Advanced Topics in

Business Valuation

204
 iiBV 204: Advanced Topics in
Business Valuation

Course Manual

IIBV 204 MANUAL - Student -2018-v2-20180310 © 2018 The Saudi Authority for Accredited Valuers
(TAQEEM)
 iiBV 204: Advanced Topics in Business Valuation

0-2-91403-603-978:‫اﻟردﻣك‬/1441/4991:‫رﻗم اﻹﯾداع‬/

© 2018 The Saudi Authority for Accredited Valuers (TAQEEM)

Table of Contents

Chapter 1. Valuing Minority Interests ........................................................................................ 1

Section A. Introduction ............................................................................................................ 1

Section B. Measuring the Control Premium and Discount for Lack of Control ........................ 7

Section C. Measuring the Discount for Lack of Marketability (DLOM) .................................. 16

Section D. Chapter Review Questions .................................................................................. 46

Chapter 2. Valuing Early-Stage Companies ............................................................................ 49

Section A. Introduction .......................................................................................................... 49

Section B. Stages of Company Development ....................................................................... 51

Section C. Characteristics of Early-Stage Companies .......................................................... 53

Section D. Estimating Equity Value for Early-Stage Companies .......................................... 61

Section E. Modeling Complex Capital Structures ................................................................. 68

Section F. Chapter Review Questions .................................................................................. 76

APPENDIX 1: Current Value Method Case Study ................................................................ 79

APPENDIX 2: OPM Case Study .......................................................................................... 81

APPENDIX 3: PWERM Case Study...................................................................................... 87

APPENDIX 4: Hybrid Method Case Study: Salalah, Ltd. Part II .......................................... 92

Chapter 3. The Valuation of Intangible Assets ........................................................................ 97

Section A. Introduction .......................................................................................................... 97

Section B. Identification of Intangible Assets ........................................................................ 99

Section C. Valuation Methodologies for Intangible Assets.................................................. 103

Section D. Case Study – Wahmi Limited ............................................................................ 114

Section E. Chapter Review Questions ................................................................................ 140

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Chapter 4. Advanced International Cost of Capital ................................................................ 143

Section A. Introduction ....................................................................................................... 143

Section B. Review .............................................................................................................. 144

Section C. Relative Volatility Model (RVM) ........................................................................ 149

Section D. Erb-Harvey-Viskanta Country Credit Rating Model .......................................... 153

Section E. Country Yield Spread Model ............................................................................. 159

Section F. The Damodaran Model ..................................................................................... 163

Section G. Special Topics .................................................................................................. 169

Section H. Chapter Review Questions ............................................................................... 176

Chapter 5. Saudi Valuation Market ........................................................................................ 180

Section A. Saudi Valuation Market Overview ..................................................................... 180

Section B. How does the KSA Macroeconomy affect the Subject Company: Questions to
ask: ..................................................................................................................................... 194

Section C. Chapter Review Questions ............................................................................... 195

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© 2018 The Saudi Authority for Accredited Valuers (TAQEEM) iii

About This Course
The International Institute of Business Valuers emphasizes that these course materials are not
authoritative. They are intended to be used as a foundation for course lectures and
discussions, in conjunction with observations by the course instructors.

The valuations process and approaches presented in the course are:

A. Not the only valuation processes and approaches used by competent valuers;

B. Not the only way that valuation analysis may be completed;

C. Not to be taken as a rote process or approach that should be used in any

valuation analysis;

Valuations should be based on a full knowledge of the facts and circumstances of the subject
company, its industry, and the economic environment. A particular valuation process or
approach that is relevant for one company at a particular point in time may not be appropriate
for the same or another company at another point in time.

The terminology and standards in this course are based on in this course are based on the
International Valuation Standards (“IVS”) published by the International Valuation Standards
Council (“IVSC”). The IVSC is an independent organization committed to building the public’s
trust in the valuation profession by issuing universal standards and seeking their adoption
around the world.

The IVS are referenced from the publication, International Valuation Standards 2017,
Copyright @ 2017 International Valuation Standards Council. Copies of the publication can be
purchased from the following website: https://www.ivsc.org/news/article/ivsc-launches-new-
global-standards-for-valuation-profession. In contexts where the IVS does not specifically
address a valuation topic, references to other standards and sources will be made such as the
International Glossary of Business Valuation Terms (“the International Glossary”) from the
American Institute of Certified Public Accountants’ (AICPA’s) Statement on Standards for
Valuation Services No. 1.

Business valuation, as with many other areas of professional knowledge, is a changing

discipline: it is subject to constant evolution, based on analysis of the capital markets, the results
of academic research and developing professional best practice. Continuing professional
education is an essential component of the professional responsibilities of those engaged in
business valuation.

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iiBV 204: Advanced Topics in Business Valuation Instructors’ Guidelines

This manual includes details of the IVSC core competencies covered by each chapter. The iiBV
core courses cover the IVSC competencies other than those which relate to the specific
circumstances of the tax and legal regimes in various countries.

COURSE OBJECTIVES

This course covers five topics:

1. Discounts & premiums

2. Valuing early-stage companies

3. The valuation of intangible assets

4. International cost of capital

5. The Saudi Arabian economic and valuation environment

By the end of the course, the candidate should be familiar with the following topics:

1. Discounts and premiums

A. Control premiums

(1) When to apply and the shortcomings of supporting data

(2) Differences between control and synergistic levels of value

B. Discounts for lack of control (DLOC) and lack of marketability (DLOM)

(1) Understand the levels of value chart

(2) Differentiate between the DLOC and the DLOM

(3) Understand the empirically-based databases and mathematically-based

models which are used to quantify and support the discounts.

2. Valuing early-stage companies

A. Understand the differences between early-stage companies and operating

companies and the valuation challenges inherent in valuing early-stage
companies

B. Understand and be able to deploy the common models for valuing the
securities of early-stage companies including:

© 2018 The Saudi Authority for Accredited Valuers (TAQEEM) v

 (1) The current value method (CVM)

(2) The option pricing model (OPM)

(3) The probability weighted expected return method (PWERM)

(4) The Hybrid Method

3. Valuing Intangible Assets

A. Understand the difference between tangible and intangible assets

B. Learn the major categories of intangible assets and specific types of intangible
assets within each category

C. Understand the common models used to value different types of intangible

assets

D. Understand the financial reporting context in which intangible assets are most
often valued which includes the purchase price allocation process

E. Appreciate how and why the firm’s weighted average cost of capital, its
weighted average return on assets, and internal rate of return should
approximate each other

4. International Cost of Capital

A. Know the commonly applied models used to develop international cost of

capital

B. Understand the source data required for each model, its availability

C. Understand the shortcomings of each model in terms of its ability to capture the
systematic and unsystematic risk in a subject company

5. The Kingdom of Saudi Arabia’s (KSA) Economic Environment

A. Know the basic structure of the KSA’s economy

B. Know the basic metrics surrounding the KSA valuation profession

C. Understand the current tax structure in KSA and how it affects the valuation of
closely-held companies

© 2018 The Saudi Authority for Accredited Valuers (TAQEEM) vi

iiBV 204: Advanced Topics in Business Valuation Instructors’ Guidelines

© 2018 The Saudi Authority for Accredited Valuers (TAQEEM) vii

Chapter 1. Valuing Minority Interests

Section A. Introduction

1. What is a minority interest?

A. A minority interest is defined in the International Valuation Standards (“IVS”)

glossary as “An ownership interest less than 50% of the voting interest in a
business enterprise”.

B. A minority investor does not have unilateral control over the operations of a
company. The term ‘minority’ actually has three levels. The degree of control
in each level will influence the amount of the discount(s) taken:

(1) 50% standoff – This level is usually referred to as ‘non-control’ since

the owner technically is not in the minority. Both shareholders need the
other to control operations; however both shareholders can block the
other 50% shareholder from pursuing an undesired path, depending on
local business law and the company’s shareholders’ agreement.

(2) Swing block – This level can access control with one other interest.
For example, assume a company is owned by three investors, two of
whom own 49% and one who owns 2%. All three blocks of stock are
considered swing blocks since each can access control by combining
votes with one other investor.

(3) True minority – This is a block of stock in which the owner has no
access to control. Assume one investor owns 98% and the minority
investor owns 2%. The 2% investor has no way to unilaterally control
operations or to access control.

2. Why are minority interests discounted from their pro rata control value?

A. Investors usually see two disincentives to acquiring a minority interest relative

to a control interest: 1) a lack of control; and 2) a lack of marketability. These
two issues are conceptually linked but are measured separately. A lack of
control regards all of the powers that the acquiring investor would be deprived
of after purchasing the minority stock. A lack of liquidity regards the potential
that after acquiring the stock, the investor would not receive annual dividends
and/or not be able to re-sell the stock in the market.

(1) The disincentives are linked since both are derived from the block’s
minority status.

(a) A minority interest owner cannot conduct operations as wants to

increase the value of the stock, which is a control issue.

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

(b) A minority investor cannot sell his stock in the market at the pro rata
value of the control price since investors recognize that they may not
receive the dividends assumed in the control price.

(2) In both cases the valuer should remember that he is measuring the
differences between two separate levels of value. The levels of value
are discussed below.

B. Lack of control – There are numerous prerogatives of control that investors

desire. When the target investment does not convey these prerogatives, then
investors will likely pay less than the investment’s pro rata control value. These
powers include, but are not limited to the following:

(1) Sell all or part of the company or liquidate its assets

(2) Declare dividends

(3) Control personnel, especially in upper management

(4) Set compensation, especially among company officers

(5) Direct the strategic direction of operations

(6) Buy and sell fixed assets

(7) Direct the company to engage in contracts with vendors

(8) Enter new markets or expand product line

(9) Change the company’s by-laws or articles of incorporation

(10) Take the company public

(11) Block any of the above actions

C. Lack of marketability – If the investor does not see his interest enjoying the
following characteristics he will require a discount for lack of marketability:

(1) Lack of periodic dividends assumed in the control value

(2) Inability to liquidate the minority investment at the pro rata control value

3. Levels of Control

A. There are four levels of control. The valuer must define the appropriate level
desired by the client during the ‘Defining the Assignment’ phase of the analysis.
Those levels are:

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

(1) Synergistic Value – Defined as “the result of a combination of two or

more assets or interests where the combined value is more than the
sum of the separate values” (IVS 2017)

(2) Control Level – Defined as “The power to direct the management and
policies of a business enterprise value”. (International Glossary of
Business Valuation Terms). A control block of stock consists of more
than 50% of the voting stock of the business enterprise.

(3) Minority, Marketable – A minority interest in an enterprise that does not

suffer from illiquidity. The interest is usually liquid because the business
enterprise is traded on a public market. However, the owner does not
share in the prerogatives of control.

(4) Minority, Non-marketable – An ownership interest consisting of less

than 50% of the voting interest in a business enterprise

LEVELS OF VALUE

Appropriate for Equitable Value,

Synergistic Synergistic Value or Investment
Value assignments.

Control

Control Premium Discount for

Lack of Control

Minority, Marketable
Appropriate for Market Value
assignments

Discount for Lack

of Marketability

Minority, Non-
marketable

B. The Synergistic Level pertains to assignments in which two distinct parties are
identified in the valuation. The buyer and seller are not hypothetical and
therefore such an assignment is outside the context of a Market Value analysis.
Synergistic Value requires the identification and measurement of synergies or
economies of scale involved in the transaction.

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

(1) Synergistic value will usually be worth more than a control value since it
considers expense categories than may be eliminated when two
companies merge. Control value does not consider such synergies
since it is a hypothetical concept and the subject company is not
considered to be merging with another entity.

C. Control, Minority-Marketable, and Minority-Non-marketable each pertain to

hypothetical or notional valuations. They therefore should be considered for an
assignment which calls for a Market Value basis.

4. When should a premium or discount be considered?

A. The initial level of value is determined by the approach to value used and the
assumptions applied in that approach. A premium or discount should be
considered depending on the required level of value and the initial level of value
reached in the valuation approach.

(1) A control level of cash flow can only be accessed by a control

shareholder.

(2) A minority level of cash flow represents the cash flow that the minority
shareholder expects to receive. An example:

Sample Company Income Statement

Revenue € 10,500,000
Cost of sales 6,125,000
Gross profit 4,375,000

Overhead
Officer compensation 2,450,000
Other overhead 1,750,000
Total overhead 4,200,000
Operating income € 175,000 = Minority cash flow

Adjustments
Reported officer comp 2,450,000
Reasonable officer comp (550,000)
Total adjustments 1,900,000

Adjusted operating income € 2,075,000 = Control cash flow

(a) If the valuer in the above example uses the €175,000 as the basis
for his income approach to value, then the resultant value is
expressed on a minority, non-marketable level.

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

(b) If the valuer uses the €2,075,000 as the basis for his income
approach, then the resultant value is expressed on a control level
since only the control shareholder can access this value, either
through setting his own compensation or through generation of
profits which he can invest back into the company.

(c) There are several types of income statement adjustments that are
considered control level adjustments including officer compensation,
above-market rent, related party transactions, and other perquisites.

(d) This discussion is depicted in the following graph.

Type of Analysis and the Resultant Level of Value

Income Approach (all methodologies) Control cash flows

Control Value
Market Approach (Guideline Company Method) used

Income Approach (all methodologies) Minority cash flows Minority, Non-

Market Approach (Guideline Company Method) used marketable Value

Asset Approach Control Value

Market Approach (Transaction Method) Control Value

B. Four steps to arrive at an appropriate level of value conclusion:

(1) Determine which level of value was determined in each approach to

value and each methodology used.

(2) Determine what level of value is called for in the engagement.

(3) Apply appropriate premiums or discounts to place each

approach/methodology on the same level.

(4) Conclude on the value based on appropriate weighting.

5. Common assignments which call for minority interest valuations

A. Most Fair Value assignments under International Financial Reporting Standards

(IFRS) or Generally Accepted Accounting Principles (GAAP) accounting require
control level determinations. Hence, some valuers who operate in these
markets may not be familiar with the challenges in valuing minority interests.

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

B. Some valuation markets include litigation and transaction analyses which often
require minority interest valuations. In the U.S., valuation for litigation and tax
purposes often require minority interest valuations.

(1) Inheritance tax – Business owners seek to minimize inheritance tax by

gifting minority shares in a closely-held company each year over a long
period of time. Each gift is considered a hypothetical valuation and
therefore discounts for lack of control and marketability are considered.
These valuations, especially the level of discounting, is usually reviewed
and often challenged by the taxing authorities.

(2) Dissenting shareholder lawsuits – A minority shareholder who is

deprived of his pro rata interest upon a sale of a company may sue a
control shareholder in some venues. Such assignments may require a
minority interest valuation.

(3) Equitable distribution – The laws of some countries require

businesses to be valued and distributed among a married couple upon
divorce regardless of which party legally owned the company’s stock.

(4) Transaction – A minority investor in a closely-held company who

wishes to sell his shares, and is allowed to do so under the terms of his
Shareholders’ Agreement, may request a formal minority interest
valuation.

C. The U.S. valuation market is the most advanced in requiring minority interest
valuations and in measuring the relevant amounts of premiums and discounts.
These measurement norms are the subject for the rest of Module 1.

(1) Valuers unfortunately cannot measure control and liquidity in the private
market by looking directly at the private markets. Therefore, control and
liquidity are measured by finding proxies for control and liquidity in the
public markets. Those measurable proxies are applied to the subject
stock values.

(a) The valuer should remember that the use of a proxy to measure any
metric involves assumptions. Those assumptions may not
universally apply to all subject companies.

(b) The valuer should also remember that the application of a premium
or discount will effectively add or remove cash value from an
originally determined valuation. The valuer is obligated to review the
final value for reasonableness.

(c) Finally, the measurement of premiums and discounts is one of the

most researched and published topics in the valuation field. It is
also the area in which some of the most egregious errors are made.

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

Section B. Measuring the Control Premium and Discount for

Lack of Control

It is axiomatic that control shares in a closely-held corporation are worth more than
minority shares. The benefits of control that were discussed in the prior Section (e.g.,
the ability to sell all or part of the company, declare dividends, hire/fire personnel, etc.)
have an impact on value which makes a controlling interest worth more than a minority
interest. The topic of this Section is how to quantify that cash value and by default also
quantify the related discount for lack of control (DLOC).

1. The Control Premium

A. The control premium is defined in the IVS Glossary as follows:

“An amount or a percentage by which the pro rata value of a controlling interest
exceeds the pro rata value of a non-controlling interest in a business enterprise,
to reflect the power of control.”

B. The valuer should conduct an analysis of several factors before deciding if a

control premium is warranted, and if so, how much the premium should be.

(1) The control premium can only be applied to a Minority, Marketable level
value. The valuer should be sure that the valuation analysis has
concluded at this level. See the Levels of Value chart in Section A
above.

(2) The valuer should assess the actual preogatives of control that are
present in the subject interest. If forecasted profits are minimal, the
power to declare dividends may not be worth much. If the company is
small with a small staff, the ability to hire and fire personnel may not
appeal to an investor. This analysis should be documented.

(3) The degrees of control, also discussed in Section A, should be

assessed in conjunction with (1) and (2) above. These degrees are
repeated here:

(a) True control (or unilateral control) – the control shareholder owns
more than 50% of the company’s stock. The valuer should note if
local business laws require a super-majority block (i.e., a block
greater than 51%) to exert control.

(b) Standoff position – two 50% shareholders. No shareholder has

unilateral control. No shareholder is true minority.

(c) Swing block – there are only minority blocks of stock but two
shareholders can combine together to exert control over one or
more other shareholders (e.g., 2%-49%-49%; or 41%-10%-10%-

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

10%-10%-10%-9%, etc.). The degree of control will affect the

quantification of the control premium and the DLOC.

(d) Shareholders’ Agreement - The Agreement may specify how control

is apportioned among the shareholders which may differ from the
mathematics of the blocks owned. The valuer must also decide if
the Shareholders’ Agreement is pertinent to the analysis.

C. Measuring the Control Premium

(1) Historically, the control premium has been measured by looking at

transactions in the public market in which whole companies have been
acquired. These transactions include a marketable, minority trading
price (i.e., the stock’s trading price on the market prior to the
transaction) and a control price, the price paid in the transaction. Since
the transactions almost always include a premium over the daily trading
amount, the difference has been assumed by the profession (rightly or
wrongly) to be a reflection of a control premium.

(a) Remember, the empirical evidence in these public transactions has

been assumed to be a valid proxy for what valuers are trying to
measure, which is a quantification of the benefits of control (e.g., the
ability to declare dividends, hire/fire personnel, etc.)

(2) The Factset Mergerstat/BVR Control Premium Study

(a) This database includes data on 10,780 transactions since 1998.

Each transaction has up to 57 data points. Control premiums are
measured as the ultimate price paid divided by varying minority
trading prices:

 1 day prior to transaction

 1 week prior to transaction

 1 month prior to transaction

 2 months prior to transaction

The historical trading prices give the valuer the option of

removing the effect of upward movement in stock prices in
anticipation of a takeover. Mergerstat also provides what they
call the “unaffected stock price” which is the price on the day
before the transaction rumors were determined to start.

(b) This study can be accessed at

www.bvresources.com

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

(c) The control premium is measured as follows:

(d) (Transaction Price/Prior Trading Price) - 1

(e) Example A: Public-A Company was acquired by Public-B Company

for €12.45 per share. One month prior to the transaction, Public-A
Company was trading at €9.10 per share. The control premium is
calculated as follow:

(f) 36.81% = (12.45/9.10) – 1

(g) The valuer can search the Factset Mergerstat/BVR study by the
following characteristics:

 Industry code

 Financial performance ratios

 Transaction characteristics

 Strategic or Financial buyers

 Strategic buyers are defined as buyers which

operate in the same business or industry as the
target company.

 Financial buyers are defined as buyers which are

acquiring the target company for investment
purposes, such as private equity funds, buyout
funds or other finance related entities.

(h) Example B: NAICS 511110 – Newspaper Publishing

Factset Mergerstat/BVR Control Premium Study

NAICS Code 511110
Newspaper Publishing

Sumary Results
# Transactions: 24 Median
Mergerstat Control Premium 21.4%
Implied Minority Discount 17.6%

The valuer searched all 10,780 transactions on the

Mergerstat database under the NAICS industry code 511110
and found 24 transactions. In this example, the median
control premium from the transactions was 21.4%. The
valuer needs to use judgment in applying this data though.
First, transactions took place between 1998 and 2017. Of

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

the 24 transactions though only one deal occurred after 2008

(a fact which would be shown in the full report which is
provided on the website), possibly due to the rapidly
changing conditions in the newspaper industry. Also, the
valuer should assess whether 24 transactions provides a
robust enough data set to extract meaningful conclusions.

