business valuation 101 smith & gesteland
TRANSCRIPT
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Business Valuation 101Demystifying Business Valuation for
Small Business Owners Theresa Zeidler-ShonatDirector of Valuation Services
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The Short Answer
• Business valuation is a process and a set of procedures used to estimate the economic value of an owner's interest in a business.
Definition: Valuation• Valuation – (noun)
the act or process of determining the value of a business, business ownership interest, security, or intangible asset.
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Definition: Appraisal
• Appraisal - (noun) the act or process of developing an opinion of value; an opinion of value.
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Estate and Gifting
• Death of business owner• Transfer of business ownership to the
next generation through gift of shares
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Divorce
• A party in the divorce holds an equity position in a closely-held company, or owns intellectual property that is considered part of the divisible marital property (“undivided one-half marital property interest”)
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Lending Scenarios
• Some SBA loans require a business valuation if a specific set of conditions exist
• Intangible assets are being used as collateral and the lender wants an idea of their worth
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Business Planning
• Strategic planning - company is considering several options and is wanting to determine the impact of several scenarios
• Succession planning• Exit Planning• Impact of expanding into new
industry or making an acquisition
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Financial Reporting
• Company has just been acquired or made an acquisition: purchase price allocations (ASC 805)– Total purchase consideration is allocated
to the acquired assets.– Includes intangible asset valuations
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Financial Reporting
• Company has goodwill or indefinite-lived intangible assets on their balance sheet from a previous acquisition - impairment testing (ASC 350)
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Financial Reporting
• Company holds a minority interest in another company and is required to mark that investment to market
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Stock-Based Compensation
• 409A valuations. – Private companies are required
by the IRS (Section 409A) to show that their common stock options are issued at fair market value, and therefore must conduct a formal valuation opinion at least once every 12 months to avoid potential tax penalties.
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Stock-Based Compensation
• ASC 718 valuations. – ASC 718 requires that all equity
awards granted to employees, consultants, and board members be accounted for at "fair value" and then expensed over the vesting term of the grant.
– This can become more difficult as additional grants are made and vesting and forfeitures add complexity to the calculations.
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Intangible Asset / Intellectual Property Monetization
• Company is considering monetizing assets - either through use as collateral or licensing the asset to a third party
• Company is contemplating sale of the asset and need help determining a price
• Company is contemplating purchase of an asset and looking to determine if price is fair
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Buy-Sell Agreement Development
• Most buy-sell agreements have a provision for determining the price at which an interest in the company is sold.– Basing this on a valuation, or requiring a
valuation in the buy-sell agreement mitigates risk
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Shareholder Buyouts
• Not all companies have a buy-sell agreement in place.
• Business valuations can provide a good point to begin negotiations, and smooth the process.
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Business Valuation Timeline
I.•Project Scoping and Engagement Letter•This typically takes a few days between initial discussions and the engagement letter
II.• Information and Data Request•This length of this step depends on how quickly client responds with requested information
III.
• Initial Modeling and industry research•This portion should take 4 to 6 days to complete
IV.
•Follow up questions for client•Questions arise during step III. Timing depends on client response time.
V.
•Finish model and finalize report•A few days to a week depending on responses received in Step IV.
VI.
•Submit final report to client• In total process typically takes 3 to 6 weeks.
So What is “Value?”
• “Value” expresses an economic concept. As such, it is never a fact but always an opinion of the worth of a property (asset)
• “Value” should always be qualified; e.g., “fair market value,” “liquidation value,” or “investment Value
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Definition: Value(USPAP, paraphrased)
• Value is the monetary relationship between properties (assets) and those who buy, sell, or use those properties (assets)
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The “Definitions of Value”
• Fair Market Value• Fair Value• Investment Value• Intrinsic Value• Liquidation Value–Orderly–Forced
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Fair Market Value
• “The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. Court decisions frequently state in addition that both the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.”
Source: IRS Revenue Ruling 59-60
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Fair Market Value• "The price, expressed in terms of
cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts."
Source: The International Glossary of Business Valuation Terms
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Fair Value (Financial Reporting)
• "The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date."
Source: ASC 820
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Investment Value• "The value to a particular investor based on individual
investment requirements and expectations."
Source: The International Glossary of Business Valuation Terms
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Intrinsic Value• "The value that an investor considers,
on the basis of an evaluation or available facts, to be the "true" or "real" value that will become the market value when other investors reach the same conclusion. When the term applies to options, it is the difference between the exercise price or strike price of an option and the market value of the underlying security."Source: The International Glossary of Business Valuation Terms
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Liquidation Value
• The most probable price that a specified interest in real property is likely to bring under extreme compulsion to sell.
