Money For Nothing

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Discussion of valuation of distressed businesses at GA Society of CPAs 10-18-08

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Money For Nothing

  1. 1. MAXIMIZING VALUE THROUGH KNOWLEDGE Money for Nothing Valuation of Distressed Businesses and Assets Georgia Society of Certified Public Accountants October 21, 2008 Michael S. Blake, CFA October 16, 2008 770-432-0308 michael@adamscapital.com 600 Galleria Parkway, Suite 1850, Atlanta, GA 30339 www.adamscapital.com 1
  2. 2. Who is Adams Capital? Boutique valuation services firm • Founded by David P. Adams, III in 1995 • Five financial professionals, including • ASA, ABV, CPA, CFA, CFE, and J.D. Participant in the GA Tech Co-op program • 40 hours of annual CPE per professional • High-end, service-oriented, entrepreneurial • MAXIMIZING VALUE THROUGH KNOWLEDGE 2
  3. 3. StartupLounge.com 501(c)(6) non-profit • Co-founded by Scott Burkett and Michael Blake • Key players: Stacy Williams, Charlie Paparelli, • Jerry Recht, Anne Simons Goal is to facilitate early-stage capital investments • in Georgia Educating entrepreneurs (podcasts, PitchCamp) – “Safe” networking meetings for entrepreneurs – (CapitalLounge) “Safe” networking for angel investors (Angel Lounge) – MAXIMIZING VALUE THROUGH KNOWLEDGE 3
  4. 4. Why Distressed Asset Value is Important We are seeing and will continue to see many • distressed businesses for the next 12-18 months In particular, smaller businesses tend to under • value distressed assets Tax and accounting implications • Required for recapitalizations • Required for bankruptcy court and/or settlement • negotiations MAXIMIZING VALUE THROUGH KNOWLEDGE
  5. 5. MAXIMIZING VALUE THROUGH KNOWLEDGE 5
  6. 6. Definition of Fair Market Value From IRS Revenue Ruling 59-60: The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts. MAXIMIZING VALUE THROUGH KNOWLEDGE 6
  7. 7. Value: What Someone is Willing to Pay? Who is “someone” and what are their • circumstances? Free to decide to buy/sell or not to buy/sell? – Is the asset made available to many buyers? – Could the buyer flip the asset at the same price quickly? – What was the second highest bid? – Is the buyer knowledgeable and privy to all relevant – facts? Were the terms of sale all cash? – Are non-financial drivers at work? – MAXIMIZING VALUE THROUGH KNOWLEDGE 7
  8. 8. Does Value Equal Price? MAXIMIZING VALUE THROUGH KNOWLEDGE 8
  9. 9. Challenges of Valuing Distressed Businesses Incomplete or fraudulent data • Many conventional valuation models don’t • work well Track record breaks down • Fundamental assumptions must change • Fewer buyers • MAXIMIZING VALUE THROUGH KNOWLEDGE 9
  10. 10. Definition of a Distressed Business The Insolvency Act 1986 (Section 123) sets • out two primary forms of validation. Cash flow test. Where the business is unable to – pay debts as they fall due Balance sheet test. The value of the business’ – assets is less than its liabilities, taking into account its contingent liabilities and prospective liabilities. MAXIMIZING VALUE THROUGH KNOWLEDGE 10
  11. 11. MAXIMIZING VALUE THROUGH KNOWLEDGE
  12. 12. Signs of Distress There are many, but some dead • ringers are – Consistently accumulating debt – Lengthening accounts payable – Multiple creditor warning letters – High borrower interest rates – High turnover in key financial/accounting functions – Revolving consultants – Behind on payroll taxes MAXIMIZING VALUE THROUGH KNOWLEDGE 12
  13. 13. Sources of Distress Manageable Impact Unmanageable Impact Loss of key customer Natural Disaster Litigation/dispute event Negative regulatory shift Event Loss Competition intellectual property Driven Negative public relations event advance Office or workplace incident Research & development failure of Industrial accident key product Discovery of fraud Over-leverage Industry obsolescence Cost structure Death of key person Systematic Cash management Low-cost foreign competition Defection of key employees Poor economic environment Under-investment Financial market movements Poor fit of management skill Unavailability of labor Poor financial record systems Unavailability of capital MAXIMIZING VALUE THROUGH KNOWLEDGE
  14. 14. Valuation of a Reorganizing Debtor Principle set forth in 1941 U.S. Supreme • Court Consolidated Rock case Core question is earning capacity • Free the enterprise from the burden of past • errors, miscalculation, or disaster Beware of Kool-Aid • MAXIMIZING VALUE THROUGH KNOWLEDGE
  15. 15. Market Approach Can be useful for individual assets • Challenges • Frequently, no profit multiples available – Hard to identify comparable companies sold – through an acquisition Hard to identify guideline public companies – In distress, the assumptions of fair market value – are routinely violated MAXIMIZING VALUE THROUGH KNOWLEDGE 15
  16. 16. Market Approach Techniques Use forward EBIT/EBITDA multiples • Add restructuring costs back to forward • EBIT/EBITDA multiples (EBITDAR?) Use different multiples • Sales multiples – Cash flow multiples – Production capacity – Tangible asset value – MAXIMIZING VALUE THROUGH KNOWLEDGE 16
  17. 17. Market Approach Checklist1 Are guideline public companies truly representative of the • subject firm What financial metrics will be used? • Should the metric(s) be based on historical or projected • financial data? Should any discounts or premiums for size, comparability, • or other factors be applied to a particular multiple? What time frame for comparable M&A transactions and • other data should be reviewed? Rule of thumb – at least 20% discount for distress • 1 Powlen, David, Triple Trouble: Valuating Companies in Chapter 11, The Journal of Corporate Renewal, October, 2008 (www.turnaround.org) MAXIMIZING VALUE THROUGH KNOWLEDGE 17
