Business Valuations in the Planned Giving Context

Business Valuations in the Planned Giving Context 38 th Annual Minnesota Planned Giving Conference November 4, 2014 Presented by: Richard C. Berning, CPA/ABV/CFF, CBA, CVA, ABAR, CMA

Why are Businesses Appraised? Buying or selling a business Sale or purchase of a business Mergers & acquisitions Initial public offerings (IPO) Allocation of acquisition price Buy/sell agreements Franchise valuations Split-ups or spin-offs Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 3

Why are Businesses Appraised? Other ESOPs Estate and gift taxes Family limited partnerships S corporation elections Charitable contributions Eminent domain Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 4

Why are Businesses Appraised? Other Adequacy of life insurance Fairness opinions Bankruptcy & foreclosures Mediation and arbitration Succession planning Stock options or grants Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 5

Why are Businesses Appraised? Litigation Dissenting shareholder actions Divorce Economic loss analysis Disruption of a business Partner disputes Wrongful death Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 6

ABCs of Business Valuation Consultants ABV: Accredited in Business Valuation ASA: Accredited Senior Appraiser CBA: Certified Business Appraiser CVA: Certified Valuation Analyst ABAR: Accredited in Business Appraisal Review Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 7

Attributes of Qualified Appraisers The experience of the financial expert is crucial Involvement in relevant professional organizations Teaching and speaking experience Understanding of relevant case law Litigation experience (when applicable) Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 8

Uniform Standards of Professional Appraisal Practices (USPAP) Standards promulgated by the Appraisal Standards Board. The Standards and the Statements on Appraisal Standards are mandatory for members of professional organizations that have adopted USPAP. Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 9

Qualified Appraisal By qualified appraiser Made not more than 60 days prior to contribution Does not involve a prohibit appraisal fee Includes required information Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 10

Prohibited Appraisal Fee Generally, no part of the fee arrangement for a qualified appraisal can be based on a percentage of the appraised value of the property. If a fee arrangement is based on what is allowed as a deduction, after Internal Revenue Service examination or otherwise, it is treated as a fee based on a percentage of appraised value. (See possible exception in Section 2 of outline) Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 11

Information in Appraisal A description of the property in sufficient detail for a person who is not generally familiar with the type of property to determine that the property appraised is the property that was (or will be) contributed, The physical condition of any tangible property, The date (or expected date) of contribution, The terms of any agreement or understanding entered into (or expected to be entered into) by or on behalf of the donor that relates to the use, sale, or other disposition of the donated property Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 12

Information in Appraisal (cont.) The name, address, and taxpayer identification number of the qualified appraiser The qualifications of the qualified appraiser A statement that the appraisal was prepared for income tax purposes The date (or dates) on which the property was valued, The appraised FMV on the date (or expected date) of contribution, Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 13

Information in Appraisal (cont.) The method of valuation used to determine FMV, such as the income approach, the comparable sales or market data approach, or the replacement cost less depreciation approach, and The specific basis for the valuation, such as any specific comparable sales transaction. Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 14

Qualified Appraiser Has earned an appraisal designation from a recognized professional appraiser organization for demonstrated competency in valuing the type of property being appraised, or Has met certain minimum education and experience requirements. The individual regularly prepares appraisals for which he or she is paid. Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 15

Qualified Appraiser The individual demonstrates verifiable education and experience in valuing the type of property being appraised. The individual has not been prohibited from practicing before the IRS under section 330(c) of title 31 of the United States Code at any time during the 3-year period ending on the date of the appraisal. The individual is not an excluded individual. Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 16

Appraiser Penalties The appraiser knows or should have known the appraisal would be used in connection with a return or claim for refund, and The appraisal results in the 20% or 40% penalty for a valuation misstatement described later under Penalty. Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 17

Appraiser Penalties The penalty imposed on the appraiser is the smaller of: The greater of: 10% of the underpayment due to the misstatement, or $1,000, or 125% of the gross income received for the appraisal. Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 18

Fair Market Value The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts. Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 19

