In each “Meet the Team” segment, we highlight a different professional on our Family Law team. The experience and expertise of our professionals allow us to bring a full suite of valuation and forensics services to our clients. We hope you enjoy getting to know us a bit better.
Karolina Calhoun: During my college experience at Rhodes College, I interned at Mercer Capital, Morgan Keegan (now known as Raymond James) in investment banking and then another internship in wealth management, and ALSAC/St. Jude Children’s Research Hospital. I also interned internationally with Ernst and Young (EY) in Warsaw, Poland, which is where I was born and have many family members that still live there.
After graduating from Rhodes College, I completed my Master of Accountancy and CPA accreditation. I started working for EY in their Audit and Assurances department. During my 3+ years at EY, I had the opportunity to work with Fortune 500 clients, as well as other sized companies in diverse industries such as chemical and agriculture, logistics, medical devices, healthcare, and wealth management and investment management. At the time that I came back to Mercer Capital, I was ready to take my public accounting knowledge and experience and pivot to finance-related client work.
Karolina Calhoun: The knowledge of accounting and financial reporting is important. It helps me quickly understand the financial statements of businesses, personal financial statements, and tax returns, among other financial documents. My auditing experience was investigative in a sense, so I have a good idea of what to look for and other red flags. Additionally, from a client perspective, individuals and attorneys tend to trust a CPA’s professional expertise in litigation cases, especially in specialized areas like valuation and forensics. My additional credentials, the ABV and CFF, further bolster the expertise I can offer clients.
Karolina Calhoun: I am so thankful for the national and global opportunities/positions I hold now with the American Institute of Certified Public Accountants (AICPA). I am serving as the Valuation Chair of the AICPA Forensic and Valuation Services (FVS) Conference and I also serve on the CFF Exam Task Force. My committee and task force positions have provided me the opportunities to be involved with thought leaders across the globe and assist our evolving profession. During my tenure so far, I have met and collaborated with many colleagues from all over the United States and beyond North America.
I became involved with the AICPA FVS Section at an early point in my career at Mercer Capital. I attended the NextGen training program, which is catered towards rising leaders in the FVS profession. After meeting and networking with AICPA staff and volunteers, I applied to be considered for future volunteer opportunities. I was so excited when I was invited to join the AICPA Forensics & Valuation Services Conference Planning Committee. Then, in 2019 I was asked to be the 2020 & 2021 Valuation Chair. In this position, I am integral in leading the Committee’s efforts in planning our annual conference, selecting topics, inviting speakers, and collaborating with the AICPA staff & speakers.
In my role on the CFF Exam Task Force, I am contributing to the efforts to pivot the CFF (Certified in Financial Forensics) accreditation towards a universal body of knowledge and examination process. Our committee evaluated the existing test bank of questions and rewrote and wrote new questions to comply with our global framework. As I mentioned earlier, I was born in Poland and interned abroad, so I love being a part of this global initiative as our profession continues to evolve.
Karolina Calhoun: During my tenure at Mercer Capital, as a CPA with an interest in finance, valuation, and forensic accounting, I have helped establish the Litigation Services Group at Mercer Capital. We have extended our services beyond valuation and financial consulting to also encompass forensic services. I think it is very valuable to be able to provide a full suite of services as oftentimes, valuation and forensic services are interconnected.
Take a divorce litigation for example. Historically, Mercer Capital would be called for the valuation of a business, and an external forensic accountant would provide the lifestyle analysis and other forensic needs. However, now Mercer Capital can assist with both the valuation and forensic scope of that divorce engagement. Extending beyond divorce litigation, our team provides valuation, forensic accounting, and financial consulting for a variety of engagements: business damages, lost profits, shareholder disputes, breach of contract, trademark infringement, and estate and tax planning, among others.
Karolina Calhoun: I enjoy the combination of accounting, economics, finance, and forensics. Litigation services is a field where we have to put all of these skills together and evaluate the facts and circumstances unique to the particular matter(s) at hand – no fact pattern is ever the same. Our Litigation Services Group at Mercer Capital is comprised of qualified professionals who have the necessary skills and experience in accounting, finance, and economics and in a wide variety of industries and types of matters.
Depository M&A activity in the U.S. has accelerated in 2021 from a very subdued pace in 2020 when uncertainty about the impact of COVID-19 and the policy responses to it weighed on bank stocks. At the time, investors were grappling with questions related to how high credit losses would be and how far would net interest margins decline. Since then, credit concerns have faded with only a nominal increase in losses for many banks. The margin outlook remains problematic because it appears unlikely the Fed will abandon its zero-interest rate policy (“ZIRP”) anytime soon.
As of September 23, 2021, 157 bank and thrift acquisitions have been announced, which equates to 3.0% of the number of charters as of January 1. Assuming bank stocks are steady or trend higher, we expect 200 to 225 acquisitions this year, equivalent to about 4% of the industry and in-line with 3% to 5% of the industry that is acquired in a typical year. During 2020, only 117 acquisitions representing 2.2% of the industry were announced, less than half of the 272 deals (5.0%) announced in pre-covid 2019.
To be clear, M&A activity follows the public market, as shown in Figure 1. When public market valuations improve, M&A activity and multiples have a propensity to increase as the valuation of the buyers’ shares trend higher. When bank stocks are depressed for whatever reason, acquisition activity usually falls, and multiples decline.
The rebound in M&A activity this year did not occur in a vacuum. Year-to-date through September 23, 2021, the S&P Small Cap and Large Cap Bank Indices have risen 25% and 31% compared to 18% for the S&P 500. Over the past year, the bank indices are up 87% and 79% compared to 37% for the S&P 500.
Excluding small transactions, the issuance of common shares by bank acquirers usually is the dominant form of consideration sellers receive. While buyers have some flexibility regarding the number of shares issued and the mix of stock and cash, buyers are limited in the amount of dilution in tangible book value they are willing to accept and require visibility in EPS accretion over the next several years to recapture the dilution.
Because the number of shares will be relatively fixed, the value of a transaction and the multiples the seller hopes to realize is a function of the buyer’s valuation. High multiple stocks can be viewed as strong acquisition currencies for acquisitive companies because fewer shares are issued to achieve a targeted dollar value.
However, high multiple stocks may represent an under-appreciated risk to sellers who receive the shares as consideration. Accepting the buyer’s stock raises a number of questions, most which fall into the genre of: what are the investment merits of the buyer’s shares? The answer may not be obvious even when the buyer’s shares are actively traded.
Our experience is that some, if not most, members of a board weighing an acquisition proposal do not have the background to thoroughly evaluate the buyer’s shares. Even when financial advisors are involved, there still may not be a thorough vetting of the buyer’s shares because there is too much focus on “price” instead of, or in addition to “value.”
A fairness opinion is more than a three or four page letter that opines as to the fairness from a financial point of a contemplated transaction; it should be backed by a robust analysis of all of the relevant factors considered in rendering the opinion, including an evaluation of the shares to be issued to the selling company’s shareholders. The intent is not to express an opinion about where the shares may trade in the future, but rather to evaluate the investment merits of the shares before and after a transaction is consummated.
Key questions to ask about the buyer’s shares include the following:
Liquidity of the Shares – What is the capacity to sell the shares issued in the merger? SEC registration and NASADQ and NYSE listings do not guarantee that large blocks can be liquidated efficiently. OTC traded shares should be scrutinized, especially if the acquirer is not an SEC registrant. Generally, the higher the institutional ownership, the better the liquidity. Also, liquidity may improve with an acquisition if the number of shares outstanding and shareholders increase sufficiently.
Profitability and Revenue Trends – The analysis should consider the buyer’s historical growth and projected growth in revenues, pretax pre-provision operating income and net income as well as various profitability ratios before and after consideration of credit costs. The quality of earnings and a comparison of core vs. reported earnings over a multi-year period should be evaluated. This is particularly important because many banks’ earnings in 2020 and 2021 have been supported by mortgage banking and PPP fees.
Pro Forma Impact – The analysis should consider the impact of a proposed transaction on the pro forma balance sheet, income statement and capital ratios in addition to dilution or accretion in earnings per share and tangible book value per share both from the seller’s and buyer’s perspective.
Tangible BVPS Earn-Back – As noted, the projected earn-back period in tangible book value per share is an important consideration for the buyer. In the aftermath of the GFC, an acceptable earn back period was on the order of three to five years; today, two to three years may be the required earn-back period absent other compelling factors. Earn-back periods that are viewed as too long by market participants is one reason buyers’ shares can be heavily sold when a deal is announced that otherwise may be compelling.
Dividends – In a yield starved world, dividend paying stocks have greater attraction than in past years. Sellers should not be overly swayed by the pick-up in dividends from swapping into the buyer’s shares; however, multiple studies have demonstrated that a sizable portion of an investor’s return comes from dividends over long periods of time. Sellers should examine the sustainability of current dividends and the prospect for increases (or decreases). Also, if the dividend yield is notably above the peer average, the seller should ask why? Is it payout related, or are the shares depressed?
Capital and the Parent Capital Stack – Sellers should have a full understanding of the buyer’s pro-forma regulatory capital ratios both at the bank-level and on a consolidated basis (for large bank holding companies). Separately, parent company capital stacks often are overlooked because of the emphasis placed on capital ratios and the combined bank-parent financial statements. Sellers should have a complete understanding of a parent company’s capital structure and the amount of bank earnings that must be paid to the parent company for debt service and shareholder dividends.
Loan Portfolio Concentrations – Sellers should understand concentrations in the buyer’s loan portfolio, outsized hold positions, and a review the source of historical and expected losses.
Ability to Raise Cash to Close – What is the source of funds for the buyer to fund the cash portion of consideration? If the buyer has to go to market to issue equity and/or debt, what is the contingency plan if unfavorable market conditions preclude floating an issue?
Consensus Analyst Estimates – If the buyer is publicly traded and has analyst coverage, consideration should be given to Street expectations vs. what the diligence process determines. If Street expectations are too high, then the shares may be vulnerable once investors reassess their earnings and growth expectations.
Valuation – Like profitability, valuation of the buyer’s shares should be judged relative to its history and a peer group presently and relative to a peer group through time to examine how investors’ views of the shares may have evolved through market and profit cycles.
Share Performance – Sellers should understand the source of the buyer’s shares performance over several multi-year holding periods. For example, if the shares have significantly outperformed an index over a given holding period, is it because earnings growth accelerated? Or, is it because the shares were depressed at the beginning of the measurement period? Likewise, underperformance may signal disappointing earnings, or it may reflect a starting point valuation that was unusually high.
Strategic Position – Assuming an acquisition is material for the buyer, directors of the selling board should consider the strategic position of the buyer, asking such questions about the attractiveness of the pro forma company to other acquirers?
Contingent Liabilities – Contingent liabilities are a standard item on the due diligence punch list for a buyer. Sellers should evaluate contingent liabilities too.
The list does not encompass every question that should be asked as part of the fairness analysis, but it does illustrate that a liquid market for a buyer’s shares does not necessarily answer questions about value, growth potential and risk profile. The professionals at Mercer Capital have extensive experience in valuing and evaluating the shares (and debt) of financial and non-financial service companies garnered from over three decades of business. Give us a call to discuss your needs in confidence.
When equity markets fell in early 2020 due to the onset of the COVID-19 global pandemic, many business owners and tax planners contemplated whether it was an opportune time to engage in significant ownership transfers. Although equity markets have recovered to all-time highs, a confluence of three factors may make 2021 an ideal time for estate planning transactions for owners of private companies:
Mercer Capital has been performing valuations for complicated tax engagements since its inception in 1982. For many high net worth individuals and family offices, complex ownership structures have evolved over time, typically involving multi-tiered entity organizations and businesses with complicated ownership structures and governance. In this article, we describe the processes that lead to credible and timely valuation reports. These processes contribute to smoother engagements and better outcomes for clients.
