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Top Down and Bottom Up Forecasts

By Rand Curtiss | Published: July 30, 2010

My last post compared bottom-up and top-down forecasts. This one expands on that comparison. To keep it very simple, let’s focus on forecasting just next year’s revenue for a startup business that has no historical track record. The business is a one-man car detailing service that will charge $100 per car and serve a market that has 20,000 cars.
(Assume that every numerical assumption has a reasonable basis, such as a motor vehicle census for the market of 20,000 cars.)

A top-down forecast is a macro take. It might go as follows. One of every 20 car owners will be interested in having their car detailed once next year. Next year, then, there will be 20,000 X 1/20 X 1 = 1,000 cars to be detailed. Our client thinks he can get a 10% share of the market, and thus detail 100 cars. His top-down revenue forecast is 100 X $100 = $10,000.

Double check: it takes one day to detail a car. Our client thus needs to reserve 100 working days (of 250 available) to do the work. This is feasible.

A bottom-up forecast is a micro take. It might go as follows. Based on the above, our client has 150 working days to make sales calls (The top-down forecast showed this). He can make 15 sales calls a day or 2,250 calls in the 150 days available. He expects a 4 to 5% close rate, or from 90 to 112 assignments. His bottom-up revenue forecast is $9,000 to $11,500.

The questions to ask about each forecast are all about the reasonability of the assumptions.

I’d venture to say that for an appraiser, the top-down forecast will be easier to think about (assuming we do not know a great deal about the business or the company), while the bottom-up one is easier for the client to think about. Both are only as good as the assumptions that underlie them: and the questions to ask about each are all about their reasonability and support.

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Lessons Learned!

By Rand Curtiss | Published: July 28, 2010

A recent engagement reminded me of some important lessons about preparing a forecast for client review (when the client does not prepare their own).

I was doing an annual ESOP valuation for a company that has had a tough year because of extraordinary circumstances (a lawsuit) that caused it to suffer big but temporary revenue and earnings declines. In previous years it had grown nicely and had always been profitable. Due to the lawsuit, the bank cancelled the Company’s line of credit, which had been used to fund seasonal intra-year cash shortfalls. The Company, expecting the lawsuit, had accumulated significant cash (about $2 million) anticipating the loss of its credit line. The lawsuit has now been settled, with minimal cost to the client, but this was not known or reasonably knowable as of the valuation date.

The first lesson: if you are valuing cash flow to equity (or invested capital), do not just blithely add 100% of valuation date cash to the (discounted / capitalized) benefit value. I explored with the client how much cash was necessary for normal operations (in the absence of a credit line) and we determined that about half, or $1 million, was truly needed to take the place of the line, so only half of the cash on hand, or $1 million, was truly excess as of the valuation date and added to the benefit value.

The second lesson: guide the client as to which assumptions have the greatest impact on the overall valuation. These are the ones you really need them to verify. In this case, the business had always had very low (on the order of 1 to 2%) operating profit margins, and most of its costs were variable with revenue. The lawsuit and associated expenses created a net loss for the Company last year, which quite naturally was disturbing to the client. Due to my own stupidity, I neglected to mention to the client that, given these facts:

A. The valuation was relatively insensitive to the levels of projected revenue, because of low margins.
B. Earnings (operating and net income) were very sensitive to the gross profit margin assumption: a change of 0.5% in margin had a huge impact (e.g. whether the Company would be profitable or unprofitable). Operating expenses were very stable and small, so these were easy to forecast with reasonable certainty and not sensitive.
C. Most of the value of the equity was represented by the excess cash (of $1 million).
D. Because of this, the overall valuation was NOT that sensitive to the gross profit margin assumption, even though it had a great impact on earnings.

Because I did not make this clear to my client, they spent a great deal of time fussing around with my original financial forecast (mainly the income statement: revenue and margin assumptions), even though their ultimate impact on the total value was minor.

The third lesson: the client’s seemingly unnecessary focus on the income statement assumptions had a HUGE benefit! Previously, they had just looked at my forecast on a total company basis (what I called a “top down” view). I would project (say) revenue growth of 5% and margins of 1% for the total company, and they would bless or revise that. In this valuation, they dug down and broke their business into four separate units, analyzing and projecting revenue and margin for each one. This was what I called a “bottom up” approach, and it showed them that one such unit was, despite significant revenue, not contributing very much at all to the bottom line. They combined the business unit forecasts and compared and reconciled the bottom-up and top-down projections. This dramatically enhanced their (and my) understanding of the finances of the company, and was also very persuasive to their bank, which has since restored their line of credit. The bottom line: a bottom up projection reconciled with a top down projection makes the forecast even more plausible.

