MSBA 2016 Mid-Year Meeting Puerto Vallarta Mexico

Valuation Issues and Common Mistakes in Family Law and Shareholder Disputes David R. Bogus, ASA - Director

Ellin and Tucker dbogus@ellinandtucker.com

February 16, 2016

Overview

• Standard of Value • Valuation Approaches and Methods • Application of Discounts

– Discount for Lack of Control – Discount for Lack of Marketability

• Goodwill and Marital Property • Questions

Standards of Value

Standards of Value (cont.) • Delaware Chancery Court: Fair Value • Fair Value is defined by the Model Business Corporation Act,

Section 13.01 (3) (1998) as: – “The value of the shares immediately before the effectuation of the corporate action to which the dissenter

objects, excluding any appreciation or depreciation in anticipation of the corporate action unless exclusion would be inequitable.”

• Section 262 of the Delaware General Corporation Law provides that Fair Value shall be determined:

– “exclusive of any element of value arising from the accomplishment or expectation of the merger or consolidation….”

• Further, in determining Fair Value: – “the Court shall take into account all relevant factors.”

• Finally, Fair Value in an appraisal context measures: – “that which has been taken from the shareholder, viz., his proportionate interest in a going concern.”

Standards of Value (cont.)

• Maryland Family Law: Fair Market Value – According to Pumphrey v. State Roads Commission, 175

Md. 498, 506, 2 A.2d 668, Fair Market Value is defined as: • “…the price which an owner but not obligated to sell would accept for the

property, and which a willing but not obligated to buy would pay therefor.”

– According to Rosenberg v. Rosenberg, 64 Md. App. 487, 497 A.2d 485, 504, Fair Market Value is defined as:

• “the amount at which property would change hands between a wiling buyer and a willing seller.”

Differences in Standards of Value Delaware Chancery Court Maryland Family Law

• Fair Value • “Going Concern Basis” • Typically Not Subject to

Discounts

• Fair Market Value

• Can be on a Controlling or Noncontrolling Basis

• Typically Subject to:

• Discount for Lack of Control AND Discount for Lack of Marketability

Common Errors Regarding Standards of Value

1. Using the wrong standard of value • Domestic disputes - varies by jurisdiction • Shareholder disputes - varies by state

2. Using liquidation value when inappropriate

Valuation Approaches and Methods

Valuation Approaches and Methods

Cost Approach

• Asset Accumulation Method

Income Approach

• Discounted Cash Flow Method

• Capitalization of Earnings Methods

Market Approach

• Guideline Merged and Acquired Company Method

• Guideline Publicly Traded Company Method

Common Error- Ignoring common valuation approaches/methods without basis or explanation.

Cost Approach

• Cost (or Asset-Based) Approach – Determines a value indication of a business, business ownership interest, or security, by using one or more methods based directly on the value of the assets of the business less liabilities

• Arrives at a value indication on a controlling interest basis • Based on the economic principle of substitution • Least commonly applied approach for valuing an operating

company • Ignores intangible value • Common Error- Using this approach when not applicable

Asset Accumulation Method - Example

FMV Adjusted As of December 31, 2015 Book Value Eliminations Adjustments Book Value

Assets Current Assets 21,000 $ (4,000) $ - $ 17,000 $ Property, Plant & Equipment, Net 75,000 (75,000) 100,000 100,000 Total Assets 96,000 $ (79,000) $ 100,000 $ 117,000 $

Liabilities and Shareholder's Equity Total Liabilities 80,000 $ - $ - $ 80,000 $ Total Shareholder's Equity 16,000 (79,000) 100,000 37,000 Total Liabilities and Shareholder's Equity 96,000 $ (79,000) $ 100,000 $ 117,000 $

Fair Market Value - 100% Equity Interest on a Controlling Interest Basis 37,000 $

Common Error - Not adjusting assets or liabilities to fair market value, for example fixed assets

Income Approach

• Income Approach – Estimates value by converting anticipated future benefits into a present single amount

• Value indication dependent upon income (benefits) stream • Can arrive at a value indication on either a controlling or noncontrolling

interest basis • Value indication depends on adjustments and/or assumptions made in

developing cash flow stream • Based on the economic principle of anticipation (expectation)

Adjustments to Income Stream • Types of Adjustments:

–Normalizing - removes unusual non-recurring expenses –Controlling - make adjustments that require control of Company

– Includes adjustments to salaries, perks

–Synergistic - adjustments are specific to buyer • Applicability of Adjustments Depends on the Nature of the Assignment • Common Errors

1. Making control adjustments when valuing a non-controlling interest 2. Making synergistic adjustments not consistent with fair market value

Weighted Average Cost of Capital (WACC)

• Required rate of return required to attract funds to an investment • Risk is the key factor in determining cost of capital • Risk is the likelihood of achieving the expected returns • Two Components:

– Cost of Equity – Cost of Debt

Cost of Equity There are two common methods for calculating the cost of equity:

• Capital Asset Pricing Model

(CAPM)

– Cost of Equity = Rf + (β x ERP) + SPs + SCs – Definitions

• Rf = Risk-free rate • β = Beta of specific company • ERP = Equity risk premium • SPs = Size (or small company) risk premium • SCs = Specific company/industry risk premium

• Build-Up Method

– Cost of Equity = Rf + ERP + SPs + SCs – Definitions

• Rf = Risk-free rate • ERP = Equity risk premium • SPs = Size (or small company) risk premium • SCs = Specific company/industry risk premium

Cost of Debt

• Based on the rate at which a company can borrow money • If company has debt, look at rates on existing debt • If debt-free, estimate based on market rates

WACC – Capital Structure

• A weighted average of the expected returns on all of a company's securities • Can be based on company’s capital structure or industry/market indicated

capital structure • Common Error - Using market capital structure when valuing a minority

interest

WACC - Example

Type of Financing

Cost of Financing X

Percentage of Total =

Weighted Cost of Financing

Debt 5% x 40% = 2%

Equity 25% x 60% = 15%

WACC 17%

Discounted Cash Flow Method - Example

For the Year Ending December 31, 2016 2017 2018 2019 2020 Terminal Value

Net Cash Flow 1,750 $ 2,100 $ 2,415 $ 2,657 $ 2,789 $ 2,929 $

Capitalized Terminal Net Cash Flow (at 17% discount rate less 5% perpetuity growth rate) 24,408

Periods to Discount 0.50 1.50 2.50 3.50 4.50 4.50 Present Value Factor (at 17% discount rate) 0.9245 0.7902 0.6754 0.5772 0.4934 0.4934

Present Value of Net Cash Flow 1,618 1,659 1,631 1,534 1,376 12,043

Total Present Value of Net Cash Flow 19,861

Concluded Enterprise Value (rounded) 19,900 $

Forecasted

Common Errors: 1. Discrete forecast does not achieve a stabilized level of earnings 2. Forecast is not achievable based on the historical or industry data for the company without explanation

Market Approach • Market Approach – Estimates value by comparing the subject to similar

businesses or business ownership interests that have been sold • Can arrive at a value indication on either a controlling or noncontrolling

interest basis • Value indication dependent upon level of ownership interest that was sold • Based upon the related economic principals of competition and

equilibrium (i.e. in a free and unrestricted market, supply and demand factors will drive the price to a point of equilibrium)

• Methods: –Guideline Merged & Acquired Company Method –Guideline Publicly Traded Company Method

Guideline Merged & Acquired Company Method

• Based on the premise that the value of the business interest is estimated

by comparing the subject company to guideline companies that have been merged or acquired during a period of time reasonably near the valuation date

• Arrives at a value conclusion on controlling basis • Merger and acquisition prices may be representative of fair market value,

investment value, or somewhere in between

Guideline Merged and Acquired Company Method - Example

Guideline Guideline Guideline SubjectTransaction A Transaction B Transaction C Average Company

Financial DataPurchase Price 300,000$ 1,000,000$ 550,000$ Sales 500,000 1,800,000 400,000 250,000 EBIT 100,000 400,000 115,000 65,000 EBITDA 125,000 450,000 100,000 70,000

Implied Value ofMultiples Subject Interest

MVIC/Sales 0.60 0.56 1.38 0.84 210,880 MVIC/EBIT 3.00 2.50 4.78 3.43 222,790 MVIC/EBITDA 2.40 2.22 5.50 3.37 236,185

Guideline Publicly Traded Company Method

• Based on the premise that the value of the business interest is estimated based on what astute and rational capital market investors would pay to own an equity interest of the subject company

• Arrives at a value conclusion on a noncontrolling basis • Common Errors:

1. Not adjusting guideline companies for different size or growth 2. Using “comparable companies” that are not in the same line of business

Guideline Publicly Traded Company Method - Example

Guideline Guideline Guideline Subject

Company A Company B Company C Average Company

Sales 90,000$ 60,000$ 40,000$ 30,000$ EBIT 12,000 8,000 5,000 4,000 EBITDA 19,000 13,000 8,000 6,500

Market Price Per Share 6.00 5.00 25.00 Shares Outstanding 10,000 6,000 1,000 1,000 Market Value of Equity 60,000 30,000 25,000 Plus: Market Value of Debt 30,000 20,000 10,000 MVIC 90,000 50,000 35,000

Implied Valueof Subject

MVIC/Sales 1.00 0.83 0.88 0.90 27,083 MVIC/EBIT 7.5 6.3 7.0 6.9 27,667 MVIC/EBITDA 4.7 3.8 4.4 4.3 28,076

Application of Discounts

Application of Discounts • Two Discounts

–Discount for Lack of Control –Discount for Lack of Marketability

• The application of discounts should always be taken in the context of: –The level of value the discount is applied to –Legal documents that control the rights and restrictions of the interest

holder –The ultimate rate of return produced for the investor

* Failure to consider these elements could often result in indications of value which are overstated or understated.