Defining the valuation project is an important step in every engagement process, but when multiple or tiered entities are involved, it becomes critical. It is insufficient to define a complicated engagement by referring only to the top tier entity in a multi-tiered organizational structure. The engagement scope should clearly identify all the direct and indirect ownership interests that will need to be valued. This allows the appraiser to plan the underlying due diligence and analytical framework to design the deliverable work product.
For example, will the appraiser need to perform a separate appraisal at each level of a tiered structure? Or, can certain entities or underlying assets be valued using a consolidated analytical framework? Planning well on the front end of an engagement leads to more straightforward analyses that are easier to defend.
During the initial discussion of the engagement, the appraiser will usually request certain descriptive and financial information (such as governing documents, recent audits, compilations, and/or tax returns) to determine the scope of analysis needed to render a credible appraisal for the master, top-tier entity and the underlying entities and assets.
Upon being retained, one of the first things an appraiser will do is to prepare a more comprehensive information request list designed to solicit all the documentation necessary to render a valuation opinion. Full and complete disclosure of all requested information, as well as other information believed pertinent to the appraisal, will aid the appraiser in preventing double-counting or otherwise missing assets all together.
Requested information for complex multi-tiered entity valuations typically falls into three
The ultimate efficiency of the project often hinges on timely receipt of all requested information. Disorganized information or data that requires a lot of handling or interpretation on the part of the appraiser adds to project cost, and more importantly, can make it harder to defend valuation conclusions that are later subject to scrutiny.
In short, providing high quality information in response to the appraiser’s request list promotes a more predicable outcome with the IRS and with other stakeholders.
Upon completing research, due diligence interviews with appropriate parties, and the valuation analysis, the appraiser should provide a draft appraisal report for review. The steps discussed thus far – careful planning and timely information collection – are not substitutes for careful review of the draft appraisal report. The complexity of many multi-tiered structures increases the need for relevant parties to review the draft appraisal for completeness and factual accuracy.
Engagements involving complicated entity and operational structures are not easily shoehorned into typical appraisal reporting formats and presentation. Unique entity and asset attributes may require complex valuation techniques and heighten the need for clear and concise reporting of appraisal results. Regardless of the
complexity of the underlying structure and valuation techniques, the appraisal report should still be easy to read and understand.
We recently wrote about the market approach, which is one of the three primary approaches utilized in business valuations. In this article, we’ll be presenting a broad overview of the income approach. The final approach, the asset-based approach, will discussed in a future article. While each approach should be considered, the approach(es) ultimately relied upon will depend on the unique facts and circumstances of each situation.
The income approach is a general way of determining the value of a business by converting anticipated economic benefits into a present single amount. Simply put, the value of a business is directly related to the present value of all future cash flows that the business is reasonably expected to produce. The income approach requires estimates of future cash flows and an appropriate rate at which to discount those future cash flows.
Methods under the income approach are varied but typically fall into one of two categories:
The question if often asked, which method should you use, or should you use multiple methods? Also, does one use single period methods, or multi-period method? It depends on the facts and circumstances, including but not limited to, whether the business is in a mature or growing business cycle, if budgets/projections are prepared in normal course of business, among other considerations. More importantly, the analyst must evaluate if trends analyzed from the business’ historical performance provide a reasonable indication of the future, and which methodology or methodologies best capture that future economic stream of benefits.
Before analyzing each method, it is important to start with normalizing adjustments, which serve as a foundation for both income approach methodologies. Normalizing adjustments adjust the income statement of a private company to show the financial results from normal operations of the business and reveal a “public equivalent” income stream. In creating a public equivalent for a private company, another name given to the marketable minority level of value is “as if freely traded,” which emphasizes that earnings are being normalized to where they would be as if the company were public, hence supporting the need to carefully consider and apply, when necessary, normalizing adjustments. There are two categories of adjustments.
Mercer Capital dives deep into this subject in this article, but here are some highlights. These adjustments eliminate one-time gains or losses, unusual items, non-recurring business elements, income/expenses of non-operating assets, and the like. Examples include, but are not limited to:
These adjustments relate to discretionary expenses paid to or on behalf of owners of private businesses. Examples include the normalization of owner/officer compensation to comparable market rates, as well as elimination of certain discretionary expenses, such as expenses for non-business purpose items (lavish automobiles, boats, planes, personal living expenses, etc.) that would not exist in a publicly traded company.
Once the analyst determines adjusted earnings, we can move forward to capitalizing these economic benefits.
The simplest method used under the income approach is a single period capitalization model. Ultimately, this method is an algebraic simplification of its more detailed DCF counterpart. As opposed to a detailed projection of future cash flow, a base level of annual net cash flow and a sustainable growth rate are determined.
The value of any operating asset/investment is equal to the present value of its expected future economic benefit stream.
If the growth in cash flows is constant, this can be simplified:
CF = Next year’s cash flow
g = perpetual growth rate
r = discount rate for projected cash flows
The denominator of the expression on the right (r – g) is referred to as the “capitalization rate,” and its reciprocal is the familiar “multiple” that is applicable to next year’s cash flow. The multiple (and thus the firm’s value) is negatively correlated to risk and positively correlated to expected growth. There are two primary methods for determining an appropriate capitalization rate—a public guideline company analysis or a “build-up” analysis (previous article by Mercer Capital where we discussed the discount rate in detail).
Businesses may be valued using the DCF method because this method allows for modeling of varying or near-term accelerated growth revenues, expenses, and other sources and uses of cash over a discrete projection period. Beyond the discrete projection period, it is assumed that the business will grow at a constant rate into perpetuity. As that point, the future beyond the projection period is capitalized as the terminal value and the method converges to the single period capitalization.
In circumstances where no changes in the business model or capital structure are expected, a single period capitalization method may be sufficient. Ultimately, the DCF’s output is only as good as its inputs, therefore, testing of assumptions and reasonableness is critical.
The discounted cash flow methodology requires assumptions, but the formula can be broken down to three basic elements:
Discrete cash flows are forecasted for as many periods as necessary until a stabilized earnings stream could be anticipated (commonly in the range of 3-10 years). Ideally, projections will be sourced from management, but if management projections are not available, a competent valuation professional may choose to develop a forecast based on historical performance, industry data, and discussions with management. It is important to test the reasonableness of the projections by comparing historical and projected performance as well as expectations based on the subject company’s history and the industry in which it operates.
A discount rate is used to convert future cash flows to present value as of the valuation date. Factors to consider include, but are not limited to business risk, supplier and/or customer concentrations, market and industry risk, size of the company, financial leverage, capital structure, among others. For a detailed look into discount rates, see a recent article published by Mercer Capital.
The terminal value captures the value of the company into perpetuity. It uses a terminal growth rate, the discount rate, and the final year cash flow to arrive at a value, which is discounted and added to the discrete cash flow projections.
The income approach can determine the value of an operating business using financial metrics, growth rate and discount rate unique to the subject company. However, each method within the income approach must be selected based on applicability and facts and circumstances unique to the matter at hand; thus, a competent valuation expert is needed to ensure that the methods are applied in a thoughtful and appropriate manner.
It may seem an odd time for some publicly traded companies to consider cash-out merger transactions because broad equity market indices are at or near record levels. Nonetheless, the changing market structure means some boards may want to consider it.
Among a small subset of public companies that may are those that are traded on OTC Markets Group’s Pink Open Market (“Pink”), the lowest of three tiers behind OTCQB Venture Market and OTCQX Best Market. Pink is the successor to the “pink sheets” which was published by a quotation firm that was purchased by investors who rechristened the firm OTC Markets Group.
Today, OTC Markets Group is an important operator in U.S. capital markets because it facilitates capital flows for 11,000 US and global securities that range from micro-cap and small-cap issuers across all major industries to ADRs of foreign large cap conglomerates. Many issuers are SEC registrants, too.
The issue that may cause some boards of companies traded on Pink to contemplate a cash-out merger or other transaction to reduce the number of shareholders is an amendment by the SEC to Rule 15c2-11, which governs the publication of OTC quotes and was last amended in 1991. Since then, markets and the public participation in markets have increased significantly as trading costs have declined and information has become more widely disseminated. The amendment applies only to Pink listed companies because those traded on OTCQB and OTCQX already meet the new requirements.
Because of a quirk in how the rule was written in conjunction with a “piggyback exception” for dealers, financial information for some Pink issuers is not publicly available. The amended rule, which goes into effect September 28, 2021, prohibits dealers from publishing quotes for companies that do not provide current information including balance sheets, income statements and retained earnings statements. OTC Markets Group requires companies to comply with the rule through posting information to the issuer’s publicly available landing page that it maintains.
While the disclosure requirement presumably is not burdensome, not all companies want to disclose such information, especially to competitors. Companies that choose not to comply with amended Rule 15c2-11 will no longer be eligible for quotation. Because shareholders of these companies historically have had the option to obtain liquidity, boards may want to evaluate an offer to repurchase shares or a cash-out merger transaction that reduces the number of shareholders.1
Also, some micro-cap and small-cap companies whether traded on an OTC market or a national exchange may not obtain as many advantages compared to a decade or so ago.
Given the rise of passive investing in which upwards of 50% of US equities are now held in a passively managed fund, companies that are not included in a major index such as the S&P 500, Russell 1000, NASDAQ or Russell 2000 are at a disadvantage given the amount of capital that now flows into passive funds. In some instances, it may make sense for these companies to go private, too.
Cash-out transactions can be particularly attractive for companies that have a high number of shareholders in which a small number of shareholders have substantial ownership. Cash-out merger transactions require significant planning with help from appropriate financial and legal advisors. The link here provides an overview of valuation and fairness issues to consider in going private and cash-out transactions for companies whether privately or publicly held.
Mercer Capital is a national valuation and financial advisory firm that works with companies, financial institutions, private equity and credit sponsors, high net worth individuals, benefit plan trustees, and government agencies to value illiquid securities and to provide financial advisory services related to M&A, divestitures, capital raises, buy-backs and other significant corporate transactions.
Going Private 2021 presentation by Mercer Capitals’, Jeff K. Davis, CFA, that provides an overview of issues surrounding a decision to take an SEC-registrant private.
In our last update regarding core deposit trends published in August 2020, we described a decreasing trend in core deposit intangible asset values in light of the pandemic. In response to the pandemic, the Fed cut rates to effectively zero, and the yield on the benchmark 10-year Treasury reached a record low. While many factors are pertinent to analyzing a deposit base, a significant driver of value is market interest rates. Although there has been some recovery in longer-term treasury rates since this time last year, shorter-term treasury rates (maturities of two years or less) have eased as investors concluded the Fed will not raise short-term policy rates in the near-term.
For the full year of 2020, bank M&A activity fell sharply to 111 announced transactions from approximately 250 to 300 transactions per year during 2014 to 2019. More deals have been announced in the first eight months of 2021 than were announced in all of 2020. As shown in Figure 2, on the next page, the majority of the 2021 announcements occurred in the second quarter.
With 63 announced deals, the second quarter of 2021 represented the highest level of quarterly deal announcements since the third quarter of 2019 (83 deals). For comparison, only nine whole-bank transactions were announced in the second quarter of 2020, representing the fewest deals announced during a quarter over the time period analyzed. At this time last year, there were several factors hindering deal activity. Unknowns surrounding credit quality and the severity of loan deferrals in the midst of the pandemic gave pause to many deal talks in progress prior to the pandemic. Constraints surrounding travel and due diligence also hampered activity.
