My current series of blog posts is titled “Mercer’s Musings.”  In the first three “musings,” I addressed USPAP and the Internal Revenue Service and concluded that the answer to the question of whether to comply with USPAP is “Why not?”  And the answer holds regardless of any certifications appraisers might hold.

The second and third musings address the issue of marketability discounts and conclude that it is not possible to comply with any valuation standards, whether USPAP or not, using only averages of restricted stock studies as a basis for “guessing” marketability discounts.  The third musing illustrates the depth of analysis necessary to reasonably address the complexities and nuances in valuing illiquid minority interests of private companies.  The first three musings are linked here for ease of reference.

• Mercer’s Musings #1: USPAP and the Internal Revenue Service
• Mercer’s Musings #2: Using Restricted Stock Studies to Support Marketability Discounts
• Mercer’s Musings #3: Marketability Discounts re Two Hypothetical Minority Interests

This fourth musing examines the guidance found in “Procedural Guideline -2 (PG – 2) Valuation of Partial Ownership Interests” in the ASA Business Valuation Standards.  Procedural Guidelines (PG) are designed to provide more detailed guidance for consideration by business appraisers than found in the base standards themselves.  Procedural Guidelines are not binding, but they are instructive of the degree of analysis that might be considered.

PG – 2 Valuation of Partial Ownership Interests

Mercer’s Musings #4 will now address a portion of PG-2: Valuation of Partial Ownership Interests.  The first section of PG-2 is its “Preamble,” which provides an overview of the intent of the guideline.  The second section is called “General Principles,” where readers find a discussion of the concept of partial ownership interests, the wide range of possibilities that are raised when such interests, and guidance regarding the differences between valuing businesses versus interests in them.

This post addresses the lengthy third section of PG-2, which is called “Factors to consider.”  The hypothetical valuation presented in Mercer’s Musings #2 and “solved” in Mercer’s Musings #3 considered a significant number of factors in developing marketability discounts for two dissimilar, 10% interests in two identical companies.  We now turn to PG-2 to provide an outline of the wide range of considerations that should be in appraisers’ minds with they begin to value partial ownership interests.

We begin with a quote from the beginning of Section III.  My comments are provided in red.

III. Factors to consider

A number of factors may be appropriate to consider in valuing partial ownership interests. The
following list is not intended to be all-inclusive. Items on the list may or may not be applicable in
specific valuation situations.

A. The purpose and definition of the valuation engagement in accordance with BVS–I General
Requirements for Developing a Business Valuation, including the applicable standard (type) and
premise of value.

B. Factors related to the underlying enterprise or asset, including:

1. The value of the underlying enterprise or asset, if applicable.
2. Enterprise-level or asset-level tax effects, if relevant.

Every appraisal must have a stated purpose and definition of the valuation (i.e., the standard of value).  The beginning point of the valuation of a partial ownership interest is almost always the value of the underlying business or asset.  This is the “base value” that has been addressed in a number of posts on this blog.  The guideline also suggests that enterprise- or asset-level tax effects might need to be considered.

C. Factors related to the subject partial interest, including:

1. Provisions in the organizational and governance documents that affect the rights,
restrictions, marketability and liquidity of the subject interest. Documents to consider may
include partnership agreements, articles of incorporation, bylaws, operating agreements,
buy-sell agreements, investment letter stock restrictions, option agreements, lock-up
requirements or others that may be relevant.

Analogous to Standards Rule 9(4), of the Uniform Standards of Professional Appraisal Practice, appraisers are instructed to examine the underlying corporate documents that might increase or decrease the risks of holding minority interests in businesses. 

C2. Applicable laws and regulations. Business examples include statutory rights to demand
dissolution of a corporation under state law, restrictions on transfer pursuant to SEC Rule
144, and many others. An asset example is included the right to partition.

C3. The existing ownership structure and configuration.

C4. Access to, availability of, and reliability of information regarding the underlying asset or
entity.

C5. The relevant pool of potential buyers, if any.

C6. Market data on transactions in similar markets, if any. Potentially similar markets might
include private placements in publicly or privately syndicated entities (including restricted
stock transactions, pre-IPO transactions, and transactions in publicly traded limited
partnerships) or tenants-in-common arrangements, etc.

Paragraphs C2 through C6 should be familiar to most business appraisers.  We must take applicable laws and regulations into account.  It is fairly standard to consider the ownership structure and configuration and influence that management might have on the value of illiquid minority interests.  The question is: How can appraisers do that?  Purely qualitative analysis seems to fall short. 

Access to reliable information is certainly an important factor since investors desire to know the factual backgrounds of their investments.

The relevant pool of hypothetical buyers is also important.  For example, if an interest has a value of $100 thousand, there may be a considerable number of potential investors.  If the interest has a value of $10 million, the pool of buyers would likely be both limited and sophisticated.  These are important considerations.

And certainly, it is important to examine relevant transactions in interests similar to a subject interest or in the interest itself.  Valuation inferences can sometimes be made from knowledge of past transactions. 

Paragraph C7 (below) focuses on the expected holding period for an investment.  This is analogous to the guidance in Standards Rule 9-4(d) of USPAP, which requires examination of holding period and interim benefits. Note, however, that many factors may influence the expected holding period. This is true because the expected holding period can seldom be estimated with certainty.  As a result, Paragraph C7.k suggests that appraisers might need to consider a relevant range of expected holding periods.

C7. Expected holding period for an investment in the subject interest, including consideration of
such factors as:

a. The extent to which the expected holding period may be uncertain.

b. Defined expiration or termination dates contained in the governing documents, or
other external factors, that may precipitate a foreseeable liquidation or sale of the
underlying entity.

c. Analysis of the age, health and other characteristics of the other owners and/or key
managers, which could provide information about the possible timing of a sale or
liquidation by the controlling owner(s).

d. The history of transactions (if any) involving partial (or possibly controlling)
interests of the subject enterprise or asset, including recapitalizations or stock
repurchases that have provided liquidity to shareholders.

e. The potential market for similar enterprises or assets (e.g., is the industry
consolidating?).

f. The emerging attractiveness of the entity for equity offering, sale, merger or
acquisition.

g. Provisions in the governing documents or buy-sell agreements, or under law or
regulation either prohibiting, restricting or allowing transfer of the subject interest.

h. Rights and powers attributable to the subject interest that may enable a sale of the
subject entity, asset or the interest itself, against the will of the other owners.

i. Historical actions of management and/or the directorate, which may provide
information about their policy and intentions regarding eventual sale of the entity or
asset, or receptivity to a potential sale or repurchase of partial interests.

j. The existence, depth and functioning of markets that might be available for interests
similar to the subject interest.

k. The appropriateness of considering a range of expected holding periods and exit
possibilities.

As suggested above, the expected holding period for an investment in a partial ownership interest can seldom be known with certainty.  Therefore, it is important for appraisers to examine the factors that might influence the length and uncertainty of the holding period.  There are a number of such factors.  For example, the governing documents of a partnership may provide for a specific termination date.  A controlling shareholder may be older and in poor health, which could trigger a potential sale of the business within a foreseeable period.

Most private companies that have been around for many years have histories of shareholder buy-outs, share repurchases, or other transactions in their shares (or interests).  If there is significant potential for future transactions, the expected holding period might be relatively shorter; and, if not, relatively longer.

It is not necessary to comment on every item in the list above with potential impacts on the expected holding period.  However, it is necessary for business appraisers to consider these factors.  In the final analysis, the length (or range) of expected holding periods may have a significant impact on the value of particular interests.  Think in terms of the time value of money as we look at the next factor to consider in valuing illiquid minority interests, that of expected economic benefits.  Know also that whether an appraiser makes a specific assumption regarding the expected holding period of an investment, there is an implicit assumption (or range of assumptions) implied by his or her conclusion.

C8. Expected economic benefits associated with the subject interest, which come from interim benefits (dividends or distributions) and a terminal cash flow when the investment is sold or liquidated.

a. Expected interim dividends or distributions to the interest, which may differ from
the expected benefits (cash flows) generated by the entity or asset as a whole.
Interest-level benefits may be affected by such factors as:

(1) The history of dividends or distributions, including both timing and amounts.

(2) Current or expected future distribution policy.

(3) Preferential dividend claims.

(4) Enterprise-level and/or interest-level tax characteristics.

(5) The outlook for one-time and/or irregular dividends or distributions.

(6) Circumstances with controlling owners that may increase (or decrease) the likelihood of future interim benefits.

Simply put, the expectation of dividends or distributions from investments in partial ownership interests is important to investors, whether hypothetical in the context of fair market value determinations, or real investors who put real money at risk.  The impact of expected distributions on present value cannot be estimated qualitatively.  The determination of the present value of expected future cash flows is inherently a quantitative exercise.

The final cash flow for minority interests is the expectation of a terminal value at the end of the expected holding period.

b. The expected terminal cash flow at the end of the expected holding period(s), which may be a function of such factors as:

(1) Possible future transactions involving the enterprise or asset as a whole, or
transactions in the subject interest itself.

(2) Current (valuation date) value and expected growth in value of the enterprise or
asset to the end of the expected holding period(s).

