Science fiction and theoretical physics have identified the paradoxes that could be created if we could travel back in time. What if we could prevent the Kennedy assassinations, Earnest Byner’s fumble in the 1988 AFC Championship Game (both hugely traumatic for me), or our parents’ meeting (in which case we would not exist)? Writers and scientists resolve these paradoxes by concluding that backward time travel that changes history creates alternate realities…

Back in the reality of business valuation, we travel backward in time when we normalize financial statements. Whether we are adjusting for extraordinary events (Type I adjustments) or owner-specific items like compensation (Type II adjustments), we indeed create alternate business and financial realities.

In these alternate realities, business owners might make different decisions. If, for example, normalized cash flow increased relative to actual, owners might have paid down (more) debt, reinvested more for growth, or paid dividends to themselves. These choices could lead to materially different risk and return profiles for their businesses, with major valuation implications.

This line of thought parallels economists’ debates about “static versus dynamic” analysis of government fiscal policy. A static analysis assumes that there will be no indirect or second-order effects from a policy change. If you cut the capital gains tax rate, then federal revenue from this source will decrease. A dynamic analysis considers whether investors might realize more capital gains (at lower taxes) because they could reinvest the proceeds to earn higher returns elsewhere. The famous “Laffer Curve” arguing that government tax receipts would increase if tax rates were cut (because of faster underlying growth) is a great example of a dynamic analytical argument.

We need to think about this when we normalize financial statements. A static analysis that assumes that (higher) normalized cash flow is simply retained in the business might not be reasonable.

Many businesses maintain two sets of books: one for financial reporting and one for income tax purposes. Financial reporting follows GAAP (generally accepted accounting principles) promulgated by the Financial Accounting Standards Board. Tax return reporting is per the U.S. Tax Code. GAAP reports higher net income than tax because GAAP permits earlier revenue recognition (e.g., when bills are sent as opposed to when payment is received) and later expense recognition (e.g., straight line as opposed to accelerated depreciation). This creates temporary and permanent differences in GAAP and tax income before taxes and tax expense as well as “deferred tax” assets and liabilities on GAAP balance sheets.

Which is better for valuation, GAAP, or tax? I was taught that GAAP is preferable in theory. Rather than arguing theory, let us take a pragmatic approach.

First, consider the purpose and use of the appraisal. If you are doing goodwill work, purchase price allocations, or employee stock option valuations for (GAAP) financial reporting, then of course you need GAAP financials. (That was easy

What about tax, transaction, and litigation jobs? You might think that tax work dictates that tax returns be used, but Revenue Ruling 59-60, right at the beginning, requires that “all available financial data” be considered. That includes GAAP statements (but see the next paragraph). Transactions are often based on investment value, which means whatever the parties can agree to. In my experience, in litigation there is rarely a law that stipulates GAAP or tax. For these three arenas, GAAP versus tax issue can be an open issue.

Now a real-world problem raises its head, but we can use it to simplify and justify things. Most small businesses prepare tax returns but not GAAP financials. It might be a big, expensive deal for them to recast their tax returns on a GAAP basis. (This is a job for their accountants. You can if you are qualified. I am not. A man has to know his limitations. On that basis, my masculinity is unarguable.)

Here is how I tackle this. I check out the RMA data and the “Type of Statements” table for the industry. I compute the percentage that are tax returns and assume that the balance is GAAP. If the tax percentage is high, then I am comfortable:

1. Comparing subject company tax return data to industry data.
2. Assuming that most of the company sales and data reported in the IBA Database and Bizcomps are tax-based. Thus, my application of the Market Approach will be apples to apples.

If the percentage is low, then I need recast GAAP statements for comparative financial analysis and the Market Approach., or I cannot complete them.

Here is another practical consideration. If I am going to use the Asset Approach (with a liquidation premise of value), then I do not care whether statements are tax or GAAP. I will adjust the balance sheet to reflect current (fair) market values.

If, however, I am going to use the Income Approach, as I often end up doing because there is too little data for the Market Approach and liquidation is inappropriate. I need a GAAP recast. As noted above, GAAP net income will be higher. However, GAAP also makes accruals and tax statements often do not. (A tax return may not reflect checks and deposits that have not cleared, because it is on a cash basis. GAAP statements remedy that.) GAAP gives a more accurate picture of net income and ultimately cash flow to equity.

However, there is yet another safety valve: materiality. Before I demand GAAP recasts, I ask the client (and their accountant) whether GAAP statements will be materially different from tax (with respect to revenue, net income, and cash flow). If not, then I use tax returns.

The bottom line is that GAAP is superior in theory to tax returns for valuation, but there are many practical reasons for which you might be comfortable using tax returns.

Several times each year I am asked to value, for estate tax purposes, interests in private entities, like real estate limited partnerships, for which the only data the executor could obtain were an operating agreement and historical K-1’s. For whatever reasons, the managers of the entities were unwilling to furnish complete financial statements, asset appraisals, forecasts of future results and distributions, and other requisite data.

What to do about these cases?

1. Generally, I do the best I can with the data furnished. I capitalize historical distributions at a low rate, assuming they will continue with low risk. I usually ignore capital account values because they reflect depreciated historical asset values, not current market values.
2. I cite the data limitations and the fact that I did my best to overcome those. I also state that I will revise my report if the regulatory authorities (i.e. the IRS) can help me obtain what I could not get.
3. I do not usually apply a lack of control discount, because historical distributions reflect the control owners’ policies.
4. I do apply a significant lack of marketability discount based on transfer restrictions as well as the lack of data available, which would make a typical buyer less willing than normal to invest.

If you are doing FAS 123R or IRC Section 409A work valuing stock options, this post is for you!

Option valuation models require as an input the volatility of the price of the underlying stock. This is mathematically defined as the standard deviation of the stock price. Volatility is easy to calculate for publicly traded stocks.

What is increasingly bothering me, however, is the need to estimate volatility when dealing with thinly traded or private (non-traded) stocks. The FAS and IRS recommended procedures involve relying on the volatilities of “comparable (publicly traded)” stocks, but in my opinion, this is not a perfect solution. I cannot, however, think of anything better than the recommended procedure, and that bothers me even more.

Volatility increases as trading volume decreases, because thinly traded stocks have more price fluctuations than do heavily traded ones. Extrapolating that to a fully private (non-traded) stock, volatility should be infinite (or exceptionally large). This blows up the results of option models. Alternatively, maybe volatility for a private stock is really zero, which also blows up the models.

If you use an average of comparable publicly traded companies, the first problem occurs if the subject is far smaller than they are, not to mention less liquid. The second one is that the volatility of the average will be less than that of the typical company, because price movements are not perfectly correlated. Some stocks in the average go up when others go down, making the volatility of the average less than that of the individual stocks. Third, there may have been discrete company-specific events (such as a merger announcement) that temporarily increase (or maybe reduce) volatility and these have to be factored out, a big statistical job. Therefore, the best solution is to identify a few comparables and infer volatility from them.

