Timothy R. Lee

This is the seventh article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here. Contingent consideration is a common feature of M&A when both parties are private, or the acquirer is public, and the target is private. There are many forms of contingent consideration in M&A. These include post closing purchase price adjustments that can alter total transaction value or that can alter the payment and realization of net proceeds through the recovery of transaction set-asides such as escrow balances or the payment of holdbacks and deferrals.What Do Earnouts Entail?The most common contingent payment is an “earn-out” that bridges the buyer’s bid and the seller’s ask by ensuring the business produces an agreed upon level of revenues and/or earnings (typically EBITDA) within an agreed timeframe before the payment is made.Earn-outs could be considered the ultimate form of confirmatory due diligence. From a buyer’s perspective, earn-outs reduce risk by reducing up-front cash and the likelihood of materially overpaying absent an adverse turn in the economy or industry conditions. From a seller’s perspective, contingent consideration allows sellers to obtain an acceptable price and sometimes a premium or stretch valuation if the Company attains the agreed-upon targets. Further, earnouts create an alignment of interests to the extent roll-over management and ownership is incented to optimize the company’s performance.In our experience, most buyers are willing to pay in a range of value that produces an acceptable return based upon conservative assumptions about the business’ future earning power (EBITDA or EBITDA less capex) and growth rate. Unless the business is viewed as having above average risk, most buyers’ required rate of return on an unlevered basis will be conservative but not ridiculously high. This reflects buyers’ natural aversion to risks that may not be readily apparent to most sellers. An earn-out is a means by which to close or narrow this gap.When earnouts are involved, buyers and sellers must understand the waterfall of post-closing events, and their respective timing and terms to gain a full understanding of transaction consideration. Earnouts are a form of purchase consideration where acquirers tender value to the target seller if certain future events occur. Earnouts provide sellers with potential value fulfillment or upside while simultaneously allowing buyers to defer payment of consideration with the possibility of recovering a designated portion of the purchase price if post-closing hurdles are not achieved.By its nature, contingent consideration adds complexity for both buyers and sellers, particularly when the features of the earnout reflect significant speculation on post-closing outcomes. These might include high growth, reversals of trend, or specific events such as new business developments or failed business retention.Despite the complexities, earnouts and other forms of contingent consideration can be critical to achieving a successful closing when market conditions are ebbing more than flowing or when winning the day requires the buyer to make a stretch offer.Mid-Market Deals Increasingly Reflect Up-Market Deal StructuresAccording to GF Data®, a firm that provides data on private equity-sponsored M&A transactions with an enterprise value of $10 to $250 million, 38% of 432 transactions in 2021 entailed either seller financing or earnouts compared to 44% of 329 deals in 2020. The reduction last year reflected a seller’s market that was characterized by too much capital chasing a limited pool of sellers. Given tighter financial conditions this year that may lead to a recession later this year or next, it would not surprise us to see the percentage of deals with an earnout increase because the risk to a target’s earnings and maybe long-term growth prospects will rise.A financial advisor can be an important intermediary for both buyer and seller to craft a well structured earnout to facilitate successful deal negotiations rather than letting a poorly crafted and/or poorly socialized earnout create a negotiation wedge that can delay or overwhelm momentum required to finalize a purchase agreement.Buyer Awareness and Financial ReportingWhile it should not impact the economics of a transaction, buyers face the added burden of accounting for contingent consideration per FASB’s ASC 805, which addresses business combinations. It requires that the fair value of contingent consideration be recorded as a liability at the acquisition date, resulting in an increased amount of goodwill or other intangible asset depending upon how value is allocated to the acquired assets. Fair value also must be re-measured for each subsequent reporting period until the contingency is settled. Mercer Capital’s years of M&A purchase price allocation work for both strategic and financial acquirers gives us unique insight into the sometimes nettlesome issues of purchase price allocations in M&A transactions.Concluding ThoughtsWhile this article is an installment in our larger buy-side series of content, it is important to draw advice for buyers from our near universal advice to sellers.We often advise sellers to be content with the consideration they receive at closing and to assess contingent consideration with a healthy degree of skeptical risk, particularly when achieving the earnout represents a stretch in future outcomes.A logical extension of that advice for buyers is to be prepared to pay even if the benchmarks are deemed a stretch. The occasional extraordinary outcome can create significant buyer liability. Whether the net effect on the buyer is a beneficial deferral of payment or a deal premium (or otherwise) must be assessed in the context of the overall offering stack.Buyers should determine the reason for using an earnout and then determine an appropriate design for the earnout. Clear, unambiguous terms and measurements are recommended to minimize negotiating friction and incent smooth post-closing integration and alignment of interests both operationally and financially.If your development needs involve growth through acquisition, and you find the market for quality targets requires the thoughtful use of earnout consideration, Mercer Capital can provide useful insight while helping quantify the real-time financial equivalency of any earnout consideration offered.

This is the second article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here. Business is good for many middle market operators and investment capital is generally plentiful. Are you an investor whose capital is industry agnostic, or does your capital need to be targeted at add-on investments that build on a pre existing business platform? All business investors are “financial” investors - the real question is how “strategic” is their ability to leverage the assets of the target. Providing practical guidance on approaching a business target and conducting initial due diligence depends on the investor’s criterion, competencies, and execution bandwidth. In this article we assume you have identified a target or group of targets and you are attempting to learn enough about the target to determine whether to proceed with developing a meaningful indication of interest. Of course, an active seller is likely prepared for the sale process and represented by an advisor who is postured to provide the financial and operating information necessary for investors to quickly determine the suitability of a deal (i.e., a pitchbook and defined protocols for communication and information access). However, many desirable targets may not be seeking a sale because business conditions are favorable, and their businesses have been managed to provide options to the owners regarding continued independence and turn-key ownership and management succession. If the former, you, as a prospective buyer may have already pinged on the radar of the seller, and if the later, you have mined for target opportunities and are ready for the next step to accomplish an acquisition. Our focus here is to summarize some practical considerations for approaching and vetting an identified target.First ContactM&A is not easy. For every transaction that is announced a very long list of items for both the buyer and seller were satisfactorily addressed before two parties entered into a merger or purchase agreement. For the acquirers, first impressions matter a lot. There are no second chances to make a good first impression.How a target is contacted can be pivotal to achieving receptivity and obtaining a critical mass of information. In cases where market familiarity or professional collegiality already exist, it can make sense for an investor’s senior leadership to make direct contact with the target’s senior management and/or owners.In cases where the target is not familiar to the investor, then following a respectful and empathic set of protocols is key. Investors using professional advisors and/or who involve their senior decision makers are likely to be taken seriously by the target. Peer-to-peer contacts too far down the chain of command are more likely to be dismissed.Owners and senior managers are keen to prevent the rumor mill from derailing business momentum and disturbing internal calm. A mindful and considerate process of first contact and initial discussions that is highly sensitive to the discrete nature of exploratory discussions will increase the probability that initial discussions and diligence can proceed to the next phase as a relationship based on trust develops.In our experience, contacting a target through a financial advisor has an important signal function that the potential acquirer is serious and has initiated a process to prioritize and vet targets. Diligence procedures will be thorough and well organized; deal consideration and terms will be professionally scrutinized. Alternatively, some business owners and investors who initiate a process may be perceived as canvassing to see what sticks to the proverbial wall. This can inadvertently serve to inflate seller requirements and expectations assuming the initial inquiry is successful.Initial Due DiligenceOnce the initial contact is established, it is important to follow-up immediately with an actionable agenda. Actions and processes include:Non-disclosure agreement;Information request list;Clear set of communication protocols involving specified individuals;A centrally controlled and managed information gateway;Establishment time frames and target dates for investigative due diligence, IOI, LOI, pre-closing due diligence, deal documentation, and ultimately closing. Organization begets pace and that pace culminates in a go or no-go decision.Preliminary ValuationProcedurally, our buy-side clients typically request that we perform a valuation of the target using a variety of considerations including the standalone value of the target and potentially the value of the target inclusive of expected synergies and efficiencies.A properly administered valuation process facilitates an understanding of the target’s business model, its tangible attributes, its intangible value, its operating capacity, its competitive and industry correlations, and many other considerations that investors use not only for the assessment of target feasibility but as an inward-looking exercise to assess the pre-existing business platform.For first-time buy-side clients, our services may also include building leverageable templates and processes for future M&A projects. Additionally, our processes may also be critical to the buyer’s Board consents, the buyer’s financing arrangements, and other managerial and operating arrangements required to promote target integration.Concluding ThoughtsConducting target searches, establishing contact, and performing initial due diligence are critical aspects of successful buy-side outcomes. In general, there are as many (if not more) consequential considerations for buyers as there are for sellers.Some buyers covet the conquest and go it alone without buy-side advisory representation. Conversely, even seasoned investors can benefit from third-party buy-side processes. Unseasoned acquirers may find their first forays into the M&A buy-side world untenable without proper guidance and bench strength.As providers of litigation support services, we have seen deals that have gone terribly wrong as if predestined by inadequate buy-side investigation. As providers of valuation services, we have valued thousands of enterprises for compliance purposes and strategic needs. As transaction advisors, we have rendered fairness opinions, conducted buy- and sell-side engagements and advised buyers concerning a wide variety of deal structures and financings. If you plan to take a walk on the buy-side, let Mercer Capital’s 40 years of advisory excellence guide and inform you.

This is the second article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here. Business is good for many middle market operators and investment capital is generally plentiful. Are you an investor whose capital is industry agnostic, or does your capital need to be targeted at add-on investments that build on a pre existing business platform? All business investors are “financial” investors - the real question is how “strategic” is their ability to leverage the assets of the target. Providing practical guidance on approaching a business target and conducting initial due diligence depends on the investor’s criterion, competencies, and execution bandwidth. In this article we assume you have identified a target or group of targets and you are attempting to learn enough about the target to determine whether to proceed with developing a meaningful indication of interest. Of course, an active seller is likely prepared for the sale process and represented by an advisor who is postured to provide the financial and operating information necessary for investors to quickly determine the suitability of a deal (i.e., a pitchbook and defined protocols for communication and information access). However, many desirable targets may not be seeking a sale because business conditions are favorable, and their businesses have been managed to provide options to the owners regarding continued independence and turn-key ownership and management succession. If the former, you, as a prospective buyer may have already pinged on the radar of the seller, and if the later, you have mined for target opportunities and are ready for the next step to accomplish an acquisition. Our focus here is to summarize some practical considerations for approaching and vetting an identified target.First ContactM&A is not easy. For every transaction that is announced a very long list of items for both the buyer and seller were satisfactorily addressed before two parties entered into a merger or purchase agreement. For the acquirers, first impressions matter a lot. There are no second chances to make a good first impression.How a target is contacted can be pivotal to achieving receptivity and obtaining a critical mass of information. In cases where market familiarity or professional collegiality already exist, it can make sense for an investor’s senior leadership to make direct contact with the target’s senior management and/or owners.In cases where the target is not familiar to the investor, then following a respectful and empathic set of protocols is key. Investors using professional advisors and/or who involve their senior decision makers are likely to be taken seriously by the target. Peer-to-peer contacts too far down the chain of command are more likely to be dismissed.Owners and senior managers are keen to prevent the rumor mill from derailing business momentum and disturbing internal calm. A mindful and considerate process of first contact and initial discussions that is highly sensitive to the discrete nature of exploratory discussions will increase the probability that initial discussions and diligence can proceed to the next phase as a relationship based on trust develops.In our experience, contacting a target through a financial advisor has an important signal function that the potential acquirer is serious and has initiated a process to prioritize and vet targets. Diligence procedures will be thorough and well organized; deal consideration and terms will be professionally scrutinized. Alternatively, some business owners and investors who initiate a process may be perceived as canvassing to see what sticks to the proverbial wall. This can inadvertently serve to inflate seller requirements and expectations assuming the initial inquiry is successful.Initial Due DiligenceOnce the initial contact is established, it is important to follow-up immediately with an actionable agenda. Actions and processes include:Non-disclosure agreement;Information request list;Clear set of communication protocols involving specified individuals;A centrally controlled and managed information gateway;Establishment time frames and target dates for investigative due diligence, IOI, LOI, pre-closing due diligence, deal documentation, and ultimately closing. Organization begets pace and that pace culminates in a go or no-go decision.Preliminary ValuationProcedurally, our buy-side clients typically request that we perform a valuation of the target using a variety of considerations including the standalone value of the target and potentially the value of the target inclusive of expected synergies and efficiencies.A properly administered valuation process facilitates an understanding of the target’s business model, its tangible attributes, its intangible value, its operating capacity, its competitive and industry correlations, and many other considerations that investors use not only for the assessment of target feasibility but as an inward-looking exercise to assess the pre-existing business platform.For first-time buy-side clients, our services may also include building leverageable templates and processes for future M&A projects. Additionally, our processes may also be critical to the buyer’s Board consents, the buyer’s financing arrangements, and other managerial and operating arrangements required to promote target integration.Concluding ThoughtsConducting target searches, establishing contact, and performing initial due diligence are critical aspects of successful buy-side outcomes. In general, there are as many (if not more) consequential considerations for buyers as there are for sellers.Some buyers covet the conquest and go it alone without buy-side advisory representation. Conversely, even seasoned investors can benefit from third-party buy-side processes. Unseasoned acquirers may find their first forays into the M&A buy-side world untenable without proper guidance and bench strength.As providers of litigation support services, we have seen deals that have gone terribly wrong as if predestined by inadequate buy-side investigation. As providers of valuation services, we have valued thousands of enterprises for compliance purposes and strategic needs. As transaction advisors, we have rendered fairness opinions, conducted buy- and sell-side engagements and advised buyers concerning a wide variety of deal structures and financings. If you plan to take a walk on the buy-side, let Mercer Capital’s 40 years of advisory excellence guide and inform you.

Many observers predict that the market is ripe for an unprecedented period of M&A activity, as the aging of the current generation of senior leadership and ownership pushes many middle-market companies to seek an outright sale or some other form of liquidity.Obviously, not all companies are in this position. For those positioned for continued ownership, an acquisition strategy could be a key component of long-term growth. For most middle-market companies, especially those that have not been acquisitive in the past, executing on a single acquisition (much less a broader acquisition strategy) can be fraught with risk. There are many elements, from finding the right targets, to pricing the deal correctly, to successfully integrating the acquired business that could derail efforts to build shareholder value through acquisition.This article is the first in a series on buy-side considerations that we will share over the next few months. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here.Our first topic starts at the beginning – identifying and assessing acquisition targets.Identifying Acquisition Targets and Assessing Strategic FitWith aggregate M&A activity setting records in 2021 and continuing a strong pace in 2022, many businesses are exhibiting a thirst for growth or conversely their shareholders are eyeing an exit at favorable valuations.With labor tightness, supply chain disruptions for capital goods, and financing costs fluctuating in real time, buyers and sellers are increasingly strategic in their mindset. Inflation and interest rates represent potential headwinds, but pent-up demand and plentiful war chests are likely to fuel elevated M&A activity in the foreseeable future. More than a few baby boomers have held on to their business assets making ownership succession and liquidity significant concerns.Additionally, many middle market business assets are churned by financial investors with defined holding periods. Large corporate players and private equity buy-out groups generally have their own corporate development teams. However, small and mid-market companies, occupied with day-to-day operations, often find themselves with limited bandwidth and a lack of financial advisory resource to identify, vet, and develop a well-crafted strategic M&A rationale and then execute it.This article provides touch points and practicalities for identifying viable merger and acquisition targets and assessing strategic fit.Motivation and ObjectivesA rejuvenated appreciation for optimal capital structures and fine-tuned operations has largely debunked the oversimplified notion that bigger is always better. However, right-sizing is about achieving a proper, often larger scale at the proper time for a supportable price. A classic question in strategizing to achieve the right size is that of "buy" versus "build."Many acquisitions are as much about securing scarce or unavailable hard assets and labor resources as they are about expanding one’s market space.Whether your investment mandate is to alleviate scarcities or to achieve vertical or horizontal diversification and expansion, tuning your investment criterion and financial tolerance to motivations and objectives is key.These collective questions, among others, help address the who and the what of recognizing potential targets and assessing the pricing and structural feasibility of a business combination in whatever form that may take (outright purchase or merger in some form).Given our experiences from years of advising clients, we have learned that the most obvious or simple solution is generally best. Many buyers already know the preferable target candidates but lack the ability to assess and the capacity to engage those targets. Additionally, many well-capitalized buyers lack the financial discipline to score, rank, and sequence their target opportunities with the expertise employed by large, active corporate developers and private equity investors.Understanding the magnitude and timing of the returns resulting from your investment options is critical. Constructing financial models to study the options of now-versus-later and the interactive nature of deal pricing, terms, and financing is vital to the process. These technical and practical needs must be addressed competently to grant buyers the freedom of mind and energy to critically assess deal intangibles that often influence the overall decision to move forward with a target or not. Cultural fit, command and control for successful integration, brand and product synergies, and many other factors ultimately manifest in an investment’s total return on investment.Scoring opportunities by way of traditional corporate finance disciplines using NPV and IRR modeling as well as using various frameworks such as SWOT Analysis or Porter's Five Forces is highly recommended. However, blind ambition and soulless math may not result in the best choice of targets.One common sense and often overlooked assessment is how a seller’s motivations may have a bearing on the risk assessment of the buyer. A seller today may be alerting today’s buyer about future realities the buyer may experience. In some cases, sellers are motivated by a deficit of ownership and management succession. In other cases, a seller’s motive may be the result of industry dynamics and disruption that may one day be the concern of today’s consolidators. Get informed, get objective and be rational when assessing a target. If you cannot do that with in-house resources, get help. If you have in-house resources, have your mandates reviewed and your target analysis checked by an experienced advisor with the right balance of valuation and transaction awareness.Take a Walk in the Seller’s ShoesWe know that sellers often fear opening-up their financials and operations to certain logical strategic buyers. This may stem from generations of fierce competition or from a concern that not selling means the seller has revealed sensitive information that will compromise their competitive position or devalue the business in a future deal. Many sellers are extremely sensitive to retaining their staff and keeping faith with suppliers and customers. Buyers should understand that sellers require comfort and assurance regarding confidentiality.Being proactive with non-disclosure agreements and even better using a third party such as Mercer Capital to establish contact may facilitate a process of mutual assessment that is initially a no-go for many tentative sellers. Buyers that demonstrate empathy for the seller’s position and who employ a well-conceived process to initiate exchange are more likely to gain access to essential information.It is common for the seller’s initial market outreach to set the hurdle price for the winning buyer. That may occur as a result of the seller having reasonably skilled advisors who help establish deal expectations or through first-round indications of interest. As such, it should be no surprise for truly strategic buyers to be able to hurdle the offers of first round financial buyers or less optimal fringe buyers.Buyers should also be aware that third party deals must win against the seller’s potential ability to execute a leveraged buy-out with family members or senior managers, which may facilitate favorable tax outcomes versus the asset-based structures in open-market M&A processes. Of course, strategic buyers should be equally aware that many private equity or family-office buyers may also be strategic in their motivations and pricing capabilities based on pre existing portfolio holdings.Awareness of competing concerns for the target must be considered if you intend to win the deal. Buyers, with the help of skilled advisors, can actually help sellers address the balance of considerations that underpin a decision to sell. Having plans for human resource, communicating employee benefits and compensation structures, and laying the groundwork for a smooth integration process are part of walking the talk of a successful acquisition.Concluding ThoughtsWhether your motivations are based on synergies, efficiencies, or simply on the inertial forces of consolidation that cycle through many industries, a well-organized and disciplined process is paramount to examining and approaching the market for hopeful growth opportunities.Regardless of your past experiences and deal acumen, we recommend retaining a transaction advisory team familiar with your industry and possessing the valuation expertise to maximize transaction opportunities and communicate the merits your firm has to offer the target and all its stakeholders.Since Mercer Capital’s founding in 1982, we have worked with a broad range of public and private companies and financial institutions. As financial advisors, Mercer Capital looks to assess the strategic fit of every prospect through initial planning, rigorous industry and financial analysis, target or buyer screening, negotiations, and exhaustive due diligence so that our clients reach the right decision regardless of outcome. Our dedicated and responsive deal team stands ready to help your business manage the transaction process.

Many observers predict that the market is ripe for an unprecedented period of M&A activity, as the aging of the current generation of senior leadership and ownership pushes many middle-market companies to seek an outright sale or some other form of liquidity. Obviously, not all companies are in this position. For those positioned for continued ownership, an acquisition strategy could be a key component of long-term growth. For most middle-market companies, especially those that have not been acquisitive in the past, executing on a single acquisition (much less a broader acquisition strategy) can be fraught with risk. There are many elements, from finding the right targets, to pricing the deal correctly, to successfully integrating the acquired business that could derail efforts to build shareholder value through acquisition. This article is the first in a series on buy-side considerations that we will share over the next few months. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here.Our first topic starts at the beginning – identifying and assessing acquisition targets.Identifying Acquisition Targets and Assessing Strategic FitWith aggregate M&A activity setting records in 2021 and continuing a strong pace in 2022, many businesses are exhibiting a thirst for growth or conversely their shareholders are eyeing an exit at favorable valuations.With labor tightness, supply chain disruptions for capital goods, and financing costs fluctuating in real time, buyers and sellers are increasingly strategic in their mindset. Inflation and interest rates represent potential headwinds, but pent-up demand and plentiful war chests are likely to fuel elevated M&A activity in the foreseeable future. More than a few baby boomers have held on to their business assets making ownership succession and liquidity significant concerns.Additionally, many middle market business assets are churned by financial investors with defined holding periods. Large corporate players and private equity buy-out groups generally have their own corporate development teams. However, small and mid-market companies, occupied with day-to-day operations, often find themselves with limited bandwidth and a lack of financial advisory resource to identify, vet, and develop a well-crafted strategic M&A rationale and then execute it.This article provides touch points and practicalities for identifying viable merger and acquisition targets and assessing strategic fit.Motivation and ObjectivesA rejuvenated appreciation for optimal capital structures and fine-tuned operations has largely debunked the oversimplified notion that bigger is always better. However, right-sizing is about achieving a proper, often larger scale at the proper time for a supportable price. A classic question in strategizing to achieve the right size is that of "buy" versus "build."Many acquisitions are as much about securing scarce or unavailable hard assets and labor resources as they are about expanding one’s market space.Whether your investment mandate is to alleviate scarcities or to achieve vertical or horizontal diversification and expansion, tuning your investment criterion and financial tolerance to motivations and objectives is key.These collective questions, among others, help address the who and the what of recognizing potential targets and assessing the pricing and structural feasibility of a business combination in whatever form that may take (outright purchase or merger in some form).Given our experiences from years of advising clients, we have learned that the most obvious or simple solution is generally best. Many buyers already know the preferable target candidates but lack the ability to assess and the capacity to engage those targets. Additionally, many well-capitalized buyers lack the financial discipline to score, rank, and sequence their target opportunities with the expertise employed by large, active corporate developers and private equity investors.Understanding the magnitude and timing of the returns resulting from your investment options is critical. Constructing financial models to study the options of now-versus-later and the interactive nature of deal pricing, terms, and financing is vital to the process. These technical and practical needs must be addressed competently to grant buyers the freedom of mind and energy to critically assess deal intangibles that often influence the overall decision to move forward with a target or not. Cultural fit, command and control for successful integration, brand and product synergies, and many other factors ultimately manifest in an investment’s total return on investment.Scoring opportunities by way of traditional corporate finance disciplines using NPV and IRR modeling as well as using various frameworks such as SWOT Analysis or Porter's Five Forces is highly recommended. However, blind ambition and soulless math may not result in the best choice of targets.One common sense and often overlooked assessment is how a seller’s motivations may have a bearing on the risk assessment of the buyer. A seller today may be alerting today’s buyer about future realities the buyer may experience. In some cases, sellers are motivated by a deficit of ownership and management succession. In other cases, a seller’s motive may be the result of industry dynamics and disruption that may one day be the concern of today’s consolidators. Get informed, get objective and be rational when assessing a target. If you cannot do that with in-house resources, get help. If you have in-house resources, have your mandates reviewed and your target analysis checked by an experienced advisor with the right balance of valuation and transaction awareness.Take a Walk in the Seller’s ShoesWe know that sellers often fear opening-up their financials and operations to certain logical strategic buyers. This may stem from generations of fierce competition or from a concern that not selling means the seller has revealed sensitive information that will compromise their competitive position or devalue the business in a future deal. Many sellers are extremely sensitive to retaining their staff and keeping faith with suppliers and customers. Buyers should understand that sellers require comfort and assurance regarding confidentiality.Being proactive with non-disclosure agreements and even better using a third party such as Mercer Capital to establish contact may facilitate a process of mutual assessment that is initially a no-go for many tentative sellers. Buyers that demonstrate empathy for the seller’s position and who employ a well-conceived process to initiate exchange are more likely to gain access to essential information.It is common for the seller’s initial market outreach to set the hurdle price for the winning buyer. That may occur as a result of the seller having reasonably skilled advisors who help establish deal expectations or through first-round indications of interest. As such, it should be no surprise for truly strategic buyers to be able to hurdle the offers of first round financial buyers or less optimal fringe buyers.Buyers should also be aware that third party deals must win against the seller’s potential ability to execute a leveraged buy-out with family members or senior managers, which may facilitate favorable tax outcomes versus the asset-based structures in open-market M&A processes. Of course, strategic buyers should be equally aware that many private equity or family-office buyers may also be strategic in their motivations and pricing capabilities based on pre existing portfolio holdings.Awareness of competing concerns for the target must be considered if you intend to win the deal. Buyers, with the help of skilled advisors, can actually help sellers address the balance of considerations that underpin a decision to sell. Having plans for human resource, communicating employee benefits and compensation structures, and laying the groundwork for a smooth integration process are part of walking the talk of a successful acquisition.Concluding ThoughtsWhether your motivations are based on synergies, efficiencies, or simply on the inertial forces of consolidation that cycle through many industries, a well-organized and disciplined process is paramount to examining and approaching the market for hopeful growth opportunities.Regardless of your past experiences and deal acumen, we recommend retaining a transaction advisory team familiar with your industry and possessing the valuation expertise to maximize transaction opportunities and communicate the merits your firm has to offer the target and all its stakeholders.Since Mercer Capital’s founding in 1982, we have worked with a broad range of public and private companies and financial institutions. As financial advisors, Mercer Capital looks to assess the strategic fit of every prospect through initial planning, rigorous industry and financial analysis, target or buyer screening, negotiations, and exhaustive due diligence so that our clients reach the right decision regardless of outcome. Our dedicated and responsive deal team stands ready to help your business manage the transaction process.

