August 21, 2012 | Issue #119-4  

DE Chancery confirms ‘default’ preference for supply-side ERP, but sides with Pratt/Grabowski on adjusting size premium

A private equity group sought to cash out its controlling interest in The Orchard Enterprises, an online music provider. When no prospective buyer agreed to pay a $25 million liquidation fee that the sale would trigger, the PE group engineered a going private merger at just over $2 per share. A group of dissenting stockholders petitioned the Delaware Court of Chancery for a statutory appraisal, claiming their shares were worth $5.40 per share.

To start, the court (in an opinion by V.C. Strine) found the $25 million liquidation preference was too speculative to include in any going concern valuation. It also rejected the market approach utilized by the company’s expert, finding his selection of comparables and multiples was geared solely to “justify an outcome.” As in recent cases, the court showed a distinct preference for the discounted cash flow (DCF) approach, but made several important decisions related to the derivation of the discount rate:

  • The court rejected the build-up method (BUM), finding that it was “larded with subjectivity” and failed to find support among “mainstream of corporate finance scholars.”
  • As a result, rather than average the experts’ results under the BUM, the court used only the capital asset pricing method (CAPM).
  • Since both experts agreed the underlying management projections were sound, any application of a company-specific risk premium was inconsistent with the CAPM approach and would, in fact, “infect” it with the subjectivity of the build-up model, the court said.
  • Given the “default” acceptance of the supply-side equity risk premium (ERP) in recent decisions such as Golden Telecom and Gearreald v. Just Care, the court rejected the historic ERP.

Finally, only the company’s expert claimed—citing a 2008 article by James Hitchner—that using the supply-side ERP required an upward adjustment to Ibbotson’s size premium. The shareholders’ expert cited Cost of Capital, by Shannon Pratt and Roger Grabowski, to persuade the court that no such adjustment was necessary in this case, leading to its ultimate valuation of $4.67 per share. Read the complete digest of In re: Appraisal of The Orchard Enterprises, Inc., 2012 Del. Ch. LEXIS 165 (July 18, 2012) in the October Business Valuation Update. The court’s opinion will be posted soon at BVLaw.

What a business owner really needs from a BV expert before a sale: consultation

In response to last week’s excerpt of an Inc. online article, which essentially said that business valuations were not worth “the money or the hassle” for an owner who is considering a sale, we received the following insightful responses:

  • “It is, of course, true that the price at which a company is sold is ultimately determined in the marketplace, and not by any formal appraisal derived value,” says Art Rosenbloom (Charles River Associates). “Some buyers will pay above theoretical fair market value if they need a company badly enough. Or, as one of my buy-side clients used to say, ‘Your price, my terms.’ Thus, the rigidity or looseness of the seller’s representations and warranties, the terms of escrows and seller indemnifications, and other non-valuation determinants inevitably play a part in determining the price of the ultimate transaction. There’s simply no way that these can be taken into consideration in an a priori valuation.

    “That said, the article fails to mention that the classic valuation theories going into an appraisal are likewise used by parties and their advisors in real-life deals. Comparative company, comparative transactions, and DCF approaches are integral to forming initial ranges of value for the seller, above, below, or within which the deal will ultimately trade.”
  • “There doesn’t appear to be anything in the article that is actually inaccurate,” says Michael Molder (Marcum). “A valuation attempts to ascertain the equilibrium price between hypothetical parties acting on general assessments of the economic circumstances at a particular point in time. Economic circumstances change, company performance changes, investment alternatives change, and all of these make the results of a valuation non-representative at some other point in time.

    “There are any number of situations which mandate a formal valuation; selling a business outright isn’t one of them. A business owner looking to sell his/her business needs consultation. Many sales transactions, like the one described in the article, involve synergistic benefits that are not captured in the hypothetical world of fair market value. These transactions are more like a chess game—assessing the prospective buyer’s potential synergies and resources against the seller’s need to do the deal. Even if counsel or accountants suggest getting a valuation, it is up to the valuation professional to recognize that a formal conclusion of value and report is not what this particular client needs, and to offer the service that is actually needed: consultation. If that isn’t part of our ethical standards, it certainly should be.”

The new ‘normal’—a look at normalization adjustments after the financial crisis

“Until a few years ago, I cannot recall ‘normalization’ referring to anything other than financial statement normalization (generally the income statement),” writes Ted Israel (Eckhoff Accountancy Corporation), in his introduction to Current Trends in Normalization Adjustments: A BVR Special Report. All that changed in 2008 when the collapse of the country’s financial markets set off the migration from equities to U.S. treasuries, resulting in a reduction of treasury yields to post-World War II levels. This brought on a “new” normalization debate, Israel says, as analysts question whether they need to normalize the risk-free rate when estimating the cost of capital.

Answers are in the special report. In addition to the introduction by Israel, BVR’s report features new articles by Rod Burkert, James Ewart, and Z. Christopher Mercer, as well as simple guidelines on how to keep normalization adjustments separate and suggestions by Duff & Phelps for normalizing the risk-free rates when market yields are abnormally law. Recent legal decisions in which the courts have considered the experts’ normalization adjustments are also included.

