Buy-a-job businesses are not just small ones! I have valued many large family-owned businesses that employ multiple (generations of) family members and pay them fair market (and sometimes greater) salaries. If you are valuing a minority interest in such a business, its fair market value might be very low! The family is not going to downsize relatives or or cut their pay!

I can think of three general situations that could make a large business a buy-a-job business:

1. Family member employment and compensation policies divert most of the return to family member labor, not owners’ return on equity.
2. The business is in an extremely competitive industry with very low operating profit margins.
3. The business is highly levered, with debt service obligations absorbing most or all operating cash flow.

I run into situations like this frequently, and am not at all embarrassed to conclude low fair market values for the stock of such businesses!

The JOP tests whether a concluded value is reasonable. Note first that the “concluded value” is the value of 100% of the common stock of a business. As described here, it cannot be used to test fractional or illiquid values (control, minority, or non-marketable minority), because it makes no allowances for premiums or discounts. It also assumes that the buyer pays cash at closing (and perhaps receives seller financing). If the buyer borrows personally to raise the cash at closing, do not count that as debt to use the JOP as described here.

The JOP uses the Income Approach applied in reverse (that is, when we have a concluded value), and asks three questions. If 100% of the stock is purchased for cash at the concluded value:

1. Can the business pay the manager (who might also be the owner of the stock) fair market compensation?

2. Can it adequately service all debt (seller financing plus any assumed business debt)?

3. Can it generate an adequate return on the buyer’s cash investment at closing? (This criterion does not apply to “buy-a-job” businesses.)

If the answers to the two or three questions are yes (demonstrate it in your report), the JOP test is satisfied.

Consider the use of the JOP relative to each appraisal approach (assume that we use only one).

1. In the Income Approach, the JOP is automatically satisfied. The value of the stock was the present value of discounted or capitalized cash flows to equity at the appropriate rate. Assuming that fair market compensation and adequate debt service were projected, the purchase price was based on an adequate return on buyer’s investment.

2. In the Asset Approach with a liquidation premise of value, the JOP does not apply: liquidated value is a cash value.

3. In the Asset Approach with a going concern premise of value, or the Market Approach, the JOP is very powerful. In both cases, we used value metrics other than cash flow to equity to value the business, so the JOP provides an independent decisive test of the concluded value.

You can also see that the JOP is a great way to rebut another appraiser’s value conclusion.

I have starting calculating a simple ratio – cash flow to equity divided by sales – the cash flow to equity analogue of net income margin. This is very informative, because it tells me how much cash flow to equity is generated per dollar of sales revenue!

Assume we are valuing a non-marketable minority interest in a local car dealership for tax purposes.

In our economic and industry analyses, we do not know what specifically drives dealership revenue. We use proxies such as projected national, state, or local vehicle sales data and make implicit assumptions about the size of the dealership’s market and its share of it.

In our financial forecast, we might decide to use historical (weighted) average revenue as a proxy for future revenue.

In our discount rate, we use proxy public market rate of return data and proxies for company-specific risk.

In our lack of control discount analysis, we might use control premiums as proxy data.

In our lack of marketability discount analysis, we might use restricted stock and other proxy data.

In a Black-Scholes model, we might use public company data to estimate volatility.

I have found that one of the best ways to improve my appraisal knowledge is to think carefully about the strengths and weaknesses of each proxy compared to the ideal (unavailable) data. For example, it is clear that restricted stock discounts (which now lapse in one year) understate the private equity lack of marketability discount, since private equity has a longer holding period. When you read court cases, academic, or professional literature, much of the discussion usually highlights the strengths and weaknesses of each proxy.

Company boards of directors may authorize the issuance of employee stock options at ANY exercise price they deem appropriate. They may decide to issue them at exercise prices below fair [market] value. (I assume in this post the equality of fair value for financial reporting and fair market value for tax purposes.) If the issue-date exercise price is below the fair [market] value of the underlying common stock, there are adverse financial / tax consequences: companies incur non-cash compensation expense and option grantees earn non-cash income equal to the difference between the fair [market] value and exercise price of each issued option.

IRC 409 and ASC 718 valuations determine issue-date common stock fair [market] value: the lowest exercise price that avoids those adverse consequences. Their ONLY purpose is to inform boards of that trigger price. Our appraisal responsibility ends when we do that correctly. What the board decides to do with that information is NOT our concern or responsibility.