Fair Value State law and case law define fair value. Differs from fair market value in many cases. For example, certain discounts that would apply in a fair market value determination may not apply when determining fair value. Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 20

Investment Value Investment value refers to a specific buyer (including synergies) or a specific seller in a particular transaction. This definition of value is usually most appropriate in merger and acquisition situations. Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 21

Define What is to be Appraised Common stock Preferred stock S corporation stock Debt Controlling interest Partnership interest Stock options Intangible assets Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 22

Valuation Analysis Revenue Ruling 59-60 1. The nature of the business and the history of the enterprise from its inception. 2. The economic outlook in general and the condition and outlook of the specific industry in particular. 3. The book value of the stock and the financial condition of the business. 4. The earning capacity of the company. Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 23

Valuation Analysis Revenue Ruling 59-60 5. The dividend-paying capacity. 6. Whether or not the enterprise has goodwill or other intangible value. 7. Sales of the stock and the size of the block of stock to be valued. 8. The market price of stocks of corporations engaged in the same or similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter. Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 24

Risk Factors to Consider External Factors: Nature of the industry General economic conditions and outlook Economic outlook for the industry Perception of the market regarding similar investment opportunities Sources and availability of capital Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 30

Risk Factors to Consider Internal Factors: Nature of the business Level and quality of earnings Financial condition of the business The stability or irregularity of earnings Dependence on circumstances and suppliers Quality of management Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 31

Risk Factor Discount Rates and Capitalization Rates The difference between a discount rate and a capitalization rate is the sustainable growth. For example, if the appropriate discount rate is 20% and the company can realistically sustain growth of 3%, the appropriate capitalization rate is 17% [20% - 3% = 17%]. This would be equal to a P/E ratio of 5.9 [1 / 0.17 = 5.9x]. Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 32

Discount Rate and Capitalization Rate DISCOUNT RATE & CAPITALIZATION RATE 4.83% ( + ) Risk Free Rate (20 Year Treasury Bond) 7.00% ( + ) Equity Risk Premium Long Horizon (20 Year) 11.83% ( = ) Average Market Return for S&P 500 5.67% ( + ) Small Company Premium 1.00% ( + ) Company Specific Risk Premium 1.50% ( + ) Industry Risk Premium 20.00% ( = ) Discount Rate (Rounded) 3.00% ( ) Expected Average Growth Rate 17.00% ( = ) Capitalization Rate Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 33

Subject Company and Subsidiaries Historical Earning Capacity December 31, December 31, December 31, December 31, December 31, 1998 1999 2000 2001 2002 Reported net income Subject Company $230,187 $6,913,633 $3,969,823 $3,609,004 $2,606,259 Subsidiaries 1,000,117 1,695,472 662,321 113,226 9,937 Adjustments: Reported income tax 5,000 5,000 5,000 5,000 5,000 Reported Officer Compensation 1,278,470 2,451,932 5,195,960 4,191,308 4,161,953 Market Officer Compensation (800,000) (825,000) (850,000) (875,000) (900,000) Discretionary Expenses 100,000 100,000 100,000 100,000 100,000 Expenses Relating to Non-Operating Assets 800,000 800,000 800,000 800,000 800,000 Other Adjustments 0 0 0 0 0 Total adjustments $1,383,470 $2,531,932 $5,250,960 $4,221,308 $4,166,953 Adjusted income before tax $2,613,774 $11,141,037 $9,883,104 $7,943,538 $6,783,149 Adjusted income taxes 1,057,790 4,508,780 3,999,690 3,214,750 2,745,140 Adjusted net income $1,555,984 $6,632,257 $5,883,414 $4,728,788 $4,038,009 Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 34

Subject Company and Subsidiaries Income Approach Capitalized Earnings Method Adjusted net after-tax Weight Year income factor Extension 2002 $4,038,009 4 $16,152,036 2001 4,728,788 3 14,186,364 2000 5,883,414 2 11,766,828 1999 6,632,257 1 6,632,257 1998 1,555,984 0 0 10 $48,737,485 Weighted Average Net Income $4,873,749 Capitalized at 17% 5.88 Indicated Value $28,657,644 Indicated value (rounded) $28,658,000 Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 35