So, to recap: analyze how much cash is really excessive, guide your client as to the value-sensitive assumptions, and urge them to do bottom-up as well as top-down forecasts!

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IBA’s New Certification Workshops Featured in the Wall Street Journal’s MarketWatch and CBS’ Money Watch

By ibaadmin | Published: July 19, 2010

 

The business appraisal profession is growing rapidly, and with these changes comes the requirement for frequent and dynamic education that meets the needs of our ever-changing business landscape.

Featured in Wall Street Journal’s MarketWatch News site and CBS’ Money Watch, IBA’s new certification workshops, 8003 Introduction to Business Appraisal and 8004 comprehensive Certified Business Appraiser, are receiving accolades nationwide. In every profession there are noted practitioners whose quality and competence stand out from the rest. In the field of business appraisal, these “stand-outs” are Certified Business Appraisers (CBA).

The nation’s first business appraisal expert witness had this to say about the Certified Business Appraisers (CBA) credential“The value of the CBA credential is enhanced immeasurably by the requirement that candidates submit two demonstration business appraisal reports showing professional competence. I review many reports for litigation, and those prepared by CBAs are consistently better than those prepared by persons with credentials that do not require demonstration reports.”

— Shannon Pratt, CFA, ARM, FASA, MCBA, CM&AA
Shannon Pratt Valuations

Effective August 1, 2010, all new business appraisers applying for IBA’s Certified Business Appraiser (CBA) designation will be required to complete IBA’s newly developed accreditation workshops 8003 Introduction to Business Appraisal and 8004 comprehensive Certified Business Appraiser (CBA) Workshop (accredited member exemptions may apply). These workshops have been redesigned By KC Conrad, CBA, CBI, CMEA, ASA and Dennis Bingham, MCBA, CFM, CMA, BVAL to enable CBA candidates to succeed in both IBA’s accreditation examination and peer review processes, as well as in the development of their appraisal practices.

Who Should Attend? The CBA credential’s reputation of excellence is unrivaled, and is sought by ABVs, ASAs, AVAs, CPAs, CFAs, CVAs, business brokers, business consultants, financial analysts, real estate appraisers, real estate brokers, and investment bankers all over the world.

Course Dates and Locations
The 8003 Introduction to Business Appraisal will be held in:

August 9–13, Newport Beach, CA at the Island Hotel
October 25–29, Washington, DC, at the Marriott Wardman Park Hotel November 8–12, Chicago, IL, the Hotel Monaco
December 6–10, Las Vegas, NV, the Mirage Hotel

The 8004 comprehensive Certified Business Appraiser (CBA) Workshop will be held in:

September 20-24, Dallas, TX, CA at the Fairmont Hotel
October 25–29, Washington, DC, at the Marriott Wardman Park Hotel
December 6–10, Las Vegas, NV, the Mirage Hotel

Throughout the new 8003 and 8004 workshops, students build a full business appraisal skills inventory through the integration of financial modeling, interactive valuation simulations, and small group think tanks. The new 8003 and 8004 workshops will supersede IBA’s Essentials of Business Appraisal Workshops 8002A and 8002B after July 30, 2010. (IBA 8002B will be offered once more July 26-29 in Orlando, FL for those who have taken IBA 8002A.) Additionally, CBA candidates are encouraged, but are not required to attend IBA’s 1010 Advanced Report Writing and Analysis Workshop and the 1006 Preparation for the CBA Examination course or webinar. Please visit www.go-iba.org to review a list of all CBA accreditation requirements or contact IBA headquarters at (800) 299-4130.

 

The Pioneer of Business Appraisal
The Institute of Business Appraisers was the first organization to adopt business appraisal standards and ethics. Established in 1978, the Institute is the pioneer in business appraisal education and professional accreditation. IBA offers four business appraisal certifications which include the Certified Business Appraiser (CBA), the Accredited in Business Appraisal Review (ABAR), the Business Valuator Accredited in Litigation (BVAL), and the highly-acclaimed Master Certified Business Appraiser (MCBA) designations. 

About IBA —The Institute of Business Appraisers is the oldest professional society devoted solely to the appraisal of closely-held businesses.  IBA’s education focuses on showing students “how to” perform the work. Our education courses provide a unique, hands-on, interactive approach to learning. IBA measures success by the professional advancement of its members. Headquartered in Fort Lauderdale, FL, and the Institute’s members receive free technical support and FREE access to IBA’s Market Database, the industry’s largest database of closely-held comparable business sales. To learn more about the benefits of an IBA membership, visit www.go-iba.org or call 800-299-4130.

