PLUSES MINUSES OF BUSINESS VALUATION James Lisi MBA
PLUSES & MINUSES OF BUSINESS VALUATION James Lisi, MBA, BSIE, CPIM
Overview What Are We Valuing? Value Drivers Methods Fair Market Value Analyst’s Job Defense for Litigation Current Issues James Lisi, American Value. Metrics
What Are We Valuing? An economic engine that converts an investment into a stream of profit Changes over Time - with economy, management plans and markets Where Future Performance is at Risk James Lisi, American Value. Metrics
What Are We Valuing? A Complex Enterprise with multiple subsystems � Production, quality, purchasing, sales, marketing, finance, accounting, banking, sales tax collection, employees, government relations, public relations, facilities, insurance, transportation, logistics, income taxes… James Lisi, American Value. Metrics
Value Drivers We develop an economic model to capture the investment to profit conversion process Value is driven by: � Cash flow - the wealth creation � Rate of Return - the measure of investment risk James Lisi, American Value. Metrics
Value Drivers Cash Flow is EBITDA + Other Non-Cash Adjustments EBITDA – Earnings Before Interest, Taxes, Depreciation & Amortization Note: Net Income is not cash flow. It can be easily manipulated by non-cash events
Value Drivers Rate of Return - Capitalization Rate or Discount Rate � As a business takes its investment capital and converts to profit, the capital is depleted and must be replenished � The cap rate indirectly represents the time it takes to recover an investment and turn a profit. � It is a measure of Investment Risk
Value Drivers Cash Flow and Capitalization Rates work like bonds in the market – when rates go up, value goes down, and rates go down, values go up. Positive Free Cash Flow Needed (Separate Test) � After Tax Net Income less Capital Expenditures � Growth Stages require capital investment throughout
Valuation Methods Rules of Thumb � OK for Main Street Business under $500 K in revenue Implicit Assumptions � Single line of business � No different from other similar businesses � Limited Growth Potential James Lisi, American Value. Metrics
Valuation Methods (Going Concern) Income Approach � Cash flow and capitalization rate from historical performance are used to derive a value Market Approach � Cash flow and a capitalization rate from market comps performance are used to derive value Liquidation Approach (Value Minimum) � Analysis to wind down operations and liquidate assets is prepared to derive value
Valuation Methods Discounted Cash Flow Approach � A projection of future cash flows is discounted back to present to derive a value � Defining the discount rate is a critical analysis Replacement Approach � Analysis to build operations up from scratch is prepared to determine value
Start-ups Since we value based on future cash flows, Value for a Start-up is shown in its Business Plan and how far along in development the company has come Since there is little or no historical record of performance, the investment is risky How risky? - The success rate of an entrepreneur’s first startup is 18%, the second 20% and the third 30%
Expect a Range of Values Multiple Business Variables and Characteristics Depends on the Investor/Buyer’s Use and Rationality Depends on the Seller’s Needs and Rationality James Lisi, American Value. Metrics
Analysis The numbers are not an end in themselves. Rather they are a means to understanding what is really happening with a company. From the valuation approaches it’s clear that the key elements in increasing company value are: � Decreasing investment risk � Increasing cash flow James Lisi, American Value. Metrics
Business, Market & Player Dynamics Cash Flow Supply & Demand Value Risk & Deman d Strategic Value James Lisi, American Value. Metrics Risk
Expect a Range of Values Range of values is from the investor/seller’s value to the buyer’s value Price will be in the Middle James Lisi, American Value. Metrics
Strong Seller Buyer Seller Fair Market Value Sale Price Buyer’s Value Seller’s Value James Lisi, American Value. Metrics
Fair Market Value (FMV) So we can see that there is a large variation in what value a buyer and seller may agree on Business valuation becomes a complex process of projecting a business model, market and unique factors Expected to yield imprecise and uncertain results To actually complete a valuation, we have to limit the circumstances. This has resulted in the definition of the concept of Fair Market Value (FMV) James Lisi, American Value. Metrics
Fair Market Value (FMV) US Tax Court Fair market value is the price at which a property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. Wikipedia: Fair market value is an estimate of the value of an asset, based on what a knowledgeable, willing, and unpressured buyer would probably pay to a knowledgeable, willing, and unpressured seller in the market. James Lisi, American Value. Metrics
Valuation Purpose Statutory � Minimum defensible value Market � Willing buyer & seller under current business plan Investment � Capital added to accelerate current business plan Strategic � Control � Synergy analyses on new business plan � Typically a buyer’s analysis James Lisi, American Value. Metrics
Strategic Buyer Competitor or Vertical Partner in Supply Chain Willing to Pay More for: � Reduced Competition and Higher Prices � Strategic Customers � To Acquire Technology or Talent � To Unlock Underutilized Assets � To Reduce Costs, Improve Buying Power Provides Higher Cash Flow, Risk Reduction James Lisi, American Value. Metrics
Strategic Buyer Waze is being bought by Google Mapping technology using cell phone data Four years old $67 million invested 47 employees What’s it worth? James Lisi, American Value. Metrics
Strategic Buyer Google is paying $1. 3 Billion. Nineteen times capital invested Who knew? James Lisi, American Value. Metrics