(3) Growth in value may be a function of expected earnings retention (distribution
policy) and the amount of and effectiveness of expected reinvestment in the
entity or asset.

If there is no expectation of future dividends, the only future cash flow is the expected terminal value.  Interim cash flows reduce risk, as seen in the hypothetical valuations in Mercer’s Musings #3.  To estimate the terminal value, it is necessary to have the current value of a business at the marketable minority/financial control level of value.  From that base, the analyst must estimate the expected future growth in value of the business over the expected holding period based on its expected business plan.  The terminal value is then estimated at the end of the expected holding period (or over a range of expected holding periods).

Paragraph 8 above, with its sub-paragraphs a. and b., provides guidance on how to examine the history of dividends or distributions, or one-time (special) dividends as a means of developing expectations for future distributions.  Once again, examining the history of owner/management needs for cash from a business can influence the outlook for future cash flows for all owners.  Certainly, preferential dividend claims can also enhance the certainty of future cash flows to illiquid interests.

The next section examines the required holding period return, or the discount rate necessary to reflect the risks associated with achieving the expected cash flows from a minority interest.

C9. Required return for investing in the subject interest. The required return may consider risks
other than risks related to the enterprise or asset as a whole, including, for example:

a. The expected length and uncertainty of the holding period.

b. The likelihood of dividends or distributions (i.e., expected distribution policy).

c. The costs of due diligence efforts required to acquire the subject partial interest.

d. The costs of monitoring the investment over the expected holding period, including
issues related to the expected receipt of timely and reliable information concerning
the investment.

e. Required returns on similar investments or investments with similar investment-specific liquidity and holding period characteristics.

f. The risk of tax liabilities from pass-through profits without guaranteed tax
distributions in entities such as limited liability companies, Subchapter S
corporations or partnerships.

g. The difficulty and cost of marketing the subject interest.

h. The risk of involuntary dilution when no preemptive rights are provided in the
articles of incorporation or bylaws of a corporation.

i. The degree of control conveyed by the subject interest.

The required holding period return is the sum of the base equity discount rate of the subject business plus an aggregate holding period premium that is estimated by appraisers.  This holding period premium is the same holding period premium demanded by investors in restricted stocks.  Keep in mind that with a restricted stock transaction, the only reason for a discount is that investors demand a “holding period premium,” or higher discount rate than for the underlying public security.  This should be clear because the expected cash flows and growth are precisely the same.  Since risk is greater, restricted share prices are lower than the public price, therefore yielding restricted stock discounts.

Appraisers sometimes think that it is not possible to estimate holding period premiums.  However, the same appraisers estimate company-specific risk premiums on a regular basis.  We do so in the context of alternative returns for similar investments.  The same is true for holding period premiums in the valuation of illiquid minority interests of private companies.

C10. Ownership-level tax effects, if relevant.
C11. Prior transactions in the subject interest, entity or asset, and their relevance to a given
assignment.

Appraisers can examine the impact of ownership-level taxes as well as prior transactions in the subject interest.

D. Interaction of the factors listed above, and their cumulative impact on the degree of control,
marketability and liquidity of the subject interest.

Paragraph D is a catchall reminding appraisers that the various factors noted above may interact with each other. 

Conclusion

There is a great deal more to valuing illiquid minority interests than “guessing” at a marketability discount based on vague references to dated and non-comparable restricted stock transactions or studies.

All appraisers would be well-served to read PG – 2 Valuation of Partial Ownership Interests in the ASA Business Valuation Standards.  Doing so should provide a different and more realistic view of the valuation of illiquid minority interests of private companies than is held by many appraisers.

Chris

In Mercer’s Musings #2, we discussed the old and cold data on restricted stock transactions that have been misused by appraisers for decades.  My conclusion is that the various restricted stock studies are inadequate to meet current business valuation standards and that they should not be used as a basis for “guessing” the magnitude of marketability discounts for illiquid interests of closely held businesses.  This conclusion applies to all appraisals, including those prepared for the Internal Revenue Service.

Some readers of this blog will want to disagree and say that the use of restricted stock studies to develop DLOMs is an “accepted” methodology for IRS-related appraisals.  Whether “accepted” or not, the qualitative use of averages of studies is inadequate to develop reasonable conclusions regarding marketability discounts given the wide variety of valuation situations facing business appraisers.  It seems that many business appraisers simply want to keep their heads in the sand and avoid changing at almost any cost.

Basic Valuation Review

The Value of a Business

The value of a business is the present value of all expected cash flows from the business (into perpetuity) discounted to the present at a discount rate reflective of the risks associated with achieving those cash flows.  In other words, value is a function of expected cash flow, growth, and risk.

Every appraisal of every business entails an examination of expected cash flows (using income capitalization methods, discounted cash flow methods, guideline public company methods, or guideline transaction methods).  Appraisals also consider growth (long-term growth rates or finite period growth rates in a DCF method and then a long-term terminal growth rate).  In guideline public company or guideline transaction methods, expected growth may be implied in the selected multiples or considered specifically by business appraisers. And appraisers develop discount rates that reflect the risks associated with achieving expected cash flows (or multiples from markets that have risk embedded in them).

Business appraisers cannot value businesses without explicit (or implicit depending on valuation methodology) consideration of their expected cash flows, the growth of those cash flows, and the risks associated with achieving the cash flows of the businesses being valued.

The Value of an Interest in a Business

The value of an interest in a business is similarly defined by the expected cash flow to the interest, the expected growth in value of the interest over the expected holding period, and the expected terminal value of the interest at the end of the expected holding period.  That terminal value is normally assumed to be the expected value of the business at the marketable minority/financial control level at the end of the expected holding period of the interest.  These expected cash flows to the interest are then discounted to the present (or to the valuation date) at a discount rate reflective of the risks associated with achieving the expected cash flows to the interest.  This definition of the value of an interest in a business parallels the definition of the value of a business noted above.

The discount rate of the business of which a subject minority interest is a portion is the base level of risk for the subject interest of the business.  Hypothetical buyers of interests of businesses recognize that there are additional risks, above the risk of the business, to the prospective buyer of such an interest.  That incremental risk can be described as a holding period premium, which is necessary to appropriately reflect the risks associated with achieving the expected cash flows to the interest.  The sum of the discount rate of the business and the holding period premium can be called the required holding period return appropriate for the interest.

Why would any business appraiser who knows that valuation is a function of expected cash flows, growth, and the risks associated with achieving them not think about the hypothetical in quantitative terms?  However, when business appraisers use averages of restricted stock studies to attempt to “guess” at marketability discounts, they are basing their conclusions on a very weak form of qualitative analysis.

Valuation Premiums and Discounts

Recall from Mercer’s Musings #2, we quoted the ASA Business Valuation Standards regarding premiums and discounts.  The quote is from “BVS VII, Valuation Premiums and Discounts.”:

II. The concepts of discounts and premiums

C. A discount or premium is warranted when characteristics affecting the value of the subject
interest differ sufficiently from those inherent in the base value to which the discount or premium
is applied.

D. A discount or premium quantifies an adjustment to account for differences in characteristics
affecting the value of the subject interest relative to the base value to which it is compared.  (bold in original, italics added)

Paragraph II.C states, paraphrasing, that discounts and premiums quantify adjustments to account for differences in characteristics affecting the value of the subject interest.

Recall the figure in Mercer’s Musings #2 that showed averages, medians, a few standard deviations, and ranges of discounts in various studies of restricted stock discounts.

Nothing in this figure addresses the expected cash flows of minority interests in any businesses, their expected growth, or the risks associated with achieving those cash flows.  Therefore, nothing in this figure can enlighten business appraisers about the appropriate marketability discounts for minority interests in any business.  It really is that simple, in spite of the desire of many appraisers to keep doing things the old way.

Restating the Hypothetical

The hypothetical posed in Mercer’s Musings #2 calls for the valuation of 10% interests in two identical corporations at the marketable minority/financial control level of value.  The hypothetical is repeated below.

As seen in Lines 1 to 6, Company A and Company B are alike in all respects leading to identical valuations of $10 million each at the marketable minority/financial control level of value.  The hypothetical then describes two 10% minority interests that have the same pro rata value of $1 million at that same level (Lines 7 and 8).  The interests differ significantly from that point on.  The interest in Company A has a high dividend yield and slow expected growth (Lines 9 to 13).

The interest in Company B has a much lower dividend yield and much higher expected growth.  Note that the combined dividend yield (3%) and expected growth (9%) total 12%, or less than the discount rate for Company B of 13%.  This suggests that there are sufficient agency costs (like excess owner compensation) that reduce the overall base expected return by 1% for the interest in Company B relative to the interest in Company A (13%).

The hypothetical calls for estimates of marketability discounts for each of the interests for five-year expected holding periods and ten-year expected holding periods.  The beginning point for the required holding period returns is the 13% discount rate for each of Company A and Company B.  The hypothetical provides a required holding period return of 18% for the interest in Company A, representing a 5% holding period premium to the base discount rate.  The given required holding period return for the interest in Company B is 19.5%.  It should be intuitively obvious why the required return for Company B exceeds that of Company A.

