The 12 Questions That Keep Family Business Directors Awake at Night

The intersection of family and business generates a unique set of questions for family business directors. We’ve culled through our years of experience working with family businesses of every shape and size to identify the twelve questions that are most likely to trigger sleepless nights for directors. Those questions are:

How Do We Promote Positive Shareholder Engagement?
How Do We Communicate More Effectively with Shareholders?
Does Our Dividend Policy Fit?
To Invest or Not to Invest?
Should We Diversify?
Does Father Always Know Best?
How Do We Find Our Next Leader?
Is There a Ticking Time Bomb Lurking in Our Family Business?
What Is the Family’s Most Valuable Asset?
What Should We Do About Estate Taxes?
How Should We Respond to an Acquisition Offer?
Who’s In and Who’s Out?

The 12 Questions That Keep Family Business Directors Awake at Night summarizes some of our thoughts, experiences, and insights around each question and suggests possible next steps.

Perhaps more importantly, though, it is an invitation to join our ongoing conversation about the questions family business directors need to think about. That conversation continues on our blog, Family Business Director, where we explore these and other topics of interest to family business directors.

Mercer Capital provides sophisticated financial advisory services to family businesses, including:

Advisory services for family business directors
Financial consulting services for family business managers
Independent valuation opinions
Transaction advisory services
Confidential shareholder surveys
Benchmarking / business intelligence services
Shareholder engagement support
Shareholder communication support

Automobile Dealership Valuation 101

Valuation of a business can be a complex process requiring certified business valuation and/or forensic accounting professionals. Valuations of automobile dealerships are unique even from valuation of manufacturing, service, and retail companies. Automobile dealership valuations involve the understanding of industry terminology, factory financial statements, and hybrid valuation approaches. For these reasons, it’s important to hire a business valuation expert that specializes in automobile dealership valuation and not just a generalist business valuation appraiser.

Terminology

Blue Sky

Unlike most valuations used in the corporate or M&A world, cash flow metrics such as Earnings Before Interest, Taxes, and Depreciation (“EBITDA”) are virtually meaningless in automobile dealership valuations. Instead, this industry communicates value in terms of Blue Sky value and Blue Sky multiples. What is Blue Sky value? Any intangible/goodwill value of the automobile dealership over/above the tangible book value of the hard assets is referred to as Blue Sky value. Typically, Blue Sky value is measured as a multiple of pre-tax earnings, referred to as a Blue Sky multiple. Blue Sky multiples vary by franchise/brand and fluctuate year-to-year.

Dealer Financial Statements

Another unique aspect of automobile dealership valuations is the reported financial statements. Unlike valuations in other industries where the preferred form of financial statements might be audited/compiled or reviewed financial statements, most reputable valuations of automobile dealerships rely upon the financial statements that each dealer reports to the franchise/factory, referred to as Dealer Financial Statements. Why are Dealer Financial statements preferred? Dealer Financial statements provide much more detailed information pertaining directly to the operations of the dealership than any audited financial statement. Valuable information includes the specific operations and profitability of the various departments including, new vehicle, used vehicle, parts and service, and finance and insurance. Each department is unique and has a different impact on the overall success and profitability of the entire dealership. Automobile dealerships are required to report these financial statements to the factory on a monthly basis. However, an experienced business valuation expert knows to request the 13th month dealer financial statements. If a year only has twelve months, then what are the 13th month dealer financial statements? The 13th month dealer financials typically include the year-end tax adjustments such as adjusting the value of new/used vehicles to fair market value by reflecting current depreciation and other adjustments.

Valuation Approaches

Asset-Based Approach

The asset-based approach is a general way of determining a value indication of a business or a business ownership interest using one or more methods based on the value of the assets net of liabilities. Asset-based valuation methods include those methods that seek to adjust the various tangible and intangible assets of an enterprise to fair market value. In automobile dealership valuations, the asset method is utilized to establish the fair market value of the tangible assets. This value is then combined with a Blue Sky “market” approach to conclude the total fair market value of the automobile dealership.

Income Approach

The income approach is a general way of determining a value indication of a business or business ownership interest using one or more methods that convert anticipated economic benefits into a single present amount.

The income approach can be applied in several different ways. Valuation methods under the income approach include those methods that provide for the direct capitalization of earnings estimates, as well as valuation methods calling for the forecasting of future benefits (earnings or cash flows) and then discounting those benefits to the present at an appropriate discount rate. The income approach allows for the consideration of characteristics specific to the subject business, such as its level of risk and its growth prospects relative to the market.

How is the income approach unique to the automobile dealership industry? First, projections are rarely produced or tracked by automobile dealers, so historical capitalization methods are mostly used. Second, most automobile dealerships are dependent on the national economy, and sometimes to a larger degree, their local economies. This is important because business appraisers need to analyze and understand the dependence of each dealership to the national and local economy which usually affects the seasonality/cyclicality of operations and profitability. Once again the automobile dealership is unique in that it can experience seasonal/cyclical fluctuation in a given year, or more importantly, it fluctuates over a longer period of more like five-to-seven years.

Market Approach

The market approach is a general way of determining the value indication of a business or business ownership interest by using one or more methods that compare the subject to similar businesses, business ownership interests, securities, or intangible assets that have been sold.

Market methods include a variety of methods that compare the subject with transactions involving similar investments, including publicly traded guideline companies and sales involving controlling interests in public or private guideline companies. Consideration of prior transactions in interests of a valuation subject is also a method under the market approach.

In the automobile dealership industry, traditional market approaches are basically meaningless. While there are a few publicly traded companies in the industry, they are large consolidators and own numerous dealership locations of many franchises in many geographic areas. Private transactions exist, but generally not in a large enough sample size of the particular franchise to provide meaningful comparisons.

So, how does a business valuation expert utilize the market approach in the valuation of automobile dealerships? The answer is a hybrid method utilizing published Blue Sky multiples from transactions of various franchise dealership locations. Two primary national sources, Haig Partners and Kerrigan Advisors, publish Blue Sky multiples quarterly by franchise. As discussed earlier, these multiples are applied to pre-tax earnings and indicate the Blue Sky or intangible value of the dealership. When combined with the tangible value of the hard assets determined under the Asset Approach, an experienced business valuation expert is able to conclude a total value for the dealership using this hybrid approach and communicate that result as a multiple of Blue Sky that will be understood and accepted in the industry.

Normalizing Adjustments

Normalizing adjustments adjust the balance sheet and income statement of a private company to show the financial results from normal operations of the business and reveal a “public equivalent” income stream. Some typical areas of potential normalization adjustments in the automobile dealership industry include, but are not limited, to the following.

Inventories

Most dealerships report the value of their new and used vehicle inventories on a Last-In, First-Out (“LIFO”) basis. LIFO accounting allows the dealership to reduce the value of their inventories and pay fewer taxes. General valuation theory calls for inventories to be restated at First-In, First-Out (“FIFO”) basis. The FIFO adjustments affect both the balance sheet and the income statement. The inventory adjustment on the balance sheet generally raises the value of the inventory. On the income statement, the inventory adjustment affects the cost of goods sold, and ultimately, the gross profit margin.

Officer/Dealer Compensation

Like all valuations, the compensation of the officer/dealer is important. Typically, a business valuation expert will review actual compensation paid and determine a replacement or market equivalent compensation level.

Rent

Most automobile dealership entities contain the operations of the dealership only and not the underlying real estate. Typically, the underlying real estate is owned by the dealer in a related entity. As such, the dealership pays rent to the related party entity. It’s important for the business valuation expert to determine if the rental rate paid is equivalent with a market rental rate. Often, this rental rate is set to create additional profitability at either the dealership entity or the real estate entity.

Working Capital

Most factory dealer financial statements list the dealership’s actual working capital, along with the requirements from the factory. It’s important for the business valuation expert to assess whether the dealership has adequate working capital, or perhaps an excess or deficiency.

Fixed Assets

As discussed earlier, most dealerships do not own the underlying real estate. In those cases, most dealerships still report some cost value of land or leasehold improvements on their factory dealer financial statements.

It’s important for the business valuation expert to determine who owns the real estate, and if not owned by the dealership, the value of the land and leasehold improvements needs to be adjusted, reflecting the true value of the tangible assets of the dealership.

Failure to properly assess and make this adjustment will skew the implied Blue Sky multiple on the concluded value for the dealership.

Other Income Items

Most factory dealer financial statements have a line item on the income statement for other income items/additions. This category can be a sizeable number for a dealership depending on its sales volume and level of profitability. The business valuation expert should determine the items that comprise this category and how likely they are to continue at historical levels.

Some common items that appear in this category include factory dealer incentives on sales volume levels for vehicles, factory dealer incentives for service performance, document/preparation fees on the sale of new and used vehicles, and additional costs for financing and other services sold as a part of the vehicle transaction referred to as PACKs.

Conclusion

The valuation of automobile dealerships can be more complex than other valuations due to their unique financial statements, varying cost structures and profitability of departments, different terminology, and hybrid valuation methods.

Hiring a business valuation expert that specializes in this industry rather than a generalist business valuation appraiser can make all the difference in providing a reasonable valuation conclusion.

Originally published in the Value Focus: Auto Dealer Industry Newsletter, Year-End 2017.

eSports: Business Models

How an eSports Team Makes Money

An eSports team can make money in a variety of ways, including broadcast revenue, sponsorships, merchandise sales, and subscriptions. The sources of revenue are detailed below.

Sponsorships

As shown in the chart above, sponsorships and advertising account for the bulk of revenue for eSports. According to Patrik Sättermon (Fnatic’s Chief Gaming Officer), “[I]t is estimated that around 95% of the money generated by our eSports teams comes directly from sponsorship deals.” The novelty of eSports has attracted many well-known sponsors; however, teams have struggled to make sponsorships a sustainable source of revenue. The relatively short life of popular games proves to be an impediment to sustained sponsorship. A game might be highly popular currently but within a year fade from public interest.

IT/Computer related sponsorships are the most common in the eSports industry as gaming equipment and accessories are prominently displayed during events. For example, HP and Intel agreed to sponsor Activision Blizzard’s Overwatch League. As part of the agreement, competitors will exclusively use HP’s OMEN gaming PCs and displays.

From a valuation perspective, consistent recurring revenue is a benefit to the value of a company. Sponsorships can provide long-term recurring revenue to an eSports teams.

Broadcast Revenue

eSports broadcasting on TV is still in its infancy as broadcasters look for eSports content that will appeal to their target demographics. ELEAGUE, an eSports content and live tournament brand, has a broadcasting deal with TBS that shows Street Fighter V and Counter Strike: Global Offensive (“CS:GO”) on TV. The recently formed Overwatch League (“OWL”), will be broadcast on the ESPN, Disney, and ABC family of networks. Perhaps most importantly, a broadcast TV deal does not cancel existing distribution agreements such as broadcasts on Twitch that were already in place.

While game developers and league creators are able to come to broadcast agreements, it is more difficult for eSports teams. eSports teams generally do not share in broadcast revenues as those agreements are negotiated between game developers/league creators and the broadcasting entities.

Merchandise Sales

As mentioned in our eSports industry overview, consumer spending on eSports merchandise remains relatively low. eSports teams offer apparel, accessories, and gaming equipment through their team websites. From a valuation perspective, merchandise sales can be a source of supplemental income. However, merchandise sales would not have a significant impact on the valuation of an eSports team because the revenue tends to be small and non-recurring.

Prize Money

Prize money typically does not go to eSports teams, but rather, to individual team members who are competing. While the team does not receive the money, being successful in tournaments is a good way to generate brand awareness.

As the eSports industry expands, so have prize pools for tournaments. In August 2018 Vancouver hosted The International 8 – the eighth annual Dota 2 championship tournament. The total prize pool of $24.8 million sets the record for largest single tournament prize pool in eSports history. The International prize pool compared to other notable sports events from 2018 is presented below.

Perhaps the most interesting note from the $24.8 million prize pool for The International is that approximately 94% was crowdfunded. Every-day Dota 2 players purchased Battle Passes that offer event-exclusive features and rewards. One-fourth of each Battle Pass was added to the prize pool.

Naming Rights

Team Liquid officially opened a new training facility March 7, 2018, in Santa Monica, California. The facility not only provides a dedicated practice area for Team Liquid members but also houses the company’s content production team, 1UP Studios. “Teams in the [U.S.] have traditionally operated out of ‘gaming houses’ where players and coaching staff for a team live and practice in a single residential home.”

The development of a dedicated training facility represents a shift away from the current model. The training facility has provided another stream of revenue for Team Liquid as they were able to sell naming rights to the facility to gaming PC brand Alienware for $4.5 million. Team Liquid’s CEO Steve Arhancet indicated the team spent over $1.5 million in building the training facility.

Generally speaking, eSports teams owning their training facilities is a recent trend. As eSports continue to grow, it is likely we will see more sales of naming rights for facilities.

Successful Teams

The table below shows the top teams based on prize money earned as well as four other notable teams.

Subscriptions

Luminosity Gaming ranked number 29 in terms of prize money earned among eSports teams. However, Luminosity also boasts arguably the most well-known eSports player in the world, Tyler Blevins (aka Ninja). Ninja recently revealed that he makes $500,000 per month from his more than 160,000 paid Twitch subscribers. On Twitch, streamers net $3.50 per subscription, which costs subscribers $5.00 per month. Twitch subscribers receive access to exclusive badges and ad-free streams.

Having high-profile players on the roster can increase the visibility of an eSports team and therefore lead to more followers and eventually subscribers. Subscriptions are another source of recurring revenue for a team.

Costs of Revenue

As with any business, there is a cost to generating revenue. eSports teams get most of their revenue from sponsorships. In order to attract sponsors, teams must perform well at tournaments and events as well as be highly visible to consumers. Typical expenses for an eSports team include player salaries, administrative personnel salaries, player housing expenses, training facility rent or operating expense, and equipment/accessory expense.

In 2017, Jerry Jones acquired an ownership interest in Complexity Gaming. Shortly thereafter, the team was moved to The Star in Frisco. The Star happens to be the Dallas Cowboys World Headquarters. The plan is for Complexity to build a “state-of-the art operations center and global headquarters including offices, production studios, and industry leading training facilities.”

Complexity are not the only team to take advantage of common ownership with another pro sports team. In April, Team Dignitas spent time with Philadelphia 76er trainers and nutritionists in order to prepare for the Intel Extreme Masters in Poland.

The Takeaway

There are numerous ways for an eSports team to make money. In general, the most common source of revenue is sponsorships. In order to increase sponsorships eSports teams need to perform well in the tournaments they enter. Merchandise sales, prize money, and broadcast revenue are other ways eSports teams can make money. Most eSports teams have similar expenses so profitability of a specific team usually depends on performance at the top line.

Chris Mercer, founder of Mercer Capital, states the two primary factors in the value of a business are risk and growth. eSports teams with a significant amount of recurring revenue (through sponsorships, subscriptions, etc.) are less risky than teams that have less consistent revenue sources (prize money, merchandise sales). The less risky an entity, the greater the value of that entity.

Originally published in Mercer Capital’s eSports: Business Models whitepaper.