(3) The valuer can apply the Factset Mergerstat/Study by isolating the
desired search criteria and evaluating the resultant data points to
determine whether she wants to apply an average or median control
premium or some other premium based on a subset of the data.

2. The Discount for Lack of Control

A. The DLOC is a discount applied to a control value to reflect the fact that the
block of stock being valued does not contain the powers of control outlined in
Section A. Again, the amount of the discount is affected by the degree of the
lack of control. The valuer should be aware of the following:

(1) The valuation approaches used arrive at a control value and the
assignment is to value a minority or lack of control block of stock.

(2) The degree to which the owner of the minority block lacks control or
access to control (Does a true control shareholder own the rest of the
company? Is the minority block of stock a swing vote?).

B. Measuring the DLOC

(1) The DLOC uses the same data from above in the Factset
Mergerstat/BVR Study and reverses the process in the following
calculation:

DLOC = 1 – [ 1/ (1 + control premium)]

Continuing the Example A from above, the relevant DLOC from the
control premium paid by Public-A Company would be:

26.91% = 1 – [ 1/ (1 + 36.81%)]

Therefore if the valuer had a control value equal to €12.45, she would
apply a DLOC of 26.91% to arrive at the minority, marketable level
value.

(2) The DLOC is measured based on the same data in the Factset
Mergerstat Study. Once a representative control premium is determined
based on the valuer’s selection criteria, the above formula is applied to
determine the relevant DLOC.

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

(3) Example B (from above): Newspaper publishing company, NAICS code

511110. The Factset Mergerstat Study provides the implied DLOC,
given the control premium data, which is 17.6%. The same advice
applies though. The valuer needs to use judgment given the number of
transactions in the search results, the dates of transactions in the
search results, the range of premiums paid, and if the economic
conditions surrounding the transactions are similar to the economic
conditions at the valuation date.

3. Critique of Using Control Premium Studies

A. As discussed, the control premium studies are intended as a proxy

measurement for the cash value of the prerogatives of control in a closely-held
company. In other words, how much is it worth to an investor to be able to
control dividends, hire and fire personnel, etc? The arrows on the levels of
value chart in the prior section are therefore between the minority, marketable
level and the control level.

(1) The main critique of the control premium studies though is that the
premium data really measures the premium and discount between the
synergistic level and minority, marketable levels.

LEVELS OF VALUE

Synergistic

Control
Are we really
measuring
Control Premium Discount for synergistic value?
Lack of Control

Minority, Marketable

B. The Eric Nath Arguments – The levels of value chart was taught with little
review or controversy throughout the 1980s and 1990s. In a series of articles
Eric Nath provided a critique of many of the assumptions that have been
discussed in this section.

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

(1) Nath argues that the differences between the private and public market
preclude using the assumptions behind the levels of value chart.1 We
assume that the premiums paid for “control” in the public market are
paid for the same elements of control that we are trying to measure in
the private market. They are not. He posits that the premiums paid for
control as observed in the Mergerstat Study are more likely for the
following items:

(a) Synergies

(b) Auction competition

(c) Tax motivations

(d) Greed, ego

(e) Regulatory factors

(2) The ‘minority-marketable’ level of value is in effect close to a control

concept from the private market perspective since the minority investor
in the public market has total liquidity. The key disincentive to acquiring
a minority interest in a closely-held company is illiquidity – either by
being deprived of dividends or an inability to sell. If these worries go
away (as in the case with a public stock in a minority-marketable level)
then what else is there to be gained?

(3) Nath argues that minority investors in public companies exert a form of
control in their ability to liquidate their investments easily. He also
argues that most minority investors do not want the so-called
‘preogatives of control’ as have been delineated in this chapter.

(4) Most public companies already trade at or near their control value (as
we define control in the private market). If most or all public companies
have a control value that exists above the level of the daily trading price
then the market would see far more transactions that it does.

(a) If there is no real demand for this definition of control then how can it
exist?

C. There are signficant differences between the public and private markets. What
is most relevant here is that in many venues, business law protects the minority
investor in public companies against abuses from controlling parties. Also
Boards of Directors bear similar responsibilty to curb management. Therefore,

1
Eric Nath, “A Tale of Two Markets”, Business Valuation Review, September 1994.

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

minority owners in public ccmpanies do not have to worry about a control owner
committing abuses that are linked to the control prerogatives.

D. Research shows that 80% to 90% of public company takeovers fail either in that
they do not achieve the forecasted returns to shareholders or literally collapse
with the break-up of the companies. This fact would tend to argue that the
control premiums are not representative of Market Value since the buyers are
either uneducated or not acting in their own best economic interest.

4. The Market Participant Acquisition Premium

A. Background

(1) In the Fair Value context, control premiums are sometimes referred to
as “market participant acquisition premiums” (MPAP). Users of
valuation analyses in the financial reporting context were concerned that
control premiums applied to the minority, marketable level of value were
potentially overstated as discussed in the critiques above.

(a) The U.S. SEC was especially concerned that the unsupported
application of control premiums in the range of 35.0% to 40.0% in
goodwill impairment analyses were being used by public companies
to avoid recognizing impairment.

(b) The principal support for the control premiums (the control premium
studies discussed in the prior section) do not provide sufficient data
to adequately measure what market participants would pay above
the so-called minority, marketable level of value.

(c) The terms used are control value, foundation value, and MPAP. The
foundation value is equivalent to the minority, marketable level of
value.

(2) The Appraisal Foundation’s Appraisal Practices Board released it’s final
publication on this issue, The Measurement and Application of Market
Participant Axquisition Premiums on September 6, 2017. This
document is the basis for discussion and research on the MPAP. (The
Appraisal Foundation in the U.S. is a Congressionally recognized
authority on valuation which issues standards, qualifications, and
guidance in the valuation disciplines. It is sponsored by 11 different
Valuation Professional Organizations [“VPOs”] in the United States.)

(3) The MPAP is defined as the premium that describes the price paid by
market participants in order to acquire a controlling interest.

(4) There are two main distinctions between the discussion of the MPAP
and the control premium discussion in the prior section:

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(a) From a market participant perspective, synergistic value may be

included in the premium if they are available to the defined group of
market participants.

 The valuer must distinguish between synergies that are

available to the group of market participants versus the
synergies that would be available to one specific buyer.

(b) Best practice dictates identifying what these synergies are and
explicitly accounting for them either in the projected cash flows, the
discount rate used, or the control premium.

 For example, if the synergistic value is encompassed in

the closure of warehouse facilities which would save the
equivalent of one million euros – and the whole group of
market participants would recognize these savings – then
the valuer would increase projected cash flows by one
million euros.

 Alternatively, the valuer could decrease the

discount rate used or increase the control
premium to capture the synergies, but this would
be a less precise approach.

B. Relationship between cash flow and control premium

(1) The main principles discussed in the prior section apply to the MPAP
discussion in terms of control and minority cash flows and adjustments
made that distinguish one from the other.

(2) The Appraisal Foundation indicates that best practice in determining the
MPAP is to model the perceived control synergies into the projected
cash flows which would preclude a separate application of the MPAP.

(a) A distinction is made between traditional cash flow modeling and

expected cash flow modeling. With expected cash flow modeling,
the valuer would present a range of expected cash flows from a
worst case to optimum case scenario and apply weights to each.

(b) In either case, the valuer should identify the specific source(s) of the
higher cash flows that market participants may extract from the
company.

 Revenue-based synergies
 New distribution channels
 Wider customer base
 New product/service markets

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 Enhanced pricing power

 Expense-based synergies
 Elimination of duplicative labor
 Elimination of surplus capacity

 Cost of Capital Synergies

 Optimal capital structure imposed on target
company
 Lower the cost of debt

(c) The prerogatives of control discussed in the last section only have
value if it can be determined that a market participant would pay for
them.

 The Appraisal Foundation allows for these prerogatives

of control to be captured as either an increase in
projected cash flows or a lower discount rate.

(d) The valuer should identify the extent to which these or other
synergies exist.

 Are these synergies available to the market participant

group or just to one or two specific buyers?

 To the extent the synergies are available to the market

participant group, how much would the market
participants benefit from them?

 To the extent the synergies are available and market

participants would benefit, how much would they pay for
them? The valuer must remember that no buyer will pay
for a benefit unless he absolutely has to.

(3) If the benefits of control are modeled into the cash flows in the income
approach, then no separate control premium would be necesssary.

(a) DCF – If synergies are projected in cash flows then no premium

would be necessary.

(b) GPC method – If synergies are reflected in target company cash

flow, then no separate control premium is necessary. If not, then a
premium should be considered.

(c) Transaction method – not often applied because transaction

multiples already reflect synergies and any premium for control

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C. The Appraisal Foundation recommends that the control premium be applied to

the invested capital value, not an equity value. Common practice in financial
reporting is to conduct valuations on the invested capital basis.

(1) Valuers should only apply a premium from the control premium studies
in rare circumstances (and even then in the company of other support),
but if such data is used, the valuer should remember that the control
premiums from the studies are an equity premium. They cannot be
directly applied to an invested capital value.

D. IVS 2017 uses the term “Market Participant Acquisition Premium” and is
planning to undertake further work in this area.

Section C. Measuring the Discount for Lack of Marketability

(DLOM)

The DLOM is applied to a Minority, Marketable level value to obtain a Minority, Non-
marketable level value. Generally there are five different tools that are used in best
practice to quantify the DLOM. The valuer can select any or all of these tools to
measure the DLOM, depending on the circumstances. The valuer should remember
that there is disagreement in the profession as to the propriety of some of the tools and
manner in which they are applied.

1. Difference in Bond Yields

A. The premium paid above the yield on short-term government bills for long-term
bonds has always been a simple and straightforward way of viewing relative
illiquidity in the marketplace. Investors in long term government bonds must be
compensated for the risk of inflation and loss of value over a longer holding
period relative to investors in short term bills. This premium is easily
observable over time.

(1) The yield spreads are not presented here as an option for actually
measuring the DLOM for the following reasons:

(a) The spreads are representative of the liquidity of debt instruments,

not equity investments.

(b) Various economic factors can skew the yield spreads in ways that
would not have a similar effect on equity investments.

 The yield spreads between 2008 and 2017 are

abnormally high due to the effects of the 2008-09
recession.

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(c) The variance in spreads on a year-to-year basis and the range of

spreads over time suggests that a central tendency conclusion
would not be relevant.

(d) The percentage difference in yields (i.e., the premium paid) is not
the arithmetical equivalent of a DLOM.

(2) However, the yields below do show a consistent trend in the market in
which a premium is required for investing in a longer term security which
lacks the liquidity of an invesment in a similar entity which has a shorter
holding period.

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United States Government Bond Yields, 1982-2017

3-Month Treasury LT Treasury

Year Bill Yield Bill Yield % Difference
1982 11.87% 13.87% 16.8%
1983 8.17% 10.39% 27.2%
1984 9.35% 11.93% 27.6%
1985 8.10% 11.69% 44.3%
1986 7.33% 9.28% 26.6%
1987 5.70% 7.44% 30.5%
1988 6.09% 8.95% 47.0%
1989 8.43% 9.09% 7.8%
1990 7.83% 8.00% 2.2%
1991 6.66% 8.14% 22.2%
1992 3.96% 7.46% 88.4%
1993 3.19% 7.33% 129.8%
1994 3.16% 6.54% 107.0%
1995 5.95% 8.07% 35.6%
1996 5.20% 6.03% 16.0%
1997 5.19% 6.85% 32.0%
1998 5.32% 5.94% 11.7%
1999 4.49% 5.42% 20.7%
2000 5.48% 6.94% 26.6%
2001 5.87% 5.46% -7.0%
2002 1.74% 5.86% 236.8%
2003 1.22% 5.05% 313.9%
2004 0.93% 5.21% 460.2%
2005 2.32% 4.84% 108.6%
2006 4.16% 4.62% 11.1%
2007 5.07% 4.87% -3.9%
2008 3.26% 4.39% 34.7%
2009 0.08% 3.22% 3925.0%
2010 0.08% 4.60% 5650.0%
2011 0.15% 4.18% 2686.7%
2012 0.02% 2.67% 13250.0%
2013 0.08% 2.63% 3187.5%
2014 0.07% 3.68% 5157.1%
2015 0.02% 2.41% 11950.0%
2016 0.22% 2.64% 1100.0%
2017 0.53% 2.78% 424.5%

Median, 1982-2008 27.6%

Median, 1982-2017 40.0%

Note: LT Treasury is 30-year bond 1982-93. After 1993 is 20-year bond.

2. Option Theory

A. A put option is a contract in which an investor purchases the right to sell a stock
at a predetermined price. The cost of the option contract is the amount that the
investor is willing to pay for the right to sell, which is called a ‘put.’ In buying the
put option, the investor safeguards himself against the possibility that the stock
will decline in value below the exercise price which is the pretermined price at
which he can sell the stock. If that happens, the investor can purchase shares

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

of stock at the market price and then exercise his option to sell those shares at
the predetermined, higher amount.

(1) Example:

ABC Company price per share @ 9/30/17 $ 10.00

Put Option Contract

# shares 100,000
Exercise price per share $ 10.00
Time period 3 years

ABC Company price per share @12/31/18 $ 6.50

Investor exercises put option

Cost of buying shares $ (650,000)
Exercise of put 1,000,000
Proceeds from exercise of put option = $ 350,000

Net gain = proceeds less cost of option

In this example, the investor buys the right to sell 100,000 shares of a
stock for $10.00 per share. The stock is also trading at $10.00 per
share on the date that the contract is signed. Fifteen months later the
stock value has declined to $6.50 per share and the investor decides to
exercise the put option. He purchases 100,000 shares (using his own
money) for a cost of $650,000. He then sells those shares to the
investor on the other side of the contract, who must pay $10.00 per
share, or $1,000,000. The option holder gets a profit of $350,000, less
whatever the original cost of the put option was.

The principle behind the use of options to measure the DLOM is that the
cost of the option represents what the investor was willing to pay to
ensure liquidity at $10.00 per share. Therefore the cost of the option,
divided by the value of the company will provide an indication of the
DLOM.

B. In 1993 David Chaffe was the first person to link the concept of lack of
marketability in the private markets with the price of stock options in the public
markets.2 Chaffe used the Black Scholes option pricing model (see below) to
determine the DLOM.

2
David Chaffe, “Option Pricing as a Proxy for Discount for Lack of Marketability in Private Company
Valuations”, Business Valuation Review, December, 1993.

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C. In 1995, Francis Longstaff, head of fixed income derivative research at

Salomon Brothers in New York City (now a finance professor at UCLA’s
Anderson School of Management) published research on the value of
marketability in stock pricing.3 Although his research did not make it into
mainstream valuation practice for ten years, his research formed the basis for
what is now a group of quantitative models which are applied to measure the
DLOM.

Longstaff likened the issue of illiquidity to an option scenario in which an

investor receives a stock which is restricted from trading for “x” number of
years. Assume the investor also has perfect foresight in the market and knows
when the stock’s price peak will occur.

(1) The value of the illiquidity would therefore equal the present value of the
difference between the proceeds from that sale at the market’s peak
and the proceeds from a sale of the stock at the end of the restriction
period. That is the value that the investor has lost due to the restriction.

(2) Longstaff referred to this as the “upper bound” of the value of

marketabililty since no investor has perfect timing or foresight. There is
the possibility that the investor might sell at a value below the peak or
even sell at a value below the price at the end of the restriction.

(3) The Longstaff Model quantifies the time period of the restriction and the
stock’s volatility in determining the lost value. This lost value is then
taken as a percentage of overall value and a discount is determined.
Longstaff’s research yields the following results when varying time
periods and varying volatilities are entered:

3
Francis A. Longstaff, “How Much Can Marketability Affect Security Values?”, Journal of Finance,
December, 1995

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

Francis Longstaff
Percentage Discounts for Lack of Marketability
Restriction STANDARD DEVIATION
Period 0.10 0.2 0.3

1 day 0.42% 0.84% 1.27%

5 days 0.94% 1.89% 2.85%
10 days 1.34% 2.69% 4.05%
20 days 1.89% 3.82% 5.77%
30 days 2.32% 4.69% 7.10%
60 days 3.30% 6.68% 10.15%
90 days 4.05% 8.23% 12.54%
180 days 5.77% 11.79% 18.08%
1 year 8.23% 16.98% 26.28%
2 years 11.79% 24.64% 38.61%
5 years 19.13% 40.98% 65.77%
Source: Journal of Finance, December 1995

(a) As shown, the amount of the implied DLOM increases as the

restriction time period increases. Also the implied DLOM increases
as the volatility increases.

 It is not unusual to have stock volatilities in the 20% to

30% range, or even higher. It is also not unusual for
closely-held stock to have anticipated holding periods
(i.e. restriction periods) of five years or more. At face
value therefore, this research suggests DLOMs in the
40% to 65% range.

 It should be remembered though that Longstaff refers to

this model as the ‘upper bound’ of the DLOM since it
assumes perfect market timing which, in reality, investors
do not possess.

(4) Chaffe and Longstaff’s research provides the basis for using option
models to measure the DLOM since the two input variables, time period
of restriction and stock volatility, are the two key inputs into option
pricing models. Theoretically, the price an investor is willing to pay for a
put option, as a percentage of a stock’s overall value, is comparable to
the DLOM:

(a) When a put option is purchased, the investor is guaranteeing

liquidity since the seller of the option must purchase the stock if the
option is exercised.

(b) The amount that the investor is willing to pay for the option contract
is a proxy for how he prices liquidity.

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(c) The valuer can therefore divide the cost of the option contract into
the total value of the company to reach a determination of the
DLOM.

(5) It should be remembered that Longstaff’s research was not focused on

the closely-held market. He was trying to measure the decline in value
caused by the market’s halting of trading in a stock or in investments in
public stock that for a variety of reasons did not enjoy instant liquidity.

D. Option Model Example

(1) The Black-Scholes Model has become a common tool for measuring the
DLOM. The model was developed by Fisher Black, Myron Scholes, and
Robert Merton in 1973 at the University of Chicago. The model is used
to price European call options (it was not developed to measure the
discount for lack of marketability). In addition to put options (the right to
sell a stock) and call options (the right to buy a stock), there are two
general types of options in the market:

(a) European option – typically can only be exercised at the end of the
contract period.

(b) American option – typically can be exercised during the contract

period.

(c) Since the European option provides less versatility to the investor,
the European option will usually sell at a discount to an American
option with similar characteristics. Therefore the Black-Scholes
model is usually seen as setting the low end of the range for the
DLOM.

(d) The Black-Scholes model has the following inputs:

 Current stock price

 Exercise price

 Risk-free rate

 Time to expiration

 Stock volatility

(2) Example: A valuer is appraising ABC Company, a closely-held software

development firm that generates $110 million revenues. A control value
was determined at $210 million and the valuer needs to determine an
appropriate DLOM since he is valuing a 5% interest (the other 95% is
owned by a sole controlling shareholder).