The expected cash flow stream for the interest in Company A is more favorable to investors than the cash flow stream for the interest in Company B, so an additional holding period premium to the base discount rate of 13% is needed.  This is clear in the following figure, which provides the expected cash flows for the interests in Company A and Company B based on the assumptions in the hypothetical.  For simplicity, we show only the first five years of the total forecast period of ten years.

We can observe the following about the expected cash flow streams of the interests in Company A and Company B.

• Looking at the far right of the figure, the interest in Company A delivers cash flow more rapidly (32% is expected over the holding period and 68% in the terminal value) than the interest in Company B (only 11% over the expected holding period and 89% in the terminal value.  The hypothetical recognized this fact and called for a higher required holding period return for Company B (19.5%) than Company A (18%).  Interestingly, Company B delivers slightly more total cash flow ($1.734 million) than Company A ($1.706 million), but the timing of expected receipt is delayed, therefore increasing the riskiness of the interest in Company B.  These differences will define a portion of the differences in the values of the interests.
• The interest in Company A is expected to have quarterly distributions, so the mid-year discounting convention is used in estimating its value.
• The interest in Company B is expected to receive dividends at the end of each year, so the end-of-year convention is used.  The differences in discounting conventions will also impact the relative values of the interests in Company A and Company B.

We can pull it all together now with a few more calculations.  The figure will show only five years of projected cash flows, but the conclusions for the ten-year expected holding periods will also be shown for further perspective.

The figure shows all key assumptions of the valuations of the 10% interests in Company A and Company B.  We observe the following regarding Company A’s interest at the top portion of the figure.

• The expected distributions and terminal value are calculated on Lines 1 thru 3, repeating the projections of the figure above.
• Present value factors are calculated based on the assumed required holding period return of 18% and the mid-year discounting convention.
• The present value of all expected cash flows for the 10% interest in Company A for a five-year expected holding period is $925,055, which represents an implied marketability discount of about 7.5% (i.e., 1 – $925,055/$1,000,000).
• The implied marketability discount for the ten-year expected holding period is $839,978, which represents an implied marketability discount of 16.0%.

These discounts, some will say, are very low.  The reason for the relatively modest discounts is that the investment in the interest in Company A represents an attractive investment.  In the context of a fair market value determination, the hypothetical negotiations of hypothetical willing buyers and sellers would recognize the “characteristics of the investment” and reflect them in its pricing.

Now we look at calculations for the 10% interest in Company B at the bottom of the figure.

• The expected cash flows are repeated from above on Lines 11 to 13.
• Present value factors are calculated based on a 19.5% required holding period return and the end-of-year discounting convention, with the present values of expected cash flows calculated on Lines 16 and 17.
• The present value of all expected cash flows for the 10% interest in Company B for the five-year expected holding period is $748,817, which represents an implied marketability discount of 25.4%.
• The present value of all expected cash flows for the ten-year expected holding period is $588,560, which represents an implied marketability discount of 41.4%.

These discounts happen to fall within the broad range of 25% to 45% from the restricted stock studies summarized above.

The discounts for the 10% interest in Company A do not fall within this range.  What should we think about that?  Well, the range of restricted stock discounts in the summary figure above is from a minus 30% (that’s a premium or a negative discount) to a high discount of 91%.  The estimates of marketability discounts for Company A’s interest certainly fall within that broad range.  However, that fact provides no support for any concluded marketability discount.

Concluding Observations

We have just conducted two shareholder-level discounted cash flow analyses to estimate marketability discounts for two dissimilar minority interest investments.  It should be clear at this point that the hypothetical cannot be solved by using the “old and cold” averages of restricted stock studies.

Mercer’s Musings #4 will address the concept of valuation premiums and discounts in the context of the levels of value, which, according to some, is not a settled issue.  We will see.

In the meantime, be well, and, of course, please do comment either on the blog or on the post when it is placed on LinkedIn.

Chris

The timing is right!  Commercial bankers are looking for good loans.  Many business owners are looking for liquidity and perhaps do not want to sell their businesses.  If the Biden Administration gets its way, taxes on dividends and capital gains are not going to be lower for the foreseeable future.  And interest rates are not expected to be lower in the future, as well.

Need appears to be meeting opportunity and it may be time for business owners to take some liquidity from their businesses and for commercial bankers to make some good loans to their customers, or if they present the idea right, to the customers of other bankers.

If yours is a family business, do all your shareholders always agree on the mix between dividends (current returns) and capital gains (future returns)? Whether a family business or not, do all your shareholders have the same goals for their ownership of your company’s shares?  Probably not.

This post, in addition to being timely in terms of execution of leveraged share repurchases or leveraged share redemptions (or buybacks), warrants consideration by most closely held and family businesses over time.  The transactions we discuss are not necessarily one-time events, but can be conducted over time and in sequence to help balance differing shareholder objectives and to provide shareholder liquidity and higher overall returns on their investments.

Corporate Finance for Private Businesses

Leveraged dividend recapitalizations and leveraged share repurchases are two corporate finance tools that are available to owners of closely held and family businesses.  These tools can be used to create liquidity outside the ownership of private businesses or interests in them.  These tools can be defined as:

• Leveraged dividend recapitalization.  A company employs leverage (i.e., borrows money, most often from a commercial bank) to use to pay a one-time dividend pro rata to all owners. The transaction accelerates returns and provides liquidity for all owners and does not change the ownership structure.
• Leveraged share repurchase.  A company employs leverage (i.e., borrows money, most often from a commercial bank) to repurchase a portion of its shares from selected owners. The transaction provides liquidity for one or selected owners and enhanced returns and enhanced relative ownership for the remaining owners as result of reducing the number of shares outstanding.

Interestingly, leveraged dividends and leveraged repurchases have very similar impacts on companies (assuming similar companies and same-sized transactions), but quite different impacts on the owners of the companies. Leveraged transactions are often talked about, but are seldom written about.

Chapters 9 and 10 of my book, “Unlocking Private Company Wealth,” provide a general discussion of leveraged dividend recaps and leveraged share repurchases and a detailed example of a leveraged share repurchase.  In this post, we illustrate the impact of a leveraged share repurchase and a leveraged dividend on the same company.  This analysis enables us to see the impact leverage has on the company and also, the different impacts the transactions have on owners.

Corporate finance principals are not the sole dominion of publicly traded companies and academicians.  The same principals apply to every closely held and family business.

The Situation at Cash Cow, Inc.

Sales and EBITDA for Cash Cow, Inc., or “Cash Cow,” were $50 million and $13 million, respectively for the latest twelve months.  The EBITDA margin of 26% is stellar, but growth has been slow, and reinvestment opportunities at Cash Cow’s cost of capital have not been abundant.  The result is that Cash Cow accumulated about $40 million in excess assets over a period of years.

Last year, after finally responding to years of complaints from family members not working in the business, the board of directors declared and Cash Cow paid, a special distribution of $40 million to its shareholders. Following that distribution, Cash Cow’s balance sheet remains strong, but there is little excess liquidity.  The shareholders were obviously pleased with this distribution, which was a real treat relative to the normal dividend of $1.0 million per year.

Cash Cow’s CEO attended one of my webinars in which I talked about leveraged dividend recaps and leveraged share repurchases and their abilities to accelerate returns to some or all owners and to enhance returns as well.  The CEO is a substantial shareholder and he thought that he wouldn’t mind some additional liquidity from selling some shares or from another dividend.  He asked me to explain how both transactions might work for Cash Cow and the impact of a significant transaction, but not too large, on the company itself and for the shareholders.

The Potential Transactions

We value Cash Cow, with $13 million of EBITDA, at a multiple of about 6.0x EBITDA, which provides an enterprise value of $77 million, and an equity value of $79 million, assuming debt is zero and cash is $2.0 million.

The  book value of equity for the business is $70 million.  There are 1.0 million shares (or units) outstanding.  Given the company’s history, I suggested that a transaction should not exceed about 40% of the equity value, whether in a repurchase or leveraged dividend transaction.  The CEO asked me to provide a comparison at the 40% of equity value level for the board to consider.  Based on an equity value of $79 million (we will see this momentarily), each transaction would be a $31.6 million deal for the shareholders.

There is $2 million of cash on the balance sheet, and it will be committed to the deal(s), so the company will borrow $29.6 million for the potential leveraged dividend and share repurchase transactions.  With debt rising from zero to $29.6 million, bankers will be interested in the impact that this new leverage will have on Cash Cow under either transaction.

The assumed interest rate on the new debt is at 6.0%.  Further, we assume that the blended federal and state tax rate for the business is 26% (on a C-corporation equivalent basis).  That’s the rate for now, at least.  The assumptions are set out in the four tables below, together with relevant calculations of the impact of the leveraged share repurchase and the leveraged dividend recap.

The use of cash and leverage for both the leveraged dividend recap and the leveraged share repurchase are identical.  One key difference in the two transactions is seen on Line 2 above.

With the leveraged share repurchase, the number of shares is reduced by 400 thousand (40%) from the beginning shares of 1.0 million.  With the leveraged dividend recap, there is no change in the number of shares.  These differences will be examined as we proceed.

Cash Cow’s Pro Forma Balance Sheet and the Income Statement

The second table shows a summary of the impact of the two transactions on the balance sheet and the income statement of Cash Cow.  The first thing to note in Lines 1-3 below is that the transactions have no impact on sales or EBITDA.  This makes sense, because (reasonable) leverage should have no impact on sales or gross earnings, or EBITDA and EBIT.