Source: Paraphrased from the Appraisal Institute, The Dictionary of Real Estate Appraisal
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The Value Equation
+
++
The Business Enterprise Equation
Value of Business Enterprise
Value of Net Working Capital
Value of Equity
Value of Tangible Assets
Value of Interest-Bearing DebtValue of
Intangible Assets
BEV =Value of
Underlying Assets=
Value of Invested Capital
= =
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Invested Capital
• Invested capital (sometimes called business enterprise value) is the value of the entire business– Think of it like the price you would
receive if you were to sell the whole business today
• Its equal to the value of the equity in the business plus the value of the debt.
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Equity
• The value of the business available to equity holders after debt service.
• Equity can be valued as a 100% interest, or a fractional interest.
Levels of Value
• Business Enterprise Value (Total Invested Capital)
• Equity Value, 100%• Equity Value, Non-controlling• Equity Value, Non-marketable• Equity Value, non-controlling, non-
marketable• Equity Value, non-controlling, non-
marketable, non-voting38
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Intangible Assets
• Intellectual Property (IP)• Marketing Intangibles• Contract-Based Intangibles• Customer-Relationship-Based
Intangibles• Artistic Intangibles
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Some Valuations have Date Requirements or Deadlines
• Estate tax: date of death• Financial Reporting: fiscal year end
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Opinion of Value (Appraisal)• a. An Appraisal is the act or process of determining the value of a
business, business ownership interest, security, or intangible asset.
• b. The objective of an appraisal is to express an unambiguous opinion as to the value of a business, business ownership interest, security or intangible asset which opinion is supported by all procedures that the appraiser deems to be relevant to the valuation.
• c. An appraisal has the following qualities:• (1) Its conclusion of value is expressed as either a single
dollar amount or a range• (2) It considers all relevant information as of the appraisal
date available to the appraiser at the time of performance of the valuation
• (3) The appraiser conducts appropriate procedures to collect and analyze all information expected to be relevant to the valuation
• (4) The valuation considers all conceptual approaches deemed to be relevant by the appraiser
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Calculation of Value• Calculation engagement, as defined in the Statement on
Standards for Valuation Services (SSVS) • A valuation analyst performs a calculation engagement
when – (1) the valuation analyst and the client agree on the
valuation approaches and methods the valuation analyst will use and the extent of procedures the valuation analyst will perform in the process of calculating the value of a subject interest (these procedures will be more limited than those of a valuation engagement) and
– (2) the valuation analyst calculates the value in compliance with the agreement. The valuation analyst expresses the results of these procedures as a calculated value. The calculated value is expressed as a range or as a single amount.
• A calculation engagement does not include all of the procedures required for a valuation engagement and were a valuation engagement to be performed, the results may be different.
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Attributes Opinion of Value
Calculation of
Value
Acceptance
Accepted by Courts X
Accepted by IRS X
Basis for Expert Testimony X
Analysis Includes
Income Approacjh X Sometimes
Market Approach X Sometimes
Cost Approach X Sometimes
Economic and Market Conditions X
Past Sales of Interest in Business X
Financial Benchmarks X
Market Research X
Industry Research X
Macro Risk Assessment X
Company-Specific Risk Assessment X
Minority and Marketability Discounts when appropriate
to subject interest
when appropriate to
subject interest
Calculation of Value vs. Opinion of Value
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Market Approach Theory
• The value of the company (or asset) reflects the price at which comparable companies (or assets) are purchased under similar circumstance.
• Requires that comparable transactions be available.
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Market Approach - Methods
• Guideline publicly-traded company method – Based on similar and relevant
comparable entities– Adjustments are often necessary to
make the comparables more similar
• Comparative transaction method– Based on actual transactions of
similar entities
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Public Company Method• Valuation relies on information
from comparable publicly traded companies
• Should have several “comparables”
• Adjustments may be necessary to make them more comparable or to normalize the comps
• Sometimes it just doesn’t make sense to use public companies
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Comparative Transaction Methods
• Transaction database multiples
• Prior “arm’s-length” transactions
• Rules of thumb
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Comparability?
• Public companies tend to be much larger, have greater resources and access to capital– Public company multiples often need to
be adjusted
• Private companies – usually don’t know terms of transaction, which can impact price
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Asset Approach Theory
• The value of the company is estimated as a function of the current cost to purchase or replace all assets held within the operating entity.
• It is based upon the principal of substitution, which states that no prudent investor would pay more for a company (or asset) than the amount to re-create or buy it.