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(a) The valuer first determined a volatility by measuring the volatilities of

the guideline companies that were used in his market approach –
GPC methodology. Two of those GPC volatilities are shown below:

ABC Company
Guideline Company Volatility Data

CommVault Open Text

Closing Date P.P.S. Equity Volatility Closing Date P.P.S. Equity Volatility

12/1/2014 51.69 9% 12/1/2014 57.55 -1%

11/3/2014 47.3 6% 11/3/2014 58.4 7%
10/1/2014 44.34 -13% 10/1/2014 54.291 -1%
9/2/2014 50.4 -9% 9/2/2014 54.587 -1%
8/1/2014 55.14 14% 8/1/2014 55.384 1%
7/1/2014 48.02 -2% 7/1/2014 54.644 15%
6/2/2014 49.17 1% 6/2/2014 47.074 3%
5/1/2014 48.92 1% 5/1/2014 45.748 -5%
4/1/2014 48.4 -29% 4/1/2014 48.273 3%
3/3/2014 64.95 -6% 3/3/2014 46.678 -7%
2/3/2014 68.88 0% 2/3/2014 49.868 3%
1/2/2014 69.07 -8% 1/2/2014 48.238 7%
12/2/2013 74.86 0% 12/2/2013 44.853 7%
11/1/2013 74.85 -4% 11/1/2013 41.795 16%
10/1/2013 78.08 -12% 10/1/2013 35.646 -2%
9/3/2013 87.92 5% 9/3/2013 36.283 8%
8/1/2013 83.83 -1% 8/1/2013 33.391 -2%
7/1/2013 84.4 11% 7/1/2013 34.132 3%
6/3/2013 75.89 8% 6/3/2013 33.135 1%
5/1/2013 70.06 -5% 5/1/2013 32.889 4%
4/1/2013 73.54 -11% 4/1/2013 31.505 10%
3/1/2013 81.98 10% 3/1/2013 28.436 7%
2/1/2013 73.95 -4% 2/1/2013 26.48 -6%
1/2/2013 76.73 10% 1/2/2013 28.113 4%
12/3/2012 69.66 5% 12/3/2012 26.928 -3%
11/1/2012 66.36 6% 11/1/2012 27.661 6%
10/1/2012 62.37 6% 10/1/2012 25.994 -2%
9/4/2012 58.66 15% 9/4/2012 26.567 2%
8/1/2012 50.42 4% 8/1/2012 25.921 18%
7/2/2012 48.52 -2% 7/2/2012 21.681 -10%
6/1/2012 49.57 6% 6/1/2012 24.042 3%
5/1/2012 46.87 -11% 5/1/2012 23.295 -15%
4/2/2012 52.07 5% 4/2/2012 26.976 -9%
3/1/2012 49.64 -4% 3/1/2012 29.467 0%
2/1/2012 51.57 9% 2/1/2012 29.448 19%
1/3/2012 47 1/3/2012 24.423

Std Dev. 9.2% Std Dev. 7.6%

Volatility 31.7% Volatility 26.4%

Average Volatility 29.1%

Median Volatility 29.1%

(b) Since the subject company is private, the stock’s volatility cannot be
directly observed. In a real case, the above example would include

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

the volatilities for a larger group of publicly held software firms. In

the above data, the standard deviation is measured across all the
data points and the annual volatility equals the standard deviation
times SQRT(12) – this is necessary to convert the monthly
measurement to an annual measurement.

(c) The current price and exercise price are set at the same value which
would equal the appraised value of the stock after a discount for lack
of control is taken, if necessary.

(d) The risk-free rate is set at the yield on long-term Treasuries at the
valuation date. The term of the Treasuries should match the time to
expiration in the model. The time to expiration should match the
expected holding period of the stock.

ABC Company
Valuation of Put Option - Marketability Discount

Class per share - net of minority discount $ 210,000,000 INPUT - current value
Put Price 210,000,000 INPUT - current value
Euler's Constant 2.7183
Annual Risk-Free Rate 2.31% INPUT - 20-yr Treasury Rate
Years to Exit 20.00 INPUT - expected holding period
Annual Deviation 0.291 INPUT - Volatility from GPCs

d1 = 1.00570 N(-d1) = 0.1573

d2 = (0.29569) N(-d2) = 0.6163

Value per Put Option $ 48,506,249

Implied DLOM (48.5/210) 23.1%

(e) In the above case, the indicated DLOM is 23.1% given the
parameters, which is a 20-year time period and a volatility of 29.1%.
The DLOM is determined by dividing the option price of $48.5 million
into the value of the company on a minority-marketable level at $210
million. Theoretically, the $48.5 million is the amount an investor
would be willing to pay to avoid illiquidity over the twenty year time
period.

(f) The model is very sensitive to the volatility measure. If the volatility
were increased to 0.40 (with all other variables remaining the same)
the DLOM increases to 34.0%. If it is decreased to 0.20, the DLOM
declines to 13.0%.

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(g) The model is less sensitive to the time to expiration variable. If the
time period is extended to 30 years, the DLOM increases to 21.2%.
If it is decreased to 10 years, the DLOM decreases to 22.4%.

(h) There is a relationship in the model between holding period and

volatility.

(i) The example above replicates what Chaffe presented in his original
1993 paper. The Black-Scholes model though, as discussed,
assumes a European style option and therefore is not the best
model to use which mimics the conditions of liquidity in closely-held
stock. Chaffe suggests that closely-held stock should have, at a
minimum, a 50% volatility variable. In the above case this would set
the DLOM at 42.3%.

(j) The Black-Scholes model has become a common quantitative tool to

measure the DLOM due to its simplicity relative to other option
models and its availability.

E. Asian Options

(1) Asian options have a payoff that is determined based on an average

price over the term of the contract. The cost of an Asian option is
typically less since the volatility factor is somewhat mitigated by taking
an average price.

(2) John Finnerty, a Professor if Finance at Fordham University, continued

the research of Francis Longstaff but replaced the perfect-timing
element of Longstaff’s “lookback” option with an Asian option in which
the payoff is set at the average price.4 The Finnerty option model yields
the following results over short holding periods

(a) The discounts in the Table below are relatively lower due to the
shorter holding periods. In practice many industries and guideline
public companies would have volatility rates at least in the 20% to
30% range during normal times. This suggests DLOMs above
25.0% when longer holding periods are considered.

4
John Finnerty, Ph.D., “Using Put Option-Based DLOM Models to Estimate Discounts for Lack of
Marketability”, Business Valuation Review, Winter, 2013.

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

John Finnerty
Percentage Discounts for Lack of Marketability

Restriction STANDARD DEVIATION

Period 0.10 0.2 0.3

90 days 2.30% 5.70% 8.50%

180 days 3.30% 8.00% 11.90%
270 days 4.00% 9.80% 14.40%
1 year 4.60% 11.20% 16.30%
2 years 6.50% 15.50% 21.80%
3 years 7.50% 18.50% 25.30%
4 years 9.10% 20.90% 27.50%

(b) Researchers have found that the results of Finnerty’s Asian Put
model more closely mimic results from the Stout Restricted Stock
Studies which are discussed below.

(c) Despite the likelihood that Asian Put Models are more appropriate
tools to measure the DLOM, the traditional Black-Scholes Model has
retained a great deal of popularity, probably due to its easy
availability and the fact that it is part of mainstream business school
education.

F. Long-Term Equity Anticipation Securities (LEAPs)

(1) A LEAP is a derivative in public companies in which an investor can

ensure protection against a price decline by purchasing a long-term
contract which locks in a price. LEAPs contracts have been
continuously studied by Robert Trout, Ph.D. (in the initial study) and
Ronald Seaman, ASA (in subsequent studies).

(2) Seaman’s studies between 2006 and 2013 stratified the companies by
market size, risk, profitability, growth and dividend yield and found that
the size of the implied DLOM increased with smaller size, higher beta,
lower growth and lower profitabilty.

(3) Four of the Seaman studies are summarized below in which LEAPs in
public companies are stratified by risk (as measure by beta) and size (as
measured by revenue). Size as measured by revenues has a strong
impact on the prices paid in the market for LEAPs.

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LEAPS Study - 2009

Implied DLOM on LEAPS by Beta
2009 LEAPS Implied DLOM
Beta Average Median
0.6 to .80 14.00% 12.40%
0.9 to 1.1 16.50% 14.30%
1.2 to 1.4 19.20% 17.30%
1.5 to 1.7 21.50% 19.60%
above 1.8 24.40% 23.00%
Ronald Seaman, FASA
Source, BVR, Spring 2008

LEAPS Study - 2011

Implied DLOM on LEAPS by Revenue
2011 LEAPS Implied DLOM
Revenues Average Median
Above $10b 37.10% 35.00%
$1b to $10b 43.90% 41.40%
Under $500m 53.70% 50.10%
Under $100m 64.60% 61.50%
Source, BVR, Spring 2008

LEAPS Study - 2013

Implied DLOM on LEAPS by Revenue
LEAPS due in 14 months (2014)
2014 LEAPs Implied DLOM
Avg Revenue (mil) Average Median
$ 67,964 14.60% 13.00%
13,060 14.90% 13.70%
5,091 18.10% 16.50%
1,815 22.00% 18.20%
332 31.00% 26.20%
Ronald Seaman, FASA
Source, BVR, September, 2013

LEAP Study - 2013

Implied DLOM on LEAPS by Revenue
LEAPS due in 26 months (2015)
2015 LEAPs Implied DLOM
Avg Revenue (mil) Average Median
$ 72,686 21.30% 19.30%
14,582 22.20% 20.70%
5,746 25.80% 23.80%
2,057 32.70% 26.70%
379 44.50% 37.20%
Source, BVR, September, 2013

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

(4) Both the LEAPs issued in 2008 and 2013 that are stratified by revenue
show that the smallest revenue size category reflects an implied DLOM
that is approximately double the largest size category.

(5) The implied DLOM data based on LEAPs is also sensitive to time since
the price of LEAPs as a percentage of the company’s stock can change
depending on market movements, industry and company developments.
The Table below shows the results from a study Seaman conducted in
which LEAPs’ implied DLOMS changed throughout the year 2010.

LEAPS STUDY - 2013

Volatility in Implied DLOMS
2010 BP CAL GPS KBR MYGN
January 17.6% 29.4% 19.5% 23.3% 25.5%
February 18.6% 31.1% 18.8% 23.3% 27.8%
March 16.9% 29.0% 17.2% 20.6% 23.8%
April 16.3% 27.1% 15.6% 20.3% 23.1%
May 19.7% 31.1% 19.8% 21.6% 24.8%
June 28.5% 29.0% 18.8% 21.2% 23.6%
July 24.1% 29.3% 19.6% 20.8% 22.5%
August 19.5% 27.5% 18.6% 20.2% 23.4%
September 22.4% 25.3% 17.3% 19.0% 24.9%
Notes: BP = British Petroleum; CAL = Continential Airlines; GPS = GAP, Inc.;
KBR - KBR, Inc.; MYGN = Myriad Genetics
Excerpted from Ron Seaman 2010 LEAPS Study
BVR, January, 2011

(a) The valuer should match her support data for the DLOM to the
valuation date since the underlying data will change. In the example
above, BP’s LEAP prices and stock price changed after the Gulf of
Mexico oil spill which began in April of 2010. In each case shown
above though, the implied DLOMs showed material change over a
ten-month period.

G. Critique of Using Option Models to Measure the DLOM

(1) Some of the option models yield unrealistic DLOMs at the upper range
of volatility.

(2) Option models were never derived to price illiquidity in closely-held

companies. They are derivatives in which investors are trying to make a
profit based on assumptions about the future price of a stock.
Therefore, the assumption that the price of an option represents an
investor’s quantification of closely-held illiquidity may not always be the
case.

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

(3) Option models are seen by novices as being a more reliable and
objective source for the DLOM since it is a quantification. In reality, the
valuer can exert significant influence over the outcome of the option
calculation, especially in the quantification of volatility which, for private
companies, depends on which GPCs are included. By editing the list of
GPCs the valuer can influence the most sensitive variable.

(4) The model has weaknesses: for example an illiquid investment with no
volatility would have no DLOM according to the model. There is also no
variation according to the size of the holding in the private company.

3. Initial Public Offering Studies

A. An initial public offering occurs when a closely-held company is listed on a

public exchange for the first time. Before the offering, underwriters value the
stock and negotiate an offering price. Usually much of the stock is acquired at
the outset by institutional investors and very few shares are available for
purchase by individuals. However, once public, the stock price is subject to
market forces.

In the U.S. private companies that plan to go public must first register their
stock (on the Form S-1) with the Securities and Exchange Commission (SEC).
This document provides extensive information on the company’s history,
industry, financial statements, management, etc. The company must also
provide details on all private transactions of its stock that occurred in the three
year before the IPO.

The pre-IPO Studies that are discussed in this section observe the potential
DLOM by measuring the difference between the price of the stock in the
company transactions before going public and the IPO price, with the former
being the illiquid value and the latter being the liquid value.

Several institutions have conducted periodic pre-IPO studies over the years.
Some of the more often cited entities include the following:

(1) Willamette Management Associates pre-IPO Studies

(a) Willamette Management Associates conducted studies between

1975 and 2000. WMA included transactions for a full three years
before the IPO and they adjusted for significant differences in the
company between the pre-IPO transaction and the IPO date.

(b) The WMA Studies are summarized below:

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

Willamette Management Pre-IPO Studies

Time # of # of Mean Median
Period Prospectuses Transactions DLOM DLOM

1975-78 17 31 34.0% 52.5%

1979 9 17 55.6% 62.7%
1980-82 58 113 48.0% 56.5%
1983 85 214 50.1% 60.7%
1984 20 33 43.2% 73.1%
1985 18 25 41.3% 42.6%
1986 47 74 38.5% 47.4%
1987 25 40 36.9% 43.8%
1988 13 19 41.5% 51.8%
1989 9 19 47.3% 50.3%
1990 17 23 30.5% 48.5%
1991 27 34 24.2% 31.8%
1992 36 75 41.9% 51.7%
1993 51 110 46.9% 53.3%
1994 31 48 31.9% 42.0%
1995 42 66 32.2% 58.7%
1996 17 22 31.5% 44.3%
1997 34 44 28.4% 35.2%
1998 14 21 35.0% 49.4%
1999 22 28 26.4% 27.7%
2000 13 15 18.0% 31.9%

(c) As seen in the Table above, the mean DLOMs tend to understate
the median DLOMs indicating that the dispersion of data may be
high. This would lessen confidence in a reliance on the mean or the
median as a representative DLOM.

(d) There has been a tendency among practitioners to gravitate toward

a central tendency statistic when citing support for the DLOM since
that is less time consuming. However, the above data does not
support using an average or median. Over the years studied, the
mean ranged from 18.0% in 2000 to 55.6% in 1979 and the median
ranges from 27.7% in 1999 to 73.1% in 1984. There also is no trend
upward or downward over time.

(e) The above data suggests little more than the likelihood that a DLOM
does exist for closely-held companies. The amount of the DLOM
though will rely on the valuer placing the subject company’s
characteristics among the range of data points in these studies.

(2) John Emory Studies

(a) John Emory conducted pre-IPO studies for twenty years between
1980 and 2000.

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(b) The studies look at transactions that occurred within five months of
the IPO.

(c) The results of his studies are shown in the Table below:

John Emory Pre-IPO Studies

Time # of # of Mean Median
Period Prospectuses Transactions DLOM DLOM

1980-81 97 12 59.0% 68.0%

1985-86 130 19 43.0% 43.0%
1987-89 98 21 38.0% 43.0%
1989-90 157 17 46.0% 40.0%
1990-91 266 30 34.0% 33.0%
1992-93 443 49 45.0% 43.0%
1994-95 318 45 45.0% 47.0%
1995-97 732 84 43.0% 41.0%
1997-00 1,847 266 50.0% 52.0%
John D. Emory, Emory & Co. Milwaukee, Wisconsin

(3) Valuation Advisors Lack of Marketability Discount Study

(a) The Valuation Advisors Studies provide a searchable database of

pre-IPO transactions going back to 1985. The database is available
via a subscription from www.bvresources.com. The Valuation
Advisors Studies have the following criteria:

 Includes studies back three years from the IPO

 Includes insider transactions

 Does not make adjustments for material events

 The IPO price is the initial price set; it is not adjusted for
fluctuations later in the initial trading day or weeks of
trading.

 Covers 13,300 transactions which are searchable by SIC

and NAICS codes, revenues, asset size, operating
income, time period and type of security.

 The transaction database includes deals from 28

countries outside the U.S.

(b) A summary of the Valuation Advisors studies from 1985 is shown

below:

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

Valuation Advisors Pre-IPO Studies

Time Period Prior to IPO Number of
Year 0 - 3 mos. 4 - 6 mos. 7 -9 mos. 10 - 12 mos. 1 - 2 years Transactions
1995 37.82% 28.62% 60.40% 50.33% 60.64% 34
1996 30.83% 52.97% 56.37% 69.38% 71.81% 270
1997 34.18% 50.00% 67.12% 76.01% 80.00% 212
1998 23.35% 46.67% 68.93% 71.41% 71.91% 212
1999 30.77% 53.89% 75.00% 76.92% 82.00% 694
2000 28.70% 45.08% 61.51% 68.92% 76.64% 453
2001 14.74% 33.17% 33.38% 52.06% 51.61% 115
2002 6.15% 17.33% 21.88% 39.51% 55.00% 81
2003 28.77% 22.30% 38.36% 39.71% 61.37% 123
2004 16.67% 22.68% 40.00% 56.25% 57.86% 334
2005 14.75% 26.10% 41.68% 46.11% 45.45% 296
2006 23.47% 20.69% 40.23% 46.51% 56.27% 264
2007 12.67% 32.55% 43.69% 56.00% 54.17% 459
2008 20.00% 24.21% 45.85% 52.17% 41.18% 41
2009 6.16% 31.85% 26.82% 41.00% 34.87% 108
2010 15.81% 29.89% 44.42% 47.54% 51.88% 358
2011 23.27% 34.62% 43.26% 50.78% 62.10% 281
2012 18.86% 24.07% 28.90% 35.48% 44.78% 3
AVG - All 21.50% 33.15% 46.54% 54.23% 58.86%
AVG - 2008-12 16.82% 28.93% 37.85% 45.39% 46.96%
Source: Valuation Advisors Pre-IPO Study, BV Resources, Inc.

 As is shown, the discounts generally appear to increase

in size the further back from the IPO date. This makes
intuitive sense since the closer the investor is to the IPO,
the more likely she will know that an IPO, a liquidity
event, is imminent.

 The implied DLOMs appear to have declined over the five

years between 2008 and 2012 at least in terms of
averages. These averages are slightly skewed by 2012
which only has three data points.

(c) Example

 A valuer has a software publishing company for which he

is trying to determine a DLOM. He searched the
Valuation Advisors Lack of Marketability Study on
www.bvresources.com. He limited his search to NAICS
code 511210 which is the industry code for software
publishing. He also limited the search to deals between
2010 and 2017 and limited the revenue size to between
$0 and $250,000,000. The search results yielded 520
pre-IPO transactions with the following metrics:

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

Valuation Advisors Pre-IPO Studies

Software Publishers
Search Results
# deals Mean Median
IPO price per share 520 $ 15.13 $ 15.00
Transaction price per share 520 $ 8.40 $ 7.89
DLOM for pre-IPO <= 2 years 367 31.7% 32.7%
DLOM for pre-IPO > 2 years 153 66.3% 76.3%
source: www.bvresources.com

 The search results show the mean and median IPO price
and pre-IPO transaction price for the 520 transactions in
the subset given the parameters entered by the valuer.
The results separate the deals into transactions that
occurred less than two years before the IPO and greater
than two years before the IPO. There is clearly a
material difference between the less than and greater
than two-year window.

 The pre-IPO studies have historically suggested DLOMs

higher than the restricted stock studies which are
discussed below.

(d) Typically the valuer will not search all transactions in the database.
He will extract the transactions that are most relevant to his subject
based on the industry and operating metrics in the Study.

B. Critique of the pre-IPO Studies

(1) The IPO prices in the first day of trading on which some of the studies
are based often overstate the value of the stock relevant to the
stabilized price that the market sees weeks or months after the IPO.
Since the IPO price on the first day or week of trading is often higher
than the stabilized price then the inferred DLOM may be overstated.

(2) The market tends to know which companies are in the pipeline to go
public for some time before the actual IPO. Therefore ‘private’
transactions actually anticipate a liquidity event (the IPO) and therefore
the values in those transactions are overstated. This mau understate
the inferred DLOM.

(3) The Studies may not account for the time difference between the private
transaction and the IPO, which could be more than a year. With longer
periods of time, operational differences may explain the price differential
rather than illiquidity.

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

(4) There may be a success bias in the data. Only the successful IPOs are
included in the studies for obvious reasons. By excluding the the
companies that planned IPOs but did not proceed, the critique is that the
IPO side of the calculations may be overstated and the implied DLOMs
may be overstated.

(5) Some of the pre-IPO transactions are related party deals. These may
not be reflective of market value.

4. Restricted Stock Studies

A. Restricted stock is a security which is commonly used in the United States

either in an acquisition or as a form of compensation. The term ‘restricted
stock’ refers to unregistered stock of a public company. This stock is usually
given to company officers, directors or to the former owners of an acquired
company.

(1) Restricted stock in publicly-held companies is registered under Rule 144

of the U.S. Securities and Exchange Commission (SEC). It is restricted
from trading in the market during a vesting period.

(a) Company officers may receive restricted stock as a form of

compensation. It is also often used as part of a purchase price in a
transaction. Instead of an all-cash purchase price, a selling
shareholder may receive restricted stock to incentivize her to
enhance the value of the acquiring firm.

(b) As of 2017, the holding period lasts six months under Rule 144.
Historically, the holding period was longer. Prior to 1997, the
holding period under the law was two years. Between 1997 and
2008, the holding period was one year. It was shortened to six
months after February of 2008.