Venture Capitalists in the Family

Many family offices are built from the success of once fledgling businesses that many would now know as household names. Successor generations seek to maintain and build that wealth through prudent investments in equities, fixed income, and private equity investments in mature companies. In recent years, however, family offices have started taking notes from their entrepreneurial beginnings and are investing more in early-stage ventures. Though more often seen as LPs in traditional venture capital funds, family offices are also increasingly taking on the role of direct—and sometimes lead—venture investors.

An analysis from Crunchbase News shows the progression of family office venture investment over the last few years. While this is a small sample, it helps demonstrate the growing trend. Crunchbase also notes several prominent family venture-backed exits including Twilio, Okta, Bitly, and Workday.

We have previously analyzed the rise of corporate venture capital and its effect on the funding landscape. So what does the increase in family office investors mean for venture capital? Here are a few of the characteristics that make venture investments from family offices unique.

Involvement

Despite an industry focus on the new wealth being built in the technology hubs of the U.S., abundant sources of potential investment lay in family offices all over the country. Family office investors are likely to source deals through their personal networks and professional ties with local business activity. Family offices typically take an active interest in each portfolio company and, therefore, may be likely to invest their capital in local ventures in order to better stay up-to-date with company developments. In order to maintain this involvement, a board seat may also be one of the requirements when a family office joins the cap table.

Motivation

Whether they hold a share of the original family company or a subsequent business investment, family offices often have a stake in mature industry players. Because of previous work within the space or an inside vantage point from an ownership position, family offices can often lend industry insight. They may also possess a unique perspective for identifying startups that could disrupt, or partner with, the incumbents in the industry. Family office investors typically enter with strategic motivations for investing, not just the lure of large returns.

Time Horizon

The primary focus of family offices is to preserve and grow capital for multiple generations. Family offices are, therefore, usually able to adopt a very long-term view of their overall portfolio. However, it should not be mistaken that family offices are willing to have their capital tied up forever. Like any other investment firm, family offices develop objectives and exit expectations for their various investments.

As family offices join the landscape of non-traditional investors in venture capital, startups may find that they have more options when it comes to funding. We expect to continue to see an increase in the diversity of funding sources, with cap tables boasting a combination of traditional, corporate, and family investors.

Originally published in Portfolio Valuation: Private Equity & Venture Capital Marks & Trends, Third Quarter 2018.

EBITDA Single Period Income Capitalization for Business Valuation

The focus on the EBITDA of private companies is almost ubiquitous among business appraisers. This session addresses the relationship between depreciation (and amortization) and EBIT as one measure of relative capital intensity. This relationship, “the EBITDA Depreciation Factor,” is then used to convert debt-free pre-tax (i.e., EBIT) multiples into corresponding multiples of EBITDA. Mercer presents analysis that illustrates why the pervasive rules of thumb suggest that many private companies were worth 4.0x to 6.0x EBITDA, plus or minus, have had such stickiness. He will then address the likely impact of the Tax Cut and Jobs Act on private company enterprise value multiples. This session suggests a methodology based on the Adjusted Capital Asset Pricing Model, whereby business appraisers can independently develop EBITDA enterprise value multiples under the Income Approach and includes private and public company market evidence

2018 Core Deposit Intangibles Update

With the Fed positioned to hike the Fed Funds and IOER rates several more times following the September meeting, it is a good time to look at the recent trend in core deposit values. Mercer Capital previously published articles on core deposit trends in 2016 just before the November election, and again in October 2017.

Coming out of the recession, the prolonged low interest rate environment held values of core deposit intangible assets acquired in bank transactions at historical lows. Deposit premiums paid in transactions likewise remained below pre-recession levels. Following the 2016 election, amid expectations of stronger economic growth and rising rates, core deposit values and deposit premiums both saw some modest increases by the fourth quarter of 2017. Three rate hikes by the Fed in 2018 have driven rates sufficiently high that banks are now beginning to price deposits more competitively as liquidity tightens.

Using data compiled by S&P Global Market Intelligence, we analyzed trends in core deposit intangible (CDI) assets recorded in whole bank acquisitions completed from 2000 through August 2018. 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 Global Market Intelligence’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.

Current CDI values reported in acquisitions remain well below long-term historical average levels, averaging approximately 1.5% in the 2017-2018 timeframe compared to averages in the 2.5%-3.0% range in the early 2000s. Chart 2 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 has become more costly in recent years, CDI values have generally ticked up as well. However, despite remaining above post-recession average levels, CDI values in the second and third quarters of 2018 (through August) have lagged the broader trend in interest rates with some decline in CDI values observed in these quarters. In addition to a flattening yield curve, some of the easing in CDI values in recent months may result from increasing deposit costs which reduces the value of deposits relative to other funding sources. Despite Fed increases in interest rates since late 2015, deposit costs have lagged the broader trend of rising interest rates (Chart 3).

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 (Chart 4). 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 (Chart 5).

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 asset quality in the acquired loan base, 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.

Deposit premiums paid in whole bank acquisitions have shown more volatility than CDI values, rising more substantially in the post-recessionary period and continuing to improve through the year-to-date 2018 period as a result of improvement in deal values. Despite improved deal values, current deposit premiums in the range of 12% remain well below the pre-financial crisis levels when premiums for whole bank acquisitions averaged closer to 20% (Chart 6).

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 are up from the 2.0-4.0% range observed in the financial crisis, but have remained in the 4.0-5.5% range since 2017, as shown in Chart 7.

For more information about Mercer Capital’s core deposit valuation services, please contact us.

Originally published in Bank Watch, September 2018.

¹S&P Global Market Intelligence defines core deposits as, “Deposits, less time deposit accounts with balances over $100,000 and foreign deposits if available or deposits, less all deposit accounts with balances over $100,000 and foreign deposits.”

Beach Reading: Notice of Proposed Rulemaking – Qualified Business Income Deduction

Struggling to find a page-turning read for that late summer beach escape? May we recommend the 184 pages of blissful decadence that comprise the Internal Revenue Service’s August 2018 Notice of Proposed Rulemaking (NPR) regarding the Qualified Business Income (QBI) deduction under the Tax Cuts & Jobs Act (TCJA). Like a tightly wound murder mystery, the regulations weave a complex web. Tax code sections take the place of characters, the regulation’s intricacies unspooling as the narrative continues, relationships between Tax Code sections becoming (somewhat) clearer as the story (i.e., the regulation) progresses. As the NPR continues its inexorable march, certain storylines (i.e., planning opportunities) are forestalled, yet the NPR creates a glimmer of other opportunities.¹

The Abridged Version of the NPR in One Sentence

Bank shareholders are eligible for the 20% Qualified Business Income deduction.²Intrigued? If so, the story continues.

Prologue

Before examining the NPR, several tax-related trends are evident in 2018 regulatory filings.

Effective tax rates are falling
More banks are converting from S corporations to C corporations
Securities portfolio allocations are evolving

Despite the attention it receives, tax reform is not solely responsible for improving bank profitability in 2018. Table 1 illustrates that pre-tax return on tangible common equity (ROATCE) has expanded in 2018, consistent with widening net interest margins for many banks and constrained credit costs. Effective tax rates declined from approximately 30% in the first half of 2017 to 21% in the comparable 2018 period, allowing banks to leverage the 50 to 100 basis point pre-tax ROATCE expansion into 150 to 200 basis points of after-tax ROATCE expansion.

Table 2 indicates conversion activity from C corporation to S corporation status. Following tax reform, conversions increased significantly, as 53 banks changed their tax status in the first six months of 2018 versus nine in the prior year period. Nevertheless, this represents only a sliver of the approximately 2,000 banks taxed as S corporations. Several large S corporation banks elected to be taxed as C corporations in 2018; as a result, banks collectively holding $44 billion of assets converted in 2018, relative to only $5 billion in the prior year period.

After passage of tax reform, some observers speculated that more conversion activity from S corporation to C corporation status would occur in states with relatively high personal tax rates, due to the $10 thousand limitation on the deductibility of state and local taxes. However, this trend is not yet apparent in conversion activity, as the states experiencing the most conversion activity include jurisdictions with both higher and lower personal tax rates.

While more banks converted from S corporations to C corporations in 2018, relatively few did the reverse. As indicated in Table 3, nine banks converted from a C corporation to an S corporation in the first half of 2018, relative to 14 such conversions in the first half of 2017.

Third, tax reform may influence banks’ investment portfolio positioning. While portfolio allocations reflect many factors, Chart 1 suggests that tax reform has affected investment strategies. Municipal securities remained relatively stable throughout 2017 at 28% of total securities; however, the proportion of municipal securities dropped to 26.9% at March 31, 2018 and 26.5% at June 30, 2018. This trend is consistent with our experience, where banks are not liquidating municipal securities due to tax reform but, at the margin, may prefer taxable alternatives for new purchases.

Refresher

Internal Revenue Code Section 199A provides a 20% deduction against the income reported by owners of sole proprietorships, partnerships, and S corporations. If only tax code provisions could be described in one sentence, though. The deduction may be taken against income generated by a Qualified Trade or Business (QTB). A QTB, in turn, is any business, other than a Specified Service Trade or Business (SSTB).

In addition, certain W-2 income and asset limitations exist that may limit the 20% deduction. Lastly, individuals with income below certain levels may escape the SSTB and W-2 income/asset limitations; therefore, these owners would receive the 20% deduction whereas owners with higher incomes would not. The NPR provides guidance regarding, among other items, the definitions of QTBs and SSTBs.

Other Issues

While banks definitely are eligible for the 20% Qualified Business Income deduction, several other items covered by the NPR may be of interest to bankers.

Qualified Trade or Business Definition

An entity must be a Qualified Trade or Business to receive the 20% QBI deduction. From the TCJA, however, it was unclear if a QTB must be a “Section 162 trade or business.” While the Internal Revenue Code and regulations contain various definitions of a “business,” Section 162 contains a relatively restrictive definition. Unfortunately for taxpayers, the NPR adopts the Section 162 definition.

While Section 162 has existed for many years, the regulations and case law interpreting the provision remain somewhat vague. One significant concern is that certain real estate entities will not be deemed Section 162 trades or businesses, therefore becoming ineligible for the 20% QBI deduction. For example, entities holding properties subject to triple net leases may face difficulties meeting the Section 162 requirements. From a credit standpoint, banks should be aware that tax savings expected by owners of certain real estate entities may not materialize.

The TCJA’s Definition of an SSTB

Entities providing professional services generally are deemed SSTBs. The business reality, though, is that some companies provide both a tangible product (like a widget) and services that would meet the definition of an SSTB (such as educational services regarding widgets). Will a company offering some consulting services, no matter how small a share of revenues, be deemed an SSTB? Under the TCJA, it was unclear. The NPR creates a de minimis exception for companies with small amounts of service revenues, although the thresholds appear relatively low to us.

The TCJA also includes a “catch-all” provision deeming as SSTBs any businesses for which the reputation or skill of its owners or employees is a principal asset. This broad provision potentially captures a large swath of small businesses; for example, the reputation of a restaurant’s chef may result in the restaurant being deemed an SSTB. This result appears inconsistent with the TCJA’s statutory intent, and the NPR significantly limits the scope of the catch-all provision.

The “Crack and Pack” Strategy

Commentators noted that the TCJA created a tax planning opportunity for businesses deemed SSTBs. For example, consider a law firm that owns a building in which it operates. The law firm is an SSTB and its partners ineligible for the 20% deduction. The partners could transfer the building to a new real estate holding company, which is not deemed an SSTB. Therefore, the law firm partners have shifted income – via rent payments from the law firm to the real estate holding entity – from the SSTB (the law firm) to an entity qualifying for the QBI deduction (the real estate entity).

Alas, the IRS cracked down on the “crack and pack” strategy. The NPR provides that income from a commonly-controlled entity that provides services to an SSTB is ineligible for the 20% deduction. However, the NPR may not entirely foreclose on all planning strategies. While the NPR limits the QBI deduction for commonly-controlled entities, commonality is deemed to exist if the businesses share 50% or more ownership. Therefore, the law firm may transfer its building to an entity owned equally by the law firm partners, an accounting firm’s partners, and a physician group. Since common control does not exist (i.e., neither the attorneys nor the accountants nor the physicians control more than 50% of the real estate firm’s ownership), the owners of the various services firms would be eligible for the 20% deduction on the real estate entity’s earnings. To bankers, business reorganizations triggered by the deduction limitations applicable to SSTBs may trigger lending requirements.

Conclusion

Like a good novel, the NPR’s “plot” is not fully resolved – some questions remain unanswered and multiple interpretations of other provisions are possible. Perhaps a sequel to the NPR is in order.

Originally published in Bank Watch, August 2018.

¹As for literary criticism, Mercer Capital does not render tax or legal advice, and readers should consult with appropriate professionals regarding the application of Section 199A to any specific circumstances.
² To expound upon our arbitrary one sentence limitation, it was relatively clear in the Tax Cuts & Jobs Act that bank shareholders are eligible for the 20% Qualified Business Income deduction, but the August 2018
NPR confirms this eligibility.

Bluegrass Community Bankers Valuation

This presentation will review the factors that impact bank valuations in the private, public and M&A markets and look at how the pricing cycle has evolved the past 25 years and ask the question: how is it different this time?

Jeff K. Davis, CFA, Managing Director of Mercer Capital’s Financial Institutions Group, delivered this presentation at the 2018 Bluegrass Community Bankers Association Convention on August 27, 2018.

eSports: An Emerging Industry

eSports is a rapidly expanding industry that has drawn viewers and investments alike. The introduction of streaming platforms as well as the improvement in mobile technology has allowed the industry to grow from its arcade hall beginnings in the 1970s to competitors streaming games to millions of viewers globally. In addition to being highly visible (192 million frequent viewers in 2017), the eSports industry is also lucrative ($906 million projected industry revenue in 2018).

The History of eSports

Sprouting from humble beginnings, researchers trace the roots of the eSports industry to informal competitions held at video game arcades in the 1970s. One of the first breakthroughs came in 1980 when Atari’s National Space Invaders Championship drew 10,000 participants across the U.S. As a spectator sport, eSports first took off in South Korea, when cable networks broadcast StarCraft tournaments in the early 2000s. By 2004, StarCraft stadium events in South Korea drew 100,000 fans. In the U.S., the coming of age moment arrived in 2013 when 13,000 people flooded the Staples Center to watch the world championship final of League of Legends.

A Growing Audience

The eSports industry has experienced rapid growth in recent years. According to data from Newzoo, an eSports researcher, the global eSports audience totaled 204 million in 2014. Approximately 56% (114 million) were considered frequent viewers/enthusiasts while the remaining 44% (90 million) were categorized as occasional viewers. By 2017, the global audience grew to 335 million, a compound annual growth rate of approximately 36% and the viewership ratio was approximately the same (57% categorized as frequent viewers/enthusiasts and 43% as occasional viewers).

The number of frequent viewers grew at a compound annual growth rate (CAGR) of 36% from 2014 to 2017 and is projected to grow at a CAGR of 12.5% to 2021.

By comparison, occasional viewers grew at a CAGR of 35% from 2014 to 2017 and are projected to grow at a CAGR of 15% to 2021.

Livestreaming Platform

The primary delivery method for eSports is Twitch, a livestreaming video platform owned by Twitch Interactive, a subsidiary of Amazon. Twitch was introduced in 2011 and, as of February 2018, the platform has 2 million monthly broadcasters and 15 million daily active users. Twitch operates like traditional television in that the broadcasters can be “channels” that are not necessarily broadcasting 24/7, differentiating it from on-demand platforms like YouTube and Netflix.