All of the preceding, however, is based on historical results and volatility, and the option models require that we input expected volatility. To make expected volatility equal to historical assumes the future will be like the past, which could be wrong. But to develop expected (implied) volatility, you have to look at individual options, identify their prices, and solve the option valuation models for the volatility that makes calculated option value equal to market price (taking into account their maturities, dividends, etc.). This is also a big statistical job. Moreover, the comparable options may differ greatly in their other characteristics (maturity, dividends on underlying stock, etc.)

Therefore, we are in a difficult situation. There is no ideal solution to the volatility estimation problem, and we know that the recommended procedure is imperfect.

Does anyone have a brainstorm about this?

Because valuation methods, data, and judgments are all imperfect, we often develop divergent value indications using the Income and Market Approaches. (The specific methods do not matter for purposes of this post.)

Let us say we are valuing a minority interest at fair market for tax purposes. We came up with an enterprise value indication of $100 using the Income Approach and:

Case 1: a Market Approach value indication of less than $100
Case 2: a Market Approach value indication of more than $100

Assume also that the Income Approach value indication is proven by the justification of purchase test, and that our Market Approach value indication is based on enough transactions to be statistically robust.

Before we apply discounts, we have to reconcile the different value indications. (Ignore the fact that the Income Approach value indication is definitely at the marketable level, and the Market Approach value might reflect some discount for lack of marketability, as when we use IBA data.)

In Case 1, decide how you want to weight the two value indications. Whatever you select, the value will be less than that for the Income Approach, and greater than that for the Market Approach. In my opinion, the over and under-valuation errors are offsetting. The concluded value will be greater than that of the Market Approach and less than that of the Income Approach. No big deal!

In Case 2, decide how you want to weight the two value indications. Whatever you select, the value will be less than that for the Market Approach, and greater than that for the Income Approach. In my opinion, the over and under-valuation errors are offsetting.

In the second Star Trek movie, “The Wrath of Khan”, we learned that, as a Starfleet cadet, Captain Kirk passed an impossible test (the Kobayashi Maru exercise) by changing its rules. The analogy to business valuation is to check the assumptions you made in developing the Income and Market Approach value indications. They should be based on the same levels of sales and earnings. If they are, then maybe your concluded valuation multiples are not consistent, and you need to think about that.

Revenue Ruling 59-60 requires that fair market valuations consider both earnings and dividend-paying capacity.

Another benefit of using equity cash flow as your Income Approach valuation metric is that it allows you to consider both capacities at once! Equity cash flow starts with net income and adjusts it for non-cash items, capital outlays, asset sales, and changes in debt, working capital and other assets and liabilities. It measures “earnings” better for valuation purposes than does net income, and it also makes it easier to apply market rates of return (discount and capitalization rates) because the latter are based on cash flow as well. In addition, it is a direct measure of dividend capacity because cash flow to equity is the change in cash after all of the above factors are accounted for but before dividends are paid.

Therefore, equity cash flow gives you a two-fer!

Because I relatively little litigation support work, when such assignments come my way, I have to do more than the usual amount of thinking about one of my favorite topics, defining the engagement parameters: date, premise, standard and level of value.

I am working on a valuation of an Ohio business in which a minority shareholder (the son in-law of the founder-control shareholder) was terminated for alleged but unknown (to me, as will be explained below) reasons. A claim (by son in-law) and counterclaim (by the company’s other shareholders) have been filed. Both sides, however, really want to negotiate a settlement out of court. Plaintiff (son in-law) is suing for lost wages alleging wrongful termination. Defendants are countersuing to redeem his minority interest. Compensation experts have been hired by both sides to help with the lost wages issue; it is not my concern, except that whatever they might agree on will have to be factored into my ultimate valuation conclusion. My job is to value the minority equity interest for settlement purposes, subject to that revision.

The valuation date is agreed upon, and the premise of value is clearly going concern because the business has always been very profitable, cash flow positive, debt-free, and is expected to remain so. (My preliminary analysis confirms that beyond a doubt).

What is not established are the standard and level of value. This is complicated by the facts that (1) there is no buy-sell mechanism in place; (2) the emphasis on settlement negotiations (not litigation); and the details of plaintiff’s claim and defendants’ counterclaim. When I asked, as I always do, to see those claims, I was refused because (apparently) there is a great deal of salacious material in them and both parties wanted me not to be influenced by that. I did ask, and it was confirmed, that the claims and counterclaims do NOT involve the exercise of dissenting shareholder’s rights.

With that information, I reasoned as follows. This is definitely not a tax case, so fair market value does not apply. Neither does fair value (dissenting shareholder sense), at least not yet. In addition, neither does fair value (financial reporting sense) because this is not a financial reporting valuation.

That left only investment value available to me as a standard. Because the valuation is for settlement purposes, I think that is the right standard, because it is based on what each party wants and their situations, not on third-party considerations. It is like a “friendly” shareholder buyout in which it is up to the parties to make a deal or no deal, not the appraiser to set a value.

This led me to conclude, after much more time than it takes to explain it here, that the level of value is up to the parties. They, not I, will decide whether discounts for lack of control and / or marketability apply. I am going to present three value conclusions for the subject minority interest: pro rata (no discounts) share of enterprise value, marketable minority (discount for lack of control only) and non-marketable minority (discounts for lack of control and lack of marketability) and let the parties decide.

I do a great deal of work for multi-owner businesses in which one or more shareholders want to buy out others. In this post, I am focusing on “friendly” buyouts that have not progressed (or regressed) to litigation (dissenting shareholder matters). As such, it is up to the parties to decide the standard, premise, date, and level of value. (They decide, with my suggestions, whether discounts apply, etc.) In these cases, they are interested not only in the value of the interest(s) to be bought out, but also in the terms of the deal (e.g. how much cash at closing, how much paid over how long a period, whether there will be earn-outs, etc.); in other words, whether they can afford the buyout. In most cases, the company (not the remaining shareholders personally) will buy the shares.

We can be of great (but not total) help to clients in this situation. The reason we cannot be of total assistance is that issues like consulting contracts or covenants not to compete involve the expertise of accountants and attorneys. We can factor their recommendations into our analysis, but we are not qualified to develop these on our own.

When we do our appraisal, we come up not only with the value of the subject interest(s) but also a forecast of net cash flow to equity for the subject business BEFORE the buyout is considered (but including the effects of changes in compensation or performance attributable to the departure of the shareholders to be bought out). The latter is developed as an element of the Income Approach.

