Implied Private Company Pricing Line

1 | © 2013-2015 Bob Dohmeyer, Pete Butler, Rod Burkert - All rights reserved.
AGN International
2015 North American Regional Meeting
Atlanta, GA May 17-19, 2015
Implied Private Company Pricing Line/Model:
A New Analytical Tool to Develop Cost of Capital

IPCPL and IPCPM Co-Developers
Bob Dohmeyer
Pete Butler
Rod Burkert

Today’s Presenter – Rod Burkert
 Rod is the founder of Burkert Valuation Advisors.
His assignments focus on income/gift/estate tax
matters and helping savvy business owners make
successful transitions.
 Rod is the co-founder of Practice Builder Academy,
a 12-month mentoring program that teaches BVFLS
professionals strategies to build their practices and
redesign their lives.
 Rod has leveraged social media to build a mobile
consulting practice, which allows him to travel full
time in an RV throughout the United States and
Canada with his wife and two dogs.
Email: rod.burkert@burkertvaluation.com
rod@practicebuilderacademy.com
Phone: 215-360-6100
Skype: rodburkert

Welcome To This Session!

The Problem
Most business appraisal assignments are for small private
companies with revenue less than $20 million … yet current
cost of capital estimation methods rely almost entirely on
relatively large public company security returns.
But these small private companies differ from large public
companies in so many fundamental ways … and issues we
know about make current methods for developing discount
rates unreliable when they are applied to small enterprises.

A Solution
IPCPL/IPCPM is steeped in market transactions of small
private businesses … think of IPCPL as the equity risk
premium of private company transaction data.
Developed to eliminate the problematic CoC issues we face
(e.g., company specific risk premium, leverage, illiquidity
discounts, tax rates for pass-through entities, etc.) and to
create a more defensible starting point to derive the WACC
of private companies with revenues less than $100 million.

Agenda
IPCPL: K0 = (FCFF1 / P0) + g
 Where we are now  Flaws of Build-Up Model
 Where we are going  Description of IPCPL
 How to use IPCPL  Introduction to IPCPM
 How to use IPCPM  Real world examples
 Q & A
 Caveat: Discussion centers on control valuations, but …

Learning Objectives
Review the pitfalls of extrapolating large public company
stock market returns to private company cost of capital1
Discuss the theory underpinning the use of IPCPL
Specify the inputs used to develop IPCPL and IPCPM
Utilize the IPCPL/IPCPM to develop and calibrate a
WACC for a small private company
4
2
3

Let’s get started …

PITFALLS OF BUM

Would you use the BUM if it launched today?
Dr. Damodaran: The build-up method is a recipe for disaster.
Dr. Paglia: In a galaxy far far away, where unicorns prance on the back
of the Loch Ness monster and privately-held companies have access to
public equity markets, appraisers estimate cost of capital … [using
returns of publicly traded equity securities]
Pepperdine Survey: 78% of respondents did not feel comfortable with
our industry’s current cost of capital methods, using returns on
publicly traded equity securities.
Toby Tatum: In the small business M&A world, (i.e., mom-n-pop and
main street business brokers) I would say that 99.9% of the brokers
value businesses via Rules of Thumb (a market approach) or use the
IBA data or BizComps, or in some cases Pratt's Stats.

There is no return data for private
companies
Without data, you are just another person with an opinion.
~ W. Edwards Deming, father of the quality revolution
Junk Bonds
Small Company Stocks
Large Company Stocks
Corporate Bonds (AAA)
Certificates of Deposit
Treasury Bonds
Treasury Bills

And the data we have, is it public or private?
The Duff & Phelps Report is designed to assist the analyst in
estimating the cost of equity capital for the subject company
as if it were publicly traded.
However, discounting expected net cash flows for a closely
held business using an “as if public” cost of capital may not
be an accurate estimate of value to the extent that market
participants consider other risks associated with investments
in closely held businesses.

How do we explain ourselves?
If we look at the details, we know what happens.

