client exit strategies and their impact on … cpa leadership webinar . october 21, 2011 . presented...

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CPA Leadership Webinar October 21, 2011

Presented by: Chris Mellen

Delphi Valuation Advisors, Inc.

CLIENT EXIT STRATEGIES AND

THEIR IMPACT ON BUSINESS VALUE

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Agenda Seminar Overview What is Exit Planning? Valuation Metrics Range of Values Concept Common Errors in the Business Valuation Process Closing Points Valuation for M&A – Building Value in Private Companies Speaker Bio & Contact Information

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What is Exit Planning? A sale to a strategic or financial buyer may not be the

appropriate exit for a given business owner. There are at least 20 different exit options available to

the business owner. The 5 main exit options include:

Sale of the business Private equity group recapitalization (PEG recap) Employee Stock Ownership Plan (ESOP) Management Buyout (MBO) Gift of company stock

The most appropriate option will depend on both the owner’s financial and mental readiness, as well as the company’s position.

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What is Exit Planning?

Uniqueness of Private Company Investment

Standard investment theory urges portfolio diversification, sufficient liquidity, and continual risk vs. return analysis, particularly over time as life circumstances, needs, and goals change.

A private company investment is all too often excluded from a financial advisor’s analysis.

Three characteristics of a private co. investment It is typically the owner’s largest investment. It is typically the riskiest security in the owner’s portfolio. It is his least liquid investment.

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What is Exit Planning? The Exit Plan “An exit plan is a written outline of an owner’s business

exit strategy that addresses his/her strategic, financial, professional, and personal issues. It also identifies and quantifies the accounting, business, insurance, legal, and tax issues involved in transitioning a private company. Although the sale of a company is an event, the exit plan is a process. Exit planning is something that is done over time and may, but does not necessarily, include selling the business. The exit plan is built around the personal objectives of the business owner.”

Source: Chris Mellen & Frank Evans, Valuation for M&A: Building Value in Private Companies, 2nd edition. Wiley: 2010, p. 96.

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What is Exit Planning? Exit planning can be described as a six-step process: Plan the exit by setting the owner’s exit goals.

Determine the owner’s financial and mental readiness.

Identify the type of exiting owner.

Learn and choose the most applicable exit option.

Understand the range of values a business can have and the one applicable to the chosen exit option.

Execute the exit strategy plan to reach the business owner’s goals and protect his/her wealth.

Source: This six-step process is sourced from John M. Leonetti, Exiting Your Business, Protecting Your Wealth (Wiley, 2008). For more in-depth guidance on the exit planning process, read this book and visit www.exitingyourbusiness.com and www.pinnacleequitysolutions.com.

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Valuation Metrics

INCOME APPROACH

MARKET APPROACH ASSET-BASED APPROACH

Guideline Public Company Method

MARKET APPROACH

Single Period Capitalization

Method

Multiple Period

Discounting Method

M&A Transactional Data Method

Adjusted Book Value

Method

Liquidation Value

Method

Guideline Public

Company Method

MARKET APPROACH

BUSINESS VALUATION APPROACHES

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Valuation Metrics

The Income Approach involves the conversion of

expected future economic benefits (e.g., cash flow or income) into present value.

The Market Approach involves valuation by comparison with transactions in “guideline” businesses or business interests using multiples of EBIT, EBITDA, net income, revenues, etc.

The Asset-based (Cost) Approach involves revaluation of the company’s assets and liabilities to achieve an adjusted net asset value.

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Valuation Metrics Market Approach Example: EBIT = $100 Multiple = 4 times No Debt Value of the Company and its Equity = $400 ($100*4)

Income Approach Example: EBIT = $100 Net Income = $60 (assuming a 40% tax rate) Net Capital Expenditures, Depreciation, and Net Working

Capital Changes = $10 No Debt Cash Flows = $50 ($60-$10) Discount Rate=16%, Growth=3.5%, Capitalization Rate=12.5% Value of Company and its Equity = $400 ($50/12.5%)

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Valuation Metrics

Growth Potential Company Size Industry Factors Economic Outlook Market Activity Barriers to Entry Competitive Position Technology

Company Reputation Supply and Demand Quality of Management Diversity of Customer Base Capital Adequacy Price Sensitivity Sources of Supply Working Conditions

Qualitative Factors Affecting Value

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Valuation Metrics

Quantitative Factors Affecting Value

Expected Future Cash Flow

Comparable Transactions

Net Assets

Integrated Net Assets and Future Cash Flow

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Valuation Metrics

Continuum of Value

Liquidation Value

Fair Market Value

Investment/ Strategic

Value

High Value Low Value

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All valuation is a prophesy of future cash flows

relative to the risks perceived by the market.

Range of Values Concept

Each privately-held business will have a range of values – it depends upon the type of transfer chosen.

Discussing exit options and the range of values is a powerful conversation to have with a business owner.

