Business Valuation Basics for Attorneys

Journal of Business Valuation and
Economic Loss Analysis
Volume 1, Issue 1
2006
Article 7
Business Valuation Basics for Attorneys
William P. Dukes∗
∗Texas Tech University
Copyright c 2006 The Berkeley Electronic Press. All rights reserved.

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Business Valuation Basics for Attorneys
William P. Dukes
Abstract
Of all of the businesses in the Nation about .5% could be classified as actively traded, the
other 99.5% require special treatment for valuation purposes. A number of the important issues
are reviewed, all of which should be understood by all Attorneys who could have clients involved
in business valuations. Issues are related to accounting practices, premiums, discounts of various
sorts, required return, capitalization rates and proxies for variables not available. Most of the issues
are illustrated in a practical valuation. Quantification of a number of the variables is illustrated as
well.
KEYWORDS: business valuation, income approach, valuation methodologies

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Dukes: Business Valuation Basics for Attorneys

With more than 25 million (IRS - 2003) businesses in the U.S. and something less
than 1 percent tradable in any meaningful way, valuation issues are much more
important for small/closely held businesses than for large cap stocks, because the
World knows about large stocks and can obtain good data on those large firms,
especially those actively traded. Consequently, in this paper an effort will be
made to identify some of the more important issues and indicate the source of the
studies that have been made to help provide a standard method where possible.

The difficulty of assessing the “value” of small companies is that some of the
variables used in the valuation process for actively traded securities are not
available for small/closely-held firms; therefore, proxies for these variables must
be used. Complicating the valuation exercise is the fact that practitioners and
academics may use the same theory (valuation model) but differ somewhat on the
nature of the variables and the way they are to be proxied. When these
differences occur they will be identified and the basis for each indicated. The
remainder of this paper is organized as follows. First, a discussion of valuation
methodologies is presented. Then a discussion of possible accounting issues,
along with a discussion of discounts and premiums is given. The paper concludes
with a case illustration and a discussion of the differences between theory and
practices.

VALUATION METHODOLOGIES

There are two fundamental bases on which a company may be valued:
1. As a going concern, and
2. As if in liquidation.
The value of a business is the higher of two valuations, one as a going concern
and the other on a liquidation basis. This approach is consistent with the appraisal
concept of the highest and best use, which requires a valuator to consider the most
optimal use of the assets being appraised under current market conditions. If a
business will command a higher price as a going concern then it should be valued
as such. Conversely, if a business will command a higher price if it is liquidated,
then it should be valued as if in orderly liquidation.

Going concern value assumes that the company will continue in business,
and looks to the firm’s earning power and cash generation capabilities as
indicators of its fair market value. There are many acceptable methods used in
business valuation at this point of time. The foundation for business valuation
arises from what has been used in valuing real estate for many years. The three
basic approaches that must be considered by the valuator are:


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Journal of Business Valuation and Economic Loss Analysis, Vol. 1 [2006], Iss. 1, Art. 7
1. The Market Approach,
2 The Asset Based Approach, and
3 The Income Approach

Within each of these approaches there are many acceptable methods
available for use by the valuator. A good valuator will test as many methods as
may be applicable to the facts and circumstances of the business being appraised.
It is then up to the valuator’s informed judgment as to how these various values
may be reconciled in deriving a final estimate of value.

The Market Approach

The market approach is the most direct approach for establishing the market value
of a business. Using this approach, the valuator tries to locate guideline businesses
that have been sold in order to make a comparison of value. This approach is
similar to what is used in appraising residential real estate.

Generally, this approach is difficult to use for small, closely held
businesses because guideline companies are scarce and reliable information is
difficult, if not impossible, to obtain. Great care must be applied in the use of this
approach, because the probability of identifying other businesses with the same
products, same size, same financial condition, and same capital structure, is
somewhat like trying to find a needle in a haystack.

The Asset Based Approach

The asset based approach, sometimes called a cost approach, is an asset oriented
approach rather than a market oriented approach. Each component of a business is
valued separately, and then summed up to derive the total value of the business.
The valuator estimates value, using this approach by estimating the cost of
duplicating or replacing the individual elements of the business being appraised,
item by item, asset by asset. As an example, a business is completely based on
renting/ leasing farm equipment to those farmers in need of equipment they do not
own personally. Each piece of equipment should be valued independently from all
other pieces and then the sum of all of the items, plus the land and any building in
use.