These valuations do NOT help boards address three major issues: incentives, dilution, and retention:

To understand the incentives issue, think of an Olympic high jump. The higher the bar is set, the more difficult it is to jump over it. The current world record is 8 feet. A 10-foot bar is too high: nobody can or will try to jump over it, so its incentive benefit is zero. (Nobody will try for the gold medal.) A 3-foot bar is too easy: everyone can and will jump over it, so its incentive benefit is also zero. (Everyone wins a gold medal.) There is an optimum height (or range of heights) somewhere between 3 and 10 feet that will motivate as many people as possible to try to clear it (because they think they can), but they are only rewarded with a gold medal if they succeed. This height creates the optimum incentive. 409 / 718 valuations do not help boards with incentives.

To understand the dilution issue, think of an [American apple] pie. An outstanding, unexercised employee stock option is a potential slice of pie. When these options are exercised, they dilute the common equity pie. This is because they are exercised only when the stock fair [market] value exceeds the exercise price. The company receives the exercise price proceeds, which are less than fair [market] value, and the number of shares rises, increasing the number of pie slices and reducing (diluting) their size (value). 409 / 718 valuations do not help boards with dilution.

The retention issue is simpler: companies need to furnish options to their key employees to attract and retain them. They view options as cheaper than bonuses because they conserve cash in the short- and intermediate terms, particularly for development-stage companies that will need multiple rounds of financing.

What follows is a purely personal opinion: your experience may be different. Based upon what I hear from them, most private-company boards do not appear to be overly concerned about incentive and dilution issues, and accept retention issues as competitive necessities. As a result, most tend to set option exercise prices at or just above fair [market] value. Food for thought: if you were a common shareholder of such businesses, how happy would you be about that?

…from Sea to Shining Sea!

Well, duh, probably every buyout you have handled has at least one of these problems, or your expertise would be unnecessary … so I will venture to say that every single one of them involved at least one!

Assume the business – all shareholders as a group, not the buyer(s) or seller(s) – has engaged us to provide objective, independent, and constructive valuation advice. Assume we have helped everyone come to agreement on enterprise value – the value of 100% of the equity or capital of the business (and that this value reflects any changes in compensation or anything else that will occur because of the buyout). If this cannot be achieved, there is no way a deal can be made on a rational basis (that is, with our quantified advice. (When engaged for this type of transaction, my letter states that if there is no agreement on enterprise value, my work is complete, I am ineligible for retention by anyone in any legal action or further engagement, and if called to deposition or testimony, I will be retained in advance by the business).

Now the owners have agreed on enterprise value: the first of the three issues is resolved. The next two are the level of value and payment terms. Remember that this is an actual transaction unbound by a buy-sell agreement – so the standard of value is investment value, not fair market or fair value. (Fair market value might be relevant if the owners are family members, but I am going to assume they are not, just for simplicity. Fair value would be relevant if dissenting shareholder litigation ensues, but my engagement precludes me from involvement in that other than to testify as to what I did in the current engagement.)

The point is that the investment value standard means that the level of value (whether discounts and premiums apply) and the payment terms are negotiable, not stipulated. What counts is not what the appraiser says, but whether the parties can agree. This is CRITICAL! All the appraiser can do is offer objective advice. The parties decide whether to take it or not. When I give advice, I try to suggest processes and procedures, not specific numbers because numbers just hang everyone up.

At this point, I like to meet with the parties in person or in a conference call – the key is for all to be present, not for me to speak to one side or the other privately (which could risk my credibility).

First, I tell the sellers that they probably expect to receive their pro rata (I explain this term) percentage of the value of the business in cash. After all, if the whole business were sold, that is what they would receive. They might also feel this way if they bought in on a pro rata basis. Despite that, they are minority shareholders who suffer from lack of control and marketability (and I explain each of these), so a third-party cash buyer would pay them less than pro rata value. I also acknowledge that this might be something they had never thought abou. The bottom line is that the cash value of their individual interests is less than pro rata value. (Now I have upset but softened up the sellers a little.)

Now I turn to the buyers and tell them that the sellers do not have to accept any discount, and that the idea of a discount or a high one may be a deal-breaker. If the buyers want to make a deal, they are going to have to make the buyers willing to accept it. (Now I have upset but softened up the buyers a little.)

[Note: at no time have I disclosed how big a discount I think might apply. As you will see below, I will have done some calculations, but now is not the time for me to opine anything! Remember, the goal is to get the parties to agree. Numbers do not help, ideas do.]