Determining Value

Controlling, Marketable Interest

Control Premium (20%) Discount for Lack of Control (16.6%)

Combined Discount of

45.8%

$120 per share

Noncontrolling, Marketable Interest (as if freely traded)

$100 per share

Discount for Lack of Marketability (35%)

Noncontrolling, Nonmarketable Interest

$65 per share

Discount for Lack of Control • A noncontrolling interest has a lower value than a controlling interest because

the holder of a noncontrolling interest in a closely-held entity would have no authority or control to:

• Change management • Appoint Board members • Determine management compensation • Manage business assets • Select target markets • Liquidate the business • Effect IPO or M&A transactions • Declare dividends

Discount for Lack of Marketability • An investment is worth more if the security is marketable since investors

prefer liquidity • Things to consider:

– Relative ease and promptness with which a security or commodity may be sold when desired without significant concession in price

– Amount of time required to convert an asset into cash or pay a liability • Common Errors:

1. Using DLOM study data without adjustment 2. Not understanding the basis for the DLOM study

Influential Factors on Discount for Lack of Marketability

• Put rights • Potential buyers • Size of interest (trading

block) • Buyer’s ability to obtain

information • Restrictive transfer

provisions • Size of distributions or

dividends

• Size of revenues • Size of earnings • Revenue growth and

stability • Earnings growth and

stability • Product risk • Industry risk

Goodwill and Marital Property

Goodwill in Marital Property

Personal Goodwill • The value of earnings

or cash flow attributable to attributes of the individual – Earnings from

consumer that return because of the individual

– New customers who seek out the individual

– Earnings from referrals made to the individual

• Not marital property

Enterprise Goodwill • The value of earnings or

cash flow attributable to attributes of the enterprise – Earnings from consumer

that return because of the enterprise

– New customers who seek out the enterprise

– Earnings from referrals made to the enterprise

• Is marital property

What is Goodwill?

Goodwill Defined • Goodwill is the total value of an enterprise less those other assets, such as

current assets, investments, fixed and intangible assets, whose value can be determined through other means.

• Goodwill can be separated into two parts: personal goodwill and enterprise goodwill.

What is Personal Goodwill?

Personal Goodwill is… • Personal Goodwill is associated primarily with the individual. It is the result of

the professional's personal reputation. “Personal goodwill, also referred to as professional goodwill, is associated with the individual practitioner. This type of goodwill is based on revenues being generated because of the practitioner’s skills, knowledge, and reputation.” (Yoon v. Yoon, 711 N.E 2nd 1265 (Ind.1999) “Personal goodwill, also known as professional goodwill, is the value of earnings or cash flow directly attributable to the individual’s characteristics or attributes.” (Goodwill Attributes: Assessing Utility, The Value Examiner at 22 (Jan/Feb 2007))

Personal Goodwill in Maryland • Prahinski v. Prahinski

• In Prahinski v. Prahinski, 75 Md. App. 113, aff’d, 321 Md. 227 (1990), the Court of

Special Appeals defined goodwill as “the probability that the old customers will resort to the old place” and elaborated that it “compromises those advantages which may inure the purchaser from holding himself out to the public as succeeding to an enterprise which has been identified in the past with the name and repute of his predecessor.”

Personal Goodwill in Maryland (Continued) • Prahinski v. Prahinski

– The Court of Appeals determined that a sole practitioner lawyer’s goodwill, inasmuch as it was not a “saleable asset” had no commercial value.

• The Court determined that goodwill in such circumstances is “not separable from the reputation of the sole practitioner. In order for goodwill to be marital property it must be an asset having a separate value from the reputation of the purchaser.”

Personal Goodwill in Maryland (Continued) • Hollander v. Hollander

– In Hollander v. Hollander, the Court of Special Appeals determined that goodwill of a dental practice may be valued in that it is marketable.

How is Personal Goodwill Determined?

• There is no “magic formula” for determining the amount of Personal Goodwill in a business.

• A good starting place is to determine the specific individuals who might have Personal Goodwill related to the business.

• A determination as to the amount of Personal Goodwill relating to each such individual will be necessary.