First, there is the risk-free rate
 Spot rate
 Normalized rate
 20-year rate (CRSP and D&P)
10-year rate (Damodaran)

Next, the equity risk premium
 Ex post approach
CRSP’s historical or supply side
 D&P’s conditional or unconditional
 Adjust for WWII interest rate bias
 Ex ante approach
Damodaran forward-looking

And the small stock premium

Don’t get us started on company specific
risk
 Pratt: “There is no specific model or formula.”
 Hitchner: “This is one of the most subjective areas of
business valuation.”

Or the courts …
 To judges, the company specific risk premium often seems like the
device experts employ to bring their final results into line with their
clients’ objectives, when other valuation inputs fail to do the trick.
 Delaware Open MRI Radiology Associates, PA v. Howard B. Kessler
 This court has also explained that we have been understandably
suspicious of expert valuations offered at trial that incorporate
subjective measures of company-specific risk premia, as subjective
measures may easily be employed as a means to smuggle improper
risk assumptions into the discount rate so as to affect dramatically
the expert’s ultimate opinion on value.
 Gesoff v. IIC Industries

Then, an adjustment for control illiquidity
 In conventional valuation, there is little scope for showing the effect of
illiquidity. The cash flows are expected cash flows, the discount rate is usually
reflective of the risk in the cash flows and the present value we obtain is the
value for a liquid business.
 With publicly traded firms, we then use this value, making the implicit
assumption that illiquidity is not a large enough problem to factor
into valuation. In private company valuations, analysts have been less willing
(with good reason) to make this assumption.
 The standard practice in many private company valuations is to apply an
illiquidity discount to this value. But how large should this discount be and
how can we best estimate it? This is a very difficult question to answer
empirically because the discount in private company valuations itself cannot
be observed.

Last, models to adjust for pass-thru taxes
 Mercer
 Treharne
 Van Vleet
 Grabowski
 Fannon (until she withdrew it)
 Delaware MRI
 And now Nancy again, along with Keith Sellers – let’s not
tax affect the earnings, let’s adjust the cost of equity

Example of BUM unreliability
RF
4.0%
RF
2.8%
ERP
5.0%
Small Stock
5.0%
AVG CSR
2.0%
ERP
6.0%
Small Stock
6.0%
Avg CSR
4.0%
Illiquidity
2.0%
Both assume $500,000 FCFF1 / (ke – 3%)
and same “everything else”
But
Appraiser A: 19.0% and $2.6 million
Appraiser B: 9.8% and $5.1 million
Unreliability self-evident from webinar polls of BUM supporters
PTE
-2.0%
PTE
0%
Illiquidity
0.0%
Sum =
22.0%
Sum =
12.8%

IMPLIED PRIVATE COMPANY
PRICING LINE

IPCPL: Begin with the end in mind
12.4%
12.9%
13.4%
13.9%
14.4%
14.9%
15.4%
15.9%
16.4%
16.9%
17.4%
$0 $10 $20 $30 $40 $50 $60 $70 $80 $90 $100
AfterTax(35%)
Ko
Revenue $Millions
4.3
4.8
5.3
5.8
6.3
$0 $10 $20 $30 $40 $50 $60 $70 $80 $90 $100
OperatingIncome
Multiple
Revenue $Millions

The inspiration
All other asset classes have return evidence.
Only rough tethering device for BUM/WACC is the market
approach and implied transaction multiples:
Lower discount rates yield values > actual transaction evidence
Higher discount rates yield values < actual transaction evidence
Pratt & Hitchner use implied market multiple in their DCF
terminal value calculations as a reasonability check.
So IPCPL looks at implied IRRs of private transactions.

Do completed transaction prices = FMV?
People make no adjustment in the
market approach for this issue.
 We assume distressed sales are
offset by eager buyers. And that biz
transition losses are offset by synergies.
 So in the aggregate, Yes.
 Remember, we are solving for IRR -
the back solve is axiomatically Price.

