partly due to proprietary processes, technology, or methods, have value in those processes or technologies. These processes should be documented in such a way as to be transferable and repeatable by a new owner.

Patents and Copyrights: Patents and copyrights for useful, saleable products or information add to the value of the company, as long as they belong to the company and not the owner.

Personal Goodwill: If a significant proportion of the company’s success is related to the owner’s knowledge, skills, personality, reputation, etc., that is called “Personal Goodwill”. This means there is significant risk to the business if the owner leaves the company (and the value leaves with the owner). Some ways to keep the value with the company and not the owner personally are to sign a non-compete agreement and to transfer the Personal Goodwill to Institutional Goodwill. This transfer happens through training remaining employees, formalizing agreements into contracts, and staying with the company after it is sold for an agreed period of time in order to train the new owner.

Certifications, Best of Breed: Certifications and recognitions of the company as a valued supplier or “best in breed” will also likely add to the value of the company. Oftentimes, communities have publications of certified suppliers, and to be included requires an application process.

In general, anything that can be done to formalize the advantages of a company into something that is transferable and repeatable should increase the Intangible Asset value.

Also, information can be determined for sales comparisons of companies with significant negative cash flows which still sell at a premium over hard asset value. This is common, for instance, in health care facilities, where the entity has significant value in licenses, certifications and entitlements, which create an expensive replacement value component, which is not discrete – that is it cannot be detached from the business and sold, and therefore contributes to non-discrete intangible asset value, or “goodwill”. A professional business appraiser can assist in determining that value, and a broker can help you market all the advantages your company has to offer.

Post by: Gerald W. Barney MS, CSBA, CMEA

American ValueMetrics Corp.
www. Americanvaluemetrics.com
info@americanvaluemetrics.com

Discrete Intangible Assets: are assets which have a legal existence in and of themselves and which may be transferred independently of the business. Examples are intellectual properties such as patents or copyrights, franchise agreements, licenses, proprietary processes and trade secrets, administrative policies and procedures, etc.

What distinguishes Discrete Intangibles from Non-Discrete Intangibles is that they meet the following criteria:

They:
•    are subject to specific identification and recognizable description.
•    are subject to legal existence and protection.
•    are subject to the right of private ownership, and the private ownership should be legally transferable.
•    have some tangible evidence of the existence of the asset.
•    have been created or have come into existence at an identifiable time or as the result of an identifiable event.
•    are subject to being destroyed or to a termination of existence at an identifiable time or as the result of an identifiable event.

Unless Non-discrete intangible assets have a stream of profits that is separable and identifiable, such as a stream of royalty payments, they are otherwise analyzed as if they are part of the going-concern value and not valued separately from it. However, their presence can significantly influence the appraiser’s analysis and judgment as regards an appropriate capitalization rate and can result in a premium on value.

Non-Discrete Intangible Assets: Intangible Assets which are not discrete, but which have an economic value are usually classified as “Goodwill Intangible Assets” or “Going Concern Value”. The value of these assets lies in the principle that when all of the elements of a business system (capital, labor, management) are combined in a going-concern (or able to be going-concern), the value of the whole exceeds the sum of the value of the parts. It is important to recognize that it is a quantifiable number, and not just a “feeling” about the business.

There are three elements that create Going-Concern or Goodwill Value.  Not all three need to be present to create the value.

They are:
•    Assets in place and ready to use as a going-concern (capital, labor and management)
•    Excess economic income over that justifiably allocated to other assets.
•    Expectation of a valuable future event, such as gains on a sale.

Book Value Intangible Asset Values: Where intangible assets of any sort are shown on the balance sheet as part of an allocation of purchase price resulting from an acquisition, they do not necessarily reflect market value. The appraiser must determine the current market value of these assets, and adjust the balance sheet by removing the “book values” and replacing them with appraised intangible asset values which are determined in the course of the appraisal process.

Personal or Professional Goodwill: When either of these exist (they are functionally identical) they are normally included in the total goodwill value shown for a business unless there is a specific reason not to. When included in the total value, the underlying assumption is that any buyer of the business will insist upon mitigation measures to preserve the personal or professional goodwill values for the business. This is normally done by non-competition agreements, employment contracts, and a period of time specified for continued involvement in the business by the holders of these assets. In divorce cases an exception arises. When a business is being valued for a marital dissolution it is necessary to further analyze whether or not mitigation measures are feasible, because the divorcing spouse who holds the personal or professional goodwill may not be willing to enter into a mitigation agreement. It is further necessary to review the prevailing court cases pertaining in the particular state. Some states count personal or professional goodwill as a marital asset, others do not. It takes coordination between the respective divorce attorneys and the appraiser to determine the proper way to handle personal or professional goodwill in these cases.

Post by: Gerald W. Barney MS, CSBA, CMEA

American ValueMetrics Corp.
www. Americanvaluemetrics.com
info@americanvaluemetrics.com

Aside from understanding the operations of a business, one of the most significant issues to evaluate is the return on your investment. To do this, a “capitalization rate” is applied to the cash flow (see this previous blog post for a description of cash flow). This capitalization rate applies an estimate of a rate of return to determine how quickly the investor can expect to recoup the investment.

Determining the right capitalization rate to apply to a business requires some knowledge – either of the dynamics of the industry itself, or access to information related to the industry. Business appraisers have access to data and ways to determine a meaningful capitalization rate for an industry and can provide objective expectations based on historical capitalization rates for the industry adjusted to current market conditions.

