I arrived in Las Vegas early Sunday evening on November 13th for the 2022 AICPA & CIMA Forensic and Valuation Services Conference. Four Mercer Capitalists are here in person, and three of us are presenting.
- Karolina Calhoun presented yesterday in two sessions on personal goodwill and on a litigation-oriented panel.
- Atticus Frank will present tomorrow and talk about why market multiples differ between and among industries.
- Yours truly will present on a panel addressing some hot valuation issues. These sessions are always lots of fun.
- David Harkins is attending a three-day, intensive expert witness training session.
- Samantha Albert is also attending, but remotely.
The conference is going well. I was told that attendance is on the order of 800, so it is a very successful, post-pandemic conference. I’m glad to be here, even though the time zone change has hit me pretty hard this trip.
A Thought on Normalizing Adjustments
I have heard many appraisers suggest that one should not normalize owner compensation when valuing minority interests “because the minority shareholder cannot change compensation.” I’d like to address this issue in this post.
Travis Harms and I cover the topic of normalizing adjustments in our book, Business Valuation: An Integrated Theory Third Edition, on pages 117-123.
It is essential to normalize the earnings of operating companies when providing appraisals either at the financial control/marketable minority level or the nonmarketable minority level. Otherwise, the appraiser is not valuing the appropriate asset.
- Assume a company has reported an EBITDA of $2.0 million, no cash, and no debt. Assume further that the appropriate EBITDA multiple is 6x and that the underlying equity discount rate is 14%. Then, based on reported EBITDA, the company is worth $12.0 million (6 x $2.0 million).
- Assume further that excess owner compensation and benefits total $1.0 million. Normalized EBITDA is, therefore, $3.0 million, and the company would be worth $18.0 million.
- At the financial control/marketable minority level, few would argue that appraisers should not normalize for excessive owner compensation or other benefits. The company is being valued at the financial control level, and its cash flows appropriately reflect normalized owner benefits. In this example, the company is worth $18.0 million based on normalized EBITDA.
- Assume, however, the assignment is to appraise this sample company at the nonmarketable minority level. Assume further that the owner plans to sell the business in about five years, and that value has been growing at about 10% per year. There are no expected distributions.
- The only cash flow that the minority shareholder can expect is the terminal cash flow in about five years.
The question is, what is the appropriate marketability discount? That discount cannot be determined based on the non-normalized value of $12.0 million. It does not reflect an appropriate base value from which to estimate a marketability discount, which would be the financial control/marketable minority level of value. It represents something less with no definition.
- At the nonmarketable minority level, where hypothetical or real buyers lack control, it is still essential to normalize cash flows. This is the only way that hypothetical buyers can understand the value of the entire asset, a small interest of which they are buying.
- Assume that an appropriate holding period premium (to the equity discount rate of 14%) is about 6%. The required holding period return for investors is, therefore, 20%.
- The expected terminal value for the illiquid investment based on the financial control value of $18.0 million is about $29.0 million. The present value based on these assumptions is $11.65 million ($29.0 divided by (1 + 20%) raised to the 5th power).
- The expected terminal value based on a $12.0 million value with non-normalized earnings is $19.3 million. Using the same calculation to calculate the present value, the present value would be $7.8 million.
Now we can see why it is essential to normalize when valuing minority interests. Let’s look at the implied marketability discounts.
- At the financial control level, the implied marketability discount is about 36%, or ((1 – 11.54/18) – 1).
- Based on the non-normalized value, the implied marketability discount is about 35%, or ((1 – 7.8/12.0) – 1)).
- Importantly, the implied marketability discount from the actual financial control value of $18.0 million using non-normalized EBITDA is not 35%, but 57%, or ((1 – 7.8/18) – 1)).
No informed seller would sell at the lower value implied by using non-normalized EBITDA in the appraisal. And by the way, rest assured that the owner would sell the company based on normalized earnings!
Another Way to Look at It
Assume that we have an LLC holding an income-producing property. You are asked to appraise a 10% minority interest. You are told the following about the investment:
- The interest pays a distribution of $100,000 per year.
- The plan is to sell the underlying real property in exactly five years from the valuation date.
- The expected rate of return for the underlying real property is about 8%.
- The expected rate of growth of the underlying real property is about 3%.
What is missing? Well, the value of the underlying real property is missing. Nevertheless, you are asked to appraise a 10% interest. The first thing you want to know is the underlying present value of the property.
In fact, you would likely not agree to conduct the appraisal unless you were provided with reliable information supporting the underlying value of the real property. Your answer would be markedly different if the underlying property value was $50 million rather than $10 million.
The same is true for the example company above. No appraiser can reasonably determine the value of an illiquid minority interest in the absence of information about the value of 100% of the underlying company.
There are two conclusions to this post.
First, the AICPA Conference is a good one. It is good to see so many appraisers from around the country.
Second, I hope that the myth that appraisers should not normalize earnings when valuing minority interests “because the minority shareholder lacks the power to change compensation” will die rapidly.
Wishing good things to all,