Ultimately, credit losses were not as significant as were feared initially, and travel has begun to normalize in the wake of widespread vaccine distribution. As a result, there appears to be a degree of pent-up demand in the bank M&A market. Moreover, many of the factors driving acquisitions have intensified over the past year.
Revenue pressure is causing institutions to seek operational efficiencies via synergies, as loan growth (excluding PPP loans) has been exceptionally weak over the past year, deposit growth has been unprecedented, and interest rates remain near historic lows. Additionally, as more consumers adopted digital banking in a socially-distancing society, banks lacking capability in this arena saw a more acute need to seek partnerships with more technologically advanced institutions.
Using data compiled by S&P Capital IQ Pro, we analyzed trends in core deposit intangible (CDI) assets recorded in whole bank acquisitions completed from 2000 through June 30, 2021. CDI values represent the value of the depository customer relationships obtained in a bank acquisition. CDI values are driven by many factors, including the “stickiness” of a customer base, the types of deposit accounts assumed, and the cost of the acquired deposit base compared to alternative sources of funding. For our analysis of industry trends in CDI values, we relied on S&P Capital IQ Pro’s definition of core deposits.1 In analyzing core deposit intangible assets for individual acquisitions, however, a more detailed analysis of the deposit base would consider the relative stability of various account types.
In general, CDI assets derive most of their value from lower-cost demand deposit accounts, while often significantly less (if not zero) value is ascribed to more rate-sensitive time deposits and public funds, or to non-retail funding sources such as listing service or brokered deposits which are excluded from core deposits when determining the value of a CDI.
Figure 3, below, summarizes the trend in CDI values since the start of the 2008 recession, compared with rates on 5-year FHLB advances. Over the post-recession period, CDI values have largely followed the general trend in interest rates—as alternative funding became more costly in 2017 and 2018, CDI values generally ticked up as well, relative to post-recession average levels.
Throughout 2019, CDI values exhibited a declining trend in light of yield curve inversion and Fed cuts to the target federal funds rate during the back half of 2019. This trend accelerated in March 2020 when rates were effectively cut to zero. CDI values have shown some recovery in the past two quarters (average of 60 basis points for the first half of 2021 as compared to 50 basis points in the second half of 2020). Despite the recent uptick, CDI values remain below the post-recession average of 1.33% in the period presented in the chart and meaningfully lower than long-term historical levels which averaged closer to 2.5-3.0% in the early 2000s.
The average CDI value declined 11 basis points from June 2020 to June 2021, while the five year FHLB advance increased 25 basis points over the same period. Although the five year FHLB advance rate has increased year-over-year, rates on FHLB advances with terms of less than two years have declined an average of 11 basis points since this time last year.
Since the beginning of the pandemic, banks have been burdened with an excess of deposits. It was initially expected that the increase in deposits would be transient in nature as the economy re-opened, PPP funds were spent or invested, and consumer confidence improved. However, the glut of deposits has endured, and deposits at US commercial banks were at a record level of $17.3 trillion at the end of July despite earning historically low deposit rates. Weak loan demand has aggravated the issue for banks, and margin pressure remains a very real concern for financial institutions.
In past cycles, when interest rates declined, the change in the CDI/core deposit ratio was mostly caused by lower CDI values (the numerator in the ratio). In the pandemic, though, CDI values declined (due to lower rates) while core deposits increased (due to the governmental response to the pandemic among other factors). With market participants unwilling to pay a premium for potentially transient deposits, the CDI/core deposit ratio was squeezed by both lower CDI values (the numerator) and higher core deposits (the denominator). Time will tell how stable deposits will be after the deposit influx experienced in 2020 and the first half of 2021, which will affect CDI values going forward.
Core deposit intangible assets are related to, but not identical to, deposit premiums paid in acquisitions. While CDI assets are an intangible asset recorded in acquisitions to capture the value of the customer relationships the deposits represent, deposit premiums paid are a function of the purchase price of an acquisition. Deposit premiums in whole bank acquisitions are computed based on the excess of the purchase price over the target’s tangible book value, as a percentage of the core deposit base.
While deposit premiums often capture the value to the acquirer of assuming the established funding source of the core deposit base (that is, the value of the deposit franchise), the purchase price also reflects factors unrelated to the deposit base, such as the quality of the acquired loan portfolio, unique synergy opportunities anticipated by the acquirer, etc.
Additional factors may influence the purchase price to an extent that the calculated deposit premium doesn’t necessarily bear a strong relationship to the value of the core deposit base to the acquirer. This influence is often less relevant in branch transactions where the deposit base is the primary driver of the transaction and the relationship between the purchase price and the deposit base is more direct. Figure 4 presents deposit premiums paid in whole bank acquisitions as compared to premiums paid in branch transactions.
As shown in Figure 4, deposit premiums paid in whole bank acquisitions have shown more volatility than CDI values. Deposit premiums in the rangeof 6% to 10% remain well below the pre-Great Recession levels when premiums for whole bank acquisitions averaged closer to 20%.
Deposit premiums paid in branch transactions have generally been less volatile than tangible book value premiums paid in whole bank acquisitions. Branch transaction deposit premiums averaged in the 4.5% to 7.5% range during 2019 and 3.0% to 7.5% during 2020, up from the 2.0% to 4.0% range observed in the financial crisis. Only eight branch transactions were completed in the first half of 2021, but the range of their implied premiums is in line with 2019 and 2020 levels.
Some disconnect appears to exist between the prices paid in branch transactions and the CDI values recorded in bank M&A transactions. Beyond the relatively small sample size of branch transactions, one explanation might be the excess capital that continues to accumulate in the banking industry, resulting in strong bidding activity for the M&A opportunities that arise–even in situations where the potential buyers have ample deposits.
Based on the data for acquisitions for which core deposit intangible detail was reported, a majority of banks selected a ten-year amortization term for the CDI values booked. Less than 10% of transactions for which data was available selected amortization terms longer than ten years. Amortization methods were somewhat more varied, but an accelerated amortization method was selected in approximately half of these transactions.
For more information about Mercer Capital’s core deposit valuation services, please contact one of our professionals.
In each “Meet the Team” segment, we highlight a different professional on our Family Law team. The experience and expertise of our professionals allow us to bring a full suite of valuation and forensics services to our clients. We hope you enjoy getting to know us a bit better.
Scott Womack: I started doing divorce work about 13 years ago. Personally, I have found this work to be very rewarding. Divorce clients are very appreciative and I feel like I am making a difference as their Trusted Advisor throughout the process, but especially in mediation or during the trial. Often the non-business or out-spouse is not directly involved in the couple’s business and doesn’t know the value of the business or understand the process of valuation. These clients look to us to educate them and guide them through the process. Business owners or the in-spouse also see us as a value-add to the process, as they may have not gone through the business valuation process during their ownership of their company.
Scott Womack: More often than not, I am involved in family law/divorce cases. The cases generally involve high wealth individuals and those that own businesses or business interests. In addition to the valuation and forensic work, I also participate in mediation to assist the client in an attempted settlement. If mediation is not successful, I generally submit a formal report to the Court and do testimony work at trial. Other litigation projects include breach of contract or shareholder disputes.
Scott Womack: A forensic credential allowed me to better analyze financial statements in divorce. Credentials help to frame your expertise and demonstrate your general ability to do your work. In a lot of divorce cases, especially if you are valuing a business, there can be forensic work. One example would be discretionary or personal expenses being paid through the business, which can have an impact on the value of the business as well as implications in the divorce such as possible dissipation or income available for support.
Scott Womack: Early in my career, the industry was comprised mostly of valuation generalists. In the early 2000s, financial statement reporting and valuations took on a whole new life of their own with purchase price allocations and stock based compensation. At this point, the valuation profession kind of exploded to become more specialized. We have people that now specialize in a specific service, be it divorce, financial statement reporting, or a particular industry. That is really what I have seen change. The movement from generalization to specialization. Especially for growth in your career, specialization is a great avenue for advancement by being able to be an expert in a field.
Scott Womack: I had a partner at my old firm who had several auto clients and I often got to work on those engagements. Some of these cases were related to divorce so I was able to see the litigation side as well. The Auto Dealership industry has some unique characteristics in its financial statements and operations. After being exposed to these differences I saw an opportunity to make an impact in this industry. I would be able to specialize in this area in order to provide the best valuation services possible.
Scott Womack: The financial statements are pretty unique in the Auto Dealership industry. Dealers have to submit monthly financials to manufacturers, and each manufacturer statement looks a little different, almost like trying to solve a puzzle. Due to the specialization and profit centers of the various departments, these statements have a lot of detail. They are very informative with not only the major categories like assets, liabilities, and revenues, but you can determine the size the service department or how many used vehicles they sold, what they’re selling them for, or how much inventory they have on the lot.
Not only do auto dealerships have to submit monthly statements, but some also report a thirteenth month statement. The thirteenth month takes the twelfth month with added year-end tax adjustments, normalization adjustments, etc. Furthermore, there is unique terminology in this industry. An example would be, “Blue-Sky”, which is the goodwill value of the dealership. It can encompass a number of factors and the Blue Sky value is often very meaningful to a dealer requesting a valuation.
There are also nuances in ownership and management that are important to know, as well as different valuation techniques and methodologies that are preferred. Someone specialized in this industry is better equipped to know what a client is looking for. I have found that my experience valuing auto dealerships has given me an advantage in knowing what to look for and what questions to ask.
Scott Womack: I have always enjoyed that the valuation and consulting business is project-based. On a project basis, you are able to work with different owners and different industries all across the board. One of my favorite parts of a project is conducting the management interviews and site visits. While the financial statements paint a picture and supply the quantitative results of operations, the management interviews provide much of the qualitative factors and allow you to gain an understanding of the company, the industry and the risk factors that they face. I enjoy meeting different business owners and learning about their successful companies and history.
In the previous article, we highlighted the various benefits of hiring a financial advisor when investigating the potential sale of a business.
In a transaction with an outside party, the buyer will almost always be far more experienced in “deal-making” relative to the seller, who often will be undertaking the process for the first (and likely only) time. With such an imbalance, it is important for sellers to level the playing field by securing competent legal, tax and financial expertise.
A qualified sell-side advisor will help ensure an efficient process while also pushing to optimize the terms and proceeds of the transaction for the sellers.
As with anything in this world, favorable transaction processes and outcomes require an investment. Fee structures for transaction advisory services can vary widely based on the type and/or size of the business, the specific transaction situation, and the varying roles and responsibilities of the advisor in the transaction process.
Even with this variance, most fee structures fall within a common general framework and include two primary components: 1) Project Fees and 2) Success Fees.
Project fees are paid to advisors throughout an engagement for the various activities performed on the project. Such activities include the initial valuation assessment, development of the Confidential Information Memorandum, development of the potential buyer list, and other activities. These fees generally include an upfront “retainer” fee paid at the beginning of the engagement.
Retainer fees serve to ensure that a seller is serious about considering the sale of their business. For lower middle market transactions, the upfront retainer fee is typically in the $10,000 to $20,000 range.
Often times, a fixed monthly project fee will be charged throughout the term of the engagement. These fees are meant to cover some, but not all, of an advisor’s costs associated with the project.
For lower middle market transactions, monthly fees are typically $5,000 to $10,000. In certain situations, the engagement will include hourly fees paid throughout the engagement for the hourly time billed by the advisor. Such hourly fees are billed in place of a fixed monthly project fee.