(c) Public companies which issue restricted stock therefore have both a
freely-traded security (i.e. their common shares that are traded on
the market) and a non-marketable security (i.e. the restricted stock).

(d) There are limited circumstances under which restricted stock can be
traded, even during the vesting periods. When these trades occur,
the parties must report the terms of the transaction to the SEC,
which makes the data available to the public.

 Trades of restricted stock therefore present an

opportunity to measure illiquidity since the buyer of
restricted stock is acquiring a stock that still has a
restriction period. By comparing the transaction price to

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

the price of the freely-traded stock in the same company,

the valuer can observe an implied DLOM.

(e) Example:

Restricted stock example

Public company ABC price per share = $ 12.00

ABC restricted stock trade = 9.00

Implied DLOM = [1 - ($9.00/$12.00)] 25.0%

 In the example above, the difference between the freely

traded price and the restricted price is a proxy for the
illiquidity that the valuer is trying to measure in the
closely-held market. In this case, the implied DLOM is
25.0%.

(f) Numerous studies have been conducted on restricted stock trades

over the past 50 years. A summary of the early studies is shown
below.

 Practitioners tended to draw simple conclusions from

these studies, some of which were erroneous.

 One assumption has been that the discounts appear to

decline over the years which is commensurate with the
decline in the holding period from two years to one year.

 Another assumption is that the data indicates that a

discount for lack of marketability should at least be in the
35% range. Even though the Studies’ discounts declined
to the 13% to 20% range by the late 1990s, the
assumption was that since a closely-held company has,
at the very least, a much longer non-marketable period,
then the DLOM should still be at least in the 35.0%
range. This assumption is based on the results of the
original studies in the 1960s and 1970s when the
discounts were higher with the longer holding periods.

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

Restricted Stock Studies Time Number Average

Summary of Pre-2000 Research Period of Deals DLOM

SEC Overall Average 1966-69 398 25.8%

SEC non-reporting OTC companies 1966-69 32.6%
Gelman Study 1968-70 89 33.0%
Trout Study 1968-72 60 33.5%
Moroney Study 1991-99 148 35.6%
Maher Study 1969-73 33 35.4%
Standard Research Consultants Study 1978-82 28 45.0%
Willamette Management Associates Study 1981-84 31.2%
Silber Study 1981-88 69 33.8%
Management Planning, Inc. Study 1980-96 53 27.1%
FMV Opinions, Inc. Study 1979-97 253 23.0%
Bruce Johnson Study 1991-95 70 20.0%
Columbia Financial Advisors Study (1) 1996-97 23 21.0%
Columbia Financial Advisors Study (2) 1997-98 15 13.0%
Source: Pratt, Reilly and Schweihs, Valuing a Business ,5th Edition

B. Restricted Stock Data after 2000

(1) China’s Split Stock Studies

(a) China used to have a split share system similar to restricted stock in
the U.S. in which companies had one class of stock trading on a
public exchange and another class of stock that could not trade that
was held by governments and institutions. Similar to U.S. restricted
stock, the Chinese private stock sometimes traded in an auction
market.

 Both classes of stock had the same voting rights and

dividend rights.

 Prior to 2005, the non-tradable shares accounted for two-

thirds of the Chinese market.

(b) Prior to 2005, the observed discounts in this market were in the
77.9% to 85.6% range.

(2) Canadian Studies

(a) Canada has non-tradable shares similar to the U.S. In 2001, Canada
shortened its holding period from 12 months to 4 months. The
implied DLOM declined from 19.0% to 8.25%.

(3) Stout Restricted Stock Study (Stout Study)

(a) The Stout Restricted Stock Study (formerly known as the FMV
Opinions Study) has analyzed 784 transactions of restricted stock

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

since 1980. The research is conducted by the financial services

firm, Stout Risius Ross, LLC (“Stout”) in conjunction with BV
Resources, Inc. (BVR). This database is available from BVR at the
following site:

www.bvresources.com

(b) To be included in the Stout Study, the transaction must meet strict
selection criteria which eliminate about 95% of the potential
transactions over time. Private placements of restricted stock are
eliminated from the Stout Study for the following reasons:

 The transaction included debt, preferred stock or a hybrid

security

 The transaction had warrants attached

 The transaction did not close

 The related stock was not a U.S. company

 The related stock traded below $1.00 per share

 There was information missing from the deal terms

 There was an ulterior strategic motivation for the deal

 The deal involved related parties

(c) The remaining 784 transactions analyzed in the Stout Study and
discussed in this course occurred between 1980 and 2016. One
premise of the Stout Study is that the mean or median discounts, if
relevant to a subject company, will possibly understate the real
DLOM relevant to the subject since the liquidity characteristics of a
private placement of restricted stock differ greatly from the liquidity
characteristics of a subject closely-held company.

 Therefore additional steps should be considered to

account for the additional illiquidity of the subject.

(d) A summary of the Stout Study transactions over the past 36 years is
shown below:

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

Stout Restricted Stock Study

2017 Transaction Summary

Statistic Count Range Mean Median

Transaction Date 784 7/1/1980 - 10/7/2016 N/A N/A
Total Revenues ($000s) 784 $0 - $14,255,000 $119,101 $15,008
Total Assets ($000s) 784 $0 - $39,261,000 $355,647 $33,059
Market Value ($000s) 784 $2,020 - $7,784,015 $226,667 $89,499
Book Value ($000s) 784 ($159,997) - $4,583,000 $68,662 $13,369
MTB Ratio 784 -26,067.19 - 2,428.69 -58.02 4.01
Transaction Discount 784 -1.289 19.10% 14.80%
EBIT Margin 693 -123,181.5% - 309.1% -844.20% -14.80%
Net Profit Margin 731 -136,403.7% - 536.4% -803.20% -12.70%
Volatility 755 2.8% - 2,024.7% 88.40% 74.50%
Z-Score 643 -1,227.33 - 14,135.33 165.03 4.62
VIX (Volatility Index) 710 11.20 - 51.89 19.41 17.81
Source: www.bvresources.com

(e) The average implied DLOM during all the years is 19.1% and the
median is 14.80%.

(f) The objective of the Stout Study is to help the valuer identify a
subset of transactions that identify with the subject company more
closely and also to measure a potential premium above the implied
discount to account for differences between the subject company
and the securities in the Study. Under the Stout Study, the
determination of the DLOM involves a three-step process:

Stout Restricted Stock Study Process

Determine Restricted Stock

Step 1.
Equivalent Discount (RSED)

Adjust RSED for Market

Step 2.
Volatility

Adjust for Privately-Held Entity

Step 3.
Illiquidity

 Step 1. Determine the RSED – After identifying the most

relevant metrics for comparison to the subject company,
the valuer searches the Stout database and derives the
initial DLOM based on restricted stock discounts. The
valuer has options for creating a subset of transactions

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

that best represents his subject stock. Rather than taking

a central tendency discount such as the 19.81% or the
14.8%, the following characteristics are suggested for
comparison:
 Market value
 Revenue size
 Total assets
 Book value
 Market to book ratio
 Profit margin

 Stout recommends that the industry not be used as a

point of comparison

 Researchers have found that larger blocks of restricted

shares require larger discounts due to the limitations on
selling restricted stock and the market’s demand for
larger blocks.

Block Size and Discounts

39.20%
40.00%
33.20%
35.00%

30.00%

25.00% 20.20%
20.00% 15.60%
15.00%
15.00%

10.00%

5.00%

0.00%
0 - 10% 10- 20% 20 - 30% 30 - 40% > 40%

Source: www.bvresources.com

 Step 2. Adjust RSED for market volatility. The DLOM will

be higher if the valuation date falls during a period of
higher market volatility.

 The Stout Study uses the VIX which is the ticker

symbol for the Chicago Options Board Volatility
Index. Stout assigns a multiplier for the relative

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

volatility of historical markets. If the valuation

date falls within a period of relatively higher
volatility then a higher multiplier would be applied
to the DLOM determined in Step 1 above.

 Stout recommends comparing the six-month

trailing average VIX at the valuation date to the
baseline VIX metrics in the Study. If the six-
month trailing VIX is higher, then an adjustment is
warranted. See baseline VIX metrics below.

The volatility issue picks up on one of the material

variables in the option pricing models discussed above.
In the options models, the more volatile the underlying
stock (or the underlying stock of the guideline
companies), the higher the DLOM.

Stout Restricted Stock Study

Multiplicative Adjustment Factors for Volatility

VIX Percentile Median Multiplicative

Group VIX Range Adjustment Factor
0 -60th 11.2 - 23.1 1.00
60 - 80th 23.1 - 25.2 1.16
80 - 100th 25.2 - 32.9 1.23
Source: www.bvresources.com
Stout Restricted Stock Study

 Step 3. Adjust for privately-held equity status – Stout links

the liquidity of closely-held companies with that of larger
blocks of restricted stock in the public market and applies
a multiplier to Step 2 based on historical observations of
the discounts for large blocks of stock.

 When this multiplier is applied, the relevant

discount is brought closer to what a closely-held
company would experience.

 Stout recommends using an adjustment for the

large blocks of stock above 30.0% to 40.0% to
equate the relative illiquidity of the private
placements of large blocks of restricted stock to
closely held companies.

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

 The median adjustment factor for block sizes of

30% to 50% of total shares outstanding falls in the
range of 1.70x to 1.80x.

(g) Example

 In the example below, the valuer selected four variables

to isolate a restricted stock equivalent discount: market
value, market to book ratio, total assets and operating
margin. Four searches were conducted on the total
database of 784 transactions which inserted the criteria
for each of these metrics, plus the requirement that the
block size of the private placements not exceed 30%.

STOUT RESTRICTED STOCK STUDY ANALYSIS

Company # Stout Study Weighted

Financial Characteristic Metric Block Size Transactions Median DLOM Weight Values

Market Value $100m - $500m < 30.0% 280 10.9% 40.0% 0.0436
Market to Book Ratio 4.0 - 6.0 < 30.0% 87 14.3% 10.0% 0.0143
Total Assets $25m - $75m < 30.0% 184 12.8% 40.0% 0.0512
Operating Margin 15.0% - 35.0% < 30.0% 57 10.3% 10.0% 0.0103

Restricted Stock Equivalent Discount = 11.94%

Volatility Adjustment Factor 1.00

Private Equity Equivalent Discount = 11.94%

Private Equity Discount Factor 1.79

Indicated DLOM 21.37%

 The valuer placed heavier weight on the operating

variables that had more transactions (market value and
total assets). The weighted restricted stock equivalent
discount is 11.94%.

 The valuer did not adjust the restricted stock equivalent

discount because the volatility factor at the valuation date
which was 13.66 (in this case assume December 31,
2016) fell into the baseline volatility category which is
11.2 to 23.1 (see data above).

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

CBOE Volatility
Index®
VIX®
1-Jul-2016 14.77
5-Jul-2016 15.58
6-Jul-2016 14.96
7-Jul-2016 14.76
8-Jul-2016 13.20
11-Jul-2016 13.54

22-Dec-2016 11.43
23-Dec-2016 11.44
27-Dec-2016 11.99
28-Dec-2016 12.95
29-Dec-2016 13.37
30-Dec-2016 14.04

Average VIX = 13.66

 Finally, the valuer applied a 1.79 private equity

adjustment to arrive at a discount for lack of marketability
equal to 21.37%.

C. Critiques of Restricted Stock Studies

(1) Restricted stock studies, especially prior to 2000, published only central
tendency data which were then applied by valuers as the default DLOM.
Many practitioners either did not acquire access to the data in the Study
or were deprived of the data (the ubiquitous 35% discount). The reality
is that the dispersion of the data in the studies is quite wide which
suggests that a mean or median DLOM is not relevant.

(2) Restricted stock is not the same as closely-held stock. Among other
differences, the holding periods are different and it is difficult to
extrapolate from one to the other. The assumption that a private
placement of a restricted stock presents a floor for the measurement of
the DLOM (i.e., the DLOM must be higher than 20.89% since closely-
held stock has a holding period longer than 6 months) may be true but
there is no empirical research which proves this.

(3) The assumption is that the difference between the stock trading price
and the restricted stock transaction is entirely due to a lack of
marketability. Research shows that other factors such as volatility may
influence the discount.

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

(4) In the Stout Study the assumption that block size in the public market is
a valid proxy for the relevant marketability of the closely-held market has
not been proven.

5. Sanity Check

A. It is important for the valuer to maintain a skeptical perspective while using the
models and studies described above to arrive at the DLOM. It is easy to get so
immersed in the data that the valuer forgets that the DLOM is measuring a loss
in cash value to the minority investor.

B. A rule of thumb sanity check is to conduct an internal rate of return analysis by

determining what the required rate of return would be with the minority value set
to equal the original cash flows. The valuer can then evaluate if the revised
rate of return is appropriate to a minority investor contemplating the control
cash flows.

C. This calculation can be determined using the Goal/Seek function in Excel

(Under the Data tab, go to the What If option).

(1) Three inputs are required using Goal/Seek.

(a) Set cell – enter the cell reference which contains the concluded
market value in the internal rate of return DCF

(b) To Value – enter the fully discounted concluded market value from
the original DCF.

(c) By changing cell – enter the cell that contains the cost of equity
(required rate of return) in the internal rate of return DCF.

D. Example – A valuer conducted a DCF analysis and arrived at a ‘control’ value

of €58.37 million for a subject company using a 17.1% required rate of return.

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

Sanity Check on DLOM

Internal Rate of Return Analysis - Base Case DCF
Assumptions
Beta 1.20
Risk-Free Rate 1.9%
Market Risk Premium 5.0%
Size Risk Premium 6.2%
Specific Risk Premium 3.0%
Perpetuity Growth Rate 3.0%
Tax Rate 35.0%
Cost of Equity 17.1%

Market Value, Equity € 58,373,388

Less: DLOM at 40.0% (23,349,355)
Market Value, Equity € 35,024,033

2018 2019 2020 2021 2022 Residual

Equity Cash Flow € 6,250,000 € 7,115,000 € 7,835,000 € 8,160,000 € 9,050,000 € 9,321,500

Cost of Equity 17.1% 17.1% 17.1% 17.1% 17.1% 17.1%

Cash Flow in Period 100.00%

Period to Discount 0.50 1.50 2.50 3.50 4.50
PV of Free Cash Flow € 5,776,070 € 5,616,067 € 5,282,035 € 4,698,480 € 4,450,622

Perpetuity Value at start of Year 6 € 66,188,166

PV of Perpetuity € 32,550,112

(1) The valuer applied a 40% DLOM based loosely on an overview of the
models and studies which discuss lack of marketability.

(2) The resultant minority, non-marketable value equals €35,024,033.

(3) The valuer wants to know what the implied cost of equity would be with
the same projected cash flows and a value of €35,024,033 and uses an
internal rate of return analysis to get the answer.

(4) In this case the valuer uses the Goal/Seek function in excel with the
following result:

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

Sanity Check on DLOM

Internal Rate of Return Analysis - Goal Seek Cost of Equity
Set cell D39
Cost of Equity using Goal Seek Function = 26.8% Equal to 35,024,033
By changing cell D37
Market Value, Equity € 35,024,033

2018 2019 2020 2021 2022 Perpetuity

Equity Cash Flow € 6,250,000 € 7,115,000 € 7,835,000 € 8,160,000 € 9,050,000 € 9,321,500

Cost of Equity 26.8% 26.8% 26.8% 26.8% 26.8% 26.8%

Cash Flow in Period 100.00%

Period to Discount 0.50 1.50 2.50 3.50 4.50
PV of Free Cash Flow € 5,551,045 € 4,984,931 € 4,330,247 € 3,557,569 € 3,112,442

Perpetuity Value at start of Year 6 € 39,218,272

PV of Perpetuity € 13,487,799

(5) The internal rate of return analysis above shows that the originally
forecasted cash flows would equal a net present value of €35.02 million
if the discount rate is 26.8%.

(a) The valuer needs to decide if the required rate of return of 26.8% is
reasonable given the circumstances of the subject company.

(6) A rule of thumb states that the required rate of return in the internal rate
of return analysis should not be more than 35% higher than the original
discount rate.

(a) In this case, the revised rate is 57% higher than the original rate
(26.8% versus 17.1%). The suggestion therefore is for the valuer to
revisit his assumptions in the 40% DLOM since the implied rate of
return is above a normal range of adjustment.

(b) It should be remembered that the 35% range is a rule of thumb and
does not apply to all situations. There are many reasons why a
minority investor may require a 40% or higher DLOM in this case.
For example, the projected returns may not apply to the minority
investor since the control shareholder aggrandizes them to himself,
such as in above-market rent and higher compensation.

(c) The valuer should though calculate the implied rate of return and be
able to defend why a minority investor would apply the return to the
actual projected cash flows.

E. Project Minority Cash Flows

(1) Another sanity check is to project minority cash flows if such information
can be reasonably obtained. The risk factor would be lower than in the

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above example since the risk of achieving minority cash flows is lower
than control cash flows. In some extreme cases, the minority investor
has no hope of receiving annual dividends and the valuer would have to
make an assumption when the company would be sold.

Section D. Chapter Review Questions

1. An assignment asks the valuer to determine a control value for a subject business. In
her income approach, the valuer discounted future earnings based on growth from
reported earnings. The valuer did not adjust for the fact that the company’s controlling
shareholder was overpaying himself by £1 million per year. What is the best course of
action for the valuer to take to determine an appropriate value given the level of value
requested?

A. Apply a control premium of 35%

B. Use a put option model to assess a DLOM

C. Redo the income approach after making the compensation adjustment

D. Use the IPO studies to determine a DLOC

2. A valuer is appraising a subject company in which there is one 95% shareholder and
one 5% shareholder. The company is highly profitable and has paid out dividends
each year to both shareholders in accordance with their respective ownership interests.
The assignment is to value the 5% interest. What is the best course of action?

A. Apply a DLOC and ignore a DLOM

B. Ignore the DLOC and apply a DLOM

C. Ignore both the DLOC and DLOM

D. Apply both the DLOC and DLOM

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 Chapter 1. Valuing Minority Interests iiBV 204: Advanced Topics in Business Valuation

3. A common critique of the IPO empirical studies is:

A. Investors will pay a premium over a normal closely-held value since they
anticipate the company going public. This understates the amount of the
implied DLOM

B. Restricted stock in a public company becomes liquid much sooner than closely-
held stock

C. Investors will pay a premium over a normal closely-held value since they
anticipate the company going public. This may overstate the amount of the
implied DLOM

D. IPO prices usually understate what the value of the public stock becomes after
it stabilizes. This may overstate the implied DLOM.

4. Which of the following statements best summarizes the research of Eric Nath?

A. Investors who buy put options are not seeking to avoid the disincentives of
owning minority interests. Therefore it is inappropriate to use put options to
measure DLOMS.

B. If there is a meaningful difference between the daily ‘minority’ trading prices of

stocks on public exchanges and the ‘control level’ value of those companies,
then there would be far more takeover transactions in which investors seek to
acquire that value.

C. Put options models such as Black-Scholes are inherently subjective since the
valuer has great leeway in assigning volatiltiy metrics. This undermines the
commonly held perception that put option models are more objective than
emprical studies.

D. Long term equity anticipation securities are a preferable way to deploy the
option concept since the stratification of implied discounts is already measured
by the market.

5. All of the following are ways to measure the DLOM, EXCEPT:

A. Restricted stock studies

B. Put options

C. Credit default swaps

D. IPO Studies

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Chapter 2. Valuing Early-Stage Companies

Section A. Introduction

This chapter provides an overview of the common techniques used to value securities
in companies before they reach mature stages of development. Early-stage
companies are characterized by a lack of revenues, lack of profits, and difficult-to-
predict commercial operations. In many cases traditional valuation approaches would
indicate that such companies have zero or little value. The framework of this chapter
relies on the accounting guidance under IFRS and GAAP which discusses how to
value share-based payments. The valuation methods used to value securities issued
as compensation are more specifically designed to measure the speculative
characteristics of early-stage companies.

There are two general concepts discussed in this Chapter: 1) assessing the entity
value of an early-stage company; and 2) assigning value to the typical equity and debt
securities that are found in early-stage companies.

1. Accounting Guidance

A. IFRS 2 - Share-based Payment

(1) IFRS 2 provides guidance for valuing shares issued as payment for
goods and services. The accounting standard does not specifically
address early-stage companies. Share-based payments are issued by
companies at all stages of development.

(a) Measurement is based either on the value of goods and services

received for the payment or, if such a measurement is not possible,
then based on the Fair Value of the equity instrument granted.