Frame of reference: K0 = (FCFF1 / P0) + g
 Gordon Growth Model rearranged to solve for K0
 K0 is WACC; not Ke
 Discount rate; not cap rate
 Control DCF (see me for minority) = FMV
 Probability neutral (not risk adjusted) cash flows
 Small, privately held company

Frame of reference (continued)
IPCPL regresses 840 small private company transactions and
directly estimates the aggregate IRR.
This ex-ante approach is fundamentally same as
Damodaran’s ERP estimation approach.
Not perfect, but we believe more reliable.
Exposure: Business Valuation Review, BV Update, numerous
webinars and conferences.
Tests: Pepperdine WACC, Hitchner, new BVR paper.

You no longer have to worry about
By using prices paid (FMV) for small privately held companies,
the issues of extrapolating public security returns are moot:
 Rf
 ERP
 SSP
 CSRP
 Illiquidity
 PTE taxes
 Optimal capital structure and unlevering/relevering beta
 How much cash to add back

IPCPL point 1: selection criteria
 Pratt’s Stats
 Revenue size of $3.5 – $15 million
 From all available dates
 Owner compensation data provided
 No medical/dental practices
 US entity
 Private acquirer
 Currently gives us 840 transactions

IPCPL reliability – law of large numbers
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
16.0%
18.0%
0 25 50 75 100 125 150 175 200 225 250 275 300 325 350 375 400 425 450 475 500
PotentialError,+or-%ofTrueMeanMultiple
# of Completed Transactions
Completed Transaction Data Reliability Analysis
At 95% Confidence Interval
Typical completed transaction sample size

Our growth estimate
 Estimating expected growth for 1 company is difficult
 Estimating the median growth for 800+ companies is easy
 BLS data, Pratt’s Stats data show 1% real growth
 1% change in growth = 0.5% change to K0

Growth: private buyer v. public buyer

Summary of other adjustments
 Seller finance adjustment
 Market compensation adjustment
 Present day adjustment
 Tax adjustment
 Income lag adjustment

And voilá! (we got point 1)
Operating Price to
Margin Sales
-3.2% 11.7%
0.3% 15.5%
3.0% 27.3%
5.4% 31.2%
7.5% 38.7%
11.4% 51.7%
15.6% 63.5%
26.1% 94.7%
Steady State Margin 8.19%
Price to Sales 0.416
Sales TTM 6,000,000$
Price 2,494,109
Operating Income TTM 491,296
Tax 171,954
Net 319,343$
FCFF1:
Net (1) 330,919$
Increase in Invested Capital 46,623
FCFF1 284,296 Y = 2.9345 0.1754
FCFF1 (Mid Period Adjusted) 306,064$
Sample period AFIT IRR (Ko) (mid period CF) 15.90%
Present Day Adjustment 0.68%
Present Day AFIT IRR (Ko) (Mid period Cash flow) 16.58%
Tax Rate 35%
IRR (mid period seed) 15.90%
Growth Rate 3.63%
Invested Capital % Sales 21.4%
Ko Estimate
Growth Rate:
Real g per BLS size study/Pratt's Stats age 1.25%
Inflation - Sample Period average 2.38%
Growth Rate 3.63%
y = 2.9345x + 0.1754
R² = 0.99422
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
70.0%
80.0%
90.0%
100.0%
-8.0% -3.0% 2.0% 7.0% 12.0% 17.0% 22.0% 27.0%
PricetoSales
Opera ng Margin
IPCPL Pricing Model