Twitch is unique in its ad revenue model, which supports the livestreaming aspect of the platform. The top 17,000 streamers, which include professional eSports players, participate in an ad-revenue-sharing program, where the players, not Twitch, decide in real time when the ads run during their streaming sessions. For example, a top eSports player might practice on Twitch and draw thousands of viewers then when the player takes a quick break, he asks viewers to watch an ad. Despite encroaching competition from YouTube, Twitch out-streams other platforms and, given its momentum, it continues attracting sponsors to reach the growing audience.

eSports Tournaments and Viewship

Like traditional sports, eSports have occasional tournaments that draw big audiences. In 2017, the Intel Extreme Masters (IEM) in Katowice, Poland drew 46 million unique viewers. IEM featured three games with a total prize pool of $688,750. This viewership figure was exceeded only by the Super Bowl, which drew 111.3 million U.S. viewers in 2017.

By comparison, the 2017 baseball World Series had average viewership of 18.7 million U.S. viewers over seven games. Therefore, the average viewership of the 2017 World Series would rank 14th on a list of worldwide eSports tournaments ranked by viewership from 2012 to 2017. The 2017 NBA Finals, which featured the Golden State Warriors against the Cleveland Cavaliers for the 3rd year in a row, averaged 20.4 million U.S. viewers over a five game series. The 2017 Stanley Cup Final trailed the other three major sports with average viewership of 4.6 million in the U.S. over six games.

To underscore the growing popularity of eSports, the combined average viewership of the championship series for three of the major sports in the United States was less than the viewership for one eSports tournament (IEM) in 2017.

The large tournament viewership has attracted the attention and dollars of global brands. Coca-Cola sponsors the League of Legends World Championship, one of the largest global eSports competitions. Since 2006, Intel has sponsored Intel Extreme Masters alongside the Electronic Sports League (ESL), the longest running eSports tournament in the world. To support the growing demand, investments in eSports sponsorships will continue to rise.

New Game Releases

Since its introduction on July 25, 2017, Fortnite has become a global phenomenon. As of June 3, 2018, Fortnite ranked as the top game watched on Twitch with 4.43 million hours watched. Counter-Strike: Global Offensive ranked second with 2.7 million hours watched (approximately 40% less hours watched than Fortnite). Other games ranking in the top 10 include: League of Legends, Dota 2, IRL, PlayerUn- known’s Battlegrounds, Overwatch, Hearthstone, Path of Exile, and FIFA 18. Releases of new games can attract viewers to those games. A challenge for Twitch broadcasters is to be up-to-date on new games so that viewers don’t get bored with older games.

Growing Revenue

Newzoo defines industry revenue as the amount generated through the sale of sponsorships, media rights, advertising, publisher fees, tickets, and merchandising. Global eSports revenues are projected to reach $906 million in 2018. North America is projected to account for approximately 38% ($345 million) of global eSports revenue in 2018. Global revenue for eSports is projected to reach $1.65 billion in 2021.

Despite the tremendous growth, eSports fan spending is lower than traditional sports. According to Newzoo, eSports enthusiasts spent an average of $3.64 per person compared to basketball fans who spent an average of $15 per person. The primary factor for this gap is that eSports content is largely available for free and spending on merchandise remains relatively small.

eSports Industry Transactions

Stack Sports Transactions

Originally named BlueStar Sports, Stack Sports began in April 2016 with the goal of transforming youth sports. With this goal in mind, Stack has acquired 20 companies as of July 2018 in order to provide a variety of services. Services provided by Stack Sports include league and competition management, athlete and team solutions, event solutions, brand advertiser solutions, and payment solutions. The company’s various tools include building team websites, online registration for leagues and tournaments, and software that analyzes game day video.

The accompanying chart was compiled using data from Crunchbase and shows Blue Star/ Stack acquisitions from May 2016 to February 2018.

Unikrn Acquires ChallengeMe.gg

Uinkrn is a Seattle based eSports betting startup. Founded in 2014 as a platform for eSports betting, Unikrn has since added hosting physical tournaments to its services. Mark Cuban, owner of the Dallas Mavericks is among the investors in the company.

ChallengeMe.gg is an eSports matchmaking service headquartered in Berlin, Germany. While an exact dollar amount was not disclosed, Unikrn CEO Rahul Sood said it was “a multi-million dollar acquisition.”

Nazara Technologies Acquires 55% Stake in Nodwin Gaming

Headquartered in Mumbai, Nazara aims to create a full eSports system including competitive online and offline play, localized leagues, and global events. Nodwin Gaming was started in 2014 and has exclusive rights for ESL (Esports League) in India, the Intel Extreme Masters qualifiers for India, and the Electronic Sports World Cup India Qualifiers. In acquiring a majority stake in Nodwin, Nazara hopes to leverage Nodwin’s relationships to create an Indian eSports ecosystem. India’s eSports audience is still developing with only 2 million enthusiasts and an additional 2 million occasional viewers according to market researchers Frost & Sullivan and Newzoo.

Unity Technologies Buys Multiplay for $25.2 Million

Multiplay is a division of UK-based Game Digital. Multiplay provides server hosting for games such as Titanfall 2, Day Z, Rocket League, and Rust. The terms of the deal provide that Unity pay $22.7 million at the time of acquisition (November 2017) and $2.5 million in July 2019. The Multiplay division includes a digital business and an eSports and events business.

Other Investments into Team Sponsorships

The growth of eSports has attracted the attention from high profile investors. For example, in November 2017 Jerry Jones along with John Goff acquired the eSports team Complexity. Complexity was founded in 2003 by Jason Lake and currently competes in six games: CS GO, DOTA 2, Call of Duty, Rocket League, HearthStone, and Gwent. Complexity will move facilities to The Star, which also houses the Dallas Cowboys World Headquarters in Frisco, Texas.

Magic Johnson and motivational speaker Tony Robbins partnered acquire ownership interest in Team Liquid, an eSports team based in Santa Monica, California. Another former Laker, Shaquille O’Neal is a co-owner of NRG eSports. The teams mentioned above compete with other eSports teams from around the world in various tournaments held throughout the year.

Conclusion

Esports is a relatively new industry with potential. Advances in streaming and mobile technology have allowed the industry to expand in recent years. Newzoo projects the global eSports audience will be approximately 557 million in 2021, a compound annual growth rate of 14.4% from 2016. In addition to a growing global audience, Newzoo projects global revenue for the eSports industry to reach $1.65 billion by 2021, a CAGR of 27.4% from 2016.

The potential growth has drawn interest from a wide range of investors as approximately 84% of 2021 global revenue is projected to be from brand investments such as media rights, advertising, and sponsorship.

Mercer Capital will continue to follow the industry and discuss the valuation issues facing the industry in future articles.

Originally published in Mercer Capital’s eSports: An Emerging Industry whitepaper.

M&A Update: Good Gets Better

After a slow start, M&A activity among U.S. commercial banks and thrifts picked up to the point where 2018 should look like recent years. Historically, approximately 2% to 4% of the industry is absorbed each year via M&A. Since 2014, the pace has been at or slightly above 4% as a well performing economy, readily available financing, rising stock prices for bank acquirers, and strong asset quality and earnings of would be sellers have supported activity.

There were 140 announced transactions according to S&P Global Market Intelligence through early July, which equates to 2.4% of 5,913 FDIC-insured institutions that existed as of year-end 2017. The average assets per transaction based upon YTD activity was $656 million, which is below the 28 year average of $1.1 billion.

Pricing has trended higher as measured by the average price/tangible book value (P/TBV) multiple, which increased to 172% in 2018 from 164% in 2017 and about 140% in 2014-2016 before the sector was revalued after the national election on November 8, 2016.

The median P/E based upon trailing 12 month earnings increased to 26x in 2018 from 23x in 2017 and 21x in 2016; however, the 2018 P/E based upon trailing 12 month earnings does not reflect a full year impact of the reduction in the top marginal federal tax rate to 21% from 35% that occurred on January 1. The adjusted P/E assuming the lower tax rate was in effect for 2017, too, is around 20-22x.

Lower tax rates notwithstanding, it appears that buyers are still paying roughly 9-13x pro forma earnings assuming all expense savings are fully realized, a level of pricing that we believe has existed for many years excluding periods when industry fundamentals are stressed. For example, Fifth Third Bancorp (FITB) estimates the $4.6 billion consideration to be paid to MB Financial (MBFI) shareholders equates to 16.4x consensus 2019 earnings and 9.6x assuming all expense savings realized in 2019 (which will not be the case due to the phase-in lag).

Cash Deals vs. Mix/Stock Deals

Dig deeper and, of course, there is more to the pricing story. The reduction in tax rates has had a material impact on profitability. Depending upon the index bank stocks rose 25-30% in the three months after the national election on November 8, 2016, on the expectation of what has mostly played out: a reduction in corporate tax rates, less regulation, higher short rates and faster economic growth.

The improvement in public market multiples has supported expansion of M&A multiples when the majority of the consideration consists of the buyer’s common shares. As shown in Table 1, the median P/TBV and P/E ratios for transactions announced in the 20 months since the election were 173% and 23.0x compared to 147% and 20.3x for the 20 months ended November 8, 2016. Multiple expansion is even more pronounced when only 2018 deals are considered because the YTD median P/TBV and P/E multiples are 193% and 25.4x.

Not surprisingly (to us), the median multiples for cash deals did not rise as much, increasing to 141% after the election compared to the 20 month pre-election median of 123%. Cash did not inflate in value over this period like public market bank stock valuations; hence, the only meaningful factor that drove the limited improvement in cash acquisition multiples was the increase in ROE.

In addition, cash activity slowed post-election because buyers and sellers waited to see if would be sellers’ earning power would increase from a reduction in corporate tax rates, which was not confirmed until late 2017. Transactions in which the primary form of consideration consisted of the buyer’s common shares did not have to wait for the tax issue to be resolved because buyer and seller both faced the issue.

Small Deals, Larger Deals, and Perhaps Big Deals

M&A is largely a story of the consolidation of the small banks by large community and small regional banks. Two decades ago the theme was the same, but overlaid was the formation of the nationwide and multi-region franchises through mega-mergers such as NCNB/Bank of America and Wells Fargo/Norwest.

Since the financial crisis, activity has mostly been confined to small deals with deal values a fraction of the pre-crisis and especially pre-2000 amounts. Annualized year-to-date deal value is $33 billion, which compares to approximately $26 billion annually during 2015-2017. By comparison, the value of announced transactions in 1997 and 1998 were many multiples greater at $97 billion and $289 billion, respectively.

During the past five years, there only have been 10 deals that exceeded $2 billion of consideration and 22 deals in which the consideration exceeded $1 billion. As shown in Table 2, the two largest transactions involved Canadian banks, while three involved the large Ohio-based banks.

Change may be afoot, however. Fifth Third’s $4.6 billion pending acquisition of MB Financial is its first bank acquisition since 2008, and it was announced a couple of days before President Trump signed into law the Economic Growth, Regulatory Relief, and Consumer Protection Act. Among other things, the financial deregulation law moved the SIFI asset threshold from $50 billion to $100 billion and provided significant relief for institutions such as Fifth Third that fall within the $100 billion to $250 billion asset bucket.

Notably, during the past five years only CIT Group crossed the prior $50 billion SIFI threshold via acquisition, and apparently did so at the urging of regulators who wanted CIT to shore up its deposit funding.

We look for more activity among mid-sized regional banks that are near or over $50 billion of assets; however, deal activity among the very largest banks is off the table given the $250 billion asset threshold for the global SIFI designation and the 10% nationwide deposit market share cap if pierced via acquisition.

The potential fly in the ointment to the robust bank M&A environment is the flattening yield curve and the attendant underperformance of bank stocks this year. If bank stocks lag and valuations compress further, then it may be difficult for buyers to meet inflated seller expectations that rarely take into account downward moves in buyers’ share prices.

How We Can Help

The adage banks are sold rather than bought is largely true, meaning most banks transact when the sellers are ready to do so. Sometimes that occurs after years of planning; sometimes it occurs unexpectedly when another institution makes a casual inquiry.

Mercer Capital has over three decades of experience as a financial advisor helping institutions navigate the process as buyer and seller. Even if your board has no interest in selling (or buying) we would be happy to present an overview to your board about the lay of the land as it relates to the public market, M&A market and what actions your board might consider to enhance value. Please call if we can be of assistance.

Originally published in Bank Watch, July 2018.

Changing Tides on Lack of Marketability in Tennessee Courts

For years, cases such as Bertuca¹ and Barnes² governed the landscape on the issue of marketability in the valuation of marital assets in Tennessee family law cases. Specifically, Bertuca involved a company called Capital Foods which held several McDonald’s franchise locations. In the decision, Bertuca did not allow for a discount to be taken for the lack of marketability for a nonpublicly traded company and offered the following reasoning:

“…no indication…has any intention to sell…thus, the value of the business is not affected by the lack of marketability and discounting the value for nonmarketability in such a situation would be improper.”

While Barnes involved a dental practice, the Court offered a similar explanation for excluding a discount for lack of marketability:

“…inappropriate because no sale was ordered and there [was] no indication in the record that the Husband ha[d] any intention of selling his minority stock.”

Both cases focused on the lack of an actual/imminent sale rather than the lack of marketability of these two underlying companies when compared to a publicly traded equivalent. The cases also left business valuation appraisers in a quandary, since this treatment of the lack of marketability didn’t seem to match the fair market value standard. The fair market value standard, discussed in Revenue Ruling 59-60, discusses the relevance of a willing buyer and a willing seller and also allows for potential discounts for lack of control and lack of marketability, where applicable.

So what has changed now? In April 2017, House Bill 348 was passed by the Tennessee legislature. This Bill amends the Tennessee Code Annotated Title 36, Chapter 4 (TCA 36-4-121), relating to the equitable division of marital property. Specifically, this Bill allows for “considerations for a lack of marketability discount, a lack of control discount, and a control premium if any should be relevant and supported by the evidence for such assets” “without regard to whether the sale of the asset is reasonably foreseeable.”

Effective July 2017, discounts for lack of marketability can now be considered in the valuation of assets in family law disputes. As with the valuation itself, it’s important to hire an accredited/credentialed business valuation appraiser to assist in the determination, documentation and support of any discounts for lack of control and marketability, along with any applicable premiums.

End Note

¹Bertuca v. Bertuca, No. M2006-00852-COA-R3-CV, 2007 WL 3379668 (Tenn Ct. App. Nov. 14, 2007).

²Barnes v. Barnes, No. M2012-02085-COA-R3-CV (Direct Appeal from the Chancery Court for Bedford County No. 27833, April 10, 2014).

Originally published in Mercer Capital’s Tennessee Family Law Newsletter, Second Quarter 2018

Valuation of a Business for Divorce: Overview of Valuation Approaches, Normalizing Adjustments, and Potential Need for Forensics Services

Valuation of a business can be a complex process requiring certified business valuation and forensic accounting professionals. Valuations of a closely held business in the context of a divorce are typically multifaceted and may require forensic investigative scrutiny for irregularities in the financials that may insinuate dissipation of business/marital property. Business valuations are a vital element of the marital dissolution process as the value of a business, or interests in a business, impact the marital balance sheet and the subsequent allocation/distribution of marital assets.