(b) Vested options are measured and recognized periodically over the
vesting period.

B. FASB ASC 718 – Stock Compensation

(1) ASC 718 provides the accounting guidance under GAAP for measuring
and recording stock options, warrants, and other share-based
payments. The guidance is generally the same as IFRS 2 with some
differences in how the values of the shares are recorded.

C. The objective of this chapter is not to study the specifics of accounting for
share-based payments. The objective is to reference the guidance for insight
into how early-stage entities can be valued.

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 Chapter 2. Valuing Early-Stage Companies iiBV 204: Advanced Topics in Business Valuation

(1) Early-stage companies rely heavily on share-based awards and

preferred stock to attract financing.

(2) There is a difference between valuing an early-stage entity and valuing

the individual securities within that entity. This difference is noted in the
different Fair Value definitions discussed below.

D. Definitions of Fair Value

(1) The accounting guidance under both IFRS and GAAP provide
alternative definitions of value when valuing securities of early-stage
companies. The definitions are similar and the guidance suggests that
there is significant overlap, but the valuer should be aware of the
difference.

(2) Fair Value defined under IFRS 13 and FASB ASC 820

(a) “the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the
measurement date.”

(3) Fair Value defined under IFRS 2

(a) “the amount for which an asset could be exchanged, a liability

settled, or an equity instrument granted could be exchanged,
between knowledgeable, willing parties in an arms-length
transaction.”

(4) Fair Value defined under ASC 718

(a) “the amount at which an asset (or liability) could be bought (or
incurred) or sold (or settled) in a current transaction between willing
parties, that is, other than in a forced or liquidation sale.”

(5) Fair Value under share-based payments are considered fair value-
based measurements as opposed to fair value measurements. An
example of this difference is provided in the GAAP guidance:

(a) When valuing restricted stock under IFRS 2 or ASC 820 the
restrictions on transfer of restricted stock to non-qualified buyers
would be considered in the valuation since the restriction would
carry over to market participants. This restriction would not be
considered under the share-based definition in ASC 718 since the
limited population of buyers is assumed to acquire the security.

(b) The concept of market participants under IFRS 13 and ASC 820 is
altered under IFRS 2

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 Chapter 2. Valuing Early-Stage Companies iiBV 204: Advanced Topics in Business Valuation

 Under IFRS 2 the valuer is concerned with the inside

investor(s) in the security, not the traditionally defined
market participant.

 The context of the valuation is the sale of the securities

within the enterprise, not the sale of the enterprise to a
market of willing and able buyers.

(6) There is significant overlap between the definitions and the general
concepts behind Fair Value under IFRS 13 generally apply to the
valuations of share-based payments.

Section B. Stages of Company Development

Six stages of company development are outlined below to provide a reference point for
the different types of financing which typically occur at each stage and the most
appropriate valuation methodologies that are used to measure the securities at each
stage. Depending on the industry and the economic environment, a subject company
may develop faster or slower than what is outlined below. Early-stage investors, which
include venture capital firms and private equity firms (other than company insiders),
typically plan for a liquidity event in a three to five year time frame after their
investment. The liquidity event could be an initial public offering, a strategic sale or a
financial sale. The common denominator is that the typical outside investors want to
get their money out of the investment within a defined time window. These stages of
development are not part of a defined body of knowledge; they are provided here for
reference only.

1. Stage 1 – Birth

A. The company exists as a business plan in its first stage of development.

Management is likely the originator of the product or idea and the company
likely has only a few other employees.

(1) Financing exists as seed capital from the founder(s), the founder(s)
friends and relatives and possibly a venture capital firm.

(2) Financing is in the form of common stock or a first round of preferred

stock.

2. Stage 2 – Infancy

A. The company has made progression in product development with investments

in production and personnel. Despite this the company is still not close to
commercialization. There are no revenues yet.

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 Chapter 2. Valuing Early-Stage Companies iiBV 204: Advanced Topics in Business Valuation

(1) A second and possibly third round of financing occurs at this level.

(2) Financing is mostly from venture capital firms and the successive
rounds are in preferred stock.

3. Stage 3 – Youth

A. The company has met milestones in its business plan and is on course to
commericalizing its product or service. Capacity has been developed with the
hiring of personnel and the development of productive assets. The company
has still not launched its product/service and no revenues have been recorded.

(1) Fourth, fifth and additional rounds of financing occur at this stage.

(2) Financing comes from venture capitalists and strategic business

partners through preferred stock.

4. Stage 4 – Commercialization

A. The company has launched its product/service and operations are underway
with the first revenue production. Additional milestones are met. The Company
is still recording losses as it gains market share.

(1) Mezzanine rounds of financing from venture capitalists and private

equity firms.

(2) Plans for an initial public offering begin at this stage.

5. Stage 5 – Profitability

A. The company achieves either its breakeven point or profitability.

(1) Additional financing would be in the form of common stock.

(2) A liquidity event such as an IPO or sale to a larger industry competitor

could occur. Preferred shares would convert to common upon certain
liquidity events, depending on the preferred rights.

6. Stage 6 – Stabilization

A. The company has establised a history of generating revenues and positive cash
flows.

(1) The company has the ability to finance operations internally. An IPO or
sale could occur at this stage. The company may remain private
according to the wishes of its common shareholders.

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 Chapter 2. Valuing Early-Stage Companies iiBV 204: Advanced Topics in Business Valuation

Section C. Characteristics of Early-Stage Companies

1. Business Plan

A. Stages 1 through 4 above normally constitute early-stage companies. If the

early-stage company is requesting a formal valuation, then it likely has a
business plan and has already reached several key objectives, or milestones in
that plan.

(1) Milestones

(a) Develop business plan with milestones and financing needed for
each stage of development

(b) Attract financing based on plan from arms-length investors

(c) Product or service viability – Product should be demonstrated as

workable and commercially viable

(d) Establish managerial staff and personnel

(e) Establish distribution network

(f) Obtain licensing (some approval processes, such as drug approval

in the U.S., are a multi-stage process which might have started
earlier in the business plan. For example, in the U.S. the process of
getting a drug approved by the U.S. Food and Drug Administration
can take 10-15 years from the initial lab testing to being approved for
sale.)

(g) Develop an operations plan for product manufacturing or service

refinement

(h) Establish sales network and customer base

(i) Achieve positive cash flow

(j) Liquidity event – Principal owners of early-stage companies usually

have set timelines for liquidating their positions. For both venture
capital and private equity firms, depending on the industry, the
desired liquidity event usually falls within a five to ten-year window
from initial investment.

(2) Financing rounds will depend on how successfully the company meets
the milestones in its business plan. Examples:

(a) Life sciences firm – Is the drug effective? Has it been approved by
the relevant government agency? Is the drug commercially viable?

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(b) Software – Does the product work? Are there comparable products
on the market that are as or more effective? What additional costs
will be required to bring the product to market?

2. Economic Environment

A. The macroeconomic and microeconomic environments affect the risk

assessment for all companies. The economic cycles can be particularly harsh
on business start-ups.

(1) What is the subject industry’s exposure to economic cycles?

(a) A life sciences start-up firm may have little to no exposure while a
software start-up may fully exposed.

(2) Is there a consolidation trend in the industry?

(a) In certain hi-tech markets the big players try to acquire smaller
companies at attractive prices to limit competition. (e.g., Google,
Microsoft, Facebook.)

(3) How will the economic cycle affect the availability of venture capital and
private equity financing?

(4) How will the economic cycle affect the ability of the company to attract
labor?

(5) What is the effect of government regulation on the company’s growth

curve (e.g.,. heavy U.S. regulation on food, drugs, and overall business
environment)?

3. Required Rates of Return

A. The risks born by early-stage investors are, as one might assume, well above
the rates discussed in iiBV 102 which pertain to established close-held
companies.

(1) Required returns would have to be higher than the typical 12% to 20%
equity rates for established companies.

(a) Projected cash flows may be speculative.

(b) Risk of failing at any stage of early development is high.

(2) Venture capitalists sometimes refer to the one-third rule. They expect
one third of their investments to fail, one-third to return their initial
investment and nothing more, and one-third to become commerically
successful.

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 Chapter 2. Valuing Early-Stage Companies iiBV 204: Advanced Topics in Business Valuation

(a) The returns from the successful third of the companies needs to
reimburse the venture capitalist for the entire portfolio of early-stage
investments.

(3) Venture capital required returns have been estimated as follows:

Sampling of Venture Capital Required Rates of Return

Harvard
QED Report (1) Bus. School (2) Sahlman (3)

Start-up 50% to 70% 50% to 70% 50% to 100%

Early development 40% to 60% 40% to 60% 40% to 60%

Expansion 35% to 50% 30% to 50% 30% to 40%

Bridge/IPO 25% to 35% 20% to 35% 20% to 30%

Source: AICPA Practice Guide: Valuation of Privately-Held-Company Equity
Securities Issues as Compensation , Wiley, 2013

1. James L. Plummer, QED Report on Venture Capital Financial Analysis (Palo Alto:
QED Research, Inc. 1987
2. Daniel R. Scherlis and William Sahlman, A Method for Valuing High Risk, Long Term
Investments: The Venture Capital Method," Harvard Business School Publishing, 1989
3. William A. Sahlman and others, Financing Entrepreneurial Ventures, Business
Fundamentals (Boston:Harvard Business School Publishing, 1998)

(a) This sampling of returns is intended to convey the band of discount

rates that would be attached to the projected cash flows of an early-
stage company.

(b) The gradation of risk rates reflects the extreme risk that investors
accept at the earliest stages of a company’s development.
Preferred investors (discussed below) will usually ensure that they
are guaranteed a return of their investment in addition to
participation rights which give them a significant share of value
above their initial investment.

(c) Actual returns will change with different industries and will change
over time with varying economic conditions.

B. Venture capitalists normally do not value prospective investments by

discounting future cash flows at a required rate of return, as suggested in the
above chart. The rates of return are presented here to reflect the relative risk
between an early-stage company and a stable operating company.

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 Chapter 2. Valuing Early-Stage Companies iiBV 204: Advanced Topics in Business Valuation

4. Financing Early-Stage Companies

A. Early-stage companies are often financed by venture capital firms. During its
development an early-stage company may see multiple rounds of financing
from venture capitalists depending on how successfully it achieves its
milestones and how fast it burns through cash. These financing rounds are
usually made through the issuance of successive rounds of preferred stock,
discussed below.

(1) More developed firms and some early-stage companies may be

financed by private equity firms. Private equity firms usually acquire an
entire existent firm (many are commerically viable and operating) and
set up a holding company to own it. The intention is to eliminate
inefficiencies, enhance value, and sell the company within a defined
time frame.

B. Debt

(1) Traditional bank financing is usually not an option for early-stage

companies.

(a) Early-stage companies usually lack any type of collateral that would
support the level of financing that they would need to reach
commercialization.

(b) Banks seek an interest rate return on debt investment over a

specified period of time. Bank covenants on long-term debt allow
the creditor to call the loan if certain financial ratios fall outside a
specified range.

(c) This type of financing is relevant only for commercially viable

operating entities which generate positive cash flow.

(d) Conditions in most early-stage companies would immediately force a

bank to call a loan. Essentially, traditional debt financing is not
conducive to the risk levels of early-stage companies, nor are banks
in the market for the levels of risk and return that early-stage
companies present.

C. Preferred stock

(1) Types of stock rights – stock rights are memorialized in shareholder

agreements in which the rights of each class of shareholder are
detailed. These stock rights generally fall into two categories, economic
rights and control rights.

(a) Economic rights

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 Chapter 2. Valuing Early-Stage Companies iiBV 204: Advanced Topics in Business Valuation

 Economic rights refer to the shareholders’ cash flow

rewards in terms of dividend rights and liquidation rights.

(b) Control rights

 Control rights refer to the shareholders’ ability to

influence the day-to-day operations of the firm.

(2) Categories of economic rights

(a) Preferred liquidation

 Non-participating, preferred – the preferred shareholder

is entitled to only the fixed liquidation proceeds defined in
the preferred stock.

 Participating, preferred – the preferred shareholder is

entitled to the fixed liquidation proceeds plus the ability to
share in any further proceeds at a specified rate with the
common stockholders. Depending on the contract, the
preferred shareholder may want to convert the preferred
into common stock.

 IPO events usually require the conversion of preferred

stock into common stock. The rights of preferred
stockholders in relation to an IPO versus another liquidity
event and their ability to steer the company in one
direction to maximize their return should be considered.

(b) Preferred dividends

 Cumulative dividends – usually are expressed as a

percentage of a stock’s price. For example, a 5%
preferred dividend on preferred shares set at 100 per
share would receive $5 per share if dividends are
declared. If dividends are declared but not paid, the
dividends remain payable in subsequent years.

 Non-cumulative dividends – unpaid dividends are not

payable in subsequent years.

(c) Mandatory redemption rights

 Guarantees the right of the preferred shareholder to

redeem shares and get return of capital.

(d) Conversion rights

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 Chapter 2. Valuing Early-Stage Companies iiBV 204: Advanced Topics in Business Valuation

 The right of the shareholder to convert preferred stock

into common stock. The preferred shareholder will
convert to common when the common share outcome
exceeds the preferred outcome. This is an important
break point in the modeling section that follows.

(e) Participation rights

 As discussed above, after the return of initial preferred

investment (including any accreted dividends, if existent),
the preferred stock may have the right to additional
returns from the remaining proceeds, which it would
share with common shareholders.

(f) Anti-dilution rights

 In case of a “down round” of financing (in which additional

investors are brought in at a price below prior rounds) the
preferred shareholder with anti-dilution rights would see
an increase in the number of shares of common stock
into which the preferred can be converted, as if the
preferred stock had converted to common stock.

(g) Registration rights

 The right to force a company to register its shares as a

public company.

(3) Liquidation waterfall example:

 Preferred stock was issued on January 1, 2015 with an

8% accretion right (meaning that it has cumulative
dividends at 8% of value) and it participates at 70%. A
waterfall of the proceeds to preferred and common
shareholders upon three different liquidation scenarios is
shown below assuming a measurement date of
December 31, 2017:

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 Chapter 2. Valuing Early-Stage Companies iiBV 204: Advanced Topics in Business Valuation

ABC Company, LTD

(€ 000)

Preferred stock € 75,000

Date of Issue 01/01/15
Annual accretion @ 8.0%
Participating preferred @ 70.0%
Scenario 1 Scenario 2 Scenario 3
Liquidation, 12/31/17 € 90,000 € 500,000 € 1,000,000

Preferred stock accreted value at 12/31/17 90,000 94,478 94,478

Proceeds available for distribution - 405,522 905,522
Preferred participates at 70.0% - 283,865 633,865
Common proceeds - 121,656 271,656

Total Proceeds to Preferred Stock 90,000 100.0% 378,344 75.7% 728,344 72.8%

Total Proceeds to Common Stock 0 0.0% 121,656 24.3% 271,656 27.2%

 At all scenarios the preferred will receive more than 70%

of proceeds since it participates above 70% after
distribution of the accreted value.

 The next example shows the same company but with the
preferred shares participating at 30%.

ABC Company, LTD

(€ 000)

Preferred stock € 75,000

Date of Issue 01/01/15
Annual accretion @ 8.0%
Participating preferred @ 30.0%
Scenario 1 Scenario 2 Scenario 3
Liquidation, 12/31/17 € 90,000 € 500,000 € 1,000,000

Preferred stock accreted value at 12/31/17 90,000 94,478 94,478

Proceeds available for distribution - 405,522 905,522
Preferred participates at 30.0% - 121,656 271,656
Common proceeds - 283,865 633,865

Total Proceeds to Preferred Stock € 90,000 100.0% € 216,135 43.2% € 366,135 36.6%

Total Proceeds to Common Stock 0 0.0% 283,865 56.8% 633,865 63.4%

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 In the second scenario, the common shareholders enjoy

a much better upside with higher liquidation scenarios.

 Preferred shareholders will try to negotiate a migration

from being in a fixed benefit position to a variable benefit
position in which they share at a higher percentage of the
liquidations at higher values above their fixed liquidation
preference.

(4) Categories of control rights

(a) Voting rights

 The ability to participate in operational control of the

company. With preferred shareholders, even if they may
own a minority of the total outstanding shares, they
usually get disproportionate voting rights that give them
control over the company. The right is conferred through
straight voting rights and board seats.

(b) Protective provisions

 See anti-dilution rights above

(c) Drag-along rights

 The right of a control shareholder to force a minority

shareholder to acquiesce to the sale of the company at
the same terms the control shareholder receives from the
deal.

(d) Participation rights (see above)

(e) First refusal rights

 The right to acquire shares from a selling shareholder

before the shareholder sells to a third party. Typically the
right of first refusal is held by the company and/or the
venture capital investors. If the common shareholder
wants to sell shares to a third party, the company, and
then the preferred shareholders have the right to demand
to buy the stock at the proposed transaction terms.

(f) Tag-along rights

 A minority shareholder’s right to participate in a control

shareholder’s transaction under the same terms.

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(g) Management rights

 The right to participate in managerial control

(h) Information rights

 Access to company operating and financial data upon

request

D. Options and warrants

(1) Stock options

(a) A derivative security. A call option is the right to purchase a stock at

a predetermined price; the right lasts for a specified period of time.
A put option is the right to sell a stock at a predetermined price for a
set period of time. (see below)

(2) Warrants

(a) A derivative security. A warrant is the right to purchase a stock at a

predetermined price; the right lasts for a specified period of time.

(3) The difference between a warrant and a call option is that a call option is
the right to purchase existing shares of the company from a stockholder.
A warrant is the right to purchase shares that would have to be issued
by the company.

Section D. Estimating Equity Value for Early-Stage

Companies

1. Traditional valuation methods are usually not feasible for early-stage companies.

A. Forecasting cash flows may be too speculative if the company has no history of
commercial operations.

B. Market multiples from a group of publicly-held guideline companies cannot be

applied to a company that has no operations. Also, the companies would be
fundamentally incomparable since the market would not perceive an
established mature company the same way it would perceive a start-up
company.

(1) For the same reasons, the market transaction method usually cannot be
applied.

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2. Alternative methods

A. The asset accumulation method

(1) The asset accumulation method is the cost approach in which each
asset and liability on the balance sheet is marked to its market value.

(2) With early-stage companies the valuer should consider adjusting the
balance sheet to capture intangible value.

(a) If intangible assets can be identified and valued, this should be

completed.

(b) Most early-stage companies do not have fully developed intangible

assets yet and those assets that do exist might be hard to value
separately. For example, many early-stage companies may have
intellectual property that shows promise:

 Patents

 In-process research and development (IPR&D)

 Software

(c) These assets might be analyzed by using a cost approach which

captures the costs invested to date in the asset.

(d) In the example below, the company has $7.18 million in reported
equity. Reported assets consists of $4.76 million in current assets
and $4.45 million of fixed assets.

(e) The asset accumulation method requires that the valuer assess the
reported assets and if they do not represent market value, then they
must be appraised and marked to market.

(f) The valuer must also consider assets that exist that are not shown
on the reported balance sheet.

 In the example below, the appraiser has identified two

intangible assets, patents and software, which have
value. These assets were appraised separately at $2.25
million and were added to the balance sheet.

 This results in an adjusted book value of $9.43 million.

 This value would be used as the estimated market value

of equity.

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Early-Stage Company
Adjusted Balance Sheet

December 31, Adjusted

20XX Adjustments Balance Sheet
ASSETS
Current Assets
Cash $ 4,750,000 $ 4,750,000
Prepaid assets 9,800 9,800
Total current assets 4,759,800 - 4,759,800

Net property, plant & equipment 4,450,000 - 4,450,000

Patents - 1,500,000 1,500,000

Software - 750,000 750,000
Total other assets - 2,250,000

Total Assets 9,209,800 2,250,000 11,459,800

Current liabilities
Accounts payable 1,750,000
Security deposits 103,000
Prepaid rent liabilities 175,000
Total current liabilities 2,028,000 - 2,028,000

Long term debt - -

Total liabilities 2,028,000 - 2,028,000

Shareholders' Equity
Preferred stock 9,000,000
Common stock 500,000
Retained earnings (2,318,200) -
Total Equity 7,181,800 2,250,000 $ 9,431,800

Total liabilities and capital $ 9,209,800 11,459,800

(g) Sometimes the intangible assets are difficult to identify and if they
are identified, the valuer may find it difficult to obtain the necessary
information to reliably assess value.

(h) An alternative simpler model is to assume that the company’s

investment to date represents built-up intangible value that can be
posted to the balance sheet. In the example below, the valuer has
added intangible value equal to the amount of retained losses to
date.

