< PreviousA PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 10 MARCH | APRIL 2021 the value examiner Figure 1: Example, Asset Side of Balance Sheet Converted to Market Value BOOK VALUEMARKET VALUE MARKET VALUE Land500,000 N/A Buildings & Improvements2,500,000 N/A Less Accumulated Depreciation-1,800,000 N/A Appraised Value of Real Property N/A 7,000,000 1,200,0007,000,000 - 85,00085,000 - - 85,00085,000 100,00057,000 -75,000- 25,00057,000 1,310,0007,142,000 5,832,000 - FIVE TREES INVESTMENTS, LLC ASSETS 31-Dec-19 OPERATING ASSETS: Real Property Total Real Property NON-OPERATING ASSETS: Current Assets Cash Accounts Receivable Total Current Assets Fixed Assets Property & Equipment Less Accumulated Depreciation Total Fixed Assets TOTAL ASSETS MARKET VALUE Market Value in Excess of Book FIVE TREES INVESTMENTS, LLC ASSETS 31-Dec-19 OPERATING ASSETS: Real Property Market Value in Excess of Book Total Real Property Intangible Assets Goodwill, Exchange Goodwill, Owner Total Goodwill NON-OPERATING ASSETS: Current Assets TOTAL ASSETS EXCHANGE VALUE Turning to the capital side of the balance sheet, Figure 2 shows the relationship between assets and capital. An increase in any of the three asset values results in a corresponding increase in equity. And when capital is supplied in the form of debt, there is a corresponding decrease in the value of equity because debt has contractual rights ahead of equity. In the M&A model, working capital adds to total assets and equity, but transfers separately from operating asset value. 9 For simplicity, the equity contribution of working capital in Figure 2 is shown to cancel to zero value. 9 Note that the key nonoperating assets needed to “restart” the business after an asset sale, such as cash and inventory, are separately supplied by the buyer. Inventory is often purchased in a second transaction, reflecting this separation of nonoperating assets out of the deal price. Commissions are customarily paid only on operating asset value, and not on nonoperating assets transferred. Accounts receivable and accounts payable traditionally do not transfer, but may be added into a deal. In the M&A model, working capital adds to total assets and equity, but transfers separately from operating asset value.A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES the value examiner MARCH | APRIL 2021 11 Figure 2: Market Value of Operating Assets vs. Market Value of Invested Capital Non-Operating Assets - Current AssetsCurrent Liabilities - Working Capital Equity Goodwill Market Value of Invested Capital Market Value of Operating Assets Intellectual Property Fixed Assets Debt In the example, since the asset has appreciated, it has a contingent capital gain tax liability of $2.4 million. This contingent cost is recognized with a liability, yielding a net asset value of $4,226,000. Each asset and liability is now at its cash-converted value; thus, the conclusion is asset utility (market value), shown as net asset value, as the M&A valuation model requires. (See Figure 3.) Market versus In-Use Value Now, change the standard of value from market value to value-if-not-sold, and the assessment of the LLC is dependent on in-use utility. Instead of buyer cash flows, the actual cash flows and an owner’s expectation for investment return are incorporated. The CRE benefit stream is called effective operating income (EOI), which is the total income a property could generate if 100-percent leased at market rent, less transitory vacancy costs, operating expenses, and capital reserves allowance. Having market value utility, the CRE appraisal uses normalized EOI—in other words, it uses the buyer’s expected cash flows after acquisition, not the LLC’s current cash flows. In the market approach, a baseline was adjusted for the subject’s “core” variables, such as number of square feet, lot size, condition, business district, etc. In the income approach, the subject’s property attributes were used to adjust the capitalization rate. Thus, the $7,000,000 conclusion is the price at which the appraiser believes a change of