The tangible assets of the business are valued using this approach,
although it cannot be used alone if there are intangible assets with value, then this
approach cannot be used.

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Dukes: Business Valuation Basics for Attorneys
The Income Approach

The income approach or investment value approach, attempts to determine the
earning power of the business rather than asset value or the market approach. This
approach assumes that an investor could invest in a business with similar
investment characteristics, although not necessarily the same business.

The computations using this approach are based on the value of the
income produced by the business capitalized by a required rate of return, or
discounting future income back to the present time. Determining the income to
capitalize or the future income to be discounted requires special judgment and
knowledge. No one knows what the future holds but we must make estimates
based on knowledge available. Historical data is generally used as a starting point
in many of the more acceptable methods. The future cannot be ignored so the
valuator has to make the best estimates based on what is known about the
business.

Liquidation Value

The liquidation value assumes that a business has greater value if its individual
assets are sold to the highest bidder and the business ceases to be a going concern.
According to Pratt (1996), liquidation is in essence, the antithesis of a going
concern value. Liquidation value means the net amount the owner can realize if
the business is terminated and the assets sold off in piecemeal. Pratt states that “it
is essential to recognize all costs associated with the enterprise’s liquidation.
These costs normally include commissions, the administrative cost of keeping the
company alive until the liquidation is completed, taxes and legal and accounting
costs. Also, in computing the present value of a business on a liquidation basis, it
is necessary to discount the estimated net proceeds at a rate reflecting the risk
involved, from the time the net proceeds are expected to be received, back to the
valuation date.”
Pratt continues by stating:
“For these reasons, the liquidation value of a business as a whole normally
is less than the sum of the liquidation proceeds of the underlying assets.”

NEED FOR PROXIES IN THE VALUATION PROCESS

Many valuation approaches in finance are based on some version of the Capital
Asset Pricing Model (CAPM). The CAPM is expectational and we have no way
of knowing what will happen, nor when it will happen, because it is necessary to
use ex-post data as proxies for their expectational counterparts. The CAPM is
given by equation (1):
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Journal of Business Valuation and Economic Loss Analysis, Vol. 1 [2006], Iss. 1, Art. 7
E(ri) = rf + B[E(Rm-rf)] (1)
Where:
E(ri) = expected or required return for firm or asset.
Rf = the risk free rate of interest.
Bi = the beta for the firm or asset i.
E(rm) = the expected return on the market.



Market Risk Premium


A standard practice is to proxy the market by use of an index of choice. Ibbotson
and Associates (2005) use the S&P 500 as a proxy for the “market.” No doubt
others would prefer to use Wilshire 5000, or Russell 3000. A choice of market
risk premium, [E(rm)-rf], is an Ibbotson suggested calculation done in the
following manor:
1+ S&P 500 return/1+Tbill return
1.123/1.038 = 1.081888-1 ≈ 8.19%
Practitioners would select a 20 year T Bond where the long-run average returns
on a 20-year Treasury Bond have been 5.8% to provide
1.123/1.058=1.0614366-1=6.14%
For the period 1926-2005, the long-run arithmetic average return on the S&P 500
has been 12.3 percent and the average return on the Treasury Bill has been 3.8
percent. In either case the risk premium is calculated by using a proxy for the
market and a proxy for the risk free rate.

Risk Free Rate

We all know and accept the fact that there is no true “Risk Free Rate,” but we
continue to function with differing proxies. In a survey Dukes, Bowlin and Ma
(1996) found that practitioners selected T Bonds over T Bills by a substantial
margin. It is instructive to note, however, that the use of Treasury bill returns as
proxies for the risk free rate is not without concern. In Harrington (1987), she
discusses her concern with the Federal Reserve Board intervention that takes the
Treasury Bill rate out of the “pure market rate” category by pointing out that these
“rates are influenced, either directly through interest rate control, or indirectly by
controlling money supply…in its pursuit of such things as employment, economic
growth, and international stability…” In addition “short-term Treasury securities
show significant variability over time.”