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Early-Stage Company
Adjusted Balance Sheet

December 31, Adjusted

20XX Adjustments Balance Sheet
ASSETS
Current Assets
Cash $ 4,750,000 $ 4,750,000
Prepaid assets 9,800 9,800
Total current assets 4,759,800 - 4,759,800

Net property, plant & equipment 4,450,000 - 4,450,000

Total other - intangibles - 2,318,200 2,318,200

Total Assets 9,209,800 2,318,200 11,528,000

Current liabilities
Accounts payable 1,750,000
Security deposits 103,000
Prepaid rent liabilities 175,000
Total current liabilities 2,028,000 - 2,028,000

Long term debt - -

Total liabilities 2,028,000 - 2,028,000

Shareholders' Equity
Preferred stock 9,000,000
Common stock 500,000
Retained earnings (2,318,200) -
Total Equity 7,181,800 2,318,200 $ 9,500,000

Total liabilities and capital $ 9,209,800 11,528,000

(i) In this example, the adjusted market value equals $9.5 million.

(j) This simpler version of the asset accumulation method would not be
appropriate unless the company has made progress in its business
plan and the intangibles likely do exist, but are just not easily
measured.

B. The back-solve method

(1) “Back-solve” is a term used for what is formally part of the market
approach to value. Under the market approach the valuer is obligated
to consider prior transactions in the subject company’s own stock as a
potential indicator of its current value.

(2) The transaction should be arms-length

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(3) The transaction should be timely. If too much time has elapsed then the
transaction should be adjusted to the current time, or if adjustments are
too speculative then the transaction should be discarded.

(4) Back-solve with simple common stock

(a) In this example, the company has issued three tranches of common
stock at successively higher per share values. The value of all the
shares equals the cumulative number of shares multiplied by the
latest share price.

Back-Solve Example 1. Common Stock

Capital Structure Issued # Shares $ Per Share

Common stock (first offering) 12/31/14 2,500,000 $ 1.00
Common stock (second) 06/30/16 5,000,000 2.50
Common stock (third) 12/31/16 5,000,000 3.00

Value using back-solve method = 12,500,000 shares x $3.00 per share

= $37,500,000

(b) This method is feasible assuming not too much time has passed
between the issuance of the $3.00 per share common stock and the
measurement date. If a number of years has passed without
additional issuance of equities, then the valuer may need to opt for
another methodology.

(5) Back-solve method with complex capital structure

(a) Assume a company has the following capital structure:

 2,000,000 shares of common stock

 2,500,000 shares of preferred stock

 Liquidation preference at $1.00/share

 Non-participating

 Converts to common upon liquidation event at 2:1

ratio

 Recent round of preferred indicates total value for

preferred stock equals $12,000,000

 Valuer needs to estimate the entity value

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Sample Company
Back Solve Calculation
($000)
Tier 1 Tier 2 Tier 3

Current Price - Valuation $ 100.0 $ 100.0 $ 100.0

Exercise Price - 2,500,000.0 7,000,000.0
Annual Risk-Free Rate 2.50% 2.50% 2.50%
Life of Option (years) 3.00 3.00 3.00

Annual Volatility 0.600 0.600 0.600

Total Fair Value

Option Value $ 100.0 $ - $ -

Tier Value 100.0 - -

Preferred A 100.0 - - 100.0

Common - - - -

Total Value $ 100.0

(b) The valuer has set up an option pricing model (“OPM”) to value the
preferred and common stock but needs an estimate of entity value
(the model above is more fully explained in Appendix B). As a start
he has inserted a dummy value of $100 into the model.

 The risk-free rate is 2.5% based on government bond

returns

 The estimated time to liquidity is 3 years

 The volatility based on an industry analysis of market

participants is .60.

(c) Using the back-solve method the valuer can now solve for an entity
value (i.e. the “Current Price - Valuation” cell under Tier 1) given the
known values for all other variables in the option model. The valuer
can use the “Goal-Seek” function in excel to solve for the entity
value since she knows the preferred value from the latest round of
financing and has reliably estimated the other variables.

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Sample Company
Back Solve Calculation
($000)
Tier 1 Tier 2 Tier 3
CELL F6
Current Price - Valuation $ 100 $ 100 $ 100
Exercise Price - 2,500,000 7,000,000
Annual Risk-Free Rate 2.50% 2.50% 2.50%
Life of Option (years) 3.00 3.00 3.00

Annual Volatility 0.600 0.600 0.600

Total Fair Value

Option Value $ 100 $ 0 $ 0
CELL I27
Tier Value 100 0 0

Preferred A 100 - 0 100

Common - 0 0 0

Total Value $ 100

- Go to DATA tab on the Menu Bar in Excel

- Select 'What-If Analysis"
- Select 'Goal Seek'

SET CELL: I27

TO VALUE: 12,000,000
BY CHANGING CELL: F6

(d) Once entering these variables in the what-if analysis, the following
solution will be presented.

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 Chapter 2. Valuing Early-Stage Companies iiBV 204: Advanced Topics in Business Valuation

Sample Company
Back Solve Calculation
($000)
Tier 1 Tier 2 Tier 3
CELL F6
Current Price - Valuation $ 19,303,706 $ 19,303,706 $ 19,303,706
Exercise Price - 2,500,000 7,000,000
Annual Risk-Free Rate 2.50% 2.50% 2.50%
Life of Option (years) 3.00 3.00 3.00

Annual Volatility 0.600 0.600 0.600

Total Fair Value

Option Value $ 19,303,706 $ 17,032,127 $ 13,619,789
CELL I27
Tier Value 2,271,579 3,412,337 13,619,789

Preferred A 2,271,579 - 9,728,421 12,000,000

Common - 3,412,337 3,891,368 7,303,706

Total Value $ 19,303,706

- Go to DATA tab on the Menu Bar in Excel

- Select 'What-If Analysis"
- Select 'Goal Seek'

SET CELL: I27

TO VALUE: 12,000,000
BY CHANGING CELL: F6

(e) If the latest round of financing indicates a value for the preferred
stock at $12 million, then, given the company’s overall capitalization
and the other variables in the option model, then the indicated value
for equity would be $19.3 million (rounded).

Section E. Modeling Complex Capital Structures

1. On the surface, it would appear that the common stock in many early-stage companies
which have complex capital structures has no value. For example, consider a
company that has not reached Stage 3 or 4 of its development, has no revenues or
profits, and has preferred stock that has a priority claim on millions in value even if
value did exist. How can the common stock have value? Forecasted cash flows are
still highly speculative, and if they were projected the discount rate would need to be so
high that the present value would likely not cover the priority claims of the preferred

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shareholders. Also, if many early-stage companies were liquidated on a measurement

date, the existent assets would come nowhere close to covering the preferred claims.

A. This presents a paradox to valuers since by other measures, common stock

does appear to have value, especially since managers and other stakeholders
in early-stage firms recognize common stock grants as a form of payment.
Also, venture capitalists appear willing to invest signficant sums of money in
ventures which are a long way from profitability.

(1) If common stock in an early-stage company with a complex capital

structure does have value, but that value cannot be measured with
traditional valuation approaches, then how should it be accounted for?

B. The finance profession addressed this problem by likening the position of a

common shareholder in an early-stage firm to the buyer of a call option.
Consider these similarities between the two positions:

(1) Both investors are “under water” or “out of the money.” This means that
if their securities were liquidated on the current day, neither would
receive any value.

(a) A holder of a call option, for example, purchases the right to buy
100,000 shares of stock in X Company for €13.00 over the following
three years. The stock though is trading at €10.00 per share on the
day he buys the option. The option is out of the money in the sense
that no one would see value in the right to buy at €13.00 when they
could buy at a market price of €10.00.

(b) Similarly, a manager receives common stock in an early-stage

company with no cash flows. There appears to be no value since
the amount of assets in the company are well below the preferred
shareholders’ priority claims on the company.

(c) Yet, people purchase call options in the market every day, and
stakeholders in early-stage companies accept common stock for the
value of their services. Why?

(2) Both investors see value in two variables that might not be appreciated
by a novice.

(a) Time

 Although both securities are out of the money, the

investors have long periods of time to wait in which
events may occur which bestow significant value on the
security.

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 The option holder may see the stock value

increase to €20.00 in two years. That’s worth
€700,000.

 The common stock holder may see product

viability and material growth in cash flows in
Stage 5 and 6 of development.

 The time period relevant to the common

stockholders in an early-stage company relates to
the anticipated liquidity event of the venture
capitalists or private equity firm, which is an IPO
or company sale.

(b) Volatility

 The more volatile a stock, the greater the chance that its
price will move appreciably from its current value. The
combination of volatility and long lead time may
contribute a significant amount to value.

 Does volatility assume though that the stock price

will only increase in value? Couldn’t volatility just
as easily lead to a decline in value?

 This is true, but investors in both a call option and

common stock have no downside risk. Neither
investor can lose more money if the stock
declines in value (or the early-stage company
collapses). Both investors have material upside
gains if the opposite occurs.

2. The current value method (CVM)

A. The CVM assumes that a company is liquidated on the measurement date. It

does not allow for any future possibilities.

B. The CVM is the simplest to apply and easiest method to understand. It is also
rarely relevant to early-stage companies.

C. In the context of a call option, value would only exist if it were “in-the-money”
meaning that the proceeds from the transaction would have to exceed the
current claims on the assets for value to exist.

D. When is the CVM appropriate?

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(1) When the company has little upside beyond its current performance,
meaning that it is in a liquidation scenario.

(2) When the company for any reason is anticipating an imminent closure
(poor performance, government intervention, management decision,
etc.)

E. Benefits of the CVM

(1) Easy to understand and appealing to non-practitioners

(2) Easy to calculate

F. Drawbacks of the CVM

(1) Does not capture upside value due to the interplay between volatility
and time.

(2) Negates the concept that the common shares of most early-stage
companies have some value, even if minimal.

G. See Appendix 1 for an example of the CVM

3. The Option Pricing Model (OPM)

A. The tools used to measure the value of call options, namely the Black-Scholes
model, lattice models and binomial models are applied to measure securities in
early-stage companies. These models capture the distribution of possibilities
that early-stage investors contemplate and avoid the idea that early-stage
companies are valueless prior to becoming commercially viable.

B. Steps in the OPM

(1) Use any relevant method to value the company.

(2) The initial value measurement should consider interim cash flows
(positive or negative) through the liquidity event.

(3) Create a payoff diagram which reflects the payoff points to each class of
stock (also called “breakpoints”).

(a) For each priority claim, at what value point does it make sense for
them to cash in?

 A priority claim refers to a shareholder’s ability to claim

value to the exclusion of another shareholder. For
example, if the company liquidates at $7,500,000 and the
preferred shareholders have a redemption right at

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$7,500,000, they have a priority claim over the common

shareholders. The preferred shareholders will take
$7,500,000 and the common shareholders will take $0.

(b) Set the exercise price equal to the breakpoints.

 The value above each breakpoint (and before reaching a

subsequent breakpoint) can be thought of as a call option
with the exercise price equal to that breakpoint.

 For example, assume an investor has the right to 100%

of the proceeds of a company transaction three years
from now on a value above $10,000,000. How would the
investor value that right? The OPM measures that right
by assessing the volatility of the underlying stock, the
time to the exercise of that right, and the risk-free rate.

 The common stock is a call option with a claim on equity

at an exercise price equal to the remaining value
immediately after the preferred stock is liquidated.

(c) Set the risk-free rate equal to the Treasury yield on a time period
relevant to the time period used in the model.

(d) Set the time period as the assumed time to liquidity event.

 Discuss with management. What is the most likely

liquidity event? (IPO, strategic sale, financial sale)

(e) Measure volatility using market participant volatilities.

 The volatility of most early-stage companies is not

comparable to the volatility of mature operating public
companies, even in the same industry.

 Volatility measurements should place a heavier emphasis

on the more volatile companies in a set of guideline
companies. Alternatively, the valuer might place more
emphasis on the fastest growing companies.

 Levered companies should use the volatility

measurement on an invested capital basis, not an equity
basis.

 Most early-stage companies do not have

traditional debt, as was discussed above.

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 Companies in stage 5 or 6 though may have debt

that would need to be considered.

(f) A series of option calculations are made with the company’s price
remaining the same, but with the exercise price changing with each
breakpoint. The first breakpoint is set at zero.

 The first claim on value equals a range between $0 and

the first breakpoint.

 The value in each option, or tier, equals the value of that

option less the value of the subsequent option.

 The value in each tier is then apportioned over the

percentage claim from each security.

 Future rounds of preferred, future issuances of options

and warrants, etc. are not considered.

(g) A discount for lack of marketability may be considered for common

stock. Common stock will normally be less liquid than preferred
stock in the same company.

C. Benefits of the OPM

(1) Provides a quantitative measurement of value which is seen in the

market as more easily supportable and auditable.

D. Drawbacks of the OPM

(1) The Black-Scholes model assumes a lognormal distribution of outcomes

which does not necessarily mirror reality.

(2) Highly sensitive to key assumptions such as volatility

E. When to use the OPM

(1) The OPM is more useful when measuring a company whose outcomes
are more speculative; generally this is interpreted as companies that are
further away from a liquidity event.

F. See an example of the OPM is Appendix 2 of this chapter

4. Probability weighted expected return method (PWERM)

A. An array of future outcomes for the business is modeled and a probability is

applied to each outcome in accordance with the likelihood of its occurrence.

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The type of outcomes in the model will vary depending on the subject
company’s circumstances. Typical outcomes include:

(1) IPO, sale, continue as private company, and dissolution

(2) Within each scenario there may be sub-possibilities

(a) IPO at varying prices

(b) Sales with different exit multiples

B. Application of the PWERM:

(1) Under each outcome, the waterfall of returns must be modeled for each
security depending on its rights given the available proceeds.

(a) Are any additional rounds of financing necessary for the existent
company to reach the modeled outcome? How are these rounds
modeled into the payoff?

(b) What is the preferred redemption price for each class of preferred
stock?

 Does the class of preferred include cumulative dividends

(accretion of value after issuance)?

(c) Does the preferred stock participate in proceeds after its

redemption?

(d) At what point does it make economic sense for the preferred stock to
convert to common? At what point does the preferred stock have to
convert to common stock?

(e) Does the company have warrants or options that would be exercised
given the outcome?

(f) Model in the proceeds and the dilution from the exercise of stock
options and warrants.

(2) Discount the value of each class of stock back to present value at a rate
which reflects the risk of the security.

(3) Assign probabilities to each outcome according to the likelihood of its

occurrence.

(4) Calculate the per share values for each class.

(5) Assign adjustments if necessary (discount for lack of marketability)

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C. Special Considerations

(1) The PWERM is best applied when the subject company’s liquidity event
can be most accurately predicted (that is to say, when the liquidity event
is imminent or a short time away)

(2) As a check, the backsolve method should be applied to ensure that

there is no conflict between the value in a recent financing round and
the value implied by the PWERM. Inconsistencies can occur due to
unsafe assumptions regarding:

(a) The time to liquidity

(b) The assigned probabilities

(c) The discount rates applied

D. Benefits of the PWERM

(1) Conceptually easy to understand and more straightforward than other

methods

(2) Considers several potential outcomes rather than a single measurement

of value

(3) If probabilities constructed carefully, the model apportionment of value

to preferred and common stock should not be sensitive to changes in
the probabilities assigned

E. Drawbacks of the PWERM

(1) Difficult and potentially expensive to implement accurately

(2) Difficult to justify the probabilities with objective evidence

(3) Less applicable for companies that require additional rounds of

financing

(4) Measures an identified array of outcomes instead of a full distribution of

outcomes

F. See an example of the PWERM in Appendix 3 of this chapter

5. Hybrid Model

A. A hybrid model is a combination of the models discussed above. Hybrid

models are useful in situations in which two or more distinct possibilities can be
identified and probabilities assigned to each.

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(1) For example assume a company is in Phase IV of clinical trials on a

promising pharmaceutical. If the drug is approved for sale, the
Company would likely go public for an anticipated amount of $500
million in a six month time frame. Due to the success of the clinical trials
to date, the company expects an 80% likelihood that the IPO will occur.
If the drug is not approved, the company would need to refocus on
several other research lines and the assumption is that they would lead
to a strategic sale of the company in a four year time frame.

(2) In this case, the valuer would apply a PWERM to model the IPO
scenario and use an OPM to model the alternative strategic sale.

B. See Appendix 4 for an example of the Hybrid Model.

Section F. Chapter Review Questions

A. Ajax Company is developing software for applications in the solar energy

industry. The Company has had one round of preferred financing but estimates
that it is still at least five years before becoming commercially viable. Its
software promises to be unique and, if successful, will likely become widely
accepted. Which of the following methods should be applied to value Ajax?

(1) PWERM

(2) OPM

(3) Discounted cash flow

(4) Current Value Method

B. A right of first refusal is:

(1) The ability to participate in a transaction on the same terms as a control

shareholder

(2) The right to deny common shareholders participation in remaining

proceeds after the redemption of preferred stock

(3) The abililty to require a common shareholder to sell his stock to other
shareholders on the same terms as a proposed external sale

(4) The right to deny lower rounds of preferred shareholders the ability to
participate in a liquidity event

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C. Oasis Company issued one round of participating preferred stock on December

31, 2014 for €20,000,000. The company’s only other stock is the founder’s
common stock issued in 2012. The preferred stock accretes annually at 8%
and participates at 65%. You are assigning value to Oasis’s common stock
assuming a liquidation of the company for €30,000,000 on December 31, 2017.
The value of the common stock (rounded) is:

(1) €1,682,000

(2) €3,124,000

(3) €25,194,000

(4) €28,318,000

D. A drawback of applying an OPM to value early-stage common stock is:

(1) Option models are not an appropriate method for valuing companies in
their earliest stages

(2) Options models were not designed to value common stock

(3) The options model is not equipped to capture additional proceeds from
an exercise of warrants

(4) A small change in the volatility measurement can lead to a material

change in value.

E. Call options and common stock in an early-stage company have which of the
following characteristics in common?

(1) Drag-along rights

(2) Accretion

(3) Volatility

(4) Participation rights

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F. Sansome Company is an early-stage life sciences firm in the United States that
was formed five years ago to research genetic treatments to compromise the
growth of brain tumors. The Company’s principal treatment program made it to
Phase II of the U.S. Food & Drug Administration trials. Unfortunately, the
company recently discovered that the treatment caused heart failure in 12% of
animals in the study and the company plans to liquidate imminently. Which of
the following methods should be used to value the company?

(1) Hybrid method

(2) OPM

(3) CVM

(4) PWERM

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APPENDIX 1: Current Value Method Case Study

Bismarck Construction Gmbh is a construction firm that started at the end of 2014. Its
capitalization table is shown below. The company has 15 million shares of common stock.
The first round of preferred stock included 10 million shares at $3.00 per share redemption
value. The Preferred B round included 5 million shares with liquidation rights at $7.50 per
share, subordinate to the Preferred A shares.

Assuming a liquidation of the Company at $59 million a CVM would indicate:

Bismarck Construction Gmbh

CVM
Capitalization Table

Liquidation
Capital Structure Issued # Shares Preference Claim Participating
Common stock 12/31/14 15,000,000 $ -
Preferred A 12/31/15 10,000,000 3.00 Senior 0.0%
Preferred B 06/30/16 5,000,000 7.50 Sub-1 0.0%
Total Capitalization

Transaction Price $ 59,000,000

Preferred A liquidation 30,000,000
Remaining Proceeds 29,000,000

Preferred B liquidation 29,000,000

Available to common $ -

Total Expected Percent

Return to Preferred A $ 30,000,000 $ 30,000,000 100.0%
Return to Preferred B 29,000,000 37,500,000 77.3%
Return to Common - - -

Under the CVM, there is no consideration of a future distribution of outcomes for growth or
alternative liquidation scenarios.

For the above valuation to be valid the valuer would have concluded that the company has no
upside potential above the $59 million value and thus the transaction on the table represents
the maximum value attainable.

• The Series A Preferred is senior to the other securities and therefore receives
its redemption value first, which is 10 million shares times $3.00 per share, or
$30 million.

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• The Series B preferred shares are subordinate to Series A preferred but senior
to the common shares, so the Series B investors receive their redemption
rights after the Series A is paid off (if available). The Series B redemption right
is $37,500,000 (5 million shares x $7.50 per share). However, given the
transaction amount, there are not enough proceeds to pay the full Series B
redemption right. There is only $29 million remaining, all of which goes to the
Series B shareholders.