owner will occur based on transferable benefits. Notably, capital structure and owner cash flows have been set aside to assess market value, but require inclusion for the in-use opinion. In the example, the difference between market and actual EOI provides an owner benefit, and is shown in Figure 4. Instead of buyer cash flows, the actual cash flows and an owner’s expectation for investment return are incorporated.A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 12 MARCH | APRIL 2021 the value examiner Income Appraisal ValueActual ValueOwner Benefit 490,000475,000-15,000 100,000150,00050,000 -20,000-5,00015,000 570,000620,00050,000 50,00045,000-5,000 5,0004,250-750 8,0007,550-450 9,5009,900400 15,000-15,000 1,8001,800 3,0003,000- Market Rate Revenue 111/CAM Vacancy Total Income Expenses Property Taxes Insurance Utilities Repairs & Maintenance Management Accounting/Legal Reserves Total Expense 90,50071,500 -19,000 EFF. OPERATING INCOME479,500548,50069,000 Five Trees Investments, LLC CASH FLOWS RECONCILIATION BOOK VALUEMARKET VALUE MARKET 1,000 15,000Accounts Payable & Accrued Expenses Accounts Payable & Accrued Expense Customer Deposits Other Current Liabilities - 1,000 15,000 - 16,00016,000 Long-Term Debt500,000500,000 500,000500,000 Built-in Gain Tax-2,400,000 02,400,000 516,0002,916,000 1,216,0001,216,000 -422,000-422,000 Paid-in Capital Dividends/Distributions E6uity in Excess of Book -3,432,000 794,0004,226,000- 1,310,0007,142,000 TOTAL LIABILITIES FIVE TREES INVESTMENTS, LLC BALANCE SHEET INVESTED CAPITAL 31-Dec-19 LIABILITIES TO THIRD PARTIES Current Liabilities Total Current Liabilities Long-Ter2 Liabilities Total Long-Ter2 Liabilities Contingent Liabilities Total Contingent Liabilities E UIT' OBLIGATION TO O%NERS TOTAL E UIT' MARKET VALUE INVESTED CAPITAL Total Current Liabilities FIVE TREES INVESTMENTS, LLC BALANCE SHEET INVESTED CAPITAL 31-Dec-19 LIABILITIES TO THIRD PARTIES Current Liabilities TOTAL E UIT' EXCHANGE VALUE INVESTED CAPITAL Long-Ter2 Liabilities Total Long-Ter2 Liabilities Contingent Liabilities Total Contingent Liabilities TOTAL LIABILITIES E UIT' OBLIGATION TO O%NERS Figure 3: Example, Capital Side of Balance Sheet Converted to Market Value Figure 4: Example, Cash Flows ReconciliationA PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES the value examiner MARCH | APRIL 2021 13 The LLC owners benefit because the LLC has secured tenants with above-market rents, property taxes lag behind market rate, and the property is self-managed. These proprietary cash flows provide the current owners higher benefits than a buyer is expected to receive. In-Use Goodwill When market and in-use cash flows diverge, the difference creates intangible value, or goodwill. Returning to the example, the cash flow benefit is now quantified into a goodwill asset by capitalization. Depending on the engagement, the viewpoint applied could be a market rate, an acquirer’s rate, the owner’s rate, or another view. A corporate buyer’s rate might be derived from its stock market multiple. An owner’s rate might be figured on alternative investment options. Here, a 15 percent rate is used. The in-use cash flow differential to the owners is positive $69,000. Capitalizing at 15 percent yields an intangible benefit of $460,000, which is added to the asset side of the balance sheet and increases equity by the same amount. (See Figures 5 and 6.) BOOK VALUE MARKET VALUE IN-USE VALUE Land500,000 N/A N/A Buildings & Improvements2,500,000 N/A N/A Less Accumulated Depreciation-1,800,000 N/A N/A Appraised Value of Real Property N/A 7,000,0007,000,000 1,200,0007,000,0007,000,000 - - - -460,000 - - 0460,000 Cash85,00085,00085,000 - - -- 85,00085,00085,000 100,00057,00057,000 -75,000 - - 1,310,0007,142,0007,602,000 5,832,0006,292,000 FIVE TREES INVESTMENTS, LLC ASSETS 31-Dec-19 OPERATING ASSETS: Real Property Total Real Property NON-OPERATING ASSETS: TOTAL ASSETS MARKET VALUE Market Value in Excess of Book FIVE TREES INVESTMENTS, LLC ASSETS 31-Dec-19 OPERATING ASSETS: Real Property Market Value in Excess of Book Total Real Property