• As to determining the specific amount, all of the methods are subjective. There is no objective way to determine Personal Goodwill. 40

How is Personal Goodwill Determined? • The following factors can be relevant in determining Personal Goodwill and thus allocating

the Goodwill between Personal and Entity Goodwill: – Type of service offered – Type of client served – Length of time at the current location – How the fees are billed – Source of new clients – The age and health of the professional – The professional’s demonstrated earning power – The professional’s reputation in the community for judgment, skill, and knowledge – The professional’s comparative professional success – The nature and duration of the professional’s practice, either as a sole proprietor or as a

contributing member of a partnership or professional corporation

(The Handbook of Divorce Valuations; Kleeman, Alerding, Miller; John Wiley & Sons, inc.; 1999; p.79)

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Example One Facts of Case: • Consulting firm for healthcare industry. Goes to clients and helps them set

up billing systems to increase Medicare, Medicaid and private insurance collections.

• 80% divorcing owner, who also wrote the software. • Gave 20% equity interest to his key employee as bonus. • Employment contracts and non-compete agreements between owner

employee and four other employees. • 50% of the revenues come from the 80% owner. • Fair market value of net tangible assets (NAV) equals $79,000, made up

mostly of cash and accounts receivable. • Little capital required to open competing business.

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Value Value of Equity - Income Approach $723,000 Less Value of Net Tangible Assets ($79,000) TOTAL INTANGIBLES AND GOODWILL (rounded) $644,000 Method One : (Top Down, Percentage basis) Value of Enterprise Goodwill 30% 193,000 Value of Personal Goodwill 70% 451,000 Method Two: (Cost) Four Months General & Administrative Expenses 156,000 Remainder is Personal Goodwill 488,000 Method Three: (Bottom up) Tangible assets 79,000 Workforce in Place, $6.40/hr profit, 40 hrs/wk 78,000 Cash Flow that comes in from website 61,000 Value equity incl Enterprise Goodwill 218,000 Remainder is Personal Goodwill 426,000 Valuation of Personal Goodwill (rounded) $455,000

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Example One

Example Two: (with/without method)

Facts of Case: • Industrial sales company. • 100% owner, in early 40’s, who also sells products to customers. • Other sales persons. • Compensation based on sales production. • Clients “assigned” to each sales person as owner/salesperson brings them in. • Can quantify cash flow without the owner. • Large amount of capital required to start new business, purchase inventory and

trucks to distribute inventory and finance receivables to large investment grade customers who pay slowly (so unlikely that sales folks making good $$ would go with owner for some time).

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Annual Cash Flow ($ thousands) Year: 1 2 3 4 5 Term With current owner 500 300 300 300 300 1500 NPV @ .20 (Enterprise value) $1,566.20 Less NAV ($100.00) Total Goodwill $1,466.20 Without current owner 450 250 250 250 250 1250 NPV @ .20 (Enterprise value) $1,332.94 Less NAV ($100.00) Total Goodwill $1,232.94 Difference (Personal Goodwill) $233.26 16% Value of XYZ without $1,332.94 personal goodwill

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Example Two

Example Three: Facts of Case: • Physician Practice.

• Divorcing party is 10% Physician Owner.

• Specialty practice.

• Compensation (also his distribution) is based on individual

production.

• Expenses assigned pro-rata by ownership percent. (because they each use two exam rooms and one nurse).

• Referrals based on long term personal relationships with internists.

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Example Three Value Value of 10% Equity - Income Approach $72,300 Less Value from 10% Equity; Asset Approach - NAV Method ($7,900) TOTAL GOODWILL (rounded) $64,000 Method One : Value of Enterprise Goodwill 19% 12,000 Value of Personal Goodwill 81% 52,000 Method Two: Two Months General & Administrative Expenses 16,000 Remainder is Personal Goodwill 48,000 Method Three: (Bottom up) Value assets from Tax Return 3,000 Accounts Receivable based on 3 yr collection rate 2,000 Value Other Accruals 3,000 Workforce in Place 8,000 Cash flow from MRI Machine 4,000 Remainder is Personal Goodwill 47,000 Valuation of Dr. Smith Personal Goodwill (rounded) $49,000

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Example Four Valuing the CNC as representative of portion of personal goodwill that is transferrable. • Makes sense in that look at what owner could get elsewhere in

compensation.

• Market comp is about $150K per year, owner works 1.5 times average person in market.

• We capitalize excess earnings at the pre-tax cap rate of 25%, which is an after tax rate of about 16%, assuming a 35% total tax rate.

(we gratefully acknowledge Kevin Yeanoplos for this example: BVR Guide to Personal vs Enterprise Goodwill, 2009 Ed.)

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Example Four Excess Earnings Value Earnings worked by professional 2,000 Average Hours worked by peer group 1,500 Excess Earnings Ratio 1.333333 Times Method One : Market Compensation $ 150,000 Times Excess Earnings Ratio 200,000 Excess Earnings 50,000 capitalized at 25% $ 200,000 Valuation of Personal Goodwill $200,000 (rounded)

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But in the end… … the final allocation is based on the: 1. Facts and circumstances of the case.

2. Experience, skill and judgment of the appraiser

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Questions?