Planning for Closely Held Business Owners - 8 Evaluation Methodologies

Question 1

What are two “Bet to Die” Strategies?

Answer 1

1) Self-Canceling Installment Note (SCIN)

2) Private Annuity

Question 2

What is the Self-Canceling Installment Note (SCIN)?

Answer 2

• The SCIN involves the sale of property in exchange for an installment note calling for a specified number of fixed payments at a specified interest rate over a
  set period of time, but also provides that the note payments terminate upon the death of the seller
• Since death terminates the seller’s right to receive payments, there is nothing of value to include in the
  seller-decedent’s estate

Question 3

What are the tax consequences when you terminate a SCIN?

Answer 3

The termination of a SCIN does have
potentially adverse income tax
consequences (Frane case) – Untaxed gain is income to the decedent’s estate

Question 4

SCIN works “best” if the seller __________ survive the term of the note

(does OR does not)

Answer 4

does not

Question 5

What is The Private Annuity?

Answer 5

The business owner (transferor) transfers ownership of the business to the family member (transferee) in
exchange for the transferee’s
promise (which must be unsecured) to make payments to the transferor for life.

Question 6

2006 Proposed Regulations would require the transferor of the business interest to recognize the entire realized gain for income tax purposes ___________ the
exchange

(at the time of OR after)

Answer 6

at the time of

Question 7

There _______ gift tax cost for private annuities

(is a OR is no)

Answer 7

is no

Question 8

What is a closely held corporation?

Answer 8

A corporation whose stock is not regularly sold or exchanged

Question 9

What should you consider when determining the value of stock in a closely held corporation

Answer 9

It is important to consider the closely held
corporation’s net worth, prospective earning power and dividend-paying capacity, goodwill, general economic conditions, management of the corporation, the values of stock of other corporations engaged in the same or similar lines of business, and other relevant factors.

Question 10

The following factors are fundamental when determining the fair market value of stock in a closely held corporation

Answer 10

• the nature of the business and the history of the enterprise from its inception;
• the economic outlook in general and the condition and outlook of the specific
  industry in particular
• the book value of the stock and the financial condition of
  the business
• the earning capacity of the company
• the dividend-paying capacity of the company
• whether the business has goodwill or other intangible assets
• sales of the stock
• the market price of actively traded stocks of other corporations engaged in the same or a similar line of business
  *A proposed merger of a closely held corporation with a publicly owned corporation

Question 11

What are different valuation methodologies?

Answer 11

1. Market Capitalization
2. Times Revenue Method
3. Earnings Multiplier
   4.Discounted Cash Flow (DCF) Method
4. Book Value
5. Liquidation Value

Question 12

Market Capitalization

Answer 12

-simplest method of business valuation
- It is calculated by multiplying the company’s share price by its total number of shares outstanding.
-For example, as of January 3, 2018, Microsoft Inc. traded at $86.35.2
-With a total number of shares outstanding of 7.715 billion, the company could then be valued at $86.35 x 7.715 billion = $666.19 billion.

Question 13

Times Revenue Method

Answer 13

-a stream of revenues generated over a certain period of time is applied to a multiplier that depends on the industry and economic environment.
-For example, a tech company may be valued at 3x revenue, while a service firm may be valued at 0.5x revenue.

Question 14

Earnings Multiplier

Answer 14

-used to get a more accurate picture of the real value of a company, since a company’s profits are a more reliable indicator of its financial success than sales revenue is.
-The earnings multiplier adjusts future profits against cash flow that could be invested at the current interest rate over the same period of time.
-In other words, it adjusts the current P/E ratio to account for current interest rates.

Question 15

Discounted Cash Flow (DCF) Method

Answer 15

-similar to the earnings multiplier.
-This method is based on projections of future cash flows, which are adjusted to get the current market value of the company.
-the sum of the cash flow in each period divided by one plus the discount rate raised to the power of the period number
-The main difference between the discounted cash flow method and the profit multiplier method is that it takes inflation into consideration to calculate the present value.

Question 16

Book Value

Answer 16

-This is the value of shareholders’ equity of a business as shown on the balance sheet statement.
-The book value is derived by subtracting the total liabilities of a company from its total assets.

Question 17

Liquidation Value

Answer 17

-net cash that a business will receive if its assets were liquidated and liabilities were paid off today.
-This is by no means an exhaustive list of the business valuation methods in use today.
-Other methods include replacement value, breakup value, asset-based valuation, and still many more.

Question 18

What are the three approaches to valuing a closely held business?

Answer 18

1. The Market Approach
2. The Income Approach
   3.The Adjusted Balance Sheet Approach

Question 19

The Market Approach

Answer 19

-compares the private company to other companies in the public securities markets.
-includes adjusting financial statements of the private company, analyzing multiples of the public securities, and making adjustments for the differences between the private company and its publicly traded counterparts.
-Private transactions of other companies bought and sold in the marketplace can also serve as evidence of the subject company value.
-information is difficult to find and sometimes not reliable.

Question 20

The Income Approach

Answer 20

involves measuring some level of income or cash flow and capitalizing these amounts into value.
-The value of a company to any investor is always the present value of its future income or cash flow.
-analysis of the private company’s past performance is the best indication of its future performance.
-sometimes forecast of future cash flows is determined to be a more reliable expectation of the company’s future performance.
-in DCF, future cash flows are projected and then discounted back to today’s value.

Question 21

The Adjusted Balance Sheet Approach

Answer 21

-used in situations such as real estate and other types of holding companies.
-involves adjusting the assets of a company to their fair market value and deducting all outstanding liabilities.
-situations for this approach arise when application of the market or income approach yields a value below the company’s book value, or when those approaches are eliminated from consideration all together.
- In those cases, the adjusted balance sheet approach is used to establish a valuation floor, since every company is worth at least the fair market value of its assets less its liabilities.

Question 22

Describe the market value valuation?

Answer 22

Compares the value of other recently sold similar businesses to arrive at a value.
Works well if enough data of comparable businesses is available.
Similar to residential real estate valuation.
Subject to judgments and goals of prospective buyers.

Question 23

Describe the asset value valuation?

Answer 23

Adds the value of the business assets and subtracts the value of the company’s liabilities to obtain a value.
Best for businesses with a lot of tangible, marketable assets.
Challenge in valuing assets that are difficult or expensive to value, when much of the value lies in the way it provides a financial benefit to the company.
Not especially useful for complex businesses

Question 24

Describe the drawbacks of market value valuation?

Answer 24

Subject to judgments and goals of prospective buyers.

Works well if enough data of comparable businesses is available.

Relies on the availability of data on comparable assets that have recently been sold in the market

If there are few recent sales or the market for the asset is illiquid, it can be difficult to obtain accurate data for the valuation

Question 25

Describe the drawbacks of asset based valuation?

Answer 25

Does not consider a company’s future earning potential

Question 26

Describe the drawbacks of a discounted cash flow model?

Answer 26

Based on value to investor, as beneficiary of future cash flows, is the sum of those future cash flows.

Based on estimates

Prone to errors

Question 27

Describe the drawbacks of multiple of earnings?

Answer 27

Multiples can change over time as investors become more or less eager to own the shares based on market dynamics

Question 28

When is market value applicable?

Answer 28

Works well if enough data of comparable businesses is available.

Question 29

When is asset value applicable?

Answer 29

Works best for smaller companies, not complex businesses

Best for businesses with a lot of tangibles, marketable assets.

Question 30

When is a discounted cash flow model applicable?

Answer 30

Used by investment banks and professional business valuation firms

Question 31

When is multiple of earnings applicable?

Answer 31

Best for companies that have highly predictable or recurring revenue