Intangible Assets Goodwill, Exchange Goodwill, Owner Total Goodwill NON-OPERATING ASSETS: Current Assets Accounts Receivable Total Current Assets Fixed Assets Property & Equipment Less Accumulated Depreciation Total Fixed Assets TOTAL ASSETS EXCHANGE VALUE Figure 5: Recast Balance Sheet for Example, Assets When market and in-use cash flows diverge, the difference creates intangible value, or goodwill.A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 14 MARCH | APRIL 2021 the value examiner Figure 6: Recast Balance Sheet for Example, Invested Capital This analysis shows the LLC to have a market value of $4,226,000 and in-use value of $4,686,000. It is the same set of facts, but different users. This makes sense because the owners’ actual cash flow benefit is greater than the benefit that a buyer acquires. If the subject were an operating business instead of CRE, exchange goodwill would have a separate value in the company assets, assuming that the value of cash flows to the buyer is greater than the operating assets employed. Exchange goodwill is constant regardless of value standard because it is shaped by the company’s intrinsic factors, such as intellectual property, growth rate, and competition; factors that transfer from seller to buyer. Owner Impact Analysis The example shows how market and in-use utility are distinguished by owner impact. Owner constraints include entity type, bylaws, buy-sell agreements, underfunding, overleveraging, cash diversions, potential dilution, and others. To assess enterprise market value, the owner BOOK VALUE MARKET VALUE IN-USE VALUE Accounts Payable & Accrued Expenses1,0001,0001,000 Customer Deposits15,00015,00015,000 Other Current Liabilities- -- 16,00016,00016,000 Long-Term Debt500,000500,000500,000 500,000500,000500,000 Built-in Gain Tax-2,400,0002,400,000 02,400,0002,400,000 516,0002,916,0002,916,000 1,216,0001,216,0001,216,000 -422,000-422,000-422,000 Paid-in Capital Dividends/Distributions E6uity in Excess of Book -3,432,0003,892,000 794,0004,226,0004,686,000 1,310,0007,142,0007,602,000 TOTAL LIABILITIES FIVE TREES INVESTMENTS, LLC BALANCE SHEET INVESTED CAPITAL 31-Dec-19 LIABILITIES TO THIRD PARTIES Current Liabilities Total Current Liabilities Long-Ter2 Liabilities Total Long-Ter2 Liabilities Contingent Liabilities Total Contingent Liabilities E UIT' OBLIGATION TO O%NERS TOTAL E UIT' MARKET VALUE INVESTED CAPITAL Total Current Liabilities FIVE TREES INVESTMENTS, LLC BALANCE SHEET INVESTED CAPITAL 31-Dec-19 LIABILITIES TO THIRD PARTIES Current Liabilities TOTAL E UIT' EXCHANGE VALUE INVESTED CAPITAL Long-Ter2 Liabilities Total Long-Ter2 Liabilities Contingent Liabilities Total Contingent Liabilities TOTAL LIABILITIES E UIT' OBLIGATION TO O%NERS ExpenseA PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES the value examiner MARCH | APRIL 2021 15 elements commonly omitted from an analysis are: • Entity type • Taxes • Debt • Strategy • Owner constraints and resources These factors are dependent variables with respect to the owner in possession, and only included for in-use value. Because the owner variables drive unique cash flows, investment risk may change from market rate. An easy example is the effect of debt and working capital on risk. A business enterprise with ownership that is short of cash and has high debt levels will be valued less than an ownership with ample working capital, no debt, and external resources available to seize new opportunities and fund emergencies. These resources are unrelated to operating cash produced by the enterprise, but do affect free cash flows to equity (FCF). Denoting in-use characteristics separately from market characteristics means that analysts are compelled to choose market or owner cash flow per the value standard and either apply market risk alone to transferable cash flow or both market and owner risk to in-use cash flow. Some company factors are shown in Table 2. Table 2: Specific Company Risk Factors EQUITY FactorBuyer Transferable?Owner Specific? Cash FlowNormalizedActual Growth RateYesNo Gross MarginYesNo Entry