Hourly fees are typically appropriate when the project is more advisory-oriented versus being focused on turn-key transaction execution. Hourly fees serve to emphasize the objective needs of the client by counter-balancing the incentive for an advisor to “push a deal through” that may not be in the best long-term interests of the client.
An hourly fee structure typically front loads the fees paid throughout the transaction process and is paired with a reduced success fee structure at closing which brings total fees back in line with market norms.
Mercer Capital has had favorable outcomes with numerous clients when fee structures are well-tailored to the facts and circumstances of the seller and the seller’s options in the marketplace.
A success fee is paid to a transaction advisor upon the successful closing of a transaction. Typically, success fees are paid as part of the disbursement of funds on the day of closing. As with project fees, success fees can be structured in a number of different ways.
A simple approach is to apply a flat percentage to the aggregate purchase price to calculate the success fee. The use of a flat percentage fee seems to have increased in recent years, and makes a fair bit of sense as it allows the client to clearly understand what the fees will look like on the back-end of a transaction.
Traditionally, the most used success fee structure employs a waterfall of rates and deal valuation referred to as the Lehman Formula. This formula calculates the success fee based on declining fee percentages applied to set increments (“tranches”) of the total transaction purchase price.
For lower middle market transactions, the simplest Lehman approach is a 5-4-3-2-1 structure: 5% on the first million dollars, 4% on the next million, and so on down to 1% on any amount above $4 million. The Lehman Formula, which can be applied using different percentages and varying tranche amounts, pays lower percentages in fee as the purchase price gets higher. Smaller deals may include a modified rate structure (for example 6-5-4-3-2) or may alter the tranche increments from $1 million to $2 million.
The Lehman Formula, in its varying forms, has been utilized to calculate transaction advisory fees for decades. While the formula may add some unnecessary complexities to the calculation (versus say a flat percentage), it has proven over time to provide reasonable fee levels from the perspective of both sell-side advisors and their clients.
A success fee can also be structured on a tiered basis, with a higher percentage being paid on transaction consideration above a certain benchmark. If base-level pricing expectations on a transaction are $15 million, the success fee might be set at 2.5% of the consideration up to $15 million and 5% of the transaction consideration above this level. If the business were sold for $18 million, the fee would be 2.5% of $15 million plus 5% of $3 million. The blended fee in this case would total $525,000, a little under 3% of the total consideration.
Escalating success fees are often favored by clients because they provide an incentive for advisors to push for maximized deal pricing rather than settling for an easier deal at a lower price.
Transaction advisory fees, on a percentage basis, tend to be higher for smaller transactions and decline as the dollars of transaction consideration increases. Various surveys of transaction advisors are available online that suggest typical fee ranges.
Consensus figures from these sources are outlined below. Based on our experience, these “typical” ranges (or at least the upper end of each range) appear to be somewhat inflated relative to what most business owners should expect in an actual transaction advisory engagement.
At Mercer Capital, we tailor fees in every transaction engagement to fit both the transaction situation at hand and our client’s objectives and alternatives.
In situations where a client has an identified buyer, we understand that our role will likely be focused on valuation and negotiation. Many sellers are unaware that price is only one aspect of the deal, and terms are another. Altering the terms of a definitive agreement can move the needle by 5%-10% and can potentially accelerate end-game liquidity by 6 to 12 months.
Accordingly, we design each fee structure to recognize what we are bringing to the process, typically utilizing some combination of hourly billings and a tiered success fee structure on the portions of the deal where our services are making a difference in the total outcome.
If we are assisting a client through a full auction process, it may be appropriate to utilize a more traditional Lehman Formula or a flat percentage calculation. A primary focus of our initial conversations with a potential client is to understand the situation in detail so that we can develop a fee structure that ensures that the client receives a favorable return from their investment in our services.
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.
Mercer Capital leverages its historical valuation and investment banking experience to help clients navigate critical transactions, providing timely, accurate, and reliable results. 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. We recommend to clients to accept the right deal or no deal at all.
Our dedicated and responsive team is available to manage your transaction process. To discuss your situation in confidence, give us a call.
In December 2020, the Securities and Exchange Commission (“SEC”) adopted a new rule 2a-5 to update the regulatory framework around valuations of investments held by a registered investment company or business development company (“fund”). Boards of directors of funds are obligated to determine fair value of investments without readily available market quotations in good faith under the Investment Company Act of 1940 (“Act”).
Rule 2a-5 specifies requirements to fulfill these obligations. Concurrently, the SEC also adopted rule 31a-4, which provides recordkeeping requirements related to fair value determinations. Rule 2a-5 was effective as of March 2021, and funds are required to be compliant upon the conclusion of an 18-month transition period following the effective date (voluntary early compliance allowed).
Prior to adopting rule 2a-5, the SEC last addressed valuation practices under the Act more than 50 years ago. Over the intervening period, the variety of securities and other instruments held by investment funds has proliferated. The volume and type of data used in valuations have also increased. Funds increasingly use third-party services to provide pricing information, especially for relatively illiquid or otherwise complex assets. In addition, accounting standards and regulatory requirements have advanced including developments related to ASC 820, Fair Value Measurement.
Against this backdrop, rule 2a-5 establishes a framework consisting of four primary functions required to determine fair value in good faith. A fund board may choose to determine fair value by executing the functions. Rule 2a-5 also allows a fund board to designate these functions to a “valuation designee.” The required functions are:
When fair value determinations are made by a valuation designee, which can be the fund adviser or an officer of an internally managed fund, the board is required to actively oversee the valuation designee’s work and compliance with the rule. In general, rule 2a-5 limits possible designees to entities that that have a fiduciary duty to the fund. While the adviser may have some conflicts, the fiduciary obligation to the fund would ensure that the valuation designee acts in the fund’s best interest and mitigates or discloses conflicts. The rule states that fund boards should approach oversight of the valuation designee’s work with a skeptical and objective view that considers valuation risks, the appropriateness of the valuation process, and the skill and resources devoted to the endeavor. In order to assist the fund board in its oversight function, a valuation designee is required to present both annual and quarterly written reports to the board.
Quarterly reports should include:
Annual reports should include:
In addition to periodic reporting to the fund board, the valuation designee is required to state the titles of the persons responsible for the valuation of portfolio investments. The valuation designee should also reasonably segregate fair value determinations from the portfolio management of the fund so that the portfolio manager does not determine or exert influence on the valuation of portfolio investments.
Rule 2a-5 updates decades-old valuation guidance from the SEC for investment funds. Fund boards have the primary responsibility to adhere to the valuation framework outlined in the rule. When a valuation designee performs these functions, active oversight is required of the board. The rule prescribes a framework that emphasizes understanding and managing risks around conflicts of interest and promotes a principles-based valuation regime that aligns with recent accounting and regulatory developments, notably ASC 820.
Originally published in the Portfolio Valuation: Private Equity and Credit, Third Quarter 2021.
COVID-19 has had a lasting impression on many industries throughout the world, but the U.S. trucking and transportation industry was among the first industries to feel the impact of the pandemic.
Lockdowns in China (initiated in December 2019) began affecting the U.S. trucking industry in very early 2020 as Chinese imports account for nearly 40% of all shipments entering the U.S. By the beginning of March, the U.S. had already begun to see massive declines in incoming freight with an escalation of shipping cancellations. The ports of Seattle and Long Beach experienced 50-60 container shipment cancellations reflecting declines of 9% relative to the prior year.
When discussing the decline of imports in the port of Seattle, Sheri Call of the Washington Trucking Association said, “That’s the kind of decline we’d normally see over the course of an entire year.” Disruption of international trade led to transportation companies reducing capacity as early as the beginning of March. Outbound rail and trucking shipments from LA dropped 25% and 20% respectively, in March 2020.
Due to social distancing requirements throughout the United States, many roadside eateries and rest areas were closed in the first several months of the pandemic, which reduced truck drivers’ access to food and other necessities for long days on the road. Trucking companies were forced to alter their transportation network, frequently carrying empty loads as a result of uneven and declining demand. According to Reuters, “trucks hauling food and consumer products north to the United State are returning empty to Mexico where mass job losses have hit demand, leaving cash-strapped truckers to log hundreds of costly, empty miles.” Empty loads increased nearly 40% worldwide in the immediate aftermath of the lockdown.
An indication of the health of U.S. trucking industry can be seen through the ratio of full north bound trips to full southbound trips at the Mexico-US border. The ratio is typically one full southbound trip to every three full northbound trips, but the ratio began to lean closer to a one to seven ratio during the pandemic with the remainder being empty or partially full. Additionally, new freight contracts have fallen 60% to 90% since the rise of COVID-19 in 2020.
Increased online shopping from consumers has led to a spike in demand for last-mile delivery services. Amazon reported $75.5 billion in 2020 first-quarter sales which was a 26% increase from the first quarter of 2019. Many last-mile delivery companies like FedEx and Amazon continued to hire workers with Amazon seeing an increase in company employment of nearly 175,000 workers from March to April of 2020. Last-mile delivery carriers also eliminated signature requirements so that they can now achieve a “contactless” delivery process.
The level of domestic industrial production is correlated to the demand for services within the transportation industry. The Industrial Production Index is an economic measure of all real output from manufacturing, mining, electric, and gas utilities.
Lockdowns that began in March of 2020, as a result of the pandemic, led to a sharp decline in the Industrial Production Index. The index began a rapid recovery during the summer months of 2020. At the end of the first quarter of 2020, the Industrial Production Index saw a quarter-over-quarter decrease of 16.7% while also being down 17.7% on a year-over-year basis. The index rebounded in the second quarter of 2020 with a quarter-over-quarter increase of 12.7%. The index continually increased over the last three quarters of 2020, but it had not reached pre-pandemic levels as of April 2021.
The outlook for the trucking industry at the beginning of 2020 was promising with economists predicting that freight rates would grow 2% over the course of the year. Strong economic growth in the first two months of 2020 was halted by the outbreak of the unforeseen pandemic. The impact was dramatic – though not entirely negative for all carriers. Carriers of essential goods like groceries, cleaning supplies, and medical supplies experienced skyrocketing demand for their services while industrial, manufacturing, and other non-essential carriers are still undergoing lasting effects from the pandemic.
One non-essential industry that experienced a downward turn at the onset of the pandemic was the vehicle shipping services industry. A strong economy with high disposable income and consumer confidence ramped up consumer spending for the American automobile industry in the periods leading up to the pandemic.
The industry’s growth prospects were halted during 2020 due to a high unemployment rate and a drop-off in disposable income. The success of the vehicle shipping services industry is closely intertwined with new car sales and consumer confidence. The graph below shows the relationship between revenue of the vehicle shipping services industry and new car sales and consumer confidence. Overall, decreased consumer confidence in 2020 led to many Americans electing to defer vehicle upgrades, which created a major economic downturn for the vehicle shipping services industry.
With many businesses closed, overall Cass Freight trucking shipments plummeted, seeing a decrease of 15.1% and 22.7% from April 2019 to April 2020. Truck tonnage also dropped 9.3% on a from March 2020 to April 2020 while declining 8.90% from April 2019 through April 2020.
The fall of the number of shipments along with overall truck tonnage caused transportation companies to lower contract and spot rates. Flatbed and reefer rates hit a five-year low in April of 2020, though they rapidly recovered and had surpassed pre-pandemic rates by the fourth quarter of 2020. Truck tonnage has not recovered at the same rate as spot and contract pricing and had not reached pre-pandemic levels by March 2021. These trends are reflected in the Cass Freight and Shipment Indices. While the Shipments index has increased relative to its April 2020 level and has surpassed pre-pandemic levels, the Expenditures index increased over 27% from March 2020 through April 2020.