IPCPL point 2: micro cap ETF – ticker IWC
IPCPL
Cost of Capital ($150 million Sales)
Micro Cap ETF - Ticker IWC(1): (Fama French Model)
Market F SMB HML Implied ERP
1.05 1.10 0.17 5.86%
Cost Weight Subtotal
Cost Of Equity 12.53% 90.00% 11.28%
Cost of Debt - AFIT (2) 3.20% 10.00% 0.32%
Cost of Capital 100.00% 11.60%
Cost of Capital - Public Company 11.60%
Private Company Indifference Discount 0.74% ( = 11.60% x 6.37% )
Private Company Cost of Capital Equivalence 12.34%
Revenue $150,000
Operating Margin 8.20%
Operating Income $12,300
Annual Staying Public Company Costs (3) $500
Annual Staying Public Company Costs as % of Operating Income 4.1%
Going Public Cost (3) 2.3%
Private Company Indifference Discount 6.37%
Notes:
(1) IWC actual median size of revenue approximately $230 million.
We adjusted SMB for $150 million according to smb relationship of SPY IWM and IWC
(2) Sample of IWC companies had slight negative net debt position - Increased to 10% for modest optimal adjustment
(3) Source: http://www.cfo.com/article.cfm/14582443/c_14582548
Size Adjustment:
Private Company Indifference Discount ($000s)

Point 1 to Point 2: Connecting the dots
 $ 6 million revenue Pratt’s Stats
to
 $150 million revenue microcap ETF
 Adjusted for cost of going and staying public
 No Arbitrage Rule
 Double Lehman formula

IPCPL: We have arrived!
12.4%
12.9%
13.4%
13.9%
14.4%
14.9%
15.4%
15.9%
16.4%
16.9%
17.4%
$0 $10 $20 $30 $40 $50 $60 $70 $80 $90 $100
AfterTax(35%)
Ko
Revenue $Millions
4.3
4.8
5.3
5.8
6.3
$0 $10 $20 $30 $40 $50 $60 $70 $80 $90 $100
OperatingIncome
Multiple
Revenue $Millions

Practical example  IPCPL output
Privately held manufacturer
 $4 million revenues
(note: less $ than point 1)
 Go to website
 www.biz-app-solutions.com
> Cost of Capital > IPCPL

Comparison with other private CoC models
 Point 1 = approximately 5x EBITDA
 Pepperdine’s Private Markets Capital Project
 Toby Tatum’s PEPM
 So can you use IPCPL in a litigation setting?
Hold on there cowboy!

IMPLIED PRIVATE COMPANY
PRICING MODEL

Uh-oh! My subject company is not “average”
 What if our privately-held $4M manufacturer is not an
“average” privately held company?
 Depart from IPCPL:
- Systematic risk (Beta)
- Unsystematic risk (Total Beta)
- Illiquidity
- Ability to obtain financing
 Go back to biz-app-solutions.com
 Cost of Capital > IPCPL > New BUM WACC Calibrator

IPCPM: 4 factors you can adjust (all else equal)
1. Systematic Risk: How correlated is the subject company or
cash flow with the economy?
2. Unsystematic Risk: How uncertain is the subject
company’s cash flow?
3. Illiquidity – Complexity, uniqueness, geography: How
shallow is the potential buyer pool?
4. Debt Finance Capacity: How acceptable are the subject
company’s assets as collateral?

Adjust for systematic risk
How correlated is the business and
future cash flow to the economy?
Expensive dinner house = 7 (high risk)
Fast food burger joint = 3
Private jet manufacturer = 9 (high risk)
Defense contactor = 2
Scale Beta
0 0.30
1 0.50
2 0.70
3 0.88
4 1.10
5 1.25
6 1.40
7 1.63
8 1.80
9 2.00
10 2.20
Compared to other small, privately held companies of the same
size … on a scale of 0 - 10 … with 5 being typical/average:

Adjust for unsystematic risk
How uncertain are the subject
company’s future cash flows?
One or two customers = 10 (high risk)
Diversified customer base and no one
customer is more than 5% of sales = 1
Scale Total Beta
0 2.00
1 2.50
2 2.80
3 3.05
4 3.20
5 3.38
6 3.56
7 3.71
8 3.96
9 4.26
10 4.76

Adjust for illiquidity
How shallow is the pool of
(hypothetical) willing buyers?
Few competitors, unique/specialized
knowledge = 8 (high illiquidity, high risk)
Many competitors, no unique or
specialized knowledge = 2
Low population density = 7
High population density = 3
Scale Liquidity
0 -3.09%
1 -2.26%
2 -1.54%
3 -0.93%
4 -0.41%
5 0.00%
6 0.41%
7 0.93%
8 1.54%
9 2.26%
10 3.09%