In this week’s Family Business Director, Tim Lee, ASA, Managing Director of Corporate Valuation and John T. (Tripp) Crews, III, Senior Financial Analyst, discuss expectations around the timeline for your business transition or sale and summarize key points to keep in mind when driving towards an internal or external sale. Ownership transitions, whether internal among family and other shareholders or external with third parties, require effective planning and a team of qualified advisors to achieve the desired outcome. In this article, we examine some “typical” timelines involved in various types of transactions and expectations you can share with your family board members.Internal TransitionsIn this section, we discuss the importance of a buy-sell agreement in a sale to the next generation. Then we take a brief look at employee stock ownership plans as another potential avenue to an internal transition.Sale to Next GenerationInternal transitions are often undertaken in accordance with provisions outlined in the Company’s existing or newly minted buy-sell agreement. A buy-sell agreement is an agreement by and between the family members and other shareholders of a closely owned business that defines the terms for the purchase when an owner requires liquidity. Buy-sell agreements typically specify how pricing is determined, including the timing, the standard of value used, the level of value, and the appraiser performing the valuation.A buy-sell agreement is an agreement by and between the family members and other shareholders of a closely owned business that defines the terms for the purchase when an owner requires liquidity.As a matter of practicality, the timing for transfers using an existing buy-sell agreement is often dependent on the readiness of financing and the service level of the assisting legal and valuation advisory professionals. Experience suggests this can take as little as four to eight weeks, but often involves processes that can require three to six months to carry out.In circumstances where a newly crafted buy-sell agreement is being developed, you should expect a lengthier process of at least several months so that the attending financial, valuation, and legal frameworks are satisfactorily achieved.Mercer Capital has published numerous books on the topic of buy-sell agreements, which readers of this article should avail themselves of, or better yet, contact a Mercer Capital valuation professional to make sure you get directed to the most useful content to assist in your circumstance.Family-owned companies with an existing buy-sell agreement and those that obtain regular appraisal work, stand the best chance of achieving a timely process. Those Companies that are embarking on their first real valuation process, and that have stakeholders who require a thorough education on valuation and other topics, should allow for a deliberate and paced process.In the event of an unexpected need for ownership transfer (death and divorce to name a few), it is sound advice to retain a primary facilitator to administer to the potentially complex sets of needs that often accompany the unexpected.Employee Stock Ownership PlansThe establishment of an Employee Stock Ownership Plans (ESOP) is a necessarily involved process that requires a variety of analyses, one of which is an appraisal of the Company’s shares that will be held by the plan.For a family business with well-established internal processes and systems, the initial ESOP transaction typically requires four to six months. In a typical ESOP transaction, the Company will engage a number of advisors who work together to assist the family and its shareholders in the transaction process. The typical “deal team” includes a firm that specializes in ESOP implementation, as well legal counsel, an accounting firm, a banker, and an independent trustee (and that trustee’s team of advisors as well).Most modern-day ESOPs involve complex financing arrangementsMost modern-day ESOPs involve complex financing arrangements including senior bankers and differing types and combinations of subordinated lenders (mezzanine lenders and seller notes). There are numerous designs to achieve an ESOP installation. In general, the Company establishes and then funds the ESOP’s purchase financing via annual contributions.ESOPs are qualified retirement plans that are subject to the Employee Retirement Income Security Act and regulated by the Department of Labor. Accordingly, ESOP design and installation are in the least, a time consuming process (plan for six months) and in some cases an arduous one that requires fortitude and an appreciation by all parties for the consequences of not getting it right up front. The intricacies and processes for a successful ESOP transaction are many.A more detailed assessment of ESOPs is provided here on Mercer Capital’s website.The following graphics depict the prototypical ESOP structure and the flow of funds.External SalesMany families cannot fathom why success in business may not equally apply to getting a deal done. In most external transactions, there is a significant imbalance of deal experience: today’s buyers have often completed many transactions, while sellers may have never sold a business. Accordingly, family businesses need to assemble a team of experienced and trusted advisors to help them navigate unfamiliar terrain.Without exception, we recommend retaining a transaction team composed of at least three deal-savvy players: a transaction attorney, a tax accountant, and a sell-side financial advisor. If you do not already have some of these capable advisors, assembling a strong team can require time to accomplish. Since many transactions with external buyers originate as unsolicited approaches from the growing myriad of private equity and family office investors, it is advisable to maintain a posture of readiness.Up-to-date financial reporting, good general housekeeping with respect to accounts, inventory, real property maintenance, information technology, and the like are all part of a time-efficient transaction process. These aspects of readiness are the things that family business directors and managers can control in order to improve timing efficiency. As is often said in the transaction environment - time wounds all deals.In most external transactions, there is a significant imbalance of deal experience ... accordingly, family businesses need to assemble a team of experienced and trusted advisors to help them navigate unfamiliar terrain.Sellers doing their part on the readiness front are given license to expect an efficient process from their sell-side advisors and from buyers. We do caution that selling in today’s mid-market environment ($10-$500 million deal size) often involves facilitating potentially exhaustive buyer due diligence in the form of financial, legal, tax, regulatory and other matters not to mention potentially open-ended Quality of Earnings processes used by today’s sophisticated investors and strategic consolidators. A seasoned sell-side advisor can help economize on and facilitate these processes if not in the least comfort sellers as to the inherent complexity of the transaction process.The sell-side advisor assists the family (or the seller’s board as the case may be) in setting reasonable value expectations, preparing the confidential information memorandum, identifying a target list of potential motivated buyers, soliciting and assessing initial indications of interest and formal bids, evaluating offers, facilitating due diligence, and negotiating key economic terms of the various contractual agreements.The typical external transaction process takes four to seven months and is done in three often overlapping and recycling phases. While every deal process involves different twists and turns on the path to consummation, the typical external transaction process takes five to seven months and is completed in the three phases depicted in the following graphics.CLICK HERE TO ENLARGE THE IMAGE ABOVECLICK HERE TO ENLARGE THE IMAGE ABOVEConclusionAs seasoned advisors participating on both front-end and post-transaction processes, we understand that every deal is unique. We have experienced the rush of rapid deal execution and the trying of patience in deals that required multiple rounds of market exposure. A proper initial Phase I process is often required to fully vet the practical timing required for an external transaction process.Mercer Capital provides transaction advisory services to a broad range of public and private companies and financial institutions. We have worked on hundreds of consummated and potential transactions since Mercer Capital was founded in 1982. We have significant experience advising shareholders, boards of directors, management, and other fiduciaries of middle-market public and private companies in a wide range of industries. Rather than pushing solely for the execution of any transaction, Mercer Capital positions itself as an advisor, encouraging the right decision to be made by its clients.Our independent advice withstands scrutiny from shareholders, bondholders, the SEC, IRS, and other interested parties to a transaction. Our dedicated and responsive team stands ready to help manage your transaction.

In this week’s Family Business Director, Tim Lee, ASA, Managing Director of Corporate Valuation and John T. (Tripp) Crews, III, Senior Financial Analyst, discuss internal and external exit options for you and your family business and summarize the possible buyers for your family enterprise. We regularly encounter family business owners contemplating the dilemma of ownership transition. After years (maybe even decades) of cultivating the business through hard work, determination, and perhaps a bit of luck, many families believe now is a sensible time to exit. Tax changes are looming, pandemic and post-pandemic winners see solutions to a myriad of operational challenges, and valuations remain favorable in most industries. However, a seller’s timing, the readiness of the business, and the readiness of the marketplace may not be aligned without careful preparation and real-time market awareness from your family business board of directors. Families often fail to realize that their preparation, their tolerance for post-deal involvement, their health and ability to remain active, and their needs for liquidity will influence the breadth and priorities of their options and will influence who the potential buyers might be and how they might target the business. Proactivity (or backfilling for the lack thereof) will also influence the design and costs of the process for effective representation. Under ideal circumstances, your family will begin planning for ownership transition well before the need for an actual ownership transfer arises. One of the first steps in planning for an eventual exit is to understand who the potential buyers might be and the different characteristics of these buyers. In this article, we discuss some exit options and summarize some of the specifics of certain types of buyers and what that could mean for transaction structure and economic outcomes.Internal Ownership TransitionPotential buyers in an internal transition generally include the next generation of the owner’s family or key employees of the company (or a mix thereof). When done carefully, an internal transition can be desirable in order to protect both the existing employees and the culture of the business. These transactions generally occur two ways: through a direct sale from the exiting owner to the next generation or through the establishment of an Employee Stock Ownership Plan (ESOP). While these transactions may not yield the pricing or turnkey liquidity that selling to an outside buyer might, they can provide comfort to the current generation of family owners regarding their legacy and the continuing prospects of the business as an independent going concern.Sale or Transfer to Next GenerationFor many family businesses, transitioning ownership and leadership to the next generation of family members is the primary exit consideration. For other families, a sale to the non-family management team makes more sense. In either event, the value of the shares being transferred is critical.Whether transferring ownership to the next generation of family members or to the non-family management team, the value of the shares being transferred is criticalFor sale transactions, the question of how the transaction will be financed is equally important. Internal transactions are often achieved by share redemptions in installments and/or through a leveraged buyout process. Often, the seller will provide financing using one of many potential structures. Seller financing carries the risk of the buyer’s inability to pay, which often requires the seller to reinsert themselves into active leadership. Many may view seller financing as desirable in order to control the terms and costs of the arrangements and to benefit from the interest and other terms of the financing.As noted, a seller’s liquidity requirements and the underlying fundamental borrowing capacity of the business play a big part in determining how much third party capital can be employed. Many sellers want their buyers, family or otherwise, to have real skin in the game by way of at least partial external financing.If the next generation of family members and/or employees are not well situated to achieve a buyout as a concentrated ownership group, then the feasibility of a more formal collective buyer group may be a good alternative. The following is a brief overview of Employee Stock Ownership Plans, which can serve as an alternative to a concentrated internal transition.Establishing an Employee Stock Ownership Plan“ESOPs” are a proven vehicle of ownership transfer. They can provide for either an incremental or a turnkey ownership transfer. They also facilitate the opportunity for legacy owners to continue contributing to the stability and success of the business while allowing employees to reap the rewards and benefits of capital ownership. Assessing the feasibility of an ESOP requires the advisory support of experienced financial and legal professionals who help ensure best practices are implemented and compliance awareness governs the transaction. To that end, family businesses contemplating an ESOP need to be keenly aware of the importance of following a well designed process that satisfies the requirements of the Department of Labor and adheres to governing rules and regulations.As a qualified retirement plan subject to regulations set forth by ERISA, ESOPs are regulated using strict guidelines for process, fairness, and administration. Accordingly, the entire life cycle of a contemplated ESOP needs to be studied in a process generally referred to as an ESOP Feasibility Study. Valuation, financing, plan design, plan administration, future repurchase obligations, and many other concerns must be assessed before venturing down the ESOP path.Establishing an ESOP includes creating an ESOP trust, which, using one of many possible transaction structures, becomes the ultimate owner of some or all the stock of the sponsoring ESOP company. ESOPs are unique in being the only qualified retirement plans allowed to use debt to purchase the shares of the employer corporation. Once an ESOP is in place, the qualifying employee participants are allocated interests in the trust annually according to the Plan’s design. As employees cycle through their employment tenure, they trigger milestone events that allow for the effective sale of their accumulated ownership positions, providing a nest egg for retirement. During their tenure of employment, the employee’s account is mostly concentrated in company stock, the valuation of which determines the amount they receive when nearing and eventually reaching retirement age. The stock accumulated during active employment is converted to cash and the Plan shares are either redeemed or recycled to perpetuate the ESOP.There are certain tax-related and transaction design features in an ESOP transaction that can benefit family business sellers in numerous different waysThere are certain tax-related and transaction design features in an ESOP transaction that can benefit family business sellers in numerous different ways. Sellers in ESOP installations must understand the necessary complexities and nuances of a well-run ESOP transaction. Sellers lacking the patience and gumption for an ESOP process or those who require turnkey liquidity in their ownership exit should consider an alternative liquidity strategy.External SaleIn general, the ability to sell your family business to an external party yields the highest proceeds. If you have succeeded in creating a sustainable business model with favorable prospects for growth, your business assets may generate interest from both strategic and financial buyers, the pros and cons of which are listed in the following sections.Strategic BuyersA strategic buyer is usually a complementary or competitive industry player within your markets or looking to enter your markets. These buyers can be generally characterized as either vertical or horizontal in nature. Such buyers are interested in the natural economies of scale that result from expanded market area and/or from specific synergies that create the opportunity for market and financial accretion (think 1 + 1 = 3).There is a good chance that a potential strategic buyer for your family business is someone or some group you already know. Such buyers don’t require the full ground-up familiarization process because they are already in tune with the risk and growth profiles of the business model. Accordingly, owners interested in a turnkey, walk-away sale of their business are often compelled toward a strategic buyer since strategic buyers can quickly integrate the family’s business into their own.The moving parts of transaction consideration paid by strategic buyers can cover a broad spectrum. We see simple nearly 100% cash deals as well as deals that include various forms of contingent consideration and employment/non-compete agreements.There is a good chance that a potential strategic buyer for your family business is someone or some group you already knowMany family owners in strategic deals are not inclined to work for their buyers other than in a purely consultative role that helps deliver the full tangible and intangible value the buyer is paying for. In many cases strategic buyers want a clean and relatively abrupt break from prior ownership in order to hasten the integration processes and cultural shift that come with a change in control. Further, strategic deals may include highly tailored earn-outs that are designed with hurdles based on industry-specific metrics. In general, earn-outs are often designed to close gaps in the bid/ask spread that occur in the negotiation process. These features allow sellers more consideration if post-transaction performance meets or beats the defined hurdles and vis-a-versa. Family business owners must be aware of the sophisticated means by which larger strategic buyers can creatively engineer the outcomes of contingent consideration.In certain industries, strategic buyers may structure consideration as part cash and part or all stock. Sellers in the financials sector are often selling equity ownership as opposed to the asset sales that dominate most non-financial sectors. In such deals, sellers who take equity in the merged entity must be cognizant of their own valuation and that of the buyer. The science of the exchange rate and the post-closing true ups that may apply are areas in which family business owners should seek proper professional advisory guidance outside their family boards and advisors.Financial BuyersFinancial buyers are primarily interested in the returns achieved from their investment activities. These returns are achieved by the conventions of 1) traditional opportunistic investment and 2) by means of sophisticated front end and back end financial engineering with respect to the original financing and the subsequent re-financings that often occur.Most traditional buy-out financial investors are looking to satisfy the specific investment criterion on behalf of their underlying fund investors, who have signed on for a targeted duration of investment that by nature requires the financial investor to achieve a secondary exit of the business within three to seven years after acquisition (the house flipping analogy is a clear but oversimplified one). Financial investors may have significant expertise acquiring companies in certain industries or may act as generalists willing to acquire different types of businesses across different industries.In general, there are three types of financial buyers:Private Equity Groups or other Alternative Financial Investors,Permanent Capital Providers, andSingle/Multi-Family Offices Despite their financial expertise, financial buyers usually do not typically have the capacity or knowledge to assume the management of the day-to-day operations of all of their investments. As such, the family’s management team at the time of a sale will likely remain involved with the Company for the foreseeable future. A sale to a financial investor can be a viable solution for ownership groups in which one owner wants to cash out and completely exit the business while other owners remain involved (rollover) with the business.A sale to a financial investor can be a viable solution in situations where one owner wants to cash out and completely exit the business while other owners remain involved with the businessWith respect to work force and employee stability, financial investors will ultimately seek maximum efficiency, but they often begin the process of making sure they secure the services of both frontline and managerial employees. In many cases, the desired growth of such investors can bolster the employment security of good employees while screening out those that resist change and impede progress.The value of the assembled workforce is becoming a more meaningful asset to prospective buyers in the marketplace, whether they be strategic and financial in nature. Further, larger acquirers often can present employees with a more comprehensive benefit package and enhanced upward mobility in job responsibility and compensation. All this said, financial investors will ultimately seek to optimize their returns with relentless efficiency.Lastly, as the financial buyer universe has matured over the past 20+ years, we have witnessed directly that many strategic consolidators are platform businesses with private equity sponsorship, which blurs or even eliminates the notion of a strictly strategic or financial buyer in many industries.ConclusionAn outside buyer might approach your family business with an offer that you were not expecting, you and your family might decide to put the business on the market and seek offers, or your family might opt to sell to the next generation of the family in an internal sale. Whatever the case may be, most owners only get to sell their business once, so you need to be sure you have experienced, trustworthy advisors in your corner.Mercer Capital provides transaction advisory services to a broad range of public and private companies and financial institutions. We have worked on hundreds of consummated and potential transactions since Mercer Capital was founded in 1982. We have significant experience advising shareholders, boards of directors, management, and other fiduciaries of middle-market public and private companies in a wide range of industries.Rather than pushing solely for the execution of any transaction, Mercer Capital positions itself as an advisor to inform sellers about their options and to encourage market-based decision making that aligns with the personal priorities of each client.Our independent advice withstands scrutiny from shareholders, bondholders, the SEC, IRS, and other interested parties to a transaction. Our dedicated and responsive team stands ready to help you and your family manage the transaction process.

That Depends on the Type of Transaction…Ownership transitions, whether internal among family and other shareholders or external with third parties, require effective planning and a team of qualified advisors to achieve the desired outcome. In this article, we examine some “typical” timelines involved in various types of transactions.Internal TransitionsSale to Next GenerationInternal transitions are often undertaken in accordance with provisions outlined in the Company’s existing or newly minted buy-sell agreement. A buy-sell agreement is an agreement by and between the owners of a closely owned business that defines the terms for the purchase when an owner requires liquidity. Buy-sell agreements typically specify how pricing is determined, including the timing, the standard of value used, the level of value, and the appraiser performing the valuation.As a matter of practicality, the timing for transfers using an existing buy-sell agreement is often dependent on the readiness of financing and the service level of the assisting legal and valuation advisory professionals. Experience suggests this can take as little as four to eight weeks, but often involves processes that can require three to six months to carry out.In circumstances where a newly crafted buy-sell agreement is being developed, you should expect a lengthier process of at least several months so that the attending financial, valuation, and legal frameworks are satisfactorily achieved.Mercer Capital has published numerous books on the topic of buy-sell agreements, which readers of this article should avail themselves of, or better yet, contact a Mercer Capital valuation professional to make sure you get directed to the most useful content to assist in your circumstance.Companies with an existing buy-sell agreement and those that obtain regular appraisal work, stand the best chance of achieving a timely process. Those Companies that are embarking on their first real valuation process, and that have stakeholders who require a thorough education on valuation and other topics, should allow for a deliberate and paced process.In the event of an unexpected need for ownership transfer (death and divorce to name a few), it is sound advice to retain a primary facilitator to administer to the potentially complex sets of needs that often accompany the unexpected.Employee Stock Ownership PlansThe establishment of an Employee Stock Ownership Plans (ESOP) is a necessarily involved process that requires a variety of analyses, one of which is an appraisal of the Company’s shares that will be held by the plan.For a Company with well-established internal processes and systems, the initial ESOP transaction typically requires four to six months. In a typical ESOP transaction, the Company will engage a number of advisors who work together to assist the Company and its shareholders in the transaction process. The typical “deal team” includes a firm that specializes in ESOP implementation, as well legal counsel, an accounting firm, a banker, and an independent trustee (and that trustee’s team of advisors as well).Most modern-day ESOPs involve complex financing arrangements including senior bankers and differing types and combinations of subordinated lenders (mezzanine lenders and seller notes). There are numerous designs to achieve an ESOP installation. In general, the Company establishes and then funds the ESOP’s purchase financing via annual contributions.ESOPs are qualified retirement plans that are subject to the Employee Retirement Income Security Act and regulated by the Department of Labor. Accordingly, ESOP design and installation are in the least, a time consuming process (plan for six months) and in some cases an arduous one that requires fortitude and an appreciation by all parties for the consequences of not getting it right up front. The intricacies and processes for a successful ESOP transaction are many.A more detailed assessment of ESOPs is provided here on Mercer Capital’s website. The following graphics depict the prototypical ESOP structure and the flow of funds.External SalesMany entrepreneurs cannot fathom why success in business may not equally apply to getting a deal done. In most external transactions, there is a significant imbalance of deal experience: today’s buyers have often completed many transactions, while sellers may have never sold a business. Accordingly, sellers need to assemble a team of experienced and trusted advisors to help them navigate unfamiliar terrain.Without exception, we recommend retaining a transaction team composed of at least three deal-savvy players: a transaction attorney, a tax accountant, and a sell-side financial advisor. If you do not already have some of these capable advisors, assembling a strong team can require time to accomplish. Since many transactions with external buyers originate as unsolicited approaches from the growing myriad of private equity and family office investors, it is advisable to maintain a posture of readiness.Up-to-date financial reporting, good general housekeeping with respect to accounts, inventory, real property maintenance, information technology, and the like are all part of a time-efficient transaction process. These aspects of readiness are the things that sellers can control in order to improve timing efficiency. As is often said in the transaction environment - time wounds all deals.Sellers doing their part on the readiness front are given license to expect an efficient process from their sell-side advisors and from buyers. We do caution that selling in today’s mid-market environment ($10-$500 million deal size) often involves facilitating potentially exhaustive buyer due diligence in the form of financial, legal, tax, regulatory and other matters not to mention potentially open-ended Quality of Earnings processes used by today’s sophisticated investors and strategic consolidators. A seasoned sell-side advisor can help economize on and facilitate these processes if not in the least comfort sellers as to the inherent complexity of the transaction process.The sell-side advisor assists ownership (or the seller’s board as the case may be) in setting reasonable value expectations, preparing the confidential information memorandum, identifying a target list of potential motivated buyers, soliciting and assessing initial indications of interest and formal bids, evaluating offers, facilitating due diligence, and negotiating key economic terms of the various contractual agreements.The typical external transaction process takes four to seven months and is done in three often overlapping and recycling phases. While every deal process involves different twists and turns on the path to consummation, the typical external transaction process takes five to seven months and is completed in the three phases depicted in the following graphics.CLICK HERE TO ENLARGE THE IMAGE ABOVECLICK HERE TO ENLARGE THE IMAGE ABOVEConclusionAs seasoned advisors participating on both front-end and post-transaction processes, we understand that every deal is unique. We have experienced the rush of rapid deal execution and the trying of patience in deals that required multiple rounds of market exposure. A proper initial Phase I process is often required to fully vet the practical timing required for an external transaction process.Mercer Capital provides transaction advisory services to a broad range of public and private companies and financial institutions. We have worked on hundreds of consummated and potential transactions since Mercer Capital was founded in 1982. We have significant experience advising shareholders, boards of directors, management, and other fiduciaries of middle-market public and private companies in a wide range of industries. Rather than pushing solely for the execution of any transaction, Mercer Capital positions itself as an advisor, encouraging the right decision to be made by its clients.Our independent advice withstands scrutiny from shareholders, bondholders, the SEC, IRS, and other interested parties to a transaction. Our dedicated and responsive team stands ready to help manage your transaction.