At Lines 3 and 5 below, we see that both transactions create pro forma interest expense of $1.776 million, which lowers pre-tax earnings by an equivalent amount.  Pre-tax income under both transactions is identical at $10.224 million, as seen on Line 6.

After taxes, pro forma net income falls from $8.9 million to $7.6 million (Line 8), and the net margin falls from 17.8% to 15.1%.  The decline in net income in both transactions is the direct result of the interest expense associated with the new leverage.  Cash Cow has been paying a dividend of $1.0 million per year and plans to continue to pay that dividend following the transaction(s).

Looking at key balance sheet items above, we see that pro forma cash is reduced to zero under both scenarios, and that debt is increased by the borrowing amount of $29.6 million. The book value of equity is reduced from $70 million to $38.4 million in both instances, or by the transaction amounts of $31.6 million.

The impact of a leveraged dividend and a leveraged share repurchase are equivalent at the Cash Cow level to this point.  They are also identical in that someone(s) receives $31.6 million, either in the form of a share repurchase or a leveraged dividend payment.

A Banker’s Perspective

We now look at what happens to value and leverage from the viewpoint of the Cash Cow and its bankers, who will provide the leverage for the transactions.  At Line 1 below in the following table, we see that enterprise value remains unchanged at $77 million (neither EBITDA nor the multiple changed).

What Will the Banker Want to See?

Market value of equity has been reduced, however, from $79 million prior to the transaction to $49.4 million on a pro forma basis for both a leveraged dividend recap and a leveraged share repurchase (Line 6 below).

Lines 7 to 12 provide a number of ratios that are often examined by bankers.  The debt/equity ratio is 77.1%, which some might think a bit high.  However, the debt/enterprise value ratio is a much lower 37.4% for both transactions, and most knowledgeable bankers who gain familiarity with Cash Cow would think so, as well.

EBITDA coverage of interest expense is a healthy 7.3x, again for both transactions.  And debt/EBITDA is only 2.3x, which should be acceptable to most bankers.  Asset intensive companies may be able to provide adequate collateralization to keep bankers happy without personal guaranties from selling or receiving owners.  For less asset intensive companies, banks are more likely to cause their owners to sign personal guaranties for loans or portions of them.

As a shorthand to avoid a lengthy projection analysis, I calculated net income minus the expected dividend of $1.0 million, and then calculated the number of years of that figure it would take to pay down the principal on the loan.  That figure, which does not consider growth prospects, is 4.5 years.  That’s not a bad result.  Should there be a cash flow issue in a given year? The Cash Cow could certainly forego paying its dividend.

The interesting thing about the analysis thus far is that, from the viewpoint of Cash Cow, a leveraged dividend and a leveraged share repurchase are essentially identical.

A Sale or a “Sale”?

Potential transactions like the two for Cash Cow provide liquidity for owners and do not require a sale of the business.  They do, however, require a “sale” to the financing bank(s).  A company desiring to engage in such transactions should consider retaining a financial advisor to assist in “selling” the company to the banks.  The great part about this sale is that while the company is “sold” to the bank, it will take a note instead of your stock.  When the note is paid off, the shareholders, except the ones who sold in a repurchase transaction, still have all their stock.  And they can sell it later, or “sell” it again to the bank in the next leveraged transaction.

What About the Shareholders?

Leveraged dividends and leveraged share repurchases do, indeed, look different at the shareholder level.  The differences relate to who gets returns from the company and when.

In a leveraged dividend recap, all owners get current cash from their investment pro rata to their ownership.  In a leveraged share repurchase some owner (or owners) get cash now, in return for selling their shares, and the other remaining owners, must wait for their returns in the future.  Regardless of the transaction, the shareholders must pay applicable taxes.  I suggested to the CEO that we have a conversation with the Cash Cow’s CPA for an informed opinion regarding tax implications.

The next table provides key pro forma results for Cash Cow’s shareholders.

On Line 1 we highlight the fact that in a leveraged share repurchase, the number of shares is reduced.  In this case, that reduction is fairly large at 40%.  In the leveraged dividend case, the number of shares remains the same.  The resulting differences in pro forma results flows from this basic difference.

To highlight the difference at the outset, suppose a Cash Flow owner holds 100 thousand of the original 1.0 million shares, or 10% of the stock prior to the transactions, and he does not sell shares in the transaction.  With a leveraged share repurchase, that owner will still own 100 thousand shares of a total of 600 thousand shares, or 16.7% of the shares outstanding.  Leveraged share repurchases increase the relative ownership of the non-selling owners.

Someone else got the current return, i.e., the owner(s) who sold their shares.  Remaining owners following a leveraged share repurchase must wait for their returns, which will come in the future.

That same 10% owner would  would continue to hold 10% of the shares following a leveraged dividend transaction, because there is no reduction in shares outstanding.  However, he would have obtained a substantial current return from the dividend.

The differences between leveraged share purchases and leveraged dividend recaps from the viewpoint of Cash Flow’s owners are reflected beginning at Line 2:

• Line 2, Earnings Per Share (EPS).  In a leveraged share repurchase, net earnings in dollar terms decline as seen above in the second table, but the number of shares declines disproportionately.  Net income declined 14.8%, but the number of shares declined by 40%.  EPS increased by 42% in the leveraged share repurchase, with EPS rising from a beginning $8.88 per share to $12.61 per share. In a leveraged dividend transaction, because net earnings decline (interest expense from leverage), EPS also decline, from $8.88 per share before to $7.57 per share pro forma.  In the leveraged dividend recap, owners trade the large, current dividend for lower earnings (and dividend and growth potential because of debt service repayment, but offset by equity growth as the debt is repaid).
• Line 3, Value Per Share.  Assuming that the price paid in a leveraged share repurchase is reasonable, value per share should rise.  In this case, value increases from $79.00 per share to $131.67 per share.  In a leveraged dividend situation, value per share remained the same at $79.00 per share.  Equity value is reduced by the extent of the new leverage, but that reduction is received by owners in the recap distribution.
• Line 5, Dividends Per Share.  We have assumed that the Cash Cow will continue to pay its $1.0 million dividend following either transaction.  Remaining shareholders benefit significantly as a result.  With the 40% reduction in shares, their dividend rises from $1.00 per share to $1.67 per share, a significant increase in current returns.  Owners in a leveraged dividend transaction will receive the same $1.00 per share dividend as before, but remember, they each got their share of the large leveraged dividend.
• Line 6, Dividend Yield.  Assuming the historical dollar dividend of $1.0 million is maintained, the dividend yield will rise in both cases.  The yield is the same on a pro forma basis for both transactions, but the yields are calculated off of different share and value bases.
• Line 7, Dividend Payout Ratio.  The dividend payout ratio increases modestly (from 11.3% to 13.2%) for both transactions.  Dollar net income is modestly lower in both cases, and the dividend remains the same.
• Line 8, Book Value Per Share.  Book value in dollar terms has declined in both transactions.  However, in the leveraged share repurchase, book value per share declines relatively less because the number of shares is reduced.  In the leveraged dividend transaction, book value per share declines and there is no offset in reduced number of shares.
• Line 9, Price/Book Value.  The beginning price/book value multiple was 112.9%.  Both the higher price and the somewhat lower book value are reduced by the new debt, so the numerator is reduced proportionately less than the denominator.  As a result, price/book value increases by a significant amount in each transaction.
• Line 10, Return on Equity. One of the best things about either transaction is that return on equity, or ROE, is enhanced.  Again, it is a function of the relationship between the reduction in net income from added interest expense (modest) and the substantial decrease in equity from the new leverage (substantial).  Return on equity increases from 12.7% to a pro forma 19.7% in both transactions.  Either transaction would provide a substantial increase in returns to Cash Cow’s shareholders.

Concluding Thoughts

Leveraged share repurchases and leveraged dividend recapitalizations are tools available to many successful, closely held, and family businesses.  Both transactions “recapitalize” a company by adding debt. The proceeds are then used to purchase shares from one or more existing owners (repurchase) or to pay a substantial dividend to all owners (dividend).

The economic impact of either transaction is virtually identical from the viewpoint of the company adding leverage. However, the economic impact to owners is quite different.

Which transaction is right for your company? Or for your client’s company?  It depends on each situation, and neither may be appropriate or feasible.  However, it is a good idea to discuss the potential use of reasonable leverage to accelerate shareholder returns or to provide ownership transitions when needed.

Let me know if you have questions or comment below.

In the meantime, be well!

Chris

Corporate Finance Resources for Private Business

Mercer Capital provides services to family businesses through our Family Business Advisory Group.  Travis Harms, CPA/ABV, CFA, the head of the group, has written a book that family business directors and the directors of all closely held businesses should read.  It is titled The 12 Questions That Keep Family Business Directors Awake at Night.  The book is available at the prior link for a modest price.  If you will email me or call me (or comment on this blog), I will send a complimentary digital copy of the book to you.

Chris Mercer | 901.685.2120 | mercerc@mercercapital.com

Travis Harms | 901.685.2120 | harmst@mercercapital.com

Other Books of Interest

Dividend policy has been the topic of a number of posts on Mercer Capital’s Family Business Director blog.  Here are a couple of recent examples.