Valuation Approaches

To begin, the financial expert will request certain information and interview management of the Company. Information requested typically includes:

Financial statements (usually the last five years)
Tax returns (usually the last five years)
Budgets or forecasted financials statements
Buy-sell agreement
Information on recent transactions
Potential non-recurring and/or unusual expenses
Qualitative information such as business history and overview, product mix, supplier and customer data, and competitive environment

The financial expert must assess the reliability of the documentation and decide if the documents appear thorough and accurate to ultimately rely on them for his/her analysis. The three approaches to value a business are the Asset-Based Approach, the Income Approach, and the Market Approach.

The Asset-Based Approach

The asset-based approach is a general way of determining a value indication of a business, business ownership interest, or security using one or more methods based on the value of the assets net of liabilities. Asset-based valuation methods include those methods that seek to write up (or down) or otherwise adjust the various tangible and intangible assets of an enterprise.

The Income Approach

The income approach is a general way of determining a value indication of a business, business ownership interest, security or intangible asset using one or more methods that convert anticipated economic benefits into a present single amount.

The Market Approach

The market approach is a general way of determining a value indication of a business, business ownership interest, security or intangible asset by using one or more methods that compare the subject to similar businesses, business ownership interests, securities or intangible assets that have been sold.

Synthesis of Valuation Approaches

A proper valuation will factor, to varying degrees, the indications of value developed utilizing the three approaches outlined. A valuation, however, is much more than the calculations that result in the final answer. It is the underlying analysis of a business and its unique characteristics that provide relevance and credibility to these calculations.

The Levels (Premise) of Value

Does it make a difference in value per share if you own 10% or 75% of a business? You bet it does. A 10% interest is a minority interest and does not enjoy the prerogatives of control. How does this affect value per share? The minority owners bear witness to a process over which they may have no control or discretion. In effect, they often play the role of silent partners; therefore, the fair market value per share of a minority owner is likely worth less per share than the shares of a 75% owner.

Likewise, a minority owner of a private business likely does not have a ready market in which to sell their interest. Minority ownership in a publicly traded company enjoys near instantaneous liquidity such as trading stock on organized and regulated exchanges. The unique uncertainties related to the timing and favorability of converting a private, minority ownership interest to cash gives rise to a valuation discount (lack of marketability discount) which further distances the minority owner’s per share value from that of a controlling owner’s value per share.

The following chart provides perspective of the various levels of value. In most cases a valuation is developed at one level of value and then a discount or premium is applied to convert to another level. These discounts are known as discounts for lack of control and lack of marketability. Knowing when to apply such adjustments and quantifying the size of these adjustments is no simple matter, requiring the need for a credentialed business valuation professional.

Importance of Normalizing Adjustments

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. Keep in mind the levels of value in business valuation, discussed above. 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.

Non-Recurring, Unusual Items

These adjustments eliminate one-time gains or losses, unusual items, non-recurring business elements, expenses of non-operating assets, and the like. Examples include, but are not limited to:

One-time legal settlement. The income (or loss) from a non-recurring legal settlement would be eliminated and earnings would be reduced (or increased) by that amount.
Gain from sale of asset. If an asset that is no longer contributing to the normal operations of a business is sold, that gain would be eliminated and earnings reduced.
Life insurance proceeds. If life insurance proceeds were paid out, the proceeds would be eliminated as they do not recur, and thus, earnings are reduced.
Restructuring costs. Sometimes companies must restructure operations or certain departments, the costs are one-time or rare, and once eliminated, earnings would increase by that amount.

Discretionary Items

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, etc.) that would not exist in a publicly traded company.

For more, refer to our article “Normalizing Adjustments to the Income Statements” and Chris Mercer’s blog.

The Need for Forensic Services

The process of valuing a business is complicated and the financial expert, during the course of his/her analysis, must consider various levels of value, normalization adjustments, as well as methods of valuation to most appropriately conclude on the business.

Valuations of a closely held business in the context of a contentious divorce can be especially multifaceted and may require additional forensic investigative scrutiny for any irregularities in the financials that may insinuate dissipation of business/marital property in anticipation of the divorce and valuation. Examples may include, but are not limited to:

Owner Compensation. Owners may reduce earnings in anticipation of divorce to appear to have lower earnings capacity. Owners or executives with ownership interest may have made arrangements within the business to receive a post-divorce pay-out. A financial expert, through review of historical financial statements and tax returns, as well as an analysis of the lifestyle of the family, may gather support of the true earnings.
Rent expense. Owners of a company may also own the land and/or building to which the business’ rent expense is paid, otherwise referred to as a related party. If the rent has increased in anticipation of the divorce, the related party may be taking on pre-paid rent or higher than market rent rates to reduce income. A financial expert may review historical expenses and assess the reasonableness of the rent expense.
Discretionary expenses. Owners may use business funds to pay for personal, non-business related expenses such as vacations, lavish cars, boats, meals & entertainment, among others. A financial expert can review historical transactions to assess if such items are non-business related and if normalization adjustments are necessary for valuation purposes.

It is important to consider these types of situations if only one spouse is involved with the operations and management of the company, otherwise referred to as the “in-spouse.” That spouse may, or may not, have been altering the financial position of the business in anticipation of divorce and a potential independent business valuation. The services of a financial expert can be vital to you and your client in such matters, as the accuracy of the valuation may impact the equitable distribution of the marital assets.

Conclusion

If suspicions do not necessitate forensic services, perhaps only a business valuation scope is necessary. Furthermore, if the business or an interest was recently bought or sold, if it was recently appraised, or if its value is in a financial statement or a loan application, that information may go a long way in establishing the value of the business (if both parties feel that this value is a fair representation). However, since a business valuation report and expert witness are admissible in court as evidence and since the value of a business or interest impacts the marital balance sheet and the subsequent asset distribution, it may be exceedingly beneficial to hire a professional for evidentiary support.

Originally published in Mercer Capital’s Tennessee Family Law Newsletter, Second Quarter 2018

AICPA Publishes Guide for FV Marks

On May 15, the AICPA’s Financial Reporting Executive Committee released a working draft of the AICPA Accounting and Valuation Guide Valuation of Portfolio Company Investments of Venture Capital and Private Equity Funds and Other Investment Companies. The document provides guidance and illustrations for preparers of financial statements, independent auditors, and valuation specialists regarding the accounting for and valuation of portfolio company investments of venture capital and private equity funds and other investment companies. The comment period ends August 15, 2018.

Weighing in at nearly 650 pages, the guide defies quick summary. As noted in the preliminary “Guide to the Guide” section, different chapters in the working draft are likely to be of greater interest to some groups of intended users than others. In this introduction to the Guide, we provide a brief overview of the chapters and appendices with which PE and VC managers should develop familiarity.

Chapter 8, Valuation of Equity Interests in Complex Capital Structures. For venture investments, valuation is often a two-step process. First, analysts must focus on the attributes, opportunities, and risks of the business as a whole. Second, analysts then need to assess how, amid the often staggeringly complex capital structures of venture-backed companies, to allocate the overall business value to the specific ownership interest held by the investor. Chapter 8 focuses on the challenges and potential pitfalls of the second step.

The Guide distinguishes between the economic and non-economic rights typical of senior classes of preferred stock. Analysts generally value the economic rights attached to different share classes using one of four methods: scenario-based methods, the option pricing method, the current value method, or the hybrid method. The Guide provides a comprehensive overview of the relative strengths and weaknesses of these methods and describes which circumstances are most conducive to the use of each.

Chapter 10, Calibration. Valuing portfolio company investments typically requires the use of significant unobservable inputs and considerable judgment in selecting appropriate company and market-level inputs and valuation techniques. Calibration is the process of using observed transactions in the portfolio company’s own instruments, especially the transaction in which the fund entered a position, to ensure that the valuation techniques that will be employed to value the portfolio company investment on subsequent measurement dates begin with assumptions that are consistent with the original observed transaction as well as any more recent observed transactions in the instruments issued by the portfolio company.

Chapter 10 of the Guide discusses the calibration framework and provides examples of how initial valuation assumptions used in valuing a debt or equity investment in a business can be calibrated with the original transaction price and subsequently adjusted to take into account changes in the subject investment and market conditions at the measurement date. When subsequent funding rounds take place, calibrating to the most recent transaction is typically most relevant, and the Guide outlines six different types of transactions and the process of potentially inferring value from these types of transactions.

Chapter 11, Backtesting. The PE/VC task force believes it is best practice for investment companies to perform periodic backtesting. Backtesting refers to the process of using the observed value of the fund’s interests as implied by the ultimate sale, liquidity event, or other significant change to assess the fair value estimated for an investment at an earlier date.

The primary purpose of backtesting is to assess and improve the valuation process going forward. The Guide provides an overview of the backtesting process and advice on how to identify and evaluate factors that can contribute to a difference in value for a particular investment between the measurement date and event date. The final section of Chapter 11 provides nine examples illustrating the backtesting process across different types of investments and under various scenarios.

Chapter 12, Factors to Consider at or near a Transaction Date. In accordance with FASB ASC 946, funds initially measure the investment as the capitalized cost including transaction costs. At the first reporting date following the transaction, funds are required to measure the investment at fair value in accordance with FASB ASC 820. Chapter 11 addresses fair value considerations at initial recognition and fair value considerations at or near exit in the context of these two apparently diverging requirements.

Appendix A, Valuation Process and Documentation Considerations. Appendix A discusses considerations related to internal control over financial reporting and identifies a set of principles that are important to the establishment and maintenance of an effective valuation process.

Appendix C, Case Studies. Appendix C includes fifteen case studies that are designed to illustrate how information would be evaluated and incorporated when estimating value.

In short, the new Guide is a welcome addition to the resources available for fund managers in developing reliable fair value measurements for portfolio investments. We expect that having a common set of acknowledged best practices will promote efficiency in the preparation and auditing of fair value measurements. We will provide more detailed comments on specific elements of the draft Guide in the coming weeks. In the meantime, please do not hesitate to call us to discuss how any element of the new Guide may affect your portfolio valuation process.

This article originally appeared in Mercer Capital’s Portfolio Valuation Newsletter, Second Quarter 2018.

Takeaways from FinXTech 2018: The Rise of Bank and FinTech Partnerships

I recently attended FinXTech, an industry event where the hosts at Bank Director bring together FinTech founders and bank directors and executives for productive conversations about the road ahead as partners (and competitors).

Those discussions occurred against a backdrop in which FinTech, as a concept to enhance the customer experience and to drive operating efficiencies, is widely accepted by bank management, shareholders, and regulators. How “FinTech” is implemented varies depending upon resources. As shown in the Table 1, there has been no surge of M&A in which banks buy FinTech companies. Only nine of 276 transactions announced since year-end 2016 entailed a bank or bank holding company acquirer. KeyCorp, which has been one of the nine active FinTech acquirers, announced in June 2018 that it would acquire digital lending technology for small businesses built by Chicago based FinTech company Bolstr. At best, activity can be described as episodic as it relates to bank acquisitions, which appears to be designed to supplement internal development.

The very largest banks such as JPMorgan Chase & Co. are spending billions of dollars annually to upgrade technology—a level of spending that even super regional banks cannot match. In contrast, community and regional banks have been left scratching their heads about how to address FinTech-related issues when money is a constraining factor.

During the FinXTech 2018, the focus shifted from the potential disruption of a bank’s franchise by FinTech to the potential to partner with FinTech companies, which stood out to me as a marked change from prior years.

Both banks and FinTech companies realize that they need each other to some degree. For banks, FinTech offers the potential to leverage innovation and new technologies to meet customer expectations, enhance efficiency, and compete more effectively against the biggest banks. For FinTech companies, the benefits from bank partnerships can include the potential to leverage the bank’s customer relationships to scale more quickly, access to funding, and regulatory/compliance expertise. Several examples of successful partnerships between banks and FinTech companies were highlighted at the FinXTech event. (You can read more about some of them here.)

The FinTech/Bank partnership theme also was evident in GreenSky’s recent IPO, a FinTech company based in Atlanta. GreenSky arranges loans primarily for home improvement projects. Bank partners pay GreenSky to generate and service the loans while the bank funds and holds the loans on their balance sheet. As more partnerships emerge, it will be interesting to see if FinTech impacts the valuation of banks that effectively leverage technology to achieve strategic objectives such as growing low-cost core deposits, opening new lending venues, and improving efficiency. One would think the answer will be “yes” if the impact can be measured and is meaningful.

Another trend to look for will be whether smaller banks become more active as investors in FinTech companies. For the most part, investments by community and regional banks in FinTech companies remains sporadic at best even though FinTech companies raised nearly $16 billion of equity capital between year-end 2016 and June 2018 in both private and public offerings. An interesting transaction we observed was a $16 million Series A financing by Greenlight Financial Technology, Inc., a creator of smart debit cards, in which the investors included SunTrust Bank, Amazon Alexa Fund, and $619 million asset NBKC Bank, among others.

FinXTech 2018 included several sessions related to due diligence for FinTech partnerships; however, with limited M&A and investing activity by banks there was little discussion about valuation issues, which can be challenging for FinTech companies and differs markedly from methods employed to value a bank.

Not surprisingly, we have lots of thoughts on the subject.

With the emerging partnership theme from FinXTech 2018 in mind, view our complimentary webinar “How to Value an Early-Stage FinTech Company.” Additionally, if you have questions, reach out to one of our professionals to discuss your needs in confidence.

Originally published in Bank Watch, June 2018.

Who’s In and Who’s Out?

As family businesses evolve, the family’s leaders need to determine the appropriate relationship between membership in the family and ownership in the business. As the third, fourth, and subsequent generations of the family reach adulthood, it becomes increasingly likely that the interests of at least some family members will diverge from the interests of the business.

Family businesses can adopt one of two broad strategies to address this situation:

Maintain broad-based ownership and make positive shareholder engagement a strategic priority; or,
Use share redemptions and liquidity programs to achieve concentrated ownership among a subset of the family.

Neither strategy is inherently superior to the other. We discussed the benefits (and challenges) of developing positive shareholder engagement in a prior article. In this article, we focus on the second strategy.

Motivations for Selling Shares

In this article, we focus on voluntary, rather than involuntary, sales of shares. Involuntary sales of shares include those triggered by, and governed by, the relevant terms of the company’s buy-sell agreement. You can find a brief overview of the issues associated with buy-sell agreements here.

In some families, selling shares in the family business is perceived as nothing short of treason. Yet, there are often legitimate reasons for family members to sell shares in the family business, such as a desire for diversification, proceeds to start a new business venture, or funding education or other major life events.

In our experience, the desire of family shareholders for liquidity (whether full or partial) can usually be traced to some form of “clientele” effect. The clientele effect names the fact that a company’s shareholder base is not monolithic: different shareholders have different portfolios, risk preferences, income needs, and expectations. In multi-generation family businesses, we find the clientele effect to be common. As the family grows numerically and spreads out geographically and occupationally, it is only natural for shareholders no longer to look so much alike. Differing shareholder needs and preferences are not wrong, but when treated as such, the resulting suspicion can lead to resentment, open conflict, and in too many cases, litigation.

