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What A Difference A Year DOES NOT Make!

By Rand Curtiss | Published: September 1, 2010

In a recent well-publicized opinion, a high-ranking judge sneered at the business valuation profession’s choice of 1926 as the starting date from which to compile market rate of return data, saying that there was nothing special about that year except it was “when Marilyn Monroe was born.” His implication was that this was a purely capricious starting point; i.e. why not choose Hedy Lamarr’s birth year (1913), or something else? Since it was capricious, the results were open to question, right?

Umm, well, with all due respect, Your Hindness, let’s consider the relevant facts, which have nothing to do with birth dates of cinematic icons. The good and kind experts at Ibbotson Associates, an acknowledged, authoritative group of qualified experts, selected 1926 because that was the earliest date that reliable information was furnished to them by the Center for Research on Security Prices at the University of Chicago. The point was to gather a large enough sample (84 years, from 1926 to 2010) of annual observations on rates of return to build strong statistical confidence in the results. That’s good science, not an opinion!

The point, your Onerousness, was that a big sample – 84 observations – means that each one makes up only 1/84th or 1.2% of the sample, so that the importance of any one year’s results, and therefore the selection of the starting year, is minimal. Of course, as we gather more data each year, each year’s importance declines. Long-term data averages out dramatic annual changes and makes the selection of the starting year less and less significant each year.

Moreover, Drudge, the idea of a long-term average is to reflect economic cycles, depressions and growth, recessions, stagflation, peace, war, and population growth, just for starters. We have to do that, because when we capitalize or discount future cash flows, we are using forecasts that extend indefinitely, years and years into the future! We would be dead wrong to apply a single year’s results to the long-term future!

Thank you very much for allowing me to comment.

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Conflicting Motives in Family Business Estate Planning

By Rand Curtiss | Published: August 31, 2010

Most of my valuations are for estate and gift taxes, concern family-owned businesses, and involve gifts or sales to family members of 100%, control and / or minority interests.

Sometimes my clients’ motivations are simply to minimize their estates and the associated estate and gift taxes. This usually happens when the senior generation is well to do. Their strategy is clear: phased gifts or sales of non-marketable minority interests with appropriate valuation discounts. Parents are happy to minimize their estates and taxes, and children are happy (if buying shares) with the low prices. (Their hidden cost: a low tax basis cost when THEY sell or gift shares, but that is far in the future and of little present concern or cost.)

When the parents are not well to do, or most of their wealth is tied up in the business, they certainly want to minimize taxes, but are not willing or able to transfer everything at discounted values, because they need the money. This requires a great deal of planning up front, because on the one hand they want to minimize taxes but on the other hand they do not want to minimize the value received. Now they must consider whether to sell the business to the children as a whole (no discounts), maybe sell a controlling interest (at an appropriate premium), or something else (maybe adopting a buy-sell agreement that stipulates non-discounted or pro rata shares of fair market value).

Sometimes the second objective – not necessarily minimizing value received – does not come up immediately at the outset of the engagement. It DOES when they see that the values of the phased minority interest gifts or sales do not give them enough money.

Always be aware of this potential complexity – it could mean a little more work for you, but if you try to determine the clients’ motives at the outset, it will not be a great deal more work.

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Tools I Do Not Use: A Personal Opinion

By Rand Curtiss | Published: August 31, 2010

This post is most definitely a personal opinion that reflects my particular experience and clientele. I am interested in comments as to whether you agree or not with my thoughts!

Although I try as hard as I can to stay current with the technology of business appraisal – how we do things – I have found that there are many analytical procedures that I just do not have occasion to use at all, or very infrequently.

Under the Income Approach, I have posted extensively as to why I do not use WACC (the weighted average cost of capital). The overriding reason is that I can always come up with explicit assumptions for the level of debt a subject company will owe each year (in a multi-period forecast), so I can always calculate cash flow to equity and value it directly.

Closely related to that, I use the multi-period discounting model rather than the single-period one, because for every engagement in which I need to develop a financial forecast, I do a multi-period one.

In those forecasts, I do not use the mid-year discounting convention because the uncertainty associated with the forecast amounts dwarfs the size of the conventional adjustment.

