7 questions to gauge marketability - John M. Leask II CPA/ABV, CVA

Viewpoint on Value
September/October 2013
7 questions to
gauge marketability
Hunting for buried
treasure — or traps
Hidden assets and
liabilities may affect value
Sorting the alphabet
soup of valuation credentials
Fair value
Court frowns on
speculative adjustments
E-mail: Mac@LeaskBV.Com
7 questions to gauge marketability
arketability is the ability to quickly convert
company’s future income stream projections or dis-
a business interest into cash, with minimum
count rate estimations.
costs and maximum certainty about the
price it will fetch. The higher the costs and the lower
2. What’s the company’s track record?
the certainty, the less the interest is worth.
Financial performance affects an investment’s appeal
in the marketplace. Investors prefer predictable,
A discount for lack of marketability (DLOM) gauges
positive income streams to volatile, subpar ones.
the relative ease of selling a business interest in the
Dividend policy also affects marketability.
marketplace. One of the most subjective, frequently
debated valuation adjustments, DLOM can be wide-
Investors earn their returns in two ways: dividends
ranging. To obtain the appropriate percentage for a
or capital appreciation. Investors typically prefer
particular business interest, appraisers must consider
to receive interim cash flows through dividends
a variety of factors. Here are seven questions that
rather than earn their returns solely in the form of
help take the guesswork out of quantifying a DLOM.
capital appreciation upon eventual sale. Companies
with histories of paying dividends — or at least the
1. How big is the subject company?
capacity to pay dividends — typically warrant lower
Small companies tend to have less sophisticated
internal controls, financial reporting and manage-
ment. Many are also less diversified and have lim-
3. How big is the business interest?
ited access to financing. Therefore, investors often
First, marketability and control are related. DLOMs
perceive smaller businesses as riskier than larger
based on initial public offering (IPO) or restricted
businesses. The pool of buyers interested
stock studies apply exclusively to minor-
in small businesses is typically smaller
ity interests. Controlling interests
than the pool of investors inter-
are subject to liquidity discounts,
ested in large companies run
which are beyond the scope of
by professional management
this article. But control is not
teams. This differential
an absolute “all-or-nothing”
reduces marketability.
Size is especially relevant
Some minority interests
when a valuator compares a
possess elements of control.
small private firm with pub-
If a business interest has
licly traded stocks — which
elements of control — such
can happen when using the
as the ability to terminate
income or public guideline
managers or pay out divi-
company approach to value a
dends — it may be more mar-
private business interest. It’s all
ketable. But again, an appraiser
relative: The greater the differ-
needs to avoid double-counting
ence between the size of the subject
this factor into marketability and
company and comparable market data,
minority interest adjustments.
the higher the DLOM.
Also consider the flip side of this issue. Some larger
When evaluating the effect of size on the DLOM,
blocks of stock are less marketable because they
however, an appraiser needs to avoid double
would flood the marketplace with excess supply.
counting what has already been considered in the
Fewer buyers also have access to the capital and
financing needed to purchase a large block of stock.
So large blocks often warrant a higher DLOM or a
separate “blockage” discount.
4. What’s the current industry outlook?
Investors prefer industries with solid growth and
income prospects. Strong industries often have
more merger and acquisition (M&A) activity than
weaker ones. An active M&A market warrants a
lower DLOM.
A valuator customarily
reduces the discount for
lack of marketability if the
company is entertaining a
purchase offer or plans to
go public in the next year.
6. Is a sale or IPO imminent?
Conversely, buyers love a bargain. Opportunistic
A valuator customarily reduces the DLOM if the
buyers looking to roll up small, weaker competitors
company is entertaining a purchase offer or plans
into larger entities may target an industry in finan-
to go public in the next year. But these prospective
cial turmoil to take advantage of economies of scale.
transactions could fall through, so the valuator also
This phenomenon creates a market for weaker play-
considers how far along — and how serious — the
ers and lowers marketability — but it also lowers the
plans are.
potential purchase price, because these buyers are
seeking deals.