Shareholder clienteles can form along many different potential axes: kinship, geography, employment status, etc. To illustrate the concept, consider the economic role the family business can fulfill in different households, as depicted in the following chart.

It is only natural that family members in the upper right quadrant view the family business very differently from their cousins or siblings in the lower left quadrant. Those in the upper right quadrant are likely to be very risk-averse, desiring preservation of capital and the current level of dividends above all else. Shareholders in the lower left quadrant will much more closely resemble public market investors, supporting corporate strategies that enhance returns at acceptable risk levels.

For public companies, the clientele effect sorts itself out because shareholders self-select; if the attributes of the company don’t align a shareholders preferences and risk tolerances, it is very easy for the shareholder to sell their holdings and find assets that are a better fit. For family businesses, however, things are not nearly so tidy.

Faced with multiple shareholder clienteles, family business leaders can seek to adopt distribution and reinvestment policies that accommodate as many shareholders as possible. Or, the family can adopt a formal share redemption or liquidity program with a view to providing shareholders greater flexibility in tailoring the economic benefits of family membership to the unique circumstances of their particular household.

Elements of a Shareholder Liquidity Program

While every shareholder liquidity program is unique, there are certain formal elements that all plans, whether formal or informal, must have.

Buyer. There has to be a source for the liquidity made available to selling shareholders. The default assumption is generally that the business will redeem the shares sold under the plan. However, the available liquidity pool may be supplemented by individual shareholders who are able and willing to purchase additional shares.
- If the business redeems shares, the relative ownership of all the non-selling shareholders increases on a pro rata basis. And, since the business is paying for the shares, the redemption will either reduce the company’s liquid assets and/or increase the company’s indebtedness. In either case, the redemption changes the financial risk profile of the family business.
- If shares are instead purchased by other family shareholders, the relative ownership of shareholders that are not a party to the transaction is unchanged. Further, the company’s financial position is unaffected, since it is serving the role of matchmaker, but is not actually a party to the transaction. If there are shareholders with the financial capacity and willingness to purchase additional shares, the family can benefit from having a liquidity program that does not take capital away from the business.
Frequency. Liquidity may be available on a continuous basis, or at specified intervals. A continuous plan provides the most flexibility for shareholders, but restricting redemptions to specific dates (annual or potentially even less frequent) is generally more efficient and predictable for the managers of the business, and allows the business to accumulate capital to fund the redemption.
Availability. Liquidity plans generally include caps on the aggregate dollar amount of liquidity to be made available, whether to individual shareholders or in total. Higher caps increase the perceived value of the liquidity program to family shareholders, but at the cost of greater uncertainty to the business. As noted above, however, the uncertainty to the business can be hedged, or even eliminated, if some or all of the purchases are made by other shareholders rather than the company.
Terms. Liquidity programs may provide for immediate cash payment, or require the selling shareholder to accept a note upon tendering their shares. While selling shareholders generally prefer cash, using notes (or a combination of notes and cash) increases the company’s flexibility and may allow for a larger redemption pool. If the terms of the note issued in exchange for shares feature a below-market interest rate, the economic value of the transaction will be less than the nominal price.
Pricing. Finally, a liquidity program must specify the price at which shares can be sold. There are essentially three options for the price to be paid, and each option has consequences for the selling and non-selling shareholders.
- Change of Control. The first option is a change of control value. This is akin to the value in exchange for the business. The change of control value contemplates that potential acquirers may anticipate making changes to the business to increase cash flow. If the acquirer is a so-called strategic acquirer, the magnitude of such changes can be quite large. While selling shareholders would prefer to receive a change of control value, it can be difficult for the company (or purchasing shareholder) to finance the purchase since the business is not actually being sold and will presumably continue to be operated with the existing level of cash flow.
- As-If Freely Traded. The second option mimics how the company’s shares would be priced if they were traded in the public stock market. If the change of control value is value in exchange, the as-if freely traded value is value in use. The as-if freely traded price contemplates that the business will continue as an independent entity, so incremental benefits to be expected by a potential acquirer are not included in the projected cash flows. While this value is less attractive to selling shareholders, it is more feasible for the purchaser (whether the company or another shareholder) to finance the purchase at this price. If the company is later sold to a strategic acquirer, shareholders taking advantage of the liquidity program are likely to themselves feel taken advantage of.
- Discounted for Illiquidity. Finally, the price used in the liquidity program may include a discount to reflect the illiquidity of family business shares. Investors prefer to have the ability to easily sell their shares, so it is widely acknowledged that minority shares in private companies are worth less than otherwise comparable shares that are publicly traded. Redemptions at a discounted price confer an economic benefit upon the non-selling family shareholders. Stated alternatively, use of a discounted price imposes an economic penalty on the selling family shareholders. Whether that is desirable or not depends in large part on the family’s posture toward selling shareholders (i.e., is selling stock akin to treason?).

The following table summarizes the various consequences of the different pricing options:

There is no inherently “right” choice for the price to be used in a liquidity program. The company’s directors should weigh the consequences of the various options noted above against the objectives of the liquidity program for the family.

Implementing the Liquidity Program

An effective and sustainable liquidity program should be predictable. Predictably is achieved by having clearly-defined terms that are well-understood by all interested parties, and having regular appraisals of the company’s shares prepared by a qualified independent business valuation expert. A qualified business appraiser will perform periodic valuations on a consistent basis, taking into account the financial performance of the family business, fundamental changes in the operations and outlook for the business and the industry, as well as relevant market changes. At the direction of the company, valuations can be prepared at any (or all) of the three levels noted above.

Implementing and liquidity program increases the importance of shareholder education. If family shareholders are going to have the ability to sell shares, they need to do so on an informed basis. It is essential that selling shareholders have a firm grasp of the company’s financial performance and strategy, and understand the key factors that drive the valuation.

Liquidity programs are not cure-alls, but when carefully designed and implemented, they can relieve many of the pressure points that face growing multi-generation family businesses.

Tax Reform and Purchase Price Allocations

On December 22, 2017, President Trump signed The Tax Cuts and Jobs Act, which resulted in sweeping changes to the U.S. tax code. The Act decreased the corporate tax rate to 21% from 35%, in addition to modifying specific provisions around interest, depreciation, carrybacks, and repatriation taxes. The change in tax rate will have the biggest impact on purchase accounting.

Cash Flows and Returns

When we evaluate prospective financial information, a lower tax rate will result in higher after-tax earnings. The value of the tax shield created by depreciation and deductions will be influenced by both the lower corporate tax rate (which reduces the tax shield’s value) and accelerated depreciation of qualifying capital equipment purchases (which increases the tax shield’s value). In most cases, a lower tax rate will increase cash flows, increasing the internal rate of return on acquisitions for a given purchase price. On the other hand, if lower tax rates drive higher purchase prices, internal rates of return may be unchanged. In terms of the weighted average cost of capital (WACC), the lower tax rate actually increases the after-tax cost of debt. Keeping other inputs constant, this modestly increases WACCs.

Relief from Royalty

Under the relief from royalty method, after-tax royalties avoided increase as the tax rate falls. However, the tax amortization benefit (TAB) component of the intangible value also declines as a result of the lower tax rate, which serves to partially offset the increase in after-tax cash flows.

Scenario Analysis

In a scenario analysis used to value a noncompete agreement, a lower tax rate will again decrease the tax amortization benefit. Since both scenarios under the with and without approach will reflect the same tax rate, the impact of the new lower rate will be muted. As a result, the fair value of noncompete agreements may well be somewhat lower under the new tax rate.

Cost Approach

The cost approach, which is often used to value assets such as the assembled workforce or some technologies, the impact depends on whether a pre-tax or after-tax measurement basis is used. If fair value is measured on a pre-tax basis, the fair value of such assets is unaffected. If measured on an after-tax basis, costs avoided net of tax will be higher under lower tax rates, although this gain will be offset somewhat by the decrease in the TAB.

Multi-Period Excess Earnings Method

The impact of the tax rate on assets valued under the Multi-Period Excess Earnings Method (MPEEM) is more ambiguous since two key elements will be affected – the contributory asset charges and the tax rate used to derive after-tax cash flows. On the cash flow side of things, the lower tax rate will result in higher cash flow but a lower TAB. As far as contributory assets are concerned:

Relief from royalty asset charges will increase under a lower tax rate
With and without scenario analysis with level payments charges will potentially decrease due to the lower base value
Cost approach asset charges may increase or decrease depending on the net effect of taxes and TAB calculations

Goodwill

The net impact of a lower tax rate on goodwill will vary by transaction. If the lower tax rate results in a higher transaction price, the aggregate increase in fair value will likely result in a larger allocation to goodwill. If, instead, the lower tax rate increases the projected IRR on a transaction, the impact on residual goodwill is harder to predict and will depend on the composition of the assets acquired.

The changes to corporate taxes under the new bill are wide-ranging. In addition to the effect of lower rates discussed in this article, fair value specialists need to be alert to how other specific provisions of the bill may influence individual companies.

Impact of Tax Rate Decrease on Valuation Method

Cash Flows/Returns Higher after-tax cash flows/impact on returns depends on transaction price
Tax Amortization Benefits Decrease
Relief from Royalty Method Increase (potential offset by decrease in TAB)
Cost Approach (pre-tax) No Change
Cost Approach (post-tax) Increase (potential offset by decrease in TAB)
With and Without Scenario Potentially lower (potential offset by decrease in TAB)
MPEEM May Increase or Decrease (depends on magnitude of other changes)

Pitfalls and Best Practices in Purchase Price Allocation

What are some of the pitfalls in purchase price allocations?

Having gone through a few of these, sometimes differences arise between expectations or estimates prior to the transaction and fair value measurements performed after the transaction. An example is contingent consideration arrangements – estimates from the deal team’s back-of-the-envelope calculations could vary from the fair value of the corresponding liability measured and reported for GAAP purposes. To the extent amortization estimates are prepared prior to the transaction, any variance in the allocation of total transaction value to amortizable intangible assets and non-amortized, indefinite lived assets – be they identifiable intangible assets or goodwill – could also lead to different future EPS estimates. While most of the time our clients approach these allocation exercises with an open mind, sometimes bridging these differences – surprises, really – can take a bit of time and effort.

Do companies ever prepare preliminary allocations, such as before a deal is even closed?

There is no universal practice we have observed. Some clients come to us with no priors, so to speak. Others will have prepared some figures – maybe placeholder-type numbers, or maybe something with a bit more underlying analysis – for tax planning or other purposes. The level of detail can also vary and may or may not include specific splits among the various types of identifiable intangible assets. Going back to the theme of sources of surprises, however, the allocation itself is only one aspect of transaction due diligence. Whether or not allocations are prepared in advance, buyers will have engaged in some form of financial modeling prior to the close of transactions.

What are the benefits of looking at the allocation process early?

The opportunity to think through and talk about some of the unusual elements of the more involved transactions can be enormously helpful. We view the dialogue we have with clients during the process as a particularly important part of the project. So, obviously, a process that starts early allows all involved more space to examine transaction items together, loop in not just FP&A and corporate development personnel but also folks from the technical teams as necessary, ask questions, and evaluate potential solutions and/or approaches. We would hope this deliberative process results in a more robust – well-reasoned and well-supported – analysis that is easier for the external auditors to review, and stands the test of time requiring fewer true-ups or other adjustments in the future. Surprises are difficult to eliminate, but as they say, forewarned is forearmed. A head-start is a luxury we are not always going to have, but we certainly like it when we get lucky on that front.

What other problems/issues do you help clients navigate as part of the process?

As part of our full suite of services, we handle a number of different kinds of special projects that corporate finance departments may be looking to outsource, completely or partially. For example, our firm helps clients think through certain financial or strategic questions – what level of cash flow reinvestment will best balance competing shareholder interests? Or, what is the appropriate hurdle rate when evaluating projects for capital budgeting exercises? In other instances, we perform financial due diligence and quality of earnings analyses for some transactions.

When it comes to purchase price allocations, however, most of the time clients contact us well after the transaction has progressed or closed. Over time, discussions with some of our clients have shifted a bit from providing fair value measurements exclusively on the back-end of transactions to getting a bit of preview as companies think through the transactions. To revisit an earlier question, we would like to think that our purchase price allocations are better – more robust, fewer surprises – when we have also worked with the clients before the close of the transactions on elements like some financial due diligence or contingent consideration estimates, or even broader corporate finance studies.

What You Need to Know about Measuring the Fair Value of Contingent Consideration

The stakes for a business combination are high. Each party must negotiate a price and deal terms that promote its own interests but accommodate the counterparty’s expectations. Reaching an agreement can be a lengthy process and may require incorporating special provisions to help close the deal. Contingent consideration is a common example of such a provision.

Measuring the fair value of contingent consideration (commonly referred to as an “earnout”) for financial reporting is a complex process – based on a number of variable inputs, unique risk profiles, and potentially complicated payoff structures. Valuation professionals must be well versed in the concepts of fair value, probability, and risk. Here’s what you need to know about what goes into that fair value measurement before it lands on your desk.

How Does an Earnout Differ from Other Purchase Price Adjustments?

While both purchase price adjustments and earnouts can affect the total consideration paid in a transaction, they differ substantially in terms of criteria and realization. Common purchase price adjustments include adjustments for working capital, client consents, and indebtedness. Purchase price adjustments, which are based on financial statement information, are observable and knowable at the closing date of the transaction, while earnouts are not. Earnouts, on the other hand, are payments based on performance that occurs subsequent to the measurement date. Although the eventual earnout payment cannot be known at the closing date, valuation specialists have developed techniques to enhance the reliability of fair value measurements.

What Criteria Must Be Established in a Fair Value Measurement?

The Purchase Agreement establishes the basic criteria, structure, and time frame for the earnout. Based on these characteristics, the valuation professional must determine several inputs for his or her modeling.

Earnout Metric

The Purchase Agreement will define one or more performance metrics for the earnout. A common example is EBITDA for the twelve-month period following the acquisition. The future outcome(s) of the relevant metrics are used to determine the future payout. For purposes of fair value measurement, valuation specialists may reference management projections, analyst expectations, and industry forecasts to model the expected payoff.

Volatility

Since the actual value of the earnout metric cannot be known with certainty at the measurement date, the expected value is paired with an estimate of expected volatility. While there are several ways to estimate expected volatility, the estimate should be reasonable in the context of the volatility observed for similar companies, the subject company’s fundamentals, and the characteristics of the specific metric.

Discount Rate

The appropriate discount rate may be estimated through a bottom-up approach, where beta is built up using earnout-related factors, or through a top-down approach, which starts with the beta implied by the equity discount rate for the company overall. In the top-down approach, the valuation professional adjusts the company level beta up or downward for differences in risk between the metric and the company’s equity. The type of risk associated with the metric will affect the model that should be used to value the earnout. The two broad categories of risk are:

Diversifiable. Diversifiable or “unsystematic” risk is specific to the subject company and can be reduced through diversification. For example, the risk associated with occurrence of a nonfinancial milestone such as patent approval is considered diversifiable.
Non-Diversifiable. Non-diversifiable or “systematic” risk is related to the risk inherent in the market. For example, the risk associated with achieving a financial target such as revenue growth is considered non-diversifiable.