At this point, I say that we can progress in a number of ways. One, the parties can just haggle. If they want to do that, I will excuse myself. On the other hand, I have an idea they might want to pursue. Would they like to hear it? (Of course!)

I propose a compromise that I call “seller’s price, buyer’s terms.” What this means is that the sellers receive their pro rata share of value – whatever number of dollar bills that is – but that the buyers get to structure the transaction to pay money out over time. For example, the buyers might accept a payout over three to five years.

[Note: I am keeping it extremely simple at this point. First, I am proposing simple seller term financing: if the payment term is 4 years, the sellers get 20% down and 20% annually for the next four years at yearend, with no interest. If the business has extremely risky prospects, I may later broach an earn-out. Also, not being an attorney, I will not get into issues of guarantees and security.)

If the parties are amenable to this, I present those three- to five-year (or whatever) payout schedules in the context of a pro forma company financial projection that assesses how easily company cash flow to equity can service the obligations.

Then I compare the present value of the payments over time (usually discounted at the company’s cost of equity capital, assuming that the payments will be subordinated to bank debt so that the payments come out of cash flow to equity; this can vary with case facts and circumstances) and compare it to the undiscounted amount. This indicates the total discount. A perceptive seller might counter that the discount rate should be the cost of debt. That is reasonable if bank financing is available, and suggests a much lower discount, which gives more room for negotiations. THEN I compare these discounts to those calculated using our traditional LOCD and LOMD methodologies.

Now I am done: I have given the parties objective, quantifiable bases to negotiate, and the rest is up to them.

In a recent case, plaintiffs were squeezed out of minority interests in a public company (domiciled in Delaware) that was acquired. The attorney advising them failed to file the appropriate paperwork on a timely basis to allow them to exercise dissenters’ rights. As a result, they were forced to accept the (cash) tender price. To his credit, the attorney admitted his error and advised his former clients to seek legal representation to claim damages incurred due to his malpractice. They did so, and the malpractice attorney who took the case called me for help.

My first question was “What damages are the plaintiffs claiming?” The answer was the lost opportunity to receive a potentially higher price by filing a dissenting shareholders’ suit. This helped a great deal: when I Googled “fair value in Delaware, the first entry that came up was a wonderful piece by none other than Chris Mercer, which can be found at:

http://valuationspeak.com/fair-value-statutory/statutory-fair-value-1-an-introduction/

Chris artfully describes the Delaware fair value standard in these words:

“…take the fairly common cases of a squeeze-out merger or a reverse stock split. The effect of either transaction is to attempt to force minority shareholders to receive the consideration offered by the controllers. If the right to dissent is triggered, affected owners can dissent to the transaction and petition the courts in their states to determine the fair value of their shares.

Fair value in such situations is a willing buyer, unwilling seller concept.

Fair market value is an objective standard. Fair value, on the other hand, is an equitable standard. Equitable is defined in YourDictionary.com as: “Fair, under widely held moral principles, often embodied in court precedents; or referring to a remedy available in a court of equity.”

A “court of equity” is defined in Wikipedia.com (footnotes omitted) as:

… A court that is authorized to apply principles of equity, as opposed to law, to cases brought before it.

These courts began with petitions to the Lord Chancellor of England. Equity courts “handled lawsuits and petitions requesting remedies other than damages, such as writs, injunctions, and specific performance.” Most were eventually “merged with courts of law.”

United States bankruptcy courts are the one example of federal courts [that] operate as courts of equity. Some common law jurisdictions–such as the U.S. states of Delaware, Mississippi, New Jersey, South Carolina, and Tennessee–preserve the distinctions between law and equity and between courts of law and courts of equity.
The point of this seeming diversion to talk about fair market value, equity, and courts of equity is to illustrate that there is potential tension between objective valuation standards and the standard of fair value as it might be interpreted based on equitable considerations by a court.

As a business appraiser, I can provide objective valuation evidence to a court in a fair value proceeding.

As a business appraiser, I cannot consider equitable issues in providing valuation evidence unless instructed by a court.”

THAT is extraordinarily on-point advice, and I thank you, Chris!

Now I knew what the standard of value was and how to interpret it: my job was to act as though I were the expert in a dissenting shareholder suit and to do the same thing (determine fair value according to Delaware law) in the damages case.