BarriersYesNo Competitive AdvantageYesNo ManagementYesNo Owner & StrategyNoYes Working Capital SufficiencyNoYes DebtNoYes Financial RiskNoYes Profit TaxationNoYes ENTITY CONCLUSIONREPRESENTATIONUTILITY ASSET VALUEOPERATING ASSETS ALONEMARKET NET ASSET VALUE ASSET VALUE PLUS ACTUAL LIABILITIES AND NON-OPERATING ASSETS MARKET EQUITY VALUE IN-USE VALUE UTILITY OF CONCLUSIONS NATURE & INDEPENDENCE OF BUSINESS VALUATION VARIABLES SPECIFIC COMPANY FACTORS These risks can be assessed in multiple ways, but under normal principles of substitution, a cash flow or risk only needs to be analyzed when it diverges significantly from market expectations. For example, if a subject company’s debt level is close to industry average, no adjustment is necessary. If a mismatch exists, it is assessed. These owner-related nonoperating analyses are important, but in practice they are completed at different points in the valuation process, and may be inadvertently applied or omitted. The naturally occurring market and in-use structure is significant. Recognizing ownership as an independent discriminator of value leads to a change in the understanding of “specific company risk,” which naturally has two parts: core risk and owner risk, which could also be described as operating risk and nonoperating risk. Applying this outcome in Table 3, three commonly requested entity opinions are shown. Level one is the operating business alone, separate from nonoperating assets. A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 16 MARCH | APRIL 2021 the value examiner Level two is net asset value, incorporating nonoperating assets and liabilities as if converted to cash on the valuation date. Level one and two are the M&A model result requested by lending institutions, small business owners, and business brokers for collateral value or transaction value. Level 3 is the investor model, which incorporates ownership factors and represents the anticipation of future benefits, called equity. This conclusion is needed to value shares for employee compensation, investor solicitations, founder exits, divorce, dispute resolution, and taxes. Source Data and Approaches Asset-equity utility is present in data sources, too, and affects modeling. Whole company selling prices and replacement costs reflect asset utility, making the cost approach and market approach a match for company market value opinions. Income approaches may provide either asset or equity outputs, depending on whether the benchmark transactions used to develop the risk rate are complete bundles of rights or partial bundles. Capitalization rates derived from whole company transaction prices produce asset risk rates and are matched to unlevered cash flows. Share prices from public markets are adjusted for capital structure and other factors to either a levered or unlevered basis and applied to their matching cash flow. This is shown in Table 4. With these classifications, market value of invested capital (MVIC) and other entity variables are categorized in Table 5. (Equity equals MVIC less debt.) Discounts The analysis would be incomplete without discussing the in- use value and market value of a partial interest. The change of owner test is also applied here, and is different for a majority versus a minority interest. A majority interest has two known advantages. It possesses control for less than 100 percent of the economic value, and it may use its power to take asymmetrical benefits by leveraging its position against the minority interests. Conversely, a minority interest suffers in these aspects and lacks liquidity because it does not possess the control required to convert the interest to cash at its discretion. The in-use community equity interest is the starting point. The nature of a community interest is that of having a portion alongside others. Its utility is based on shared economic benefits under common agreements made with the company. So, in a transfer between a current equity holder and the company, or between equity holders, the appraisal viewpoint is that of the community. Having