With the interest value(s) and cash flow forecast in hand, we have what we need to give a preliminary assessment of affordability. If, for example, we concluded that the interests to be bought out were worth $50,000 and the business will have net cash flow to equity of $25,000 per year, it would take two years to buy out the interests if we ignore (1) cash on hand in the business (2) business debt incurred to finance the buyout, (3) cash contributed personally by buyers (since this is a corporate redemption). However, this would leave no cash flow available in case something goes wrong, and it might violate bank loan covenants. Therefore, we might suggest extending the buyout period to four years, in essence, reserving half of each year’s equity cash flow for the use of the business and committing half of it to the redemption. If the business is very volatile, we would suggest raising the amount dedicated to the business and lowering the buyout amount (extending the term).

This is a rough sketch of how the affordability analysis works. If covenants not to compete or consulting contracts are introduced, they can easily be factored in (on an after-tax basis) to the cash flow analysis. So could any of the excluded factors in the previous paragraph.

As a follow-up to my previous post, a good example of the difference in perspective between operators and investors comes up when we talk about profit versus cash flow (to equity). Business owners are very familiar with the former, but not necessarily with the latter.

The discussion often starts like this. Operator says: “In the stock market they always talk about P/E (price to net income per share) multiples. When deals are made, they talk about price to EBIT or EBITDA multiples. In my industry, they talk about multiples like one times sales.”

Let us try to explain this from the client’s point of view.

You are right about that! When we talk about what other companies sold for, we often use multiples like the ones you just mentioned. This is called the Market Approach to valuation, and it is based on sales of comparable businesses. Houses are valued based on comparables, too.

The problem is that your business is too small to be compared to big companies and deals. Those companies are much larger, more diversified, have deeper management and more financial resources than you do. Therefore, they are worth more, pound for pound. We have to look for comparable sales of smaller businesses like yours. The problem is that, unlike houses, business sales are not usually reported. Therefore, there is often little or no data on comparables.

People who want to buy your business are interested in cash on cash return on investment. They want to know how much they will have to pay to buy it (and when) and how much cash they can expect to earn from it (and when). They are also very interested in how risky or uncertain your business is. The more risky it is, the higher the return they have to earn to compensate them for taking the risk. You can buy a government bond that will yield you 4% today, with no risk. However, if you want to buy a stock, whose price and dividends are not guaranteed, you expect a lot higher rate of return, often about 20% or more.

Buyers of your business want to be sure that:

1. They will earn a fair salary for managing it (or pay that to someone else to do so).
2. They will be able to pay back all acquisition and assumed debt, with interest, in a timely and safe manner.
3. They will earn a reasonable rate of return (in cash) on their investment. (This does not apply to buy-a-job businesses).

This way of valuing a business is called the Income Approach. It is not based on comparables, but rather on the cash investment, cash return, and risk of the business. Things like sales and EBIT do not measure cash and cash flow. They measure profit, which is a different thing. The ultimate cash return on investment from a business is, very simply, the change in cash each year after all bills are paid, payroll is met (including a fair salary for you as manager), debt is serviced, and before any dividends are paid.

Let’s look at your financial statements. There are accounts receivable and payable. These reflect sales you made but for which you have not been paid, and things you bought which you have not yet paid for. The income statement reflects your sales and profits, but it does not show what is happening to your cash. If you pay your bills in 30 days but aren’t paid for sales for 60, a great deal of cash is tied up in receivables. If your sales go up, so will your profits, but the receivables will eat up more and more of your cash. Eventually you will have to borrow or put more money into the business to keep it solvent. This is a case where profits are growing but cash flow is negative. That is going to cause problems for you and a buyer.

Very simply put, you cannot spend profits, but you can spend cash. We look at cash flow because that is how buyers will value your business.

Last night I watched the classic Paul Newman movie “Cool Hand Luke”. The scene where the warden utters the famous phrase “What we have here is a failure to communicate” inspired this post, which compares the mindsets of business owners and business appraisers.

My thesis is that if you talk like a business appraiser, you risk confusing (or worse) your client because they may have no idea what you mean. Your reality (valid as it is) is simply not the same as theirs (valid as it also is). If they do not understand what you are talking about and why, they will probably not be willing to hire you. This builds on the great work done by Rob Slee in identifying the different “Value Worlds” of business and by Frank Evans, who works extensively with private company owners, helping them to view their businesses differently to increase their value.

If I had to summarize the different perspectives of owners and appraisers in two words, it would be “operator” versus “investor”.

The business owner is the operator (who both owns and manages it), focused on running their business and “making money”. Their time horizon is usually short (last month, today, and next month). They do not have a well thought out business plan. They want to “make money” by taking as much compensation out of the business as they can and minimizing this year’s income taxes. They think about the value of their business in terms of “what I could sell it for”, “what I need to sell it for (and retire)”, anecdotal evidence such as “industry multiples” (of what or rules of thumb, book value plus “goodwill” plus “potential”, all of which are vague. They probably do not have a well-trained, competent successor in place. The business is very dependent upon them, their health, skills, contacts, experience, and undocumented knowledge. Major change is anathema to them. The concepts of lack of control (for minority interests) and lack of marketability (for private equity) are often things they have never considered. Their feelings about debt are often emotional (“I hate it”, or “I borrow as much as I can”). They also have strong motivations for the value direction (high if they are selling, low for tax purposes, etc.) They may want us to come up with a valuation “formula”.

As appraisers, we try to replicate the behavior of typical buyers, who are investors in the equity of the business. Investors think about the future, not the past. They look for cash flow (to equity) as the measure of return – realized as dividends or appreciation (if reinvested), discounted for risk, over a multi-year time horizon. Forecasts are essential. So are comparable sales of private businesses. They are very concerned about key person risk – if the seller retires, will they have to pay for consulting or a non-compete, and can they find a competent manager (if they are not going to be active owners). They understand discounts for lack of control and marketability. They understand the difference between return on labor (fair market manager compensation) and return on equity. They will use debt prudently. Investors and appraisers employ numerous approaches and methods to develop and verify their value conclusions, based on careful analysis of the environment, the economy, the industry, and the company.

In addition, depending on the situation, appraisers understand that different standards of value apply. There is a big difference between fair market value for tax purposes, fair value (in the dissenting shareholder or financial accounting applications), and investment value. Moreover, if we are acting as appraisers, we have to be independent and objective.

If you do not believe that the different perspectives (operator versus investor) exist, I have a question for you. How much time have you devoted to thinking about your practice as an investor would, rather than as you do as its operator?

This is a broad treatment of the difference in perspective between operator-owners and appraiser-investors. I hope it helps you bridge the gap between them when working with clients.

I have had a flurry of great questions from blog readers lately! Thank you so much, and please keep them coming. Your great questions guide me as to topics for this blog.

Is there a lack of marketability discount (LOMD) for control (or 100%) interests?