An Overview of the Different Types of Buyers for Closely Held, Mid-Market CompaniesWe regularly encounter business owners contemplating the dilemma of ownership transition. After years (maybe even decades) of cultivating the business through hard work, determination, and perhaps a bit of luck, many prospective sellers believe now is a sensible time to exit.Tax changes are looming, pandemic and post-pandemic winners see solutions to a myriad of operational challenges, and valuations remain favorable in most industries. However, a seller’s timing, the readiness of the business, and the readiness of the marketplace may not be aligned without careful seller preparation and real-time market awareness.Little do most sellers realize that their preparation, their tolerance for post-deal involvement, their health and ability to remain active, and their needs for liquidity will influence the breadth and priorities of their options and will influence who the potential buyers might be and how they might target the business. Proactivity (or backfilling for the lack thereof) will also influence the design and costs of the process for effective M&A representation.Under ideal circumstances, the planning process for an exit will begin well before the need for an actual ownership transfer arises. One of the first steps in planning for an eventual sale is to understand who the potential buyers might be and the different characteristics of these buyers.In this article, we discuss some exit options and summarize some of the specifics of certain types of buyers and what that could mean for transaction structure and economic outcomes.Internal Ownership TransitionWhen done carefully, an internal transition can be desirable in order to protect both the existing employees and the culture of the business. Potential buyers in an internal transition generally include the next generation of the owner’s family or key employees of the company (or a mix thereof).These transactions generally occur one of two ways: through a direct sale from the exiting owner to the next generation or through the establishment of an Employee Stock Ownership Plan (ESOP).While these transactions may not yield the pricing or turnkey liquidity that selling to an outside buyer might, they can provide comfort to exiting owners regarding their legacy and the continuing prospects of the business as an independent going concern. Sale to Next GenerationA key consideration in selling to family members or to employees is price. Equally important is the question of how the transaction is financed.Internal transactions are often achieved by share redemptions in installments and/or through a leveraged buyout process. Often, the seller will provide financing using one of many potential structures.Seller financing carries the risk of the buyer’s inability to pay, which often requires the seller to reinsert into active leadership. Many may view seller financing as acceptable, if not necessary or desirable, in order to control the terms and costs of the arrangements and to benefit from the interest payments and other terms of the financing.As noted, a seller’s liquidity requirements and the underlying fundamental borrowing capacity of the business play a big part in determining how much third party capital can be employed. Many sellers want their buyers, family or otherwise, to have real skin in the game by way of at least partial external financing.If the next generation of family members and/or employees are not well-situated to achieve a buyout as a concentrated ownership group, then the feasibility of a more formal collective buyer group may be a good alternative. Following is a brief overview of Employee Stock Ownership Plans, which can serve as an alternative to a concentrated internal transition.Establishing an Employee Stock Ownership PlanESOPs are a proven vehicle of ownership transfer. They can provide for either an incremental or a turnkey ownership transfer. They also facilitate the opportunity for legacy owners to continue contributing to the stability and success of the business while allowing employees to reap the rewards and benefits of capital ownership.Assessing the feasibility of an ESOP requires the advisory support of experienced financial and legal professionals who help ensure that best practices are implemented and that compliance awareness governs the transaction. To that end, owners contemplating an ESOP need to be keenly aware of the importance of following a well-designed process that satisfies the requirements of the Department of Labor and adheres to governing rules and regulations.As a qualified retirement plan subject to regulations set forth by ERISA (Employee Retirement Income Security Act), ESOPs are regulated using strict guidelines for process, fairness, and administration. Accordingly, the entire life cycle of a contemplated ESOP needs to be studied in a process generally referred to as an ESOP Feasibility Study. Valuation, financing, plan design, plan administration, future repurchase obligations, and many other concerns must be assessed before venturing down the ESOP path.In function, the establishment of an ESOP includes the creation of an ESOP trust, which, using one of many possible transaction structures, becomes the ultimate owner of some or all of the stock of the sponsoring ESOP company. ESOPs are unique in being the only qualified retirement plans allowed to use debt to purchase the shares of the employer corporation.Once an ESOP is in place, the qualifying employee participants are allocated interests in the trust annually according to the Plan’s design. As employees cycle through their employment tenure, they trigger milestone events that allow for the effective sale of their accumulated ownership positions, providing a nest egg for retirement.During their tenure of employment, the employee’s account is mostly concentrated in company stock, the valuation of which determines the amount they receive when nearing and eventually reaching retirement age. The stock accumulated during active employment is converted to cash and the plan shares are either redeemed or recycled to perpetuate the ESOP.There are certain tax-related and transaction design features in an ESOP transaction that can benefit sellers in numerous different ways. Sellers in ESOP installations must understand the necessary complexities and nuances of a well-run ESOP transaction. Sellers lacking the patience and gumption for an ESOP process or those who require turnkey liquidity in their ownership exit should likely consider an alternative liquidity strategy.External SaleIn general, the ability to sell your business to an external party yields the highest proceeds. If you have succeeded in creating a sustainable business model with favorable prospects for growth, your business assets may generate interest from both strategic and financial buyers.The Strategic BuyerA strategic buyer is usually a complementary or competitive industry player within your markets or looking to enter your markets.Strategic buyers can be generally characterized as either vertical or horizontal in nature. Such buyers are interested in the natural economies of scale that result from an expanded market area (cost and operational leverage in our terminology) and/or from specific synergies that create the opportunity for market and financial accretion (think 1 + 1 = 3).There is a good chance that a potential strategic buyer for your business is someone or some group you already know. Such buyers don’t require the full ground-up familiarization process because they are already in tune with the risk and growth profiles of the business model. Accordingly, owners interested in a turnkey, walk-away sale of their business are often compelled toward a strategic buyer since strategic buyers can quickly integrate the seller’s business into their own.The moving parts of transaction consideration paid by strategic buyers can cover a broad spectrum. We see simple, nearly 100% cash deals, as well as deals that include various forms of contingent consideration and employment/non-compete agreements.Most sellers in strategic deals are not inclined to work for their buyers other than in a purely consultative role that helps deliver the full tangible and intangible value the buyer is paying for. In many cases, strategic buyers want a clean and relatively abrupt break from prior ownership in order to hasten the integration processes and cultural shift that come with a change in control.Additionally and/or alternatively, strategic deals may include highly tailored earn-outs that are designed with hurdles based on industry-specific metrics. In general, earn-outs are often designed to close gaps in the bid/ask spread that occur in the negotiation process. These features allow sellers more consideration if post-transaction performance meets or beats the defined hurdles and vice versa. Sellers must be aware of the sophisticated means by which larger strategic buyers can creatively engineer the outcomes of contingent consideration.In certain industries strategic buyers may structure consideration as part cash and part or all stock. Sellers in the financial sector are often selling equity ownership as opposed to the asset sales that dominate most non-financial sectors. In such deals, sellers who take equity in the merged entity must be cognizant of their own valuation and that of the buyer. The science of the exchange rate and the post-closing true-ups that may apply are areas in which sellers should seek skilled professional advisory guidance.The Financial BuyerFinancial buyers are primarily interested in the returns achieved from their investment activities. These returns are achieved by the conventions of 1) traditional opportunistic investment and 2) by means of sophisticated front-end and back-end financial engineering with respect to the original financing and the subsequent re-financings that often occur.Most traditional buy-out financial investors are looking to satisfy the specific investment criteria of their underlying fund investors, who have signed on for a targeted duration of investment that, by nature, requires the financial investor to achieve a secondary exit of the business within three to seven years after the original acquisition (the house flipping analogy is a clear but oversimplified one). Financial investors may have significant expertise acquiring companies in certain industries or may act as generalists willing to acquire different types of businesses across different industries.In general, there are three types of financial buyers:Private Equity Groups or other Alternative Financial InvestorsPermanent Capital ProvidersSingle/Multi-Family Offices Despite their financial expertise, financial buyers usually do not have the capacity or knowledge to assume the management of the day-to-day operations of all of their business investments. As such, the seller’s management team at the time of a sale will likely remain involved with the Company for the foreseeable future. A sale to a financial investor can be a viable solution for ownership groups in which one owner wants to cash out and completely exit the business while other owners remain involved (rollover) with the business. With respect to work force and employee stability, financial investors will ultimately seek maximum efficiency, but they often begin the process by making sure they secure the services of both frontline and managerial employees. In many cases, the desired growth of such investors can bolster the employment security of good employees while screening out those that resist change and impede progress. The value of the assembled workforce is becoming a more meaningful asset to prospective buyers in the marketplace, whether they be strategic or financial in nature. Further, larger acquirers often can present employees with a more comprehensive benefit package and enhanced upward mobility in job responsibility and compensation. All this said, financial investors will ultimately seek to optimize their returns with relentless efficiency. Lastly, as the financial buyer universe has matured over the past 20+ years, we have witnessed directly that many strategic consolidators are platform businesses with private equity sponsorship, which blurs or even eliminates the notion of a strictly strategic or financial buyer in many industries.ConclusionAn outside buyer might approach you with an offer that you were not expecting, you and your partners might decide to put the business on the market and seek offers, or you and your partners might opt for an internal sale. Whatever the case may be, most owners only get to sell their business once, so you need to be sure you have experienced, trustworthy advisors in your corner.Mercer Capital provides transaction advisory services to a broad range of public and private companies and financial institutions. We have worked on hundreds of consummated and potential transactions since Mercer Capital was founded in 1982. We have significant experience advising shareholders, boards of directors, management, and other fiduciaries of middle-market public and private companies in a wide range of industries.Rather than pushing solely for the execution of any transaction, Mercer Capital positions itself as an advisor to inform sellers about their options and to encourage market-based decision making that aligns with the personal priorities of each client.Our independent advice withstands scrutiny from shareholders, bondholders, the SEC, IRS, and other interested parties to a transaction. Our dedicated and responsive team stands ready to help you manage the transaction process.

The conventions for defining value may never be more important than when making decisions related to business continuity and financial restructuring.  Countless clients have demonstrated a sense of confusion regarding the various descriptors of value used in valuation settings.  More than a few valuation stakeholders have mused that the value of anything (a business or an asset as the case may be) should be an absolute numerical expression and unambiguous in meaning.  Unfortunately for those seeking simplicity in a trying time, the conditional cliché “it depends” is critical when defining value for the assessment of bankruptcy decisions and workout financing.  The elements that underpin the Premise of Value provide a convenient base for introducing some of the vocabulary used in the bankruptcy and restructuring environment.  Gaining a thorough familiarity with the Premise of Value provides a cornerstone for understanding the financial considerations employed in valuing business assets and evaluating financial options. Defining value is a science of its own and can be subject to debate based on facts and circumstances.  With respect to business enterprises and assets, as well as business ownership interests, there are numerous defining elements of value.  These elements generally include the Standard of Value, the Level of Value, and the Premise of Value.  More confusing is that real property appraisers, machinery & equipment appraisers and corporate valuation advisors may not use the same value-defining nomenclature and may have varied meanings for similar vocabulary.  When the question of business value or asset value arises, the purpose of the valuation, the venue or jurisdiction in which value is being determined and numerous other facts and circumstances have a bearing on the defining elements of value. Everyone has seen the “inventory liquidation sale” sign or the “going out of business” sign in the shop window.  For the merchant and the merchant’s capital providers, the ramifications of how assets are monetized for the purposes of optimizing returns on and of capital is a key focus of the valuation methods employed in the restructuring and bankruptcy environment.  The international glossary of business valuation terms defines the Premise of Value and its components as follows: Premise of Value - an assumption regarding the most likely set of transactional circumstances that may be applicable to the subject valuation; for example, Going Concern, liquidationGoing Concern Value - the value of a business enterprise that is expected to continue to operate into the future. The intangible elements of Going Concern Value result from factors such as having a trained work force, an operational plant, and the necessary licenses, systems, and procedures in place.Liquidation Value - the net amount that would be realized if the business is terminated and the assets are sold piecemeal. Liquidation can be either “orderly” or “forced.” Orderly Liquidation Value - liquidation value at which the asset or assets are sold over a reasonable period of time to maximize proceeds received.Forced Liquidation Value - liquidation value, at which the asset or assets are sold as quickly as possible, such as at an auction The Premise of Value is a swing consideration for distressed businesses and their lenders.  For businesses in financial distress, achieving a return on capital shifts to the priority of asset protection and capital value preservation via a deliberate plan to mitigate downside exposures.  In most situations where a business is dealing with an existential financial threat, the preference for the business is to remain a Going Concern (at least initially), whereby the business continues to operate as a re-postured version of its former self.  In the context of bankruptcies and/or restructurings, the business that remains a Going Concern is referred to as the Debtor in Possession (DIP). DIPs remain a Going Concern using the protection of Chapter 11 bankruptcy to achieve a fresh start where their financial obligations are restructured through modification and/or specialized refinancing.  Chapter 11 involves a detailed plan of reorganization, which may be administered by a trustee and is ultimately governed under the specialized legal oversight of the courts.  Reorganization under Chapter 11 is the preferred first step for most operating enterprises whose business assets are purpose?specific and for which the break-up value of the assets would be economically punitive to capital investors.  Intuitive to the Going Concern premise are valuation methods and analyses that study potential business outcomes using detailed forecasts and the corresponding potential of the resulting cash flows to service the necessary financing to achieve the outcome.  One valuation discipline among numerous possibilities is the establishment and testing of a value threshold at which the capital returns are deemed adequate to their respective providers (e.g. an IRR analysis) based on the risks incurred.  If remaining a Going Concern delivers an acceptable rate of return under a plan of reorganization, then liquidation might be avoided or forestalled. The alternative to remaining a Going Concern involves the process of liquidation.  In bankruptcy terms, a business entity files for Chapter 7 and begins the cessation of business operations and seeks a sale of assets to re-pay creditors based the creditors’ respective position in the capital stack.  The “liquidation” premise is generally a value-compromising proposition for the bankruptcy stakeholders with the economic consequences are scaled to whether the liquidation is achieved in an orderly process or a forced process. Modern, global economies and increasingly technology inspired business models have resulted in a certain amount of disruption, the consequences of which often compromise the value of purpose-specific business assets in obsoleting or excess-capacity industries (e.g. coal in the face of growing energy alternatives and concerns for climate change).  Assets that have productive capacity are typically sold in an orderly market and may achieve a value commensurate with the capital asset expenditures expectations of industry market participants.  Real property assets and operating assets that can be successfully transitioned or re-purposed are often liquidated in an orderly fashion to maximize value.  Specialized assets and/or assets with inferior productive capacity or which are positioned in unfavorable circumstances likely lack the ability to attract buyers due to the deficiencies and/or inefficiencies of relevant markets.  Accordingly, the time value of money and the demands of the most senior creditors may suggest or dictate that a forced liquidation sooner is more favorable than a deferred outcome. Most restructuring and bankruptcies involve a total rationalization of operating assets and business resources.  For large integrated businesses, it often occurs that a combination of value premises applies to differing types of tangible and intangible assets based on the go-forward strategy of the business and the availability of markets in which to monetize assets.  For example, an initial liquidation may occur with respect to certain business operations and properties to create the resources necessary to achieve debt restructuring or DIP financing.  Accordingly, advisory engagements often take into consideration a wide range of options based on the timing of asset sales and the sustainability of continuing operations.  The Premise of Value is a quiet but critical defining element for assessing the collective value proposition associated with a plan of reorganization. Many bankruptcy advisory projects necessarily involve comparing the Going Concern value to Liquidation value.  Each premise involves an inherently speculative set of underlying models and assumptions about the performance of the business and/or the timing and exit value achieved for business assets.  And, each may be developed using a variety of scenarios with differing outcomes and event timing.  Setting aside the qualitative aspects of decision making, the Premise of Value with the best outcome is typically the path of pursuit based on the necessity for an objective criterion required under the legalities of the bankruptcy process and the priority claims of creditors. A fundamental understanding of the defining elements of value is critical to distressed businesses and their creditors.  Valuation advisors are required to clearly detail the defining elements of value employed in the determination of asset values and enterprise valuations.  The Premise of Value must be comprehended in the context of other defining elements of value.  If you have a question concerning the design and valuation of varying plans of reorganization or bankruptcy strategies, please contact Mercer Capital’s Transaction Advisory Group.

Selling a business is a three-step process.  Some sellers elect to stop at Phase I or II and don’t proceed to closing, while others decide to complete the transaction process.  In reality, each of the phases overlaps to some degree, making the process more of a continuum than a finite set of procedures.  A turnkey, orderly process will often require four to six months.  When extra time is required to prepare and/or when multiple rounds of market outreach are involved, we’ve managed deals that required six to eighteen months and more to reach a close or no-close decision.Ultimately, the collective team goal as seller and advisor is to win the race, whether it be at the pace of the hare or the tortoise.Phase I involves “taking inventory.”  Taking inventory means gathering and analyzing financial and operating data for the family business.  The milestone goal of this process for most clients is obtaining a valuation in order to establish decision-making baselines and to set transaction expectations.  The valuation undertaking helps the advisor learn about the business and relate the “story” of the business to the financial and operating data for the company and its industry.  Equally important, Phase I promotes forthright discussions about family and ownership objectives that in turn help the advisor identify the selling family’s priorities and preferred transaction structures.  Telling the company’s story in a clear and compelling way is important in creating effective marketing materials. If, on the basis of value expectations and market option assessments from Phase I, the family decides to move forward with testing the market, we then enter Phase II.Phase II involves staging and organizing the relevant financial and operating data into a confidential information memorandum (CIM).  The CIM is designed to tell the story of the business, expound on the merits of the business and its market position, and describe the seller’s preferred transaction structure.  The CIM should provide enough information for prospective buyers to form an expression of interest (i.e. the initial offer).  Of course, prior to receiving the CIM, prospective buyers must execute non-disclosure agreements, which are designed to protect the seller from having their confidential information revealed to unintended audiences. Parallel with the preparation of the CIM, the financial advisor will create a list of prospective buyers.  These prospective buyers often include a mix of competitive and/or friendly industry players, private equity investors, and family offices.  Phase II may also involve conducting meet-and-greet exchanges with prospective buyers in order to negotiate and secure expressions of interest in the form of indications of interest (IOIs) or letters of intent (LOIs).  After careful study of the offers, the financial advisor will help the selling shareholders select the preferred bid.  Signing an IOI/LOI generally marks the end of Phase II. Phase III By signing and IOI/LOI, the selling shareholder commits to dealing exclusively with that buyer.  One of the first steps in Phase III is satisfying the buyer’s due diligence requirements.  Parallel with this process, legal advisors to the buyer and the seller begin drafting the legal documents required to complete the transaction. It is important to understand that the negotiating process from Phase II carries forward until the deal is closed.  Deal terms often contain various structural features including non-compete agreements, earn-out arrangements, equity roll-over provisions, escrow and holdback terms, working capital thresholds, real estate considerations, and other important make-or-break considerations.  The terms of these side elements can represent a significant portion of total deal value and cannot be overlooked.  The wording of the documents is part of the negotiating and deal monitoring process.  The focus is making sure that the offer and all its terms are clearly captured in the actual transaction documents. Assuming everything passes muster, closing occurs.  But even then the transaction is not completely finished until the selling family receives all of the consideration promised in the deal.  A portion (often 5% to 20%) of the total purchase price is usually held in escrow for 12 to 24 months after closing against potential claims of the buyer for violation of seller representations and warranties.  The amount, duration, and conditions of escrow release are important elements of the legal documents governing the transaction.  The significance of these terms points to the importance of remaining vigilant and engaged in the process to maximize the outcome. We hope this quick tour of the selling process helps readers better understand the steps involved in selling the family business.  Family shareholders and family business directors owe it to themselves and to their stakeholders to be aware of the liquidity options that may available in the expanding market for private companies.

In Valuation and Transaction Advisory Considerations for Wholesale Beverage Distributors, Tim Lee offers important insights for principals of distributorships, their legal advisors, as well as wholesaler CFOs, board members, and lenders. This paper includes an in-depth discussion of industry rules of thumb, helps you understand basic valuation theory and how the realities of the industry reconcile to the fundamentals of financial valuation and M&A strategy. The paper also includes examples of differing transaction scenarios and tools for assessing how transaction values and deal financing translate to investment return.The author, Tim Lee, is an expert on valuation and transaction issues in the beverage industry. This comprehensive paper (45 pages) equips the reader with the knowledge to understand how valuation relates to big-picture decision making.