Subject Company and Subsidiaries Income Approach Discounted Cash Flow Method Year 1 2 3 4 5 Terminal Sales $83,781,000 $90,651,000 $97,087,000 $103,009,000 $106,099,000 $109,282,000 Cost of sales 69,790,000 75,512,000 80,873,000 85,806,000 88,380,000 91,032,000 Gross profit $13,991,000 $15,139,000 $16,214,000 $17,203,000 $17,719,000 $18,250,000 Operating expenses: 5,781,370 6,254,810 6,699,040 7,107,110 7,320,190 7,540,380 Operating income/(loss) $8,209,630 $8,884,190 $9,514,960 $10,095,890 $10,398,810 $10,709,620 Other income (expense): (838,000) (907,000) (971,000) (1,030,000) (1,061,000) (1,093,000) Income/(loss) before tax $7,371,630 $7,977,190 $8,543,960 $9,065,890 $9,337,810 $9,616,620 Income taxes 2,983,300 3,228,370 3,457,740 3,668,960 3,779,010 3,891,840 Net income $4,388,330 $4,748,820 $5,086,220 $5,396,930 $5,558,800 $5,724,780 Cash flow adjustments: Add depreciation/amortization $2,681,000 $2,901,000 $3,107,000 $3,296,000 $3,395,000 $3,497,000 Less fixed asset expenditures (2,681,000) (2,901,000) (3,107,000) (3,296,000) (3,395,000) (3,497,000) Less reserve for working capital (335,285) (343,500) (321,800) (296,100) (154,500) (159,150) Less changes in long-term debt 0 0 0 0 0 0 Net cash flow available $4,053,045 $4,405,320 $4,764,420 $5,100,830 $5,404,300 $5,565,630 Discounted at 20% 0.9129 0.7607 0.6339 0.5283 0.4402 Discounted present value $3,699,907 $3,351,240 $3,020,348 $2,694,676 $2,379,161 Discounted present value of discrete net cash flow period $15,145,332 Discounted present terminal value using Gordon Growth Model 14,412,848 Indicated value $29,558,180 Indicated value (rounded) $29,558,000 Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 36

Market Approach Transactions of the subject company itself - Arms length transaction? Buy-sell value - Less relevant if previously ignored Transactions of similar companies (private/public) - Similarity in financial structure - Similarity in revenue base - Similarity in organizational and operating structure Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 37

Industry Multiples 1. Wholesale Trade: Market Value of Invested Capital (MVIC) to sales. 2. Retail Trade: MVIC to Discretionary Earnings. 3. Finance, Insurance and Real Estate: MVIC to book value. 4. Newspaper: Equity price to gross cash flow. Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 38