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Tax Court Rejects Taxpayer’s Appraisal As “Not Qualified.” Thus Sidestepping Any Evidence of Value

By ibaadmin | Published: July 19, 2010

TAX COURT REJECTS TAXPAYER’S APPRAISAL AS “NOT QUALIFIED,” THUS SIDESTEPPING ANY EVIDENCE OF VALUE
Assuring the Quality of an Appraisal is More Important than Ever
By Howard A. Lewis, Executive Director

The United States Tax Court, in a memorandum decision (Scheidelman v. CIR, T.C. Memo. 2010-151, No. 15171-08), dated July 14, 2010, sustained deficiencies and penalties assessed against the taxpayer, disallowing deductions claimed for charitable contributions of an historic façade easement. Most tax valuation disputes center on the value of the property. The IRS rarely asserts deficiencies and even more rarely tries cases on the basis of the qualifications of the appraiser or the quality of the appraisal. I believe Scheidelman is an important signal, from the IRS and the Tax Court, and the appraisal community is well advised to take heed.

     Notwithstanding the memorandum nature of the decision, the IRS and its appraisers will understandably see this decision as further reason to inquire deeply and analyze critically both appraiser qualifications and appraisal quality. In this instance, the IRS argued that the taxpayer’s appraisal did not satisfy the requirements of Regulation Section 1.170A-13(c), which specifies the elements required to be contained in a qualified appraisal. The fact that this matter involves a charitable contribution deduction is less important than the understanding that comes from an analysis of the Service’s approach to appraiser qualifications and appraisal quality. Most of the evidence at trial dealt with the valuation of the property. The Court opined, “Because we conclude that the Drazner report is not a qualified appraisal, we do not discuss this evidence or reach a conclusion as to the value of the easement.” I admit that I argued for years that the IRS should pay more attention to the rules governing appraiser qualifications and appraisal quality and, I admit, I am glad they are doing so. It makes the value of our profession’s education and accreditations more important than ever, and IBA is uniquely positioned to address the specific issue of “what constitutes a qualified appraisal?”

  Appraisers interested in learning some of the ways that IRS appraisers review appraisal reports can attend IBA’s course Business Appraisal Review (ABAR) Accreditation Workshop held in Newport Beach California on August 9-12, 2010 and Washington, D.C. on October 25-28, 2010.

   Course 1044 and the associated ABAR accreditation ensures that practitioners and firms are equipped to optimize the quality of business appraisals produced by firm associates by teaching a 5 step process for reading and critically evaluating the quality of a business appraisal report. Avoid potential penalties by ensuring that your reports meet a strict quality assurance protocol as demonstrated in IBA’s ABAR accreditation workshop. You and your taxpayer can both be penalized if your appraisal is determined to be disqualified.

   Appraisers interested in distance learning can now attend the Accredited in Business Appraisal Review (ABAR) Designation Available via Distance Learning- A Four Part Webinar Series held on September 13, 2010, October 12, 2010, November 05, 2010, and December 03, 2010. Contact IBA at 800-299-4130 for details or to receive a personal consultation on how your firm can benefit from the ABAR workshop.

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IBA Announces a Special Webinar Entitled,”Loss Claims Resulting from the Deepwater Horizon Oil Spill and the BP Claims Process”.

By ibaadmin | Published: July 15, 2010

Loss Claims Resulting from the Deepwater Horizon Oil Spill and the BP Claims Process

On July 29, 2010 the Institute of Business Appraiser (IBA) will co-host a cutting edge two hour webinar to address the economic loss claims that inundate the gulf coast region as a result of the BP Oil Spill. Businesses throughout the gulf coast region have already felt the impact of the Deepwater Horizon Oil Spill. However, there is no estimate that can predict how far reaching of an economic impact the BP Oil Spill will have on small businesses around the country. 

On May 27 at a Senate hearing in Washington, D.C., Small Business Development Center director, Carmen Sunda, testified as to how the spill is affecting businesses, such as fishermen, seafood processors, used car dealership owners, and construction contractors in the gulf coast region. 

In her testimony Mrs. Sunda stated, “The worst part is that it has no foreseeable end. People can’t estimate the value of their long-term losses or the long-term impact, because they can’t define ‘long-term’ – does it mean this season, a few years, or a life-time?”  Every day, more businesses will be impacted by the spill. Unlike other catastrophes, there is a system in place to file claims for businesses and individuals that have incurred losses. 