This article first appeared as a whitepaper in a series of reports titled Appraisal Review Practice Aid for ESOP Trustees. To view or download the original report as a PDF, click here. This publication provides general insight about emerging issues and topics discussed in recent forums and events sponsored by the ESOP Association (“EA”), The National Center for Employee Ownership (“NCEO”) and elsewhere. Much of the current discussion is related to general valuation discipline, but none are new to a longstanding agenda within the ESOP community. Heightened Department of Labor (“DOL”) attention and the recent settlement agreement concerning the Sierra Aluminum case are driving renewed discussion of numerous critical topics within the ESOP fiduciary domain. All guidance, perspective and other information contained in this publication is provided for information purposes only. The issues and treatments highlighted in this publication do not produce the same response from all ESOP professionals and valuation practitioners. Certain treatments and perspectives contained herein lack consensus in the valuation profession and may be addressed or treated using alternative rationales. This publication is not held out as being the position of or recommended treatment endorsed by the EA or the NCEO. The purpose of this publication is to alert and inform ESOP stakeholders and fiduciaries regarding the rising standards of practice and prudence in the valuation of ESOP owned entities.IntroductionIn recent years there has been increasing concern among ESOP sponsors and professional advisors (trustees, TPAs, business appraisers, legal counsel) regarding the scrutiny of the DOL, the Employee Benefits Security Administration (“EBSA”), and the Internal Revenue Service (“IRS”). These entities (and agencies thereof) are tasked with ensuring that ESOPs comply with the Employee Retirement Income Security Act (“ERISA”) as well as with various provisions of the federal income tax code concerning qualified retirement plans (including ESOPs). Citing concerns for poor quality and inconsistency in business appraisals, the DOL has sought in recent years to expand the meaning of “fiduciary” under ERISA to include business appraisers. In the most recent forums of exchange and deriving from various court actions, there are numerous areas of concern that DOL/EBSA appear to have regarding ESOP valuations. These areas of focus include but are not limited to:Valuation Issues Receiving Recent Attention and ScrutinyThe use of financial projections in ESOP valuationThe prevalence and manifestation of conflicts of interest concerning pre- and post-transaction advisory servicesThe use and application of control premiums in ESOP valuationThe valuation of and implications stemming from seller financing used in a great many transactions now coming under reviewThe poor quality of ESOP valuation reports and the attending inconsistencies between narrative explanations and methodological execution; and, The lack of or inconsistent consideration of ESOP repurchase obligation and how it interacts with ESOP valuationThese topics have received heightened attention from numerous committees of the ESOP Association including the Advisory Committees on Valuation, Administration, Fiduciary Issues, Finance, and Legislative & Regulatory. This paper will focus on the use of financial projections in ESOP valuations. While all of the cited issues are of importance, the use (or misuse) of financial projections is often the most direct cause of over- or under-valuation in ESOPs. Other Mercer Capital publications provide insight regarding control premiums, the market approach, and other important ESOP valuation topics.Projections Used In ESOP Valuations: Assessing Growth Rate Assumptions In ValuationBusiness appraisers who practice valuation using one or more credentials in the field are required to adhere to their respective practice standards (ASA, AICPA, NACVA, CFAI). Additionally, there are overarching standards and guidance that generally dictate to and govern the valuation profession and the general considerations and content of a business valuation. The Appraisal Standards Board of The Appraisal Foundation promulgates the Uniform Standards of Professional Appraisal Practice (“USPAP”) and the IRS issued Revenue Ruling 59-60 (“RR59-60”) more than 50 years ago.Collectively, these standards and protocols provide a basic outline for procedural disciplines, analytical methodologies, and reporting conventions. Specificity on the disciplines and procedures for vetting a financial projection (and growth rates in general) are generally lacking in the body of valuation standards, but that does not exempt appraisers and trustees from the core principle that a valuation must collectively (and in its constituent parts) constitute informed judgment, reasonableness and common sense.Traditional financial and economic comparative analysis suggest vetting a projection by way of studying it from numerous perspectives:How do the projections compare to the historical and prevailing financial performance of the subject enterprise being valued (“relative to itself over time”)?How do the forecasted results compare to the past and expected performance of peers, competitors, the industry, and the marketplace in general (“relative to others over time”)?How do the projections reflect the specific outlook and capacity of the subject enterprise (“relative to its specific opportunity”)?The answers to these questions provide the appraiser a foundation upon which to construct the other required modeling elements in the valuation. An appraiser may elect to disregard projections in the valuation process in situations where forecasted outcomes are deemed beyond the organic and/or funded capacities, competence, and/or opportunity of the subject enterprise. An appraiser may elect to consider justifiable risk and/or probability assessments, among other adjustments, that serve to hedge the projections and their respective influence on the conclusions of the valuation report. Regarding valuation and the general concern for rendering valuations that heighten an ESOP trustee’s anxiety for a sustainable ESOP benefit over time, many appraisers elect to capture only proven performance capacity, avoiding the counting of eggs with questionable fertility. If today’s projection proves excessive in the light of future days (when the DOL/EBSA comes calling), the concern for a prohibited transaction rises and poses significant risk and potentially fatal consequences for the plan and the parties involved.Discrete Projections versus Implied ProjectionsA complete, formal appraisal opinion requires the consideration of three core valuation approaches. These approaches are the Cost, Income, and Market Approaches. Generally speaking, valuations of business enterprises using the Income or Market Approaches contain either an explicit projection in the methodology or capture an underlying implicit projection embedded in (or implied by) a singular perpetual growth rate assumption or in a singular capitalization metric. Appraisers and reviewers that fail to recognize this are simply blind to the basic financial mechanics of income capitalization. Accordingly, the concern for projections, in the view of this practitioner, extends beyond the discrete modeling of cash flow to the broader domain of growth in general. For the sake of further discussion, assume the following comments relate specifically and only to the Income Approach and its underlying methods.Discounted Cash Flow Method versus Single-Period CapitalizationThe size and sophistication of the subject enterprise often dictates whether or not an appraiser will enjoy the benefit of management-prepared projections. Projections are often crafted for purposes of promoting operational and marketing outcomes, or for satisfying the reporting requirements that many companies have with their lenders, shareholders, suppliers and other stakeholders. In cases where the subject enterprise is small and its performance subject to unpredictable patterns, appraisers commonly employ a single period capitalization of cash flow or earnings. In lieu of a series of discrete cash flows projected over the typical five-year future time horizon, the appraiser simply employs a measure of current or average performance and applies a single-period capitalization rate (or capitalization multiple as the case may be) in order to convert a base measure of cash flow directly into an indication of value. Seeking not to speculate on a finite sequence of future growth rates, many appraisers employ a rule-of-thumb mentality by correlating cash flow growth to a macroeconomic, inflationary, or industry-motivated rate, often ranging from 3% to 5%. In many instances this could be appropriate; in others it could reflect surprisingly little attention regarding the most basic long-term market externalities and/or internal opportunities of the subject company.The veil of a single-period capitalization approach does not relieve the appraiser from examining the various combinations of growth that could reasonably apply to the base measure of cash flow assumed in an appraisal. Many appraisers are of the mind that in the absence of management-prepared projections, no discrete projection can be developed and thus no Discounted Cash Flow Method can be employed. In lieu of fleshing out the dynamics of operational cash flow, the required capital investments, working capital needs, or the cash flow benefits deriving therefrom, the appraiser simply defaults to the time-honored single period capitalization of cash flow and calls it a day. The binary position that an appraiser cannot prepare cash flow projections lacks credibility and in some cases is simply flawed thinking. Furthermore, any appraiser that applies a perpetual growth rate assumption to develop a capitalization rate is, in fact, asserting a projection over some projection horizon. This is the simple and inescapable mathematical construct that is the Gordon Growth Rate Model. With all due respect and concern about projections - appraisers, trustees and regulators must recognize the inherent projection represented by a perpetual growth rate assumption in a single-period capitalization method. In essence, there is no income approach without either an explicit or implicit projection of future cash flows.Performing Due Diligence On Company Issued ProjectionsImagine you are a trustee tasked with reviewing an ESOP valuation prepared by the plan’s “financial advisor.” Business appraisers in their role as the trustee’s financial advisor issue opinions of value they believe to be supported by the facts and circumstances, but ultimately the appraisal of the plan assets is the trustee’s responsibility. How can the stakeholders and fiduciaries of an ESOP gain understanding and comfort in projections prepared by the Company and employed by the appraiser?The foundation begins with the general process of examining historic and prospective growth. Company projections must make sense to gain inclusion in the valuation of an ESOPowned company. A disconnect or sudden shift (whether in magnitude, trend or directionality) in expected performance is a red flag that requires specific explanation. Absent a sound rationale for a significant change in the pattern of future performance, projections that seem too good (or too bad) to be true must be reconciled with management and potentially disregarded in the appraisal process.Not all projections are created equally. Some are prepared for budgetary purposes and are constrained to a single year of outlook. Projections may be prepared for many reasons including the study of operational capacity, financial feasibility concerning capital investments, debt servicing and lender requirements, sales force management, incentive compensation, and many other reasons. Projections may be the product of a bottom-up process (originating in the operational ranks of the business) or may originate as a top-down exercise (descending from the C suite).Business appraisers cannot be indiscriminate in their employment of forward-looking financial information. Understanding the goals, intentions, motivations, and possible shortcomings of a budget or projection is vital to assessing the viability of a direct or supporting role for the projections in the valuation modeling. The nature and maturity of the business are also significant to understanding and troubleshooting a projection. For the sake of further commentary we will assume that most ESOP companies are relatively mature and not subject to the intricacies and uncertainties of valuing a start-up business (albeit, even mature business can experience significant swings in business activity).Projection Due Diligence InquiriesWho prepared the projections?What is the functional use or purpose of the projection?How experienced is the Company in preparing projections?When were the projections prepared?Do the projections incorporate increased (new) business, and if so, in what manner is the new business being generated?Do the projections reflect the discontinuation of specific segments of the revenue stream?Are the financial projections reconciled to or generated from a meaningful expression of unit volume and pricing?Does the company operate as the exclusive or concentrated agent for certain suppliers and/or customers?How does the company’s current projection reconcile to past projections?How closely does the company’s most recent actual performance compare to the prior year’s projection?Does the projection depict a transition in industry or economic cycles that may justify near-term abrupt shifts in expected outcomes?How comprehensive are the projections and the supporting documentation?What are some typical warning signs that a projection may be too aggressive or pessimistic?Who prepared the projections?A bottom-up process whereby front-line managers project their respective business results, which are then combined to create a consolidated projection, is often the most informative projection. Motivation mindset can be important as many projections are designed to “under-promise” results. Conversely, some projections are deliberately overstated to impart a mission of growth or goal-oriented outcomes. Projections that emanate and evolve through multiple levels of an organization are typically subject to more checks and balances than projections that originate in the vacuum of a single executive’s office. Conversely, such a process can also depict an organizational mob mentality that could distort reasonable expectations.A CFO’s budget may vary significantly from the sales projection of a sales manager or the projections of a senior executive. In some cases, an appraiser may review projections prepared for a lender that vary from a strategic plan projection. Often the differences can be reconciled. Projections prepared for external stakeholders such as lenders and as communicated to shareholders and possibly endorsed by a board of directors are likely to be the most relevant and appropriate for the valuation.If numerous projections exist, the trustee and appraiser are best advised to inquire about the outlook that best reflects a consensus of the most likely outcome as opposed to aspirational projections that are tied to new and/or speculative changes in the business model. In a recent engagement, a client was deploying significant capital to extend core competencies into adjacent markets. Rather than the hockey stick of growth most typical of such projections, this client’s net cash flows were relatively neutral in the foreseeable future because they included significant capital and working capital investment, which effectively paid for increased business volume. The premise behind their strategy was simply one of being larger and more diverse under the assumption that size and diversity facilitated a less risky business proposition and a broader range of potential long-term outcomes for the business.What is the functional use or purpose of the projection?Functional use is often linked to who prepares the projection. Be wary of projections that may intentionally (or as a byproduct of purpose) under or over shoot actual expected forecast results. In many cases a bottom-up projection process receives the review of senior management before becoming a functional element of business planning and accountability.How experienced is the Company in preparing projections?Are past projections reconciled to actual results with adequate explanation for variances? Firms with consistent and organized processes often produce more informative projections. Granted, a company may consistently under or over perform their projection. The quality of a projection may be better measured by its consistency over time than by its ultimate accuracy in a given year. One clue to the experience and care taken in the projection process is the model underlying the projection itself. For example, was the forecast model developed using numerous discrete modeling assumptions (such as year-to-year growth, and year-to-year margin) or from more global assumptions that are carried across all years in the projections? While modeling complexity can serve to obscure and is not automatically a sign of a well-developed projection, the inability of a projection model to be adapted quickly to alternative scenarios and assumptions may be a sign that the model was not studied for its sensitivity and reasonableness. A projection that appears to be “living” and easily modified could be a sign that the company actually uses the projection and modifies it in real time to assess variance and to modify assumptions as business conditions evolve and change. Appraisers and trustees should empower themselves with the ability to study the sensitivity and outcomes of a projection. Projections that lack detailed growth and margin details (year-to-year and CAG) should be replicated and/or reverse engineered in some fashion to facilitate basic stress testing and/or sensitivity analysis before the appraiser simply accepts the projections.When were the projections prepared?In general, valuation standards call for the consideration of all known or reasonably knowable information (financial, operational, strategically or otherwise) as of the effective date of the appraisal, which for most ESOPs is the end of the plan year. As a matter of practicality, financial statements (audits and tax returns) are not prepared for many months subsequent to the plan year end. Likewise, projections are often compiled in the first few months of the following year and may be influenced by the momentum of activity after the valuation date.Appraisers typically cite financial information delivered after the valuation date to be known or knowable and projections, while potentially exposed to a hint of subsequent influence, are often integrated without much question regarding their timeliness to the valuation date. In many cases, clients struggle to get information to us in order for their 5500s to be filed in a timely fashion (typically July 31st). In most cases we find that projections prepared after the end of the plan year are perfectly fine to employ. We inquire with management if there are aspects of the projection that were influenced by subsequent events and if so, with what degree of certainty could the subsequent event or activity have been expected at the valuation date. In some situations it may be advisable or reasonable to alter a projection’s initial year due to subsequent influences; typically the more distant years of a projection follow a pattern of knowable expectation unless there has been a material subsequent event that alters the global posture of the business. If a material subsequent event occurs that is not factored into the projections, then as a matter of common sense, the appraiser may elect not to perform a DCF, or better yet, may request that the projections be modified to take the event into financial consideration so that a DCF can be more accurately informed regarding changes in business posture.Do the projections incorporate increased (new) business, and if so, in what manner is the new business being generated?If a projection reflects a pattern of significant change in business activity, it is vital to consider whether new business represents an extension or replication of past expansions. If the company has proven the ability to expand and absorb new business (territory, staffing, productive capacity, etc.) then a projection depicting such an increase is likely reasonable, but should be gauged by past similar experiences whenever possible. And, any business expansion must be reflected in the investment and working capital charges applied to develop net cash flows. We refer to this as “buying the growth” – remember there is no free lunch.Projections with significant topline and profit growth must reflect adequate investment. This investment may take the form of the organic investment in the existing business lines or strategically by way of acquisition. If the projections include a speculative expansion into new revenue areas, the appraiser should properly assess the likelihood of successfully achieving the projection. Business extensions into logical adjacencies which leverage pre-existing supply and customer relationships may be more believable than the widget company whose projections include entry into the healthcare industry.In cases where projections include speculative ventures, the appraiser has numerous potential treatments that can temper speculative (high-risk) contributions, essentially replicating the framework applied in the valuation and capital raising processes for start-ups or early-stage companies. In some cases the appraiser may request the projection be revised to eliminate contributions from new growth projects that lack adequate investment or are simply too speculative to consider until they become observable in the reported financial results of the business. In some rare cases, not only is the projection hard to believe, but concerns are compounded by the risky and foolish deployment of capital. Betting the farm on the next reinvention of the wheel is not the making of a sustainable ESOP company.Perhaps it’s a dirty little secret in the hard-to-value world of closely held equity, but valuations using the standard of fair market value (as called for under DOL guidance) are inherently lagging in nature and typically less volatile than is the stock market or the public peers to which a company may be benchmarked. This is generally a function of regression to the mean captured in virtually every conservatively constructed projection and DCF model. The terminal value of a DCF is effectively a deferred single period capitalization using the Gordon Growth Model and often comprises 50% or more of the total value indicated under the method. Near-term performance swings (whether favorable or not) get smoothed out in the math of the terminal value calculation. As depicted in the appended growth scenarios and projection modifications, the regression of future performance to a targeted benchmark can have a similar influence on valuation as the old-guard habit of using historical averages in a single period capitalization method. The primary valuation differences between such a DCF and single period capitalization stem from the specific cash flows during the discrete projection period (years one through five).Do the projections reflect the discontinuation of specific segments of the revenue stream?A sound reason for employing a DCF model is to capture the pro forma performance of a business based on its going-forward revenue base. Most mid to large sized businesses, particularly mature ESOP companies, experience contraction and rationalization of business lines and markets over time. In many cases, the valuation might reasonably improve based on the discontinuation of unprofitable operations and the recapturing of poorly deployed capital. However, care must be taken to understand how all P&L accounts from revenue down to profit are affected by changes in facilities, products, services, staffing, etc. Projections that pretend unsupportable improvement by way of the deletion of a relatively small portion of the business lines are inclined to excessive optimism and may suggest the belief in bigger issues that management deems too daunting to fix. Regarding profitability, so-called “addition through subtraction” is similar to the concern public market investors have with public companies that cut expense merely to manufacture earnings in the near term.As the maxim goes, you can’t cut your way to success in the business world.Are the financial projections reconciled to or generated from a meaningful expression of unit volume and pricing?Financial projections that lack an operational perspective can be difficult to assess. Not all business are margin based, many are spread based – meaning that profits are more of a function of a nominal spread over cost as opposed to some percentage of sales. This is particularly true of service businesses, financial services entities, and commodity driven operations. Accordingly, neither past nor future performance can be properly understood without some idea of how much stuff is getting sold and at what price. In many cases, the required comfort level of a projection simply cannot be reached without it. Breaking revenue into primary volume and price components, as well as further into its departmental or categorical groupings, allows appraisers and trustees a better understanding of the projection and its relation to past performance and market expectations. Revenue per full-time equivalent employee, units produced per labor hour and many other performance metrics are helpful in teasing out reality from a potentially fictional projection.Does the company operate as the exclusive or concentrated agent for certain suppliers and/or customers?Our comments here exclude the consideration of risk associated with high levels of concentration on the rain-making parts of a business – such considerations are often tackled in the appraiser’s assessment of the cost of capital by way of firm-specific risk.Many dealerships, distributors, parts manufacturers, fabricators and service companies owe their existence to market demand created by their suppliers and customers. Many companies service the needs of customers and suppliers by effectively outsourcing some aspect of their respective industry model to an external provider. For example, a producer of value-added materials may use an external company to provide sales and logistical support to get product to its end users (i.e. classic bulk breaking, repacking and transportation). Regardless of which leg of the multi-leg industry the subject business may represent, the assessment of projected growth should include a consideration of what is happening to suppliers and customers (the other legs of a common stool). This same path of inquiry serves the dual purpose of understanding the risk side of the valuation equation. If these multiple legs of consideration don’t reconcile, the projection could prove too unstable for use in the valuation.How does the company’s current projection reconcile to past projections? How closely does the company’s most recent actual performance compare to the prior year’s projection?Studying projection variance can be a highly useful tool in communicating about value and in assessing the correlation between expectations and actual results. Let’s face it - we all like it when people do what they say they are going to do. But the first thing we know about any projection today is that it will be wrong tomorrow. Variances need to be explained and reconciled against the continuing willingness of the appraiser (and the trustee) to employ projections moving forward. Providing financial feedback to management and the trustee during the process of due diligence and in the form of a valuation can help refine the projection process over time. Just as we reserve the right to improve how we do things in the valuation world, so too must our clients have the leeway to refine and improve their processes.Valuation is a forward looking (ex-ante) discipline. History can be highly instructive regarding how projections are scrutinized in real time. Projections that under-promise and over-deliver tend to undervalue companies in real time. Conversely, projections that over-promise and under-deliver can lead to an over-statement of value. In the case of the later occurrence, most appraisers operate under the axiom of “fool me once shame on you, fool me twice shame on me.” Ultimately, attempts at value engineering via optimistic projections need to be balanced with an equal measure of devil’s advocacy from both appraiser and trustee. Ultimately, a DCF model views the impact of any projection through a risk-adjusted lens. The process of hedging a projection generally begins with an observation of historical variances in projected performance and actual results over time, with the primary emphasis place on most recent periods. Projections that appear to overshoot are often hedged either through risk assessment, probability factoring, or a more exotic multi-outcome analysis.Does the projection depict a transition in industry or economic cycles that may justify near-term abrupt shifts in expected outcomes?In recent decades the concept of the traditional five-year business cycle lost favor in some circles. Thought evolution evolved to encompass a lengthier cycle of ten years, mitigated volatility (not so high and not so low as in the past), higher fundamental causation (such as globalization) versus the classical cyclical drivers (such as swings in productivity), continuing evolution of the information sector, disruptive technologies, and since the early 2000s, the persistence of and sensitivity to geopolitical and terrorist events. Then along came the debt crisis followed by the great recession. Lessons of business cycles past have now garnered renewed attention and distant economic history seemed more relevant despite the modernization, globalization and regulation of the economy.Presently, we are witness to a reasonably stable economy that is slowly being weaned from years of fiscal and monetary life support and subsidization. For us business appraisers, we are beginning to lock in on the new norms of our clients’ businesses. For the last many years, our clients were reticent to speculate on a projection (“no visibility”). Many clients recall with anger and humility the great glory projected from atop the last peak cycle in 2006. Almost a decade later, many have finally re-achieved their former glory. Many others can only look up from the corporate grave. From this point forward we can only assume that some version of the business cycle is still with us. Many are now disposed to the concept of a prolonged period of relatively modest and unevenly distributed economic performance, similar to the patterns demonstrated by Japan and characterized as “secular stagnation.” The academicians can argue about how to brand it; valuations professionals and ESOP Trustees are faced with how to consider it in our valuations.Speaking from personal experience, there is a greater appreciation for industry cycles as opposed to macroeconomic cycles. Given such, we see companies vacillate between boom and bust based on numerous underlying elements and drivers that are not purely correlated to the overall economy. Recall the classic business cycle (peak / contraction / trough / expansion / peak). Appraisers and trustees must be attentive and weary of projections that cannot be supported by reasonable facts and circumstances. Some may wonder - when are projections unrealistic? The truthful answer often includes the echo: “not sure, but I know it when I see it.”Companies emerging from the trough of a business/industry cycle may have unusually robust projections. High growth during a period of recovery does not constitute grounds for the dismissal of the projection. Likewise, declining growth from a peak level of performance is not necessarily overly pessimistic. As discussed in the growth scenarios studied in the appended examples, regression to a mean level of future expectation can be achieved in varying ways. The concern for appraisers and trustees alike is the comfort and common sense of near-term expectations relative to recent performance and the level of steady-state performance assumed in the terminal value modeling of the DCF. Ex-post and ex-ante trend analysis, as well as benchmarking to relevant indices from both public and private sectors is vital to establishing the context of a specific projection.On the weight of evidence and common sense, if a projection is highly contrary to external expectations and lacks symmetry with the proven capabilities of the company, appraisers and trustees are cautioned from directly using the projection. An alternative approach for employing the projection is iterating the discount rate and terminal value modeling assumptions required to equate the DCF value indication to value indications developed from other methods (past and present). There are many instances when data lacks reliability during a given period or cycle. In such cases we tend to study the information and reconcile it to the alternative valuation results deemed more reliable. In this fashion we alert the report reviewer that projections exist that may appear contrary to the weight of history and/or external expectations.How Comprehensive are the Projections and the Supporting Documentation?Are the projections lacking detail and limited in supporting documentation? Projections that are not integrated into a full set of forward looking financial statements and that lack explanation for critical inputs may be unreliable or require significant augmentation before being integrated into a DCF valuation model. As a matter of practicality, many companies do not project more than a simple income statement. Does the lack of a balance sheet and a cash flow statement automatically exclude the projection from consideration? Not in my view, however, under many circumstances there could be a need for augmentation to consider numerous significant aspects required to develop the typical DCF model. These considerations include:Capital expenditures, which initially decrease cash flow before generating the returns that constitute future growth. Not only is the dollar amount a significant consideration, but the capacity/volume effect of physical additions relates to future growth modeling.Incremental working capital requirements, which typically absorb a portion of growth dollars in perpetuation of higher operating activity, or which may accumulate on the balance sheet in a downturn when demand for financial resources can temporarily decline.In cases where a DCF is used to directly value the equity of an enterprise, changes in net debt must be captured. Are the cash flows sufficient to cover the company’s term debt and line of credit obligations? Are new sources of debt capital required to support capital and working capital grow?Collectively, these cash flow attributes can have a significant effect on the discrete cash flows of an entity during the projection. Absent a balance sheet and/or cash flow statement, the impact of these considerations may be difficult to properly assess. In cases where the business is not deploying significant new capital and the projection is following a more or less mature pattern, capital expenditures and incremental working capital may be easily determined based on historical norms and comparative analysis with peer data. Accordingly, a full detailed projection of the balance sheet may not be required to develop reasonable modeling and outcomes. As always, a vetted and complete projection of the financial statements is desirable. Supporting documentation can take numerous forms. Reconciliation of modeling assumptions to external drivers, operating activities, market pricing, throughput capacity, supplier expectations and trends, bellwether industry peers and market participants, downstream and upstream expectations and many other supporting considerations is always helpful but generally lacking for many projections. Often, a review of the projections using such benchmarks leads to a modification or adjustment of the projections by management. In this fashion, the appraiser’s and/or trustee’s review serves to effectively adjust the projections before and/ or during their use in a DCF model – thus the need for a flexible and adaptive modeling platform built from the projection.What are some typical warning signs that a projection may be too aggressive or pessimistic?A baseline for assessing reasonableness or believability is always a good first step. A graphic representation of revenue, EBITDA and key volume measures can assist a reviewer in studying the reasonableness of a projection. Supernormal and/or counter-trend activity requires a compelling justification. Let’s use the information in the following graphic as a baseline for demonstrating some fundamental curiosity and addressing some basic questions regarding reasonableness. The five-year trend for adjusted EBITDA at the valuation date reflects a pattern of strong growth (illustrated by the dotted blue line in Figure 1), but at a decelerating rate (illustrated by the columns in Figure 1). The projected annual growth rate for each of the next five years is 10%. In this case, management represents that the 10% annual growth projection is based on the compound annual growth rate for the five years leading up to the valuation date. This is an all too familiar “technical” rationale for growth forecasting. However, it begs the question of why the decelerating trend would suddenly flip favorable as opposed to continuing its decline or perhaps stabilizing at the most recent level of modest growth. Of course, the current trend could mature as a contraction in performance before an upturn that repeats the prior cycle. Figure 1 depicts a wide variety of plausible alternative projections based on a technical review of the trend and a healthy dose of analyst scrutiny of management’s optimistic projection. The projection provided by management could easily be an order of magnitude overstated relative to other plausible outcomes. If EBITDA growth remains at the most recent rate (5% annually) then management’s projection is overstated 25% by year five (the orange dotted line). If EBITDA flatlines at current levels management’s year five projection is overstated by 60% (the black dotted line). If the deceleration of growth actually turns to a steady contraction (5% annually) then management’s projection is almost 100% overstated. If a modest near-term contraction is followed by a renewal of the previous growth cycle (the green dotted line), then management’s base 10% annual growth projection is overstated by 35% in year five. We could iterate infinite variations in future outcomes, but I submit that the variations shown above stem from a reasonable risk averse, conservative framework. The real concern is how well the projection reconciles to external and internal drivers that have proven to influence past business outcomes and/or drivers that are virtually assured to influence future outcomes. In the present case example, the platform of management’s projection is built on the prevailing economy (generally favorable but inconsistent growth) and involves a market-beta industry (highly correlated to the overall economy). More specifically, the subject company is a construction contracting concern whose early growth began from a deep trough in the cycle, then was temporarily juiced with shovel-ready government funded activity which eventually dried up as the general economy stabilized. New norms are uncertain but project budgets and financings are expected to be more difficult as real interest rates become more than zero and underwriting hurdles remain quite high. In this light, a simple extension of the five-year CAG into the future for five more years appears to ignore the decelerating trend. Absent specific contracts and backlog, industry-based drivers, and perhaps geographic hotbeds of significant in-migration, management’s projection outcome appears over optimistic if not outright aggressive. Projections that appear contrary to external trends and opportunities and which are not reconciled to the company’s capacity (whether existing or planned with the associated capital required) may need to be disregarded in the valuation process. Alternatively, the appraiser and trustee could view the projections with heighten concern for their realization and elect to effectively hedge the projections using appropriate discount rates, probability assessments, or other treatments that mimic the behavior of hypothetical investors. Ultimately, the reliance or weight placed on a projection based valuation method demonstrates the comfort of the appraiser/trustee with the method. If the final weights or reliance are placed on alternative valuation methods with materially different value indications than the DCF, the appraiser/trustee is effectively disregarding or modifying the projection. Surely, every valuation conclusion, under any valuation approach or method, has an underlying implied projection through which the same value outcome is produced.Rules Of Thumb For Growth RatesRecent Macro-Economic HistoryAssuming a company’s growth and/or projected financial performance is highly correlated to general macroeconomic growth is often an underpinning of long-term sustainable growth rates. Care must be taken when observing data reported from government agencies as such data can be “real” or “nominal” in quantification. Real rates are generally representative of movements net of the influence of inflation and nominal growth is generally total growth including inflation. Accordingly, growth rates in valuations that mirror inflation are effectively zero real growth rates. Gross domestic product is almost always reported and discussed in real terms, meaning the addition of a long-term inflation rate is typically called for in cases where the appraiser/trustee considers a company’s performance to be similar to that of the overall economy. For perspective, Figure 2 presents the history of economic cycles and the more recent performance of real GDP over the last several years (Figure 3). On the basis of inflation of approximately 2.5% in recent years, nominal overall economic growth has approximated 4.5% to 5% subsequent to the great recession. Ah, the rule of 5% +/- for growth. There is a wide variety of alternative economic measures and subsets of GDP that could serve as a proxy for long-term sustainable growth in most valuations. Of course, such growth rates may fail to capture all the underpinnings of a given industry or market and may also fail to recognize the specific financial and operational details of a given company. Most companies tend to grow in phases as capital investment, hiring, product offerings and other business attributes evolve over time. This discussion could extend to an infinite spectrum of data and benchmarks.Equity Market PerspectiveAppraisers employ various tools and data resources to determine the appropriate cost of capital for use in a valuation. Employing a bit of analytical deduction using the disciplines of the Capital Asset Pricing Model and the Gordon Growth Model, one can observe some tendencies regarding the markets’ implied earnings growth expectations. One of the most frequently employed resources is the annual Morningstar/Ibbotson SBBI publication. Given this data, and an assumed range of price-to-earnings ratios, one can deduce the implied perpetual earnings growth rates embedded in the market’s pricing over time. This framework can be applied to a specific company, a group of companies, or an industry. The example in Figures 4 and 5 demonstrates market-based influences regarding analyst predispositions about earnings growth over time. As with other tools and sensitivity analyses in this publication, changes to the inputs can result in significantly different outputs. Relative to the growth dynamics of the different sized public companies depicted in the preceding table, it’s no wonder that the closely held, mostly mature, mid-market companies typically seen in the ESOP world (with enterprise values ranging from $10-$500 million) are imbued with net cash flow growth rates on the order 3% to 5% in the appraisal process (the “comfort zone” ). However, the timing of growth during the projection can be significant to a DCF value indication and can also influence growth rates in single-period capitalizations to measures outside of the comfort zone.Framework for Studying Projections and Growth Rate AssumptionsBy convention, virtually all business valuations include a presentation composed of five years of historical financial performance. Depending on the nature of the underlying financial reporting of the sponsor company, the presentation will include balance sheets, income statements and cash flow statements. The notes to the reported financials may also contain a myriad of underlying detail and disclosures supporting the chart of accounts displayed on the core financial exhibits. Commonly, these financial exhibits are augmented with derivative analysis to study the common size (percentage of assets) balance sheets, common size income statements (historical margins expressed as a percentage of revenue), financial ratios, peer/ industry data sets, and year-to-year and compound annual growth rate measurements.The foundation for studying the reasonableness (or believability) of a forecast derives from a firm grasp of the relevant history of the subject enterprise. The reported financial statements are often recast to reflect the proper historical base from which most projections are cast. Ultimately, the valuation methodology captures the adjusted, pro forma financial performance and position of the company that serve as the appropriate base from which forecast results are projected to emerge.Financial history is not the only context for vetting projections. To the extent possible, the financial exhibits should be annotated and/or augmented with operational data (and graphics) that allow the appraiser to demonstrate and consider how the company’s activities relate to its financial performance. In addition to common size financial data, revenue and profit segmentation can be critical to understanding what aspects of a business are performing well and what parts are hindering results. In addition to perspectives on revenue mix, the report should also reflect a functional unit volume analysis that promotes an understanding of how pricing and activity volumes drive revenue and profitability. In turn, these observations help inform the appraiser about the physical capacities, break even levels, labor resources, and other aspects of the business model and operational flows that should dove-tail with the projections.For example, if a projection implies that a business will exhaust its current operating capacities or markets, then an adequate and properly timed charge to cash flow for capital expenditures should be included in the forecast to promote continued growth. Otherwise, little or no growth (beyond the price component of revenue) should be reflected in the model. Additionally, the duration of the discrete forecast should span the number of periods required for the company’s operating and financial performance to reach a reasonable normative state from which a steady level of continuing performance can be expected. Thus, a five-year projection may require augmentation of a few periods to regress a high-growth model to a mature state, or a negative growth model to a new state of sustainable performance. Ultimately, the timing of when growth occurs can be an important value determinant in a DCF model as well as a vital consideration to developing a perpetual growth rate for cash flow.When assessing a perpetual growth rate assumption, which is required in a single-period capitalization of earnings or net cash flow, one key to estimating a reasonably correct growth rate is an understanding of the internal and external factors that drive the assumption. While some appraisers are of the mind that projections cannot or should not be developed by an appraiser; surprisingly there is no debate as to the requirement of postulating a perpetual growth rate. These seemingly different disciplines are in fact one in the same. Arguably, an appraiser seeking to quantify or justify a perpetual growth rate must employ elements of the DCF mentality to define what that growth rate should be. Of course, the base amount of the cash flow is a vital starting point. For those appraisers who gravitate to the 3%-5% perpetual growth rate range, the use of a multi-period cycle-weighted historical average of cash flow can create a significant error in the valuation.Let’s construct a simple example to demonstrate the valuation issues that could result from two different historical conditions that have the same average of performance. As crazy as it may be in practice, it is not uncommon for appraisers using multi-period averages to effectively ignore prevailing conditions and use a nominal long-term average growth rate that is correlated to GDP or some other prominent macroeconomic or industry performance measure. This mentality renders real time trends and real time expected directionality in performance as irrelevant. The following example is engineered to demonstrate how far astray the mentality for averaging and the failure to model growth can lead the valuation.Example ConditionsThe average after-tax net cash flow is $10,000,000Depreciation and capital expenditures are substantially offsettingIncremental working capital needs are minimalThe cost of equity is 15%The “assumed” perpetual annual growth rate in net cash flow is 5% As can be seen in Figure 6, relative to the common valuation of $105,000, Scenario 1 represents undervaluation by approximately 30% (10 x $15,000 = $150,000) relative to recent annual performance, while Scenario 2 reflects an overvaluation by over 100% (10 x $5,000 = $50,000). More disturbing than two quite different trends giving rise to a common valuation of $105,000 is the spread of the value range from $50,000 to $150,000 derived from the “Current CF” measures of each scenario. Which valuation is more reasonable? Are there alternatives to modeling growth that represent more plausible projections or growth rates? As can be seen in Figure 8, a valuation of $105,000 is derived from the two distinctly different historical scenarios. How might alternative projections be modeled that provide an enhanced perspective from which to study a reasonable perpetual growth rate for each scenario? Frankly, most seasoned valuation professionals would admonish the appraiser in each of the example scenarios for failing to study a projection that “engineers” the prevailing cash flows from their current respective conditions to an assumed cycle-neutral point five years hence. Simultaneously, how could a discrete projection be modeled that develops the value associated with a series of future cash flows that reconciles to a reasonable steady-state measure of cash flows and forward growth? Taking Scenario 1 first, the five-year average cash flow ($10,000) results in a measure of cash flow well below the current performance ($15,000). What might a superior path of analysis be to capture the concern that current performance is unsustainable in the near-term? Substituting the implied growth rate of cash flow resulting from the assumed perpetual growth rate of 5% and a base average of $10,000, one might postulate a more believable pattern of performance and valuation as in Figure 9. Note that the year five CF is determined as the same amount ($12,763) ultimately reached in both implied forward cash flow scenarios using the 5% perpetual growth from the base average cash flow of $10,000. An alternative modification to the original implied projection would be to regress the current cash flow performance ($15,000) to the forward year five adjusted base ($10,000 x 1.055 = $12,763). The valuation resulting from the modified projection is 7.4% higher due to a less abrupt decline than the default first year drop from $15,000 to $10,500. While this is not a radical percentage difference in the valuation, the alternative smoothed projection is a more intuitively appealing and believable model. Such a construct allows for analysis to support the development of a growth rate applicable to the cyclical high Current CF of $15,000. Using the following proof we can devise a perpetual growth rate that will reconcile the Current CF to a similar adjusted valuation of approximately $113,000. Based on Figure 9, a growth rate of approximately 2% could have been reasonably applied to the Current CF ($15,000), lending enhanced credibility to a single-period capitalization than using 5% against the multi-year average performance of $10,000. The original, default approach used by many appraisers represents a 50% immediate first year disconnect from prevailing performance that lacks a reasonable basis. This is not to say that some circumstances don’t call for an abrupt shift in assumed cash flow versus prevailing cash flow, but that is typically a fundamental issue such as the loss or gain of a significant product, territory or customer. Too often this type of flaw is the result of the default five-finger rule to averaging five years of cash flows and using a 5% growth rate. Repeating the previous exercise for Scenario 2 results in Figure 10. Based on the example in Figure 10, a growth rate of approximately 8.7% could have been reasonably applied to the Current CF ($5,000), lending enhanced credibility to a single-period capitalization than using 5% against the multi-year average performance of $10,000. Again, this is not to say that some circumstances don’t call for an abrupt shift in assumed cash flow versus prevailing cash flow, but such a scenario is typically a fundamental issue such as the loss or gain of a significant product, territory or customer. Now that both of the implied projections have been modified to reflect more gradual regression to a mean level of assumed stable performance and sustainable future growth, the valuations reveal differentials from approximately 7.2% higher to 8.9% lower relative to the $105,000 derived from the default valuation mentality often employed. More significantly, the respective valuations are better suited to the prevailing cash flows and the expected directionality of performance. Each model now reflects a more thoughtful consideration of the time value of money. Figure 11 shows how the respective projections for each scenario converge on an estimated cyclically neutral level of future performance. The respective valuations, either in the form of a DCF or in the form of a single-period capitalization, are refined to capture the time value of money corresponding to a more believable performance regression/progression forecast. It should seem logical that the refined projection showing a gradual decline (Scenario 1) that starts with an above historical average level of performance, results in a higher value than the original $105,000. Likewise, the increasing projection (Scenario 2) that starts with below historical average performance results in a lower valuation than the original treatment. The chart in Figure 11 implies that performance has a gravitational attraction to the five-year outcome as a notional level of future performance ($12,763). An alternative and perhaps more realistic projection would craft a regression of the growth rate rather than a regression of performance to a notional future amount. Decelerating growth from either its peak performance (Scenario 1) or applying rapid growth during a mode of recovery (Scenario 2) seems more logical in most real world situations than the default trend. These competing projections are depicted in Figure 12. The valuations resulting from the smoothed growth patterns are developed in Figures 13 and 14 respectively. Of course, the pattern of future deceleration or acceleration requires specific study and support. The assumed patterns are presented for example purposes. A study of these alternative modeling inputs suggests that the original valuation of $105,000 is potentially flawed. Let’s summarize the various valuation outcomes from the two different scenarios. Remember, common averaging techniques coupled with seemingly benign growth assumptions result initially in the same valuation under both scenarios. However, scrutiny of the growth and/or projection modeling reveals some dramatic differences. Admittedly, in most valuations there would be underlying facts and circumstances supporting one of three modeling conditions applied to each scenario. One can easily see how valuations can be viewed quiet differently by differing parties under differing circumstances. The primary valuation differential for each stems from the implied projection and growth modeling. The common appraiser mentality of using historical average performance (rule of thumb mindset) combined with the typical “normal/benign” assumptions concerning growth and the cost of capital, can serve to understate or overstate value. Growth analysis and reasonable forecasting (birds of the same feather) allow for a more believable and optically pleasing analyses and conclusions. Comparing alternative projections from otherwise implied projections can provide better insight into growth modeling and promote more rational forecasting.Appendix A | Case Analysis: Understanding Growth RatesOne of the most debated and poorly supported assumptions in business valuation is that of the growth rate in performance, be it earnings, net cash flow, or debt-free cash flow. The default reliance on macroeconomic or industry based data is a good beginning but often falls short of the full growth profile for a specific business in a specific industry in a specific geography at a specific point in time. The real world is often lumpy and most companies experience shifts in top-line activity, cost efficiencies, and operating leverage throughout the business cycle or in conjunction with changes in the business model. Skill and experience are powerful influencers for what feels “right,” but too often the five finger-growth mentality rules the day. What tools can an appraiser use to develop and defend growth rate assumptions and how can such a tool be used as a critical review tool?Let’s study an example featuring a combination of typical facts and circumstances.Example Conditions:The economy is stable, with nominal GDP on the order of 4% and real GDP on the order of 2%The subject Company is stable, and operating with consistent resultsThe Company is twenty years old and has experienced 10% growth in annual sales over the last five yearsThe subject Company has moderate pricing power and operates in an industry with commodity players as well as value-added players (implying a range of profit margins and revenue sizes)Historical pricing for the Company’s goods and services follows a more or less inflationary pattern (say 2.0%), and the markets resist price increases such that Company profits can be squeezed without constant attention to expensesThe goal for the Company is to expand its market from the current 25 states to all 50 states in the next five years (all states represent equal market opportunity)With margins constant, sales growth represents a reasonable proxy for growth in earnings and net cash flow (EBITDA margin +/-10%)Public companies, larger and already national in market exposure, are expecting 5% annual sales volume growth over the next five years (consistent with industry expectations) and 10% annual earnings growth (implying margin expansion)Capital structure is expected to remain unchanged for the foreseeable future (debt free) » The Company has no excessive or abnormal risk exposures or concentrationsThe Company’s goods and services do not represent new or disruptive/paradigm technologyIt is not uncommon for an appraiser to uncover the above information in the course of due diligence. Yet, the same management team that can relate such feedback to the appraiser will not “speculate” on a projection. A competent appraiser should be able to cobble together the framework of a projection for purposes of quantifying a growth rate for a single-period capitalization as well as performing a summary DCF analysis (perhaps as a test of reason or as additional direct valuation evidence). Figure 16 depicts how the facts and circumstances are expected to play out in sales and EBITDA. Most often the typical approach would be to grab a recent average level of performance and use a growth rate likened to nominal GDP (4%), perhaps influenced up a bit to reflect the recent growth performance. However, the 6.3% perpetual growth rate developed does not tie directly to the underlying data and general information. For an appraiser to get the single-period perpetual growth rate correct, he/she would simply have to get that “just right” feeling. Clearly, a bit of extra effort and the constructive extension of logic would allow for an anecdotal or direct DCF-type study that could offer support for the generally favorable growth rate required in the analysis. Figures 16-18 serve notice that macroeconomic growth rates, sprinkled with a little current and near term company performance are often misleading and can fail to capture the influence of timing on the value of future cash flows.Reconciling Multi-Stage Growth Rates to a Single, Perpetual Growth RateReport reviewers are frequently confined to terse, misguided, or unjustified positions concerning growth rates. Typically, report users are bludgeoned with anecdotal growth evidence or with historical observations that fail to translate directly into reasonable future expectations. The time value of money is frequently obscured by a failure to reconcile multi-stage growth expectations into a meaningful single-period growth rate. Figure 19 displays a matrix of single, perpetual growth rates derived from the blended short term and long term growth rate expectations based on a 15% equity discount rate. Given a beginning measure of net cash flow or earnings, the table provides the single-period growth rate necessary to derive the same value result as a DCF using a five years of annual growth from the vertical axis (displayed left) and a terminal value developed using the growth rate from the horizontal axis (displayed top). For example, a company expecting to achieve 10% annual growth for years one through five and a terminal value growth rate of 5% would require a perpetual growth rate of 6.4% to equate a Gordon-style capitalization to a DCF valuation. The 6.4% perpetual rate may lack direct or specific support anywhere in the industry or economic data, but it may functionally capture the short-term and long-term expectations that are reasonable. Some appraisers may find this simple concept too burdensome to develop and communicate and thus a trustee often ends up with the five-finger approach to growth analysis. Figure 19 provides a quick and powerful tool for assessing growth rates in valuation reports (at the specific 15% equity discount rate). Even if future growth lacks “visibility,” the fact is that years one through five are more predictable than beyond five or more years. That being a matter of common sense, a given company’s prevailing and near term trends might reasonably serve as the annual growth rate for years one through five while an industry/GDP/inflationary assumption might reasonably serve as the perpetual growth rate after the initial five-year implied projection (e.g. the terminal value growth rate). Figures 19-21 are based on alternative equity discount rates. The use of the subject’s company’s equity discount rate is vital to developing a proper growth rate perspective. We note that growth rates applicable to alternative cash flows, such a cash flow to total invested capital, can also be studied using a similar approach as described in these examples. Replicating the math of these growth tables is relatively easy for any experienced analyst or reviewer.Appendix B | Case Analysis: Testing Projection Outcomes Using DCF AnalysisFor purposes of the following case study analysis, let’s refer to the various projection scenarios depicted in Figure 22. Additionally, let’s frame the effect on the valuation from the projection scenarios using a valuation of the unadjusted management projections. Figure 22 highlights the various projection scenarios one might reasonably develop as alternatives to the base management projection. Figure 23 depicts both a DCF and single-period capitalization developed from a base projection. As can be observed in Figure 24, the valuation using a modified growth rate reduced the total equity valuation by 20%. If the appraiser and/or the trustee concur that this lower growth scenario is a more plausible outcome than management’s original projection, particularly in light of the trustee’s core concern for a long-term sustainable and serviceable ESOP benefit, then all things held constant in the base projection model, the use of an equity risk premium on the order of 2.0% applied to the equity discount rate of the original model (making it 17% versus the original 15%) would converge the value of the original projection with that of the alternative 5% growth scenario. Using this technique, the appraiser/trustee has not directly modified the projection, but the valuation is hedged for the horizon risk believed to be associated with management’s base numbers. This is a simplified but powerful example of how the appraisal process can serve to effectively adjust the valuation outcome for the uncertainty of achieving a projection. Numerous other DCF treatments including discounting timing conventions, terminal growth rates, terminal value methods, capital structure for determining the WACC, working capital assumptions, and other tweaks can individually or collectively result in significantly different valuation outcomes using the same projection. These adjustments and modeling exercises can aid appraisers and trustees in determining reasonable and credible valuation outcomes. It goes without saying that these adjustments cannot simply be arbitrary. Rather, they must be reasonable and supportable in the context of the company’s capabilities and the marketplace for ESOP ownership interests in the company. With regard to valuations over time, changes in assumptions and modeling techniques should not be buried or obscured and should be clearly reconciled for the benefit of both the appraiser and the trustee. As can be observed in Figure 25, the valuation using the 0% growth scenario reduced the total equity valuation by 37% from the original growth projection. If the appraiser and/or the trustee concur that this alternative growth scenario is a more plausible outcome than management’s original projection, particularly in light of the trustee’s core concern for a long-term sustainable and serviceable ESOP benefit, then all things held constant in the base projection model, the use of an equity risk premium on the order of 4.0% applied to the equity rate (making it 19% versus the original 15%) would converge the value of the original projection with that of the alternative 0% (no) growth scenario. Using this technique, the appraiser/trustee has not directly modified the projection, but the valuation is hedged for the horizon risk believed to be associated with management’s base numbers. As can be observed in Figure 26, the valuation using a declining growth scenario reduced the total equity valuation by 48%. If the appraiser and/or the trustee concur that this alternative growth scenario is a more plausible outcome than management’s original projection, particularly in light of the trustee’s core concern for a long-term sustainable and serviceable ESOP benefit, then all things held constant in the base projection model, the use of an equity risk premium on the order of 6.0% applied to the equity rate (making it 21% versus the original 15%) would converge the value of the original projection with that of the alternative -5% annual growth scenario. Using this technique, the appraiser/trustee has not directly modified the projection, but the valuation is hedged for the horizon risk believed to be associated with management’s base numbers. As can be observed in Figure 28, the valuation using a modified growth rate reduced the total equity valuation by 32%. If the appraiser and/or the trustee concur that this alternative growth scenario is a more plausible outcome than management’s original projection, particularly in light of the trustee’s core concern for a long-term sustainable and serviceable ESOP benefit, then all things held constant in the base projection model, the use of an equity risk premium on the order of 3.3% applied to the equity rate (making it 18.3% versus the original 15%) would converge the value of the original projection with that of the alternative cyclical growth scenario. Using this technique, the appraiser/trustee has not directly modified the projection, but the valuation is hedged for the horizon risk believed to be associated with management’s base numbers.Synthesis of Outcomes Using Alternative Projections/ Equity Discount RatesFigure 28 depicts the various growth rates scenarios studied for this example. This serves as an example of the type of sensitivity and stress testing the trustee/appraiser can employ to support the due diligence process and the documentation of the projections employed (and/or not employed) as called for under the DOL settlement protocols. As previously stated, alteration of numerous other modeling inputs could be studied in the same fashion as this example using growth rates and reconciling equity (horizon/projection) premiums. The various scenarios can be used to support concerns for downside risk concerning the valuation, the ability to service debt, and the ability to support ESOP repurchase obligation (all procedures and considerations called for under the settlement protocols). These same sensitivity processes can be used to assess the quality and relative value of the subject ESOP company to transaction data and/or guideline public company data employed and/or adjusted in the valuation.As can be seen in Figure 28, modeling alternative growth scenarios can be a powerful tool in assessing the risk profile and alternative outcomes associated with a given set of projections. While this lengthy working example has examined downside scenarios associated with projection shortfalls, the same framework can be used to assess upside potential in cases where management projections appear conservative in light of past performance and/or external business drivers. It could be argued that the assessment of repurchase obligation should include the potential impact from positive budget variances, as undervaluation today could result in an underestimation of future repurchase liability, which could lead to under-informed and potentially adverse business decisions by the sponsor company.Appendix C | SETTLEMENT AGREEMENT (DOL V. GREATBANC)UNITED STATES DISTRICT COURT | CENTRAL DISTRICT OF CALIFORNIA | Case No. ED-CV12-1648-R(DTBx)THOMAS E. PEREZ Secretary of the United States Department of Labor (Plaintiff) V. GREATBANC TRUST COMPANY, et al. (Defendants)This SETTLEMENT AGREEMENT (“Settlement Agreement”) is entered into by and between Thomas E. Perez, Secretary of the United States Department of Labor (“Secretary”), acting in his official capacity, by and through his duly authorized representatives, and GreatBanc Trust Company (“GreatBanc”), by and through its duly authorized representative (individually, a “party” and collectively, the “parties”), to settle all civil claims and issues between them.WHEREAS, the Secretary’s predecessor, Hilda L. Solis, acting in her official capacity, pursuant to her authority under Title I of the Employee Retirement Income Security Act of 1974 (“ERISA”), 29 U.S.C. § 1001, et seq., as amended, filed this action in connection with the June 20, 2006 purchase of Sierra Aluminum Company (“Sierra”) stock by the Employee Stock Ownership Plan sponsored by Sierra (the “Sierra ESOP”), and Thomas E. Perez, current Secretary of the United States Department of Labor, in his official capacity, substituted for Hilda Solis and is now the plaintiff in this action;WHEREAS, the Secretary and GreatBanc have negotiated this Settlement Agreement through their respective attorneys in a mediation process;WHEREAS, the Secretary and GreatBanc have engaged in a constructive and collaborative effort to establish binding policies and procedures relating to GreatBanc’s fiduciary engagements and to its process of analyzing transactions involving purchases or sales by ERISA-covered employee stock ownership plans (“ESOPs”) of employer securities that are not publicly traded. Those policies and procedures, to which the parties have agreed, are set forth in Attachment A hereto, which is incorporated herein as an integral part of this Settlement Agreement (hereinafter collectively, “Settlement Agreement”);WHEREAS, each party acknowledges that its representations are material factors in the other party’s decision to enter into this Settlement Agreement;WHEREAS, the parties agree to settle on the terms and conditions hereafter set forth as a full and complete resolution of all of the civil claims and issues arising between them in this action without trial or adjudication of any issue of fact or law raised in the Secretary’s Complaint in this action and other claims and issues as set forth in this Settlement Agreement;[.][Terms and conditions delineated as items A through U omitted]Attachment A Of The Settlement Agreement AgreementConcerning Fiduciary Engagements And Process Requirements For Employer Stock TransactionsThe Secretary of the United States Department of Labor (the “Secretary”) and GreatBanc Trust Company (“the Trustee”), by and through their attorneys, have agreed that the policies and procedures described below apply whenever the Trustee serves as a trustee or other fiduciary of any employee stock ownership plan subject to Title I of ERISA (“ESOP”) in connection with transactions in which the ESOP is purchasing or selling, is contemplating purchasing or selling, or receives an offer to purchase or sell, employer securities that are not publicly traded.A. Selection and Use of Valuation Advisor – General. In all transactions involving the purchase or sale of employer securities that are not publicly traded, the Trustee will hire a qualified valuation advisor, and will do the following:prudently investigate the valuation advisor’s qualifications;take reasonable steps to determine that the valuation advisor receives complete, accurate and current information necessary to value the employer securities; andprudently determine that its reliance on the valuation advisor’s advice is reasonable before entering into any transaction in reliance on the advice.B. Selection of Valuation Advisor – Conflicts of Interest. The Trustee will not use a valuation advisor for a transaction that has previously performed work – including but not limited to a “preliminary valuation” – for or on behalf of the ESOP sponsor (as distinguished from the ESOP), any counter-party to the ESOP involved in the transaction, or any other entity that is structuring the transaction (such as an investment bank) for any party other than the ESOP or its trustee. The Trustee will not use a valuation advisor for a transaction that has a familial or corporate relationship (such as a parent-subsidiary relationship) to any of the aforementioned persons or entities. The Trustee will obtain written confirmation from the valuation advisor selected that none of the above-referenced relations exist. C. Selection of Valuation Advisor – Process. In selecting a valuation advisor for a transaction involving the purchase or sale of employer securities, the Trustee will prepare a written analysis addressing the following topics:The reason for selecting the particular valuation advisor;A list of all the valuation advisors that the Trustee considered;A discussion of the qualifications of the valuation advisors that the Trustee considered;A list of references checked and discussion of the references’ views on the valuation advisors;Whether the valuation advisor was the subject of prior criminal or civil proceedings; andA full explanation of the bases for concluding that the Trustee’s selection of the valuation advisor was prudent.If the Trustee selects a valuation advisor from a roster of valuation advisors that it has previously used, the Trustee need not undertake anew the analysis outlined above if the following conditions are satisfied: (a) the Trustee previously performed the analysis in connection with a prior engagement of the valuation advisor; (b) the previous analysis was completed within the 15 month period immediately preceding the valuation advisor’s selection for a specific transaction; (c) the Trustee documents in writing that it previously performed the analysis, the date(s) on which the Trustee performed the analysis, and the results of the analysis; and (d) the valuation advisor certifies that the information it previously provided pursuant to item (5) above is still accurate. D. Oversight of Valuation Advisor – Required Analysis. In connection with any purchase or sale of employer securities that are not publicly traded, the Trustee will request that the valuation advisor document the following items in its valuation report,1 and if the valuation advisor does not so document properly, the Trustee will prepare supplemental documentation of the following items to the extent they were not documented by the valuation advisor:Identify in writing the individuals responsible for providing any projections reflected in the valuation report, and as to those individuals, conduct reasonable inquiry as to: (a) whether those individuals have or reasonably may be determined to have any conflicts of interest in regard to the ESOP (including but not limited to any interest in the purchase or sale of the employer securities being considered); (b) whether those individuals serve as agents or employees of persons with such conflicts, and the precise nature of any such conflicts: and (c) record in writing how the Trustee and the valuation advisor considered such conflicts in determining the value of employer securities;Document in writing an opinion as to the reasonableness of any projections considered in connection with the proposed transaction and explain in writing why and to what extent the projections are or are not reasonable. At a minimum, the analysis shall consider how the projections compare to, and whether they are reasonable in light of, the company’s five-year historical averages and/or medians and the five-year historical averages and/or medians of a group of comparable public companies (if any exist) for the following metrics, unless five-year data are unavailable (in which case, the analyses shall use averages extending as far back as possible). a. Return on assets b. Return on equity c. EBIT margins d. EBITDA margins e. Ratio of capital expenditures to sales f. Revenue growth rate g. Ratio of free cash flows (of the enterprise) to salesIf it is determined that any of these metrics should be disregarded in assessing the reasonableness of the projections, document in writing both the calculations of the metric (unless calculation is impossible) and the basis for the conclusion that the metric should be disregarded. The use of additional metrics to evaluate the reasonableness of projections other than those listed in section D(2)(a)-(g) above is not precluded as long as the appropriateness of those metrics is documented in writing. If comparable companies are used for any part of a valuation – whether as part of a Guideline Public Company method, to gauge the reasonableness of projections, or for any other purpose – explain in writing the bases for concluding that the comparable companies are actually comparable to the company being valued, including on the basis of size, customer concentration (if such information is publicly available), and volatility of earnings. If a Guideline Public Company analysis is performed, explain in writing any discounts applied to the multiples selected, and if no discount is applied to any given multiple, explain in significant detail the reasons.If the company is projected to meet or exceed its historical performance or the historical performance of the group of comparable public companies on any of the metrics described in paragraph D(2) above, document in writing all material assumptions supporting such projections and why those assumptions are reasonable.To the extent that the Trustee or its valuation advisor considers any of the projections provided by the ESOP sponsor to be unreasonable, document in writing any adjustments made to the projections.If adjustments are applied to the company’s historical or projected financial metrics in a valuation analysis, determine and explain in writing why such adjustments are reasonable.If greater weight is assigned to some valuation methods than to others, explain in writing the weighting assigned to each valuation method and the basis for the weightings assigned.Consider, as appropriate, how the plan document provisions regarding stock distributions, the duration of the ESOP loan, and the age and tenure of the ESOP participants, may affect the ESOP sponsor’s prospective repurchase obligation, the prudence of the stock purchase, or the fair market value of the stock.Analyze and document in writing (a) whether the ESOP sponsor will be able to service the debt taken on in connection with the transaction (including the ability to service the debt in the event that the ESOP sponsor fails to meet the projections relied upon in valuing the stock); (b) whether the transaction is fair to the ESOP from a financial point of view; (c) whether the transaction is fair to the ESOP relative to all the other parties to the proposed transaction; (d) whether the terms of the financing of the proposed transaction are market-based, commercially reasonable, and in the best interests of the ESOP; and (e) the financial impact of the proposed transaction on the ESOP sponsor, and document in writing the factors considered in such analysis and conclusions drawn therefrom.E. Financial Statements.The Trustee will request that the company provide the Trustee and its valuation advisor with audited unqualified financial statements prepared by a CPA for the preceding five fiscal years, unless financial statements extending back five years are unavailable (in which case, the Trustee will request audited unqualified financial statement extending as far back as possible).If the ESOP Sponsor provides to the Trustee or its valuation advisor unaudited or qualified financial statements prepared by a CPA for any of the preceding five fiscal years (including interim financial statements that update or supplement the last available audited statements), the Trustee will determine whether it is prudent to rely on the unaudited or qualified financial statements notwithstanding the risk posed by using unaudited or qualified financial statements.If the Trustee proceeds with the transaction notwithstanding the lack of audited unqualified financial statements prepared by a CPA (including interim financial statements that update or supplement the last available audited statements), the Trustee will document the bases for the Trustee’s reasonable belief that it is prudent to rely on the financial statements, and explain in writing how it accounted for any risk posed by using qualified or unaudited statements. If the Trustee does not believe that it can reasonably conclude that it would be prudent to rely on the financial statements used in the valuation report, the Trustee will not proceed with the transaction. While the Trustee need not audit the financial statements itself, it must carefully consider the reliability of those statements in the manner set forth herein.F. Fiduciary Review Process – General. In connection with any transaction involving the purchase or sale of employer securities that are not publicly traded, the Trustee agrees to do the following:Take reasonable steps necessary to determine the prudence of relying on the ESOP sponsor’s financial statements provided to the valuation advisor, as set out more fully in paragraph E above;Critically assess the reasonableness of any projections (particularly management projections), and if the valuation report does not document in writing the reasonableness of such projections to the Trustee’s satisfaction, the Trustee will prepare supplemental documentation explaining why and to what extent the projections are or are not reasonable;Document in writing its bases for concluding that the information supplied to the valuation advisor, whether directly from the ESOP sponsor or otherwise, was current, complete, and accurate.G. Fiduciary Review Process – Documentation of Valuation Analysis. The Trustee will document in writing its analysis of any final valuation report relating to a transaction involving the purchase or sale of employer securities. The Trustee’s documentation will specifically address each of the following topics and will include the Trustee’s conclusions regarding the final valuation report’s treatment of each topic and explain in writing the bases for its conclusions:Marketability discounts;Minority interests and control premiums;Projections of the company’s future economic performance and the reasonableness or unreasonableness of such projections, including, if applicable, the bases for assuming that the company’s future financial performance will meet or exceed historical performance or the expected performance of the relevant industry generally;Analysis of the company’s strengths and weaknesses, which may include, as appropriate, personnel, plant and equipment, capacity, research and development, marketing strategy, business planning, financial condition, and any other factors that reasonably could be expected to affect future performance;Specific discount rates chosen, including whether any Weighted Average Cost of Capital used by the valuation advisor was based on the company’s actual capital structure or that of the relevant industry and why the chosen capital structure weighting was reasonable;All adjustments to the company’s historical financial statements;Consistency of the general economic and industry-specific narrative in the valuation report with the quantitative aspects of the valuation report;Reliability and timeliness of the historical financial data considered, including a discussion of whether the financial statements used by the valuation advisor were the subject of unqualified audit opinions, and if not, why it would nevertheless be prudent to rely on them;The comparability of the companies chosen as part of any analysis based on comparable companies;Material assumptions underlying the valuation report and any testing and analyses of these assumptions;Where the valuation report made choices between averages, medians, and outliers (e.g., in determining the multiple(s) used under the “guideline company method” of valuation), the reasons for the choices;Treatment of corporate debt;Whether the methodologies employed were standard and accepted methodologies and the bases for any departures from standard and accepted methodologies;The ESOP sponsor’s ability to service any debt or liabilities to be taken on in connection with the proposed transaction;The proposed transaction’s reasonably foreseeable risks as of the date of the transaction;Any other material considerations or variables that could have a significant effect on the price of the employer securities.H. Fiduciary Review Process – Reliance on Valuation Report.The Trustee, through its personnel who are responsible for the proposed transaction, will do the following, and document in writing its work with respect to each: a. Read and understand the valuation report; b. Identify and question the valuation report’s underlying assumptions; c. Make reasonable inquiry as to whether the information in the valuation report is materially consistent with information in the Trustee’s possession; d. Analyze whether the valuation report’s conclusions are consistent with the data and analyses; and e. Analyze whether the valuation report is internally consistent in material aspects.The Trustee will document in writing the following: (a) the identities of its personnel who were primarily responsible for the proposed transaction, including any person who participated in decisions on whether to proceed with the transaction or the price of the transaction; (b) any material points as to which such personnel disagreed and why; and (c) whether any such personnel concluded or expressed the belief prior to the Trustee’s approval of the transaction that the valuation report’s conclusions were inconsistent with the data and analysis therein or that the valuation report was internally inconsistent in material aspects.If the individuals responsible for performing the analysis believe that the valuation report’s conclusions are not consistent with the data and analysis or that the valuation report is internally inconsistent in material respects, the Trustee will not proceed with the transaction.I. Preservation of Documents. In connection with any transaction completed by the Trustee through its committee or otherwise, the Trustee will create and preserve, for at least six (6) years, notes and records that document in writing the following:The full name, business address, telephone number and email address at the time of the Trustee’s consideration of the proposed transaction of each member of the Trustee’s Fiduciary Committee (whether or not he or she voted on the transaction) and any other Trustee personnel who made any material decision(s) on behalf of the Trustee in connection with the proposed transaction, including any of the persons identified pursuant to H(2) above;The vote (yes or no) of each member of the Trustee’s Fiduciary Committee who voted on the proposed transaction and a signed certification by each of the voting committee members and any other Trustee personnel who made any material decision(s) on behalf of the Trustee in connection with the proposed transaction that they have read the valuation report, identified its underlying assumptions, and considered the reasonableness of the valuation report’s assumptions and conclusions;All notes and records created by the Trustee in connection with its consideration of the proposed transaction, including all documentation required by this Agreement;All documents the Trustee and the persons identified in 1 above relied on in making their decisions;All electronic or other written communications the Trustee and the persons identified in 1 above had with service providers (including any valuation advisor), the ESOP sponsor, any non-ESOP counterparties, and any advisors retained by the ESOP sponsor or non-ESOP counterparties.J. Fair Market Value. The Trustee will not cause an ESOP to purchase employer securities for more than their fair market value or sell employer securities for less than their fair market value. The DOL states that the principal amount of the debt financing the transaction, irrespective of the interest rate, cannot exceed the securities’ fair market value. Accordingly, the Trustee will not cause an ESOP to engage in a leveraged stock purchase transaction in which the principal amount of the debt financing the transaction exceeds the fair market value of the stock acquired with that debt, irrespective of the interest rate or other terms of the debt used to finance the transaction. K. Consideration of Claw-Back. In evaluating proposed stock transactions, the Trustee will consider whether it is appropriate to request a claw-back arrangement or other purchase price adjustment(s) to protect the ESOP against the possibility of adverse consequences in the event of significant corporate events or changed circumstances. The Trustee will document in writing its consideration of the appropriateness of a claw-back or other purchase price adjustment(s). L. Other Professionals. The Trustee may, consistent with its fiduciary responsibilities under ERISA, employ, or delegate fiduciary authority to, qualified professionals to aid the Trustee in the exercise of its powers, duties, and responsibilities as long as it is prudent to do so. M. This Agreement is not intended to specify all of the Trustee’s obligations as an ERISA fiduciary with respect to the purchase or sale of employer stock under ERISA, and in no way supersedes any of the Trustee’s obligations under ERISA or its implementing regulations.