Adjust for ability to obtain financing
How bankable are the subject
company’s collaterizable assets?
Low inventory, AR, and FFE = 3 (low
bankability, high risk)
High inventory, AR, and FFE = 7 (high
bankability, low risk)
Scale Debt/capital
0 0.00
1 0.10
2 0.18
3 0.25
4 0.30
5 0.33
6 0.37
7 0.42
8 0.49
9 0.57
10 0.67

Calibrator example – no adjustment
2.95% 4,000,000$
6.00%
6.00% 5.00
2.00% 5.00
2.50% 5.00
0.00% 5.00
0.00%
25.00%
7.00%
35.00%
3.00%
02 1 15
Liquidity input adjusted
After-tax Cost of Equity (Ke) 19.45% 19.45%
After-tax WACC 15.73% 15.73% 15.93%
Subject Company's Build-Up Method Variables
Risk Free Rate
Equity Risk Premium
Small Stock Premium
Industry Risk Premium
Company Specific Risk Premium
PV Equity Liquidity Discount %
Cost of Equity - Other Adjustment
IPCPM Calculated After-Tax WACC
Adjusted after-tax WACC
Unsystematic Risk
Illiquidity - Complexity, Uniqueness, Geographic
Debt Finance Capacity
Subject Company BUM / MCAPM Outputs
IPCPM Adjustment Factors:
Subject Company's IPCPM Variables
Subject Company's Revenue
Systematic Risk
Buyer Debt Financing's % of MVIC
Debt Interest Rate
Tax Rate Applied to Income
Terminal G
Valuation Date
98.71%Subject Company's BUM after-tax WACC / IPCPM after-tax WACC ratio
IPCPM Advisor indicates that the WACC indication via the BUM is reasonably acceptable
Red = Unacceptable
Yellow = Moderately acceptable/ borderline
Green = Reasonably acceptable

Calibrator example – BUM too low
2.95% 4,000,000$
6.00%
6.00% 8.00
2.00% 7.00
2.50% 6.00
0.00% 5.00
0.00%
25.00%
7.00%
35.00%
3.00%
02 1 15
After-tax WACC 15.73% 15.73% 18.30%
Risk Free Rate
Equity Risk Premium
Small Stock Premium
Unsystematic Risk
Systematic Risk
Debt Interest Rate
Terminal G
Valuation Date
IPCPM Advisor indicates that the WACC indication via the BUM is too low
Red = Unacceptable

Calibrator example – BUM too high
2.95% 4,000,000$
6.00%
6.00% 5.00
2.00% 5.00
8.00% 5.00
0.00% 5.00
0.00%
25.00%
7.00%
35.00%
3.00%
02 1 15
After-tax WACC 19.85% 19.85% 15.93%
Risk Free Rate
Equity Risk Premium
Small Stock Premium
Unsystematic Risk
Systematic Risk
Debt Interest Rate
Terminal G
Valuation Date
IPCPM Advisor indicates that the WACC indication via the BUM is too high
Red = Unacceptable

RESOURCES

Most of what you need to know
 BV Update, last page, cost of capital center
BVR email notification when IPCPM updated
Monthly update: www.bvmarketdata/IPCPL
 Monthly update: www.biz-app-solutions.com

WRAPPING UP

Closing thoughts

Closing thoughts
The chief characteristic which distinguishes the
scientific method from other methods of acquiring
knowledge is that scientists seek to let reality speak for
itself, supporting a theory when a theory's predictions
are confirmed and challenging a theory when its
predictions prove false …
~ Wikipedia: definition of Scientific Method

Closing thoughts
… among competing hypotheses that predict equally
well, the one with the fewest assumptions should be
selected. Other, more complicated solutions may
ultimately prove to provide better predictions, but – in
the absence of differences in predictive ability – the
fewer assumptions that are made, the better.
~ William of Ockham English Franciscan friar
and scholastic philosopher and theologian