• Dividend Policy in 30 Minutes 
• Five Things to Keep in Mind When Evaluating the Dividend Policy of Your Family Business 

Dividend policy is an important tool for managing the wealth created in closely held and family businesses.

Every Company Has a Dividend Policy

I begin with a not-so-obvious declaration: Every company, whether public or private, has a dividend policy.  In many private companies, the dividend (or distribution) policy may not be articulated or even discussed.  However, rest assured, every company has a dividend policy.

This causes me to ask two questions for business owners and their advisers:

• Is your company’s (or your client’s company’s) policy a good one that is meeting the needs of your shareholders for current income and capital appreciation?
• If you have not articulated your dividend policy, are you working on developing a policy that meets the needs of your shareholders?

“Economic Dividends”

Tax pass-through entities almost always make distributions to owners to pay their pass-through tax liabilities. For C corporations, those taxes are paid directly by the corporations themselves, because, as taxable entities, they are responsible for their corporate taxes.  The dividends we are talking about today are what I call “economic dividends.”  Economic dividends are those received by owners of businesses after federal and state income taxes have been paid, whether by the corporation directly or indirectly, after passing through distributions to owners to pay pass-through taxes.  So let’s see what we mean when we say that every company has a dividend policy.

Net Operating Cash Flow and Economic Dividends

Every company, whether publicly-owned or privately-owned, generates what we will call for today’s post “Net Operating Cash Flow,” or “NOCF.”  If we add back taxes and interest, we will have EBITDA, the subject of several posts on this blog.  There are five uses for a company’s NOCF, as can be seen in the figure below.

The figure above is conceptual in nature and makes no distinction regarding life cycles or maturities of businesses.  From a company’s net operating cash flow, five things can happen that are good for shareholders.

1. Repay principal on debt.  Bankers and other lenders really want their loans made to businesses to be repaid, both in terms of principal and interest, on a timely and/or scheduled basis.  A portion of NOCF may be used to repay principal on debt.
2. Invest in working capital.  Growing companies need working capital to finance inventories and receivables and to be able to pay all expenses on a timely basis.  A portion of NOCF may be invested in working capital to fund a company’s growth.
3. Replace existing capital assets.  All companies make investments, even if minimal for some, in capital assets.  To maintain sales and operations, depreciating plant equipment and computer assets must occasionally be replaced.  So, a portion of NOCF may be used to replace existing capital assets.
4. Invest in new capital assets for growth.  We make a distinction between replacement capital expenditures and growth expenditures to be sure that we always focus on a company’s realistic growth opportunities.  For example, mature businesses with few growth opportunities may focus on replacement capital expenditures and investment in growth capital assets may be minimal.  A portion of NOCF may be invested in new capital assets to take advantage of growth opportunities.
5. Owner dividends/distributions/repurchases.  Any remaining net operating cash flow after the first four uses may be used to make economic distributions to owners.  We include share repurchases in this last use of operating cash flow because they represent, just like economic dividends, current returns to owners.  The difference between dividends and repurchases is that all owners receive their pro rata share of dividends, and only selling owners receive current returns from company repurchases.  Remaining owners benefit from repurchases, but their benefits are generally realized in future periods.

The figure above shows that uses #1 – #4 above contribute to capital appreciation, which is a long-term benefit for owners.  If we add the economic distributions, which are current returns to owners, to capital appreciation for any period, we have the total return to shareholders.

Companies that are experiencing significant growth opportunities may consume all operating cash flow in uses #1 – #4 above.  They will repay debt on schedule, of course, even if they borrow additional funds to finance their growth.  Rapidly growing companies seldom pay economic distributions to owners.  Mature companies with limited growth prospects, on the other hand, likely have no debt and little need to reinvest for future growth.  Mature companies often pay substantial economic dividends.  Companies in between rapid growth and mature stages will likely reinvest subject to the limits of their growth opportunities and pay a portion of earnings in economic distributions.

The figure above does not have a slot for a sixth misuse of NOCF – reinvestment in cash and other low or non-earning assets.  These investments lower the rate of return for all shareholders and should be avoided absent compelling reasons.

Your Company Has a Dividend Policy

Virtually all public companies have stated dividend policies.  They may pay out a certain portion of earnings, say 40%, or target a certain yield on value, say 2%.  Others pay a fixed per share amount for a period, and then periodically adjust the dividend (hopefully up).  Some private companies have similar stated dividend policies.

Often, private companies do not have a stated dividend policy.  When we work with companies, we always ask owners (often the principal managers) about their dividend policies.  I have received replies like this on many occasions: “Dividend policy? We do not have one.  We have never paid a dividend and don’t plan to.” I then suggest that their decision not to pay economic dividends to their shareholders is a policy.

Every company generates net operating cash flow (hopefully positive).  What a business does with that NOCF reflects its dividend policy, or alternatively, its reinvestment policy.  Economic dividends provide a portion of total shareholder returns for each period of operation.  Two questions come to mind:

1. If your company is not paying an economic dividend, does your expected (and historic) capital appreciation warrant the absence of a current return to owners?
2. If your company is paying an economic dividend, are your reinvestment decisions providing a reasonable total return to your owners?

The bottom line is this: Your company (or your client’s company) has a dividend policy.

If you would like to talk about dividend or distribution policy for your company, or any other valuation-related matter, feel free to call me 901-685-2120 or email me mercerc@mercercapital.com to talk in confidence.  Travis Harms is available at the same phone number and his email address is harmst@mercercapital.com.

Until next time, be well!

Chris

This video post asks business owners and advisers two questions: 1) Is your company’s (or your clients’ companies for advisers) dividend policy a good one that is meeting the needs of its owners for current income versus capital appreciation? And 2) If not, do you need to be working on your dividend policy to improve its effectiveness?

Your company or your client’s company has a dividend policy.

I’ll begin this Valuation Video from beautiful Port Orange, Florida and my makeshift board with two questions: One, is it a good dividend policy? In other words, is it meeting the needs of your shareholders for income and capital appreciation? Or, two, do you need to be working on your dividend policy?

In the last written post, I talked about dividend policy. I’ll continue in this video post.

Every company has net operating income after taxes, and there are five things that you can do with it. Number one, you can repay debt, the principal on the debt, and that’s a good thing because lenders like to be repaid. Look here to get free IVA help for clearing your debt. Then two, you can invest in working capital, because growing companies need working capital to finance inventories and accounts receivables and current operations. Three, you can replace your existing capital stock when it depreciates. Four, you can invest in growth capital expenditures. And, if there’s anything left, number five, you can distribute to owners. These five things are the five things that you can do with that operating income. The first four yield the appreciation of the business, and the capital appreciation of the business is a component of the total return to shareholders. The fifth, the dividends are economic distributions, or distributions after taxes, that provide current returns to shareholders, or the dividend yield. And the total return is equal to capital appreciation plus the dividend yield.

There are a variety of kinds of companies, of course, and companies have different life cycles. Let’s consider a company that is mature. There are very little required expenditures needed to repay debt, or to invest in working capital, or to invest in capital expenditures for growth. And, consequently, this company may provide heavy distributions, or, number five. Now consider a company in the growth phase, all of its net operating cash flow, net operating income, might be consumed with repayment of debt, working capital replacement, capital expenditures, and growth capital expenditures. And so there might be no dividend. In the mature company, the total return would be low in terms of capital appreciation and high in terms of dividend yield. With the growth company, the total return should be high in terms of capital appreciation and low or none in terms of the dividend. So companies can have a variety of dividend policies.

Let’s just look at a couple of them and mention them. Number one, a constant dollar policy. Your company may be paying a hundred thousand or a million or three million dollars a year, and you’ve been paying that for a long time, and you plan to continue to do that. Next, a percentage of income. Some companies pay out about 40% of net income, 20% of net income, something like that, so a percentage of that income. Next, a constant yield some companies have valuations every year, and that’s a good thing, and then, they pay their dividend based upon a set percentage of value. Perhaps, one percent or three percent of the current valuation. Some companies occasionally make a special dividend. Some companies have an occasional, or sporadic, dividend, and some companies never pay dividends. Still, other companies don’t pay dividends but accumulate cash, and that diminishes the total return for all the shareholders, which is not a good thing.

So now we have two questions: 1) Is your company’s dividend policy a good one? Is it meeting the needs of the shareholders, their desires for current income versus capital appreciation? Is it? Well, if it’s not, 2) Do you need to work on it to improve your dividend policy?

If you need to work on your dividend policy, feel free to call me or feel free to call any of our professionals in our Family Business Services Group at Mercer Capital. We will work with you to develop a better dividend policy for your company.

Until the next Valuation Video, this is Chris Mercer. Good day.

Every company, whether public or private, has a dividend policy.  In many private companies, the dividend (or distribution) policy may not be articulated or even discussed.  However, rest assured, every company has a dividend policy.  Tax pass-through entities almost always make distributions to owners to pay their pass-through tax liabilities. For C corporations, those taxes are paid directly by the corporations themselves, because, as taxable entities, they are responsible for their corporate taxes.  The dividends we are talking about today are what I call “economic dividends.”  Economic dividends are those received by owners of businesses after federal and state income taxes have been paid, whether by the corporation directly or indirectly, after passing through distributions to owners to pay pass-through taxes.  So let’s see what we mean when we say that every company has a dividend policy.