This article first appeared as a whitepaper in a series of reports titled Appraisal Review Practice Aid for ESOP Trustees. The market approach is a general way of determining the value of a business, business ownership interest, security, or intangible asset by using one or more methods that compare the subject to similar businesses, business ownership interests, securities, or intangible assets that have been sold. Functionally, market methodologies are similar to direct capitalization income methods in that a benefit (or performance) measure of the subject business is converted to value by a capitalization factor. It is the specificity of the data supporting the capitalization factor that differentiates market methodology from income methodology.In general, income methodologies rely on indirect, broad market rates of return on capital (Ibbotson, et al.) and on various data sets and trends to establish growth rates. For cases in which there is more direct information from a comparable market, such information is used in a market approach to develop a value for the subject entity. These comparable markets offer evidence of either direct- or relative-value metrics based on transaction activity among investors. Such markets can be described as direct—in that a similar ownership interest or security in the same subject entity has transacted—or as indirect—in that a group of publicly traded securities of similar companies can be observed and/or that transactions of entire entities can be observed. The market approach includes numerous methods, which are generally named according to the nature of the direct or relative-value market data. Naming conventions for certain market methods differ among valuation practitioners but most fall into three categories: (1) the transaction method, (2) the guideline public company method, and (3) the guideline transactions method. As with market data sets used in income methodology, the appropriateness of the data (i.e., its comparability and overall strength of relevance) is the primary concern. Market evidence may require adjustment to address a variety of issues before it can be used to value the subject interest. These adjustments differ based on which of the various market methods is employed as well as on the nature of the transactions observed. The following provides an overview of the primary elements of comparability and adjustments under the three primary categories of market methodology.Valuation Methods Under The Market ApproachThe market approach includes a variety of valuation methods under which pricing metrics are drawn from transactions of interests in companies that are comparable to the subject company. The three primary valuation methods under the market approach are summarized below.Transactions Method — derives value using pricing metrics of historical or contemporaneous transactions of interests in the subject company.Guideline Public Company Method — derives value using transaction information drawn from publicly traded securities of companies in the same or similar lines of business as the subject company.Guideline Transactions Method — derives value using pricing metrics of mergers and acquisitions involving controlling interests of companies (public and private) in the same or similar lines of business as the subject company.The comparability and reliability of observed transactions is the central concern. The three core market methodologies yield differing types of valuation information for a given ownership interest or entity. Based on the market in which the observed transaction(s) occurred, there can be differing relative valuations. The transaction method may yield valuation information at various levels of value (control or minority). The guideline public company method generally yields valuation information at the marketable minority interest level of value. The guideline transactions method generally yields valuation information based on the controlling interest level of value. Accordingly, the value definition used for an appraisal may suggest which single method or combination of methods might directly apply in the appraisal process. Rarely is a guideline transactions method employed in a valuation calling for the minority interest level of value. Conversely, observed transactions in minority ownership interests of the subject entity may not provide appropriate valuation information for valuations in which the engagement calls for use of the controlling interest level of value. Although market methods can result in valuations at varying levels of value, each of which may differ from the level of value defined for a given appraisal, there can be useful information in transaction activity even if such activity implies a valuation that is not directly equivalent to the value definition specified in the appraisal engagement. Frequently, there are circumstances in which the appraiser may observe activity that provides indirect support for the valuation or that can be reconciled to the value definition called for in the appraisal report. As with income methods, the valuations developed using market methodology can result in a value indication for the equity of the subject or for the assets (invested capital) of the subject. In the latter case, the market value of debt is subtracted to derive the equity value of the subject. Appraisers may elect to use market methods that result in direct value indications that differ from the value definition called for in the appraisal engagement. In such cases, valuation discounts and premiums are usually applied to adjust the value indication to the specified level of value defined for the engagement.Rules of ThumbA valuation rule of thumb relates an operational or financial measure of a company to a measure of value. Most metrics are operational in nature (based on some unit of business activity or volume) or are financial (representing a multiplier to capitalize revenue, cash flow or some other financial benefit stream). There is rule-of-thumb valuation innuendo in almost every industry. In some cases, such information provides useful insight into the mentality and predisposition of what an owner of a business or business interest believes their holding is worth. This is particularly true of industries whose participants adhere to a relatively narrow range of norms in operating, financial, and/or physical composition.A rule of thumb value indication is typically a controlling interest level of value. In some cases, rules of thumb reflect a strategic value as opposed to a financial controlling interest value. Appraisers using or referring to rules of thumb must be aware, to the degree possible, of the origin of the rule of thumb in order to assess whether it captures synergies or other premium benefits (or expected profitability) available only to specific strategic investors. Because most rules of thumb have their genesis within a given industry or trade group, strategic elements are often included. Accordingly, ESOP valuations using the fair market value standard may result in conclusions lower than the common industry rules of thumb. However, industry rules of thumb may also coincide with fair market value if the hypothetical investor is closely aligned with likely market participants in the industry or market.Most rules of thumb relate to the total enterprise value of assets as opposed to the total equity value of a business. Hence, the determination of equity value requires the subtraction of debt from the total enterprise value. As with the private transaction databases, rules of thumb generally require adjustment for certain types of assets and liabilities that are not typically part of transactions. Cash balances, certain liabilities, working capital, real estate, and other balance sheet amounts may be treated separately from core business assets.Rules of thumb can be highly misleading as most subject companies differ from the stereotypical company in the stereotypical market with a steady-state cycle of performance. Even when such normalcy appears evident, there are marketplace and economic factors that result in valuations that deviate from the central point of a suggested range. Some valuation texts refer to the use of a rule of thumb as a valuation method. Likewise, there are proprietary transaction databases that, when viewed across multiple industries over extended periods of time, are promulgated to represent meaningful information in the valuation of small business enterprises. Appraisers have the task of determining whether or not such data rise to an acceptable level of reliability and/or relevance. In most cases, we see such data as constituting a rule of thumb, and, therefore, subject to healthy scrutiny and devil’s advocacy.Many small- to middle-market companies (enterprise valuations of $5 to $500 million) have enjoyed increased access to capital funding alternatives and exit strategies in recent years. The rise of private equity buyout firms and the general increase in knowledge among business owners has influenced evolution in rules of thumb. Historically simplistic references to unit revenue measures have evolved and been reconciled to financial measures.For example, an old-guard rule of thumb in the beverage distribution industry was based on annual volume of cases sold. A distributor of a given type or brand of product might generally assume or expect a certain business value based on annual case-volume activity. However, changes in product mix caused by evolving consumer preferences over time rendered these rules less reliable in explaining the value of a given distributor whose margin was below or in excess of norms. Eventually, the industry vernacular became more focused on gross profit, which better characterizes profit by taking into account the mix and pricing of product offerings. However, operating expense structures of distributors vary to the extent that gross profit is often inadequate in explaining value differentials in transactions. In the current environment, rules of thumb have taken the next step by reconciling to financial measures (such as a multiple of cash flow). Any rule of thumb based on an industry metric (i.e., tons, cases, etc.), can be reconciled to a financial equivalency. Doing so facilitates easier value comparisons and provides a financial basis for reconciling the concluded value in an appraisal to a broad industry rule of thumb.Consistent with the business valuation standards issued by the professional organizations, we do not suggest using a rule of thumb as a stand-alone valuation method under the market approach. However, when valuing a subject entity or interest using a controlling interest level of value, we do encourage appraisers and reviewers to be aware of any rule of thumb that may characterize value in the subject’s industry. In most cases, an indirect reference to a rule of thumb can provide support for a value conclusion developed under more conventional and financially sound methods. If a conclusion deviates from a rule of thumb, it can be useful for the appraiser to explain why.Transactions MethodThe transactions method is a market approach that develops an indication of value based upon consideration of observed transactions in the ownership interests of the subject entity. Transactions should be scrutinized to determine if they have occurred at arm’s length, with a reasonable degree of frequency, and within a reasonable period of time relative to the valuation date. Inferences about current value can sometimes be drawn, even if there is only a limited market for the ownership interests and relatively few transactions occur.The timeliness of a transaction is important. However, time itself is not the only parameter that determines whether a transaction is reliable for use in a given appraisal. If internal and/or external business conditions or other factors have changed or evolved in a significant way from the time of the observed transaction to the date of the valuation, then use of the transaction may be unreliable. This could also be true for a transaction occurring in close proximity to the valuation date. While a dated transaction may be unreliable in absolute value terms, the implied relative value of the transaction may be useful to examine (such as price to book or enterprise value to cash flow). Arguably, any transaction that has occurred in reasonable proximity to the valuation date should be disclosed and distilled even if it is not directly considered toward the valuation. In such a case, the appraiser may need to explicitly qualify why a transaction is not being given direct weight in the valuation. In select cases where entity and market performance have remained stable over time, transactions that are somewhat dated may provide meaningful direct or indirect support to the appraisal. Transactions occurring subsequent to the valuation date should not be considered unless the facts and circumstances of such activity were known or reasonably knowable as of the valuation date and there is (was) a high likelihood of the transaction closing.There are many corporate and shareholder events in the ordinary course of business that may produce meaningful transaction data. Shareholder redemptions, capital raising, transactions among the ownership group, recapitalizations, buy-sell trigger events, equity compensation grants, business acquisitions, dispositions, and other events are not unusual, particularly in larger entities or in entities with large and/or active ownership groups. It is important that any transaction used to develop an indication of value for the entity, or more directly for the subject interest, be considered in the proper context (in terms of value definition) of other valuation methods developed in the appraisal. Frequently, transactions must be adjusted using estimated (and reasonable) discounts or premiums to derive a meaningful base of comparison to the subject interest.Guideline Public Company MethodThe Guideline Public Company Method (GPCM) involves the use of valuation metrics from publicly traded companies that are deemed suitably comparable to the subject entity. Direct comparability is difficult to achieve in many situations, as most public companies are larger and more diverse than the subject, closely held entities in most business appraisals. However, the threshold for direct comparability need not be so inflexible that public companies with similar business characteristics are disqualified from providing guidance in the valuation of the subject company. In some cases, public companies may not be reliable for direct valuation purposes but may yield information helpful in ascertaining norms for capital structure assumptions and growth rate analysis.There are relatively few industries in which direct comparability is readily achieved, and most of those present challenges by the sheer scalar differences between the public operators and most private enterprises. The selection of, adjustment of, and application of public company valuation data can be a complicated process involving significant appraiser skill and experience. Absent proper execution, the GPCM can render valuation indications that differ significantly from other methods and thus lead to confusing and/or flawed appraisal results.Guideline companies are most often publicly traded companies in the same or similar industry as the valuation subject and/or that provide a reasonable basis for comparison to the subject company due to similarities in operational processes, supply and demand factors, and/or financial composition.Investors in the public stock markets often study the P/E ratio of a security for purposes of assessing the merits of the investment. The P/E ratio of a stock is utilized in a common variation of the GPCM whereby a guideline public P/E ratio is used to capitalize the subject company’s net income. Other variations include the use of valuation metrics to capitalize pre-tax income, numerous versions of cash flow, book value, revenues, or other performance measures of the valuation subject.Investors in the public securities markets are said to be transacting minority investments (non-controlling) in the issuer’s security, and such investors enjoy the benefit of regulated exchanges and mandatory information disclosures by the issuer. Regular filings by publicly traded companies allow investors to assess the valuation of the security in relation to an almost endless array of operational and financial performance measures for the public company. Guideline company valuation metrics produce marketable minority interest valuation indications. The term “as- if- freely- traded” is often used to describe value indications under the GPCM. Guideline companies are used to develop valuation indications under the presumption that a similar market exists for the subject company and the guideline companies.Ideal guideline companies are in the same business as the company being valued. However, if there is insufficient transaction evidence in the same business, it may be necessary to consider companies with an underlying similarity of relevant investment characteristics such as markets, products, growth, cyclical variability, and other salient factors.Although a guideline group may provide some indication of how the public markets value the subject company’s shares, there are limitations to the method. For example, it is virtually impossible to find identical guideline companies. In addition, analysts must assume that all relevant information about a company is embedded in its market price. A guideline group can sometimes provide useful valuation benchmarks, but it is ultimately left to the analyst to derive an appropriate capitalization factor for a subject company based upon a thorough comparison of the selected group of guideline companies to the subject company.Variations of the Guideline Public Company MethodThe GPCM can be used to develop value indications for both invested (or enterprise) capital and equity capital. There are numerous sub-methods for performing both types of valuations. The nature of the denominator in a guideline valuation metric or ratio determines the nature of the value indication. Consistent with the rules governing proper income method execution (namely, matching the discount rate to the proper measure of the subject’s earnings or cash flows), the benefit stream of the valuation subject should be capitalized by the appropriate guideline valuation metric. Performance measures and benefits streams have one primary differentiating feature – they are either before debt-service costs or after. The performance or benefit measures that capture cash flows before the payment of debt costs (i.e., interest expense) are used to develop value indications for the invested capital (i.e., total assets) of the guideline companies and, therefore, result in the same valuation for the appraisal subject. The performance measures that capture cash flow after debt service are used to develop value indications for equity capital. As with any approach or method that results in a direct valuation of invested capital, debt is subtracted to arrive at the value of equity. Although it is true that a valuation metric can relate a pre-debt cash flow to equity value (and vice versa an after-debt cash flow to invested capital), we view this as a likely source of valuation error and would discourage such methodology unless there is a convincing reason to do so. We would likely disregard the use of the GPCM if such mixing of benefit streams and capitalization factors were the only calculations developed (e.g., price-to-sales or priceto-EBITDA, etc.).Appraisers have the task of developing guideline company cash-flow measures and value metrics in a fashion consistent with the cash flows and valuation math used for the valuation subject. Mismatching the guideline valuation metric with the wrong benefit measure of the subject is a common mistake. Appraisers are encouraged not to take valuation multiples for a given public company or group of companies from a published or electronic data source unless the underlying definition and/or development of the metric is adequately detailed. There can be subtle but meaningful variations in how an appraiser tabulates a benefit measure, such as EBITDA, versus how it was tabulated in the cited source material.Appraisers must also be mindful of understanding the implications of developing guideline company valuation metrics using financial information and pricing data from periods that are reasonably consistent with the benefit measures of the valuation subject. Public market stock pricing conventions follow a rolling four-quarter or 12-month norm. Often, the acronym LTM (last twelve months) or TTM (trailing twelve month) is used to denote that a given cash flow or earnings measure was tabulated using the most recent annualized performance measure of the public company. That is, a given P/E ratio or MVIC/EBITDA ratio is based on the market capitalization as of a defined date and the most up-to-date, 12 month earnings or cash flow measure of the public company.Although it is not absolute that timing of the data used in developing a guideline valuation metric must be applied to the subject’s benefit measure from the same period, it is recommended that this be the base convention in most business valuations. Due to performance fluctuations and the timing of the business cycle (among other things) from the valuation subject to a given peer guideline company group, some appraisers may use average pricing metrics spanning several years for the guideline companies against a similar average of cash flows or earnings for the valuation subject. This type of execution seemingly parallels common disciplines used in various income methods in which an ongoing, average expression of earnings and cash flow is capitalized by a factor whose underlying discount rate and growth rate were derived from data observed over some historical time frame.We urge caution when not following consistency of timing regarding pricing measures and/or benefit streams from subject to peer. For example, when a multi-year average of subject earnings is capitalized using the median LTM P/E ratio from a guideline group, the valuation of the subject can be characterized as being adjusted for fundamentals resulting in a valuation that is higher or lower than would be the case had the LTM P/E ratio been applied to the LTM earnings of the subject. This type of fundamental adjustment is but one of many implicit or indirect adjustments that an appraiser can capture under the GPCM. These adjustments need not be construed as flawed as long as there is adequate purpose and explanation for why such a discipline was employed and perhaps even a calculation of the impact on the valuation indication versus a valuation using the typical timing conventions (i.e., guideline LTM to subject LTM).For valuations in which the GPCM is employed, the guideline data may serve an additional purpose. A properly developed appraisal opinion may have numerous value indications under the cost, income, and market approaches. Value indications from various methods are typically correlated with, or weighted toward an overall valuation conclusion that attempts to reflect the entirety of process and consideration captured in the valuation. Some appraisers have long practiced providing a relative value analysis at the end of their valuation reports that educates the reader on numerous observations of relative value. In such a fashion, the appraiser can present the valuation conclusions from perspectives that extend beyond the direct methodology employed. Accordingly, the appraiser may effectively assert that the conclusions directly developed are consistent with alternative or additional valuation methods that had would support the conclusions reached had such alternative or additional valuation methods been employed.The relative value analysis is often used to articulate the sanity and appropriateness of the conclusions based on comparing various valuation ratios to broad-market norms, market transactions, or public market pricing for similar (guideline) companies. Relating the valuation conclusion to the reported book value of equity, to the adjusted value of tangible equity, to various measures of cash flow, etc. is an often used technique to support the valuation and to provide a basis for explaining why the conclusion reflects or differs from various peer measurements. In some cases, a guideline company group may have been identified but not used directly. Regardless, when such market evidence is reasonably observable, comparing the data and reconciling it against the valuation conclusions can be a useful and informational exercise.For example, consider a valuation in which equal weights were applied to the cost approach (e.g., net asset value method) and the income approach (e.g., direct capitalization of earnings), resulting in a correlated equity value of $8,000,000 (marketable minority interest level of value). The subject has $2,000,000 of debt, implying a market value of invested capital (MVIC or TEV) of $10,000,000. Assume the subject entity has a debt-free net cash flow of $1,000,000, EBIT of $1,667,000, and EBITDA of $2,000,000. The resulting MVIC ratios to EBIT and to EBITDA are approximately 6.0x and 5.0x, respectively. If market data were identified but not directly employed, it may be that the valuation conclusion can be compared and reconciled to the market data. All such comparisons must be assessed using the same level of value for both the guideline peer data and the subject company. The table in Figure 1 presents an example of a multi-method execution of the GPCM. Some of the valuation metrics result in a valuation for equity and some for invested capital. In the example, it is by design that each indication of value is the same. Valuation indications from varying methods within the GPCM will vary, and, in some cases, the variations can be significant. We note that capitalized revenue and capitalized book value will often yield different valuation indications than capitalized earnings or cash flow. In such cases, the appraiser must develop and/or select from those methods and indications believed to be reliable for the appraisal assignment and the definition of value called for therein. Several caveats and considerations are required to properly execute a GPCM.There is a fundamental adjustment of 20% applied to each equity value indication developed under each method. A following section of this publication will provide an overview of how fundamental adjustments for guideline data can be developed.There is a line item for the market values of non-operating assets (and liabilities). Appraisers should apply adjustments to the earnings and other performance measures to eliminate the effects of non-operating assets because the values of such assets are typically captured on the back end of the analysis in order to develop the final indications of value. Failure to adjust the performance measures can result in double counting errors.There is a line item providing for the potential application of a control premium. Such a premium applies only when the engagement definition calls for the controlling interest level of value. The consideration of a control premium at this stage serves as a proxy for other adjustments not otherwise captured in previous adjustments or reflected in the guideline multiples or applied as a subsequent treatment after a correlation of the GPCM with other methods employed in the appraisal. We caution that blind application of published control premiums is a frequent source of flawed, over-stated valuation. Published control premiums are consequential measures of investor expectations for efficiencies and other value pick-ups from the reported transactions. They reflect expectations of post-deal operating and strategic economies. In the context of appropriately adjusted performance measures and other valuation inputs, most financial control premiums for small private companies are quite modest to nil. This can be particularly true in ESOP situations where the entity is remaining an independent going concern and will not benefit from postmerger efficiencies and synergies embedded in most market-based transactions.A memo section in the example displays what each value indication implies on a relative basis by way of comparison of each value method to the subject’s book value, net income, and EBITDA. In this fashion, appraisers and users of valuations can assess how a valuation indication using one valuation metric relates to another.When multiple indications of value are developed using the GPCM, the appraiser may elect to average the indications into a singular expression of value or may elect to carry individual value indications from the GPCM into a broader exercise to correlate the overall conclusion of value from all methods developed using the three core approaches to value. We believe both of these presentations to be appropriate, but we caution that appraisers and report users should be aware of the total consideration applied to each methods and approach.Identifying Guideline CompaniesThe initial stage generally includes the identification of relevant subject company characteristics to serve as a basis for a public company or transaction search. These characteristics include (among other things):The subject entity’s portfolio of products and/or servicesThe subject entity’s vertical and/or horizontal integration in its respective industryThe subject entity’s market share in the industry or in subsets of geography or by customer type, and so forth (to whom and where are the subject’s products and services sold?)The subject entity’s operational and organizational structureThe characteristics outlined in this list can be used to identify codes under the Standard Industrial Classification (SIC) and North American Industrial Classification Systems (NAICS - used in the United States, Mexico, and Canada). These codes can be used to identify transacting companies and public companies with common economic activities to the valuation subject. Appraisers may need to augment such global screenings with key word searches or perform parallel searches of other SIC or NAICS codes that represent businesses with substantially similar business attributes. Screening of electronic and web-based resources is a virtual standard in valuation practice today. Such resources often include industry data and noteworthy public and private participants. Additional criterion used for selecting and narrowing selections include consideration of the subject’s and the guideline companies’ financial performance and composition, the nature of the assets, the supporting capital structure, trends in absolute and relative performance via size and margin considerations, and consideration of internal and external factors that drive or influence business activity. Choice of Valuation MetricThe valuation metrics applied in a given appraisal should be commonly accepted and recognized as relevant to the subject’s industry (earnings, EBITDA, book, etc.) and should be reflective of business cycle or other relevant issues affecting the subject, its industry, and its guideline peer group. For example, guideline capitalized net income is a common valuation norm for many financial institutions and service companies, while capitalized EBITDA is a more recognized valuation norm for asset-intensive business such as manufacturers. In many valuation engagements, the value of an entity in relation to its book value can be important.The reliance of securities markets on various types of valuation information can shift during economic and industry cycles. Businesses that typically have higher valuations during economic expansions may be valued with higher reliance on capitalized cash flow or earnings, while valuations in recessionary periods or down cycles may place greater reliance on asset-based valuation methods. The point is that valuations performed from one time to another or for one purpose to another may require differing degrees of reliance on and consideration of the GPCM as a whole, as well as differing degrees of reliance on and consideration of varied indications of value underlying the GPCM. A rigid average of underlying methods in the GPCM as well on other methods and approaches in an appraisal may constitute little more than a rule-of-thumb or formulaic approach to value and can lead to flawed valuation results.The Fundamental AdjustmentUnder both the guideline public company method and the guideline transactions method, it is necessary to adjust the market evidence observed in transactions of comparable companies for fundamental differences between the subject company and the guideline companies.Adjusting Guideline Valuation Metrics for Use in Business ValuationWhat is a fundamental adjustment? The term “fundamental adjustment” is not a universal term, but it is a universal treatment applied explicitly or implicitly in virtually every GPCM and guideline transaction method (GTM). Where market-value evidence is observed, screened, and modified for use in the GPCM or GTM, one can be virtually assured that some adjustment has been applied to the data. The adjustment of market-value evidence, whether it is through selection criterion, central tendency observations, or otherwise is what we refer to as a fundamental adjustment. Labels and terms aside, we acknowledge the need for an explanation of how an appraiser adjusts market-value evidence used in the appraisal process. The obfuscation of or failure to consider such adjustment is a common feature of and/or source of error in many appraisals.Figures 2 and 3 provide perspective concerning the conceptual framework of market-value evidence and its adjustment for use in business valuations. Figure 2 relates to the marketable minority level of value that by default is the typical level of value arising from the GPCM. We note that the financial and strategic control levels of value may differ from guideline to subject using the same concepts discussed here.The necessity for fundamental adjustments is frequently overlooked. These adjustments are required to reconcile differences between the subject company and the selected group of guideline companies (or transactions as the case may be). Fundamental adjustments are generally applied as discounts to the observed market-value evidence (reflecting a typically smaller and riskier valuation subject versus larger public companies that populate a guideline company group), but they can also represent premiums in relationship to the base market-value evidence.Core comparative considerations between the valuation subject and the guideline companies include the following:Size. Publicly traded guideline companies are often larger and more diversified than the valuation subject. Diversification and scale regarding geographic footprint, customer concentration, supply inputs, and other common risk factors typically favor guideline public companies and acquirers in transactions. All things being equal, this would imply a lower valuation multiple for a relatively smaller subject entity.Growth. The growth expectations of guideline companies may be materially different than the growth expectations for the subject company. All things being equal and using the basic representative equation of valuation and the underlying elements of a valuation multiple, higher growth translates to higher valuation multiples and vice versa.Access to and Composition of Financing. The ability to obtain financing and negotiate favorable terms can facilitate future growth and provide superior returns on investment. The capital structures and financing power of large public companies can reduce the cost of capital and provide greater operational and strategic flexibility. Such factors translate to higher valuation multiples than may be reasonable for smaller companies lacking such resources.Financial/Operating Strength. Guideline companies may be better capitalized and have greater depth in their respective management teams.The underlying need for fundamental adjustments arises because of differences in the risk profile and growth prospects of the valuation subject in relation to the companies whose trading and transaction data are used in a valuation. By process, the adjustments are developed (through explicit analyses or otherwise) by substituting the risk and growth attributes captured in the guideline data with the risk and growth attributes of the valuation subject. In this fashion, the appraiser attempts to answer the question – how would the market-value evidence differ if the guideline companies and/or the transaction participants had the same risk profile and growth prospects as the valuation subject? This question provides the genesis for understanding a quantitative method for assessing the magnitude of a fundamental adjustment. There are numerous variations of quantitative adjustment and most are predicated on the principle of substitution. Quantitative Process for Assessing a Fundamental AdjustmentAs a preface to the following example, readers are reminded of the build-up and ACAPM methods for developing the required rate of return on equity capital. These CAPM-based disciplines provide the basis for disaggregating the P/E ratios of public companies in a fashion that facilitates the process for substituting the subject risk profile and growth of the subject and determining the effect on the P/E ratio. Such quantification may suggest the magnitude of an appropriate fundamental adjustment. The following assumptions and conditions are used in the example. The figures and assumptions in this example are purely for demonstration purposes.Ten public companies were identified as guideline public companies. The median P/E ratio of the group was 10x. The reciprocal of this P/E ratio equals a capitalization rate of 10%.The median equity market capitalization of the 10 guideline companies would place the hypothetical guideline company near the bottom of 9th decile of public companies according to the Morningstar/ Ibbotson SBBI Yearbook. The 9th decile companies reflected an implied size premium on the order of 4.0% in excess of returns on the S&P500 index (large cap stocks). The median beta was 1.0, implying equal volatility to the S&P500.Financial composition and performance of the subject company were reasonably consistent with the guideline company. The elements of risk were primarily related to differences in firm size.Stock analysts following the guideline companies were projecting annual earnings growth of approximately 10% for the next five years. Long-term industry prospects suggested annual earnings growth on the order of 4%. The guideline growth rate expectations equate to a perpetual earning growth rate of approximately 6%. The implied required rate of return for the hypothetical median guideline company is 16%. This measure of return minus the perpetual growth rate of 6% equals the observed capitalization rate of 10%. The subject company was mature and displayed recent earnings growth of 10%, near-term growth expectations were expected to decline by 1% each year and level out at a long-term growth rate similar to the overall industry (4%). The subject growth rate expectations equate to a perpetual earning growth rate of approximately 5%.At the valuation date, the risk-free rate of return on long-term U.S. Treasury bonds was 5%. The assumed large stock equity premium was assumed to be 7%. The size premium deemed appropriate for the subject company was 6%, and firm-specific risk was assumed to be 1%.The table in Figure 4 depicts the changes in the median guideline P/E ratio via the sequential and combined substitution of subject growth and risk into the build-up process. The differences between the resulting adjusted capitalization factors and the median guideline P/E ratio represents the fundamental adjustment.The risk differential (combined size- and firm-specific) suggests the median guideline P/E ratio be reduced by 23% solely based on the valuation subject’s risk. The growth differential suggests the median guideline P/E ratio be reduced by 9% based solely on the valuation subject’s risk. Considering risk and growth differentials, the median guideline P/E ratio would be reduced by 29%. In operation, this adjustment would be applicable to pricing metrics that result directly in value indications for total equity or could be applied to the resulting equity value derived after subtracting debt from value indications for invested capital. Using the foregoing example, we might see an appraiser use a fundamental adjustment of 15% to 25%. Every situation is unique, and the exact quantified result of this technique is not the absolute adjustment that need apply.Fundamental Adjustments in DisguiseThe following bullet points highlight some of the possible implicit adjustments we see applied to market-value evidence. These points are random in fashion and are designed to spark the necessary analytical curiosity required to scrutinize valuation methods under the market approach.Most appraisers, even those who have never employed the term “fundamental adjustment,” have employed the same concept in appraisals. In fact, any appraiser who has selected guideline company multiples other than the median (or perhaps, the average), whether above or below, has implicitly applied the concept of the fundamental adjustment. Based on comparisons between private companies and guideline groups of companies, appraisers often select multiples above or below the measures of central tendency for the public groups.Analysts routinely add a small stock premium to the base, CAPM-determined market premium based on historical rate of return data. In addition, analysts routinely estimate a specific company risk premium for private enterprises, which is added to the other components of the ACAPM or build-up discount rate. Implicitly, analysts adjust public market return data (from Ibbotson or other sources) used to develop public company return expectations to account for risks related to size and other factors. In other words, they are making fundamental adjustments in the development of discount rates.What are the differences between the subject company and the guideline companies, and how does one incorporate them into the analysis? If all of the guideline companies were identical to one another and the subject company was identical to the guideline companies, then subject value would be equal to the values of the guideline companies. Because this is never the case, the analyst has to identify the important differences and determine what adjustments are required to arrive at a reasonable estimate of value for the subject.The actual value measure applied to the subject may be anywhere within (or sometimes even outside) the range of value measures developed from the market data. Where each measure should fall will depend on the quantitative and qualitative analysis of the subject company relative to analysis of the companies that comprise the market transaction data. Valuation pricing multiples are influenced by the same forces that influence capitalization rates, the two most important of which are: (1) risk and (2) expected growth in the operating variable being capitalized.Therefore, in order for the analyst to make an intelligent estimate of what multiple is appropriate for the subject company relative to the multiples observed for the guideline companies, the analyst must make some judgments about the relative risk and growth prospects of the subject compared with the guideline companies.The analyst should be aware that a search criterion could represent the beginning of a fundamental adjustment in the eyes of potential users of a report. The analyst can unwittingly (or overtly) apply a fundamental adjustment before the mathematical process even begins.As with any discount or premium, a fundamental adjustment has limited meaning unless the base against which the adjustment is applied is clearly defined. Define such base in error, through either commission or omission, and the selection and adjustment of public company valuation metrics may be faulty.Use of generic methodology in lieu of an emphasis on relevant metrics can be construed as a fundamental adjustment.Ultimately, as a result of weighing alternative valuation methods to the ultimate valuation conclusion, the valuation may reflect a significant discount to public company multiples and potentially a higher (or lower as the case may be) fundamental adjustment than explicitly articulated (or implicitly captured) under the guideline method.ConclusionAs with many tools in the valuation, there are variations of this process. Some appraisers may elect to quantify adjustments for application to differing valuation metrics so as to take into consideration specific differences in profit margins or capital structure. Fundamental adjustments can be small or large and can be positive or negative. Appropriate quantification techniques can be useful tools in augmenting qualitative-based adjustments. Fundamental adjustments can be explicit in nature or implicit and disguised in numerous ways. Ultimately, it is the appraiser’s responsibility to select and reasonably adjust market-value evidence for use in the GPCM or the GTM.Guideline Transactions MethodThe transactions method and the GPCM follow a generally recognized (more or less) set of procedures and practices. The guideline transaction method (GTM) is inherently different in its requirements due to potential idiosyncrasies in the underlying data.The largely private purveyors of market-value evidence used in the GTM provide varying degrees of data from varying markets. Transaction events are generally classified by industry, facilitating SIC- and NAICS-enabled screening. However, transaction consideration and various valuation ratios may follow differing definitions. Certain adjustments are required to add or subtract values associated with excluded assets or to compensate for the effect of specialized transaction consideration and other deal terms in order for an appraiser to develop an appropriate valuation of the subject.The required adjustments and considerations vary from one data source to the next. Such adjustment items may include employment contracts, non-compete agreements, contingency payments, seller financing terms, working capital, real estate, specialized expressions of cash flow and other transaction attributes. Care must be taken to ensure that the methodology results in value indications that are consistent with the value definition required in the appraisal description. Appraisers and report users are cautioned that data sources should be reviewed to understand what kind of valuation is captured in the transaction data (typically it is the market value of invested capital) and how that data needs to be adjusted to derive the intended subject valuation (equity value in most valuation engagements). Confusion in the proper use of transaction data bases has fueled a veritable professional niche of publications intended to instruct appraisers on the proper use of market-value evidence from the various databases. This suggests that transaction observations be supported by sufficient (perhaps significant) underlying financial detail.In operation, the GTM is similar to direct capitalization income methods and to the GPCM in that a specified subject performance measure is capitalized by a capitalization factor that is derived from observable market-value evidence (transactions). As with other guideline data processes, capitalization factors are typically drawn from numerous transactions implying some average valuation metric or ratio. Adjustments to reconcile fundamental differences between subject and guideline follow similar considerations as discussed in the GPCM. Differing valuation metrics may be used to describe transaction values based on the nature and industry of buyers and sellers in the cited transactions. As with income methods and other market methods, consistency between performance measures and capitalization multiples is required.Valuations using transaction data result in a controlling interest valuation indication. As such, the GTM may not be employed (or useful) in a valuation intended to develop a minority interest level of value. Alternatively, a controlling interest value can be adjusted by valuation discounts to derive alternative levels of value. Market transactions are used to develop valuation indications under the presumption that a similar market exists for the subject company.As with the guideline public company method, ideal guideline transactions involve companies which that are in the same business as the company being valued. However, if there is insufficient transaction evidence in the same business, it may be necessary to consider companies with an underlying similarity of relevant investment characteristics such as markets, products, growth, cyclical variability, and other salient factors.One or a combination of data sources are typically employed in the GTM. Additionally, there are countless other potential sources of information that are reported by specialized industry trade groups, investments banking concerns, industry consultants, and other market participants. Information may also be gleaned from the corporate development activities of publicly traded buyers and sellers because such data may be reported in SEC filings. There is a wealth of potential information from diverse providers of financial and market market-based information including (among others) SNL Securities, Thomson Reuters, and Bloomberg.Virtually every caveat and caution discussed for the GPCM and the transaction method extend to the GTM (and then some). Appraisers are challenged with adequate documentation of transactions, proper application of the data, and proper adjustment of the results. Many appraisers include citation of transaction data in their reports but may elect to use such data as a supporting element to an appraisal conclusion derived from alternative methodologies. Direct use of transaction data is often reserved for situations in which adequate transaction volume can be observed, the transactions occurred within a reasonable timeframe of the valuation data, and the transaction participants’ data and deals can be reasonably adjusted and reconciled to the valuation subject.