Even though contract rates did not have as sharp of a decline in March of 2020 as spot rates, both experienced a drop-off at the onset of the pandemic. Spot rates dropped below numbers that had been seen in recent years. After the sharp decline of spot rates in March, rates for all categories began to steadily increase. Rates hit a seasonal decline at the end of December due to decreased consumer spending after the holiday season. Rates resumed their climb during the first months of 2021. Overall, the rising price of contract and spot rates spins a positive image for overall outlook of the trucking industry, while also encouraging new competition to enter the market.
At the beginning of 2020, there were strong predictions for revenue in both the long distance and local trucking industries. Once the COVID-19 pandemic hit, revenues for both parts of the trucking industry dropped along with future revenue predictions. After a few months of lockdowns, the trucking industry began a rapid rebound as a result of businesses reopening and increased online retail. Future revenue predictions from March and April of 2021 from both the long distance and local sectors exceed predictions made in October 2020.
Industrial production and consumer spending, spurred on by the substantial stimulus programs enacted by federal government, have recovered more rapidly than initially expected. This rapid recovery has seemingly reduced the expected long-term impacts of COVID-19 on the long-distance and local trucking industries.
The effects of rising trucking rates and revenues coupled with optimistic outlooks for both categories can be seen in the number of long-distance and local trucking establishments. Lured in by appealing spot and contract rates, March 2021 predictions for the number of establishments in the trucking industry look to be on the rise. Naturally, there was a drop-off in the number of establishments in 2020, but the industry seems to have recovered with numerous new entries into the market in 2021. The long-distance trucking industry is projected to have more than one hundred thousand more establishments than originally forecasted in January of 2020.
While many business owners have a general sense of what their business may be worth and a threshold selling price in mind, going at it alone in a transaction process involves more than a notion on pricing – it involves procedural awareness, attention to detail, as well as a good measure of patience despite the desire for an immediate outcome.
In most external transactions (i.e., a business owner selling to a third party rather than to family or employees) there is an acute imbalance of savvy and experience between buyers and sellers. For certain sellers who owe their business successes to personal effort, brute force, and honed skills, it’s a difficult decision and an act of faith to turn the business asset over to an advisory team.
Buyers, both financial or strategic in nature, have completed many transactions while most sellers have never bought or sold a business. Given this near universal lop-sidedness in experience and resources, sellers need to assemble a team of experienced advisors to assist in navigating unfamiliar terrain. The time intensity and distractions of the process can cause the business to suffer if ownership sacrifices on operational oversight and foregoes the attention to detail that made the business an attractive acquisition target in the first place.
We strongly recommend hiring a full transaction team composed of, at a bare minimum, three primary players:
By securing a turnkey transaction team, business owners benefit from the multi-perspective expertise and overlapping skillsets of the team. The diversity and breadth of the team often facilitates proactivity and response capability for a wide variety of developments that can derail or compromise the timing, process and financial outcome of the final deal.
The following are a few of the many benefits of hiring a qualified sell-side advisor to assist in the transaction process.
The core components and key terms of a transaction are often complicated and sometimes deceptively obscured in the legal rhetoric of an LOI, APA or SPA. Hiring a sell-side advisor with the right experience and expertise can help business owners maximize the net proceeds from the transaction. Financial intricacies and other points of negotiation, such as working capital true-ups or contingent consideration arrangements, often require careful analysis and modeling in order to foster clear decision making regarding competing and differently structured deals.
A good sell-side advisor encourages objective comparative assessment of competing offers, negotiates key points, and helps acclimate sellers to certain realities of getting a deal done.
Sell-side advisors have years of experience reviewing purchase agreements and will work with ownership’s legal counsel to ensure the transaction documents accurately reflect the agreed upon value and terms. These documents can often be cumbersome and need to be reviewed and crafted with the utmost attention to detail. Experienced advisors can help streamline the fine-tuning of these documents to assist the business owner(s) in negotiating favorable (or acceptable) terms of sale.
At some point in most deals, a seller has to pick the fights worth fighting and concede on those terms that aren’t likely to change or have no real benefit. A good advisor should be frank and forthright with sellers, even when the recommendations or choices are not entirely satisfying. Sellers must be aware that a buyer needs a few wins and concessions to justify their investment. An informed seller, using the advice of a good seller representative, can better identify and prioritize the issues that impact the deal.
Seasoned sell-side advisors have often worked on hundreds of transaction engagements. This range of experience can be of great help if and when unexpected issues arise, and unexpected issues almost always arise. Sell-side advisors will work with the rest of the transaction team to manage these issues and provide the information necessary to make critical decisions regarding proposed solutions with the end-goal of driving a transaction to closure.
Revealing a contemplated transaction to your employees and stakeholders can often lead to undue stress, which compounds the strain already present on ownership and management during a transaction process. With the help of a sell-side advisor, ownership and management can maintain their focus on running the business and generating profits while knowing that the transaction process is progressing in the background.
Ownership can also gain peace of mind in knowing that the transaction will become “public information” at the appropriate time, which allows the business to function normally throughout the entire process. Many of the delays and sensitivities involved in the selling process, represent the potential for unexpected breaches of information to employees and other stakeholders. Owners can avoid many water cooler dilemmas by using an outside representative who collects, organizes, and disseminates information and manages exchanges between the parties.
Admittedly, we are valuation and transaction advisory providers – go figure, that our advice is to retain us, if you desire strong representation that we believe will pay for itself. If you have a good business asset to sell, it’s likely you have been highly concentrated in your capital investments and your personal efforts to create that wealth. Selling such an asset is not only the opportunity to diversify your wealth but to outsource much of the pain and worry that accompanies the process of selling.
Mercer Capital offers a seasoned bench of professionals with a diversity of experience unmatched by most pure-play brokers and M&A representatives. We combine top-shelf valuation competency with a vast array of litigation, transaction advisory and consulting experience to facilitate the best available strategic outcomes for our clients. To discuss your situation in confidence, give us a call.
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 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.
The 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.
Many 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.
As 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.
We 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.
When 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.
A 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.
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 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.
In 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.
A 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.
Financial 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:
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.
An 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.
A truck driver’s lifestyle is typically portrayed as being lackluster due to exhausting work hours and countless days away from home. As a result of the work environment for a driver, prospects debating entering the labor force in this career field ponder whether driving would be an enjoyable lifestyle. Due to the notion that the younger generation typically finds a career path in trucking unappealing, the demographics of this industry lean towards older males with 27% of truck drivers being over the age of 55 and the median age being 46.
Once the COVID-19 pandemic hit the United States in 2020, the demand for truck drivers increased sharply as many consumers turned towards online shopping. Even though trucking services were in high demand, the trucking industry struggled to grow its workforce during this time period.
Many eligible drivers elected to enter early retirement rather than waiting to return to work at the conclusion of the pandemic. Additionally, many prospects in the job market feel that they can achieve better working conditions and benefits along with similar wages working somewhere besides the transportation industry. Driver turnover is another factor that contributes to the abundance of available positions. Historically, truck drivers have a yearly turnover rate of 87%. During the 4th quarter of 2020, truck driver turnover reached 92%. High turnover rates coupled with mediocre working conditions have directly contributed to the current driver shortage that the United States is facing today. We last looked at this driver shortage in December 2018 – the situation has not changed and driver hiring and retention remains a concern for many trucking companies.
Logistics companies have been forced to raise wages for their current drivers. Many have seen wage increases of up to 50% since 2018 due to lack of available drivers throughout the U.S. Leah Shaver, CEO of the National Transportation Institute told Transport Topics that the ongoing duration of driver shortage is leaving companies with no choice but to raise pay. “For the last few weeks, it seems every couple of hours, some fleet is increasing pay,” she said. “The fleets are telling us because capacity is so tight, they could do four times the amount of work, if only they had enough drivers.” It harkens back to basic supply and demand – increasing wages for truck drivers is an approach that many transportation companies have instituted in order to fill vacant driver positions.
Hiking wages for drivers has had a serious economic impact on the economy. Elevated wages for drivers have forced retailers to increase their prices. Retailers reason that they must raise their prices as a result of the increased shipping costs so that they can maintain their current profit margins. As a result, the consumer price index has been steadily on the rise every month in 2021. The CPI surged 4.2% in April, 2021, causing it to reach a 13 year high surpassing pre-Recession levels. For the 12 months ending March 31, 2021, the CPI increased 2.6% overall, with food prices seeing a rise of 3.5% and energy prices skyrocketing 13.2%.
This will be a three part series where we focus on key areas to assist family lawyers and divorcing parties.
Form 1040 is used by taxpayers to file an annual income tax return. It calculates the total taxable income of the taxpayer(s) and determines the amount that should be paid or refunded. There are five filing statuses – single, married filing jointly, married filing separately, head of household, and qualified widow(er) with dependent children.
Form 1040 provides a general understanding of a taxpayer’s financial status and can be a guide to finding additional information about one’s finances. It can serve as a starting point to get a picture of an individual’s (or couple’s) income(s), assets and liabilities, and lifestyle. Form 1040 is supplemented with additional schedules and documentation which lend detail and insight into one’s lifestyle and financial matters. Ultimately, for divorce purposes, multiple years of tax returns should be reviewed and can be a source of inputs for the marital estate subject to division, as well as data for further financial analyses like income determination and lifestyle analysis/pay and need analysis.
Below is a snapshot from Form 1040:
Line 1: Wages, Salaries, and Tips – Line 1 details wages, salaries, and tips. This amount should match the income reported in Box 1 of the Form W-2. The amount on Line 1 is not gross income. It is likely that there are pre-tax deductions, such as contributions to a 401(k) account. You should refer to the underlying W-2(s) for more information about these deductions as well as gross income.
Line 2 & Line 3: Interest and Dividends – An entry in Line 2 indicates interest income, while an entry in Line 3 indicates dividend income. Both point to ownership of assets and documentation of these assets should be requested. Furthermore, income earned from interest and dividends can be considered as a source of income when calculating spousal and child support. Details about interest and dividend income can be found on Schedule B, Form 1099-INT, and Form 1099-DIV
Line 4: IRA Distributions – An entry in Line 4 shows distribution from an individual retirement account, signaling that the taxpayer has an IRA account and documentation of these assets should be requested. A withdrawal from a retirement account may also point to possible dissipation of marital assets, if not readily identifiable or available by account documentation. Details about retirement distributions are on Form 1099-R.
Line 5: Pensions and Annuities – An entry in Line 5 indicates existence of pensions and annuities, which may be wholly or partially marital property. These must be carefully considered for property division as well as sources of income when calculating spousal and child support.
Line 6: Social Security Benefits – Like pensions, Social Security benefits should be considered as sources of income when calculating spousal and child support. Details can be found on Form SSA-1099, which is a form provided to the taxpayer who receives these benefits. Estimates of an individual’s future monthly payments can be extracted from the Social Security Administration website.
Line 7: Capital Gains or Losses – Line 7 indicates capital gains or losses, which means that an asset (or multiple assets) was sold and some sort of monies were made or lost on the transaction. Not only does this information indicate ownership of assets, it can also be important in tracing analyses as well as other forensic analyses when reviewing several years of tax returns. Details can be found in Schedule D and Form 8949.
Line 8: Other Income – An entry in Line 8 should be further reviewed as it often indicates income from gambling winnings or other unusual sources (for example, prizes, jury duty pay, or the taxable portion of disaster relief payments). Information about the sources of other income can be found in Form 1099-MISC (miscellaneous income) or Form W-2G (which is a form that records gambling winnings). However, these incomes are typically not recurring in nature, and are not always reported which may require scrutiny and potential forensic analyses.