This is an unresolved and controversial issue because we have no data with which to measure directly a control LOMD, if it exists. All of the marketability discount studies involved MINORITY interests. These suggest an upper bound for the control LOMD, if it exists.

Some believe that a control LOMD is offset by the ability of the control owner to appropriate free cash flow while the business is being sold. That may be true, but what if there is little or no free cash flow?

In my view, there is a control LOMD but it is less than that for minority interests. This is because it takes months or even years to sell a privately owned business. Therefore, there is a time value – a discount, or opportunity cost – associated with a sale that takes a long time. In addition, that cost is related to the cost of equity capital, which is usually about 20% (pretax to the investor) or more.

If you are submitting CBA demonstration reports, the way to handle this issue is to first state that it is controversial, and why. Then take your stand as to how big it is (if you decide to take one) and why. (Hint: see the above

What is the cost of equity capital for a “buy-a-job” business?

This question is actually self-contradictory. If a business offers a buyer only the prospect of employment, and the buyer is interested only in employment, then what we are saying is that they are NOT motivated by return on equity! Therefore, the capitalized or discounted value of equity cash flow is irrelevant, as is the cost of equity capital!

Think about it this way. The Justification of Purchase Test is a tool we use to check the validity of a value conclusion. We used the Market Approach to come up with a value for the business. The Justification of Purchase Test says that that value is reasonable if the business, acquired for that amount, can:

1. Pay the buyer (owner / manager) a fair market or reasonable salary.
2. Adequately repay all assumed and acquisition debt (interest and principal).
3. Generate an adequate return on equity investment.

For a buy-a-job business (like my solo appraisal practice), the third criterion is irrelevant! If the business can be bought for a price that pays the buyer a fair salary and can adequately service debt, then the price is justified. What this means is that when you project the results of the acquired business (with buyer’s salary and debt service included), there should be little or no money left over for dividends or distributions. THAT IS OKAY! The buyer does not care about generating dividends or distributions, i.e. return on equity.

What we are doing here is using the Income Approach as a means of double-checking the Market Approach value. The only twist is that all that counts is salary and debt service, not cash flow to equity (as long as the latter is zero or positive).

Now, you might ask, but if there is little or no cash flow to equity, then the buyer’s return on investment is near zero. How does that jibe with the 20% cost of equity capital? MY POINT IS THAT THE BUYER DOES NOT CARE, since all he or she wants is a job and to be able to repay debt.

Tying together report sections (economic, industry, and company analysis) with your valuation analysis (financial forecast and determination of discount rate).

I conclude each major report section with a paragraph highlighting the implications of that section for the valuation of the subject company. I discuss what it means for:

1. Revenue growth
2. Operating profit margin (EBIT)
3. Debt financing cost (interest rates)
4. Business risk (volatility of EBIT)
5. Financial risk (risk of insolvency or worse)

Items 1-3 suggest assumptions for your financial forecast. Items 4-5 come into play when estimating the discount rate and company-specific equity risk premium.

A note on style. IBA’s sample reports have separate sections for the Company qualitative analysis (management, products, markets, etc.) and quantitative analysis (historical results, percentages, trends, ratios) and financial forecast. I combine them into one big Company section in my reports, and draw the above implications at the end of it.
This is a matter of style, not substance. Do whatever makes the most sense for you. I find it hard to draw implications from the Company qualitative analysis alone; it is much easier after I have done the numbers.

“Stale comparables” from the IBA or similar private company transaction databases.

Some years ago, Ray Miles analyzed the ENTIRE IBA database (combining all of the industries and data) and found that price multiples for the whole were remarkably stable over time. I do not know whether that study has been updated.

Obviously, a study of the whole database over time cannot be used to make inferences about a specific industry. You have to look at that industry by itself to see if multiples are stable or not. If, based on your industry analysis section, you might find that there have been material changes in factors affecting the industry. Then, the reliability of older transactions is obviously questionable and you have a decision to make about how far back to go before data become stale and irrelevant.

The best is saved for last: how long should a full valuation report be?

First, let us make a distinction between demonstration and real reports! In demos, you are required to show that you can utilize the whole gamut of appraisal approaches, methods, and procedures, and you have to explain them in detail. My demo reports (which, of course, were heavily criticized the first time around) were each about 60 pages excluding exhibits. Since that time, I have boiled down my template for a full actual report to about 25 to 30 pages (excluding appendices). Some are much shorter (i.e. when a company has negative net worth and is unprofitable with no chance to turn around), and some are longer (when there are complexities). Nevertheless, 30 is a good goal to shoot for, after you have earned your CBA.

I was playing around with YouTube this weekend when I had what might be an interesting idea.

What if we inserted video clips into our appraisal reports? Most of us probably deliver many of them electronically, so this is easy if you have video cam capability, which is cheap to acquire and easy to use.

Here is a laundry list of ideas:

1. Stating value conclusions with the effective and report dates. (The video would be date- and time-stamped). This would make it impossible to tamper with a written report.
2. Video of the site visit, with pictures of us as well as those we met, highlights of important findings (e.g. showing inventory stacked to the roof, an environmental problem, etc.)
3. “Virtual representations” by clients regarding key assumptions.
4. Links to other useful videos, such as a client’s own video of their facilities.
5. Explanations of critical assumptions and limitations. If we are involved in litigation and data has been denied, a video statement of what we wanted and could not get would be very powerful, anticipating deposition.
6. Video explanation of issues relating to Revenue Ruling 59-60, Section 3, Paragraph 3 which concerns information known or reasonably knowable as of the valuation date.
7. Supplementing what could be cold text and numbers with personal commentary that makes us more human.
8. Adding a personal thank-you to clients and referrers with best wishes for the future, suggestions for follow-up, or comments that might fall outside of the appraisal.

I hope that anybody who reads this entry will post comments – favorable and unfavorable – in response to it. I think I have just scratched the surface of what we can do with video technology.

Every day, we read about financial turmoil caused by meltdown of the housing and mortgage-backed securities markets. Many mortgage loans (someone’s assets) are “upside down”, as they say, because house prices are below their loan balances (insufficient collateral), and borrowers have insufficient incomes to repay their debts.

What used to be thought of as liquid, appreciating assets – houses, mortgage loans, and mortgage-backed securities – are now revealed to be illiquid due to an excess of supply of houses, loans, and mortgage-backed securities and a scarcity of demand. This has created a huge “crisis of confidence”, another current buzzword.

Financial institutions of all kinds – commercial banks, investment banks, hedge funds, Fannie Mae and Freddie Mac, et al. – and various federal regulators are all scrambling to find a way out of the crisis.