7. What else impacts marketability?
The last step in quantifying a DLOM is to determine
5. Do any contracts or shareholder
what other factors — such as the national, state and
agreements restrict marketability?
local economic outlook as well as the expected hold-
ing period of the subject interest — might affect the
Contractual agreements between owners may contain
marketability of a company’s stock. This step serves
provisions that restrict transfers (such as a right-of-
as a reminder to extend the analysis as far as neces-
first-refusal clause, which would increase the DLOM)
sary to incorporate any particular or unusual factors
or that establish buyout protocol (creating an effec-
specific to the subject company’s marketability into
tive “market” for the business interest). Valuators
the analysis.
double-check that these agreements are current and
legally enforceable, however, before relying on them
when quantifying a DLOM.
Cover all the bases
While these questions are intended to offer a system-
Put rights, typical in employee stock ownership plans,
atic approach to quantifying DLOM (as well as to
may lower DLOM by creating a market for transfer-
demystify an appraiser’s thought process), there’s no
ring ownership. The owner of a put option has the
cookie-cutter approach to valuing a business interest.
right, but not the obligation, to sell the interest at a
But asking these seven questions helps ensure all the
prescribed price for a prescribed time period.
bases have been covered. l
Hunting for buried
treasure — or traps
Hidden assets and liabilities may affect value
o determine what a business is truly worth,
Management should review accounts receivable
appraisers must consider many aspects of its
regularly to determine which accounts they probably
operations — from management, to products,
won’t collect, and then adjust the allowance accord-
to the health of its industry. They also need to look
ingly. The result after the adjustments is the net real-
beyond the balance sheet, seeking any hidden assets
izable value of the receivables.
or liabilities that may affect value and bringing them
to light.
Inventories. Of course, inventories make up an
important part of many companies’ net worth. The
Whether in divorce matters or other kinds of litiga-
prevalent use of the last-in, first-out (LIFO) method
tion, appraisers often need to search for unusual,
for valuing inventories could result in undervaluation
nonrecurring events in a company’s financial state-
if proper adjustments aren’t made. Thus, it’s usually
ments. Such searches can provide a clearer picture of
proper to adjust inventory in accordance with the
the company’s normal operations and help ensure the
first-in, first-out (FIFO) method.
numbers better reflect reality.
Fixed assets. For book purposes, companies may
record depreciation on fixed assets (such as furniture,
Unearth hidden assets
fixtures, tools and equipment) in several ways. Net
An appraiser starts with the line that reports total
book value, for instance, will usually differ drastically
net worth on a company’s balance sheet. That’s
from the actual fair market value. This difference
the upfront part of the equation. From there, the
would alter the business’s net worth. The appraiser
appraiser hunts for unrecorded liabilities or contra
compares the net book value of a company’s fixed
assets, such as those with a negative credit balance.
assets with their fair market value.
Here are several areas to examine:
Uncollectible receivables. Customer and fac-
Fine-tune the value
tory receivables — those related to warranties and
After a valuator makes a preliminary estimate of a
incentives — make up a significant portion of many
company’s value, he or she considers addi-
companies’ total receivables. Holding items on
tional fine-tuning. Before finalizing the
the books that are overaged, and that the
conclusion, the valuator assesses
business is unlikely to collect, mis-
exactly what the preliminary value
represents its overall finan-
estimate includes. If anything is
cial picture.
missing, the valuator makes
a last-minute alteration.
Common last-minute alterations include changes to:
Detecting fraud
Excess/deficit working capital (compared with the
company’s operational needs),
In marital dissolution cases, valuators may
have to watch out (and adjust) for spouses
Contingent or unrecorded assets and liabilities,
trying to dissipate their businesses’ values.
For instance, the moneyed spouse may
Nonoperating assets, and
attempt to hide business assets, delay revenue
recognition or overstate expenses.
Real estate (if most industry participants rent
their facilities).
A lower bottom line benefits a moneyed
spouse in two ways. First, to the extent that
When making last-minute adjustments, a valuator
a company’s value is based on its earnings,
also adjusts the earnings for any income or expenses
reduced income lowers value. Therefore, low
these assets or liabilities generate, including any tax
profits increase a moneyed spouse’s share of
benefits or consequences.
the marital estate’s remaining assets. Some
moneyed spouses will even hide physical
Dig up the truth
assets or use fraudulent accounting tactics to
Digging up hidden assets and liabilities will likely
lower profits reported before their divorce.
lead to a fairer presentation of a business’s true
Of course, the nonmoneyed spouse has less
value. To make the appropriate adjustments, an
experience and knowledge of the business,
appraiser needs to perform detailed analysis and
and such a charge may be baseless. But to
have a good overview of the company’s current and
determine whether the claim is justified or is
future operations. l
completely without merit, valuation — and
forensic accounting — expertise is essential.