Line 9: Total Income –This line is the summation of above lines and yields total income of the taxpayer and can give you information about how the taxpayer earns their income. This number may be used when determining spousal or child support as it does not include any adjustments.
Line 11: Adjusted Gross Income – Adjusted Gross Income (AGI) is the amount used to determine one’s taxable income. The AGI is total income less adjustments. A few common adjustments are deductions for educator expenses, health savings account deductions, and student loan interest deductions. Many of these adjustments are optional, and excessive use could potentially be used to skew spousal or child support amounts. Therefore, gross income (line 9) is often considered over AGI when determining spousal or child support amounts. More information on the adjustments claimed can be found on Schedule 1.
Line 13: Qualified Business Income (QBI) Deduction – If the taxpayer is taking this deduction, it indicates that they own a business, which should lead to requests for related business documents. The QBI deduction is for pass-through businesses, and therefore a Schedule C or Schedule K-1 should also be included with the tax return. Examples of pass-through businesses are sole proprietorships, LLCs, partnerships, and S-Corporations.
Line 37: Amount You Owe Now – Line 37 indicates the incremental amount owed based on the total tax liability less any federal tax withholding, estimated payments, and credits. Reviewing the amount owed or amount to be refunded over several years can potentially uncover intentional over or under payment. However, business owners or self-employed individuals who pay quarterly taxes may have fluctuating incomes from year to year. It is important to understand that quarterly tax payment estimates are based on prior year realized income levels, which may or may not be the reason for over or under payment. A financial expert can accurately assess these types of scenarios.
Knowing how to navigate key areas of Form 1040 can be quite useful in divorce proceedings. Information within the tax return can provide support for marital assets and liabilities, determination of spousal and child support, and potential further analyses. Reviewing multiple years of tax returns is typical as multi-year overviews may reveal trends, provide helpful information, and may even indicate the need for potential forensic investigations.
While we do not provide tax advice, Mercer Capital is a national business valuation and financial advisory firm and we provide expertise in the areas of financial, valuation, and forensic services.
Stay tuned for the upcoming Parts II & III, where we will focus on details from various schedules of the tax return, including those unique and specific to business ownership.
It is imperative for estate planners to engage valuation analysts that perform the proper procedures and follow best practices when performing valuations for gift and estate planning purposes. It is necessary to have a well-supported valuation because these reports are scrutinized by the IRS and may end up going to court. The recent decision by the U.S. Tax Court in Estate of Michael J. Jackson v. Commissioner provides several lessons and reminders for valuation analysts, and those that engage valuation analysts, to keep in mind when performing valuations for gift and estate planning purposes.
Michael Jackson, the “King of Pop,” passed away on June 25, 2009. His Estate (the “Estate”) filed its 2009 Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, listing the value of Jackson’s assets. After auditing the Estate’s tax return, the Commissioner of the Internal Revenue Service (the “Commissioner”) issued a notice of deficiency that concluded that the Estate had underpaid Jackson’s estate tax by a little more than $500 million. Because the valuation of some assets were considered to be so far off, the Commissioner also levied penalties totaling nearly $200 million on the Estate. The IRS and the Estate settled the values of several assets outside of court. The case involved three contested assets of Michael Jackson’s estate:
We discuss the key topics that the Tax Court ruled on and addressed that inform valuation analysts in the preparation of quality valuation reports.
It is important that valuation analysts only rely on information that was known or knowable at the valuation date.
In the decision, the Tax Court rejects the analysis of experts on several occasions for using information that was “unforeseeable at the time of Jackson’s death.” The Tax Court goes on to state that “foreseeability can’t be subject to hindsight.”
It can be difficult to distinguish and depend on only the information known or knowable at the valuation date especially when a significant amount of time has passed between the current date and the valuation date. Therefore, a careful examination of all sources of information is necessary to be sure that it can be relied upon in the analysis.
As can be seen from the Tax Court’s opinion, valuation analysts and experts can undermine their credibility by relying on information that was not known or knowable at the valuation date.
The Tax Court, in this specific case, did not accept the tax affecting of S Corporations: “The Estate’s own experts used inconsistent tax rates. They failed to explain persuasively the assumption that a C corporation would be the buyer of the assets at issue. They failed to persuasively explain why many of the new pass-through entities that have arisen recently wouldn’t be suitable purchasers. And they were met with expert testimony from the Commissioner’s side that was, at least on this very particular point, persuasive in light of our precedent. This all leads us to find that tax affecting is inappropriate on the specific facts of this case.” The Tax Court did, however, leave room for the possibility of tax affecting being appropriate by stating, “we do not hold that tax affecting is never called for.”
At Mercer Capital, we tax affect the earnings of S corporations and other pass-through entities. Given that this issue continues to be a point of contention, it is imperative that valuation analysts provide a thorough analysis and clear explanation for why tax affecting is appropriate for S corporations and other tax pass-through entities.
In the valuation of NHT II, the Court found it more reasonable to use the projections of Sony/ATV in the development of a forecast used in the income approach rather than relying on historical financial performance to inform the projection. The Tax Court based its decision on the fact that “the music-publishing industry was (and has remained) in a state of considerable uncertainty created by a long series of seismic technological changes. We think that projections of future cashflow, if made by businessmen with an incentive to get it right, are more likely to reflect reasonable estimates of the short-to-medium-term effects of these wild changes in the industry that even experts, much less judges, are unlikely to intuit correctly.”
This decision makes it clear that valuation analysts need to fully understand the industry in which the company operates and develop a forecast that is most reasonable given the information available as of the valuation date.
In cases where analysts have access to a projection developed by management, valuation analysts should have a clear, well-reasoned rationale for not relying on the forecast should they decide not to use it in the analysis. However, valuation analysts should not blindly accept management’s forecasts as truth but should perform proper due diligence to assess the reasonability of the forecast and clearly articulate any deviations from management’s forecast.
A few other topics of note are addressed throughout the decision that can help valuation analysts provide reliable valuation analyses.
On more than one occasion, the Tax Court sided with the expert that provided a compelling explanation for the use of a certain assumption rather than arbitrarily using an assumption without explanation. The Tax Court also sided with one expert simply because they provided a clear citation for their source when another expert did not. The Tax Court also called out the inconsistency of an expert in their report and testimony. These topics addressed by the Tax Court demonstrate that consistently explaining and citing the sources of assumptions and key elements of the valuation analysis help to produce a supportable valuation
Finally, the expert for the Commissioner seriously damaged their credibility in the eyes of the Tax Court when the expert was caught in a couple lies during the trial. The Tax Court found that the expert “did undermine his own credibility in being so parsimonious with the truth about these things he didn’t even benefit from being untruthful about, as well as not answering questions directly throughout his testimony. This affects our fact finding throughout.”
The table below presents the valuation conclusions of the Estate, Commissioner, and the Tax Court at trial. This decision has shown that it is critical for valuation analysts to present quality valuation reports that are clear, supported, and follow accepted best practices.
At Mercer Capital, estate planners can be confident that we follow the proper procedures, standards, and best practices when performing our valuations for gift and estate planning. Mercer Capital has substantial experience providing valuations for gift and estate planning as well as expert witness testimony in support of our reports. Please do not hesitate to contact one of our professionals to discuss how Mercer Capital may be able to help your estate planning needs.
Recently, the Biden Administration announced elements of its tax agenda in the American Families Plan. The Biden Administration aims to make some significant changes to current tax law.
These changes are highlighted by the following:
Another substantial proposal includes the elimination of the step-up in basis. The potential elimination of the step-up in basis presents an estate planning opportunity to high-networth individuals and family business owners or should at least spur them to contemplate revisiting their estate plans.
The step-up in basis refers to the current tax environment that allows individuals to transfer appreciated assets at death to their heirs at the current market value without heirs having to pay capital gains taxes on the unrealized capital appreciation of those assets that occurred during the individual’s life. In other words, heirs currently benefit from a “step-up” in tax basis of inherited assets to the market value on the day of death, and no taxes are paid on unrealized capital appreciation of the assets.
The Biden Administration is proposing to eliminate this step-up in basis. This means that the heir would be responsible for the taxes on the unrealized capital appreciation of the assets being transferred as if the assets had been sold. This would result in a large tax burden on the heir especially when considering that the Biden Administration is also aiming to increase the top capital gains tax rate to 39.6%. Specifically, the proposal would end the step-up in basis for capital gains What Does the Step-Up in Basis Tax Proposal Mean for High Net Worth Individuals and Family Businesses? in excess of $1 million (or $2.5 million for couples when combined with existing real estate exemptions). So, the first $1 million of unrealized capital gains would be exempt from taxes and only the excess would be taxed. However, the proposal does state that “the reform will be designed with protections so that family-owned businesses and farms will not have to pay taxes when given to heirs who continue to run the business.” These protections and exemptions seem to provide some relief for family businesses, but the details of the protections have yet to be specified.
These proposals are certainly not set in stone and may change as the proposals are debated and legislature eventually makes its way through Congress. However, the Biden Administration’s current tax proposals could have a significant impact on the estate planning environment.
The potential elimination of the step-up in basis is yet another reason for high-net-worth individuals and family business owners to make estate plans or revisit their current estate planning techniques. When considered alongside other Biden Administration proposals such as an increase in the capital gains tax and the fact that the increased lifetime gift and estate tax exclusion limits are set to sunset in 2025, now is a great time to have a conversation about planning. Contact a professional at Mercer Capital to discuss your specific situation in confidence.
M&A activity in North America (and globally) is rebounding in 2021 after falling to less than $2.0 trillion of deal value in 2020 for just the second time since 2015 according to PitchBook; however, deal activity has accelerated in 2021 and is expected to easily top 2020 assuming no major market disruption due to a confluence of multiple factors.
The rally in equities, like low borrowing rates, has reduced the cost to finance acquisitions because the majority of stocks experienced multiple expansion rather than material growth in EPS. It is easier for a buyer to issue shares to finance an acquisition if the shares trade at rich valuation than issuing “cheap” shares.
As of June 3, 2021, the S&P 500’s P/E based upon trailing earnings (as reported) was 44.9x compared to the long-term average since 1871 of 16x. Obviously trailing earnings were depressed by the impact of COVID-19 on 2020 earnings, but forward multiples are elevated, too. Based upon consensus estimates for 12 months ended March 31, 2022, the S&P 500 is trading for 21x earnings.
High multiple stocks can be viewed as strong acquisition currencies for acquisitive companies because fewer shares have to be issued to achieve a targeted dollar value. As such, it is no surprise that the extended rally in equities has supported deal activity this year. However, high multiple stocks may represent an under-appreciated risk to sellers who receive the shares as consideration. Accepting the buyer’s stock raises a number of questions, most which fall into the genre of: what are the investment merits of the buyer’s shares? The answer may not be as obvious as it seems, even when the buyer’s shares are actively traded.
Our experience is that some if not most members of a board weighing an acquisition proposal do not have the background to thoroughly evaluate the buyer’s shares. Even when financial advisors are involved there still may not be a thorough vetting of the buyer’s shares because there is too much focus on “price” instead of, or in addition to, “value.”
A fairness opinion is more than a three or four page letter that opines as to the fairness from a financial point of a contemplated transaction; it should be backed by a robust analysis of all of the relevant factors considered in rendering the opinion, including an evaluation of the shares to be issued to the selling company’s shareholders. The intent is not to express an opinion about where the shares may trade in the future, but rather to evaluate the investment merits of the shares before and after a transaction is consummated.