Irrational Seller Retiring company founder of a 30 year old manufacturing firm Used to making decisions on his own Knows what the company is worth using Industry Rules of Thumb from years in the industry association Asking $7 million - 3 times earnings plus inventory Does he get it? James Lisi, American Value. Metrics
Irrational Seller You bet. The seller didn’t account for the fact that over 30 years the company had grown into a higher earnings multiple for valuation. Based on market comparables for that size of operating income and projected earnings, the seller left $3 million on the table. Lesson: At a certain value and risk, it’s profitable to use good advisors James Lisi, American Value. Metrics
Angel Investor Will not be able to get cash out for a long period of time Expecting a 70% Failure Rate Invests in ten companies to assure a positive investment return Seeks a 10 X return on each investment - a 3 X payback of invested capital
Analyst’s Job Determine Cash Flow from Financial Statements Determine Capitalization Rate Evaluate Projections of Future Cash Flows Select & Construct Appropriate Market Comparisons Prepare each Valuation Approach Reconcile the Approaches to a Value Determine Discounts for Secondary Analyses � Control � Marketability. James Lisi, American Value. Metrics
Accreditation Recognized as a separate appraisal discipline in 1978 50, 000 professionals value at least occasionally 10, 000 accredited valuation analysts 2, 000 full time firms 300 Master Analysts in Financial Forensics James Lisi, American Value. Metrics
Standards Uniform Standards of Professional Appraisal Practice (USPAP) is the U. S. standard for real property, personal property, intangibles, and business valuation appraisal analysis and reports. USPAP is not required for business and equipment valuation. Federally regulated institutions require USPAP. So federally guaranteed loans, such as SBA loans, must have a supporting USPAP James Lisi, American Value. Metrics compliant appraisal.
Standards USPAP Key Differentiators � Requires Market Comparisons � Must be a Self-Contained or Full Report James Lisi, American Value. Metrics
Defense for Litigation What makes a valuation opinion valuable is the degree to which it is defensible Courts generally say “Show your Reasoning” in order to accept a valuation conclusion. One way to improve defensibility is to ensure that competing approaches are considered in the valuation process and assessed for their relevance. James Lisi, American Value. Metrics
Litigation Issues Daubert Challenges � Opposition tries to knock out the rival appraiser before trial by attacking their credibility � Formulaic approaches often thrown out completely � Proven Appraisers withstand a Daubert challenge James Lisi, American Value. Metrics
Current Issues Private Equity � Use of financial derivatives – such as stock options – that require valuation as done by public markets Government Attention � Recognizing taxable events � Regulating toward independent valuation Fair Value Accounting � To prevent crises due to over/undervalued assets James Lisi, American Value. Metrics
Private Equity Shift Classic Private Equity was: � Family Business � Regional Markets � Stable Growth � Manageable Capital Needs � No Intellectual Property Valuation Triggers � Sale � Estate Plan or Gift � Dispute or Divorce James Lisi, American Value. Metrics
Private Equity Shift Growth companies moving from public financing to private markets Ongoing needs for Capital and Management Talent Valuation Triggers: � Outside investors with preferred stock � Management with Stock options � Acquisition Activity � Intangible Assets � Impairment James Lisi, American Value. Metrics
Private Equity Shift Valuing this new private equity venture calls for � a knowledge of the drivers of business value � a quantification of business risk � adapting business valuation techniques used for illiquid markets to private stock, financial derivatives and incentive compensation We have a number of academics valuing business based on theory and formula, particularly option modeling – it fails because it bases private stock valuation on public market data James Lisi, American Value. Metrics
Government Attention Advocating for arms-length valuation by third party valuators Provides safe harbor for third party valuation in IRC 409 a for private stock option valuation James Lisi, American Value. Metrics
Fair Value Accounting Also called Mark-to-Market accounting An ideal “exit value” for assets or liabilities through orderly transactions at a particular time Reflects conditions at the balance sheet date � Bubble Markets � Depressed / Illiquid Markets James Lisi, American Value. Metrics
Fair Value Accounting Pros: � More accurately communicates current value � Self correcting over time � Best platform for communicating current enterprise value to investors James Lisi, American Value. Metrics
Fair Value Accounting Cons: � Recognizing non-cash gains & losses makes owners’ equity volatile and could create systematic investment risk � Added cost for recurring valuation of assets � Tax basis and Reporting basis may require separate accounting James Lisi, American Value. Metrics
Take-Aways DECREASE RISK, INCREASE VALUE. That's because risk and value move in opposite directions. We see it every day in the bond markets. Fair Market Value (FMV) is a judgment, a calculated opinion. Price is negotiated and may be higher or lower than FMV. Prepare like you are going to court – and you rarely do. Anticipate competing approaches and address them in the analysis. We see a much broader size and range of financial activity in private markets today that has been placed through public markets in the past. Use caution with analyses founded solely on financial theories, James Lisi, American Value. Metrics those without some basis in markets.
Contact Info James (Jim) Lisi American Value. Metrics james. lisi@americanvaluemetrics. com 805 -797 -1710 www. americanvaluemetrics. com James Lisi, American Value. Metrics
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