• The common shareholders receive no proceeds since the $59 million

transaction amount was not sufficient to pay off both the Series A and B
preferred.

• Therefore, given a transaction at $59 million the Series A preferred

shareholders would receive 100% of their redemption rights, Series B
preferred shareholders would receive 77.3% of their redemption rights and the
common shareholders would receive nothing.

As was discussed in the outline, such an analysis precludes a consideration of the upside
scenarios that are possible. The accounting guidance suggests that common stock, even in
early-stage companies where current assets are not enough to cover all of the preferred rights,
would most likely be appropriated some value, even if minimal.

First, consider the fact that managers and other stakeholders regularly accept common stock
as payment for services rendered in early-stage companies, indicating the fact that personnel
see value in such stock.

Second, as the outline suggests, common stock in early-stage companies can be equated to
call options. Call options that are out-of-money are purchased in the market every day.
Consider an option in which an investor purchases the right to buy a stock at $13.00 that is
currently trading at $10.00 per share. If liquidated on the day of purchase, the option would be
obviously worthless. However, given time and volatility, the call option may deliver substantial
value to the investor.

Such is the case with early-stage company common stock. Given time and volatility, the
common stock could deliver substantial value. Therefore, the only situation in which the CVM
should be applied is when neither time nor volatility are possible for the subject company.
That is to say, a liquidation of the company, for one reason or another, is imminent.

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APPENDIX 2: OPM Case Study

Al Bartawi Group was formed on December 31, 2015 with 15 million shares of common stock.
The preferred stock characteristics are below:

• 10 million shares of preferred stock with a liquidation preference at $1.00/share

• The shares receive a paid-in-kind (PIK) dividend at 8% per year. This means
that instead of receiving $800,000 as a cash dividend, the preferred
shareholders receive 800,000 additional shares of preferred in the first year,
and so on.

• Preferred stock converts to common stock upon any kind of liquidation event
on a 1:1 ratio.

The measurement date is December 31, 2017 (i.e., one year after the preferred stock was
issued). The valuer estimated the Group’s fair value at $18,000,000 as of that date. As of the
measurement date, the Group anticipates a liquidity event three years later, on or around
December 31, 2020. The first step in the OPM analysis is to model the breakpoints at which
the preferred shareholders receive value.

Al Bartawi Group
OPM Analysis
Capitalization Table

PIK Preferred Stock Accreted Value

Capital Structure Issued # Shares Rate Face Per share 2016 2017 2018
Common stock 12/31/15 15,000,000
Preferred Stock 12/31/16 10,000,000 8.00% 10,000,000 $1.00/sh $ 10,000,000 $ 10,800,000 $ 11,664,000

Preferred stock receives a paid-in-kind dividend at 8% per year

Preferred stock converts at 1:1 ratio

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OPM - Breakpoints
$40,000

$35,000
preferred

$30,000
common

$25,000

$20,000

Second payoff goes to common shareholders

$15,000

$10,000

$5,000
First payoff goes to preferred shareholders
$-
$2,500 $5,000 $7,500 $10,000 $12,500 $15,000 $17,500 $20,000 $22,500 $25,000 $27,500 $30,000 $32,500 $35,000

Payoff #1 – Preferred shareholders’ liquidation preference

At December 31, 2017 the preferred shareholders would have a liquidation preference at
$1.00 per share. Since they would have received an additional 800,000 PIK shares during
2017, the redemption value equals $10,800,000 (10 million shares plus 800,000 shares times
$1.00). As the graph above shows, the preferred shareholders would receive 100% of the
value below the $10,800 on the Y axis.

The first option calculation sets the strike price at zero (the derived values are relative to each
other so the first option calculation is set at zero since the preferred shareholders receive all
value between $0 and $10,800,000). The second option sets the exercise price at
$10,800,000 since the preferred shareholders are entitled to 100% of the measured value
between $0 and the first payoff point of $10,800,000.

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Payoff #2 – Value between $10,800,000 and $15,800,000

The common shareholders receive all value between $10,800,000 and $25,800,000.

The preferred shareholders have two options: 1) liquidate at the $10.8 million redemption
value (at which they receive $1.00 per share) or convert their shares to common and receive
proceeds with all other common shareholders. It would not make sense to convert to common
until the conversion value of their common shares would be above $1.00 per share.

If the preferred shareholders converted at values below $25,800,000, they would receive less
than $1.00 per share. Let’s assume the value of the company were $20,000,000 and the
preferred shareholders converted their shares into common stock. After converting, there
would be a total of 25,800,000 common shares (the original 15 million shares plus the
10,800,000 converted shares). The value per share would equal $0.78 cents per share. It is
not until the value reached $25,800,000 that the fully diluted value of common would reach
$1.00 per share.

Therefore, the original common shareholders receive all value up to $25,800,000, as the graph
above depicts.

Breakpoint #3 – Value above $25,800,000

As stated above, it would be economically advantageous for the preferred shareholders to

convert to common at a value of $25,800,000 (15,000,000 original common + 10,800,000
converted shares, all at $1.00/share) which equals the total number of shares at the
measurement date at $1.00 per share. At that point, all the shares in the company would be
common shares. The original preferred shareholders would own 41.9% of the stock (their
converted 10.8 million shares divided by a total of 25.8 million shares) and the original
common shareholders would own 58.1%.

Calculation of Value using Black-Scholes

Al Bartawi’s capitalization table calls for a three-tiered option model in which three separate
option calculations are made to measure the three ranges of relevant payoffs:

1. Payoff 1 = Value between $0.00 and $10,800,000

2. Payoff 2 = Value between $10,800,000 and $25,800,000

3. Payoff 3 = Value above $25,800,000

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The Black-Scholes calculations below calculate the relevant values for the preferred and
common shares.

Assumptions:

Time Period – As per the discussion with management the liquidity event is assumed to be
three years after the measurement date.

Risk-free rate – The risk-free rate represents the yield to maturity on a developed country bond
that matches the assumed time period.

Volatility – As discussed in this chapter, the volatility would need to be measured from a group
of guideline companies, or assumed from some other industry measure since Al Bartawi
Group is closely-held. It is recommended that if volatilities are taken from an established
group of GPCs, then the valuer select a volatility rate from the upper quartile since it is
assumed that an early-stage private company would be more volatile than the mature GPCs in
the same industry.

The option values are calculated as follows:

Al Bartawi Group
Option Pricing Method
($000)
Tier 1 Tier 2 Tier 3

Current Price - Valuation $ 18,000,000 $ 18,000,000 $ 18,000,000

Exercise Price - 10,800,000 25,800,000
Annual Risk-Free Rate 2.50% 2.50% 2.50%
Life of Option (years) 3.00 3.00 3.00

Annual Standard Deviation 0.400 0.400 0.400

Preferred receives
Total Fair Value 100% liquidation
Option Value $ 18,000,000 $ 8,975,345 $ 3,165,266 preference

Tier Value (1) 9,024,655 5,810,079 3,165,266 Common receives

everything above
Preferred 9,024,655 - 1,324,995 10,349,650
Preferred converts at
1:1 but has PIKed
Common - 5,810,079 1,840,271 7,650,350 up to 41.86% of
shares
Total Value $ 18,000,000.0
Notes:
(1) Tier value equals the total option value minus the subsequent option value.

The value in each tier is calculated as the difference in option values between the tiers.

Tier 1 – The preferred shareholders receive a liquidation preference of $1.00 per share. The
exercise price in the first calculation is set at $0. The exercise price of the second option
calculation is set at $10,800,000 which is the accreted number of the preferred shares at the
measurement date. The value of the liquidation preference equals the difference between the

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company value and the option value in the first breakpoint, $8,975,345; this equals
$18,000,000 minus $8,975,345 or $9,024,655. The preferred shareholders receive 100% of
this value since they have a priority claim between $0 and $10,800,000. Given the volatility of
the company and other economic assumptions, this value equals $9,024,655.

Tier 2 – Above a value of $10,800,000 and below a value of $25,800,000, the common
shareholders receive 100% of the value. Between these values it would make no sense for
the preferred shareholders to convert their shares since they would receive less than $1.00
per share, or less than their liquidation preference.

The second tier option value is calculated with a strike price of $10,800,000 and the third tier
option calculation is calculated with a strike price of $25,800,000. This equals the total
number of shares (15,000,000 common plus 10,800,000 converted preferred) multiplied by
$1.00. The two option calculations equal $8.975 million and $3.165 million. The value of this
tier therefore equals the difference between the two values, $5.81 million. The common
shareholders receive 100% of this value due to the logic described above.

Tier 3 – The preferred shareholders convert their shares to common shares because the value
of the company will yield them value above $1.00 per share. At that point there would be
$25,800,000 shares. There is no breakpoint above that range since there is only one class of
stock. Technically, therefore, all the value belongs to the common shareholders. However,
the point of the exercise is to attribute value to the original preferred shareholders. Therefore
the value of the last tiered option is allocated according to the percentage of common stock
owned by the original preferred shareholders (10,800,000/25,800,000 = 41.9%; the original
common shareholders are apportioned the remaining 58.1%).

As a result of the above OPM, the values per share at the measurement date are calculated
as follows:

OPM Preferred Value

Tier 1 $ 9,024,655
Tier 2 -
Tier 3 1,324,995
Total Preferred Value 10,349,650
Preferred per share at value date 10,800,000 $ 0.96

Note that the per share value of the preferred is based on the 10,800,000 shares existent at
the valuation date.

The fair value of the preferred is $0.96 as of December 31, 2017.

The value of the common shares is shown below:

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OPM Common Value

Tier 1 $ -
Tier 2 5,810,079
Tier 3 1,840,271
Total Common Value 7,650,350
Common per share at value date 15,000,000 0.51
Less: DLOM @ 20.0% (0.10)
FV, Common Stock per share $ 0.41

Note that the common shares have no value from the first tier. The second tier goes 100% to
the common shareholders, and the third tier represents its 58.1% of the diluted common
shares.

The valuer deducted a 20% discount for lack of marketability to reflect the disincentive to
purchasing the common stock of an early-stage closely held company. The resultant Fair
Value of the common equals $0.41 per share as of December 31, 2017.

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APPENDIX 3: PWERM Case Study

Salalah Ltd. is a software company formed with 10 million shares of common stock on
December 31, 2012. The company issued 10 million shares of preferred stock at $10.00 per
share on December 31, 2013. The preferred stock has the right to receive cumulative
dividends at a rate of 7.0% per year. The preferred also participates in liquidation proceeds at
an 80% rate after redemption. Upon an IPO, the preferred converts to common stock
automatically at an 80% pro rata rate.

A valuation is required as of December 31, 2016 for the common and preferred stock for
financial reporting purposes. Salalah anticipates an IPO at the end of 2017, one year from the
valuation date. Salalah management has been told by its investment bankers that the
company would most likely go public at an invested capital price ranging between $200 million
and $230 million. Since the company was running short on cash, management obtained a $10
million bridge loan to ensure liquidity through the IPO. The bridge loan carries an interest rate
of 8.0%.

In case the IPO does not occur, management plans to sell the Company during 2018.
Management anticipates that the company’s invested capital would be valued at an
EV/EBITDA multiple (enterprise value/EBITDA) between 8.0x and 11.0x, dependent on market
conditions and the company’s operations at that time. Management expects that a sale,
should it become a possibility, would occur around June 30, 2018, one and a half years from
the valuation date.

Salalah’s capitalization table below reflects the three forms of financing, the loan, the preferred
stock and the common stock.

Salalah Ltd.
PWERM Analysis
Capitalization Table
($000)
Stated 30-Jun
Capital Structure Issued # Shares Rate Face 2013 2017 2018
Bridge Note 12/31/16 8.00% $ 10,000 $ - $ 10,800 $ 11,222
Preferred A 12/31/13 10,000,000 7.00% 100,000 100,000 131,080
Common stock 12/31/12 10,000,000

Preferred Stock accretes at 7% per year

Preferred stock participates at 80% and converts into 80% of common stock upon an IPO.

As is shown, the amount owed on the bridge loan is $10,800 at the end of 2017. However, the
transaction is assumed to be June 30, 2018 so the accrued interest on the loan and the loan
balance would have increased to $11,222.

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Three possible scenarios were determined for the IPO exit, a pessimistic outcome of $200
million, a base case of $215 million and an optimistic outcome of $230 million. Upon an IPO
the preferred shareholders must convert to common stock, at which point they are guaranteed
an 80.0% pro rata share of the fully diluted common stock. As is shown below, after the payoff
of the bridge loan, there would be a range of $189.1 million to $219.2 million available for
payout to the preferred (now converted to common) and the original common shareholders.
Upon conversion, the preferred shareholders would receive 80% of these proceeds. The
original common shareholders would receive 20% of the proceeds after the preferred
redemption.

Salalah Ltd.
Initial Public Offering Analysis
(000)
Initial Public Offering Scenario
Proceeds Analysis Pessimistic Base Optimistic
IPO Proceeds $ 200,000.0 $ 215,000.0 $ 230,000.0
Less: Bridge Loan 10,800.0 10,800.0 10,800.0
Available for Equity Payout 189,200.0 204,200.0 219,200.0

Preferred Stock Conversion

Available proceeds 189,200.0 204,200.0 219,200.0
Preferred conversion to common [email protected]% 151,360.0 163,360.0 175,360.0
Proceeds accruing to original common shareholders 37,840.0 40,840.0 43,840.0

Preferred Stock Value Pessimistic Base Optimistic

Total Proceeds to Preferred Stockholders
151,360.0 163,360.0 175,360.0
Present value at discount rate of 18.0% 128,271.2 138,440.7 148,610.2

Common Stock Value Pessimistic Base Optimistic

Total Proceeds to Common Stockholders
37,840.0 40,840.0 43,840.0
Present value at discount rate of 25.0% 30,272.0 32,672.0 35,072.0

The total proceeds to the original preferred shareholders equals the value of their converted
stock which is 80% of the amount available for an equity payout. The total value to the
common shareholders equals 20% of the proceeds. The proceeds to both preferred and
common are discounted back one year at an appropriate discount rate. In the above case, the
analyst selected an 18% rate of return for the preferred stock and a 25% rate of return for the
common stock.

In addition to the IPO scenario, management has considered the potential that the IPO may
fail for a number of reasons. In this case, management would move to sell the company as

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soon as possible. Management anticipates that the company would sell quickly in the market
and anticipate a sale by the middle of 2018, only six months after the IPO.

Salalah Ltd.
Transaction Analysis
(000)
Sale Scenario
Proceeds Analysis Pessimistic Base Optimistic
EBITDA $ 15,750.0 $ 15,750.0 $ 15,750.0
Exit Multiple 8.0 9.5 11.0
Transaction Price for invested capital 126,000.0 149,625.0 173,250.0
Less: Bridge Loan (11,222.2) (11,222.2) (11,222.2)
Available for Distribution to Preferred & Common 114,777.8 138,402.8 162,027.8
Accreted Value of Preferred at 12/31/17 ` 114,777.8 131,079.6 131,079.6

Preferred Hurdle IRR Met (1=Yes and 0=No) 0 1 1

Preferred Stock Conversion

Available proceeds to common after preferred redemption 0.0 7,323.2 30,948.2
Preferred conversion to common @ 80.0% 0.0 5,858.6 24,758.6
Proceeds accruing to original common shareholders 0.0 1,464.6 6,189.6

Preferred Stock Value Pessimistic Base Optimistic

Total Proceeds to Preferred Stockholders
114,777.8 136,938.2 155,838.2
Present value at discount rate of 18.0% 89,543.7 106,832.1 121,576.9

Common Stock Value Pessimistic Base Optimistic

Total Proceeds to Common Stockholders
0.0 1,464.6 6,189.6
Present value at discount rate of 25.0% 0.0 1,048.0 4,429.0

The transaction waterfall of proceeds to preferred and common shareholders is similar to the
IPO analysis with a few exceptions. Instead of IPO proceeds, an analysis of the market
indicates that EBITDA multiples in a transaction would range between 8.0x and 11.0x.
Management projects an LTM EBITDA at that time equal to $15.75 million. This results in
transaction proceeds ranging from $126.0 million to $173.25 million. For this example we
ignored the transaction fees that would normally be accounted for.

The bridge loan, including accrued interest, is deducted from the transaction proceeds. The
pessimistic transaction outcome does not generate enough cash to cover the entire preferred
stock liquidation preference. After receiving the preferred liquidation redemption, the preferred
shareholders share in the remaining proceeds at 80%. One other difference from the IPO
scenario is that the above proceeds are brought back to present value at 1.5 years since the
anticipated transaction does not occur until mid-2018.

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A summary of the allocated values and a weighting of the outcomes is shown in the table
below.

Salalah Ltd.
PWERM Analysis Summary
($000)
Preferred Stock
Initial Public Offering Scenario Transaction Scenario Fair Value
Pessimistic Base Optimistic Pessimistic Base Optimistic
Probability 15.0% 25.0% 10.0% 15.0% 25.0% 10.0%
Preferred Stock Indication 128,271 138,441 148,610 89,544 106,832 121,577
Preferred Weighted Value 19,241 34,610 14,861 13,432 26,708 12,158 $ 121,009
# Preferred shares = 10,000
Preferred FV per share = $ 12.10

Common Stock
Initial Public Offering Scenario Transaction Scenario Fair Value
Pessimistic Base Optimistic Pessimistic Base Optimistic
Probability 15.0% 25.0% 10.0% 15.0% 25.0% 10.0%
Common Stock Indication 30,272 32,672 35,072 - 1,048 4,429
Common Weighted Value 4,541 8,168 3,507 - 262 443 16,921
# Common shares = 10,000
Common FV per share = $ 1.69

The IPO scenario was appropriated a 50% probability and the transaction scenario was
appropriated a 50% probability. Within each outcome, the pessimistic outcome was given a
15.0% probability, the base case a 25.0% probability, and the optimistic outcome was given a
10.0% probability. Each outcome was weighted and the weights added to arrive at the Fair
Value estimate.

After per share values are calculated, the resultant conclusion is that the preferred stock is
worth $12.10 per share and the common stock is worth $1.69 per share.

The above sample is a very basic example of the PWERM. Most early-stage companies will
have more tranches of preferred stock with varying economic rights that would have to be
modeled. These models can become extremely complicated.

An analysis like this would be reviewed by Salalah’s management team and by their
accounting firm. The auditors would have many questions regarding the assumptions made in
the analysis. For example:

(1) What is the support for the range in IPO price outcomes?

(2) What is the support for the range of EBITDA multiples?

(3) What is the support for the 50%/50% probability between the two
outcomes and what is the support for the 25%/15%/10% breakdown
within each scenario.

(4) Why was no discount for lack of marketability considered?

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(5) Was any thought given to what happens if the company does not sell as
easily or quickly as assumed herein? Should there be another scenario
which allows for a transaction later, or another form of exit?

(6) Should there have been a failure scenario in which neither the IPO nor
the transaction occur?

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APPENDIX 4: Hybrid Method Case Study: Salalah, Ltd. Part II

After a review of the PWERM analysis with Salalah’s management, it was decided that if an
IPO were unsuccessful, it would be highly unlikely that a transaction would occur within 1-2
years. It was decided that the probability of an IPO occurring within one year was 75%.
However, if the IPO failed, then the company would probably take much longer to sell in a
transaction. They estimated the transaction would occur five years from the measurement
date, or 2021.

Under the accounting guidance the PWERM is appropriate for liquidation events that can be
forecasted over the short-term. The OPM is appropriate in situations where a liquidation event
is further out on the horizon. In this case, it is appropriate to apply a hybrid model which
considers both a PWERM analysis and an OPM. The PWERM is appropriate to measure the
IPO and the OPM is appropriate to measure the transaction scenario.

The case facts are taken from the prior PWERM analysis for Salalah, Ltd. The capitalization
table below shows the bridge note and preferred stock taken out to 2021.

Salalah Ltd.
Hybrid Model
Capitalization Table
(000)
Stated
Capital Structure Issued # Shares Rate Face 2016 2017 2018 2019 2020 2021
Bridge Note 12/31/16 8.00% 10,000.0 $ 10,800 $ 11,664 $ 12,597 $ 13,605 $ 14,693
Preferred A 12/31/13 10,000 7.00% 100,000.0 122,504 131,079 140,255 150,073 160,578 171,818
Common stock 12/31/12 10,000

Preferred Stock accretes at 7% per year

Preferred stock participates at 80% and converts into 80% of common stock upon an IPO.

The PWERM analysis for the IPO is presented below as it was considered in the prior case.
The only change is that the transaction scenario was removed from the analysis.