Key questions to ask about the buyer’s shares include the following:
The list does not encompass every question that should be asked as part of the fairness analysis, but it does illustrate that a liquid market for a buyer’s shares does not necessarily answer questions about value, growth potential and risk profile. We at Mercer Capital have extensive experience in valuing and evaluating the shares (and debt) of financial and non-financial service companies garnered from over three decades of business.
In the December 2020 BankWatch, we provided our M&A outlook for 2021 and touched on themes that we believed would drive deal activity for the year. Our view was that the need to reduce costs in the face of revenue pressure would create urgency for banks to engage in M&A and lead to increased deal activity, given that credit quality remained stable and the economy avoided a double-dip recession.
Specifically, we noted that these drivers may cause mergers of equals (“MOEs”) to see more interest. Indeed, four of the largest bank deals in 2020 were structured as MOEs or quasi-MOEs (low premium transactions), and we believed the trend would only gain more traction as economic clarity emerged.
Thus far in 2021, against the backdrop of economic reopening, stable asset quality, and favorable bank stock performance, deal activity in the industry has picked up, and MOEs remain a hot topic. S&P Global Market Intelligence reported 53 U.S. bank deals year-to date through April 30, compared to 43 during the same period in 2020. The pace increased notably in April as 19 deals were announced in the month, including two large MOEs. BancorpSouth (BXS) announced a merger with Cadence (CADE) on April 12, and Webster (WBS) announced a deal with Sterling Bancorp (STL) one week later on April 19.
Bank MOEs are not a new concept, but they have occurred more frequently over the past several years, with the most notable being the BB&T – SunTrust combination to form Truist Financial (TFC). The BB&T-SunTrust combination has been reasonably well received, while it is perhaps early to judge some of the more recent deals. These types of transactions certainly have their merits and can appear strategically and financially compelling. However, MOEs involve a number of risks that should not be overlooked. For management teams considering an MOE, it is important to assess both the benefits and potential risks of such a deal.
Perhaps the most apparent benefit is the opportunity to reduce costs and improve operational efficiency. This is especially valuable in the current environment as revenue growth opportunities are limited. Reported estimates for cost savings in recent MOEs have been on the order of 10% to 15% of the combined expense base. These savings are often achieved by consolidating back office and administrative functions and/or right-sizing the branch network. With the increased adoption of digital banking, branch networks have become less central to banks’ business models and can be a drag on efficiency. MOEs provide management teams an opportunity to re-evaluate their banks’ physical distribution systems and reap the benefits of optimizing the branch network.
The savings from efficiencies and branch consolidation can be invested in upgrading the bank’s technological capabilities. Almost all recent merger press releases include some type of statement indicating management’s intent to invest in the pro forma bank’s digital capabilities. While the specifics of such investments are often not disclosed, it is clear that management teams view the ability to invest in technology as a key piece of the rationale for merging. By gaining scale, banks can dedicate the necessary resources to develop sophisticated financial technology solutions.
With a challenging loan growth outlook, many banks are considering entering new markets with favorable demographic characteristics. Unlike a de novo strategy or a series of small acquisitions, an MOE provides an opportunity to quickly establish a sizeable presence in a desired market. In merging with Cadence, BancorpSouth will in a single transaction more than double its deposit base in Texas where it previously had been acquiring smaller banks, with three sub-$500 million asset bank acquisitions since 2018. As banks look to position themselves for growth, MOEs are a potentially attractive option to gain meaningful exposure to new markets.
A merger offers opportunities to diversify the revenue stream by either gaining new lending expertise or entering a new fee income line of business. The more retail-focused First Citizens Bancshares will significantly diversify its lending profile when it completes its combination with the commercial-oriented CIT Group, announced in October of last year. Similarly, IberiaBank diversified its revenue stream by combining with First Horizon which has a sizeable fixed income operation. As revenue growth remains challenging, management teams should consider if a transaction might better position their bank for the current environment.
While an MOE can offer benefits on a larger scale, it also presents risks on a larger scale. The risks detailed below largely apply to all mergers and are amplified in the case of an MOE.
Culture is often the arbiter between success and failure for an MOE. Each of the subsequent risks detailed in this section could be considered a derivative of culture. If two banks with conflicting management philosophies combine, the result is predictable. The 1994 (admittedly before my time) combination of Society Corporation and KeyCorp was considered a struggle for several years as Society was a centralized, commercial-lending powerhouse while KeyCorp was a decentralized, retail-focused operation. Potential merger partners need to honestly assess cultural similarities and differences and evaluate the proposed post-merger management structure before moving forward.
It is also important that merging banks be on the same page regarding post-merger ambitions. If one views the merger as “fattening itself up” for a future acquirer while the other desires to remain independent, they will likely diverge in their approach to other strategic decisions. When executives or board members frequently clash, the pro forma entity will struggle.
There is usually some level of employee fallout with an acquisition, but if enough key employees leave or are poached by competitors, the bank’s post-merger performance will suffer. This is an especially important consideration when acquiring a bank in a new market or with a unique lending niche. If employees with strong ties to the communities in a new market leave for a competitor, it will be difficult to gain traction in that market. Likewise, a new lending specialty or business line can fail if those with the knowledge and experience to run it do not stick around for long.
Acquiring a bank of the same or similar size requires a tremendous amount of effort. Loan and deposit systems must be consolidated, customers from the acquired bank must be onboarded to the new bank’s platforms, and branding must be updated across the franchise. If the acquirer’s management team has little experience with acquisitions, successfully integrating with a large partner may prove difficult. When considering an MOE, the acquiring bank must assess what tasks will be necessary to combine the operations of the two organizations and achieve the projected cost savings. Management teams must consider whether their organization has the expertise to do that or, if not, what external resources would be needed.
Credit quality issues from an acquired loan portfolio can come back to bite a bank years after the acquisition. Merger partners need to be sure they have performed thorough due diligence on each bank’s loan portfolio and are comfortable with the risk profile. While recent credit quality concerns in the industry have not materialized and greater economic clarity has emerged, would-be acquirers need not be lulled to sleep by the current credit backdrop. The past year has shown that the future is unpredictable, and that forecasts are not always correct.
In recent MOEs and low premium transactions, acquirers’ shares have faced an adverse reaction from investors with declines of 5% to 7% in the days following announcement. First Citizens is an exception as its shares were up 34% five days after announcing its acquisition of CIT, which largely reflects the favorable price paid (44% of tangible book value). While it is not uncommon for buyers’ shares to decline following the announcement of an acquisition, these drops could reflect the market’s concerns around the heightened execution and integration risk of an MOE. It is early to judge whether the deals will create value in the long run or if the market’s initial reaction was justified.
We believe M&A will continue at a strong pace in the coming months as the economy continues to reopen and banks dust off previously shelved pre-Covid deals. We also expect MOEs will continue to garner more interest due to the aforementioned benefits. Management teams may be more willing to negotiate now than before on price, management roles, board composition, branding, etc. A balanced consideration of the benefits and risks of an MOE is imperative for making the optimal decision. Mercer Capital has significant experience in advising banks as buyers and sellers in transactions, including MOEs.
A thoughtful business valuation will likely rely on multiple approaches to derive an indication of value. While each approach should be considered, the approach(es) ultimately relied upon will depend on the unique facts and circumstances of each situation. This article presents a broad overview of the market approach, which is one of the three (the other two being asset and income) approaches utilized in business valuations.
The market approach is a general way of determining a value indication by comparing the subject company or ownership interest to similar businesses, business ownership interests, securities, or intangible assets that have been sold. Within each of the three approaches, there are varying methodologies. Within the market approach, there are two primary methods: the guideline public company method (based on valuation multiples derived from publicly traded companies in similar industries), and the guideline transactions method (based on valuation multiples derived primarily from merger & acquisition transactions involving companies similar to the subject company). Historical transactions in the stock of a company being valued can also be considered under the guideline transactions method.
The guideline public company method develops an indication of value based on consideration of publicly traded companies that provide a reasonable basis for comparison to the subject company. The valuation professional will typically conduct a search to identify a group of guideline public companies based on subject company’s industry, and review operating, financial, geographical, industry, and/or market characteristics to ensure that they are reasonable for inclusion.
Analysts express the relationship between the value of a company and a corresponding performance metric in the form of a valuation multiple, as shown in the following equation.
Applied to the subject company, the equation becomes:
The valuation professional must select the most relevant valuation multiples based on a number of factors, including the subject company’s size, profitability, growth prospects, industry, and capital structure. Common valuation multiples include EV (enterprise value) to sales, EV to EBITDA (earnings before interest, taxes, depreciation, and amortization), and Price to Earnings (P/E).1 Additionally, the valuation professional may deem it appropriate to adjust valuation multiples for size, risk, growth, and/or other attributes of the subject company relative to the guideline public companies from which the multiples were derived.2
The guideline public company method relies on objective, empirical data that can be used to draw inferences about a subject company’s value. And given that public company stocks trade daily, there won’t be a meaningful gap between the relevant valuation date and the data used in the analysis.
However, the method also has drawbacks. Depending on the subject company’s industry, there may be not sufficiently comparable publicly traded companies. Public companies are typically much larger than a private subject company. Public companies will also often have more product and/or geographic diversification. No two companies are identical, so operational, financial, and market factors must be assessed by the valuation professional. Also, two valuation professionals may deem different companies as comparable or not comparable.
While some commonalities may appear obvious, the guideline public company method requires considerable research and diligence. Access to databases that consolidate public company information like Bloomberg, Capital IQ, and TagniFi is helpful, as well.
The valuation professional also needs to understand the general economic environment and how it impacts the subject company and its industry. In a volatile year (such was the one we have experienced with COVID), earnings metrics may approach (or go below) zero, yielding multiples that are sky-high or negative, rendering this method, and potentially the entire market approach, unreliable and inappropriate for use.
A guideline public company group can sometimes provide useful valuation benchmarks. However, it is ultimately left to the analyst to determine if this method is appropriate given the facts and circumstances of subject companies. If deemed appropriate, then the analyst must develop valuation multiples for a subject company based upon a thorough review of a selected guideline group relative to the subject company.
The guideline transactions method is similar to the guideline public company method. However, instead of deriving values from public company stock prices, values are derived from transaction consideration in mergers & acquisitions. It is even sometimes referred to as the M&A method.
Unlike public company stock prices, which can be viewed on a daily basis, guideline transactions occur at a single point in time. As such, market conditions may have changed between the guideline transaction date and the subject company valuation date. Timing is one important consideration. Reliability and accuracy of data is another.
The data for market transactions is typically sourced from various databases, with varying databases for public or private deals. While the providers of private deals attempt to ensure that data is accurate, the underlying information they source is typically self-reported, or sometimes provided by business brokers or investment bankers, instead of being derived from audited and publicly available financial statements for public companies. Additionally, transactions involving comparable companies may in fact take place, but details regarding transaction consideration and/or the target company’s earnings or performance metrics may not be disclosed, making it impossible to use these transactions for valuation inferences.
Market transactions can also have complexities not present in the guideline public company method (which is based on a public company’s common stock price). A market transaction may be structured with an earnout, in which the seller will receive additional consideration at a later date if the acquired company achieves certain financial or operating milestones. A transaction could include a lucrative employment agreement for the primary shareholder, which may influence how much the shareholder is willing to accept for the overall business. Additionally, the seller may provide attractive financing, influencing how much the buyer is willing to pay.
Without knowing all the details of guideline transactions, it is difficult to quantify the impact of these items on transaction consideration, and is often unclear, especially regarding earnouts, how transaction databases incorporate these items.
