November 10, 2010 | Issue #98-2  

Is one discount rate enough for your next valuation?

“By the time you arrive in business school, you’re already brainwashed about how you describe risk,” Aswath Damodaran (NYU Stern School of Business) told attendees at the AICPA National Business Valuation Conference in DC yesterday.  “It’s a number—the standard deviation.  It’s variance.”  But, perhaps this isn’t the right view. Damodaran asks  “let’s say you buy Google at $500 a share, hoping for 20% return.   Perhaps it doubles, or perhaps it goes down 70%.”  All of the risk is in the future, he points out, yet all our risk analysis data is in the past. 

He also is concerned that valuation methods as generally practiced gloss over the fact that the cost of equity changes over time.  An extreme example: a venture-capital financed company startup.  It’s reasonable, given the probability of default in the early stages, that the cost of equity goes from 20% for round one financing to 8% in round three—which could occur over a very short time period.   “We’re stuck in this model of one discount rate, and I think we may have to let go of that idea.   It can be very dangerous,” Aswath warns.

An engagement letter pricing option when key management leaves during a valuation

During the AICPA National BV Conference one member of the audience commented that he’s added a contingency to his fee agreements in case the existing CFO leaves the subject company.  ”We have multi-year agreements that set prices, with price hikes built in if there’s a new CFO,” the appraiser commented, referring to 409A work.   Great idea, considering the extra work and risk associated with negotiating assumptions with a new financial team.

Newest members of the AICPA BV Hall of Fame!

Congratulations to Kevin Yeanoplos and Robyn Taylor.  They received this honor earlier yesterday in a special meeting of the AICPA FVS membership.  BVR applauds both Kevin and Robyn for all they’ve given to the profession. Asked about what the award means to him, Kevin was humble as usual.  ”There are no degrees of cool,” he told BVWire reporters.

Congrats to Kevin and Robyn!

Some new changes under consideration on AICPA practice aid on 409A valuations

Neil Beaton (Grant Thornton) offered AICPA National BV Conference attendees a list of some of the updates they’re considering as they update the 2004 AICPA practice aid on cheap stock valuations:

  • Adding treatment of debt. "When the Aid was originally done, most of the financing was venture capital.   Now there’s so much private equity, so we need to consider valuation of debt,” explained Neil.
  • Clarifying the use of the PWERM methodology including examples of best practices. "This model considers the probability of the various exit strategies, such as IPO, sale, ceasing operations, or continued operations,” said Neil. "But, we hope to provide guidance on estimating volatility for highly levered companies.” This is particularly important where selling to the founders becomes a exit strategy as people try to recoup losses in a better way than liquidating. Neil also says that there is a lot better information now on the probability of various outcomes, so we can measure these better than when the original Aid was created.
  • Introducing hybrid methods with examples of best practices. "Using the updated Aid, you could actually walk through the term sheet you have and do an OPM, for example.”  Neil points to a new “backsolve method” that will be demonstrated in the update.
  • Discussing adjustments for marketability and control. "This is the most controversial and hard fought, and perhaps least understood part” of the cheap stock valuation practice,” Neil says.  "Many feel that the discounts are just too high.”
  • Applying ASC 820 and its relevance to cheap stock valuation.
  • Providing recommendations on how to apply SEC/FASB guidance on cheap stock. "Some of the key considerations include best practices on contemporaneous vs. retrospective valuations, and also the new GAAP disclosure requirements,” Neil says
  • Including updated cost of capital tables and discussion, to at least include and update information on sources that may not have been available in 2004.
  • Updating the Practice Aid to refer to AICPA SSVS-1.

Divorce laws vary state-by-state, but valuation mistakes are often the same

Last Sunday at the AICPA National BV Conference, Nicholas San Filippo (Lowenstein Sandler PC) informed the audience that the legal standards in oppression cases and valuation cases not only vary across states but are different within each state for the type of entity involved. “The distinctions are important, so when you interface with counsel you need to protect yourselves to make sure you understand what the parameters so you don’t get caught short.“

“Because valuation is not an exact science and there is no one right answer,” added Nicole Bearce Albano (Lowenstein Sandler PC), “the trial court or jury has the critical role of making the factual findings necessary for valuation.  These findings are typically afforded ‘great deference’ and will be upheld unless they are clearly erroneous or an abuse of discretion.” In addition, expert testimony is often significant to the courts.