This article first appeared as a whitepaper in a series of reports titled Appraisal Review Practice Aid for ESOP Trustees. The correlated indication of value is a value that is arrived at through some reasonable, well-articulated, replicable, and credible process of selection, averaging or otherwise, of the total valuation evidence generated from the valuation methodologies employed. Correlating a valuation conclusion that subsumes all the information, processes, analyses, and market evidence in a valuation engagement is no simple task.The term used by some appraisers for the resulting valuation distillation is “correlated indication of value.”For valuations in which the value methodology directly results in the value definition specified in the engagement, the correlated indication of value may represent the final conclusion of value.For cases in which the value definition differs from the direct results of valuation methodology, the correlated indication of value is typically adjusted by valuation discounts or premiums (typically the former) to develop the value definition specified in the engagement. Figure 1 depicts the typical correlation framework.There are numerous variations and potential interjecting steps and adjustments.In operation, developing a correlated indication of value may appear reasonably straightforward (sometimes it is), but the considerations in the process can reach back to the smallest of details and considerations in the underlying valuation methodologies. A brief review of the global valuation approaches provides a good review for the subsequent observations. Figure 2 presents the three valuation approaches.Global Considerations in the Correlation ProcessThe following provide some global considerations used by many appraisers to navigate the correlation process (which is not to say all are best practices).These points are not listed in any order of significance because the priority of consideration changes with every appraisal.Nature and Industry of the Subject BusinessManufacturing, distribution, retail, service, professional, contracting, etc. Differing business models have differing value drivers and differing financial infrastructures.Some methods will be the primary or sole path to value for some types of businesses.The relative asset-intensity of a business may influence the selection of valuation methods. Manufacturing concerns make capital investments differently than do professional service firms; the methods weighed should reflect this basic reality.All businesses have resources at risk in the marketplace and should by logical extension rely on earnings (cash flow) as the core driver of value.In other words, the capitalized cash flow of the subject company should at least validate the value of underlying net asset value.In a very real sense, the value of capitalized cash flow defines the value of underlying net assets, based on risk, return, and growth parameters.Yet many businesses, at different points in their life cycles, are more appropriately valued based on (or with partial reliance on) underlying net assets.It is the job of the appraiser to determine the driver(s) of value in general and on a given valuation date and to utilize that perspective in fashioning a conclusion.Although all firms employ assets to generate profits, some are better at it than others.The store of value in hard assets can serve to sustain value (or soften downturns) for many types of businesses, particularly in times when profits are low or non-existent.For businesses lacking significant hard assets (and other balance sheet resources), a lack of earnings or cash flow, when coupled with poor business prospects, likely means a lack of value.Businesses that hold assets are typically valued using the appraised values of the underlying assets and/or on asset values that can be readily evidenced from an active, observable market.In such cases, a singular method such as the net asset value method may be employed.Additional analysis based on income and market methods may be used to support valuation discounts that are applied to the direct asset-based value indication.Most closely held businesses are too small or narrow in focus to be valued using the market approach.Accordingly, many (most) appraisals do not employ the guideline public company method. In similar fashion, other market methods may not apply either.Stage of Business Maturity and DevelopmentMature businesses with established performance may be valued using methods that are not appropriate for early stage businesses or businesses in decline.Start-ups or liquidating business should be valued using methods that capture the eventual or ultimate expected economic norms or outcomes for the business.In such cases, there is little correlation required because only one method may be used.Position in Industry or Economic CycleBusinesses that display periodic down cycles may be valued with more weight placed on balance sheet indications of value, particularly when projected performance is uncertain or lacking all together.However, income methods showing little to no value may be weighted as a proxy for lack of control issues (also known as minority interest discount), to capture appraiser concerns regarding the economic obsolescence of assets, or to capture anticipated financial losses for the period of time until a return to profitability or stabilized performance is can be expected to be achieved.The weighting of low-to-no value income methods serves to effectively discount the asset-based method in many valuations.Businesses performing at historic average levels and/or with continuing expectations for stability will likely be valued using income methods or with market methods that focus on earnings and cash flow.Businesses in high or low cycles may be valued using discrete projection methods that adjust the business up or down over time toward a steady state of performance that is more in keeping with proven history or is better aligned with industry performance and/or expectations.Nature of Underlying Adjustments in the Valuation MethodsAll valuation methods require underlying adjustments. Asset-based methods follow a mark-to-market discipline. Income methods may be adjusted for unusual expenses. Projections may be more or less believable in the context of history and external market expectations. Market methods may rely on market evidence that is not directly comparable or is unreliable due to an economic or industry shock.The point is that many valuations include methodologies and results that are more or less speculative than other methods. This can be acute when a business is at a peak or trough in its cycle.Under the ubiquitous standard of fair market value, appraisers must take into account the balance of considerations from both the hypothetical buyer’s and hypothetical seller’s perspectives.Standard and Level of Value (The Value Definition)An appraisal performed using the controlling interest level of value may rely more heavily on the higher value indications than on the lower value indications. This kind of consideration may serve as a proxy for the highest and best use or operation of the underlying business assets.It can also lead to error and/or alleged bias.Conversely, a minority interest value definition may influence the consideration of lower value indications or indications from methods that are believed more reflective of the expectations of investors who lack the prerogatives to bring about the changes or choices that might otherwise increase the indicated value.This too, can lead to error and/or alleged bias.Some appraisals are performed for specific purposes using a standard of value other than fair market value.In such cases, certain methodologies may be dictated and others prohibited.Fair value under FASB reporting requirements may require considerations and perspectives very different than under fair market value.Fair value (yes, a different “fair value”) under operation of law (either by statute or judicial guidance) can vary from state to state and from issue to issue.Dissenter’s rights, marital dissolution, securities fraud, and other matters in which an appraisal is developed for expert consulting or expert witness purposes may require unique valuation considerations and often include specific instruction from legal counsel concerning what “counts” in the calculations and how.In matters requiring a very specific set of defining elements, the value definition must be top of mind when developing or reviewing the work product, which is often a scope of report other than the typical appraisal opinion.The Quality and Availability of Subject Financial DataThe lack of proper financial reporting does not provide license for an appraiser to resort to obtuse measures such as total assets or gross sales as a foundation for establishing value.Some situations may require consideration of broad financial measures and/or somewhat remote market evidence as a basis for speculating on value when the quality of net worth and /or the visibility of cash flow are obscured.Such situations may require the valuation to be qualified as falling short of a formal appraisal opinion under most professional standards.In other cases, an appraiser simply has to operate with the available information.These considerations are based on experience, observations of public and private markets over time, and a dose of informed judgment; differences, both semantic and substantive, can exist from one appraiser to the next.One could ask:When should a valuation not reflect balanced consideration of all approaches and methods?The right answer is – never.It is always helpful to assess the value indications from all approaches and methods in the context of one another.However, consideration and direct reliance are different things.In many cases, there is simply not ample information, market evidence, or cause to develop values under each approach.Appraisers owe the users of their reports a credible explanation of where reliance was placed and in what proportion.There are times when financial information and valuation evidence suggest that brevity is the high road and that too much analysis along lines that are ultimately not relied upon in the valuation is confusing or misleading.Appraisers simply must use the judgments extended them by the appraisal standards to present a complete picture of the relevant methodological landscape.However, appraisers and their audiences benefit from the use of a core set of processes and considerations for deriving and displaying the correlation of value.The table in Figure 3 is provided for perspective.We note that the valuation of most business enterprises is ultimately driven by the economic returns generated on the assets that comprise the business.As such, the income approach is the primary indicator of value in most business appraisals where the business is a going concern and not simply a fund of underlying net assets.Unfortunately, the income approach can be difficult to model in certain circumstances such as a recession.For ESOP appraisals, the above perspectives can be shift based on the comfort and confidence of the appraiser/trustee in the company’s ability to maintain a sustainable ESOP benefit.Repurchase obligations ultimately require cash flow.Depending on the overall design and management of the ESOP plan, appraisers and trustees are cautioned when relying on asset-based value indications without taking into consideration the ability of the company to sustain the asset base when cash flows fall short of servicing the ESOP’s needs, let alone the needs of the business.ESOP companies that experience a decline in business activity and which have little prospects of recovering to past performance levels (or worse, remaining a going concern) should likely include consideration of a liquidation premise.The liquidation premise is often developed and studied using an asset value perspective, adjusted for the time-value and liquidation consequences that could befall the assets as they are sold.Such a premise need not be a death sentence for the ESOP or the Company, but may relevant to consider during a time of reorganization for the sponsor company.When businesses are displaying significant volatility and/or a fundamental change in business posture (particularly on the downside), appraisers and trustees are encouraged to communicate about the underlying methodology and the potential need to redefine the level and premise of value for the appraisal.Such changes could materially rebalance the consideration of the underlying approaches and methods toward the conclusion.Correlation ExamplesFollowing are some typical examples of a correlated indication of value.We have provided differing examples based on varying scenarios.The numerical values and weights are for demonstration purposes; the weights applied are not based on any rigid formula and will vary for each appraisal based on the totality of underlying factors for each appraisal.Example 1 in Figure 4. Small to medium service business; stable market, consistent performance and expectations; valuation definition is FMV minority interest, correlated value before discount for lack of marketability. Example 2 in Figure 5. Small distribution business; challenging market conditions and sub-par expectations; company owns real property and other fungible assets; valuation definition is FMV minority interest, correlated value before discount for lack of marketability.Example 3 in Figure 6.Large producer of value-added capital assets; stable markets and expectations; advanced financial management and capital resources; value definition is FMV minority interest, correlated value before discount for lack of marketability.In Figure 6, we can see that the income approach was allocated two-thirds of overall weighting. Looking deeper, if the GPCM exclusively considered cash flow calculations (say net earnings and EBITDA), then income measures were effectively weighted 100 percent in the overall valuation; the only difference being the specificity of the market evidence used to value the income and cash flows.For cases in which the GPCM is used, there may be reasons that some calculations should receive greater underlying consideration than others (say capitalized book value rather than EBITDA).This may simply be a variation of the same theme of shifting weights between asset-based and income-based methods to address issues related to business and economic cycles.Variations on these examples are almost endless.There are often circumstances in which value indications vary greatly and require thoughtful explanation about why a value that appears at one end of a spectrum was exclusively weighted.In some cases, a simple average might be appropriate but appraisers should be cautious when averaging a potentially non-meaningful indication with a meaningful indication. Rarely does the averaging of an unreliable indication make the end result correct unless additional explanation and support are provided about how the resulting correlation relates to the most meaningful valuation evidence.Accordingly, a relative value analysis, as in Figure 7, may be a useful tool in helping explain how each indication relates to other indications.Let us expand on the third example with some additional information to see how the various indications compare to each other.Such a comparison could be used in an iterative fashion to reach a final weighting scenario as well as to provide support for the conclusions reached in the report.Note that the relevant comparisons are being made at the marketable minority interest level of value. At the marketable minority interest level of value, the subject’s relative value measures can be directly compared to the relative value measures of the guideline public companies. Relative value assessments that compare subject valuation results to peer valuation evidence must be performed using an appropriate and comparative level of value for both the subject and the peer.Section 5 of Revenue Ruling 59-60 addresses the weight to be accorded to various factors in an appraisal.In the context of an operating company appraisal, judgment is required to reconcile what may be diverging indications of value among the various valuation approaches (or even methods within a single approach or method).Although averaging widely diverging indications of value from various valuation methods may be appropriate in a particular valuation, appraisers should assess why such large differences exist.Do indications from the market approach suggest that assumptions made in methods within the income approach be revisited?Or do the results from an income approach shed light on the appropriate fundamental adjustment (or selection of guideline companies)?Within the market approach, indications of value can vary widely, depending on the financial measure capitalized.The appraiser may glean hints with respect to the weight to a particular indication by considering why such differences occur.Differences between indications derived from capitalized net income and EBIT are a function of the financing mix. Differences between indications derived from EBIT and EBITDA may reveal varying degrees of asset intensity.Capitalized revenue measures provide a view of “normalized” margins – are the margins of the subject company likely to improve or deteriorate?Finally, capitalizing measures of physical volume (number of subscribers or units sold, for example) could reveal unit-pricing disparities between the subject and the selected guideline companies.There can be no fixed formula for weighing indications of value from various valuation methods.Responsible appraisers, recognizing this, should apply common sense and informed judgment in developing a correlated indication of value. ConclusionGiven the potential diversity of valuation evidence and methodology in most business appraisals, a well-reasoned and adequately documented process is required to support the initial and final valuation conclusions derived in a business valuation. In this publication we provided insight on the functional processes and analytical considerations underlying the determination of a correlated indication of value. Additionally, we discussed methods and perspectives that can be used to justify the underlying methodology and valuation evidence relied upon while providing relative value observations to support the reasonableness of a valuation conclusion.