Does this remind you of anything? As Professor Peabody used to say on the Rocky and Bullwinkle Show, “Sherman, let’s step into the Wayback Machine” and go back 20 years to 1989, at which point…

We arrive at the Savings and Loan (S&L) Crisis! (Check out the Wikipedia entries for “Savings and Loan Crisis” and “Resolution Trust Corporation” (RTC) for great backgrounders.) In that crisis, bad loans by savings institutions led to the failure of over 700 thrifts, which were taken over by the RTC, which supervised asset sales and liquidations. This cost us taxpayers $125 billion, by the way. There is a lot to learn from studying history. For example, some private investors made major fortunes by cherry-picking good assets from bankrupt S&L’s.

Incidentally, the S&L Crisis also led to the FIRREA legislation that created the Appraisal Foundation, USPAP and went a long way toward legitimizing appraisal as a distinct profession.

Back to the present, it seems to me that the crisis of confidence is really a crisis of liquidity. The supply of houses, mortgages, and mortgage-backed securities exceeds demand. There is definitely a price at which these assets will sell. I will not go as far as to say that it is going to be a fair market value price, because there exists coercion (financial distress), lack of information, and many other factors that will make such prices non-fair market value. If you could buy a $100,000 mortgage (that is upside down as above) for $1, you would probably be motivated to take an option- or lottery-like chance on it, right? Therefore, we know there are willing buyers. The only question is how high the price has to be to entice willing sellers to unload their upside down loans and extra houses. That price will be discovered over time due to two forces: (1) some mortgage creditors are going to be forced to liquidate assets to meet their own obligations; and (2) as more buyers materialize, more information about those loans will become available. This process might be expedited if a 2008 version of the RTC is created.

Moreover, does the preceding paragraph describe something that sounds familiar to you? To me, it shouts “LACK OF MARKETABILITY DISCOUNT”, a phenomenon with which private business appraisers, buyers, and sellers are intimately familiar. Some of us can even quantify it using different data and methodologies! We deal with LOMD’s all the time, and as such, they are second nature to us. They are NOT second nature to homeowners, mortgage lenders and the investment banks that securitize those loans, and those groups are going to learn an expensive lesson from that.

Finally, I wonder if we appraisers will be able to mine the data developed from the coming liquidation period to support our LOMD studies.

Unsophisticated owners often place impossibly high selling prices on their businesses before they encounter the reality of the marketplace that forces them to adjust their expectations to realistic levels. This post explains why.

Your client owns and manages (full-time) a fine private company, an “S” corporation (I assume this just to make tax calculations easier). Each year he earns a $100,000 salary (which is at fair market) and a $50,000 bonus (taken as an “S” distribution), reducing net income to $0. After 40% income taxes on his salary and bonus, he nets $90,000 yearly.

After the sale, he desires to continue to earn $90,000 after taxes. He will invest the sale proceeds in high-rated (safe) tax-free bonds yielding 5%. He must therefore realize ($90,000 / 5% =) $1.8 million from the sale, after capital gains taxes. (Assume there is no AMT, another nuisance.) He has a zero basis. Capital gains are taxed at 25%. He must therefore gross $2.4 million from the sale.

As a check on my math, if he sells the business for $2.4 million (cash at closing), he incurs a capital gain of that amount and pays $600,000 in capital gains taxes, netting $1.8 million. He earns ($1.8 million X 5% =) $90,000 in tax-free (after-tax) income.

A $2.4 million selling price equates to a price / pretax income ratio of ($2.4 million / $50,000 =) 48 times. Ain’t no way!

What’s wrong with this picture?

1. Not the math. You can adjust my assumptions and / or add tax complications (AMT, “C” corporation, non-zero basis) as much as you want, but will still come up with a ridiculous multiple and price.
2. The first change is that the current owner is no longer going to work (in the business). His return on labor will go from $100,000 to $0. He did not consider this.
3. The second change is that the current owner will disinvest a risky asset (his business) and reinvest in a (virtually) risk-free asset (high-rated municipal bonds). His rate of return should go down accordingly.
4. He will almost certainly not get 100% cash at closing.
5. He failed, of course, to justify the purchase price from the buyer’s perspective. A P/E of 48 is equivalent to an income yield of 2.1%, below the risk-free rate. The buyer would pay $2.4 million and earn $50,000 in distributions, equal to the 2.1% yield. The buyer would be paid $100,000, a fair market salary, for replacing the seller as manager.

Business owners must confront these realities when they are serious about selling. Be of great service by educating them!

We have valued the equity of a business for tax purposes. A minority interest is to be transferred to a family member by sale or gift. We did our thing and concluded that, regardless of the premise of value (going concern or liquidation) or valuation approach (market, income, or asset), 100% of the equity was worth $1 million. We also developed discounts for lack of control and marketability of, say, 30% for the minority interest.

Our client has reviewed our report and says, “I agree with everything you did – your assumptions, data, methods, and conclusion – but I would never sell my business for less than $2 million. Please use that as the value but also apply the 30% discount you developed.”

Question 1: What appraisal concepts does this request involve?

Question 2: How would you handle it?

(Please scroll down for my answers after you think about these questions.)















Question 1: Appraisal Concepts

1. The standard of value

a. For tax purposes, fair market value applies: it is the value to any willing buyer and seller.
b. The client is asking for investment value based on his or her particular desires.

2. Are we missing something in our assumptions?

a. How would the client justify the $2 million value in terms of cash-on-cash return?
b. Are there control adjustments we missed? If so, we need to redo our analysis.
c. Are there synergies from a potential strategic buyer? Maybe so, but these are not part of fair market value.
Question 2: How to Handle

1. I would point out the above to our client. Assuming our analysis was correct (no missed control adjustments), our fair market value is strongly justified.
2. If the client still insists for some reason on using the higher value, there is nothing wrong with this (except that they will use more of their unified credit or pay more gift taxes than necessary).
3. We could and should include our analysis showing that fair market value was $1 million in our report, but then state that the client has asked us to use an even higher value, which is eminently reasonable and very conservative.
4. In my opinion (you might disagree with this) this does not impair our objectivity or independence. The IRS should be delighted that a taxpayer wants to be so generous! We have done our independent analysis and disclosed it, as well as the client’s decision to use a higher value.

Assume that:

1. A sole or control shareholder of an historically cash-flow positive business elected to pay herself less than fair market value compensation over the last few years.
2. As a result, the business accumulated $5,000 of excess cash as of the valuation date (today), on which it is electing “S” corporation status.

All of the following arguments conclude that the $5,000 of excess cash should not be included in the value conclusion. What is wrong with each of them?

A. The shareholder believes that the excess cash is really “hers” personally since she was underpaid by that amount.
B. She believes that value should be based on a fair market salary to her, which would have eliminated the excess cash by reducing earnings.
C. She is going to increase her salary (or bonus) immediately to pay out the excess cash and avoid future accumulation of it.
D. Alternatively to (C), she will pay you $5,000 to appraise the business, thus reducing its value.

