OPPORTUNITIES AND SURPRISES IN BUSINESS ENTITY VALUATIONS
Applications in Bankruptcy and Insolvency
Several aspects of a bankruptcy proceeding or insolvency situation may require valuation of an entire
company or an interest in a company. The primary applications include:
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Adequate protection
Claims determination
Asset recovery (including preferences, fraudulent transfers, and reclamation)
Plan confirmation
Liquidation values
Intangible assets
Use, sale or lease of property
Obtaining credit
Premise of Value
The first question facing a business valuation analyst is the choice of the appropriate premise of value.
Premise of value is the most likely of the market conditions that might reasonably be encountered.
The premise of value should reflect the facts and circumstances underlying each valuation. This is also
true in bankruptcy and insolvency situations unless the premise has been predetermined by the
Bankruptcy Code, cases, or applicable laws.
The two main premises of value are going concern and liquidation values. This choice lies at the heart of
most bankruptcy valuation disputes.
Going-Concern Value
The first main premise of value is the going-concern value. Going-concern value is the value that would
be expected assuming the continuation of the business.
Liquidation Value
The second main premise of value is liquidation value. Liquidation value is the net amount that would
most likely be realized if the business were terminated and the assets sold.
The liquidation values are determined based on an orderly or forced liquidation assumption. The main
difference between orderly and forced liquidation is the amount of time before an asset is sold.
Orderly liquidation value assumes that each asset has normal exposure to the marketplace. Generally, a
9- to 15-month liquidation period is assumed. Ideally, the time period chosen should be that which
enables the company to realize the largest value possible in a reasonable time period.
Forced liquidation value assumes that all assets are sold as quickly as possible, such as at an auction sale.
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Valuation Approaches and Methods
There are three basic approaches to determine value:
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Market approach
Income approach
Asset-based (cost) approach
Each of these three approaches needs to be considered in every valuation situation.
Market Approach
The first basic valuation approach is the market approach. This approach determines value by analyzing
similar companies and completed transactions. Multiples are derived from the comparative companies
and are then applied to the subject company.
Commonly used multiples include:
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Price/earnings
Price/gross cash flow
Price/revenues
A thorough search for comparable companies and transactions must be performed, and adjustments must
be made to account for the differences between the comparable companies and the subject company.
The bankruptcy environment presents a challenge in using the market approach. Presumably, the most
comparable companies were in a similar state of insolvency or bankruptcy. Also, the comparable
company data will need to be adjusted to reflect the subject company’s special financing terms and any
special restrictions imposed by the bankruptcy court.
The three primary methods used under the market approach are:
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The guideline company valuation method.
The comparable transaction method.
Internal transactions of the subject company’s stock.
The first method used under the market approach is the guideline company valuation method. This
method compares the subject to comparable public (guideline) companies.
The second method used under the market approach is the comparable transaction method. This method
uses multiples derived from actual sales of closely held businesses, and mergers and acquisitions
transactions involving publicly traded companies.
The third method used under the market approach involves analysis of internal transactions of the subject
company’s stock. When prior arms’ length transactions exist, the circumstances surrounding the
transaction should be analyzed to determine if the situation was similar to the current valuation.
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Income Approach
The second basic valuation approach is the income approach. This approach determines value by
estimating the present value of a future benefit stream. Future benefits are estimated for a projection
period and capitalized or discounted using a rate that is comparable to other similar investment yield rates
in the market.
Generally speaking, “benefit stream” is any measure of income or cash flow that can be converted into
value. Therefore, more than one type of benefit stream may be used, such as net income, net cash flow,
or pretax income. Many valuation analysts prefer net cash flow because it measures cash, which is the
ultimate benefit stream that can be realized.
There are two major income approach methods:
1. Discounted future returns (either earnings or net cash flow)
2. Capitalized returns (either earnings or net cash flow)
Since the discounted net cash flows method is the income approach that is most widely used, I will
explain it in some detail.
Discounted Net Cash Flows Method
Under the discounted net cash flows method, the value consists of three components:
1. Cash flows from operations.
2. Residual or terminal values.
3. The value of assets that will not be needed for operations by the reorganized entity.
The first component of discounted net cash flows is cash flow from operations. It is defined as the
difference between the net cash inflows and outflows from operating activities less capital expenditures
and increased working capital requirements. Depreciation and other noncash items are omitted.
Projection periods of net cash flows are usually between 5 and 7 years.
The second component of discounted net cash flows is the residual (or terminal) value. It represents the
value that the emerging entity will generate beyond the projection period.
Several techniques are used to estimate the residual value. Possibilities include liquidation value, the
perpetuity method, market-to-book ratio, and price/earnings ratios.
If it is invested capital (both debt and equity) that is being valued, the cash flow from operations and the
residual value are discounted at the cost of capital to determine the value of the entity. The cost of capital
is normally determined by calculating the weighted average of the cost of debt and the cost of equity.