This article first appeared as a whitepaper in a series of reports titled Appraisal Review Practice Aid for ESOP Trustees. There is a protracted and clouded legacy of information and dogma surrounding the universe of discounts and premiums in business valuation. It seems logical enough that as elements of business valuation, the underlying quantification and development of discounts and premiums should be financial in basis, just as other valuation methods are founded on financial principles. Much of the original doctrine surrounding the determination of discounts and premiums was based on reference to varying default information sources, whose purveyors continue the ongoing compilation of transaction evidence (public company merger and acquisition activity, restricted stock transactions, pre-IPO studies, etc.). After begrudging bouts of evolution, there has been maturation toward more disciplined and methodical support for valuation discounts and premiums. Perhaps as the state of the profession concerning discounts and premiums has progressed, so, too, has the divide in skill and knowledge among valuation practitioners become wider. Certainly this seems to be the case regarding many users and reviewers of appraisal work (ostensibly the legal community, the DOL and the IRS). There remains ample debate concerning numerous issues in the discount and premium domain. Unfortunately, in the quest for better clarification on the determination of discounts and premiums there has developed an arms’ race of sorts. Despite the emergence of compelling tools and perspectives, no method or approach appears to have the preponderance of support in the financial valuation community. Nowhere is this truer than with the marketability discount (also known as discount for lack of marketability or DLOM). Within the ESOP community much of the confusion over DLOMs is mitigated due to the presence of put options designed to ensure reasonable liquidity for ESOP participants. However, in the ESOP community a legacy of concern over control premiums has now become an acute issue as stakeholders and fiduciaries have increasing concerns regarding flawed valuations and prohibited transactions.The Levels of ValueRegarding the concept of control premiums and minority interest discounts (also known as “lack of control discounts”), there is less conflict and more uniformity on how and when these discounts are used in a business appraisal. That is not to say that differences among appraisers don’t exist regarding certain issues. For purposes of establishing a platform to converse on valuation discounts and premiums, let us use the conventional levels of value framework to anchor the discussion. Figure 1 provides structure about where the traditional valuation discounts and premiums are applied in the continuum of value.The integration of the basic income equation of value into the levels value chart results in the equations and relationships shown in Figure 2. It is here that we can begin to understand that valuation discounts and premiums are not devices in and of themselves. Each is the product (consequence) of the relationships among and between the underlying modeling elements that constitute financial valuation(cash flow, risk and growth). We note that the conceptual core of the mathematical relationships is generally centered on the freely traded world of the public stock markets, which is characterized as the “marketable minority” level of value (enjoying readily achievable liquidity in a regulated, timely, and efficient market). Although other levels of value can be directly observed in various markets, the marketable minority interest level of value characterizes the empirical world from which most valuation data and observations are made (i.e., Ibbotson).CF = cash flow; CFe= cash flow to the business enterprise; CFsh = cash flow to the shareholder; subscript “c,f” and c,s” denote, respectively, CF available to financial control investors and CF available to strategic control investors.R = risk as expressed by the required rate of return on investment; Rmm, Rfand Rsdenote risk as perceived through the eyes of marketable minority investors, financial control investors and strategic investors, respectively.G = growth rate in cash flow or value (see notes above on “R”). Gmm, Gfand Gsdenote growth as expected from the perspective of marketable minority investors, financial control investors and strategic investors, respectively. Gv differs from the other growth expressions in that it is an expression of the growth rate in value for the subject security in an appraisal exercise. All other expressions of “G” are growth rates in the cash flow of the business enterprise.The take away from the relationships depicted in Figure 2 is that risk is negatively correlated to value (the universal reality of the time value of money) and that cash flow and the growth rate in cash flow are positively correlated to value. According to the preceding relationships, a control premium only exists to the degree that control investors reasonably expect some combination of enhanced cash flows, lower risk, or superior growth in cash flow, all as a result of better financial and operational capacity (financial control). Taking the financial control relationships one step higher via specific synergies results in a strategic control premium (which is not considered within the continuum of fair market value and generally exceeds adequate consideration for ESOP transaction purposes). Conversely, a marketability discount exists to the degree that investors anticipate subject returns (yield and capital appreciation) that are sub-optimal in comparison to the returns of a similar investment whose primary differentiating characteristic is that it is freely traded (also known as liquid). That is to say, minority investors (buyers and sellers) in closely held businesses that have investment-level considerations such as higher risks, lower yield, and/or lower value growth require some measure of compensation to compel a transaction in the subject interest. Otherwise, the investor would seek an alternative.Perspective on the Control PremiumWhat is a control premium? The American Society of Appraisers (ASA) defines a control premium as an amount or a percentage by which the pro rata value of a controlling interest exceeds the pro rata value of a non-controlling interest in a business enterprise, to reflect the power of control. In practice, the control premium is generally expressed as a percentage of the marketable minority value.Based on this definition, it might seem that no controlling interest valuation can be developed without an explicit quantification to increase a value that is initially developed using a marketable marketable-minority interest level of value. This might be true in for circumstances in which the control value is not the direct result of the underlying methods. The fact is that most controlling interest value appraisals are developed based on adjustments and methods that result directly in the controlling interest level of value. Therefore, no explicit control premium is required. Consequently, the appraiser cannot explicitly define the magnitude of the control premium in the appraisal.In many cases, the appraiser may state that no control premium is added because all the features and benefits of control have been captured in the earnings adjustments and/or through other modeling assumptions in the underlying methods. We have seen numerous situations in which an appraiser was accused of failing to develop a control valuation because there is no explicit control premium applied to the correlated value or to the individual methods that are weighed in the correlation of value. Archaic though it may be in the context modern valuation practice, such accusations still exist even when the valuation features all the perfunctory control adjustments and treatments. For cases in which normalization and control adjustments were applied to cash flows and other elements, the additional application of a discrete control premium implies that there are further achievable control attributes. In such cases the control premium is likely quite small in comparison to typical published measures. If control adjustments are applied and a control premium is also applied, there is a potential overstatement in the valuation. This type of circumstance is a hot bed issue with the Department of Labor as such treatments could be the underpinning of a prohibited transaction. Appraisers and trustees are cautioned about the potential for double counting when applying an explicit control premium.The primary published source for control premium measurements is Mergerstat Review,published annually by Mergerstat FactSet. Mergerstat Review reports control premiums from actual transactions based on differences between public market prices of minority interests in the stock of subsequently acquired companies prior to buyout announcements and actual buyout prices. It is worth noting that Mergerstat’s analysis indicates that higher premiums are paid for public companies than for private concerns because publicly traded companies tend to be larger, more sophisticated businesses with solid market shares and strong public identities. From a levels-of-value perspective, most of the transactions reported in Mergerstat Review are believed to contain elements of strategic value, which explains the relatively high level of control premiums cited therein. This strategic attribute of the data also makes it potentially troublesome when relied upon in ESOP appraisals.Noteworthy is the now widely accepted presumption that public stock pricing evidence is reflective of both the marketable marketable-minority and controlling financial interest levels of value. Referring to the expanded levels of value chart, minority interest discounts and financial control premiums are thought to be much lower in comparison to annually published data in Mergerstat Review.Thus, the two central boxes in the four-box vertical array of the expanded levels of value chart are essentially overlapping as in Figure 3.The parity of value between financial control and marketable minority requires a few assumptions: normalized earnings adjustments are required, and these adjustments include some considerations that certain appraisers believe are not part of the minority interest equation (namely owners’ and executive compensation). We believe that return on labor and return on capital are reasonable to segregate in valuations based on all levels of value. However, there may be differences between financial control and marketable minority valuations based on enterprise capital structure. There may be some consideration for the lack of liquidity to both control and minority investors when adjusted income streams overstate the real economic cash flows available for distribution or other shareholder-level benefits (including cash flows necessary to sustain an ESOP). There may be some justifiable difference in value for situations in which the valuation subject’s capital structure appears more conservative than its peers. However, wanton manipulation of capital structures (for example, in the development of a weighted average cost of capital or WACC) in deriving the cost of capital is a frequent source of error in appraisals using a discounted future benefits (DFB) method. Such errors can lead to under- or over-valuation.Control Premiums — Substance Over FormMost appraisals that employ a controlling interest level of value definition do not (or should not) display a discrete or explicit control premium. That is because the adjustment processes underlying most individual valuation methods provide for the full consideration of control and thus do not require or justify further adjustment in the form of an explicitly applied control premium. So, despite the lack-of-control form that many control appraisals have, there is ample structure within the methodologies to capture the substance of a control premium. The following perspective plays off the basic equation to business valuation as well as the levels of value chart that depicts the relationships between risk, growth, and cash flow as one moves up and down the levels of value conceptual framework.Control premiums can be the result of earnings adjustments that eliminate discretionary expense, such as excess and non-operating compensation. Shareholder compensation paid to individuals who do not contribute to operations or management, directors’ fees paid to family or others for non-vital roles, management fees paid to retired owners, loan guarantee fees paid to shareholders whose capital resources are not required, and other similar types of expenses are often the underlying control “pick-up” in an appraisal. Arguably, many of these adjustments should be part of the normalizing process for all appraisals so that returns on capital are clearly differentiated from returns on labor. When such adjustments are used to underpin an ESOP transaction, subsequent expenses and policies of the ESOP sponsor in future periods should confirm the credibility of the adjustments.Control premiums can take the form of adjustments that place related party income and expense at arm’s length pricing. Rents paid to related parties, management fees paid to affiliated entities, optimizing value or discretionary income from non-operating assets, and many similar adjustments that optimize the subject benefit stream are all part of the control mindset.Control premiums can be related to the optimization of capital structure. Many businesses enjoy the quality of having little to no interest interest-bearing debt. Perhaps in the paradigm of today’s financial landscape, this is a better quality than previously appreciated. However, if a hypothetical investor can easily use debt in an efficient and responsible fashion to provide for the financial needs of the business, the subject’s cost of capital may be reduced and correspondingly, the return on equity of the business can be improved. That is not to say that increased debt, as low cost as it may be, does not increase the potential risk profile of equity holders. All things equal, a reasonable blend of debt in the capital structure for a bankable group of assets and cash flow will provide a potential enhancement of return on equity. Many appraisals that refer to public company debt ratios or to private peer balance sheet ratios to support an assumed capital structure that is different than actually employed at the subject entity. This can constitute a control premium. However, when taken too far or when assumed in a fashion that does not properly capture the incremental risk that a higher level of debt has on equity investors, the manipulation of capital structure can result in material valuation flaws.Control premiums can emerge from weights applied in the correlation of value. In many cases, the valuation methods used to value a business result in similar value indications for both control and minority situations. However, a control valuation may include differing weights on the value indications such that the correlated value is higher than would result from the weighting scenario applied in a minority interest appraisal. Additionally, if a guideline transaction method is used in a control valuation and is weighed toward the correlation of value, the resulting value may represent a premium to the other indications of value developed in the appraisal.In tandem, capital structure efficiencies, income and expense efficiencies, and the consideration of peer transaction evidence are significant, albeit seemingly silent, control premiums.Perspective on the Minority Interest DiscountWhat is a minority interest (lack of control) discount? The ASA defines a minority interest discount as the difference between the value of a subject interest that exercises control over the company and the value of that same interest lacking control (but enjoying marketability). In practice, the minority interest discount is expressed as a percentage of the controlling interest value. A minority interest is an ownership interest equal to or less than 50 percent of the voting interest in a business enterprise (or less than the percentage of ownership required to control the assets and/or the discretionary expense structure of a business).As with the control premium, the minority interest discount is infrequently called upon in the valuation (as an explicit treatment) of most operating businesses because the majority of methodologies used to value nonmarketable minority interests results in an initial value at the marketable minority interest level of value. Accordingly, only a discount for marketability is required to derive the end nonmarketable minority valuation result.Minority interest discount discounts are a more common feature in the valuation of certain types of investment holding entities such as limited partnerships. This is because such entities have highly diverse purposes versus the relatively narrow operating focus of most operating business models. As such, the assets owned by the entity are generally best appraised by a specialty appraiser or from direct observation of market evidence concerning the asset. That being the case, most such entities are valued using an asset-based approach, which inherently captures the controlling interest level of value for the underlying assets. This makes it necessary for the business valuation to be adjusted first for lack of control considerations and second for lack of marketability concerns. Additionally, in cases involving operating business that hold operating and/or non-operating real property assets, such assets may need to be appraised by an appropriate expert and adjusted with a minority interest discount when integrated into the minority interest enterprise value of an operating business.Although minority interest considerations are captured in the majority of appraisals by reference to returns on marketable interest investments in the public marketplace, there are techniques for developing the discount. One such method involves mathematically imputing the discount based on an assumed control premium. Other methods involve observations of securities trading values in the context of the valuation of the issuer’s underlying assets, such as the case with closed closed-end funds and other securities in which underlying assets have an observable value that can be compared to the security’s trading price.The following formula provides an expression of the percentage minority interest discount as a function of an assumed percentage control premium. Although the expression is useful in identifying the minority interest discount as a percentage of an assumed or developed measure of control value, it is rarely used in a direct sense in the valuation of minority interests.In the valuation of minority interests in asset investment entities (limited partnerships et al.) that are invested in various classes of assets, many appraisers look to the observed discount to net asset value (NAV, the market value of a fund’s asset holdings less its liabilities) that closed-end funds (CEF) typically trade at as evidence of an applicable minority interest discount for a subject partnership or similar ownership interest. As a general rule, CEFs report their net asset values and the price-to-NAV relationship typically reflects a discount. Observed discounts to NAV reflect the consensus view of the marketplace toward minority investments in the underlying portfolios of securities. That is, the discounts are illustrative of the market’s discounting of fractional interests in assets, making them somewhat comparable to a minority interest in an entity that is heavily invested in other assets (such as marketable securities and other asset classes).Discounts to net asset value for closed-end funds have been consistently observable for many years. The precise reasons for such discounts are subject to debate, but common attributes include the following factors:A lack of investor knowledge about the underlying portfolio;Absence of investor enthusiasm about the underlying portfolio;Enthusiasm, or lack thereof, about the fund’s manager;Expense ratios;Tax liabilities associated with embedded gains;Lack of management accountability; andLack of investment flexibilityAlthough closed-end funds may not be directly comparable to the subject interest in an appraisal, the discounts typically observed are evidence of the market’s discounting of portfolios of generally liquid securities, and, therefore, offers valid indirect evidence of minority interest discounts applicable to asset-holding entities and operating businesses.Marketability DiscountsThe ASA defines a marketability discount as an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability. Augmenting the consideration of marketability is the concept of liquidity, which the ASA defines as the ability to readily convert an asset, business, business ownership interest, security, or intangible asset into cash without significant loss of principal. Lack of marketability and lack of liquidity overlap in many practical regards. However, lack of liquidity is often attached to a controlling interest, while marketability discounts are used to describe minority interests.Despite the proliferation of marketability discount studies and models, most models fall into one of three primary categories. These categories are based on the underlying nature of the analysis or evidence from which each model emanates. They include market-based perspectives (commonly referred to as benchmark analysis), options-based models, and income-based (rate of return) models. Although it is not our place to define a given model as the model, we do recognize that some models (or perspectives) provide general guidance for the appraiser regardless of the specific model employed. The following is a list of the so-called Mandelbaum factors, which are derived from the Tax Court’s ruling in Mandelbaum v. Commissioner (T.C. Memo 1995-255, June 12, 1995). In essence, these factors serve a similar guidepost for the assessment of marketability, as does Revenue Ruling 59-60 for the valuation of closely held interests in general.The value of the subject corporation’s privately traded securities vis-à-vis its publicly traded securities (or, if the subject corporation does not have stock that is traded both publicly and privately, the cost of a similar corporation’s public and private stock);An analysis of the subject corporation’s financial statements;The corporation’s dividend-paying capacity, its history of paying dividends, and the amount of its prior dividends;The nature of the corporation, its history, its position in the industry, and its economic outlook;The corporation’s management;The degree of control transferred with the block of stock to be valued;Any restriction on the transferability of the corporation’s stock;The period of time for which an investor must hold the subject stock to realize a sufficient profit;The corporation’s redemption policy; andThe cost of effectuating a public offering of the stock to be valued, e.g., legal, accounting, and underwriting fees.This list extends to considerations beyond the pure question of marketability. However, the ruling is instructive in its breadth. The Mandelbaum process is characterized by many appraisers as a qualitative or scoring procedure. However, most of the parameters are mathematically represented by financial elements and assumptions under the income- and options-based models. Such parameters are also used, to the degree possible, in searching out market evidence from restricted stock transactions, which are documented in varying degrees by numerous studies over several decades. Benchmarking analysis relies primarily on pre-IPO studies and restricted stock transactions. In essence, benchmarking calls for the use of market-based evidence to determine a lack of marketability discount. Some appraisers have pointed out the oxymoron of benchmarking (market transactions) analysis for use in determining marketability discounts. On the same note, other appraisers cite the restricted stock studies for capturing market evidence that at its core demonstrates the diminution to value associated with illiquidity. Imputed evidence concerning the implied rates of return for restricted stock lends support for more specific analyses within certain marketability models. Options-based models, most of which are derivations and evolutions of the Black Scholes Option Model, are based on assessing the cost to insure future liquidity in the subject interest. Rate return models are based on modeling the expected returns to the investors as a means for determining a valuation that results in an adequate rate of return given the investment attributes of the subject interest. There is no one method that is acknowledged as superior to all others. Indeed, virtually every method employed in the valuation universe has been challenged or debated in the courts as well as by and among the professional ranks of appraisers. Perhaps the best approach, stemming from a review of the IRS’s DLOM Job Aid, which was discovered and published a few years ago, is the use of multiple disciplines in a fashion consistent with the breadth of valuation approaches called for in business valuation (principally the income and market approaches).DLOMs in ESOP ValuationNotwithstanding the previous perspectives on DLOMs and the methods and processes for developing them, most ESOP appraisals that involve a minority interest definition of value reflect a relatively minimal DLOM of 5-10%. This is due to the obligatory put option feature required for qualified retirement plans holding closely held employer stock.The virtual guarantee of a market for the ESOP participants’ interests is believed to all but eliminate the DLOM. The consensus treatment from most appraisers is that a DLOM applies and is relatively small (say 5-10%) but not 0%.Some appraisers use the DLOM as a proxy for concerns about future liquidity as it relates to the sponsor company’s ESOP repurchase obligation. If a business is floundering, has a significant bubble of participants requesting near-term liquidity, has pour cash flow, has limited financial resources or financing options, and/or any other underlying fundamental challenge, some appraisers will use a DLOM to reflect this concern.DLOMs quantified in the correct fashion may indeed be a viable approach to capturing the cash flow needed to service repurchase obligations and the associated effect on the sustainable ESOP benefit (the stock value). However, many appraisers use a more direct and explicit approach to studying and treating the repurchase obligation by iterating the associated expense into the valuation modeling (generally using an income method).The expense is determined through a repurchase obligation study which informs trustees, sponsors, and plan administrators what measure of cash flow will service the foreseeable needs of the plan. To the degree that the assumed ongoing retirement plan funding is insufficient to service the obligation, an additional expense may be applied or a single present-value adjustment may be quantified to adjust the total equity value of the business.ConclusionThe application of a discount or premium to an initial indication of value is an often controversial and necessary input to the valuation process. Fortunately, appraisers are equipped with numerous income and market methodologies to derive reasonable estimates of the appropriate discount or premium for the subject interest.As with the determination of the initial indication of value, it is ultimately up to the valuation analyst to choose the appropriate methodology based on the facts and circumstances of the subject interest.None of the available methodologies are perfect, and all of them are subject to varying degrees of criticism from the courts and members of the appraisal community. Critics of the various market approaches often cite the lack of contemporaneous transaction data that are rarely comparable or applicable to the subject interest.Arguments against the income methodologies often focus on the model’s inputs, particularly the holding period assumption, which is typically uncertain for most private equity investments.The number of discount methodologies and their respective criticisms will, in all likelihood, continue to expand into the foreseeable future. It is ultimately up to the appraiser to consider the various options and determine the appropriate model or study applicable to the subject interest.There are no hard-and-fast rules or universal truths that are applicable to all appraisals when it comes to the selection of an appropriate discount methodology. Appraiser judgment is ultimately the most critical input to any valuation, particularly in regard to the application of an appropriate discount methodology or control premium.Admittedly, the number of discount methodologies and their corresponding criticisms can be a bit overwhelming to anyone unaccustomed to reviewing or writing business valuation reports.At the end of the day, the most important thing to keep in mind is how reasonable the discount (or premium) is in light of the liquidity and/or ownership characteristics of the interest being appraised.An appraisal may have carefully considered all the pertinent discount methodologies and their criticisms, but if the ultimate conclusion is not reasonable or appropriate for the subject interest, it will probably not hold up in court or communicate meaningful information for the end user of the report. Appraisers should investigate the reasonableness of their conclusions when preparing valuation reports and related analyses.