Come on, make me proud, post, or email me your answers. The first correct one wins a prize (NOT the $5,000 of excess cash, which is hypothetical

I am embarrassed to admit how much time I have invested during the past few years trying to understand the Black-Scholes Option Pricing Model. I have been all over the Web, met with math professors, and studied finance and math textbooks, all to no avail. I cannot explain the mathematics. (If there are any mathematicians out there, you can be of great service by writing an article that does this

I have thus retreated to the following position on Black-Scholes:

1. The academic community accepts it as a means of valuing stock options. Its creators won Nobel Prizes for it.
2. The financial community accepts and uses it for the same purpose.
3. It is difficult to grasp, but because of its acceptance, it is reasonable to use it. This is like being able to drive a car without being a mechanic.

What follows is adapted from an article at www.investopedia.com that is the best non-technical explanation of Black-Scholes that I have found so far.

When a call option expires, its value is either zero (if the stock price is less than the option exercise price) or the difference between the stock price and the option exercise price. The latter is the payoff of the option (if it is “in the money”).

Say you buy a call on XYZ stock with a $100 exercise price. This gives you the right (the option) to buy one share of XYZ stock for $100, but not the obligation to do so.

On the day the option expires:

1. If the XYZ stock price is less than $100 (say $80), the option is worthless. If you wanted to buy XYZ stock, you could purchase it on the market for $80. Why pay $100 by exercising your option?
2. If the XYZ stock price is greater than $100 (say $120), the option is worth $20. Exercise the option (paying $100), get the stock, and sell it for $120. You would not purchase the stock on the market for $120 when you could buy it for $100 by exercising your option.

The higher XYZ’s stock price, the more the option is worth. The difference between the stock price and the option exercise price is the value of the call option. The option can never be worth less than $0. Its value can be anything above that, because XYZ’s stock price can increase without limit.

The valuation problems are:

1. We do not know what XYZ’s stock price will be when the option expires; and
2. We have to value the option today, not at its expiration.

Black-Scholes addressed the first problem by assuming that the stock price rises over time with a certain rate of variability. This is based on the current price of XYZ stock, the option exercise price, and the option term (time to maturity). Variability is measured by volatility. These are four of the five assumptions we input to the model. Its higher mathematics converts the assumptions into a probability distribution, a mathematical giving the probability that XYZ stock will sell at a given price (or less) on the date the option expires.

Black-Scholes addressed the second problem by something we are all familiar with (at last – present valuing future prices at the risk-free rate, the fifth of the five assumptions we input to the model.

Black-Scholes rests on a brilliant insight by its creators. They developed way to model the value of a stock option that lends itself to mathematical analysis. (This is the hard part of understanding what they did. Bear with me. There is no higher math, just an explanation of their method.) They realized that an investor could achieve the same payoff (stock price minus exercise price) as a call option by buying the underlying stock and financing the purchase by borrowing.

Instead of buying an XYZ call option, buy a share of XYZ stock for $100 (its price as above) and borrow the $100 purchase price. When the option expires, XYZ stock is selling for $120 (as above). You sell the stock for $120, pay back the $100 loan, and net the $20 difference (less interest on the loan). At any stock price above $100, the payoff from buying the option is the same as buying the stock and borrowing the purchase price. Black-Scholes calls buying stock and borrowing the purchase price the “replicating portfolio” because it replicates (exactly mirrors) the payoff from buying an XYZ option.

The above replication is as of the expiration date of the option, which is in the future, not the present (valuation) date. How do we bring this to present value? You can still match the future payoff by creating a replicating portfolio. This one has to be smaller than the one above because we are moving backward in time from the expiration date and we expect the stock price to rise. Therefore, you buy less than one share of XYZ at $100 per share and borrow less than $100 to do so. How do you know how much of a fractional share to buy? The Black-Scholes model tells you based on the five assumptions (current stock price, option exercise price, maturity, risk-free rate, and volatility). Black-Scholes’ creators proved that that the value of the call option today (not at maturity) equals a fraction of the stock's current price minus a fraction of the exercise price.

If the current stock price is way above the exercise price, the fraction is close to one, and the call option is worth close to the difference between the stock's current price and the present discounted value of the exercise price.

If the current stock price is way below the exercise price, the fraction is close to zero, and the call option is worth very little.

I hope this helps you understand the Black-Scholes model.

I am mentally exhausted.

A few ideas that have been rattling around my mind (such as it is):

1. Try to make your valuations - assumptions, methods, conclusions and reports – as clear as you can for your readers. They should be white boxes, not black ones.
2. If you are considering moving to a home office, you just need the discipline to focus on work. Few clients come to see you and few really care where you work. The economic and lifestyle benefits are enormous.
3. Check out the Wikipedia entry for Business Valuation. It’s pretty good, and is a great reference for clients and referrers.
4. If you are working with public company clients or comparables, check out Google Alerts. You can set them up to give you a daily email list of links to new online material on a given subject (e.g. “General Motors”).
5. The next President and Congress are going to have to address the idiotic estate tax regime that now eliminates them in 2010 and reverts to the original rules in 2011.

I am currently helping one of my closest friends to prepare his business for sale by valuing it. Because we are so close, we are sharing a lot more information than is normally the case with a client and his advisor, and I am learning a great deal as a result.

What struck me most is that my client / friend - a very sophisticated professional as well as a sensitive, nice person – keeps telling me “You are helping me see my business in a way I never have. I have always been concerned with growing it, running it, and trying to make money. I never really thought of myself as having invested in it.”

This harks back to a great point that my friend (except as concerns matters of professional football, as he is from Pittsburgh while I am from Cleveland) Frank Evans made at last month’s IBA Symposium. Frank, who works extensively with business owners to help them increase and realize the value of their businesses, emphasized that owners are not often used to talking or thinking about their business at the shareholder level of value; i.e. looking at them as they would an investment in their portfolio.

(How many times have you seriously considered your practice as an investment rather than simply as a means of earning a living? Me neither.)

When a business owner decides to sell, they quite naturally have to think at this new level, which is somewhat abstract and foreign to them, while we appraisers of course operate at it routinely. This puts the onus on us to explain and educate, to get the business owner comfortable with this new level.

I started my valuation discussion with my friend as I always do, by asking him what price he hoped to realize. At first, he responded as most owners do, by saying, “that’s what I want you to figure out”, but I pressed on (as I always do) by saying. “Look, if I said you could get $100 million for your business you would say ‘Where do I sign?’ and if I told you to expect $10,000 you would say ‘Forget about it!’ Do not be ashamed to tell me what you want. The best way I can help you is to determine if your expectations are realistic.”
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He gave me a number. I explained that job 1 was to see if that number was in the ballpark, and that part of job 1 was to justify that purchase price from the buyer’s perspective: could the buyer earn a fair salary for running the business, pay back all acquisition debt in a reasonable period of time and with a reasonable margin of safety, and earn a satisfactory return on his or her investment? My friend was very taken with this – a key learning point for me. He admitted that his asking price was simply one he hoped to get (with some but not strong knowledge of industry rules of thumb) but that he had never thought about how to show a buyer that it was reasonable.