Public Companies Historical TTM Historical TTM Historical TTM Price Earnings Earnings EBITDA EBITDA EBIT EBIT Ticker Per Share Per Share Per Share Per Share Per Share Per Share Per Share Comparable A ABC 18.74 1.30 2.61 4.00 6.30 2.52 4.40 Comparable B DEF 9.86 1.14 0.76 3.00 3.23 1.99 1.56 Comparable C GHI 21.92 1.10 1.35 2.27 2.91 1.77 2.28 Comparable D JKL 25.41 1.53 1.15 3.77 4.22 2.79 3.12 Public Companies Price/ Price/ Price/ Price/ Price/ Price/ Price Historical TTM Historical TTM Historical TTM Ticker Per Share Earnings Earnings EBITDA EBITDA EBIT EBIT Comparable A ABC 18.74 14.42 7.18 4.69 2.97 7.44 4.26 Comparable B DEF 9.86 8.65 12.97 3.29 3.05 4.95 6.32 Comparable C GHI 21.92 19.93 16.24 9.66 7.53 12.38 9.61 Comparable D JKL 25.41 16.61 22.10 6.74 6.02 9.11 8.14 Subject Company and Subsidiaries 4,567,690 4,038,009 10,617,612 10,001,745 8,384,229 7,520,188 Debt 9,253,919 9,253,919 9,253,919 9,253,919 Non-Operating Asset 4,000,000 4,000,000 4,000,000 4,000,000 4,000,000 4,000,000 Subject Company and Subsidiaries Historical TTM Historical TTM Historical TTM Ticker Earnings Earnings EBITDA EBITDA EBIT EBIT Comparable A ABC 69,845,008 32,993,214 44,489,593 24,497,303 57,095,467 26,775,245 Comparable B DEF 43,506,512 56,387,854 29,642,632 25,277,724 36,288,040 42,277,526 Comparable C GHI 95,021,604 69,565,302 97,273,859 70,085,686 98,577,889 67,045,432 Comparable D JKL 79,859,479 93,222,442 66,309,349 54,969,858 71,105,672 55,992,228 Subject Company and Subsidiaries Historical TTM Historical TTM Historical TTM Earnings Earnings EBITDA EBITDA EBIT EBIT Ratio Selected 9.00 8.00 5.00 4.00 6.00 5.00 Subject Company and Subsidiaries 45,109,210 36,304,072 47,834,141 34,753,061 45,051,455 32,347,021 Conclusion V alue Indicated From Selected Ratios $ 38,356,326 Value Indicated From Comparable A $ 38,073,169 Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 39

Valuation Reporting Know what type of valuation report is accepted by the intended recipient. Many end-users, including the Tax Court and certain Family Court Judges, require a comprehensive valuation report in place of direct testimony. 1. Comprehensive Report 2. Limited/Summary Report 3. Letter Report or Calculations 4. Oral Report 5. Fairness Opinion 6. Appraisal Review Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 43

Factors Affecting the Cost of a Business Valuation Cooperation from the company Appraiser s involvement beyond the business valuation Adequacy of records Specific industry factors Complexity of business structure Type of written report requested Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 44

Pitfalls and Challenges Unrelated Business Income Tax (UBIT) as S shareholder UBIT for gain on S Corporation stock sale CRTs are not eligible to be S Corporation shareholders Watch buy-sell and other agreements Prearranged sales Closely held business to private foundation not qualified appreciated stock limited to basis Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 46

Prearranged Sales If determined that a prearranged sale existed when contributed, donor may be treated as having realized the gain, then donated cash to charity. Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 47

Prearranged Sales Prearranged sale when: Legally binding agreement to sell the stock that exists at time of gift. (Palmer v. Commissioner) Or a sale was a practical certainty. (Ferguson v. Commissioner) Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 48

Charitable Bail-Out Gift of stock followed by corporate redemption of stock. Remaining shareholders will own proportionally greater % of the Company. Charity cannot: Be legally bound to sell stock, OR Be compelled by the Company to sell stock Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 49

Buy-Sell Agreements Common Characteristics of buy-sell agreements: 1. Restrict voluntary transfers 2. Restrict involuntary transfers 3. Allow transfer to qualified individuals or trusts 4. S corporation savings provisions Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 51

Buy-Sell Agreements Common Valuation Techniques: 1. Price fixed annually by shareholders 2. Book Value 3. Annual Appraisal 4. Forumula price 5. Mandatory valuation at trigger date Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 52

Buy-Sell Agreements For IRS to adopt buy-sell agreement value: 1. Bona fide business arrangement 2. Not a device to transfer at < adequate consideration 3. Arrangement comparable to similar armslength arrangements Copyright 2014: Berning & Heidebrecht, Ltd. All Rights Reserved. 53

THANK YOU! Presented by: Richard C. Berning CPA/ABV/CFF, CBA, CVA, ABAR, CMA rick@bhexperts.com Berning & Heidebrecht, Ltd. 809 Meander Court Medina, MN 55340 952-544-1212