Sorting the alphabet
soup of valuation credentials
ot every financial professional is qualified to
requirements of the most common business valua-
value a business — especially if a third party
tion designations.
will rely upon the appraisal. Earning a valua-
tion credential requires specific coursework, testing,
Save now, pay later
peer review and other prerequisites.
Do-it-yourself appraisals might save money up front,
but they can be costly later. Consider the owner of
Sorting through the alphabet soup of valuation
a print shop who asked his CFO to testify about the
credentials can be daunting. Here, we explain why
value of his interest at his divorce hearing. The CFO
credentials are a must-have and summarize the
knew the ins and outs of the printing business. And
he was familiar with industry rules of thumb and the
business valuation experience for accreditation. After
rumored purchase price of a nearby competitor three
two years of valuing businesses, a candidate may use
years earlier.
the Accredited Member (AM) designation, if all the
other requirements have been met.
But what the CFO didn’t know was how to value
a business. The owner’s wife hired a credentialed
Certified Valuation Analyst and Accredited
valuation expert who testified about the perils of
Valuation Analyst (CVA/AVA). NACVA merged
relying exclusively on industry rules of thumb and
two credentials into one designation (CVA) in April
hearsay. Instead, she presented a conclusion based on
2013. Formerly, the only difference was that CVAs
a sophisticated discounted cash flow analysis, which
were also CPAs, whereas AVAs required an MBA
was supported by an alternate calculation based on 25
or other business degree. NACVA requires CVAs
comparable transactions from a proprietary database.
to take a 45-hour class, pass an exam, submit a case
study or demonstration appraisal report for peer
The court relied exclusively upon the wife’s expert’s
review, and complete two years of related experience
conclusion because her analysis was more thorough
(or perform ten valuations).
and objective. And the requirements the expert had
met to earn her valuation designation qualified her to
Certified Business Appraiser (CBA). Since the
appraise the business.
NACVA/IBA merger, CBAs must take the same
courses as those who earn the CVA designation.
Valuation’s secret code
CBAs also must submit two demonstration reports
and pass a five-hour exam.
Several organizations offer business valuation creden-
tials, including the American Institute of Certified
Public Accountants (AICPA), the American Society
Requisite standards
of Appraisers (ASA), and the National Association
All appraisal organizations require members to have
of Certified Valuation Analysts (NACVA), which
four-year degrees and to take continuing professional
merged with the Institute of Business Appraisers
education (CPE) courses. It’s a good idea to double-
(IBA) last summer. The most common business valu-
check to ensure your expert is current on his or her
ation credentials you’ll likely encounter are:
CPE requirements.
Accredited in Business Valuation (ABV). This
Each organization also has its code of ethics and pro-
requires a CPA license and AICPA membership.
fessional standards. ASA is the only organization that
Candidates also must take 75 hours of coursework,
requires members to follow the Uniform Standards
pass an exam and complete six valuations (or 150
of Professional Appraisal Practice (USPAP), although
hours of valuation experience).
many nonmembers voluntarily comply with these rig-
orous standards. All CPAs, regardless of the valuation
Accredited Senior Appraiser (ASA). These profes-
credentials they hold, must conform to the Statement
sionals undergo 123 hours of coursework, a series
on Standards for Valuation Services (SSVS). Review a
of six exams, approval of a demonstration appraisal
valuator’s report to ensure he or she is in compliance
report and five years (or 10,000
with all requisite standards.
hours) of full-time
Read the signals
No valuation credential necessarily trumps another —
and more credentials after an expert’s name doesn’t
necessarily equate with more reliable results. But valu-
ation credentials do demonstrate an expert’s experi-
ence level and commitment to the appraisal discipline.
Those who stay current with their CPE and profes-
sional standard requirements also are more likely to
be in touch with the latest theories and trends. l
Fair value
Court frowns on
speculative adjustments
he Delaware Chancery Court recently awarded
ruled that Delaware law and legal precedent require
dissenting minority shareholders more than
appraisers to focus on going-concern value, not spec-
double the merger cash-out price in a fair
ulative liquidation values.
value appraisal decision. In Re: Appraisal of Orchard
Enterprises Inc. highlights the importance of using
Breaking ground on
well-supported, objective inputs throughout the
other valuation issues
appraisal process.