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Range of Values Concept The more commonly known range of value and price

(really perception more than range) is the discrepancy often seen between a buyer and a seller.

The Seller may calculate price as follows:

The owner might earn $200,000 from his business. Alternatively, he could pay someone $150,000 to run it and earn

$50,000 as a passive investor. He feels he can earn 5% a year on his investments over time. He would need to sell it for $4,000,000 ($200,000/5%) to maintain

his income. Therefore, he needs to sell his business for $4,000,000.

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Range of Values Concept The Buyer’s calculation of price is much different:

The Buyer agrees that a salary of $150,000 is acceptable. The Buyer also agrees that the business earns $50,000 in profit. He is willing to pay 5 times earnings (an arbitrary, but

reasonable number for this illustration). Therefore, he offers $250,000 (5 x $50,000) for the business.

The Seller does not distinguish between return on labor and return on investment. He also is not understanding the need to adjust the expected return for the risk inherent in the business.

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Range of Values Concept Continuum of Value for Various Exit Options*

Liquidation Fair Market Value (FMV) Investment Value Value

$15,000 $19,000 $31,000 $35,000 $41,000

Liquidation -> Gift -> ESOP -> MBO -> PEG Recap -> Strategic Buyers

Implied EBIT

Book Value (1) $15,000 FMV of Minority Interest (2) $6,900 $19,000 FMV of Controlling Interest (3) $7,650 $31,000 Investment Value - Horizontal Integration (4) $8,650 $35,000 Investment Value - Vertical Integration (5) $10,150 $41,000

* See notes on next page.

Value

Source: Chris Mellen & Frank Evans, Valuation for M&A: Building Value in Private Companies, 2nd edition. Wiley: 2010, p. 106.

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Notes to Continuum of Value Example (1) Company's book value at the Valuation Date (Year 5) for liquidation purposes.

We assume no additional adjustments to book value. (2) Fair market value of a minority interest for gifting purposes. This assumes that FMV

is based on a 4 times EBIT multiple and discounted for lack of marketability by 30%. Because a minority interest is being valued, adjustments for excess compensation are not made.

(3) Fair market value of a controlling interest, potentially for a PEG recapitalization. This also assumes that FMV is based on a 4 times EBIT multiple. EBIT is adjusted for excess compensation of $750 and no DLOM is applicable.

(4) Investment value to a strategic buyer seeking horizontal integration (i.e., expansion into different products that are similar to current lines). Adjusted EBIT of $7,650 is further adjusted for reduced expenses, resulting in a $1,000 increase in EBIT. For purposes of this example, a 4 times EBIT multiple is paid, but investment value often reflects a higher multiple (lower discount rate) than FMV.

(5) Investment value to a strategic buyer seeking vertical integration (i.e., expansion into areas that are at different points of the same production path). Adjusted EBIT is further adjusted for increased revenues as well as reduced expenses, resulting in an additional $1,500 increase in EBIT.

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Let’s discuss the basics of:

1. Investment Value 2. Synergy Value

3. Fair Market Value

Source: Valuation Segment of Pinnacle Equity Solutions’ Two-Day Exit Planning Workshop.


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Note: These three different definitions of value used in this presentation vary slightly from the terminology typically used by business appraisers. Commonly used Standards of Value include: “Investment Value”, “Fair Market Value”, “Fair Value”, and “Liquidation Value.” There is no specific Standard of Value called “Synergy Value.”

The definition of “Investment Value” applied in business valuation is:

“The value to a particular investor based on individual investment requirements and expectations. This is in contrast to the population of hypothetical willing buyers, as is the case in fair market value.”


20 Risk vs. Return

Money Market

4% 5% 11% 16%

Small Stocks

Large Stocks

Gov’t Bonds CDs

2%

Private Business,

Mature

Private Business,

Early Stage

16%

35% 60%

35%

Risk

Expected Return

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What is Cash Flow?

Like many other financial terms, cash flow has many definitions, but it ultimately measures the tangible economic benefit of ownership (cash flow available for distribution) rather than profit:

• Gross Cash Flow

• Operating Cash Flow

• Net Cash Flow

• Net Free Cash Flow

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Measuring Multiples of Cash Flow

100 = 2.9 times 100 = 5.8 times

35% 17%

So, according to these return expectations, the multiples of cash flows that a buyer will pay for this business falls into a

general range of:

2.9 times to 5.8 times cash flow

The greater the perceived risk the lower the multiple, i.e. offering price.

Note: Growth expectations are also reflected in this multiple.


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Investment Value

Cash Flow x A risk factor for the Company = Selling Price

$ 2,000,000 x 20% Risk Factor, equals =

5 times multiple $ 10,000,000

This exiting owner’s cash flow of: $ 2,000,000

can be converted into a selling price of: $ 10,000,000


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Synergy Value

Cash Flow x A risk factor for the business = Selling Price

$ 2,500,000 x 20% Risk Factor, equals =

5 times multiple $ 12,500,000

The exiting owner argues for a ‘sharing’ of the synergies. Note: Synergy value may also reflect a lower risk factor attributable to the buyer.