Additionally, a strategic buyer could have specific motivations to acquire a company due to various synergistic or strategic benefits. Data from strategic transactions are not generally useful in fair market value determinations, which typically do not include strategic benefits.
However, the guideline transactions method has its merits. While guideline public companies are typically much larger in size than private companies, market transactions take place across the size spectrum. Data can be filtered based on the size of the subject company. If the data set is large enough, further filters can be applied based on the subject company’s geographic location and other attributes. This results in companies likely being more directly comparable to the subject company relative to the larger guideline public companies. Ultimately, it is up to the valuation professional to determine the appropriateness of using the guideline transactions method.
Transactions in the stock of a subject company can be used as a subset of the guideline transactions method to develop value indications. With public companies, the best indication of value for shares of a company’s stock, e.g., Microsoft, is the current trading price for its shares.
While private companies, by their very nature, do not have an active trading market for their stock, there are certain circumstances where the guideline transactions method can be applied. However, an important requirement for the application of the guideline transactions method is that the transaction was “arm’s length,” meaning that it took place between independent parties acting in their own self-interests. Transfers among family members or grants to employees are not necessarily representative of fair market value. Timing is also important. How much time has passed since the transaction? In what condition is the business and industry at the valuation date relative to the time of said transaction?
Sometimes we value startup companies, which come with additional considerations. If the company has recently been raising capital, the terms of recent investments can be used to imply a value for an interest. However, the valuation professional must take care to understand any differences between the interest acquired in the transactions and the interest that is being valued. Venture capital investments will often be in the form of preferred stock, which may have attributes that make the shares more valuable than the corresponding shares of common stock (e.g., liquidation preferences, anti-dilution provisions, etc.). Because of the complex nature of pricing preferences in venture capital and private equity transactions, a skilled valuation professional should be involved.
The market approach can be one of the most straightforward and compelling ways to derive the value of a subject company. However, each method within the market approach has its own merits and drawbacks, and thus a competent valuation expert is needed to ensure that the methods are applied in a thoughtful and appropriate manner given the unique facts and circumstances regarding the subject company.
1 The appropriate value for the numerator is based on whether the metric in the denominator is reflective of all capital providers (in which case enterprise value or total capital value is appropriate), or just equity holders (in which case just the equity value should be included in the numerator). Mercer Capital’s Chairman, Chris Mercer, discusses the distinction between enterprise and equity multiples in more detail here.
2 This is often referred to as a “fundamental adjustment.” A detailed discussion of the fundamental adjustment is outside the scope of this article, though Mercer Capital has a primer on the topic here.
Barring another recession or material reduction in bank stock valuations in the public markets, M&A activity should improve as 2021 progresses.
However, some boards that would like to sell may have a hard time accepting a lower price versus what was obtainable a couple of years ago.
One way to bridge the bid-ask gap is to consider transactions with more rather than less consideration consisting of the buyer’s common shares. Cash deals “cash-out” shareholders who then reinvest after-tax proceeds. Stock deals allow the target’s shareholders to remain invested in a sector that still trades cheap to longer-term valuations.
This session, presented as part of the 2021 Acquire or Be Acquired Conference sponsored by Bank Director, addresses these issues.
In recent years, credit unions have been increasingly active as acquirers in whole bank and branch transactions. This session focuses on the top considerations for credit unions when assessing and valuing bank and branch franchises in the current environment.
For bankers, this session should enhance your knowledge regarding how credit unions identify potential targets, assess potential opportunities and risks of a bank or branch acquisition, and ultimately determine a valuation range for target banks and branches.
This session, presented as part of the 2021 Acquire or Be Acquired Conference sponsored by Bank Director, addresses these issues.
The discount rate is the key factor in business valuation that converts future dollars into present value as of the valuation date. For a layperson, the discount rate utilized in a business valuation may appear to be subjective and pulled out of a hat. However, the discount rate is a crucial component of the valuation formula and must be assessed for the specific company at hand.
Using any method under the income approach, the valuation formula comes down to three things:
In valuations that “feel” too high or too low, one of the potential culprits may be an aggressive discount rate, either on the high or low end. There are several generally accepted methodologies to build up discount rates employed by valuation analysts. In this article, we will examine the various components of a discount rate. Then, we will relate the discount rate to rates of return of other investments that should provide a commonsense road map for what is reasonable and what is not.
Companies with larger cash flows are likely to be more valuable, as are those with cash flows that are growing at a faster rate. Each of these statements makes perfect sense. Now, if the future cash flows are less certain, they are deemed to be riskier, which reduces the value of the business. The discount rate “discounts” future cash flows to a present value. As we have all heard, “a dollar today is better than a dollar tomorrow.” Measuring the present value of future earnings allows us to develop a value for a business today.
The discount rate goes by many names including “equity discount rate,” “return on investment,” “cost of capital,” and “rate of return.” For companies that use debt, the appropriate way to discount cashflows may be the weighted average cost of capital, or “WACC.” Thinking about a discount rate as a rate of return is likely the most intuitive approach.
Returns to an equity investor come after all other parties have been paid. Debt capital providers are paid before equity capital providers, typically at a fixed or floating interest rate (for example, a company’s line of credit could be 4.0% fixed rate or vary, such as 1% over the prime rate). After generating revenue, paying expenses and taxes, and reinvesting funds needed in the business, any remaining cash flow is shared by the equity investors. Because equity investors come last, they require the highest rate of return in order to provide equity capital to a business. Intuitively, this explains why the cost of equity, or “discount rate,” is higher than the cost of debt, or interest rate.
Before we delve into what is reasonable and what is not, one must first understand the components of a discount rate as these help the attorney understand how an appraiser estimates this rate. We describe the development of an equity discount rate with a description of each component below.
Risk-Free Rate: As alluded to previously, we would all prefer a dollar today over a dollar tomorrow, which both removes the uncertainty of receipt and quells any potential concerns about lost purchasing power from rising prices. To build up the discount rate, we begin with a base rate called the “risk-free rate,” which compensates for the time value of money. An example of a risk-free rate is the 20-Year Treasury Bond yield as of the valuation date. If an appraisal uses an alternative figure that is materially different than the prevailing rate, the assumption would likely require justification.
Equity Risk Premium: Next, to capture generic market risk for the equity market, appraisers employ an “equity risk premium,” frequently in the range of 4.0% to 7.0%, which captures what an investor would expect for an investment in the equity market over a less risky investment like the bond market. Again, something out of this range would likely require justification. 
Beta: The equity risk premium is then multiplied by a selected beta. The beta statistic measures a company’s exposure to market risks, with a beta of 1.0 indicating typical market risk. Low beta companies or industries are less correlated with market risk, while high beta companies are more exposed to market risk. For example: auto dealers and airlines tend to ebb and flow with the economy, doing well when the market is good and declining when economic activity contracts, meaning they tend to have betas of 1.0 or higher. In contrast, grocery stores tend to have a beta below 1.0. When the economy contracts, consumers increase their consumption at grocery stores instead of restaurants to save money. Consumers also need toilet paper regardless of the economic environment, and companies that sell such durable goods (like grocery stores) tend to be lower beta companies.
To this point, we have built up the equity discount rate under the Capital Asset Pricing Model (“CAPM”) for a diversified equity market investment. The risk-free rate plus the equity risk premium (assuming a beta of 1.0) gives a rate of return of approximately 7.0% to 8.0%. This should sound familiar because money managers and retirement planners frequently say equity investors should anticipate investment returns on the order of 7.0%, or something in this range. While Mercer Capital makes no such investment advice, this is a reasonable consideration for large, diversified equity portfolios in the context of building up a discount rate for a smaller private company. However, in recognition of the greater risks inherent in privately held smaller companies, business valuation analysts frequently consider two other sources of risk premia: size and specific company.
Size Premium: Smaller companies tend to be subject to greater issues with concentration and diversification. Smaller companies also tend to have less access to capital, which tends to raise the cost of capital. To compensate for the higher level of risks as compared to the broad larger equity market, appraisers frequently add a premium of approximately 3.0% to 5.0% (or more, for very small businesses) to the discount rate when valuing smaller companies. To get an idea of reasonableness, we can consider the following example. A company valued at over $200 million may seem large, but it is actually relatively small when compared to most publicly traded companies. As such, a size premium would still apply, albeit on the lower end. Valuation analysts source these size premiums from data which provides empirical evidence in support of risks associated with smaller size. This data is updated annually, and providers such as Duff & Phelps are frequently cited.
Specific Company Risk Premium: The final component of a discount rate is the specific company risk premium. This represents the “risk profile” specific to the individual subject company above and beyond the factors above – i.e., what is the required return an investor requires to invest in said company over any other investment?
To illustrate with an example, a soon-to-retire CEO of a small business maintains all client relationships. In assessing the potential risk(s) to the business, we would inquire about and assess the risk of clients leaving when the CEO retires. In addition to the risk of losing clients, there are other risks associated with the departure of a key executive. Valuation analysts refer to these risks as “key person risk,” or “key person dependency.” We would also assess depth of other management and succession planning. A few additional examples, but certainly not all, of company specific risk are shown below:
When determining a specific company risk premium, some analysts may choose to assess a company through a SWOT analysis – strengths, weakness, opportunities, and threats of the company – relative to past performance, performance of its peers, the industry, and the broader economy. Put simply, what is the risk profile of the business? If there are risks (or lack thereof) that are specific to said company, how much higher or lower does the discount rate have to be for an investor to be willing to invest in this company instead of an alternative company or investment?
The specific company risk premium is frequently an area where experts may differ due to selection of varying levels of risk for a company. While understanding what “feels” reasonable here takes nuance and experience, a valuation analyst should provide the attributes which support the selected risk premium.
Following our equity build-up example in Figure 1, adding a size premium of 5.0%, and specific company of 4.0% to an equity market return of 7.75% leads to a discount rate of 16.75%. For a smaller, riskier company, this could be higher; however, for a larger, less risky company with consistent history of strong earnings, this could be lower. An equity discount rate range of 12% to 20%, give or take, is likely to be considered reasonable in a business valuation. This is about in line with the long-term anticipated returns quoted to private equity investors, which makes sense, because a business valuation is an equity interest in a privately held company. Again, while many of the specific terms utilized in the build-up of a discount rate may be new to attorneys, rates of return quoted in that context are more familiar to many.
A business appraisal with a discount rate below 10% likely deserves more scrutiny, but it may be reasonable if the company is sufficiently large, diversified, well-capitalized, less exposed to market risk, has a strong management team and succession plan, and generates consistent cash flow and/or growth.
On the other end of the spectrum, a company with a discount rate in excess of 25% may be undervalued, and such a discount rate similarly deserves justification. However, there could be numerous reasons why this is ultimately reasonable given specific facts and circumstances. Early stage/start-up companies without sufficient history of earnings and performance would likely have a high discount rate. While there could be certain instances where a discount rate above 25% may be reasonable, a proper appraisal will enumerate in detail why such a large discount rate is warranted.
In financial situations that may be scrutinized by courts and other potential adversaries, an expert’s financial, economic, and accounting experience and skills are invaluable. These complex analyses are best performed by a competent financial expert who will be able to define and quantify the financial aspects of a case and effectively communicate the conclusion.
 Mercer Capital regularly reviews a spectrum of studies on the equity risk premium and also conducts its own study. Most of these studies suggest that the appropriate large capitalization equity risk premium lies in the range of 4.0% to 7.0%.
 W.F. Sharpe, “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk,” Journal of Finance, Vol. 19 (1964): pp. 425-442.