I then gathered the usual information and drafted a (limited calculation) report for him along these lines. What came out of the draft was that it would be impossible for another individual (financial, non-synergistic) buyer to justify his asking price. It would take a strategic buyer (someone already in his business). However, and most interestingly, there were more than sufficient potential synergies to make his asking price not only justifiable to a strategic buyer but also to offer additional upside to the buyer. (I identified perhaps $200,000 in potential synergies, of which $100,000 were virtually certain with the balance possible but dependent on the characteristics of the buyer).

I told my friend that this alone would justify his asking price to buyers and excite them because of the additional upside. (The business is a very stable one, not particularly dependent on my friend, who has built a strong staff, so the downside risk is low.)

The issue we are now discussing is what price he should ask for the business. He understands that my calculation was designed to justify where he and the buyer should end up. As I see it, he could put this price out on a firm basis (not quite “take it or leave it”, but specify it and a basic set of terms, indicating that the price was firm but some of the terms are negotiable. His other advisors – his attorney and accountant, are urging him to ask a higher price and expect to negotiate it downward. He could justify a somewhat higher price by claiming more of the synergies for himself, but I am not sure that he is in strong enough bargaining position to do so. Moreover, because he is going to sell to competitors, we do not want him to expose his business to the market and then pull it off after giving them an inside look.

Stay tuned for further developments and learning!

I hope this post helps you save time and brainpower when you have to deal with partial or short-year financial statements. I used to waste a great deal of both with these, but have learned how not do to do.

We often have to work with partial year results when:

1. The valuation date does not coincide with fiscal year end.
2. Companies changed (or are changing) to a calendar fiscal year end (as when they elect “S” status)
3. You are going to complete a valuation as of a future fiscal yearend (or other) date when those financials are available, but that is going to be awhile and you and / or your client wants to have a preliminary draft.

The most important things to watch for in these situations are:

1. Major yearend transactions such as dividends, bonuses, debt drawdowns, or repayments.
2. Major yearend accounting items such as depreciation, amortization, and inventory.
3. Inaccuracies that can result from simple annualization (e.g. just doubling six-month results to estimate full-year results). This assumes that revenue and expense flow evenly throughout the year.

I suggest that, rather than trying to figure these out by yourself, you ask the Company and their accountants to provide this information, ideally in the form of estimated financial results for the partial or full year in progress, compared with the prior period of the same starting date and length. You can then consider, question and understand their work. This is a very reasonable request that usually does not impose too much upon them or cost a great deal, and it saves you mass quantities of time and effort.

This has been simmering in the back of my mind (such as it is) for a while, and finally came into focus for me.

Personal goodwill and key person risk (the key person discount) are two sides of the same coin! It might be obvious to you, but it was not to me, because I do not do divorce work and the issue of personal goodwill is not one that I often confront.

I have measured key person risk by (in conjunction with the key person and others in the business), trying to estimate the loss of cash flow and / or the increase in business risk that would result from the death, disability, or departure (without a covenant not to compete) of the key person. This is a logical framework, but obviously, the assumptions can sometimes be hard to pin down. The difference in value between the business with the key person (healthy and) in place and without him or her is one measure of the key person discount.

Another is the cost (in terms of the present value of after-tax cash outflows) of entering into a covenant not to compete with the key person (if facts and circumstances warrant). I have found this much more difficult to quantify, and there are always legal issues about enforceability, but it is no doubt another way to get at the key person discount in terms of “cost to cure” or “prevent”.

Another is to estimate the cost of replacing (recruiting, training, compensating) the key person (assuming they are dead, disabled, or departed but not competing). This is also highly subjective. Some “key people” might not be very key at all, and easy (inexpensive and low-risk) to replace (e.g. in a multi-partner professional firm, if the key person retires but, in cooperation with his former partners, deftly manages the transfer of his former clients to his former partners). Others might be almost impossible to replace at any cost.

Still another might be based on a valid and thorough buy-sell agreement that specifies what happens (and at what cost) when a key person departs.

The last one I can think of, which helped me link key person risk and personal goodwill, would be to do an intangible asset allocation analysis that identifies the key person’s skills, reputation, contacts, etc. and treats them like a patent. I have not had the opportunity to try this out, but I will at some point and report the results!

This post falls into the broad category of “do as I say, not as I have done”. Learn from my mistakes, as evidenced by my numerous but not fatal (yet) battle scars!

You get a phone call. Someone wants you to “value their business” to buy out or be bought out by his or her business partner. It may or may not be friendly. (First suggestion: ignore what they say: it will probably end up being hostile.) There is no buy-sell agreement. It may or may not be easy to value the total business (what if it is six months old. They may not have any (reasonable) idea or basis for their negotiating positions, or any realistic knowledge of valuation. They may be highly emotional and minimally logical. There may be compelling but awful personal circumstances (one of the partners is hooked on coke.)

Right off the bat, we have three major appraisal problems:

1. What is the standard of value? Is it investment value (based on what buyer and seller want and freely negotiate between themselves) or fair value (as stipulated by state law governing dissenting shareholder litigation)?
2. Will discounts for lack of control and marketability apply?
3. What kind of normalization (control) adjustments will apply (such as elimination of the departing partner’s compensation and compensation for someone else assuming their duties, etc.)

However, those are not what you must focus on! There is a much bigger problem to be dealt with.

I strongly suggest that your first question be “How are you both going to use my appraisal?” Ask both parties! They have to agree on the answer!

Perhaps 1% of the time they will agree to abide by your appraisal and make a deal based on it. (I am still waiting for a 1%-type case.) In this situation, they are implicitly asking and empowering you to serve as a binding arbitrator. Make that explicit. Require them both to agree to it in writing. Be engaged by their company, so that you are in effect paid by each party in proportion to their ownership, and neutral with respect to the parties. It is up to you to decide the standard of value, level of value, control adjustments and other issues. This might be easy, or it might be hard. Nevertheless, it is just like any other appraisal except that you have been granted temporary superpowers to decide what might otherwise be issues of equity, law, ethics, or morality.

In the other 99% of cases, they will not be able to answer your question. In fact, it will stop them cold. (They will ask you what you mean by this question.) This is because they have not thought the dispute process through. That is where the danger to them, and to you, lies!

Your role, and the use of your appraisal, is undefined and certainly not agreed upon. This is a surefire recipe for trouble. Avoid it by helping (forcing) them think through how your appraisal will be used. If they cannot agree, walk. If they cannot agree on the dispute resolution process, how can they agree on value? (Think about the Middle East.)