Closing thoughts
An important scientific innovation rarely makes its way
rapidly winning over and converting its opponents; it
rarely happens that Saul becomes Paul. What does
happen is that its opponents gradually die out and the
growing generation is familiarized with the idea from
the beginning.
~ Max Planck, German physicist, quantum theory founder

Today’s Presenter – Bob Dohmeyer
 Bob is the founder of Dohmeyer Valuation Corp., a business
valuation and M&A consulting firm. Bob provides professional
valuation advice and appraisals primarily for bankruptcy and family
law matters. He also specializes in complex valuation issues and
provides consulting work for other appraisers in that regard.
 Bob has lectured and published several papers on various valuation
topics and is on the review boards of the Journal of Business Valuation
& Economic Loss Analysis and the Business Valuation Review.
 Prior to forming his company, Bob was employed by a Fortune 100
conglomerate where he was responsible for estimating the firm’s
cost of capital, analyzing and evaluating merger and acquisition
candidates and hedging/trading crude oil.
 Bob received a Bachelor’s degree in Finance from California State
University, Fullerton and is an ASA.
Email: dohmeyer@gmail.com
Phone: 214-499-5954

Today’s Presenter – Pete Butler
 Peter Butler, CFA, ASA, Principal at Valtrend, has more
than 20 years of financial/business valuation experience.
He invented and co-developed the Butler Pinkerton
Calculator. He is also a co-developer of the Implied Private
Company Pricing Line (the “IPCPL”) and the Implied
Private Company Pricing Model (the “IPCPM”)
 Peter has published articles in all of the major U.S. business
valuation journals, as well as in a Romanian journal. He has
been invited to speak at regional, national and international
valuation conferences.
 He holds a BS in mechanical engineering from Annapolis
and an MBA from San Diego State. Peter served as a four-
term president of the CFA Society of Idaho and taught
corporate finance as an Adjunct Faculty Professor at
George Fox University.
Email: pete@valtrend.com
Phone: 208-371-7267

Seller finance adjustment
Actual Cash Price something less than reported with
seller financing
69.1% of transactions had owner financing, resulting in a 6.4%
premium
69.1% x 6.4% premium = 4.4% discount to MVIC

Market compensation adjustment
 Separate labor and business value

Present day adjustment

Pre-tax net cash flow adjustment

Income lag adjustment
 Current Implied ERP = 5.40%
 Sample Period Implied ERP Avg. = 4.36%
 Difference = 1.04%
 Divide by 1.04%/1.5
 Increase Ko by 0.70%

Other IPCPM example
 Live demonstration of Calibrator in Use
 Expensive Steakhouse
 Funeral Service and Crematories
 Requests from the audience (time permitting)

Expensive Steakhouse
2.95% 2,500,000$
5.50%
6.00% 7.00
-2.66% 5.00
4.00% 5.00
0.00% 3.00
0.00%
25.00%
8.00%
35.00%
3.00%
02 1 15
After-tax WACC 13.14% 13.14% 17.70%
Risk Free Rate
Equity Risk Premium
Small Stock Premium
Unsystematic Risk
Systematic Risk
Debt Interest Rate
Terminal G
Valuation Date
IPCPM Advisor indicates that the WACC indication via the BUM is too low
Red = Unacceptable

Funeral Home
2.95% 5,000,000$
5.50%
6.00% 3.00
1.82% 5.00
4.00% 5.00
0.00% 3.00
0.00%
25.00%
8.00%
35.00%
3.00%
02 1 15
After-tax WACC 16.50% 16.50% 15.14%
Risk Free Rate
Equity Risk Premium
Small Stock Premium
Unsystematic Risk
Systematic Risk
Debt Interest Rate
Terminal G
Valuation Date
IPCPM Advisor indicates that the WACC indication via the BUM is reasonably acceptable
Red = Unacceptable

Implied Private Company Pricing Line

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Editor's Notes