Moreover, I use the build-up method to develop discount rates, and not CAPM, in which the problem of estimating volatility for a small private company is huge.

Considering the Market Approach, I have not had occasion to value a subject company using public guidelines or transactions simply because the vast majority of the subjects are too small to be compared to public companies. For the few that are larger, they have all been financial reporting related assignments (e.g. 141-142 or 718 (formerly 123R)) in which the company was owned and independently valued by a private equity fund. The fund used public companies and transactions to value its subject; I merely confirmed that what they did was reasonable.

Also under the Market Approach, when I use the Direct Market Data Method I rarely (maybe once in every ten or more assignments) have a large enough sample of guideline companies to use any sort of statistical analysis (such as regression).

Under the Asset Approach, I have not had occasion to use the Asset Accumulation Method (in which all individual tangible and intangible assets are identified and separately valued) except in the occasional 141 or 142 assignment. For all the rest, this method is extremely time-consuming and expensive, and better and easier results are obtained by the Market and Income Approaches, which do not break out these values (and for which there is no need to do so).

With regard to discounts for lack of control, I do not use market studies to determine control premiums and values; I look at the individual control prerogatives and their cash flow benefits and quantify the effect on cash flow. I do use them as a high-end limit (the low end being closed end fund discounts) when I benchmark them.

For option-related valuations, I have come to rely on the binomial model rather than Black-Scholes because it is less restrictive. (The reasons for this are very technical, but if you use the BVR 123R model developed by Derivative Value Associates, they include a great explanation of this in their documentation.)

By the same token, I do not use the option-related models for quantifying the lack of marketability discount because their output ranges are so wide: I get narrower and better results by benchmarking and double-checking with the QMDM.

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Pants First, Then Shoes

By Rand Curtiss | Published: August 30, 2010

The title is based on one of my favorite Far Side (RIP) cartoons depicting a guy rising from bed and looking at a wall poster with that as the text. I remember learning this the hard way when I was figuring out how to dress myself 55+ years ago.

How many times have you received a request like this? “I am selling my company, and the deal is closing next week. I want to transfer [a minority interest] to [an heir, an affiliated entity, a defective grantor trust, etc.] with discounts [for lack of control and lack of marketability]. How big will the discount be, what will the appraisal cost, and can you get it done by then?”

My immediate mental response is “0%, sure, and $0” because I am not going to take on this job! Why? Because the potential client put their shoes on before their pants: the shoes are closing the deal and the pants are the interest transfer.

The fact that the deal is closing next week is PARAMOUNT. It removes all of the uncertainty about the transaction price (assuming for simplicity that: (1) there are no obstacles to closing; (2) there is no contingent consideration such as an earn-out; and (3) 100% of the company’s stock is being sold)). There is no lack of control discount because all of the stock is being sold. There is no lack of marketability discount because the transaction establishes the “market” price.

Occasionally I might agree to a small, on the order of 5%, discount for the risk that the deal might not close, but there has to be a good basis, such as unresolved contingencies precedent to closing or the buyer’s inability to obtain financing. In the dotcom era I opined discounts as high as 25% for pre-revenue companies that aspired to go public…but those days are long gone.

Revenue Ruling 59-60, Section 3, Paragraph 3 tells us that information known or reasonably knowable as of the valuation date is relevant, and that transactions subsequent to the valuation date that indicate value are relevant if they indicate but do not affect the value. Both apply.

This client SHOULD HAVE done the minority interest transfer WELL BEFORE embarking on the sale of his business, thus putting on his pants before his shoes. I wish I could state exactly HOW LONG before, but that is a matter of common sense, informed judgment, and reasonability that is heavily dependent on the facts and circumstances of each case. I think that a year or more is fairly safe, but there are times when things change or happen faster, and I cannot generalize usefully about that.

Don’t take on an anxious client’s problem (putting on their shoes before their pants) when they have not done their estate planning before their transaction planning.

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The Relevance of Prior Transactions

By Rand Curtiss | Published: August 28, 2010

I have had to consider prior transactions in a company’s securities in a large number of recent fair market value-based engagements. As you know, prior transactions, because they are highly visible, attract a great deal of IRS scrutiny and are also quite naturally of great interest to the parties to, for example, a minority interest redemption.