Payoff Structure

The structure of the earnout reflects the provisions established in the Purchase Agreement. Questions that a valuation specialist may ask include:

Is the underlying metric risk diversifiable (unsystematic) or not (systematic)?
Is the payoff structure linear or non-linear?
If multiple periods are involved, are the periods dependent on, or independent of, the other periods?

The answers to these questions can help the valuation professional determine the structure of the payoff and whether a scenario based model or option pricing model is best suited to the fair value measurement of the earnout liability.

Term

The term over which the metric is measured is established in the Purchase Agreement. The earnout may be determined after one period or over a multi-period time frame. Payments may be made throughout the earnout period, at the end of the earnout period, or at a later date. Additional time to payment may increase counterparty risk, or the risk that the Buyer will default on the earnout payment due.

Credit Risk of the Buyer

Earnouts typically represent a subordinate, unsecured liability for the Buyer. Thus, risk should be considered for the Buyer’s ability to meet the earnout obligation, commonly called counterparty credit risk or default risk. A valuation professional will look for any mitigating factors that could reduce or eliminate this risk, including:

Guarantee by a bank or third party
Escrow account for full or partial funding of the earnout
Earnout structured as a note to increase its security ranking

What Methods Are Used to Measure Fair Value?

The two primary methods used to measure fair value are the scenario based method and the option pricing method. Selection of the method and model most appropriate for a given situation will depend on to the structure and risk profile of the subject earnout.

Scenario Based Method

Under the scenario based method, valuation specialists apply probability weights to the relevant metrics, and then discount the corresponding payouts at an appropriate rate. This method is most appropriate when the underlying metric for the earnout has a linear payoff structure or the underlying risk is diversifiable. Models within this method can effectively conform to any distribution assumption. This method is intuitive and is likely to mimic how the parties to the transaction thought about the earnout. However, these models can be perceived as unreliable since the inputs are qualitative in nature.

Option Pricing Method

When applying the option pricing method, valuation specialists use models such as Black-Scholes to measure the fair value of a portfolio of financial instruments that replicate the potential payouts of the earnout structure. This method is best suited for earnouts with nonlinear payoff structures and metrics with non-diversifiable risk. A significant benefit to the method is that the use of historical data to estimate volatility, correlation, and the discount rate creates consistency among input assumptions. However, the complexity of the mathematics associated with the models is not well understood by those without financial expertise, rendering them much less intuitive.

Understanding the Differences

A simple example of an earnout that could be modeled with the scenario based method is as follows: a payment of 30% of the next fiscal year EBITDA. The payoff in this model is linear since it has a constant relationship with the relevant metric, meaning that a payout is due whether EBITDA is $1 million or $100 million (Example 1 below).

In contrast, an earnout with a threshold or cap is better suited to an option pricing method. For example, a payment of 30% of the next fiscal year EBITDA only if EBITDA meets or exceeds $50 million. The payoff is the same as the linear scenario after EBITDA reaches the threshold; however, the payoff is $0 for any value of EBITDA below that.

The second example can be modeled as a portfolio of options, where the threshold value of the metric ($50 million) acts as an effective strike price.

What Guidance Exists Regarding Fair Value Measurement of Contingent Consideration?

The measurement of contingent consideration has historically been a matter of considerable diversity in practice. While some common practices have generally been followed, new guidance clarifies best practices. A working group formed by The Appraisal Foundation issued a first exposure draft of new guidance regarding the measurement of contingent considerations in February 2017. This guidance details the methods described above and best practices for their application. The exposure draft endorses the risk-neutral valuation framework as the preferred basis for fair value measurements. A risk-neutral framework makes risk adjustments to the earnout metric to account for the unsystematic risk inherent in the metric. The guidance is expected to promote the consistency and reliability of fair value measurements.

What Are the Implications of Fair Value on Financial Statements?

Earnouts can act as a way to “bridge the gap” between what the Buyer wants to pay and what the Seller wants to receive. They can provide downside protection for the Buyer and upside potential for the Seller. These benefits contribute to the common use of earnout provisions in business combinations. However, the financial reporting consequences of an earnout may be counterintuitive once the transaction has closed and the Buyer becomes the owner of the acquired company. Subsequent to this point, if the relevant metric exceeds initial expectations, the Buyer will report a loss on its income statement associated with remeasuring the contingent liability at its new, higher value. In effect, if business goes well, the Buyer will report a loss. In contrast, if business goes poorly, the Buyer will report a gain upon remeasurement of the contingent liability at its new, lower fair value. Sophisticated deal makers understand the short-term implications for the Buyer’s financial statements but remain focused on the long-term goal.

Conclusion

The uncertainty associated with contingent consideration means that the fair value of the earnout will rarely equal the amount that is actually paid out at the future payment date. While valuation professionals do not know what the future holds, they do have tools and techniques to reliably measure the fair value of the earnout liability as of the date of the transaction. While the nuances encountered in fair value measurement of earnouts can extend well beyond the scope of this article, we hope it provided some insight into what goes into the numbers before they reach your company’s accounting department.

The inclusion of an earnout in a transaction negotiation can serve various purposes.

Bridge the differences in Buyer and Seller expectations
Serve as a form of alternative financing and defer a portion of the purchase price
Provide incentive for management to help the company meet post-transaction targets
Shift and allocate risk between the various parties involved

The motivation behind an earnout can influence management’s choice of earnout structure in order to achieve the intended purposes.

Definition of Fair Value (ASC 820)

“The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

Objective of Fair Value Measurement (ASC 820)

“To estimate the price at which an orderly transaction would take place between market participants under the market conditions that exist at the measurement date.”

Did You Know Your Family Business Was For Sale?

Successful businesses don’t have to go looking for potential acquirers – potential acquirers are likely to come looking for them. Most of our family business clients have no intention of selling in the near-term, and yet they often receive a steady stream of unsolicited offers from eager suitors. Many of these offers can be quickly dismissed as uninformed or bottom-fishing, but occasionally serious inquiries from legitimate buyers of capacity appear that require a response.

What Kinds of Buyers are There?

Buyers are generally classified into two categories.

Financial buyers are groups like private equity funds that purchase businesses with a view toward earning a return on their investment over a finite holding period. These buyers generally use financial leverage to magnify their returns, and expect to exit their investment by selling the business to another buyer after three to seven (or maybe even ten) years. While financial buyers may have specific plans for making the business run more efficiently and profitably, they are generally not anticipating significant revenue synergies or expense savings from wholesale changes to the business. Rather, they tend to be more focused on incremental changes to boost value and clever financial engineering to be the principal engines driving their returns.
Strategic buyers are competitors, customers, or suppliers of the business who have a strategic goal for making the acquisition. Such buyers certainly want to earn a return on their investment, but that return is expected to come from combining the target’s operations with their own, rather than through financial engineering. In other words, strategic buyers look to long-term value creation through assimilating the target into their existing business, not a short-term return from buying low and selling high. Strategic buyers may anticipate revenue synergies through the combination or may foresee the opportunity to eliminate operating expenses in either the acquired or legacy businesses to fuel cash flow growth.

Distinguishing between financial and strategic buyers is important for evaluating unsolicited offers, but we suspect that a more important distinction is that between motivated buyers and opportunistic buyers. Successful family businesses will attract motivated buyers who have the capacity to pay an attractive price for the business, but should strive to avoid opportunistic buyers who are seeking to take advantage of some temporary market dislocation or cyclical weakness to get the business at a depressed price.

Evaluating Acquisition Offers

Evaluating acquisition offers is ultimately the duty of the board of directors, not the family at large. Uncle Charlie may have strong opinions on the proposed deal, but if he is not a director, he does not have the responsibility or authority to respond to the offer. That does not mean that the directors will not care about Uncle Charlie’s perspective. As we’ve discussed in previous posts, it is critical for the board to understand what the business “means” to the family, and the meaning of the business to the family may well inform how the directors evaluate the offer. For larger families, the prospect of receiving a potentially-attractive unsolicited acquisition offer underscores the value of a regular survey process, whereby the board and senior management periodically take the pulse of the family on topics at the intersection of business and family.

Family business directors should evaluate offers along several dimensions:

Buyer Motivation. What has prompted the offer? If it is a strategic acquirer, what sort of operational changes would be expected post-transaction? Will a sale result in facility closures, administrative layoffs, or discontinuation of the business name? Or, could the sale increase opportunities for employees and expose the brand to new markets? If the suitor is a financial buyer, what sort of debt load will they place on the company post-acquisition? Will the company’s ability to withstand normal economic downturns be compromised? Will the buyer want members of the family active in senior management to continue to run the business? The answers to these and similar questions should be considered in the context of what the business means to the family and help inform whether the offer should be entertained further.
Buyer Capacity. Does the buyer have the financial capacity to actually execute the transaction if it is agreed to? If external financing is required, will it be available to the buyer when needed? Basic due diligence goes both ways. Going through a lengthy negotiation and due diligence process only to have the transaction fall apart at the closing table due to lack of financing will leave a bad taste in the family’s mouth.
Price & Transaction Structure. What seems on the surface to be an attractive price may, upon further examination, turn out to be a far less attractive transaction. A sale of stock may have a lower nominal price than a sale of assets, yet result in higher after-tax proceeds. A high nominal price may be subject to contingencies regarding future performance which cause the economic value of the offer to be far less. Or, a high nominal price may be payable, in part, in shares of the buyer rather than cash – what is the family’s appetite for trading stock in the family business for stock in a different business over which they will likely have no control? There are many other components of transaction structure, such as required representations and warranties or escrow provisions that can significantly influence how attractive an offer really is.
Price is not everything. Just because the price is adequate and the terms are acceptable does not mean that the timing is optimal for a sale. Directors should carefully weigh the potential outcomes for shareholders by deferring a transaction: Is the family better served by taking the bird in hand or waiting for more birds to materialize in the bush? If the company is on a growth trajectory or has its own acquisition opportunities to pursue, it may command a larger multiple down the road. Understanding the risks and opportunities associated with the timing of a transaction requires directors to be well-attuned to company, market, and industry dynamics. Family directors-in-name-only are unlikely to have anything meaningful to add to such deliberations.
Reinvestment Opportunities. Does the family have a plan for putting sale proceeds to work? Once again, what the business “means” to the family comes to the fore. Will proceeds simply be distributed to the various branches of the family, to use or invest as they see fit? Or will proceeds be retained at the family level and redeployed in other assets for the benefit of the family? If so, are there reinvestment opportunities available that will “fit” the cash flow needs and risk tolerances of the family? Will such investments provide the same degree of family cohesion as the legacy business? A sale of the family business may have unintended, and potentially far-reaching consequences for the family.

Responding to Acquisition Offers

Once the board has evaluated the unsolicited offer, there are essentially four responses to choose from:

Reject the offer. If the directors conclude that the proposed price and/or terms are unattractive, or if the timing of a transaction does not align with the broader goals of the family, the board may elect simply to reject the offer.
Negotiate with the potential acquirer. If the directors conclude that the timing is right and that the suitor would be an attractive acquirer, the board may elect to negotiate with the buyer with a view toward consummating a transaction. If the perceived “fit” between the family business and the potential acquirer is good, proceeding directly to negotiating price and terms of the transaction may result in the quickest and smoothest path to close. However, without any exposure to the market, there is a risk that the negotiated price and terms are not really optimal. There is a reason private equity firms like to tout their “proprietary” deal flow to potential investors – direct negotiation with sellers presumably results in lower purchase prices than winning auctions does.
Engage in a limited sale process. Given the potential for underpayment, directors may elect to discreetly contact a limited number of other potential acquirers to gauge their interest in making a competing bid for the business. The benefit of doing a limited market check is that it can generally be done fairly quickly without “putting the company up for sale” with the attendant publicity that the family may not desire. The initial suitor will, of course, generally prefer that even a limited sale process not be engaged in, and may seek some sort of exclusivity provision which precludes the seller from talking to other potential buyers. Directors will need to consider carefully whether the potential benefits of a limited sale process will outweigh the risk that such a process will cause the initial suitor to rescind their offer and walk away.
Engage in a full sale process/auction. Finally, the board may conclude as a result of their deliberations that the unsolicited offer signals that it is an opportune time to sell the business because pricing and terms are expected to be favorable in the market and the family’s circumstances align well with a sale. In a full sale process, the company’s financial advisors will prepare a descriptive investment memorandum for distribution to a carefully vetted list of potential motivated acquirers. After initial indications of interest are received, the universe of potential buyers is then narrowed to a manageable group of interested parties who are invited to view presentations by senior management and engage in limited due diligence with a view to making a formal bid for the business. With the help of their financial advisors, the directors evaluate the bids with regard to pricing, terms, and cultural fit, selecting a company with which to negotiate a definitive purchase agreement and close the transaction. A full sale process will likely involve the most time and expense, and may expose to competitors the family’s intention to sell, but carries with it the potential for achieving the most favorable price and terms.

Bringing Together the Right Team

There is a sharp experience imbalance in most transactions: buyers have often completed many transactions, while sellers may have never sold a business before. As a result, sellers need to assemble a team of experienced and trusted advisors to help them navigate the unfamiliar terrain. The transaction team will include at least three primary players: a transaction attorney, a tax accountant, and a financial advisor.

Definitive purchase agreements are long, complicated contracts, and an experienced attorney is essential to memorializing the substantive terms of the transaction in the agreement and ensuring that the sellers’ legal interests are fully protected.

Business transactions also have significant tax consequences, and the tax code is arcane and littered with pitfalls for the unwary. Trusting the buyer to do your tax homework can be a very costly mistake. An experienced tax attorney is essential to maximizing after-tax proceeds to the family.

The financial advisor takes the lead in helping the board evaluate unsolicited offers, setting value expectations, preparing the descriptive information memorandum, identifying a target list of potential motivated buyers of capacity, assessing initial indications of interest and formal bids, facilitating due diligence, and negotiating key economic terms of the definitive agreement. My colleague Nick Heinz leads Mercer Capital’s transaction advisory practice, and Nick likes to say that his job in a transaction is to run the transaction on behalf of the company so the company’s management can focus on running the business on behalf of the shareholders. Transactions can be time-consuming and mentally draining, and it’s simply not possible for company management to devote the necessary time to managing the transaction process and the business at the same time. An experienced financial advisor takes that burden off of management.

When it comes to assembling the right team, business owners sometimes blanch at the cost. However, the cost of a quality and experienced team of advisors pales next to the cost of fumbling on the transaction. The family will only sell the business once, and there are no do-overs. As we recently heard someone say, “Cheap expertise is an oxymoron.”

If you have recently received an unsolicited offer for your family business, or would like to discuss whether selling the business now is right for your family, please give us a call to discuss your situation in confidence.

A Taxing Matter for Family Businesses

Family business owners cite different motives for investing their time, energy, and savings to build successful businesses. Some have entrepreneurial zeal, while others are creators who see problems in the world that they can solve. Others are natural leaders who are inspired by the job opportunities and other “positive externalities” that successful enterprises generate for employees and the communities in which they operate. But common to nearly all family business owners is the desire to provide financially for their heirs. As a result, one of the most common concerns such owners cite is the ability to transfer ownership of the family business to the next generation in the most tax-efficient way.

The Internal Revenue Service defines the estate tax as follows: “The estate tax is a tax on your right to transfer property at your death.” The amount of tax is calculated with reference to the decedent’s gross estate, which is the sum of the fair market value of the decedent’s assets less certain deductions for mortgages/debts, the value of property passing to a spouse or charity, and the costs of administering the estate.