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Asset Approach
• Useful for:–Asset-intensive businesses–Real estate holding
companies–Entities that hold mostly
securities (or cash)–Some contracting businesses
that bid for work
Asset Approach• Often requires outside
appraisals• Must identify non-operating
assets like excess cash or obsolete inventory
• Company may have intangible assets that contribute to business value that aren’t listed on the books
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Income Approach Theory
• Predicated upon the value of the future cash flows that an asset will generate over its remaining useful life.
• It involves the projection of the cash flows the company (or asset) is expected to generate.
• These cash flows are then converted into a present value equivalent through discounting.
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Income Approach - Methods
• Discounted cash flow method• Capitalization of earnings method• Other methods exist, but are less
commonly used
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Discounted Cash Flow Method
• Converts a stream of projected earnings or other benefit stream into present value by applying a discount rate
• The earnings from each period are discounted to present value and then a “terminal” value is added to arrive at the total value
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FCFFn (1 + g) (1 + WACC)0.5
PV = FCFF1 + FCFF2 + … + FCFFn + WACC - g
(1 + WACC)0.5 (1 + WACC)1.5 ( 1+ WACC)n - 0.5 (1+WACC)n
Where:PV = Present ValueFCFF = Free Cash Flow to the Firmn = Number of Periods in Discrete Projection Periodg = Long-Term Sustainable Growth Rate in FCFWACC= Weighted Average Cost of Capital
Discounting Formula
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Present Value
Value today Years of saving$1.00 1 year$1.00 2 years$1.00 3 years
Amount received Years till cash flow$1.10 1 year$1.21 2 years$1.33 3 years
$1.00$1.00
What will savings be worth?
Examples of Present Value
$1.21$1.33
$1.10
Saving Today at 10%
Discounting Future Cash Flows at 10%What is this cash flow worth today?
$1.00
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Projected Earnings
• Predict future performance based on analysis of historical performance and current and expected operating and industry conditions– Various tools are available to
assist the valuator in predicting future performance
– Common sense and informed judgment must be the deciding factors
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What Is the Discount Rate?
• The rate of return, or cost of capital, necessary to convert a monetary sum, payable or receivable in the future, into present value
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How Do We Develop a Discount Rate?
• Weighted Average Cost of Capital (WACC)– Capital Asset Pricing Model (CAPM)
• Published industry standards
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Weighted Average Cost of Capital
WACC = (Ke x We) + (Kd x Wd)
Where: Ke = Cost of Equity
Kd = Cost of Debt
We = Weight of Equity
Wd = Weight of Debt
WACC Formula
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Cost of Equity
Cost of Equity = Rf + β(RPm) + RPs + RPu
Where: Rf =
β =
RPm =
RPs =
RPu =
(1) Modified Capital Asset Pricing Model
Risk premium for specific company ("unsystematic risk)
Risk premium for small size
Cost of Equity Formula (1)
Rate of Return for a risk-free security as of the valuation date
Subject company's beta coefficient
Equity risk premium for the market
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Cost of Equity
Cost of Equity = RPm + Rf + RPs + IP + RPu
Where: RPm =
Rf =
RPs =
IP =
RPu =
(1) Modified Capital Asset Pricing Model - Build-Up Method
Risk premium for specific company ("unsystematic risk")
Cost of Equity Formula (1)
Equity risk premium for the market
Rate of Return for a risk-free security as of the valuation date
Risk premium for small size
Industry Risk Premium
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Example of a Build-Up Method to Developing the WACC
Risk-Free Rate (20-year Treasury-Bill) 2.5%Equity Risk Premium 7.0%Size Premium 3.5%Company and Industry Specific Risk Premium 5.0%
Total Equity Discount Rate 18.0%
Less: Long-Term Growth 5.0%
Equity Capitalization Rate 13.0%
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Capitalization of Earnings Method
• Like other income approach methods, this is based on the principle that the value of the business can be estimated by the future benefits received from ownership of the business.