  18. 18. Asset Approach Can appraise value of individual assets • Tangible assets – Intangibles – Customer lists • Patents, trademarks, trade dress • In-process research & development • Brand • Copyrighted material • Web domain name • MAXIMIZING VALUE THROUGH KNOWLEDGE 18
  19. 19. Premises of Asset Value Value in continued use; going concern 1. Value in place; not a going concern 2. Piecemeal value under orderly liquidation 3. Piecemeal value under forced liquidation 4. Bankruptcy courts generally have required the going concern premise since 1974. MAXIMIZING VALUE THROUGH KNOWLEDGE
  20. 20. Dead or Alive Value-destroying firm MAXIMIZING VALUE THROUGH KNOWLEDGE
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  22. 22. Income Approach • Capitalized earnings not generally usable • Discounted cash flow is helpful • Is flexible enough to factor in changing revenues • Factor in changing cost structures • Provides a time line continuity between past performance and future expectations/goals • Factor in impact of net operating loss tax benefits • Factor in restructuring expenses • Factor in additional risk and new capital structure MAXIMIZING VALUE THROUGH KNOWLEDGE
  23. 23. Hard-to-Believe DCF MAXIMIZING VALUE THROUGH KNOWLEDGE
  24. 24. Easier-to-Believe DCF MAXIMIZING VALUE THROUGH KNOWLEDGE
  25. 25. What is Negotiable • Debt holders and creditors become stakeholders • Opportunity to delay/defer expenses if • You prove you’re likely to pay later – Creditor doesn’t have a ready customer Landlords • Service providers, including utilities • Some tax obligations • Lenders • MAXIMIZING VALUE THROUGH KNOWLEDGE
  26. 26. Cost of Capital and Capital Structure Cost of debt and cost of equity will increase with • distress In current environment, debt may not be available • at any acceptable price Lenders will frequently demand warrants for • “upside” Debt takes on characteristics of equity, and can in • effect become equity Cost of capital and discount rate goes up, value • comes down MAXIMIZING VALUE THROUGH KNOWLEDGE
  27. 27. Cost of Capital Shift MAXIMIZING VALUE THROUGH KNOWLEDGE
  28. 28. How Debt Becomes Equity Equity swaps • Default clauses • Convertibility • Warrant coverage • Equity Erosion • MAXIMIZING VALUE THROUGH KNOWLEDGE
  29. 29. Equity Erosion MAXIMIZING VALUE THROUGH KNOWLEDGE
  30. 30. Capital Structure Considerations1 Who has control and leverage of firm policy? 1. Is the composition concentrated or diffuse? 2. Do any investors have veto capabilities? 3. Who are the holders of the securities? (banks, 4. individuals, venture capitalists, hedge funds, friends & family) Are they likely to have different objectives? – How do they impact the overall risk of the 5. company? 1Lurvey, David et al., Hidden Treasures: Techniques for Valuing Distressed Enterprises, The Journal of Corporate Renewal, October, 2008 (www.turnaround.org) MAXIMIZING VALUE THROUGH KNOWLEDGE
  31. 31. Option Modeling – the 21st Century Approach Option models don’t require a finite view or • set of views of the future Option models all have the following • elements Time to expiration (expected time to recover) – Current price – Exercise price – Holding return – Volatility (variability of returns over time) – MAXIMIZING VALUE THROUGH KNOWLEDGE
  32. 32. Option Features and Value Option Feature Value Impact Time to expiration increases Increased value Current price increases Increased value Exercise price increases Increased value Holding period return increases Decreased value Volatility increases Increased value MAXIMIZING VALUE THROUGH KNOWLEDGE
  33. 33. Volatility Examples High Volatility Low Volatility Lower upside Higher upside MAXIMIZING VALUE THROUGH KNOWLEDGE
  34. 34. Liabilities • Liabilities must be re-valued because face value has lost its meaning • Likelihood of repayment • Likelihood of partial payment • Change in timing of payments • Prospect of forgiveness • Valuation of contingent liabilities • Debt itself discounted due to default risk and interest rate that is below market given the company’s current condition MAXIMIZING VALUE THROUGH KNOWLEDGE
  35. 35. Asset vs. Stock Sale • Asset sales allow transfer of key sources of value while leaving liabilities behind • If prior to default, state and federal law (Section 544 of the Bankruptcy Code) can nullify the sale up to 6 years in arrears • Sale intended to defraud, hinder or delay creditors • Sale was less than fair market value, and seller was insolvent at the time or sale rendered seller insolvent • Value may be higher in bankruptcy in a Section 363 sale, which is approved by the court MAXIMIZING VALUE THROUGH KNOWLEDGE
  36. 36. Insolvency • Balance Sheet Test • Is net equity (net tangible equity) positive? • Cash Flow Test • Can company pay bills as they are due? • Thin Capital Test Can the business operate – out of distress in the future? MAXIMIZING VALUE THROUGH KNOWLEDGE
  37. 37. Summarizing Thoughts Distress adds uncertainty to the business and makes • valuation more challenging Valuation tools work differently • Assumptions require close scrutiny • Option models can capture uncertainty more robustly • Capital structure is critical • Distress and insolvency are related but different • Don’t forget about liabilities • MAXIMIZING VALUE THROUGH KNOWLEDGE
  38. 38. MAXIMIZING VALUE THROUGH KNOWLEDGE Thank you for your attention Questions? 600 Galleria Parkway, Suite 1850, Atlanta, GA 30339 www.adamscapital.com 38

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