The weights that are used should be those that are planned or targeted over the projection period. For a
chapter 11 debtor, the weights should be based on the expected capital structure of the entity as it emerges
from bankruptcy.
The rate that would generally be used for the cost of debt is the long-term yield currently being
demanded, reduced by the tax impact of the interest expense.
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The cost of equity is not as easy to determine. In theory it is the implicit rate of return necessary to attract
investors to purchase the entity’s stock. One approach commonly used to estimate that cost of equity in
chapter 11 proceedings is based on the Capital Asset Pricing Model (CAPM). Under the CAPM the cost
of equity is equal to the risk-free rate plus the equity risk premium.
The third and final component of discounted net cash flows is the present value of nonoperating assets.
This is added to the value of the discounted cash flows and the residual value. Included here would be
excess cash or working capital, excess plant and equipment, and other nonproductive property held for
liquidation.
In summary of the income approach, calculating the value of a debtor in a bankruptcy is difficult because,
among other reasons, there are changes that will be made in the debtor’s operations as a result of the
reorganization proceedings. Bankruptcy courts have accepted this approach for the determination of
reorganized values in a cramdown.
Asset-Based (Cost) Approach
The third and final valuation approach is the asset-based (cost) approach. The basic theory here is:
Current value of the assets minus current value of the liabilities equals the current value of the equity.
When available, generally accepted accounting principles (GAAP) balances are used as a starting point in
applying the asset approach. However, because the assets and liabilities must be revalued, the resulting
balance sheet usually differs significantly from the GAAP balance sheet. Therefore, a GAAP balance
sheet should not normally be used as a proxy for the final valuation product.
The asset-based approach usually works best with companies that have the following characteristics:
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Substantial tangible assets.
A company in the early stages of its life.
Where the future viability of the company is doubtful.
The barriers to entry in the industry are minimal.
Valuation Synthesis
The three valuation approaches are performed to provide a value conclusion. Using more than one
approach may yield similar results and then it doesn’t matter how the different approaches are weighted.
However, when different approaches result in materially different value indications, the results of the
different approaches must be weighted. For instance, if cash flow available to owners is the primary
value driver of a company, then the income approach may dominate.
Discounts and Premiums
Before the final estimate of value is reached, the application of discounts and premiums must be carefully
considered.
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Control Premium and Minority Interest Discount
The degree of control is measured by the control premium and the minority interest discount. A
controlling shareholder enjoys benefits that are not enjoyed by minority interest owners. Minority
interests are therefore usually worth less, often considerably less, than a proportionate share of the total
entity.
Under most definitions, a controlling shareholder owns more than 50% and a minority shareholder owns
less than 50%. This simplistic distinction is usually not acceptable for valuation purposes. Factors that
affect the degree of control include the following:
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Cumulative versus noncumulative voting.
Contractual restrictions.
Effects of regulations, including state statutes.
Financial condition of the business.
Effects of distribution of ownership.
The main sources of obtaining control premium estimates are financial services that analyze acquisitions
of controlling interest of public companies. One such source indicates that since 1987, the median control
premium has been approximately 32% and the implied average minority interest discount has been
approximately 25%.
However, the actual control premium and minority interest discount depends on the factors affecting the
degree of control in each case. Control premiums are often between 25% and 75% of a pro rata share of
the company’s estimated value and minority interest discounts often range from 25% to 50%.
Discount for Lack of Marketability
The degree of marketability is measured by the discount for lack of marketability. The concept of
marketability deals with the liquidity of an ownership interest, that is, how quickly and easily it can be
converted to cash. By definition, ownership interests in closely held companies are typically not readily
marketable compared to similar interests in public companies. This may be true to some extent regardless
of whether a controlling interest or a minority interest is being valued.
The factors that affect a company’s marketability are:
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Restrictions on transfers.
Size of dividend payouts.
Prospect of a public offering.
Size of block being sold.
Buy-sell agreements.
Empirical studies have attempted to determine average levels of discounts for lack of marketability over
the past 25 years. The studies clearly indicate that substantial discounts for lack of marketability are often
required when valuing a closely held company. The range of discounts is quite wide, and the median
discounts are not very consistent from one study to the next. All of this indicates that the selection of a
discount for lack of marketability should be based on the factors that affect the subject company’s
marketability. There is considerable evidence that the marketability discount for a closely held stock
compared with a publicly traded counterpart should average between 35% and 50%.
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Discount for Lack of Voting Rights
Another important discount is the discount for lack of voting rights. Closely-held entities often create
types of interests that have no voting rights.
A number of empirical studies have been conducted that compared nonvoting, publicly traded minority
shares with their voting publicly traded counterparts. These studies have indicated that for small minority
interests, the difference has a negligible impact on value, normally between 1.5% and 5%.
Other Discounts
There are other types of discounts and premiums including the following:
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Swing vote premium.
Blockage discount.
Key person discount.
Portfolio discount.
Environmental liability discount.
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