• Future benefits of ownership are assumed to be reliably predicted by past performance,
• Only appropriate for companies in stable growth phases
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Capitalization of Earnings Method
PV = NCF1
k-g
Where:PV =NCF1 =
k =g =
Present valueNet Cash Flow expected in period 1, the period immediately following the valuation dateWeighted Average Cost of CapitalExpected long-term growth rate in net cash flow
Capitalization of Earnings Formula
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Discounted Earnings Method vs. Capitalization Method
• DCF is applied when– Future performance is not expected to
be consistent and/or stable
• Capitalization is applied when– Company performance is expected to be
stable or grow at a stable rate
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Factors that Affect Business
Value
External
Business owner can't really
change these
Internal
Business owner can change these
and impact business value
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External Factors That Impact Company Value
Increase Value
• Expanding markets• A dominant market
position• Barriers to entry• Expanding industry• Expanding economy• Shift in consumer
preference to company product
Decrease Value• Shrinking market• Challenged market
share• Lack of barriers to
entry• Contracting industry• Contracting Economy• Shift in consumer
preference away from company product
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Market Timing
SIC Code Industry Pre-Recession (1) Recession (2) Post-Recession (3)
5812 Eating Places 0.49 0.38 0.35
7231 Beauty Shops 0.49 0.40 0.36
7349 Building Cleaning and Maintenance Services 0.68 0.65 0.65
7389 Business Services, Not Elsewhere Classified 1.01 0.99 0.93
7538 General Automotive Repair 0.48 0.42 0.39
7991 Physical Fitness Facilities 0.66 0.76 0.64
8299 Schools and Education Services, NEC 1.07 0.66 0.94
Notes: (1) Pre-recession is defined as 1/1/03 through 11/31/07
(2) Recession is defined as 12/1/07 through 8/31/09
(3) Post-recession is defined as 9/1/09 through 12/1/14
Transactions Multiples Throughout the Business Cycle
MVIC to Sales
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Internal Factors That Impact Company Value
Increase Value• Organized up-to-date
financials• Strong gross margins• Projections of strong
cash flow• Sufficient working
capital to support operations
• Systems and structures• Cross trained employee
base
Decrease Value
• Declining Sales• Inconsistent yearly
financial performance• Unreported cash, or
off-balance sheet loans
• Lack of key employees• No formalized
business and marketing plan
Levels of Value
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Investment or Synergistic Value
Control Value (Freely-Traded)
Minority Value (Freely-Traded)
Non-Marketable, Minority Interest Value
$14
$12
$10
$7
Marketable, control value
Marketable, control value
Marketable, non-control value
Non-marketable, non-control value
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Discounts & Premiums
• Discount for lack of control• Premium for control• Discount for lack of marketability• Key person discount• Depend on the interest to be valued
and the techniques used to establish the value conclusion
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Value of Control
• Control attributes– Hire and fire– Distribute earnings/declare dividends– Buy and sell assets– Enter into contracts– Liquidate the business– Set strategic objectives and goals– Set compensation and performance
standards
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Lack of Control
• Lack of control in a closely held company implies you are at the mercy of the controlling owner(s)
• Substantial discounts may be necessary to attract an investor to purchase a minority interest in a closely held company
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Determination of Discount/Premium
• Control premium studies
• Mergerstat Control Premium Studies
– Measures how much over the market price is paid to gain control of a company– Looks at the price of the stock before
and after the announcement of an acquisition or merger
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Marketability
• Ability to convert ownership interest to cash
• Time required to do so affects the level of marketability
• Other factors that affect marketability– Distributions of earnings– Active market or industry roll-up– Key person– Number and profile of owners– Restrictions on transfer of stock
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Discount for Lack of Marketability
• From Pre-IPO studies– Comparing the price of a company’s
stock before and after the announcement of “going public”
• From Restricted Stock Studies– Compare Letter Stock restricted from
trading for a certain time period to its publicly traded counterpart
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Marketable, control value 5,000,000$
Discount for lack of control 20% 1,000,000$
Marketable, minority value 4,000,000$
Discount for lack of marketability 30% 1,200,000$
Non-Marketable, minority value 2,800,000$
Example of Lack of Control and Lack of Marketablility Discounts
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Adjustments to Financial Statements
• One objective of financial statement analysis is to provide a financial picture that can be reliably used to estimate future performance.
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Adjustments to Financial Statements
• Historical financial statements may need to be adjusted for certain items that distort the picture of the true operating performance of the business.
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Reasons for Financial Adjustments
• To develop a starting point from which to predict future earnings
• To present historical financial information on a normalized basis
• To adjust for accounting practices that are a departure from industry or GAAP standards
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Reasons for Financial Adjustments
• To facilitate comparison of a given company to itself, to other companies within the same industry, or to an accepted industry standard.
• To compare the debt and/or capital structure of the company to that of its competition or peers
• To compare compensation with industry norms
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What is Adjusted?
