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.

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!

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.

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.

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).

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.

1. The valuation date
2. The entity to be valued
3. The interest to be valued
4. The standard of value
5. The level of value (e.g. non-marketable minority)
6. The premise of value (e.g. going concern)
7. The user of the report (e.g. client and advisors)
8. The use of the report (e.g. gift taxation)
9. The critical assumptions (e.g. whether a new contract will be obtained)

Most of the time, there is only one answer for each parameter. For example, we are appraising the December 31, 2009 non-marketable minority fair market value of a 5% common equity interest in Family Business, Inc., a going concern, for tax purposes so that Mr. and Mrs. Owner can make gifts to their children with the help of their attorney. We are relying on the integrity of compiled financial statements.

What happens if there are multiple answers for any of the parameters? I am only going to address this individually for each of the nine parameters; if more than one have multiple answers, I would never finish this post?

If multiple valuation dates are needed, I usually recommend that a separate report be issued as of each valuation date. Moreover, I take great pains to do the earliest dated report first, and to identify whether any subsequent events were known or reasonably knowable as of the (earlier) valuation date. I state in my report that either there were none, or how I considered the subsequent events. The later report(s) will consider these as having happened (if they did so before the later valuation date(s), and reconsider whether they were known or reasonably knowable if they did not. This comes up a lot in matrimonial valuations where the valuation date is often impossible to establish.

If there are multiple entities, I ask the client and their advisors what they would prefer. If the entities are affiliated (under common ownership or related in some way), I usually suggest one report covering all of them so that the interrelationships, and the fact that I handled them consistently for all entities, are clearly explained.

If there are multiple interests to be valued, I also suggest one report, but make it very clear as to the differences between them (usually in the level of value, if applicable).

If there are different standards of value, I usually recommend separate reports except in the case where a client asks for a “constellation of values” to help them decide whether to gift partial interests (fair market value) or sell the whole company (strategic or investment value).

If there are different levels of value, I suggest just one report that highlights the differences in the applicable premiums and discounts. This comes up often with multi-owner businesses with no buy-sell agreements, which raises the issue of whether discounts for lack of control and / or marketability will apply.

If there are different premises of value, I suggest just one report that highlights the differences. Sometimes I will weight them to come up with a single value, sometimes not. This one is highly dependent on individual case facts and circumstances.

Multiple user (counting the client and his / her advisors as one user) situations come up when we are, for example, jointly retained by disputing parties. I issue one report to all parties.

When there are multiple uses of the report (e.g. gift taxation and buyout of an owner) and everything else has one answer, I will suggest one report, but am equally happy to issue one for each use (because it takes about ten minutes to make the necessary edits to generate the second report from the first).

Finally, if there are multiple critical assumptions (e.g. the contract is secured or it is not) I will issue one report and cover both circumstances, possibly giving them some sort of probability weight to arrive at a final, single value conclusion.

Finally, when in doubt, ask the client and their advisors what they would prefer!

I have found it very helpful, at least once a year, to segment the market for business valuation services into niches so that I can decide which ones to go after. I do this with a number of different “cuts”:

1. Use of appraisal: taxation, transactional, litigation, and compliance, in conjunction with the demand for the given use. Transactional is real deals – purchase and sales of whole businesses or interests in them, and includes fairness opinions (if you want to do them). Litigation includes dissenting shareholder matters, divorce, and damages. Compliance includes ESOPs, financial reporting, and SBA lending. You might choose to categorize these uses in a different way, this one works for me. I may have left some out: if so, I apologize, let me know what I missed!
2. Size of company: startups, buy-a-job businesses, small, medium, and large (you decide how to quantify the last three! I do not do very much public company work; the big national valuation and accounting firms are set up much better for those usually huge projects. I like to have a large number of small engagements going or in the pipeline, on the theory that singles and doubles add up to a lot of runs over time.
3. By what you are good / bad at and / or like or don’t. (I dislike litigation and do little of it. I eat FLPs for breakfast.)
4. By geographic area: what radius or communities can you effectively service? I generally target the northeastern quadrant of my home state, Ohio: anything within easy driving distance. I will not turn down an engagement outside my market area unless it is going to involve extensive travel, this because there is so much business in Northeastern Ohio. With Skype I can do virtual plant tours and management interviews.
5. By what types of industry are prevalent and doing well in your market. If you live in my area, you need to know about machine shops, steel service centers, and injection molders!
6. Ruling out industries that require special expertise that you do not have (in my case, mainly medical practice valuations.)
7. Ruling out work you are not qualified or permitted to do by other professional standards: business appraisers are not qualified to value fixed assets, and CPA’s are prohibited from doing certain kinds of work for tax / audit clients.

Everyone will come up with different niches, and these will change over time. This is a worthwhile exercise to do every year. I take myself on a one-day personal retreat to do it.

My practice started out heavy on transactional and tax work and has remained so. I let litigation come to me, and am very selective about it. A big growth area for me has been valuations for financial reporting; I took courses, talked to colleagues, and read the literature on this to get up to speed. This has worked out well for me.

On the other hand, about 15 years ago, there were 26 hospitals and an untold number of independent medical practices in Cleveland alone. A huge wave of consolidation was about to occur. I started getting many requests for medical practice valuations from hospitals that were buying them. After a period of reflection, I concluded that although the short-term benefit of getting this expertise was high, in the long term there would be little demand for it in my geographic area. So I passed it up. As things turned out, the consolidation went really fast; within three years there were two major hospital groups and almost no attractive independent medical practices left. I would have worked like crazy (and done well) for a short time, but would have neglected my other niches to my long-term detriment.

Again, your assessment of your niches will be different than mine: the important thing is to think it through both short- and long-term!

For the very few who ask for signed hard copies, I print, sign and have Fedex / Kinko’s bind and mail them, at no additional cost to clients.

Go green, and save trees, paper, ink, time, and money!