These new articles and abstracts “may open your eyes to some things you have overlooked or forgotten, or they may reinforce what you already know and practice,” Israel writes. “Whatever the effect, it is worth your time to read them.”

PE deal market stalls, but still rewards size
and quality

Despite all the available capital, the improvements in corporate performance, and the anticipation of a federal tax rate increase, the “expected torrent of deal activity” in the private equity market didn’t materialize, says Andrew Greenberg, CEO of GF Data, which provides subscription reports on M&A transactions in the $10 million-to-$250 million value range completed by middle-market PE firms.

The latest GF Data report shows only 30 completed deals in the second quarter of 2012, well off the average of 45 deals in each of the preceding three quarters. The trend toward higher premiums for larger companies continues, however: In the first half of 2012, companies in the $50 million-to-$250 million value range commanded prices, on average, of 6.9 times trailing 12 months (TTM) EBITDA, compared to a 5.6 multiple for companies valued at less than $50 million. Average equity contribution in the second quarter was 53% on the larger deals, compared to 47% on the smaller. The data reflect a “double-whipsaw in favor of larger sellers,” Greenburg said. “Their buyers get more leverage and are inclined to stretch more on equity to get deals done.”

Quality also continued to command a premium: “Businesses with above-average financial characteristics sold for an average five percent premium over other firms. The health-care services sector continued to shine, posting average multiples of 7.9 times TTM EBITDA.”

ASA editors pass the baton, and 2012 BV conference approaches

For over two years, Rick Warner (Great Lakes Valuation) did a “yeoman’s job” of editing the ASA’s weekly e-letter to members, writes Linda Trugman, in her latest missive to members. Warner “went above and beyond” his duties by filling in for authors at the last minute and extending his tenure to allow for the next transition, to Arlene Ashcraft (Columbia Financial Advisors), who takes over from Warner this month. Welcome to Ashcraft and kudos to Warner—whose followers can still track his lively insights on the BV profession at the BVWire News blog, where Warner, as a contributing editor, most recently posted his thoughts on when it’s appropriate (and safe) to use calculation engagements.

And don’t forget: There’s a little over a month left until the ASA’s 2012 Advanced BV Conference begins on October 7 in Phoenix. Click on the “sessions” tab and check out the new pod cast summaries of some presentations, such as the one by Anthony Aaron (Ernest & Young) on “Raising the Bar for the BV Profession” or “Navigating the IRS & DLOM Practice Aid,” by Michael Gregory (Michael Gregory Consulting).

Shareholder InSite acquires Quist’s venture services practice

Shareholder InSite Inc., a provider of shareholder management and analytics solutions to venture capital, private equity, and private companies, has just acquired the venture services division of Quist Valuation (formerly Quist Financial Inc.). The deal did not include Quist’s tax and transaction services division, which will remain independently owned by Quist Financial in Boulder, Colo.

External venture equity investors in InSite are funding the acquisition as well as future growth plans, according to a release. The combined entities will offer “full cap table and documentation management, deal analysis and financial modeling, a suite of self-valuation features and full-service 157 and 409a valuation offerings,” a “first of its kind” for the VC, PE, and private company market.

FASB releases ASU on presentation of reclassified income items

Last week, the Financial Accounting Standards Board (FASB) issued its Proposed Accounting Standards Update—Comprehensive Income (Topic 220): Presentation of Items Reclassified Out of Accumulated Other Comprehensive Income.

The proposed ASU should improve the presentation items reclassified out of “accumulated other comprehensive income” (ACOI) “in a manner that balances the benefits to users of financial statements, without imposing significant costs to preparers of financial statements,” says an accompanying release. “The proposed amendments would apply to all public and private organizations, but not to not-for-profit organizations.” A two-page summary is also available in the latest FASB In Focus. Comments on the ASU are due by Oct. 15, 2012.

Last, last chance for summer CPE

Okay—we jumped the seasons a bit last week, when we announced that only two chances remained to fulfill your summer CPE requirements. In fact, now only two BVR webinars are left—plus a workshop to kick off the fall:

  • On August 23, join James Andersen, a veteran appraiser in northern California’s wine region, for Valuing Wineries & Breweries. As an added bonus, five attendees, selected at random after the webinar, will have a chance to win a premium bottle of wine or beer from BVR’s home region of Portland, Ore.
  • On September 13, join William Kennedy (FTI Consulting) for the Advanced Workshop on Regression Analysis, a four-hour intensive, interactive workshop that will use case studies and “live” examples to demonstrate appropriate regression analysis techniques and interpretation.



To ensure this email is delivered to your inbox, please add to your e-mail address book. We respect your online time and privacy and pledge not to abuse this medium. To unsubscribe to BVWire™ reply to this e-mail with 'REMOVE BVWire' in the subject line or use the link below. This email was sent to %%emailaddress%%

Copyright © 2012 by Business Valuation Resources, LLC
BVWire™ (ISSN 1933-9364) is published weekly by
Business Valuation Resources, LLC

Contact Editor
| Advertise in the BVWire | Reprint Requests


Search All BVR

Share on LinkedIn Upcoming Training Opportunities

Business Valuation Resources, LLC | 1000 SW Broadway, Suite 1200 | Portland, OR 97205-3035 | (503) 291-7963 |