Despite theoretical capitalization rates, the real issue to consider is how the investor will look at the opportunity. Part of the thought process for understanding the expected rate of return (capitalization rate) is the idea of the opportunity cost of investing in a particular company versus investing somewhere else. The two considerations are the “return on capital” and the “return of capital.” In short, an investor will want to receive a current return of at least a “risk free” investment. But his only way to mitigate risk is to receive a return of the total investment in an acceptable period of time. This will ultimately determine the acceptable capitalization rate for the buyer. In concept it’s simple. If the buyer wants the equivalent of a risk free 5% return, and wants to recover his investment (pre-tax) in five years (20%  per year), then the acceptable capitalization rate will be 5% plus 20%, or 25% total. The normalized adjusted net operating cash flow is normally divided by the capitalization rate to determine the value. A particular buyer’s acceptable capitalization rate may be significantly different than one derived by an appraiser. It is his personal standard. That is why an appraised value is really the most probable value for a sale within a range of possible values.

It is actually easier to use the inverse, or reciprocal, of the capitalization rate, which becomes a multiplier. So if the cap rate is 25%, the inverse is 4.0 (1/.25) and the value would be 4 X the normalized adjusted net operating cash flow.

At a minimum, a company should be expected to produce enough cash flow to provide a reasonable return on the fixed assets. Any cash flow beyond this minimal level is called “Excess Earnings” and is applied to the intangible asset value. This is a way of determining the goodwill value.

Other items to review include inventory and accounts receivable. It is important to understand the inventory situation (if applicable to the company). This includes calculating inventory turns and understanding the amount of obsolete inventory. Companies with low inventory turns tie up their precious cash in non-productive uses for longer than necessary. Similarly, companies with a history of collection issues and/or receivables that are left in aging too long are not maximizing their cash position. Both inventory and receivables can add or subtract value depending on how well they are managed.

To show maximum investment value requires thorough documentation in an Offering Memorandum (or Private Placement Memorandum). This is usually prepared based upon an appraisal, but contains other information relevant to the investment potential.

In summary, a business is basically an intangible asset, though it may contain some tangible assets. The perceived value depends on how well the intangible aspects are shown to have value.

Post by: Gerald W. Barney MS, CSBA, CMEA

American ValueMetrics Corp.
www. Americanvaluemetrics.com
info@americanvaluemetrics.com

But the data itself is problematic.  The most common databases are Pratt’s Stats and BizComps.  These sources of data are organized by Standard Industry Codes (SIC).  This may seem reasonable, but in fact there is as much variation within a particular SIC as between different SICs.  The reason is there are an infinite number of business models, and each produces a different return on investment.  This, and other facts outlined below indicate that the so-called “data” is not really data at all as used in the statistical analysis sense.  It is really a series of loosely correlated data points, which much be interpreted virtually as anecdotal evidence.  It also is usually unverifiable, coming from third party volunteer sources.

The shortcomings generally are that they represent different:

1.    dates
2.    observers
3.    accounting methods
4.    business models
5.    scale (i.e. gross sales)
6.    geographic areas
7.    economic climates

In analytical terms it is a multivariate array which makes attempts to analyze it with conventional statistical analysis tools, using normal distributions and standard deviations, meaningless.

So how do you deal with this information? American ValueMetrics uses a methodology known as “heuristics.”

What is Heuristics?  Heuristics is a “decision support” methodology.  It is a predictive method (in appraisal, predicting a value).  It is an important methodology that appraisers, and users of appraisals, should become familiar with.  It is an alternative to mathematical/statistical analysis that can be used when data does not meet the relatively rigid requirements for use of mathematical/statistical analysis methodologies.

The Source of the word “Heuristics” (pronounced hyu-RIS-tiks) is the Greek “heuriskein” meaning “to discover”.  This is the same source as the word “Eureka” meaning “I have found it.”

In the past twenty years it has been refined into a modern problem solving and analysis methodology, usually associated with systems science.

It deals with decision making where specific reliable data is not available, and/or the time and cost of obtaining such data necessary for a conventional statistical analysis is simply not feasible.  Heuristics is the art of drawing inferences when faced with limited, incomplete or fuzzy data.

For valuations in the area of business assets, or unregistered, exempt, closely held securities or where transaction data is sparse, it is an appropriate methodology for determination of central tendencies, such as price/earnings ratios.  It is especially valuable in evaluating minority and control discounts in a defensible way.

In practice, the information is ranked and weighted, based upon the judgment of the appraiser.  This requires experience.  The heuristics process is dependent upon an innate quality of the human brain called “pattern recognition.”  We all operate this way.  A good example is our understanding of words in a language context.  Words are comprised of letters, which approximate sounds, which are strung together to convey ideas.  When you hear a spoken sentence, your mind completes pattern recognition and you can intelligently understand (hopefully) what the speaker is saying without trying to analyze each letter or each sound.

The same process holds true in an appraiser’s analysis of comparable business sales data.  An experienced appraiser sees patterns in the data, and can readily rank or weight the data as to relevancy to his subject business.  The problem is broken into many small decisions, and reintegrated using a mathematical approach, usually a weighted average.  When the resultant is a capitalization rate or a capitalized value, it is amazing how accurate it is.

So when data is not limited to one variable, and is not widely available, and is not verifiable, the heuristics approach is the most efficacious approach available for making sense of the comparable sales data.