I have found it very helpful to ask MANY questions about a prior transaction to determine its relevance to a current valuation.

First, was the prior transaction a “real deal”? A rejected offer to buy or sell was not a completed transaction.

Second, was fair market-based consideration paid? If a minority shareholder was bought out in exchange for a 20-year balloon note (no principal due for 20 years) or at an interest rate vastly different from an appropriate market rate, that would not be market-based. If the prior transaction was based on an outdated buy-sell agreement (value) or a stock option whose exercise price was established when the company’s value was much different, the consideration was probably not fair market.

Third, was the transaction negotiated at arms’ length? Were the parties interests truly opposed? In a family situation, they might not be. Son would want to buy out mother on the cheap, and if Mom was wealthy and generous, she might not be opposed to that. Was a qualified, independent appraiser retained, and did they do a good job? Were the parties represented by attorneys or other qualified advisors? Were there real negotiations?

Fourth, after the prior transaction and up to the valuation date, did anything material change with regard to the business, its operating or financial position or its environment? If so, this could invalidate the prior transaction’s comparability unless its value could, with strong support, be adjusted to account for the change(s).

Fifth, was the prior transaction at the same level of value as the current one? This reflects (lack of) control and liquidity factors.

Sixth, did the prior transaction reflect any investment value considerations (aspects unique to the buyer or seller)? Stated bluntly, was something else going on? I recently considered a prior transaction that involved a premium to resolve a costly, long-standing and bitter shareholder dispute. The buyer basically paid the seller to go away and avoid legal costs. That was not fair market value! Did it include other things, such as a covenant not to compete or a consulting agreement or other benefits? If the seller was not really in a position to compete (say disabled) or provide real consulting services (they retired and moved far away), maybe these payments were really structured to reduce buyer’s cost, since covenants and consulting fee expenses are tax-deductible.

Seventh, were the parties well informed? A widow with no knowledge of her late husband’s business would not be.

Eighth, was anybody compulsed? If the widow faced bankruptcy, she might cave in and accept an unfairly low buyout price.

The answers to these questions will provide ample and strong evidence of the relevance of a prior transaction. Ask all of them, and report the answers!

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Hyper-Precision

By Rand Curtiss | Published: August 27, 2010

Here are some examples of the sin of being overly precise:

1. A business owner wanted me to express the $5.2 dollar value of his firm as $5,205,156 (using my un-rounded weighted average value conclusion). There were 1 million shares outstanding; the difference in per share value was $5.200 versus $5.205 or less than 0.1%!
2. The highly regarded editor of a national business valuation publication as well as a court made a big deal out of a recent case in which experts clashed over the equity risk premium. One used a supply-side estimate of 6.0%, the other the historical average of 7.1%. There was no discussion of the experts’ other assumptions that built up the cost of equity capital (such as the highly uncertain company specific equity risk premium) or their (presumably very different) equity cash flow forecasts.
3. An attorney engaged in unbelievable word-smithing of a valuation report, quarreling over the placement of commas and demanding precision in the estimates of uncertain market data (such as the benchmark for lack of marketability discounts).
4. An accountant reviewing a valuation insisted on applying precise progressive corporate income tax rates to a business that earns over $4 million per year.

This demand for precision completely misses the point that financial forecasts as well as all of the market data we use (except for the risk-free rate on a given day) are inherently uncertain, some enormously so. To insist on precision to the penny per share or 1 basis point in a discount rate is impossible to obtain because of these uncertainties. Values are almost always a range of reasonable values or even a probability distribution, not a single, hyper-precise number (unless they are $0).

Worse, those who insist on over-precision often fail to fully comprehend the significance of major assumptions. For example, in a partnership value dispute where there is no buy-sell agreement, will discounts for lack of control and / or marketability apply? This will have a huge, uncertain impact on the value conclusion!

Even worse, when I work with someone who is obsessed with over-precision, I have yet to be fully successful in persuading them to focus on the big, sensitive issues that have huge value effects, rather than the picayune details. I often feel that I am talking to a brick wall when I bring up the macro versus micro focus.