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Dukes: Business Valuation Basics for Attorneys


Market Return

In the calculation of the market risk premium, the market return is proxied by
one's expectation of the market's return or use of Ibbotson's 80 year average
(1926-2005) of the markets return. It takes a lot to change an average of 80 years,
whether arithmetic or geometric mean. Even so, the recent bear market of 2000-
2002, because of its severity, has lowered the long-run average annual return on
the market.

Required Rate of Return


For many of us, the required rate of return means we use the CAPM, however
modified from theory to proxy as a benchmark for what stocks are expected to
provide in returns. Again we have Markowitz to thank for the lead even through
it was William Sharpe (1963), a student of Markowitz's that gave us the CAPM in
usable form.


Whether we proxy the risk free rate with T Bills or T Bonds the required
return is proxied using the CAPM. The required return is used whether we are
discounting, capitalizing or making comparisons. However, it is important to note
the distinction between a discount rate and a capitalization rate. Discounting is
used more properly when there is a series of dividends and the analyst wants to
determine the present value of the series which contains a growing pattern, or the
series is changing from one time period to the next, we discount each item in the
series to determine the present value of the series. Capitalization is appropriate
when the series is unchanging or the high's and low's offset each other to permit
an average to be sufficient for definition, the average amount is divided by the
required rate of return or capitalization rate to determine the value of the series.

ACCOUNTING ISSUES


The valuation of any business enterprise usually requires adjustments to financial
statements because of different accounting practices followed by different firms.
If audited financial statements are available, they should be used. Unfortunately,
audited statements may not be available for smaller companies. On occasion the
only type of financial statement available may be the income tax return for the
business. In addition to the problems with available financial statements, there
are a few areas of concern associated with small companies.

Officer compensation, in particular, may require an adjustment for small
firms in order to represent an appropriate cost and to show the true earning power
of the firm. The salary of the owner could be determined more by the earnings of
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Journal of Business Valuation and Economic Loss Analysis, Vol. 1 [2006], Iss. 1, Art. 7
the business than any set figure. An adjustment to the owner's salary is done for
valuation purposes only. When the salary consumes most, if not all, of the
earnings of the firm, one way to make the adjustment is to obtain salary data from
Robert Morris Associates or other industry sources. To illustrate, assume that the
owner's average salary is about $500,000 annually. Data for a like size and nature
of the business may indicate that a manager could be hired to perform all
functions of the owner for $100,000 a year. That would leave $400,000 to flow
through to before tax income for the business. The valuation would then assume
earnings of the firm to follow the adjustment because any buyer would have that
option.

Another issue deals with the depreciation of fixed assets. There could be a
tendency for depreciation allowances to be increased in good business times and
to be lowered in bad economic times due to the discretionary power of the owner
of a small closely held business. If this activity is pursued the tendency could be
that taxes would be minimized during years of good earnings. An analyst should
be aware that this possibility could exist and to account for it in the valuation.
Some business owners have been known to charge personal expenses to their
businesses. Identification of these charges is difficult at best and in many cases
inconsequential in amount. Looking for, identifying and justifying these charges
could be more costly than the charge itself, and could be less than cost effective in
looking for, identifying and trying to correct.

Some small business owners have built portfolios and show the assets as
long-term assets of the business. When these assets are recognized as investments
which are not needed nor used in the functioning of the business, the valuation
should break out the investments, and make separate valuations of each part, one
in the operation of the business and the other as a portfolio of the owner.
In a slightly different way, a business can hold excessive cash or cash
equivalent in the form of CD’s or other short-term instruments. When identified
as such, a firm with excess liquidity should be evaluated as such. As an example,
assume that the normal working capital is $100,000, and the amount on hand
amounts to $1,250,000. The business should be valued with working capital of
about $100,000 and the excess of $1,150,000 should be additive to the value of
the business.