invested on a basis of equivalency, and with no change in the bundle of rights, an arbitrary discount, such as the discount for lack of marketability (DLOM), 10 would provide a windfall for one investor over another, discriminating between interests. Thus, pro rata distribution of in-use value applies to investment and buyout situations 11 if there is no agreement to the contrary. Note that in-use value prior to an equity holder exit may be different than value at or after the exit date. In-use value includes contingent costs to be incurred by the company to exit the equity holder and is subject to company (owner) resource constraints. For example, the exit price will be different if the amount is small and paid out of company cash on hand, compared to a large exit amount that requires borrowing or selling an asset. These impacts are to be shared among all interests in the community. The market value of a partial interest, however, is viewed as if independent of the enterprise, as a resource to its buyer, with the capital structure broken into pieces. The buyer is focused on the cash flows he or she will receive, and the enterprise cash flows do not have a direct relationship to the cash flows going to the interest holder. As an M&A buyer values a company based on EBITDA, a buyer of a block of shares values the partial interest based on the net cash distributions expected after purchase. Aside from interim dividends, the cash conversion scenarios are: (1) the interest is independently sold in the future, incurring offering and due diligence costs; (2) the interest converts to cash when the enterprise is sold; or (3) the interest is never converted to cash. The profession lacks suitable transaction data for direct appraisal of the above scenarios, so the common practice is to benchmark from the community equity interest. A minority interest is appraised with a DLOM analysis, which assumes that the original investment and appreciation will be recovered. This recovery is impaired by a cash conversion cost and an illiquidity period, subject to a risk-adjusted discount rate. For a majority interest, a premium to the community interest can result from its economic leverage. While it has cash conversion costs, it has no liquidity issue. The full set of relationships and analysis steps are summarized in Figure 7. 10 DLOM is a valuation step where a nonmarketable partial interest is assessed as if it were hypothetically placed in the open market for sale to an unrelated party. The shares are valued based only upon the benefits that transfer to the buyer. 11 The pro rata outcome is also widely supported by case law in shareholder oppression and divorce matters, and also by the Model Business Corporation Act (MBCA), which is the basis of most state law in this area.A PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES the value examiner MARCH | APRIL 2021 17 EQUITYENTITY CONCLUSIONREPRESENTATIONUTILITY ASSET VALUEOPERATING ASSETS ALONEMARKET NET ASSET VALUE ASSET VALUE PLUS ACTUAL LIABILITIES AND NON-OPERATING ASSETS MARKET EQUITY VALUE NET ASSET VALUE ADJUSTED FOR IN-USE CASH FLOWS & RISKS SUCH AS LEVERAGE, POTENTIAL DILUTION, ENTITY TYPE IN-USE VALUE UTILITY OF CONCLUSIONS NATURE & INDEPENDENCE OF BUSINESS VALUATION VARIABLESSPECIFIC COMPANY FACTORSDATA SOURCESAMPLE UTILITYVALUE TYPE SAMPLE COMPOSITION BASELINING MVIC ISSUES CASH FLOW MEASURE CRE APPRAISALASSETMARKET OPERATING ASSET ONLY NONE EFFECTIVE OPERATING INCOME WHOLE COMPANY TRANSFERASSETMARKET OPERATING & NON- OPERATING ASSETS NON- OPERATING ASSETS EBITDA PUBLIC MARKET SHARESEQUITYIN-USE ALL ASSETS, LIABILITIES, DISCOUNTS, BYLAWS NON- OPERATING ASSETS, LIABILITIES, DISCOUNTS NET INCOME OR FREE CASH FLOW BASELINING MARKET VALUE OF THE OPERATING ASSETS Table 3: Value Utilities Table 4: Data Source and Conversion to Operating Asset Utility Table 5: Classification of Variables VARIABLEASSET EQUITY REPRESENTATIONCOSTBENEFIT VALUE STANDARDOPEN-MARKETIN-USE TRANSACTION DATAWHOLE COMPANY TRANSFERSHARES TRANSFER DATA SOURCEBROKERAGEPUBLIC MARKET MVIC CALCULATIONDIRECTTRANSLATION