Even worse, I have no effective response to someone who charges that lack of hyper-precision will risk the credibility of the valuation. I recently completed a draft valuation of a company that, according to my industry comparative financial analysis, performed better than average but not superbly. Using the Direct Market Data Method with a large sample, I therefore assigned the company a 75th percentile (25% of the sample was above and 75% was below the) valuation multiple. The advisors reviewing the draft demanded precise support for the 75% assumption, saying things like “the IRS will never accept that, they will jump on it as a guess” and so forth. They could not believe that there was no formulaic way to justify the percentile, which meant that they really could not accept the necessity of judgment as a supplement to sound qualitative and quantitative analysis.

If you have an effective response, please post it as a comment!

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How Much Do Your Readers Know?

By Rand Curtiss | Published: August 25, 2010

In addition to my full-time appraisal practice, I recently took on a new assignment, serving as a part-time instructor at a local university, something I have always wanted to do. This semester I will teach introductory macroeconomics, a survey of the U.S. economy and how it works.

Luckily for me, the course has been taught many times and the previous professor gave me her lecture notes. As I read them, I was struck by how technical they were: full of abbreviations, acronyms, and technical terms that by themselves would be incomprehensible to first-year students (and to some extent, to a 60-year old former economics major trying desperately to cram for his new teaching gig!) I am going to have to be sure to provide a great deal of careful explanation as I go along.

This also applies to business valuation reports. It is easy to (inadvertently) assume that a business owner knows a lot more than they really do about finance and valuation, and to confuse them by failing to explain important concepts. I tested this by rereading a recent report of mine, and was shocked to see that I had introduced the concept of a cash flow discount rate with no explanation at all! Shame on me, but I fixed that in my template.

Put yourself to the test: reread a report of yours and see if you can spot any undefined or inadequately explained terms. There is an art to this: we cannot be professors of valuation to knowledge-free readers, starting from ground zero and writing 500-page textbook-type reports, but at the same time we cannot be too cursory with important concepts that form the foundations of our conclusions.

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Think Like An Accountant

By Rand Curtiss | Published: August 6, 2010

If to err is human, boy, am I human! Perhaps you can learn from my most recent error!

I was valuing a business that was owed money by a shareholder. I was asked to assume that the loan receivable was uncollectible and valueless because the debtor was bankrupt. In my financial model, I therefore reduced the loan receivable to zero. When I finished my analysis, I noted that the Company’s cash balance went up, but because of brain lock I could not see why. So I called the Company’s accountant for help.

She immediately caught my mistake and taught me a great lesson: think like an accountant in terms of double entry bookkeeping. By only reducing the loan receivable to zero, I was implicitly and incorrectly assuming that it was paid (not written off). My implicit accounting entry was: debit cash (wrong) / credit loan receivable (right). The correct accounting entry was debit shareholders’ equity (or debit bad debt expense) / credit loan receivable (ignore the tax consequences just to keep it simple). Once I made the correct adjustment, everything was cool.

Bottom line: think like an accountant and make sure your adjustments follow the proper double-entry bookkeeping!

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A Note on the Justification of Purchase Test

By Rand Curtiss | Published: August 4, 2010

The justification of purchase (“JOP”) test requires that the business, if purchased for the indicated amount:

1. Can pay the owner-manager reasonable (fair market) compensation.
2. Can adequately service assumed and acquisition debt.
3. Can earn a satisfactory return on investment. (This applies only to businesses that are not “buy-a-job” entities.)

A colleague called because his JOP test was not working out, although he was sure he had reasonable assumptions and his math was correct. To make a long story short, the problem arose because of non-operating assets, in this case a hefty excess cash balance.
My colleague was subjecting the value of the equity INCLUDING THE EXCESS cash to the JOP test. The indicated rate of return on this basis was LESS than the cost of equity capital.

The JOP only considers the OPERATING ASSETS AND LIABILITIES of the business. Non-operating assets should be excluded from it. These (in this case, the excess cash), are not expected to earn a hefty return; bank deposits pay only about 1% as this is written; they are valued separately (outside of the JOP).

If you are using the Asset Approach to value a business, there is no JOP. The assets and liabilities are independently valued. If you are using the Income or Market Approach, use only the operating assets and liabilities as your justifiable value.

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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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