I discussed this with the attorney and he was in agreement with me. From additional research, I knew that I would be able to use the Market and Income Approaches, and had a game plan for the valuation and more than enough data to do the job right. Everything was copacetic…

Until a couple of nights later, when I woke up, as I often do, with a new thought. I knew I could develop a supportable fair value of the minority shares…but there was a twist. Just because I opined it, was there not a risk that the judge who heard the case might come to a different conclusion? What if the expert on the other side did a good job and came up with a lower value? The judge might not accept my opinion of value. Was this an additional risk? If so, was it relevant to my opinion? How would I assess it and adjust my opinion for what I called “judge risk?”

Fortunately, I have friends who do a lot of damages work. They told me that judge risk is not part of the damages opinion. I confirmed that with the attorney.

It is now a week later, I am in the middle of my engagement, and have slept well since that fateful night. I hope to keep doing so, but I never know, my subconscious seems to run 24/7!

I started wondering about the source of the rule about considering five years of historical results. I learned this in my appraisal courses, and the earliest citation I can find is in Revenue Ruling 59-60, Section 4, Paragraph 2(d). In 1959, after a very tranquil decade, a five-year look-back was certainly useful. Today, not so much!

Revenue Ruling 59-60 has certainly stood the test of time. Most of its guidance remains valid today. I think its most perceptive suggestion is that appraisers use “common sense, informed judgment, and reasonableness” (Section 4, Paragraph 3.17).

My valuation teachers recommended that I reread Revenue Ruling 59-60 often. I do so. Every reading gives me new insights!

In a price allocation for financial reporting, the most important reader is the client’s auditor, who will almost certainly be knowledgeable about valuation. In a selling price analysis for a small business, the most important reader is the prospective buyer, who may not know anything about valuation. Tax-related valuations fall in the middle: IRS agents have varying knowledge levels.

I write to the knowledge level of the most important reader. I write more briefly and cogently to knowledgeable readers than I do to those with less knowledge, for whom I add explanatory details and highlight crucial assumptions and explanations in bold type. There is a tradeoff between brevity and clarity: briefer reports may not be as understandable as longer ones, but longer ones risk wasting knowledgeable readers’ time. I designed my report templates for less knowledgeable readers. I reduce or eliminate explanatory details for knowledgeable ones.

I ask all readers whether my report was too brief or long, and whether it provided sufficient explanation. The ongoing feedback allows me constantly to tweak my templates to achieve brevity and clarity.

Here are useful recent reader comments that led me to (I hope) be briefer and clearer:

1. An IRS agent mentioned that, with the publication of the IRS DLOM Job Aid for Valuation Professionals, they are aware of the relevant market studies’ strengths and weaknesses. If I cite them in a summary table (rather than regurgitating all of the details), that is all they need. (THEN they can challenge my conclusion!)

2. A sophisticated CFO asked me to explain the table row and column labels and calculation formats in my report. He was kind enough to suggest changes. The improved version was something I never would have developed myself!

3. Another CFO’s comment was exceptionally illuminating. He understood my report (a Section 409A valuation for option grants) and proved it by asking sharp, relevant questions. Then he said that the most important readers of the report were the company’s directors, many of whom had little valuation knowledge. He did not want me to expand my report, but he did ask me to go through it with him in detail so that he could answer anticipated questions. He also asked me to attend the board meeting, and he did such a great job with his explanations that I had nothing to add!

4. In an estate tax valuation, the attorney said right up front that she was a stickler for language, demanded that everything be just so, and told me to expect to go through perhaps half a dozen revisions (just on language). She was certain that the estate tax return was going to be audited (because of issues unrelated to the business I was appraising) and wanted a “bulletproof” report. She understood that no appraisal is bulletproof because there are always subjective judgments, but she wanted to make sure there were no other (admittedly nit-picking) weaknesses. I appreciated her candor: we went through 17 revisions, but I knew what to expect, that it was not personal, and the report that emerged was, at least in language, one of the best I have ever produced!

This is a classic case of a business whose revenues cannot be projected with any confidence whatsoever. No willing buyer would believe them or pay for any highly speculative growth; the business’s backlog is maybe 3 months of contracted revenue at any time.

All we can do in situations like this is to look at history and take an average of some sort to estimate a “typical” year’s performance. That’s how a buyer would value the business. This is where the single-period capitalization model is preferable to a multi-period discounting model. We are assuming that the future will be like the past: highly volatile, and that is all we can say about it!