IBA’s webinar, Loss Claims Resulting from the Deepwater Horizon Oil Spill and the BP Claims Process, will help business appraisers, financial professionals, legal professionals, and business owners understand the claims process. The webinar presented by, M. Jason Weil, Esq. and moderated by IBA Governor, Marcie D. Bour CPA/ABV, ABAR, CVA, CFE, BVAL, CFFA, will cover the legal basis for claims and cover the claims process. Attendees will learn when it is appropriate to file claims and which damages should be included in separate claims. The webinar will also address which documents are required to support claims and what options are available to a business when its claim is denied.

The webinar presenter, M. Jason Weil, holds a law degree from Nova Southeastern University, Sheppard Broad School of Law, a graduate degree in Computer Science from Harvard University, and a Bachelors of Arts degree majoring in Psychology from the University of Colorado in Boulder, Colorado. Prior to his legal career, Mr. Weil worked in several industries, including health care, telecommunications, and the internet as a business analyst and technology developer. Prior to joining Krupnick Campbell Malone Buser Slama Hancock Liberman & McKee as an associate in the areas of international and environmental law, he practiced in the areas of bankruptcy, probate, and commercial litigation. Jason is a member of the American Bar Association and is an admitted member of the Florida Bar, and the United States District Courts for the Southern and Middle Districts of Florida.

 

The webinar moderator, Marcie D. Bour, is President of the Florida Business Valuation Group and a member of the American Business Appraisers National Network. She provides business appraisal services, forensic accounting and litigation consulting services. She has over 25 years of professional experience. She has extensive experience in preparing business damages and has worked on a number of claims and has lead a team of experts in developing a three day, Business Interruption Losses and Claims, workshop.  Marcie is an IBA Governor and was IBA’s Chair of the NACVA/IBA 2010 Consultants Conference. More 

Click here to learn more and register for this important webinar. Financial professionals interested in learning how to calculate damages are encouraged to attend, Business Interruption Losses and Claims, a three day workshop scheduled in Newport Beach, California on August 9-11 and Atlanta, Georgia on November 15-17, 2010.

 This Loss Claims Resulting from the Deepwater Horizon Oil Spill and the BP Claims Process two-Hour Live Webinar Presentation was developed in partnership with the Institute of Business Appraisers, the Consultants Training Institute, and the National Association of Certified Valuation Analysts. 

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ESOPs and “S” Corporations

By Rand Curtiss | Published: July 6, 2010

Most appraisers I know believe that “S” corporation earnings should be tax-effected. I do, too.

Having said that, however, I have run into an exception: “S” corporations owned all or in part by ESOPs. ESOPs are income tax-exempt. A client owns 60% of an “S” corporation,and the ESOP owns the rest. The Company makes distributions to cover the client’s personal tax liability. It must also make a proportional distribution to the ESOP. The ESOP’s distributions are not taxed, so the distributions inure to the vested participants (or, if there are unallocated ESOP shares, to their unallocated value).

The bottom line: do not tax-effect when valuing ESOP shares owned by “S” corporations.

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The Case of the Undefined Engagement Parameters

By Rand Curtiss | Published: July 2, 2010

I just completed (early July 2010) a valuation of a controlling business interest owned by a trust benefiting the children of a decedent (he passed away in 2009). The minority interest is owned by the husband of one of the beneficiaries. That individual has served very capably as the chief executive officer of the business for many years, and this has resulted in steady, profitable growth and a very strong balance sheet. The CEO wants to buy the controlling interest from the trust. There is no intention to sell the controlling interest to a third party: the trustee, beneficiaries, and son in-law are extremely concerned about the risks of exposing the company’s intellectual property to others and about the potential adverse consequences for employees (including the son in-law) if a third party acquired control.

The trustee, an independent individual unrelated to the parties, asked me to value the controlling interest without any knowledge of offers made by the son in-law. The trustee will use my valuation to evaluate those offers. The trustee was reluctant to direct me in any way as to the engagement parameters (date, level, standard, and premise of value). The purposes of the appraisal were clear: to assist the trustee in discharging his fiduciary responsibility to ensure fair dealing and a fair price for the beneficiaries; and to comply with tax laws to make sure there is no bargain purchase with adverse tax consequences.

The trustee provided financial statements through April 30, 2010. He asked me to recommend the other engagement parameters. This was a little different than most of my engagements, for which the parameters are clear. I not only gave a great deal of thought to my recommendations but substantiated them (in much more detail than presented below). This is a must when these fundamental assumptions are unclear; you do not want to get way down the road with a valuation only to discover than you erred on any of them.