In recent years there has been increasing concern among ESOP sponsors and professional advisors (trustees, TPAs, business appraisers, legal counsel) regarding the scrutiny of the DOL, the Employee Benefits Security Administration (“EBSA”), and the Internal Revenue Service (“IRS”). These entities (and agencies thereof) are tasked with ensuring that ESOPs comply with the Employee Retirement Income Security Act (“ERISA”) as well as with various provisions of the federal income tax code concerning qualified retirement plans (including ESOPs). Citing concerns for poor quality and inconsistency in business appraisals, the DOL has sought in recent years to expand the meaning of “fiduciary” under ERISA to include business appraisers. In the most recent forums of exchange and deriving from various court actions, there are numerous areas of concern that DOL/EBSA appear to have regarding ESOP valuations.This whitepaper, which serves as an Appraisal Review Practice Aid for ESOP Trustees, focuses on the use of financial projections in ESOP valuations. The use (or misuse) of financial projections is often the most direct cause of over- or under-valuation in ESOPs.

ESOP valuation is an increasing concern for Trustees and sponsor companies as many ESOPs have matured financially (ESOP debt retired and shares allocated), demographically (aging participants), and strategically (achieved 100% ownership of the stock).Given these and other evolving complexities (including the proposed DOL regulation which would designate ESOP appraisers as fiduciaries of the plans they value), it is sometimes necessary or advisable for ESOP Trustees and the Boards of ESOP companies to change their business valuation advisor.This article addresses why a Trustee or sponsoring company might or should opt for a new appraisal provider, as well as what criteria, questions, and qualities drive the process of selecting a new appraiser.

In this whitepaper, we provide insight on the functional processes and analytical considerations underlying the determination of a correlated indication of value.

This whitepaper provides an overview of the primary elements of comparability and adjustments under the three primary categories of market methodology.

Debate over discounts and premiums in business valuation persists. Nowhere is this truer than with the marketability discount (or DLOM). Within the ESOP community, much of the confusion over DLOMs is mitigated due to the presence of put options. However, a legacy of concern over control premiums has now become an acute issue.