Net Operating Cash Flow and Economic Dividends

Every company, whether publicly-owned or privately-owned, generates what we will call for today’s post “Net Operating Cash Flow,” or “NOCF.”  If we add back taxes and interest, we would have EBITDA, the subject of several recent posts.  There are five uses for a company’s NOCF, as can be seen in the following figure.

The figure is conceptual in nature and makes no distinction about the life cycles or maturities of businesses.  From a company’s net operating cash flow, five things can happen that are good for shareholders.

1. Repay principal on debt.  Bankers and other lenders really want their loans to businesses to be repaid, both in terms of principal and interest, on a timely and/or scheduled basis.  A portion of NOCF may be used to repay principal on debt.
2. Invest in working capital.  Growing companies need working capital to finance inventories and receivables and to be able to pay all expenses on a timely basis.  A portion of NOCF may be invested in working capital to fund a company’s growth.
3. Replace existing capital assets.  All companies make investments, even if minimal for some, in capital assets.  To maintain sales and operations, depreciating plant equipment and computer assets must occasionally be replaced.  So a portion of NOCF may be used to replace existing capital assets.
4. Invest in new capital assets for growth.  We make a distinction between replacement capital expenditures and growth expenditures to be sure that we always focus on a company’s realistic growth opportunities.  For example, mature businesses with little growth opportunities may focus on replacement capital expenditures and investment in growth capital assets may be minimal.  A portion of NOCF may be invested in new capital assets to take advantage of growth opportunities.
5. Owner dividends/distributions/repurchases.  Any remaining net operating cash flow after the first four uses may be used to make economic distributions to owners.  We include share repurchases in this last use of operating cash flow because they represent, just like economic dividends, current returns to owners.  The difference between dividends and repurchases is that all owners receive their pro rata share of dividends, and only selling owners receive current returns from company repurchases.  Remaining owners benefit from repurchases, but their benefits are generally realized in future periods.

The figure shows that uses 1 – 4 above contribute to capital appreciation, which is a long-term benefit for owners.  If we add the economic distributions, which are current returns to owners, to capital appreciation for any period, we have the total return to shareholders.

Companies that are experiencing significant growth opportunities may consume all operating cash flow in uses 1 – 4 above.  They will repay debt on schedule, of course, even if they borrow additional funds to finance their growth.  Rapidly growing companies seldom pay economic distributions to owners.  Mature companies with limited growth prospects, on the other hand, likely have no debt and little need to reinvest for future growth.  Mature companies often pay substantial economic dividends.  Companies in between rapid growth and mature stages will likely reinvest subject to the limits of their growth opportunities, and pay a portion of earnings in economic distributions.

Your Company Has a Dividend Policy

Virtually all public companies have stated dividend policies.  They may pay out a certain portion of earnings, say 40%, or target a certain yield on value, say 2%.  Others pay a fixed per share amount for a period of time, and then periodically adjust the dividend (hopefully up!).  Some private companies have similar stated dividend policies.

Some private companies do not have a stated dividend policy.  When we work with companies, we always ask owners (often the principal managers) about their dividend policies.  I have received replies similar to this on many occasions: “Dividend policy? We don’t have one.  We have never paid a dividend and don’t plan to.” I then explain that their decision not to pay economic dividends to their shareholders is, in itself a policy.

Every company generates net operating cash flow (hopefully positive!).  What a business does with that NOCF reflects its dividend policy, or, alternatively, its reinvestment policy.  Economic dividends provide a portion of total shareholder returns for each period of operation.  Two questions come to mind:

1. If your company is not paying an economic dividend, does your expected (and historic) capital appreciation warrant the absence of a current return to owners?
2. If your company is paying an economic dividend, are your reinvestment decisions providing a reasonable total return to your owners?

The bottom line is this: Your company (or your client’s company) has a dividend policy.

If you would like to talk about dividend or distribution policy for your company, or any other valuation-related matter, feel free to call me (901-685-2120) or email me (mercerc@mercercapital.com) to talk in confidence.

Until next time, be well!

Chris

Over many months, my most viewed historical posts are those that address the question of dividends, or distributions, for private companies.  I find this interesting, because dividend policy is not a topic that is raised very often in my discussions with private company managers and owners.

Almost no one wants to talk about dividends or dividend policy, but lots of folks seem to have it on their minds.  At the outset, let’s be clear what we mean when we talk about dividends or distributions.

• For C corporations.  These entities pay taxes directly to the IRS, so we mean dividends paid to owners after all appropriate taxes have been paid to the IRS and other taxing authorities.
• For S corporations and other tax pass-through entities.  We assume that profitable pass-through entities will provide tax distributions to owners necessary to pay their pass-through tax liabilities.  The distributions we refer to for pass-through entities is what we call “economic distributions,” or distributions in excess of those required for the owners to pay their taxes.

We make these points to avoid any confusion over questions of dividend policy.

Dividend Policy Is One of Three Corporate Finance Questions for Businesses

Business owners are faced with three universal questions as they run their businesses.  These questions are addressed by every business every year, one way or the other, directly or indirectly, consciously or unconsciously:

1. What is the best capital structure for my company? Every company is financed with a combination of equity and debt.  The question for any company right now is this: “Are we using the right combination of equity and debt to maximize returns to our owners?”  This is an important question and deserves your attention.
2. Of all available reinvestments, which ones warrant selection this year?  Every year, every business has an array of investment opportunities, ranging from replacement of existing capital assets to investment in new capital projects to investments in acquisitions to, well, simply holding onto cash.  The selection process is aided by knowing the cost of capital, or the required return of the owners of a business.  Alternative investments can be arrayed in order of their prospective returns.  Those that exceed a company’s cost of capital warrant consideration.  Those that don’t meet the cost of capital, if implemented, subtract from the returns available to all owners.
3. What are the preferences of the owners of a business for the form of their returns?   Shareholder returns come in two forms, capital appreciation, or the growth in value of a business over time, and current returns, as measured by dividends or distributions.  Shareholders often have preferences.  Unfortunately, the preferences of all shareholders of a business may not always coincide.  Nevertheless, this third question regarding dividend policy is the one that generates so much interest and so little conversation.

These three questions are at the heart of what is called corporate finance.  That may seem like a fancy term to many business owners, but they are engaged in that process in their businesses every year.

I’ll write more about these questions — and dividend policy — in future posts.  For now, let me refer you to an excellent series written by my colleague, Travis Harms.  The white paper series is titled Corporate Finance in 30 Minutes: A Guide for Directors and Shareholders.

Take the time to download the paper.  Travis has written three more papers, with each of them addressing one of the three corporate finance questions.  I’ll point you to them in future posts.

In the meantime, be well!

Chris

Reminder

Valuation is important for business owners for many reasons.  One of these reasons is for the operation of buy-sell agreements.  If you are thinking about your buy-sell agreement (and you should be), then take a look at Buy-Sell Agreements for Baby Boomer Business Owners, my Kindle book on the topic.

I’ve priced it at $2.99 so you won’t have to think about the expense.  So click on the image of the book.  You will be taken to Amazon.  Then buy the book.  Don’t be mislead by the price.  It is a full length book.  If you like it, as most readers have, please take a few minutes and review the book on Amazon!

Additionally, my two most recent books are available in an Ownership Transition Bundle.  The bundle, priced at $35 plus s/h, has been attractive for many business owners, appraisers, and attorneys.

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Mercer Capital added a new page to our website reflecting a suite of services we have been providing to private company clients for a number of years.  The page, titled “Corporate Finance Consulting,” is a place where we talk to business owners, company directors, and their advisers about corporate finance for private companies.  We are excited to make our experience in corporate finance consulting more visible and more available to our clients and referral sources.

Corporate Finance in 30 Minutes

Mercer Capital’s Travis Harms wrote a series of four whitepapers under the umbrella of Corporate Finance in 30 Minutes.  The first paper is an introduction to corporate finance for private businesses and introduces the three key questions of corporate finance that owners of private businesses face. The subsequent whitepapers address each of these questions.  If you don’t read anything else in the series, do read this first whitepaper.  Per the first whitepaper, the basic corporate finance questions are:

1. What is the most efficient mix of capital?  In other words, is there such a thing as too little or too much debt?  This question addresses the issue of capital structure for private businesses.  Every business has a capital structure.  The corollary question is whether it is reasonable or optimal for each business. The whitepaper addressing this question is Capital Structure in 30 Minutes.
2. What capital projects merit investment?  In other words, given the expectations of those providing capital to the business, how should potential capital projects be evaluated and selected?  Every business has a cost of capital, or discount rate that is a function of the first question, or the mix of debt and equity on a balance sheet.  The question is, do the capital investment decisions of a business achieve or exceed its cost of capital?  If they don’t, then the selected investments detract from value.  The whitepaper addressing this topic is Capital Budgeting in 30 Minutes.
3. What mix of returns do shareholders desire?  In other words, do shareholders prefer current income or capital appreciation?  Do these shareholder preferences “fit” the company’s strategic position?  Can these shareholder preferences be accommodated within the existing capital structure?  Shareholder returns come in the form of interim returns, or dividends (from C corporations) and economic distributions (above the level of pass-through taxes) for pass-through entities.  This question is addressed by a company’s dividend or distribution policy.  I’ve written a good deal about dividend policy and some about capital structure on this blog.  The whitepaper addressing this question is Distribution Policy in 30 Minutes.