San Filippo, Albano and Robert Reilly (Willamette Management Associates) discussed over a dozen pitfalls made by testifying valuation experts in business divorce cases, including:

  • Failure to define the standard of value (judges have wide latitude here) or using an inappropriate standard of value.
  • Failure to disclose sources of information contained in the valuation process.
  • Failure to prepare a comparative financial analysis with industry performance (quantitative evaluation).
  • Failure to define “earnings” adequately or to estimate a “normalized” earnings base realistically; can result in undervaluation or overvaluation.
  • Confusing capitalization rates with discount rates.
  • Failure to consider an alternative capital structure when valuing a controlling interest.

“It is easy to lose credibility and very difficult to get it back,” San Filippo added.

Three Google research tricks for appraisers
from Lang

Eva Lang (Valuation Products & Services and Financial Consulting Group) advised the audience at the AICPA National BV Conference that there are better ways to use Google than entering one or two keywords. 

Here are a couple of search tips Lang provided:

  • When using a search engine like Google, use quotes“” to search for a phrase. For example, “Discount for Lack of Marketability”
  • Use the hyphen to pick up adjacent words. “health-care” gets results including: health care and healthcare
  • The tilde ~ retrieves synonyms, for example, typing in ~physicians will also retrieve physicians, doctors and medical 

Lang also said that the Google and the web is just one source data necessary for BV research, and said fee-based sources are also necessary for certain types of projects.  Some of these sources include:

BVR announces new FMV DLOM calculator and free webinar

The FMV Restricted Stock Study™—the premier online database for determining discounts for lack of marketability—has the new addition of the FMV DLOM Calculator™.  The FMV DLOM Calculator is available for free to subscribers, and can be used on a single-search basis for non-subscribers.

With the new FMV DLOM Calculator, users can fully implement the FMV Opinions’ methodology to determine a discount for lack of marketability that is driven by the financial characteristics of the user’s subject company, as well as the volatility of the market as of the user’s valuation date – in a drastically reduced amount of time! The results can be exported into Excel, or printed and inserted directly into your valuation report.

On Tuesday November 16, Kyle Vataha (FMV Opinions) will join BVR for the first look of the new FMV DLOM Calculator.  Join us for this free, one-hour webinar, in which Vataha will show us how to use the calculator and how it was built.  He'll answer your questions along the way.  For more information, or to register for this one-hour, one-CPE credit program, click here.

Advanced Webinar Series on Lost Profits Damages continues…

BVR’s training calendar will turn its attention to lost profits damages in January 2011, as the Lost Profits Damages Webinar Series continues with a course of four advanced topics.  Starting January 7 and running each Friday of the month, expert contributors to The Comprehensive Guide to Lost Profits Damages, 2010 Edition, will provide comprehensive training on some of the most important and contentious issues in economic damages calculations, analysis, and testimony. 

Programs include:

Purchase each program individually, or sign up for the series and receive special discounts on The Comprehensive Guide to Lost Profits Damages and its online companion guide.  For more information on each program, click here.

Measuring the fair value of a business combinations a market for BV practitioners

Mark Edwards (Grant Thornton) and Mark Zyla (Acquitas) outlined the groundwork to perform fair value measurements during the “Fair Value Measurements Case Study: Introduction to Fair Value in Business Combinations” session last Sunday at the AICPA National BV conference.  Acquirers obviously hire appraisers to value the entity and/or specific assets, Edwards said, but, in addition, the audit team often hires valuation practitioners to test management’s fair market value in areas such as mathematical computations, methods and assumptions, and the team’s reasonableness of FMV conclusions.

Edwards gave the audience some hints “from someone who reviews reports during the audit process.” One point he made was the importance for the valuation analyst to call the reviewer. “It is a comforting call for both the auditor and preparer because the process will be less contentious,” he says.  A member of the audience addressed the matter of independence on such a call.  “Independence is important on audit side,” Edwards replied. “As the auditor I won’t tell you what to do, but if I hear something that concerns me I might bring it up. But the call is about the basics. I won’t tell you what discount rate to use, for example.”