As with all taxes, things are not as simple as they seem. Before calculating the estate tax due, two adjustments are made. First, all taxable gifts previously made by the decedent (and therefore no longer in the estate) are added to the gross estate. Second, the sum of the gross estate and prior taxable gifts is reduced by the available unified credit. The unified credit for 2018 is just over $11 million. The following table illustrates the calculations for the taxable estate of an unmarried individual.

To complicate things a bit further, estates have benefited from the introduction of “portability” to the estate tax regime in 2011. Portability refers to the ability of an individual to transfer the unused portion of their available unified credit to a surviving spouse. The ultimate effect of portability is that for married family business owners, the total available unified credit is slightly more than $22 million.

Taxes are never fun, but what proves to be especially vexing about the estate tax for family business owners is that a substantial portion of their estate often consists of illiquid interests in private company stock. Going back for a moment to our prior example, if the decedent’s assets consist primarily of a portfolio of marketable securities, it is relatively easy to liquidate a portion of the portfolio to fund payment of the tax. If, on the other hand, the decedent’s assets are primarily in the form of shares in the family business, liquidating assets to pay the estate tax may prove more difficult (estate taxes are payable in cash and may not be paid in-kind with family business shares). As a result, family businesses may be sold or be forced to borrow money to fund payment of a decedent’s estate tax liability.

Attorneys who specialize in estate taxes have devised numerous strategies for helping families manage estate tax obligations. Strategies range from relatively simple, such as a program of regular gifts to family members, to complex, such as the use of specialized trusts. While the finer points of various potential strategies is beyond the scope of this post, the concept of fair market value is essential to understanding and evaluating any estate planning strategy.

What is Fair Market Value?

As noted above, fair market value is the standard of value for measuring the decedent’s estate, and therefore, the estate tax due. The IRS’s estate tax regulations define fair market value as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.”

So far, so good.

But how does all this work for a family business? To understand the underlying rationale for much estate planning, we need to explore how the standard of value intersects with what is referred to as the level of value. In other words, the fair market value of family business shares in an estate depends not just on the fundamentals of the business (expected future revenues, profits, investment needs, risk, etc.) but also on the relevant level of value.

If an estate owns a controlling interest in a family business (in most cases, more than 50% of the stock), the fair market value of those shares will reflect the estate’s ability to sell the business to a competitor, supplier, customer, or financially-motivated buyer such as a private equity fund. In contrast, the owner of a small minority block of the outstanding shares of a family business has no ability to force the business to change strategy, seek a sale of the business, or otherwise unilaterally compel any action. As a result, the owner of the shares is limited to waiting until the shareholders that do have control decide to sell the business or redeem the minority investor’s shares. In the meantime, they wait (and, potentially, collect dividends). If there is a willing buyer for the shares, they may elect to sell, but that buyer will be subject to the same illiquidity, holding period risks, and uncertainties, so the price is unlikely to be attractive.

Business appraisers often describe the levels of value with reference to a chart like the following:

The levels of value chart captures two essentially common-sense notions regarding value. First, investors prefer to have control rather than not. The degree to which control is valuable will depend on a whole host of case-specific facts and circumstances, but in general, having control is preferred. Second, investors prefer liquidity to illiquidity. Again, the magnitude of the appropriate marketability discount will depend on specific factors, but not surprisingly, investors prefer to have a ready market for their shares. Fair market value is measured with respect to both of these common-sense notions.

Estate Planning Objectives

As a result, one objective of most estate planning techniques is to ensure – through whatever particular mechanism – that no individual owns a controlling interest in the family business at his or her death. Of course, minimizing taxes is only one possible objective of an estate planning process, which might include asset protection, business continuity, and providing for loved ones.

Therefore, family businesses should carefully consider whether an estate planning strategy designed to minimize estate taxes will have any unintended negative consequences for the business or the family.

For example, an aggressive gifting program that causes the founder to relinquish control prematurely may increase the likelihood of intra-family strife, or jeopardize the family’s ability to make timely strategic decisions on behalf of the business.
Or, adoption of an unusually restrictive redemption policy in an effort to minimize the fair market value of minority shares in the company may lead to inequitable outcomes for family members having a legitimate need to sell shares.

In short, families should be careful not to let the tax tail wag the business dog. Families should consult legal, accounting, and valuation advisors who understand their business needs, family dynamics, and objectives to ensure that their estate plan accomplishes the desired goals.

What Is Your Family’s Most Valuable Asset?

European investment banking icon Rothschild & Co. recently announced that 37-year old Alexandre de Rothschild will be taking the reins at the firm, succeeding his father at the bank’s May shareholders’ meeting. The new chairman is a member of the seventh generation of the family. While the future performance of the bank under the younger Mr. Rothschild will be the ultimate barometer of success, the Rothschild family clearly has fostered a culture of developing the next generation. Few families have the long history of next-gen development that the Rothschild’s do, but it is a task that becomes more important with each successive generation. The long-term health of any organization ultimately depends on the quality of the rising generation of leaders, and families are no different.

From our experience working with successful family businesses, talking with family business leaders, and reviewing relevant research, we’ve identified the following themes that are common to successful family businesses when it comes to developing the next generation of shareholders:

Successful families recognize that each succeeding generation will be different, and that’s okay. As families mature and grow, succeeding generations naturally become more diffuse than their parents’ generation. Family members move away, pursue careers and interests outside the family business, and have different personal and financial objectives. While this increasing family diversity can be intimidating, successful families embrace the new experiences, opportunities, and challenges that this growth brings. Imposing obligations on the next generation to do things just like grand-dad did, generally prove to be stifling and counter-productive (and, in all likelihood, contrary to grand-dad’s mindset when he was achieving his greatest business successes). The differences between Boomers, Gen Xers, and Millennials are real and matter for family businesses. Groups like the Center for Generational Kinetics publish fascinating research on the differences between generations and how to make those differences productive for your family and business.
Successful families identify the core business and family attributes that the family wants to persist across generations. This is the counter-weight to the prior theme: families have “social ballast” that can help the business maintain its balance in the inevitable rough seas. This “social ballast” comprises the core family and business attributes that maintain and preserve identity across generational changes. The key is to identify the root causes of the family’s success. Without saddling the next generation with a mandate to do things just like grand-dad did, can the family identify the core attributes underlying grand-dad’s success that can transcend generations? For example, what are the two or three core attributes that make a Rothschild business a Rothschild business? Identifying these attributes does not limit the next generation’s flexibility, but rather frees the next generation from having to develop – out of whole cloth – a framework within which to meet the unique family and business challenges with which it will be faced.
Successful families acknowledge that experiences outside the family business promote development of next generation leaders. While growing up in the family business provides development opportunities that are not easily replicated, many successful families are recognizing the benefit of gaining professional experiences outside the family business. Family employment policies often mandate that before becoming eligible to work in the business, family members must have three to five (or more) years of external professional experience. Such policies have multiple potential benefits, not least of which is exposing the next generation to the ideas, processes, and strategies of other successful businesses. As noted in the article linked above, the younger Mr. Rothschild spent the first five years of his career working at other financial firms before joining the family business. Furthermore, even in the context of non-employee roles (shareholder, family council member, director), successful families value and encourage the “outside” experiences of the next generation.
Successful families provide development opportunities for both employee and non-employee shareholders. Regardless of the current family composition, the likelihood that rising generations will include a mix of employee and non-employee shareholders is high. Next generation development is not limited to future employees, but should include members of the rising generation that do not plan to work in the business. Development opportunities include both education and service. No one is born knowing what has made the family business successful, how to read the company’s financial statements, or how to think about the tradeoffs between current distributions and investment for future growth. Successful families are intentional about providing ongoing education on these and other topics for the next generation. With regard to service, rotating membership on a family council can create great opportunities for non-employee members of the next generation to actively contribute to the success of the family.
Successful families allocate resources to fostering next generation innovations. The next generation is a natural source of innovation necessary to keep the family business relevant in evolving markets. Successful families consider multiple potential strategies for accomplishing this goal. Some families follow a corporate venture capital model, providing seed capital to fund new ventures headed by members of the next generation (subject, of course, rigorous vetting procedures). If there is some organic connection between the proposed venture and the family’s core operations, such investments may be made by the family business itself. If the proposed venture is a bit further afield, a holding company structure may be used to make the investment. Or, if the risk-return preferences of various family members do not all accommodate venture investing, the family may explore setting up a captive venture fund in which family members may, but are not obliged to, invest. Still, other companies view significant ongoing distributions as the seed money for the next generation to put into new ventures of their own choosing.
Successful families use philanthropy as a tool in next generation development. Perhaps the most effective way to develop the next generation is to provide for active involvement in the family’s philanthropic efforts. Having a voice in the family’s giving and other charitable activities can be a great way for the next generation of the family to develop a sense of the responsibility for managing and stewarding the wealth created by prior generations for the benefit of their communities and other worthy beneficiaries. For many families, this is such an important component of developing the next generation that they include even teens and pre-teens in their philanthropic efforts.

At the risk of sounding overly sentimental, a family’s most valuable asset is its next generation. If the current generation of business leaders is focused on the long-term sustainability and health of the family business, developing the next generation of family shareholders must be viewed as a strategic priority.

Orthopedics Overview

The worldwide market for orthopedic products in 2016 was estimated to be nearly $48.2 billion, an increase of 3.2% from 2015. Demographics will continue to be a key driver of industry expansion, with population growth and rapidly-growing international markets driving the need for musculoskeletal care. Increasing life spans, the increasing prevalence to remain active, and increasing obesity rates will impact the number of individuals with joints subject to degeneration, thereby increasing demand for orthopedic/joint replacement procedures.

Subspecialties

Orthopedic devices are commonly divided into several primary sectors that correspond to the major subspecialties within the orthopedic field. These subspecialties include:

Large Joints: Implants, instruments, and surgical assistance systems to replace or revise failed knee and hip joints. Generally dominated by large medical device players (Zimmer, Stryker, J&J, Smith & Nephew).
Spine: Implants and instruments and surgical assistance systems used in the treatment of degenerative disc disease, herniated discs, scoliosis, vertebral fractures, or other spinal conditions. Devices used include pedicle screws, plates, rods, interbody cages, artificial discs. Medtronic and J&J are market leaders, with other smaller players (Nuvasive, Globus Medical) controlling sizable share.
Trauma: Implants and instruments for internal and external use (plates, screws, nails, pins, wires, staples, external fixators). May be referred to as fracture repair. Market led by large incumbents, some smaller players focusing on extremities.
Arthroscopy/Soft Tissue Repair: Arthroscopy devices include arthroscopic visualization products, fluid management systems, manual instruments, and powered instruments, while soft tissue repair includes devices utilized in cruciate ligament, hip, meniscus, and shoulder fixation. Also referred to as “Sports Medicine.” Arthrex and Smith & Nephew have over 50% market share, with J&J and Stryker also controlling a large portion of the total market.
Orthobiologics: Biologic products such as allograft tissue, synthetic bone grafts, autologous platelet/ plasma systems, and cell-based repair systems. Products utilized in other orthopedic segment settings. Low market concentration relative to other orthopedic segments.
Extremity: Implants, instruments, and surgical assistance systems to replace or revise failed joints in the shoulder, elbow, wrist, ankle and digits. Market led by both large incumbents and small niche players, such as Wright Medical, Exactech, and Orthofix.

Product Segmentation

Knee, hip, and spine represent the largest medical device segment based on total revenue. These segments are generally controlled by larger, diversified industry participants who are able to leverage their size and efficiencies to capture market share at relatively lower costs. The remaining segments, particularly biologics, arthroscopy, and extremities are smaller pieces of the total market but represent growth opportunities for both small niche players and larger device manufacturers.

Major Companies & Market Shares

Five multi-national companies currently dominate the orthopedic industry, each with approximately $2 billion or more in annual sales and combined revenue of nearly $29 billion (59% total share). This represents a slight decline over the last several years, falling from 61% total market share in 2015 and 63% in 2014.

Global Trends

The worldwide orthopedics market is expected to grow at an annualized rate of 4.0% between 2016 and 2022, slower than the average growth expected for the medical device industry overall (5.1%). Certain challenges are expected to weigh on the orthopedic device market over the next several years. Increased competition between manufacturers for market share in a mature market will continue to put downward pressure on prices, along with new reimbursement regimes in the U.S. and in Europe.[1]

While overall orthopedic growth is projected to grow slower than other device segments, certain areas within orthopedics are expected to outperform over the next several years. The maturing hip (2.3%), spine (2.0%), and knee (3.7%) markets saw slower growth in 2016, while the extremities (8.0%) and arthroscopy / soft tissue segments (5.6%) realized more robust sales growth over the year. Momentum in these niche segments is expected to continue over the next several years as manufacturers look to diversify into these underserved and untapped device markets.

[1] Growth estimated per “EvaluateMedTech” utilizes sales data differing from total sales data cited previously. Growth rates utilized for perspective.

Is There a Ticking Time Bomb Lurking in Your Family Business?

When we talk with family business owners, most confess a vague recollection of having signed a buy-sell agreement, but only a few can give a clear and concise overview of their agreement’s key terms. Yet no other governing document has such potentially profound implications for the business and for the family. My colleague of nearly twenty years, Chris Mercer, literally wrote the book(s) when it comes to buy-sell agreements. Chris and I recently sat down to talk about buy-sell agreements in the context of family businesses.

Travis: Chris, to start off, what is the purpose of a buy-sell agreement? Why should a family business have one?

Chris: A buy-sell agreement ensures that the owners of a business will have as fellow-owners only those individuals who are acceptable to the group. A buy-sell agreement formalizes agreements in the present – while everyone is alive and well – regarding how future transactions will occur, with respect to both pricing and terms, when the agreement is “triggered.”

Every business with two or more owners should have a buy-sell agreement, and that includes family businesses. What I can tell you, after many years of working with companies and their buy-sell agreements, is that once an agreement is triggered, e.g., by the death, disability or departure of a shareholder, the interests of the departed and remaining shareholders diverge. When interests diverge, an agreement is virtually impossible even, or especially, within families. So, a well-crafted buy-sell agreement establishes an agreement in advance, so the family can avoid problems and conflict in the future.

Travis: The title of your first book on buy-sell agreements described them as either reasonable resolutions or ticking time bombs. How could a buy-sell agreement become a ticking time bomb for a family business?

Chris: Sure – here’s a quick example. Some agreements specify a fixed price for shares that the shareholders have all agreed to. The price is binding until updated to a new agreed-upon price. The idea sounds good in principle, but in reality, the owners almost never agree on an updated price. Years later, after a substantial increase in a company’s value renders the agreed-upon price stale, a trigger event occurs. The ticking time bomb explodes on the departing shareholder who receives an inadequate price for their shares. A second explosion occurs with the ensuing litigation to try to “fix” the problem. Needless to say, I do not recommend the use of fixed-price valuation mechanisms in buy-sell agreements.

Travis: Buy-sell agreements often define a formula for determining value when triggered. Can a “formula price” provide for a reasonable resolution?