In this series of white papers, Travis Harms makes something that can sound arcane and difficult, like corporate finance, accessible for business owners and advisers.

One More Question Regarding Private Company Value

I would suggest that there is a fourth corporate finance question for owners of private businesses.  This fourth question relates to valuation.  The major corporate finance texts are written primarily from the viewpoint of publicly traded companies.  All public companies must address Travis’ three questions.  However, they do so in the context of historical, current, and evolving knowledge of the value of their businesses through the pricing of their publicly traded shares. Check out this noble gold investments review if you need expert advice on investing in precious metals.

Private companies do not have actively traded shares in a public forum.  In order to assess value on a regular and meaningful basis, it is necessary to obtain periodic valuations.  For example, one simply cannot calculate historical returns, or analyze returns in terms of interim returns and capital gains without such information.  So my suggested fourth question for private company corporate finance is:

4. What is the value of a private business, both historically and currently and how can we capture emerging value as we progress into the future?

The answer, of course, lies in a regular appraisal process.  I jokingly say that when speaking 20 or more years ago, I suggested annual appraisals for private companies because it would be good for Mercer Capital’s business.  Now, I unabashedly make the recommendation of regular appraisal because I know it is good for our clients’ businesses and their owners and directors.

The Takeaway

If you are an owner or a director of a closely held or family business, the takeaway from this short post is that I recommend that you go to Mercer Capital’s website and take a look at the series, Corporate Finance in 30 Minutes, by Travis Harms.  If the thought of reading four whitepapers is daunting, I challenge you to read the first one.

If you have questions about our Corporate Finance Consulting Services or Corporate Finance in 30 Minutes, please feel free to call Travis Harms or me.

Be well,

Chris

Reminder

Valuation is important for business owners for many reasons.  One of these reasons is for the operation of buy-sell agreements.  If you are thinking about your buy-sell agreement (and you should be), then take a look at Buy-Sell Agreements for Baby Boomer Business Owners, my Kindle book on the topic.

I’ve priced it at $2.99 so you won’t have to think about the expense.  So click on the image of the book.  You will be taken to Amazon.  Then buy the book.  Don’t be mislead by the price.  It is a full length book.  If you like it, as most readers have, please take a few minutes and review the book on Amazon!

Corporate finance is about maximizing the value of a firm or business.  Alternatively, it is about maximizing the returns to the owners of that business subject to acceptable risk levels.  Returns come in two forms: capital appreciation, or the growth in value of a business over time, and dividends (for C corporations) or economic distributions (in excess of pass-through tax liabilities) for pass-through tax entities like S corporations and limited liability companies.

All a firm’s activities can, in some sense, be considered part of corporate finance.  These activities, including sales, marketing, production, manufacturing, service, distribution, accounting, human relations, strategy and more, lead to the earnings (say EBITDA, net income, or net cash flow), which are then allocated according to a three-part corporate finance decision tree. Managing your finances and a regular flow of working capital mississauga is crucial.

At the outset, let me say that my colleague, Travis Harms, has written a wonderful series called Corporate Finance in 30 Minutes.  He has a paper on each of the corporate finance decisions and I highly recommend the series to readers.

The three parts of the corporate finance decision tree for public and private businesses are:

1. The investment (or reinvestment) decision.  The  investment decision is referred to as the capital budgeting decision in usual corporate finance terms.  I prefer the terms investment (or reinvestment) to focus on the fact that business owners and boards must make decisions regarding the reinvestment of the cash flows generated by their businesses.
2. The financing decision.  This decision is referred to as the capital structure decision in usual corporate finance terms.  Decisions are made regarding the level of debt and equity that businesses will use to finance themselves.  These decisions determine the cost of capital, or the hurdle rate, for a business.
3. The dividend (or distribution) decision.  To the extent that there is residual cash flow, or, that there are not sufficient capital projects to invest in at or exceeding a company’s hurdle rate, then the decision may be made to return cash flow to its owners in the form of dividends.

By addressing each of these three decisions with the help of TaxBite Accountants, corporate managers and boards determine what will be done with all available cash flows of a business, whether from the operation of the business itself or from financing sources such as debt or the sale of stock.  The effectiveness with which they make these decisions determines, in large measure, the success of value creation for private firms.

Decision #1: The Reinvestment Decision

The capital of a business each period must be allocated productively to maximize value.  Available investment dollars, whether from the reinvestment of earnings or the acquisition of debt (or sale of stock), must be allocated.

The reinvestment decision is also called the capital budgeting decision because companies must allocate their capital.  I call it the reinvestment decision because for most companies in most periods, the majority of investable assets are generated from the business’s operations and are available for reinvestment.

In the figure below, we show components of the reinvestment decision in the context of a company’s conceptual cash flow statement, beginning with its net (after tax) income.  In the case of tax pass-through entities, this is income after the payment of all corporate taxes and the distribution of pass-through tax liabilities to owners.

To the net income of a business (Line #1), we add depreciation and amortization, the non-cash charge (Line #2), and account for the net investment in working capital (Line #3).

The basic decision guide for capital allocation is called the “hurdle rate” or the required return.  Projects that have expected returns in excess of the hurdle rate are considered to create value.  Projects that have expected returns less than the hurdle rate are unfavorable and, if implemented, will diminish value and returns.  The hurdle rate is each company’s weighted average cost of capital or WACC.

I like to think of two kinds operating investments.  The first is replacement of existing capital assets which have reached or exceeded their useful lives (Line #4).  The second is new projects (Line #5).  Sometimes it is difficult to distinguish between these two kinds of investments.  Nevertheless, both should be subjected to analysis to determine if they meet the hurdle rate test.  We are, of course, assuming that the new projects meet the basic test of common sense and fit into the strategy of a business.  For purposes of this discussion, we have included any sale of operating assets in the reinvestment decision.

We lump a third type of investment in the “operating” category, that of investments in low-yielding cash or marketable securities and other assets unrelated to the nature of the business (i.e., nonoperating assets) (Lines #8 and #9).  We do this because many private companies do, indeed, invest in excess nonoperating assets.  They will not meet the hurdle rate test, nor will they meet the test of common sense, or fit the business model.

Nonoperating assets suck up cash flow and, because of their normally low yields, dampen returns.  Often, the reason for accumulating cash is “for a rainy day” or for the unexpected acquisition.  In my experience, such assets tend to burn holes in the pockets of managers who sit and look at the assets on their balance sheets.  So there is an additional risk that the nonoperating assets will be spent on investments that do not meet a company’s hurdle rate.

The sum of Lines #7 and #10 combined provide the net investment in all assets (operating and nonnoperating) at Line #11.  At the end of the year, a company will have invested less than, equal to, or more than its available net operating cash flow for the period.  At this point, analytically at least, we move to Decision #2, the financing decision.

Decision #2: The Financing Decision

The financing decision is important because all investments must be financed.  Financing decisions determine the capital structure of a business, or the relative use of debt and equity in the capital structure. If you are looking for financial tips, you can also read this new blog post about how to do your bookkeeping.

If the cash flow does not come from operations (Line #11), it must come from borrowings or the sale of stock.  The financing decision is summarized in the following figure.

We bring Line #11 over as the beginning point for the financing decision.  A company will want to borrow funds, which are lower cost than equity, until the point where its cost of capital is minimized.  For a more detailed discussion, see Travis Harms’ Capital Structure in 30 Minutes.  Corporate value is maximized when the cost of capital is optimized.

In any event, corporate management determines the extent of leverage that will be utilized for a company.  That leverage decision, together with the investments made in the investment decision, determine the extent of necessary debt acquisition (Line #12) or debt retirement (Line #13) in a given period.  It may also be necessary or appropriate for the company to sell additional stock (Line #14).  The net of both decisions, reinvestment and financing, determines the cash flow available to equity owners (Line #16).

In corporate finance terms, the capital structure decision relates to the relative use of debt and equity at their respective market values, and not their book values.  For debt, in most instances, the stated book values can be assumed to be at or near market values.

Equity is a different story.  Many businesses generate market values substantially in excess of their book values.  Therefore, to make appropriate capital structure (i.e., financing) decisions, corporate owners and boards must have current information about the market values of the equity in their businesses.  This information will not be available in the absence of a regular appraisal process for a business.

Decision #3: The Dividend (or Distribution) Decision

In the conceptual analysis thus far, we have looked at the reinvestment and financing decisions.  These two decisions are interrelated.  Reinvestment decisions (capital budgeting) are made based on the hurdle rate, for example, which is established through the financing decision (capital structure).

The net results of the reinvestment and financing decisions determine the amount of cash flow available for allocation to owners through the third corporate finance decision, i.e., the dividend decision.  We see the dividend decision in the following figure.