The court also resolved discrepancies between the
experts’ valuation appraisal methodologies. The mar-
Court sides with dissenters
ket approach was rejected, because the comparables
Public company Orchard Enterprises, an online
Orchard’s expert used were insufficiently similar to
music provider, was unable to find a third-party
the subject company.
buyer. So its controlling shareholder, Dimensional
Associates, decided to delist it and buy out the
When quantifying the cost of equity, the court pre-
common shareholders for $2.05 per share in 2010.
ferred the capital asset pricing model (CAPM) to
Orchard sold for $1.34 per share on the NASDAQ
the build-up method, because the latter was “larded
before announcing its going-private transaction.
with subjectivity.” Although the court allowed a size
premium, it stated that company-specific risk factors
Dissenting shareholders asserted that the fair value
belong in cash flow projections, not embedded in the
of Orchard’s stock was $5.42 per share. Orchard’s
subject company’s cost of capital. And the historic
expert appraised the stock at $1.53 per share. The
equity risk premium was rejected in favor of the
primary reason for the discrepancy was a $25 mil-
supply-side equity risk premium.
lion preferred-stock liquidation preference that the
respondent’s expert subtracted from the equity’s
Controlling shareholders ante up
value before allocating value to the common shares.
The result of these findings was a fair value of
$4.62 per share — more than double the original
The court decided that the
merger cash-out price. The
liquidation preference hadn’t
respondent learned some
been triggered and, there-
hard lessons: Use methodo-
fore, shouldn’t be subtracted,
logies supported by the latest
because it was speculative. The
academic research, minimize
company hadn’t dissolved, sold
the use of subjective data
all of its assets or been sold to
and avoid speculative adjust-
an unrelated third party.
ments when valuing a busi-
ness. You can avoid the
Orchard argued that poten-
respondent’s mistakes by hir-
tial buyers would discount
ing an experienced valuator
their offers for the preferred
who knows how to achieve
stock liquidation preference.
the proper balance between
Although the respondent’s
subjective judgment and
argument “may be grounded
objective analysis. l
in market realities,” the court
This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other
professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In
addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations. ©2013 VVso13
John M. Leask II CPA, LLC.
Business Valuation Services
765 Post Road, Fairfield, Connecticut 06824
John M. Leask II (Mac), CPA/ABV, CVA, values 25 to 50 businesses annually. Often, Mac’s valuations,
oral or written, are compiled in conjunction with the purchase or sale of a business, to assist shareholders
prepare buy/sell agreements, or to set values when shareholders purchase the interest of a retiring share-
holder. Here are examples:
Due Diligence & Assist with Purchase of a Business. Mac has assisted purchasers of businesses
by determining or reviewing the offer. He helps negotiate the price, perform due diligence prior to
closing and/or helps structure and secure financing. Services have included, but are not limited to,
verifying liabilities and assets, reviewing sales and expense records, and identifying critical issues
relating to future success, and helping management plan future operations.
Family Limited Liability Partnerships, Companies & Closely Held Businesses. Mac regularly values
various sized business interests for estate and gift tax purposes. He provides assistance to estate and trust
experts during audits of reports prepared by other valuators.
Mac also helps business owners and their CPAs and/or lawyers in the following ways:
• Planning — prior to buying or selling the business
• Prepare valuation reports in conjunction with filing estate and gift tax returns
• Plan buy/sell agreements and suggest financing arrangements
• Expert witness in divorce & shareholder disputes
John M. Leask II CPA, LLC.
• Support charitable contributions
Business Valuation Services
• Document value prior to sale of charitable entities
• Assist during IRS audits involving other valuators’ reports
• Succession planning
• Prepare valuation reports in conjunction with pre-nuptial agreements
• Understanding firm operations & improving firm profitability
More information about the firm’s valuation services (including case studies) may be found at www.LeaskBV.com.
To schedule an individual consultation or to discuss any other points of interest, Mac may be reached at 203 – 255 – 3805.
The fax is 203 – 380 – 1289, and e-mail is Mac@LeaskBV.Com.
If you have a business valuation problem, Mac is always available to discuss your options — at no charge.
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