Synergies reveal an increase in cash flow: $ 500,000

Value of the Synergies is $ 2,500,000


New Synergy Value

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Fair Market Value

The “Fair Market Value” is a standard that is derived by specific sets of rules.


The “Fair Market Value” standard required to be used for:

- Employee Stock Ownership Plans

- Gifting Programs

“Fair Market Value” may require discounts.

Discounts can work for the exit (gifting) or against it (ESOPs)

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Fair Market Value Defined The price at which the property would change hands between

a willing buyer and a willing seller when the buyer is not under any compulsion to buy and the seller is not under any

compulsion to sell, and both parties having reasonable knowledge of relevant facts. The hypothetical buyer and

seller are assumed to be able and willing to trade and to be well informed about the property and concerning the market

for such property.

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Fair Market Valuation Process

1. Define valuation premise (going concern or liquidation)

2. Determine size of interest to be valued 3. Consider all elements of Revenue Ruling 59-60 4. Use the three broad approaches (asset – income-

market) 5. Employ appropriate methods 6. Determine if any discounts or premiums should be

applied 7. Derive a value conclusion

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Appraisal Transaction Pros Cons

Fair Market Value ESOP, Gifting

Defensible, Accepted (discount, estate plans) (1042 possible)

No synergies (discounts)

Synergy Value Sale, Ind. Buyer Highest Value Sell Control

Investment Value PEG Recap.

High Value, Keep Job Get money at close

Sell Control

Investment Value Mgmt. Buyout

Controlled Transaction Less money at close

No synergies No risk transfer

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Common Errors in Business Valuation Process

1. Applying wrong standard of value for purpose 2. Incorrect valuation method 3. Levels of value 4. Inadequate consideration of economic and/or

industry conditions 5. Incorrect adjustments to financial statements 6. Improperly developed financial forecasts 7. Capitalizing cash flows of a company

experiencing high growth, temporary decline, or general cyclicality

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8. Capital expenditure projections 9. Not matching working capital requirements to

growth expectations 10. Errors in estimating risk relevant to the subject

business 11. Not matching benefit stream to discount or

capitalization rate 12. Long-term growth greater than GDP 13. Tax treatment (Sub S, built-in gains)

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14. Misapplication of market data 15. Use of 2006 or 2007 transaction data in 2009 16. Inadequate use of guideline public company

multiples 17. Misapplication of valuation discounts 18. Not considering intangible asset value 19. Math errors 20. Not doing a sanity check – Does it make sense?

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While there are many errors and pitfalls in the business valuation process, one of the biggest pitfalls is not fully understanding the impact the purpose of the valuation can have in completing a valuation of a business, and how much value can range for a given company.

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Closing Points Exit planning is a process, not an event. There are many exit options available to business

owners. The most appropriate option depends on the owner’s

financial and mental readiness. Exit planning is a six-step process. The fifth step involves understanding the range of

values. Business valuation is both a quantitative and a

qualitative assessment of a company.

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Closing Points There are three approaches to value: income, market,

and asset-based. We looked at the range of values concept using three

distinct examples. There are different standards of value, and the purpose

of valuing a business determines the applicable standard.

Value ranges are impacted by the level of cash flow (return) and the discount rate or market multiple (risk).

Beware of the many pitfalls in the business valuation process.

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Valuation for M&A

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Valuation for M&A

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Speaker Bio Chris M. Mellen is the President of Delphi Valuation Advisors,

and the Managing Director of American Business Appraisers. His experience includes completion of over 2,000 business and intangible asset valuations over the past 22 years. Chris holds the Certified Merger & Acquisition Advisor (CM&AA), Accredited Senior Appraiser (ASA), Master Certified Business Appraiser (MCBA), and Accredited in Business Appraisal Review (ABAR), and designations. He has served on several valuation committees, published several articles, led numerous seminars, and provided expert testimony in court. Chris is co-author of VALUATION FOR M&A: BUILDING VALUE IN PRIVATE COMPANIES, 2nd edition. Prior to founding Delphi in 2000, he held senior level positions in the valuation practices of a large regional accounting firm in Boston (CBIZ Tofias) and KPMG. Chris earned his MBA with a concentration in Finance from Babson College and his BA with a joint major in Economics and Industrial Relations from McGill University.

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Speaker’s Contact Information

Chris M. Mellen, ASA, MCBA, CM&AA, ABAR

Delphi Valuation Advisors, Inc. 100 River Ridge Drive, Suite 201

Norwood, MA 02062 Phone: (781) 551-8258

Fax: (781) 551-0850 [email protected] www.delphivaluation.com

client exit strategies and their impact on … cpa leadership webinar . october 21, 2011 . presented...

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