A Cursory 2-Minute Review
Ensure You Have a Qualified Appraisal
Volumes could be written as to what constitutes an acceptable level of work product that would pass the Daubert challenge, if litigated. While not all inclusive, this brief article strives to highlight some of the most basic aspects.
Nature and history of the business: The year formed and a cursory examination of financial summary is hardly adequate. Past transfers, examination of provisions in by laws, agreements, articles, legal documents and the impact of management’s skill, education, depth and health are several areas that should be commented upon whether the entity is an operating or asset holding company.
Economic and Industry Outlook: Businesses do not operate in a vacuum. In today’s economy capital for purchasing equity or debt to finance growth is difficult to come by even by banks and publicly traded companies. This has had a significant downward influence on most companies’ values. Tighter capital tends to reduce growth and curtail profitability. Some industries are prone to being impacted more than others. If the restaurant your used to making reservations 2-months now accepts walk-ins, rest-assured its value has likely declined. Averaging the past several years’ performance is counter-intuitive in this case. Think of a publicly traded company’s stock price after market analysts recommend a “SELL” from a “HOLD” position. The stock price is likely to take a 5% or 10% “haircut” (value reduction) based on current events, not solely historic.
Book value of the stock and business’ financial condition: Understand that the more the business relies upon tying up money in equipment, real property and inventory, the more likely the value will be more proximate to its book value. Conversely, a company with significant intellectual property and/or reputation, such as a service or technology business, will have most of its value associated with intangible assets, which will seldom be reflected on the company’s balancer sheet. The reliance on debt is favorable up to an optimal period; however, the higher the debt above this amount the greater the risk of insolvency. If there’s nominal discussion about these factors and the profitability and liquidity of the entity compared to external industry comparative data, then it’s inadequate.
Earning and Dividend-paying Capacity: Simply put, has there been a history of distributions and at what level and frequency. If the company is holding onto excess cash and investments beyond what it needs to grow the company (working capital needs); then these values would be stripped out and added back after the value of the operating company is determined. Management should have an understanding of cyclical issues, such as seasonality or varying costs of materials that allows it to hold what is needed with a reasonable cushion. Looking at officers’ compensation may also indicate, over- or under-compensation. These issues require the analyst to look at many line items on the financial statement, such as occupancy and labor to ensure they’re not influenced by related-party expenditures.
Existence of intangible assets: If every building and piece of equipment were destroyed and every employee of Coca-Cola called in sick is there any doubt that the brand trademark and the patent for Coke’s recipe would be worth billions of dollars. The same issues hold true to relationships, time and resources invested in research and intellectual property that may or may not be generating royalty fee income. Professional practices and sole and separate property as well as passive and active efforts have significant implications, whose values cannot be adequately determined in the absence of human determination of an expert, not a software programmer.
Sales of stock and block size: Often prior stock transactional history, if at arm’s length and at the appropriate standard of value, provides as good, if not a better benchmark, of a non-duress arms’ length transaction. The premium or the impairment (discount) for control, voting rights/governance as well as the repurchase liability (liquidity) influence adjustments to value. The size and rights of a 2% interest may be considerable if there are two 49% shareholders (2% + 49% = 51%) and provisions call for a majority over 50%. This would differ from fifty 2% shareholders. The analyst must also be clear that s/he is valuing equity and not the enterprise. Equity value is commonly the enterprise value less all interest-bearing debt.
Market price of traded stock of same or similar companies in a same or similar industry: Because the availability of data is relatively thin for closely held businesses, the transactional data must be closely evaluated to determine whether it provides a reasonable (not exact) proxy of the equity being valued. When there are aspects of the transaction, such as if it was all cash or (un)favorable financing, time frame, duration of listing, the cyclical nature of the industry making multiples of earnings or revenues more challenging to isolate, it is imperative that these issues are described and addressed.
Bottom line is there are cookbook valuations following a formulaic process that can be woefully inadequate; especially, when a software program is doing most of the calculating. One might liken it to commoditizing the legal professions’ services by inputting the type of matter, dates, and the issues/needs with a range of possible outcomes as the output. I’m sure my litigation, estate planning and business law clients might be horrified by such a preposterous suggestion. Welcome to our world!