What are the different ways they might use your appraisal?

1. 1% of the time they will submit to your binding arbitration. Have fun, Judge/God! (Get paid up front.)
2. They will commission your appraisal but ultimately ignore it. (They go back to square one, but have to pay your fee. Get it up front.)
3. They will use it as a basis for negotiations, coming up with a different value but eventually making a deal. The outcome for you is the same as (2): you are done and are paid. Perhaps they will ask you to modify some assumptions, akin to updating your report. Charge them by the hour against a retainer. (Get it up front.)
4. They hire attorneys and litigate. This will get very messy and complicated. One or both may hire other appraisers as their testifying experts. One party may like your conclusion and want you to testify as “their” expert. Now you have morphed from being a neutral, jointly appointed appraiser, paid proportionately by both parties, to a neutral expert paid by one side. This will get, feel, and look awkward. Make sure your initial engagement agreement, signed by both parties, covers this eventuality, including your compensation. (Yep, get it up front.) You do not want to be dragged into litigation as a “fact” witness, for which your compensation, to use a highly technical appraisal term, will be bupkes (a Yiddish word meaning “almost nothing”). Put language in your initial engagement agreement that prohibits you from testifying. That said, however, I am not sure that this will be controlling. Make sure your compensation for testimony is covered by a retainer. (You know when to get it. Make it a big one, and insist upon it.)

“Business divorces” like the example I started with are inherently transactional by nature, just like mergers and acquisitions, capital raises, and leveraged buyouts. They are “real deals” in which business interests change hands between unrelated parties for consideration. As such, the investment value standard initially applies, and governs until or unless litigation ensues, in which case the fair value standard (normally) governs. Moreover, the only rule about real deals (in the private company sector) is that there are no rules. Anybody can offer whatever he or she wants to, whenever, and anybody can respond however and whenever he or she wants to. Not only is the standard of value dependent on what the parties want (the essence of investment value), but so are the rules (the process by which the dispute will be resolved).

Contrast this with everything else we do: estate / gift tax, compliance (ESOP and financial reporting) and litigation assignments. Each one has generally well-defined standards of value, timelines, and rules that govern the valuation process.

That said, in business divorces (actually, in “business marriages” – partnership buy-ins as well) the parties establish the standard of value and the rules of the process. Unless appraisers are granted arbitral power, we must first help the parties to agree on and abide by them before we can start the valuation process.

Every single one of my numerous scars resulted from my not knowing or not heeding the previous sentence!

Two of the most important IBA Standards are Replicability and Supportability, which require that we make it possible for readers of our reports to understand exactly how we reached our conclusions and effectively check our work. This means, for example, that:

1. Information must be attributed to specific sources.
2. Calculations must be explicit.

In ancient times, this meant that I had to attach voluminous appendices of source data to my reports, and spend hours formatting and typing tables. Today, however, thanks to email, online data, scanners, and integrated word and spreadsheet programs, I can prepare, transmit, and file reports electronically. Everyone saves time, money, and energy (not to mention trees) by:

1. Clicking on hyperlinks to publicly available data like Federal Reserve reports, or scanned versions of subscription data like RMA.
2. Being able to click on embedded spreadsheets in documents to see the details of calculations.

(I know, I know, I am using more electric power than I used to, but I hope that the incremental savings outweigh those costs).

The one area in which I am a little uncomfortable involves the use of sophisticated mathematical / financial models like Black-Scholes and lattices to value options. I have a spreadsheet version of the former and subscribe (via BVR) to an online lattice calculator (provided by Derivative Valuations, LLC), but I confess to not totally understanding the higher mathematics on which they rest. Here, I simply state the sources of the models and the assumptions that I use, and that they are generally accepted in the financial community.

At this week’s great IBA Symposium in Chicago, a comment by a colleague suggested a very interesting and easy analysis that we can easily perform in any discounted cash flow valuation involving non-marketable interests. My colleague mentioned that he would like to be able to incorporate lack of marketability in his discount rate in the Income Approach. This was a very interesting idea!

Regardless of how we develop our equity cash flow discount rate – build up, CAPM, or whatever – we end up with a rate applicable to the marketable level of value, because all of the data and methods use marketable securities prices. Then we do our discounting to come up with the value of a marketable interest. Then we apply a discount for lack of marketability to get to non-marketable value.

I did a very simple analysis with these assumptions and calculations:

1. Equity cash flow is $100 next year, and then grows 5% annually.
2. Discount rate is 20%.
3. Marketable value is calculated to be $610.
4. LOMD of 30%.
5. Non-marketable value is calculated to be $427.

Then:

1. Equity cash flow is same as above.
2. Non-marketable value is $427, same as above.
3. I iterated a 26.5% discount rate to get to the $427 value.

In other words, in this case a LOMD of 30% is equivalent to an additional 6.5% “illiquidity premium” (26.5% - 20%).

Obviously, every case is different, because it depends on the magnitudes of the individual cash flows by year and the size of the (marketable) discount rate.

Interesting, indeed!

Yesterday I met with a client to begin a purchase price allocation engagement. During our conversation, he asked whether I would be willing to disclose any “proprietary information or methods” I used so that his auditors (a Big 4 firm) could trace exactly what I did and why.

I had to think about this for a while, but I concluded (and told him) that nothing is “proprietary” except for the format and text explanations in my reports. This is founded on IBA Standard 1.8, Replicability, which requires that “the appraiser’s procedures and conclusions in the formal report must be presented in sufficient detail to permit the reader to replicate the appraisal process.” In other words, every assumption and its basis is disclosed, the application of every approach and method is explained and reproducible, and all calculations are shown explicitly.

In my reports, all quantified assumptions (e.g. the risk-free rate) are attributed to a source, simple calculations are shown in one-line statements (e.g. “the value of the subject interest is 1% X $1,000,000 = $10,000”) and complex ones like a full financial forecast income statements, balance sheets, and cash flow statements) are shown in tables. The tables are Excel spreadsheets embedded in the text; a reader wishing to see the details of the spreadsheet just clicks on them to open them for inspection. It is all WYSIWYG: what you see is what you get.

The only exception I can think of arises when I perform Black-Scholes or lattice calculations, for which I use calculators available on the Internet. For these, I list the assumptions, their bases, and the resulting value, with a hyperlink to the URL of the calculator so that anybody who wants to check my work by following my steps can easily do so.

As I see it, the only risks I take with my WYSIWYG approach occur in litigation:

1. Another appraiser could copy my report and use it for other engagements. This happened once about ten years ago in a litigation case. Although I was not present at that appraiser’s deposition, the deposing attorney told me it was very interesting when he showed that appraiser a much earlier copy of a different report of mine that had the pirated language!
2. Someone could alter my signed report. This has never happened, but if it does, I have my signed, dated reports electronically filed.