Planning for Closely Held Business Owners - 8 Evaluation Methodologies Flashcards
What are two “Bet to Die” Strategies?
1) Self-Canceling Installment Note (SCIN)
2) Private Annuity
What is the Self-Canceling Installment Note (SCIN)?
- 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
What are the tax consequences when you terminate a SCIN?
The termination of a SCIN does have
potentially adverse income tax
consequences (Frane case) – Untaxed gain is income to the decedent’s estate
SCIN works “best” if the seller __________ survive the term of the note
(does OR does not)
does not
What is The Private Annuity?
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.
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)
at the time of
There _______ gift tax cost for private annuities
(is a OR is no)
is no
What is a closely held corporation?
A corporation whose stock is not regularly sold or exchanged
What should you consider when determining the value of stock in a closely held corporation
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.
The following factors are fundamental when determining the fair market value of stock in a closely held corporation
- 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
What are different valuation methodologies?
- Market Capitalization
- Times Revenue Method
- Earnings Multiplier
4.Discounted Cash Flow (DCF) Method - Book Value
- Liquidation Value
Market Capitalization
-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.
Times Revenue Method
-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.
Earnings Multiplier
-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.
Discounted Cash Flow (DCF) Method
-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.
Book Value
-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.
Liquidation Value
-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.
What are the three approaches to valuing a closely held business?
- The Market Approach
- The Income Approach
3.The Adjusted Balance Sheet Approach
The Market Approach
-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.
The Income Approach
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.
The Adjusted Balance Sheet Approach
-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.
Describe the market value valuation?
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.
Describe the asset value valuation?
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
Describe the drawbacks of market value valuation?
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
Describe the drawbacks of asset based valuation?
Does not consider a company’s future earning potential
Describe the drawbacks of a discounted cash flow model?
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
Describe the drawbacks of multiple of earnings?
Multiples can change over time as investors become more or less eager to own the shares based on market dynamics
When is market value applicable?
Works well if enough data of comparable businesses is available.
When is asset value applicable?
Works best for smaller companies, not complex businesses
Best for businesses with a lot of tangibles, marketable assets.
When is a discounted cash flow model applicable?
Used by investment banks and professional business valuation firms
When is multiple of earnings applicable?
Best for companies that have highly predictable or recurring revenue