• Unusual items• Nonrecurring items• Extraordinary items (both unusual and
nonrecurring)• Non-operating items• Items affected by changes in accounting
principle• Items that are not in conformance with
GAAP• Degree of ownership interest, including
whether interest has control
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Unusual Items
• Events or transactions that posses a high degree of abnormality
• Unrelated to, or only incidentally related to, the ordinary and typical activities of the entity
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Nonrecurring Items
• Events or transactions that are not reasonably expected to recur in the foreseeable future
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Extraordinary items
• Events or transactions that are distinguished by their unusual nature and infrequency of occurrence
• Item must be both unusual and nonrecurring to be classified as extraordinary
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Extraordinary items
• Events or transactions that are distinguished by their unusual nature and infrequency of occurrence
• Item must be both unusual and nonrecurring to be classified as extraordinary
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Unusual, Nonrecurring, and Extraordinary items
• Strikes and other types of work stoppages
• Litigation expense or recoveries
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Unusual, Nonrecurring, and Extraordinary items
• Uninsured losses due to unforeseen disasters like fire or flood
• One-time realization of revenues or expenses due to nonrecurring contracts
• Gain or loss on the sales of a business unit or business assets
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Unusual, Nonrecurring, and Extraordinary items
• Discontinuation of operations• Insurance proceeds received on the
life of a key person or from property or casualty claim
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Non-Operating Items
• Excess cash• Marketable securities (in excess of
reasonable needs of the business)• Real estate (if not used in business
operations)• Private planes, entertainment, or
sports facilities• Antiques, private collections, etc.
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Changes in Accounting Principal• A change in the method of pricing
inventory (e.g., LIFO to FIFO)• A change in the method of
depreciating previously-recorded assets (e.g., straight-line to MACRS)
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Changes in Accounting Principal• A change in the method of
accounting for long-term construction-type contracts
• A change to or from the full-cost method of accounting in extractive industries
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Nonconformance with GAAP
• Financial statements prepared on a tax or cash accounting basis
• Unrecorded revenue in cash business
• Inadequate bad debt reserve
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Nonconformance with GAAP
• Understated amounts of inventory, failure to write off obsolete or slow moving inventory, etc.
• Unrecorded liabilities such as capital lease obligations, workforce-related costs (wages, sick/vacation pay), deferred income taxes
• Capitalization/expense policies for fixed assets and prepaid expenses
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What is Goodwill?Two commonly used definitions of goodwill
- The bundle of all intangible assets of a company- The residual intangible value remaining after all identifiable intangible assets have been valued.
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What Is Goodwill?
• Personal Goodwill is the goodwill that attaches to the persona and personal efforts of the individual.– Generally considered
to be difficult to transfer, if it is transferable at all
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Where Does Personal Goodwill Arise?
• Traditionally, the issue of personal goodwill arose almost exclusively in the context of a professional practice owner.
• The line gets “fuzzy” in the commercial business arena
• Personal goodwill in a commercial business might be more “key person risk” than actual personal goodwill
• Look for special relationships with customers or suppliers
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Separating Personal from Entity
• No generally accepted methodologies to divide goodwill into personal and entity components– Methods to calculate personal goodwill can
depend on case or jurisdiction– Multi-Attribute Utility Model–With and Without Analysis– Excess Earnings
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Factors the Impact Personal Goodwill
• Age and health of professional• Earning power• Reputation• Comparative success• Practice duration• Marketability• Types of Clients and Services
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Factors that Impact Personal Goodwill
• Location and Demographics• Fees• Source of New Clients• Production• Workforce• Competition• Non-Compete Agreements
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Valuation isn’t Taught in Law School
• Judges don’t necessarily understand valuation theory– Contradictory Case Law proves this out– Valuation report needs to make valuation
theory and the intuition behind it crystal clear
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Short Window in which to Obtain
Info• Need to anticipate all future info needs as part of discovery process
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Short Window in which to Obtain Info• Valuation Process Often Goes Like
This:1. Request info2. Go through info and determine if additional info is
required3. Request follow on info4. Repeat step two/three as needed5. Valuation and report writing6. Last round of questions to cover issues that came up
in the valuation process/dot the i’s and cross the t’s.7. Finalize and issue report
• Steps 3, 4, and 6 can be challenging
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Problematic Information Flow
• Spouse may be unwilling to share info, or actively attempting misdirection
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Incentive to Hide Value• Perceived advantage to
making business look less valuable• Postpone signing
contracts that guarantee business income
• Defer follow-on rounds of financing
• “Business Shift” Syndrome
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“BS”• A sudden shift in
business performance around the time of the divorce filing.
• Business owner trying to make business appear less valuable.
• Could also be the result of macroeconomic or industry conditions. Careful assessment is necessary
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In summary…
• Valuation is a process that leads to an opinion of value.
• There are many scenarios in which a valuation is needed or helpful.
• There are three approaches to value, but many valuation methods.
• You can value invested capital, equity, or individual assets.
• Certain situations have special considerations to be aware of.
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Theresa Zeidler-Shonat
Director of Valuation Services
Smith & Gesteland, LLP
608.828.3154