Conceptually, the dividend decision is straightforward.  We begin with Line #16 from the financing decision, or cash flow available to equity owners.  Returns to owners come in two forms.  The first is dividends to shareholders (or economic distributions to pass-through entity owners) as seen on Line #17.

Dividends are current returns to owners in the form of cash.  These current returns are then available to owners for reinvestment or for consumption.  They form an important aspect of shareholder returns.

In the alternative, companies can allocate cash flow available to equity owners through selective share repurchases.  Share repurchases provide liquidity to specified owners and enhanced returns through capital appreciation for the remaining owners.  For example, share repurchases reduce the number of shares outstanding and increase future earnings per share and dividends per share (assuming similar earnings) for remaining owners.

Note that in the reinvestment decision discussion above, we talked about reinvestment in nonoperating assets as part of operating cash flow.  This is intentional, because some private companies make the decision to invest in cash and low-yielding nonoperating assets.  They may do so at the expense of additional investments or dividends to shareholders.

The accumulation of nonoperating assets has the effect of lowering current returns (because dividends are not paid) and dampening shareholder returns (because they do not yield a company’s hurdle rate for successful investments).  My advice has long been to get those low-yielding assets off the balance sheet.

We can make one more important point about the dividend decision.  Every company has a dividend policy.  I wrote about this in an earlier post.  The questions are, what is that policy and how effective is it in terms of maximizing owner returns?

#4: Valuation Results and Shareholder Returns

Whether private business owners and boards think consciously about the three corporate finance decisions above, every company makes capital budgeting decisions (reinvestment), capital structure decisions (financing), and dividend decisions.  The end result of these decisions lies in the change in value of a business over time and the current returns paid to its owners over time.

We said earlier that shareholder returns are comprised of current returns (dividends) and capital appreciation, or the growth in value of a business from period to period.  Symbolically, we see shareholder returns in the following equation:

For public companies, the change in value calculation is easy.  A public company’s stock has a price at the beginning of a year (V₀) and at the end of that year (V₁).  The change in value over a year is simply (V₁ – V₀).  Add the current owners’ returns to that and divide by the beginning value (V₀) to calculate shareholder returns for the year.

It is not so easy for a private company.  There is no public pricing of its shares.  However, conceptually, returns are shown in the following figure:

We add the current return to owners (Line #19) and capital appreciation (Line #20) to obtain the total return to equity owners (Line #21).  That sounds easy; however, unless there is a beginning appraisal for the private company (V₀) and an ending appraisal (V₁), there is no means of calculating the actual shareholder returns as in the equation above.

For private companies that obtain annual appraisals, the return calculation is possible.  We make these calculations for all of our recurring (annual) clients, so that their owners and boards can stay focused on shareholder returns and can compare their company’s performance with appropriate benchmark returns.

Concluding Observations

This introduction to private company corporate finance begins with three important decisions: (1) the reinvestment or capital budgeting decision, (2) the financing or capital structure decision, (3) and the dividend decision.  In this post, we have followed these decision in the context of the cash flow statement of a private company.

These three decisions account for all of the cash flows of a business for any period.  If investment opportunities are abundant, all operating cash flow will be invested in these projects and additional financing may be employed to make further investments.  If investment opportunities are abundant, there may be no residual for current dividends to owners.  However, owners should be satisfied if the investments bear fruit and create value and growth for the business.  Capital gains opportunities through value growth offset the benefit of current dividends.

If investment opportunities are not abundant, and there is residual cash flow after those commitments that meet the company’s hurdle rate, then the owners and board may decide to make distributions to the owners during such periods.  It should be clear from the discussion above that investment in excess cash, other than for a specific short-term objective, is not an optimal investment for most private companies.

Be well,

Chris

Reminder

Valuation is important for business owners for many reasons.  One of these reasons is for the operation of buy-sell agreements.  If you are thinking about your buy-sell agreement (and you should be), then take a look at Buy-Sell Agreements for Baby Boomer Business Owners, my Kindle book on the topic.

I’ve priced it at $2.99 so you won’t have to think about the expense.  So click on the image of the book.  You will be taken to Amazon.  Then buy the book.  Don’t be mislead by the price.  It is a full length book.  If you like it, as most readers have, please take a few minutes and review the book on Amazon!

On Monday, July 25, 2016,  Verizon announced the acquisition of the operations of Yahoo for $4.8 billion.  I waited on this post because it really isn’t about Yahoo, but about lessons for closely held business owners and their advisers.  In any event, that $4.8 billion value for Yahoo’s operation was a far cry from previous indications of value for Yahoo.

Peak Market Capitalization of $125 Billion

Yahoo was started in 1994 by Jerry Yang and David Filo.  By January 2000, Yahoo had a equity market capitalization of about $125 billion, which turned out to be its peak.  It has been said that Yahoo is a company that never really defined itself.  Think of Google/Alphabet and think of search.  Think of EBay and think of auction.  Think of Yahoo and I don’t know what to think. Others don’t either.  A string of six CEOs was unsuccessful in defining the company’s strategy.

In 2008, Steve Balmer wanted to acquire Yahoo and bid $45 billion, which represented a 62% premium to its then market price.  At that time, Yahoo’s 15% investments in Alibaba and its investment in Yahoo Japan were known, but their values were not transparent.  The bid reflected significant value for Yahoo’s core operations.

Contrast this with the $37 billion market capitalization of Yahoo following the Verizon announcement on January 25th (and before, give or take a bit).  The price two weeks later still reflects a market capitalization of $37 billion.

Since the Microsoft offer in 2008, Alibaba has gone public and has a market capitalization on the order of $200 billion.  Yahoo’s 15% stake in Alibaba is worth about $30 billion at the current market price.  In addition, Yahoo owns a stake in Yahoo Japan that is worth $8-9 billion.  Yahoo also has some $5.1 billion of cash (net of debt) on its balance sheet.  The implication is that the markets place no value on the operations of Yahoo for which Verizon is paying $4.8 billion – or for that matter, the $5.1 billion of cash.  So if the deal closes, Yahoo will have its stakes in Alibaba and Yahoo Japan and about $10 billion in cash.

What About Yahoo Shareholders?

If you were a continuing shareholder in Yahoo, would you like to have had Steve Balmer’s $45 billion offer in 2008, have taken your cash, paid your taxes, and reinvested elsewhere?  Or would you rather have your shares in Yahoo today valued at $37 billion (after billions of share repurchases since 2008).  You could at least be comforted by the fact that Yahoo repurchased nearly $7 billion in shares since 2008, so you would have a bit larger piece of the remaining Yahoo pie.

And after all, you would be invested in what amounts to an investment holding company with minority stakes in two more successful companies and about $10 billion in cash that will be run by the current management and board of directors.  Sound exciting?

The other choice, since Yahoo is a public company, was to have sold shares near the time of the offering to get what you could get, reinvest in something else, and try to forget.

So What’s the Point?

Private companies do not have public markets.  Shareholders in closely held and family businesses are dependent on their managements and boards to work for their benefit.  Returns come in two forms, dividend yield (say the C-corporation equivalent yield based on beginning value), and share price appreciation.  We can add in the effect of share repurchases, but these tend to be infrequent in private companies.

Travis Harms, my colleague at Mercer Capital, just wrote a wonderful white paper titled Corporate Finance in 30 Minutes.  After a brief review of the corporate finance fundamentals of risk and return, the paper addresses three critical questions for business owners and boards.

1. What’s the most efficient mix of capital?  How much equity and how much debt is appropriate?  In other words, what is the appropriate capital structure for a business?
2. What capital projects merit reinvestment? I tend to call this the investment question or, sometimes, the reinvestment question.
3. What mix of return do shareholders desire?  Shareholders have expectations regarding dividends or distributions as well as expectations for capital appreciation.  In light of shareholder preferences, what is a reasonable mix of dividends (for current returns) and reinvestment (for capital appreciation)?

By the way, I highly recommend that you download Travis’ white paper and read it.  Feel free to share it with your colleagues.

Now, back to the point.  Shareholders in private companies are, for the most part, “stuck” with their investments in the absence of active markets for their shares.  Unlike the shareholders of Yahoo, who had the ability to “walk away” and sell their shares, this is not feasible, at least in the short run.  The question is: Is this a good thing or a bad thing?  The answer, as with so many questions in life is: It depends.

It depends on how management and the board addresses the three questions in Travis’ paper.  It depends on the type of returns (and the form) being generated.

If you are an attorney or other adviser to business owners, let me suggest that you download Corporate Finance in 30 Minutes.  The paper is easy to read and you don’t need to have a finance degree to understand.

If you are a business owner or a director of a private business, download Corporate Finance in 30 Minutes.  After each section, Travis poses questions for board discussion.  These questions will help focus your attention on private company corporate finance.  If you address the questions in the paper, you will almost certainly improve relations with other owners.

So what’s the point?  Don’t be like Yahoo and forget the basics of business and corporate finance and shareholder relations. Begin with this helpful tool from Travis Harms, Corporate Finance in 30 Minutes.

Share this paper with your friends and colleagues.  It is that good!

Be well,

Chris

Reminder

My two most recent books are available in an Ownership Transition Bundle.  The bundle, priced at $35 plus s/h, has been attractive for many business owners, appraisers and attorneys.