CASH FLOWEBITDAFCF OWNERNONESPECIFIED DEBTNONESPECIFIED ENTITY FORMNONESPECIFIED STRATEGYIN TRANSITIONSPECIFIED UTILITY & INDEPENDENCE OF BUSINESS VALUATION VARIABLESA PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES 18 MARCH | APRIL 2021 the value examiner Figure 7: Variables and Standards Relationships FAIR MARKET VALUE ASSET VALUE GAAP FAIR VALUE NET ASSET VALUE IN-USE VALUE (EQUITY) INVESTMENT VALUE EQUITY VALUE PARTIAL INTEREST VALUE TO OWNER EXCHANGE VALUE (ASSET) FMV AND GAAP CONTROL INTEREST MARKET VALUE MINORITY INTEREST MARKET VALUE MARKET VALUE (ASSET) AND PRO RATA OWNERSHIP RISK CASH BENEFITS & COSTS LACK OF LIQUIDITY HIGHER RISK NON-OP ASSET& LIABILITY ACTUALS CASH BENEFITS & COSTS LIQUIDITY LOWER RISK Conclusion Value Standard UtilityA PROFESSIONAL DEVELOPMENT JOURNAL for the CONSULTING DISCIPLINES the value examiner MARCH | APRIL 2021 19 Conclusions Laws are absolute truths that science works to reveal. Under economic pressures to compete, some solutions are found more fit than others. The one that ends on top is the winner, and is an expression of an underlying law. In that regard, the M&A approach is a valuation law because it represents billions of dollars of private transaction value every year. Similarly, the investor approach is another law developed out of public market observations. Bridging the two utilities, a scientifically sound structure of independent and dependent variables explains the difference. This means: • Every business enterprise has two different entity values, a market value and an in-use value—i.e., a price based on normalized market benefits to a buyer, and worth based on future benefits to its owners. • Owner goodwill results from exercised owner rights that change cash flows from those that are transferable to a buyer. •Investor risk differs from buyer risk because the owner in possession has exercised exclusive rights and has finite resources. • Every block of shares has two different values, an in-use value and a market value—i.e., a community value to owners based on a contract, and an independent price to a buyer based on its cash benefits. • The dependency test for a variable is whether a buyer can immediately change it upon gaining control of the asset. If the variable cannot be changed, it applies to market value. If the variable can be changed, it applies to in-use value. VE James A. Lisi, CVA, MBA, CPIM, is owner of Santa Barbara Valuations Inc. and represents The Mentor Group’s investment banking services. He has significant experience in M&A and angel investment, and his expertise spans valuation of businesses, real property partnerships, intellectual property, brands, cryptocurrency, and equipment. Mr. Lisi has valued over 350 business entities and equity interests with extensive practice in start-up, 409a, estate, gift, and ESOP situations. His reports have supported IRS mediations, civil lawsuits of partner disputes, employee separations, and divorce. He has presented at NACVA national conferences and some of his technical solutions are published in the NACVA online library. Email: jim@sbvaluations.com. Acknowledgements Gerald Barney, founder, American ValueMetrics Corporation, mentor and friend, and contemporary of Shannon Pratt, who explained that variables of entity type, debt, and non- operating assets are not pertinent to market value because buyers change the financial structure to suit their own objectives. William J. Morrison and Jay E. Fishman, co-authors of The Business Valuation Bench Book, who open their book with the declaration that only two fundamental premises of value exist: value in exchange and value to the owner, an “aha moment” for me. Brad Penkala, science teacher, Goleta Valley Junior High School, who provided another “aha moment” when he presented scientific method procedure at Back-to-School Night, which is the method applied for hypothesizing and testing the main principle of this article. Investor risk differs from buyer risk because the owner in possession has exercised exclusive rights and has finite resources.Next >