Chris: Travis, I’ve said many times that some owners and advisers search for the perfect formula like the Knights Templar sought the Holy Grail. The perfect formula does not exist. Given changes in the company over time, evolving industry conditions, emerging competition, and changes in the availability of financing, no formula will remain reasonable over time. It is simply not possible to anticipate all the factors an experienced business appraiser would consider at a future date. All this assumes that the formula is understandable. Some formulas in buy-sell agreements are written so obtusely that reasonable people reach (potentially quite) different results. As you might suspect, I do not recommend the use of formula pricing mechanisms in buy-sell agreements.

Travis: Other agreements provide for an appraisal process upon a trigger event. What are benefits or pitfalls of such appraisal processes?

Chris: The most common appraisal process found in buy-sell agreements calls for the use of two or three appraisers to determine the price to be paid if and when a trigger event occurs. One of the biggest problems out of the gate is that no one knows what the price of their shares will be until the end of a lengthy and potentially disastrous appraisal process.

Let me explain. Assume that the shareholders have agreed on an appraisal process to determine price upon a trigger event. The Company retains one appraiser and the selling shareholder retains a second. Far too often, the language describing the type of value for the appraisers to determine is vague and inconsistent. The selling shareholder’s appraiser interprets value as an undiscounted strategic value, say $100 per share. The company’s appraiser interprets the same language as calling for significant minority interest and marketability discounts and concludes a value of, say, $40 per share. The agreement calls for the two appraisers to agree on a third appraiser who is supposed to resolve the issue. How? The two positions are not reconcilable. Litigation, unhappiness, wasted time and expense follow as the time bomb, which has been in place for years, explodes on all the parties.

Travis: So if fixed price, formula price, and appraisal process agreements all have serious drawbacks, what kind of pricing mechanism do you recommend for most family businesses?

Chris: Based on my experiences over many years, I have concluded that the best pricing mechanism for most family businesses is what I call a Single Appraiser, Select Now and Value Now valuation process. The parties agree on a single appraiser (I’d recommend Mercer Capital, of course!). The selected appraiser provides a valuation now, at the time of selection, based on the language in the buy-sell agreement. This ensures that any confusion is eliminated at the time of signing or revision. The appraisal sets the price for the buy-sell agreement until the next (preferably annual) appraisal. With this kind of process, virtually all of the problems we’ve discussed are eliminated, or reduced substantially. All the shareholders know what the current value is at any time. Importantly, they all know the process that will occur with every subsequent appraisal. The certainty provided by this Single Appraiser, Select Now and Value Now process far outweighs the uncertainty inherent in other processes at a reasonable cost. At Mercer Capital, we provide annual appraisals of over 100 companies for buy-sell agreements and other purposes.

Travis: Finally, what is your best piece of advice for family business owners when it comes to buy-sell agreements?

Chris: The best advice I have for family business owners is to be sure that there is an agreement regarding their buy-sell agreements. Many companies have had agreements in place for many years, often decades, without any changes or revisions. No one knows what will happen if they are triggered. Agreement regarding a buy-sell agreement should be the result of review by all shareholders, corporate counsel, and, I recommend, a qualified business appraiser. The appraiser should review agreements from business and valuation perspectives to be sure that the valuation mechanism will work when it is triggered. Discussions are not always easy, since shareholders from different generations and different branches of the family tree have differing objectives and viewpoints. Yet if all parties can agree now, the family can avoid unnecessary strife and litigation in the future. So the best advice I have is to “Just Do It!”

Conclusion

Your family’s buy-sell agreement won’t matter until it does. As families prepare for their next business meeting, leaders should carefully consider putting a review of the buy-sell agreement on the agenda.

Five Trends to Watch in the Medical Device Industry in 2018

Medical Devices Overview

The medical device manufacturing industry produces equipment designed to diagnose and treat patients within global healthcare systems. Medical devices range from simple tongue depressors and bandages, to complex programmable pacemakers and sophisticated imaging systems. Major product categories include surgical implants and instruments, medical supplies, electro-medical equipment, in-vitro diagnostic equipment and reagents, irradiation apparatuses, and dental goods.

The following outlines five structural factors and trends that influence demand and supply of medical devices and related procedures.

1. Demographics

The aging population, driven by declining fertility rates and increasing life expectancy, represents a major demand driver for medical devices. The U.S. elderly population (persons aged 65 and above) totaled 49 million in 2016 (15% of the population). The U.S. Census Bureau estimates that the elderly will roughly double by 2060 to 95 million, representing 23% of the total population.

The elderly account for nearly one-third of total healthcare consumption. Personal healthcare spending for the population segment was $19,000 per person in 2012, five times the spending per child ($3,600) and almost triple the spending per working-age person ($6,600).

According to United Nations projections, the global elderly population will rise from approximately 610 million (8.3% of world population) in 2015 to 1.8 billion (17.8% of world population) in 2060. Europe’s elderly are projected to reach nearly 29% of the population by 2060, making it the world’s oldest region. While Latin America and Asia are currently relatively young, these regions are expected to undergo drastic transformations over the next several decades, with the elderly population expected to expand from approximately 8% in 2015 to more than 21% of the total population by 2060.

2. Healthcare Spending and the Legislative Landscape in the U.S.

Demographic shifts underlie the expected growth in total U.S. healthcare expenditure from $3.3 trillion in 2016 to $5.7 trillion in 2026, an average annual growth rate of 5.5%. While this projected average annual growth rate is more modest than that of 7.3% observed from 1990 through 2007, it is more rapid than the observed rate of 4.2% between 2008 and 2016. Projected growth in annual spending for Medicare (7.4%) and Medicaid (5.8%) is expected to contribute substantially to the increase in national health expenditure over the coming decade. Healthcare spending as a percentage of GDP is expected to expand from 18% in 2016 to nearly 20% by 2026.

Since inception, Medicare has accounted for an increasing proportion of total US healthcare expenditures. Medicare currently provides healthcare benefits for an estimated 57 million elderly and disabled people, constituting approximately 15% of the federal budget in 2016. Medicare represents the largest portion of total healthcare costs, constituting 20% of total health spending in 2015. Medicare also accounts for 26% of hospital spending, 29% of retail prescription drugs sales, and 23% of physician services.

Owing to the growing influence of Medicare in aggregate healthcare consumption, legislative developments can have a potentially outsized effect on the demand and pricing for medical products and services. Net mandatory benefit outlays (gross outlays less offsetting receipts) to Medicare totaled $588 billion in 2016, and are expected to reach $1.1 trillion by 2026.

The Patient Protection and Affordable Care Act (“ACA”) of 2010 incorporated changes that are expected to constrain annual growth in Medicare spending over the next several decades, including reductions in Medicare payments to plans and providers, increased revenues, and new delivery system reforms that aim to improve efficiency and quality of patient care and reduce costs. On a per person basis, Medicare spending is projected to grow at 4.5% annually between 2016 and 2026, compared to 5.1% average annualized growth realized between 2000 and 2016.

As part of ACA legislation, a 2.3% excise tax was imposed on certain medical devices for sales by manufacturers, producers, or importers. The tax had become effective on December 31, 2012, but met resistance from industry participants and policy makers. In late 2015, Congress passed legislation promulgating a two-year moratorium on the tax beginning January 2016. In January 2018, the moratorium suspending the medical device excise tax was extended through 2019.

3. Third-Party Coverage and Reimbursement

The primary customers of medical device companies are physicians (and/or product approval committees at their hospitals), who select the appropriate equipment for consumers (patients). In most developed economies, the consumers themselves are one (or more) step removed from interactions with manufacturers, and therefore pricing of medical devices. Device manufacturers ultimately receive payments from insurers, who usually reimburse healthcare providers for routine procedures (rather than for specific components like the devices used). Accordingly, medical device purchasing decisions tend to be largely disconnected from price.

Third-party payors (both private and government programs) are keen to reevaluate their payment policies to constrain rising healthcare costs. Several elements of the ACA are expected to limit reimbursement growth for hospitals, which form the largest market for medical devices. Lower reimbursement growth will likely persuade hospitals to scrutinize medical purchases by adopting i) higher standards to evaluate the benefits of new procedures and devices, and ii) a more disciplined price bargaining stance.

The transition of the healthcare delivery paradigm from fee-for-service (FFS) to value models is expected to lead to fewer hospital admissions and procedures, given the focus on cost-cutting and efficiency. In 2015, the Department of Health and Human Services (HHS) announced goals to have 85% and 90% of all Medicare payments tied to quality or value by 2016 and 2018, respectively, and 30% and 50% of total Medicare payments tied to alternative payment models (APM) by the end of 2016 and 2018, respectively. A report issued by the Health Care Payment Learning & Action Network (LAN), a public-private partnership launched in March 2015 by HHS, found that 29% of payments were tied to APMs, a 6% increase from 2015 to 2016.

While the shift toward value-based care is continuing, the pace could slow under the new administration. In November 2017, the CMS partially canceled bundled payment programs for certain joint replacement and cardiac rehabilitation procedures. However, indications are that the CMS supports value-based care and wants pilot programs to accelerate. Ultimately, lower reimbursement rates and reduced procedure volume will likely limit pricing gains for medical devices and equipment.

The medical device industry faces similar reimbursement issues globally, as the EU and other jurisdictions face increasing healthcare costs, as well. A number of countries have instituted price ceilings on certain medical procedures, which could deflate the reimbursement rates of third-party payors, forcing down product prices. Industry participants are required to report manufacturing costs and medical device reimbursement rates are set potentially below those figures in certain major markets like Germany, France, Japan, Taiwan, Korea, China and Brazil. Whether third-party payors consider certain devices medically reasonable or necessary for operations presents a hurdle that device makers and manufacturers must overcome in bringing their devices to market.

4. Competitive Factors and Regulatory Regime

Historically, much of the growth for medical technology companies has been predicated on continual product innovations that make devices easier for doctors to use and improve health outcomes for the patients. Successful product development usually requires significant R&D outlays and a measure of luck. However, viable new devices can elevate average selling prices, market penetration, and market share.

Government regulations curb competition in two ways to foster an environment where firms may realize an acceptable level of returns on their R&D investments. First, firms that are first to the market with a new product can benefit from patents and intellectual property protection giving them a competitive advantage for a finite period. Second, regulations govern medical device design and development, preclinical and clinical testing, premarket clearance or approval, registration and listing, manufacturing, labeling, storage, advertising and promotions, sales and distribution, export and import, and post market surveillance.

Regulatory Overview in the U.S.

In the U.S., the FDA generally oversees the implementation of the second set of regulations. Some relatively simple devices deemed to pose low risk are exempt from the FDA’s clearance requirement and can be marketed in the U.S. without prior authorization. For the remaining devices, commercial distribution requires marketing authorization from the FDA, which comes in primarily two flavors.

The premarket notification (“510(k) clearance”) process requires the manufacturer to demonstrate that a device is “substantially equivalent” to an existing device that is legally marketed in the U.S. The 510(k) clearance process may occasionally require clinical data, and generally takes between 90 days and one year for completion.
The premarket approval (“PMA”) process is more stringent, time-consuming and expensive. A PMA application must be supported by valid scientific evidence, which typically entails collection of extensive technical, preclinical, clinical and manufacturing data. Once the PMA is submitted and found to be complete, the FDA begins an in-depth review, which is required by statute to take no longer than 180 days. However, the process typically takes significantly longer, and may require several years to complete.

Pursuant to the Medical Device User Fee Modernization Act (MDUFA), the FDA collects user fees for the review of devices for marketing clearance or approval. The current iteration of the Medical Device User Fee Act (MDUFA IV) came into effect in October 2017. Under MDUFA IV, the FDA is authorized to collect almost $1 billion in user fees, an increase of more than $320 million over MDUFA III, between 2017 and 2022.

Regulatory Overview Outside the U.S.

The European Union (EU), along with countries such as Japan, Canada, and Australia all operate strict regulatory regimes similar to that of the FDA, and international consensus is moving towards more stringent regulations. Stricter regulations for new devices may slow release dates and may negatively affect companies within the industry.

Medical device manufacturers face a single regulatory body across the EU. In order for a medical device to be allowed on the market, it must meet the requirements set by the EU Medical Devices Directive. Devices must receive a Conformité Européenne (CE) Mark certificate before they are allowed to be sold in that market. This CE marking verifies that a device meets all regulatory requirements, including EU safety standards. A set of different directives apply to different types of devices, potentially increasing the complexity and cost of compliance.

5. Emerging Global Markets

Emerging economies are claiming a growing share of global healthcare consumption, including medical devices and related procedures, owing to relative economic prosperity, growing medical awareness, and increasing (and increasingly aging) populations. As global health expenditure continues to increase, sales to countries outside the U.S. represent a potential avenue for growth for domestic medical device companies. According to the World Bank, all regions (except Sub-Saharan Africa) have seen an increase in healthcare spending as a percentage of total output over the last two decades.

Global medical devices sales are estimated to increase 6.4% annually from 2016 to 2020, reaching nearly $440 billion according to the International Trade Administration. While the Americas are projected to remain the world’s largest medical device market, the Asia/Pacific and Western Europe markets are expected to expand at a quicker pace over the next several years.

Bonus Items for 2018

The following is a (non-ordered) list of items likely relevant for the medical device and med tech industry over the shorter-term.

Tax Reform

Passage of tax reform legislation in late 2017 appears to have invigorated market participants across many sectors of the economy. While the full effect of the new legislation will likely play out over the course of the rest of the year and beyond, the implications for valuation (multiples) are generally expected to be positive. The effective tax rates for many multinational medical device companies were already below the new corporate rate. Accordingly, reductions in overall tax burdens for device companies are likely modest. A more immediate effect materialized in the form of a transition tax on corporate cash parked outside the U.S. (for example, Johnson and Johnson reported a one-time $13.6 billion charge related to the new tax law). With a lower tax rate available on deemed repatriation, many corporations will likely have a more direct access to hitherto-unused overseas funds.

Innovation

Given the structural underpinnings (discussed in earlier sections), continued innovation is probably a low-risk bet vis-à-vis the medical device industry and is likely to materialize along three dimensions. First, the traditional product pipeline nursed by the industry over the years is likely to continue turning out iterative and transformative changes to improve or create new devices (hardware). Second, cost pressures as well as technological developments outside the industry will likely fuel new data analysis and tele-communication products and services (software) that augment or complement the traditionally product-only offerings of device and med tech companies. Finally, business model innovations in response to the changing pricing and competitive landscape will become increasingly relevant, especially for the more mature devices.

M&A

The level of deal activity in the industry observed in 2017 will likely continue in 2018 as consolidation within certain sub-sectors could provide (a degree of) inoculation against the ravages of competitive forces. Some potential acquirers will also be buoyed by the unlocking of the cash resources previously trapped overseas. As in 2017, transaction motivations will likely mirror the three dimensions of innovation as firms pursue i) acquisition of complementary products, ii) access to newer higher-growth markets or segments, and iii) ability to address changes in the modes of care delivery that increasingly favor lower acuity settings over lengthy hospital stays.

Summary

Demographic shifts underlie the long-term market opportunity for medical device manufacturers. While efforts to control costs on the part of the government insurer in the U.S. may limit future pricing growth for incumbent products, a growing global market provides domestic device manufacturers with an opportunity to broaden and diversify their geographic revenue base. Developing new products and procedures is risky and usually more resource intensive compared to some other growth sectors of the economy. However, barriers to entry in the form of existing regulations provide a measure of relief from competition, especially for newly developed products.