DISCOUNTS/PREMIUMS

Because of the special nature of closely-held businesses, certain
discounts/premiums are generally used to “adjust” standard valuation approaches.
Several of these discounts/premiums are discussed below.
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Dukes: Business Valuation Basics for Attorneys

Marketability

Most small/closely-held businesses will have a problem with marketability (i.e.
liquidity risk) in any sale of stock or the entire business. Marketability is one of
the more important issues that must be assessed in any attempt to value
small/closely-held businesses. Much time and energy have been expended in
trying to quantify the amount of the discount (from an indicated value)
appropriate in the valuation process.

a. Restricted Stock


A Restricted Stock (or a Letter Stock) is one that is the same as other stock that is
freely traded but has a restriction placed on it because the letter stock may have
been issued for acquisition or raising capital purposes but has not been registered
with the Securities and Exchange Commission (SEC). Founders stock that has
not been registered with the SEC falls into this same category. The difference in
price between the actively traded and the restricted stock has been the subject of
much work in identifying the amount of the discount. Table 1 contains a
summary of eleven research efforts which have identified the spread in values
between restricted and actively traded stock which are identical in all other
respects. The finding is an average discount of about 32.44 percent. The
restricted stock tends to sell at a price that is about 32.44 percent less than its
unrestricted equivalent. The problem with this large amount of research on
restricted stocks is that most small/closely-held businesses will never issue
restricted stock that could be marketable in a couple of years or less and in fact,
most will never be marketable.


b. Initial Public Offerings (IPO)

Another body of research that is considered to be much more appropriate for
discount estimation is the Initial Public Offerings (IPO) comparisons. Emory
(1995) presents data for Table 2 that covers the time period of 1980-1995. Of the
219 transactions reported in his study, only 44 were sales transactions. Most of
the others were options granted. For the 44 sales transactions the median discount
was 51 percent. Therefore, the better indicator would be the median of 51 percent
rather than the mean of 43 percent shown.
Another series of studies using IPO data, is shown in Table 3 with a
median discount of 51.9 percent, conducted by Willamette Managements
Associates, and published in Pratt, Reilly and Schweihs (1996).
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A third series of IPO studies, as shown in Table 4, prepared by Willamette
Management Associates, covering the period 1975-1992 show a median discount
of 62.11 percent. If the outliers are removed the median is about 62.88 percent.

If we equally weight the three series shown in Tables 2, 3 and 4 the median
discount average is 55 percent, much larger and much more appropriate than the
restricted stock research. This conclusion is drawn because small/closely held
firms do not issue restricted stock, but in some instances small companies grow to
the point that an Initial Public Offering (IPO) is the next step in growth and or
expansion.
The 55 percent discount for non-marketability is justified by the empirical
studies shown in tables 2, 3, and 4, but courts are more likely to “split the
difference” between what the Internal Revenue Service wants and what is
requested by tax payer’s representatives. Therefore, we are more likely to see
non-marketability discounts of about 40 percent rather than the 55 percent
justified by the empirics.

Minority Interest

The typical (erroneous) belief when the issue of "minority interest" is considered
is that the “percentage of ownership” is the same as “percentage of control.” The
value of a minority interest holding in a business is very small. Consider the
following scenario. Some time ago, Mr. Small approached Mr. Big regarding his
desire to acquire a partial interest in Mr. Big's oil well servicing and supply
company. The agreement reached was that for $X, Mr. Small would have a 25
percent interest in the business. Some time later Mr. and Mrs. Small had a
disagreement and they agreed to part ways. Since they could not agree on the
value of Mr. Small's 25 percent, the issue was referred to the court to decide the
value of a 25 percent interest in an oil field business that was earning very little if
anything. Mr. Big held 75 percent interest and Mr. Small held 25 percent interest.
No matter what the issue Mr. Small could not outvote Mr. Big. (Someone
suggested that Mr. Small bought the right to be employed). As long as Mr. Small
performed his assigned function he would receive his salary. He was satisfied
with his salary and Mr. Big was satisfied with Mr. Small's performance. After
sitting through many days of a trial, Mrs. Small decided to accept the pretrial offer
made to her by Mr. Small. If forced, her 12½ percent could not be sold and
would provide no income. The business had never paid a dividend. Having an
ownership of 12 ½ percent of nothing wasn't as good as the pretrial offer.
Another illustration of the difficulty in placing a value on a minority
interest is the Family Limited Partnership. In the "Y" Family Limited
Partnership, Mr. Y had a 2% ownership interest as the General Partner. In total
there were six members of the "Y" Limited Partnership. The General Partner held
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