Here’s what I recommended:

1. The valuation date was April 30, 2010, the latest for which financials were provided. I stated that the value as of this date would last as long as: (1) there was no subsequent material change in the business or its financial condition up to the report date; and (2) there was no knowledge of possible or actual events subsequent to April 30, 2010 that might materially impact the valuation. If more recent financials were provided, if there was a subsequent material change, or if knowledge of subsequent material events becomes available, I reserved the right to update my report accordingly, at additional cost.

2. I recommended a control marketable value level. Control was obvious. I recommended marketable because the existence of lack of marketability discounts for controlling interests is theoretically unproven and rather controversial. I indicated that I was open to developing a non-marketable value (applying a discount for lack of marketability) if the trustee so desired, but that because of the theoretical controversy and lack of empirical data, this would involve a great deal of subjectivity.

3. I recommended a going concern premise of value. As it turned out, this was obvious based on the profitability and cash flow of the business (a service firm). A brief analysis proved beyond doubt that going concern value exceeded liquidation value. There was no external compulsion (e.g. bank foreclosure) for liquidation.

4. I recommended a fair market value standard. This is obviously required for tax compliance. I explained additionally that the parties’ desire to restrict the sale to the son in-law took strategic buyers and synergistic value off the table. The son in-law, because he has run the business so well for many years, has in all likelihood maximized business value on a financial buyer basis. This reinforces the applicability of the fair market value standard. It represents the minimum price the son in-law should pay for the interest, which is also precisely the information the trustee needs to ensure financial fairness and tax compliance.

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Capitalization Rates and Declining Businesses

By Rand Curtiss | Published: July 1, 2010

Can we capitalize the earnings or cash flow of a declining business? As Curly of Three Stooges fame would say: “Soitenly!”

Two businesses have the same current earnings or cash flow and risk level and a 20% discount rate. One is growing at 5% annually, the other declining at 5% annually. The cap rate for the growing firm is 20% – 5% = 15% and its valuation multiple is 1/15% = 6.7 times. The cap rate for the declining firm is 20% – (-5%) = 25% and its valuation multiple is 1/25% = 4.0 times. This makes perfect sense: a growing business has a higher multiple and is worth more than a declining business with the same risk and current earnings or cash flow.

For the mathematically minded, the discount rate – growth rate = cap rate formula is based on summing an infinite series. It is explained and derived in many valuation books. The key point is that the formula is general – it is derived using algebra with no constraints on the values of the discount rate or growth rate. It does not require the growth rate to be positive or zero; it can be negative.

For the TRULY mathematically minded, there is a restriction after all. The absolute value of the decline rate cannot exceed the discount rate. If our business has a 20% discount rate and a 25% decline rate, the implied capitalization rate is 20% – (-25%) = -5%. This is nonsensical. This is because a business declining that fast will in the long term have no appreciable earnings or cash flow. (In mathematical terms, the infinite series used to compute its discounted earnings or cash flow converges.) At some point, the business will be worth more on a liquidated basis than a going concern, so the general formula cannot be applied (because it does not account for liquidation).

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A Closer Look at the Justification of Purchase Test

By Rand Curtiss | Published: June 30, 2010

When we apply the Justification of Purchase (JOP) test to check the reasonability of a value conclusion, we ask:

1. Can the business pay the owner-manager fair market compensation?
2. Can the business adequately service assumed and acquisition-related debt?
3. Can the business earn its owner a satisfactory return on investment?

There are many important assumptions implicit in the JOP test. If they are not valid, the JOP may not apply:

1. We are valuing equity, not assets – a stock sale, not an asset sale, is assumed.
2. The business is and will be a going concern. If not, we use a liquidation premise and consider net asset value.
3. The business is sufficiently profitable to generate cash flow after (net of) owner-manager compensation. If not, it is just a hobby.
4. The business is sufficiently profitable to generate cash flow after (net of) compensation and debt service (interest and principal). If it is not, it will go bankrupt.
5. The business is not just a “buy-a-job” operation. If it is, then question 3 above is not relevant; no return on equity is expected. But questions 1 and 2 still apply.
6. The relevant ownership benefit metric is cash flow to equity (not just profits). Owner-manager compensation, debt service, and return on equity must all be measured on a cash flow basis. Owners cannot pay their salaries, dividends or their lenders “profits”. All of these must come in the form of cash.

Finally, when you use the JOP, be careful when part of the equity value comes from non-operating assets (like excess cash or owned real estate). Deduct this amount from the total equity value to arrive at the value of the business excluding it. THAT is the price used in the JOP. The non-operating assets are valued separately; the buyer will pay 100% of their value in addition to whatever the value of the business (excluding the non-operating assets might be.

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Embedding Tables and Graphs In Your Reports

By Rand Curtiss | Published: June 29, 2010
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