Industry research from BizMiner updated to include 2Q10 data

“Responding to feedback we received from the last BizMiner “mid year” update, we’ve reconfigured the reporting years (not metrics) slightly,” reports Jon Brandow (BizMiner). The new release will carry over the year-end data and add an additional column that represents a mid-year update (in most cases, for the 12 months ending QII-10).

The following series have been updated:

  • Industry Financial
  • Micro Firm Profit and Loss
  • US Market Research
  • Local Market Research
  • Regional Business Profile

BizMiner covers 16,000 lines of business in 300 U.S. markets. For more information about accessing these reports click here.

ASA’s new BV201 course next week

The American Society of Appraisers announces the new BV201 course, Introduction to Business Valuation - Part I, and encourages attendance at the forthcoming course in Chicago (Skokie, IL) November 11 – 14.  The course, written by Gary Trugman, deals with valuation theory and the market approach, including guideline public companies and transactional analysis.  This course is designed for students seeking a better understanding of market evidence in business valuation assignments as well as for those seeking the premier accreditation in business valuation.

Click here for more information or call ASA at 800.ASA.VALU.   Members $995, non-member $1,195.

Do you use Ibbotson or Duff & Phelps?

Both.   That’s the answer provided by Neil Beaton, Stacy Collins (Financial Research Associates), Ron Seigneur (Seigneur Gustafson), and Dave Dufendach at the final “Hardball” session at the AICPA National BV Conference.   Dufendach and Beaton, both from Grant Thornton, also include other sources.   So, for example, if you’re doing the build-up method, these experts would develop it twice, using both inputs.   “Then you’d reconcile the two approaches, before moving on to unsystemic risk,” said Seigneur.  Harold Martin (Keiter Stephens), who moderated the session, agrees, and reported “I was on a cost of capital panel with Shannon Pratt a few weeks ago, and he’s similarly doing two calculations for both CAPM and BUM, using both sources.”

Earnouts present an opportunity for BV practitioners

During the session “Merger & Acquisition Disputes: Addressing Earnout Issues and Assessing Damages” at the AICPA National BV conference Robert Gray (ParenteBeard) told the audience that in today’s recessionary climate, the private equity community is still struggling to lever deals.  Hence, earnouts remain a critical part of any deal negotiation, and Gray thinks there are untapped opportunities.

Earnouts appeal to buyers because they:

• Protect buyer from overpaying for the target business.
• Are effectively seller financing that reduces cash necessary at closing.
• Can distinguish buyer’s bid when multiple suitors are competing for target.
• Indicate sellers’ confidence.
• Provide motivation of seller management when seller management will continue to be involved in business post-closing.

Earnouts appeal to sellers because they:

• Protect seller from failing to realize value in their business.
• May allow sellers to obtain greater consideration that they might receive otherwise.
• Can be advantageous in difficult economic climates (such as today).
• May allow seller to control its own destiny when seller management will continue to be involved in business post-closing. 

However, “earnouts are a difficult area in M&A because it is hard to enforce and it is hard to take into account all of the contingencies,” said Jeff Litvak (FTI Consulting).  Because of the current economic climate earnouts are here to stay,” he added.

Jeremy Kasner (Stout Risius Ross) continued the discussion of earnouts in the presentation Valuation of Contingent Consideration. “Despite the improving M&A markets, the valuation gap between buyers and sellers remains an obstacle in closing a deal,” Kasner told the audience. Earn-outs and clawbacks can help bridge the perceived valuation gap.” But financial reporting and measurement relating to contingent consideration can be complex and confusing. 

According to Kasner, issues to consider in contingent consideration valuations include:

  • Expected future cash flows “are consistent”. “You have to model in the factors that are driving the earnout,” he said.
  • The need to account for likelihood of hitting earn-out targets
  • Even “slam dunk” earn-outs must be adjusted for the time value of  money and credit risk. “There is still going to be credit related issues that have to be accounted for in the valuation”

The income approach is the most frequently employed approach, says Kasner.  “One of the good things about the income approach is that there are several methodologies you can use, such as DCF and Probability or Scenario-Based Methods. “Which one you use depends on the situation.”


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Introducing the FMV DLOM Calculator - A Free BVR Webinar
November 16, 2010
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Show Me the Money! The Exploration, Examination and Dissection of Reasonable Compensation
December 2, 2010, 10:00am - 11:15am PT


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