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Step 1. Use PWERM analysis on the IPO

Salalah Ltd.
Hybrid Model
Initial Public Offering Analysis
(000)
Initial Public Offering Scenario
Proceeds Analysis Pessimistic Base Optimistic
IPO Proceeds $ 200,000.0 $ 215,000.0 $ 230,000.0
Less: Bridge Loan 10,800.0 10,800.0 10,800.0
Available for Equity Payout 189,200.0 204,200.0 219,200.0

Preferred Stock Conversion

Available proceeds to common after preferred redemption 189,200.0 204,200.0 219,200.0
Preferred conversion to common @ 80.0% 151,360.0 163,360.0 175,360.0
Proceeds accruing to original common shareholders 37,840.0 40,840.0 43,840.0

Preferred Stock Value Pessimistic Base Optimistic

Total Proceeds to Preferred Stockholders
151,360.0 163,360.0 175,360.0
Present value at discount rate of 18.0% 128,271.2 138,440.7 148,610.2

Common Stock Value Pessimistic Base Optimistic

Total Proceeds to Common Stockholders
37,840.0 40,840.0 43,840.0
Present value at discount rate of 25.0% 30,272.0 32,672.0 35,072.0

The results of the PWERM IPO scenario are the same but since there is no transaction
analysis, the weights appropriate to the pessimistic, base, and optimistic scenarios have been
scaled up to 30%, 50%, and 20% respectively. This results in preferred market value of
$13.74 per share and a common market value of $3.24 per share.

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 Chapter 2. Valuing Early-Stage Companies iiBV 204: Advanced Topics in Business Valuation

Salalah Ltd.
Hybrid Model
PWERM scenario - Initial Public Offering
(000)
Preferred Stock
Initial Public Offering Scenario Fair Value
Pessimistic Base Optimistic
Probability 30.0% 50.0% 20.0%
Preferred Stock Indication 128,271 138,441 148,610
Preferred Weighted Value 38,481 69,220 29,722 $ 137,424
# Preferred shares = 10,000
Preferred FV per share = $ 13.74

Common Stock
Initial Public Offering Scenario Fair Value
Pessimistic Base Optimistic
Probability 30.0% 50.0% 20.0%
Common Stock Indication 30,272 32,672 35,072
Common Weighted Value 9,082 16,336 7,014 32,432
# Common shares = 10,000
Common FV per share = $ 3.24

Step 2. Use OPM Analysis on Transaction

The OPM is then applied to consider the effect of the transaction five years from the valuation
date (four years after the projected IPO). A current value for the company was determined to
be $180 million. The following breakpoints are considered:

The bridge loan is deducted to arrive at proceeds of $169.2 million. The preferred
shareholders have a priority claim on the net projected invested capital.

Breakpoint 1 – The preferred stock liquidation preference would be $131,079 (accreted value
through 2017). Preferred shareholders receive 100% of the liquidation value and participate at
80% above the liquidation value.

Breakpoint 2 – The preferred shareholders would convert to common when their shares
exceed the liquidation preference $13.11 ($131,079,000/10,000,000). On a fully diluted basis,
the shares would need to exceed $262,159,000 ($13.11 x 20 million shares). This equals their
preferred share value multiplied by the fully diluted number of shares (preferred shares plus
common shares). Preferred shareholders convert to 80% of the common stock so the original
preferred shareholders receive 80% of this value.

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 Chapter 2. Valuing Early-Stage Companies iiBV 204: Advanced Topics in Business Valuation

Salalah Ltd.
Hybrid Model
Option Pricing Method
(000)
Tier 1 Tier 2 Tier 3

Enterprise Value $ 180,000 $ 180,000 $ 180,000

Bridge loan (10,800) (10,800) (10,800)
Current Price - Valuation 169,200 169,200 169,200
Exercise Price - 131,079 262,159
Annual Risk-Free Rate 2.50% 2.50% 2.50%
Life of Option (years) 5.00 5.00 5.00

Annual Standard Deviation 0.400 0.400 0.400

Total Fair Value

Option Value $ 169,200.0 $ 79,976.9 $ 41,951.1

Tier Value (1) 89,223.1 38,025.8 41,951.1 Preferred shares

at 80%

Preferred 89,223.1 30,420.7 33,560.9 153,204.6

Common - 7,605.2 8,390.2 15,995.4

Total Value $ 169,200.0

OPM Preferred Value

Total Preferred Value 153,205
Preferred per share at value date 10,000 $ 15.32

OPM Common Value

Total Common Value 15,995
Common per share at value date 10,000 1.60
Less: DLOM @ 20.0% (0.32)
FV, Common Stock per share $ 1.28

The conclusion below weights the IPO-PWERM results at an 80% probability and weights the
transaction results at a 20% probability.

Salalah Ltd.
Hybrid Model
Conclusion
(000)
Scenario Fair Value
IPO Transaction
Probability 80.0% 20.0%
Preferred Stock Indication $ 13.74 $ 15.32 $ 14.06
Common Stock Indication 3.24 1.28 2.85

Preferred Fair Value = $ 14.06

Common Fair Value = $ 2.85

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Chapter 3. The Valuation of Intangible Assets

Section A. Introduction

1. Overview

A. The purpose of this chapter is to introduce the valuer to the basic concepts of
valuing intangible assets and show the common models used to appraise the
more frequently encountered intangibles. Intangible asset valuation is
presented here within the structure of a purchase price allocation for an IFRS 3
– Business Combination assignment.

By the end of this Chapter, the valuer should be familiar with the following:

(1) The reasons for valuing intangible assets

(2) The VPO and accounting guidance for valuing intangible assets

(3) Identification of intangible assets

(4) The categories of intangible assets

(5) Common valuation methods used

(a) Income methods, market methods, cost methods

(b) Contributory asset charges and their role in the intangible asset
valuation

(c) Tax amortization benefits and their role in the intangible asset
valuation

(6) Documentation that should be maintained during the valuation process

(7) Basic models for valuing the following intangible assets:

(8) Reconciliation of the separate analyses within the overall entity valation

(a) Weighted average cost of capital (WACC)

(b) Weighted average return on assets (WARA)

(c) Internal rate of return (IRR)

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 Chapter 3. The Valuation of Intangible Assets iiBV 204: Advanced Topics in Business Valuation

B. Intangible versus Tangible Assets

(1) The distinction between tangible and intangible assets is often

inaccurately described as ‘tangible assets can be touched and felt, while
intangible assets cannot’.

(2) Actually tangible assets derive value from their physical properties. We
can touch inventory and machinery. But we cannot touch accounts
receivable or prepaid assets. Then why are receivables and prepaid
assets considered tangible assets? These are tangible assets since
value is derived from the cash value that they represent.

(3) The value of intangibles derives not from their physical ability to
generate cash flow, but from the rights associated with them.

(a) The value of the McDonald’s trademark is derived from the mental
process that a customer goes through when he sees the trademark,
not from the physical sign. This is the characteristic that makes it an
intangible asset.

C. Case Study – A case study inclusive of an excel model is presented to

exemplify the topic at the end of this chapter.

2. Reasons for Valuing Intangible Assets

A. General Valuation – Identification of value drivers

B. Purchase price allocation in financial reporting

(1) The case study below presents an example of valuing intangible assets
in the context of a purchse price allocation.

(2) Guidance for purchase price allocations can be found in IFRS 3 or ASC
805

C. Taxation

D. Bank financing

3. Guidance for valuing intangible assets

A. VPO Guidance

(1) IVSC 210 addresses intangible assets. The standard does not address
how to value each class of assets but does define intangibles in the
context of valuation for financial reporting.

B. Accounting Guidance

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 Chapter 3. The Valuation of Intangible Assets iiBV 204: Advanced Topics in Business Valuation

(1) IFRS 3 – Business Combinations, IAS 38 – Intangible Assets

(a) The transaction price does not necessarily equal fair value. The
valuer must assess whether a market participant would pay that
amount for the company on the measurement date. It could be a
case in which the acquirer overpaid or underpaid for the target
company.

(2) FASB ASC 805 – Business Combinations

(3) FASB ASC 820 – Fair Value Measurements and Disclosures

(4) FASB ASC 350 – Intangibles, Goodwill and Other

(5) CEIV training

Section B. Identification of Intangible Assets

A. Distinction between tangible and intangible assets

(1) Tangible assets are usually recognized on a balance sheet using the
historical cost recognition in which the asset is booked at its original
costs and depreciated or amortized over time if it is depleting asset.

(2) Intangible assets are typically not booked to the balance sheet unless a
transaction has taken place and certain intangibles are identified as
being acquired in the transaction. These assets are booked on the
acquiring company’s financial statement.

(a) In a business combination accounted for under IFRS or US GAAP,

an intangible asset is only recognized to the extent that it:

 is separable, i.e. capable of being separated or divided

from the entity and sold, transferred, licensed, rented or
exchanged, either individually or together with a related
contract, identifiable asset or liability, regardless of
whether the entity intends to do so, or

 arises from contractual or other legal rights, regardless of

whether those rights are transferable or separable from
the entity or from other rights and obligations. (IVS 20.7)

(b) Goodwill – Goodwill is not separable from the company but is

booked as an asset under financial reporting rules and tested
periodically for impairment. Goodwill is defined in the IVS as:

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 Chapter 3. The Valuation of Intangible Assets iiBV 204: Advanced Topics in Business Valuation

 Goodwill is any future economic benefit arising from a

business, an interest in a business or from the use of a
group of assets which has not been separately
recognized in another asset. The value of goodwill is
typically measured as the residual amount remaining
after the values of all identifiable tangible, intangible and
monetary assets, adjusted for actual or potential
liabilities, have been deducted from the value of a
business. It is often represented as the excess of the
price paid in a real or hypothetical acquisition of a
company over the value of the company’s other identified
assets and liabilities. (IVS 20.6)

B. Transaction documents

(1) In a purchase price allocation as part of a business combination, the

purchase agreement and other transaction documentation will possibly
refer to the specific assets that were part of the deal. These documents
should be scrutinized to determine which intangibles exist.

(2) For financial reporting purposes the key determination will be if the
assets are seen by market participants as separable and valuable
subsequent to the business combination.

C. Management discussions

(1) According to the accounting guidance, it is management, not the valuer,

who bears responsibility for the identification of the intangible assets.

(a) The valuer should have discussions with management to determine

which assets were part of the transaction or, in the absence of a
transaction, which intangible value drivers contribute to value.

(b) The graph below depicts the two sides of the balance sheet. In the
context of a transaction, the invested capital value, or business
enterprise value may be depicted by the fair value. That fair value is
then allocated across the left side of the balance sheet.

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Net Working Capital (C/A - C/L)

Fixed Assets
Land
Capital Structure Interest-bearing Debt
Buildings
Machinery & Equipment
Vehicles
Other
Invested Capital

Other Assets
Other tangible assets
Identified intangibles
Goodwill
Shareholders' Equity

D. Documentation for identification of intangible assets

(1) Discussions with management including the rationale for the transaction
price

(2) Description of each intangible asset

(3) Explanation for how each intangible asset meets the requirements
under IFRS 3 as being separable, legal or contractual

(4) Explanation as to why certain assets were excluded

(5) If outside experts or subcontractors were used the valuer should keep
their valuations or calculations with an explanation as to how they affect
the valuer’s work.

(6) Identification of the market participants

E. Categories of Intangible Assets

(1) Customer related intangibles

(a) Customer list/ customer relationship – the knowledge of the

company on the part of the customer; the likelihood that the
customer’s knowledge will lead to further patronization in the future.
The customer relationship does not need to be in the form of a legal
agreement such as a supply contract.

(b) Customer backlog – orders for goods or services which exist at the
measurement date. This asset is usually valued separately from the
customer list since it may have a different discount rate.

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(c) Customer/supplier contracts

(2) Technology related intangibles

(a) Software/database – Not all software has intangible value. The

asset must generate some competitive advantage or unique quality
which distinguishes it from similar software.

(b) Patents – Usually a patent provides the owner with protection from
competition for a defined period of time which represents the
patent’s defined life.

(c) In-process research & development

(d) Management processes/ trade secrets

(3) Contract-oriented intangibles

(a) Franchise agreements

(b) License agreements

(c) Broadcast rights

(d) Non-compete agreement

(e) Employment agreement

(f) Supplier contract

(4) Marketing related intangibles

(a) Brand name

(b) Trademark, trade name

(c) Domain names

(d) Non-competition agreement

(5) Artistic related intangibles

(a) Copyright

(b) Artistic works (literary, musical, etc.)

F. Intellectual Property (IP)

(1) Intellectual property refers to assets which are created through an

owner’s intellectual efforts, such as designs, artwork, trademarks,
patents, copyrights, inventions, etc.

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 Chapter 3. The Valuation of Intangible Assets iiBV 204: Advanced Topics in Business Valuation

(2) IP carries legal rights in some jurisdictions which distinguish the asset
from similar assets that may not be protected under the law. IP rights
provide the owner with protection against infringement by a competitor
who seeks to use the property for his own gain.

(3) The protection that IP enjoys will vary from country to country. In
countries without legal protection it is not unusual for companies or
individuals to infringe on IP rights.

(4) Due to the legal protection many IP assets will have a higher royalty rate
(or lower discount rate) due to the lower risk.

(5) Not all intangible assets constitute intellectual property. Some patents,
trade names, trademarks, copyrights, etc. may have legal protection that
expired or for another reason never had legal protection. These are still
considered intangible assets.

Section C. Valuation Methodologies for Intangible Assets

1. Introduction

A. For an intangible asset to have value, it must have the following characteristics:

(1) Legally permissable – A patent on a new pharmaceutical may be

worthless in the United States since the U.S. Food & Drug
Administration has not approved the drug for sale. However, the drug
may be legal outside the U.S. which provides patent value in that
jurisdiction.

(2) Physically possible – A design for a new product will not have value if
the materials for the design are rare or in short supply.

(3) Financially feasible – A new drug may be proven to effectively treat a

disease but if its cost is €1 million per dose, it will not be commercially
viable.

(4) The use of the asset must be its highest and best use

(a) The value can be external (i.e. it can be sold outside the company)
or it can be internal (i.e. the company’s cash flows are higher by
owning the asset versus not owning the asset - or it decreases its
costs).

2. Defining the Asset’s Life (IVS 210, prg. 100)

A. Types of lives

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(1) Legal life – the asset may have an indefinite life but if it will lose value
after its legal protection expires, then this must be considered.

(a) Example: patents – a patent will expire and lose its value with the
loss of its legal protection, although the underlying technology may
continue to have value.

(2) Contractual life – if a legal agreement gives rise to the asset, the asset
may have value only for the duration of the time line in the agreement.

(a) Example: Supply contract

(3) Technological/ functional life – The valuer must consider all

obsolescence factors which will deplete the value of the asset.

(a) Example: Software, technology

(4) Economic life – theoretically, all assets have an economic life. To the
extent the intangible asset generates above market cash flows,
competition will, sooner or later, erode the value of the asset.

(5) Some intangible assets may have indefinite lives. This is not to say that
the asset will provide value forever, but it is expected to last for a
discrete period long enough that the out years of the forecast have an
immaterial present value.

B. Attrition (IVS 210, prg.100.5)

(1) Attrition applies to the analysis of a customer list’s useful life. There are
several ways to measure customer attrition, some of which may include
the use of complex modeling. The following factors should be
considered:

(a) Attrition may be based on revenues or on the number of customers

lost over time.

(b) Customers may need to be divided into separate groups and

measured separately.

 A security/alarm company may have individual residential

customers as well as corporate customers. The two
groups might have different attrition rates.

(c) Attrition may be expressed as a constant rate of loss or a variable

rate of loss depending on the age of the customer.

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(2) Usually, a mid-year convention is used in projecting customer cash flow

since not all the customers projected to be lost during the period would
disappear on the first day of the period.

(3) The customer revenues may grow at the same time the number of
customers is declining. Growth and attrition may be separately
expressed in the attrition model.

(4) See the Case Study example for the customer list valuation at the end
of this chapter.

3. Income Approach

A. Multi-Period Excess Earning Method (MPEEM)

(1) The MPEEM is a form of the excess earnings method. The income
attributable to the intangible asset being valued is isolated by projecting
the entity’s entire cash flow and deducting a contributory asset charge
(see below) on the other assets in the enterprise. The cash flows (or
excess earnings) are brought back to present value by applying a
discount rate appropriate for the subject asset.

(2) Information required for MPEEM:

(a) Fair values for all classes of tangible assets

(b) Required rates of return for all classes of tangible assets

(c) Fair values and rates of return for intangible assets not being valued.

(3) An example of a customer list MPEEM is shown below:

Sample Company
Customer List MPEEM Model
In Thousands

BASE YEAR CUSTOMER CASH FLOW ANALYSIS

EXISTING CUSTOMER REVENUE ESTIMATE $100,000.0 Enter the amount of revenue attributed to the customer list being valued.

EBITDA 5.6% 5,600.0 Enter the company's EBITDA margin, adjusted to remove
CAPEX TO MAINTAIN EXISTING RELATIONSHIPS 93.3 sales and marketing costs that would be expended
to attract new customers
OPERATING INCOME 5,506.7
TAXES 35.0% 1,927.4 If there are capital expenditures that are necessary to mainting existing
customers these should be deducted.
AFTER-TAX INCOME 3,579.4
AFTER-TAX CONTRIBUTORY ASSET RETURNS 2.4% $2,400.0 Represents the returns to all tangible and intangible assets in the
company except the customer list.
EXISTING CUSTOMER CASH FLOW $1,179.4

ATTRITION RATE 5.0% Percentage decline in customer list per year. Represents the percentage
GROWTH RATE 4.0% of customers who leave the company annually.

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 Chapter 3. The Valuation of Intangible Assets iiBV 204: Advanced Topics in Business Valuation

Cash Flow from Customer List

Total Remaining Discount PV Present Time

Year Cash Flow Remaining % Cash Flow Rate Factor Value Period

1 $1,226.5 97.5% $1,195.9 17.0% 0.9245 $1,105.6 0.5000 Note that an entire attrition percentage is not
2 1,275.6 92.6% 1,181.5 17.0% 0.7902 933.6 1.5000 taken in first year since not all customer will leave
3 1,326.6 88.0% 1,167.4 17.0% 0.6754 788.4 2.5000 on the first day of the year. Similar to mid-year
4 1,379.7 83.6% 1,153.3 17.0% 0.5772 665.7 3.5000 convention concept.
5 1,434.9 79.4% 1,139.5 17.0% 0.4934 562.2 4.5000
6 1,492.3 75.4% 1,125.8 17.0% 0.4217 474.7 5.5000
7 1,552.0 71.7% 1,112.3 17.0% 0.3604 400.9 6.5000
8 1,614.0 68.1% 1,099.0 17.0% 0.3080 338.5 7.5000
9 1,678.6 64.7% 1,085.8 17.0% 0.2633 285.9 8.5000
10 1,745.8 61.4% 1,072.8 17.0% 0.2250 241.4 9.5000
11 1,815.6 58.4% 1,059.9 17.0% 0.1923 203.8 10.5000
12 1,888.2 55.5% 1,047.2 17.0% 0.1644 172.1 11.5000
13 1,963.7 52.7% 1,034.6 17.0% 0.1405 145.4 12.5000
14 2,042.3 50.1% 1,022.2 17.0% 0.1201 122.7 13.5000
15 2,124.0 47.5% 1,009.9 17.0% 0.1026 103.7 14.5000
16 2,208.9 45.2% 997.8 17.0% 0.0877 87.5 15.5000
17 2,297.3 42.9% 985.8 17.0% 0.0750 73.9 16.5000
18 2,389.2 40.8% 974.0 17.0% 0.0641 62.4 17.5000
19 2,484.8 38.7% 962.3 17.0% 0.0548 52.7 18.5000
20 2,584.1 36.8% 950.8 17.0% 0.0468 44.5 19.5000
21 2,687.5 35.0% 939.3 17.0% 0.0400 37.6 20.5000
22 2,795.0 33.2% 928.1 17.0% 0.0342 31.7 21.5000
23 2,906.8 31.5% 916.9 17.0% 0.0292 26.8 22.5000
24 3,023.1 30.0% 905.9 17.0% 0.0250 22.6 23.5000
25 3,144.0 28.5% 895.1 17.0% 0.0214 19.1 24.5000

TOTAL PRESENT VALUE $7,003.6

Tax Benefit Cash Flow Factor 1.166x

Economic Value 8,166.8

Less: Backlog Value Enter
Adjusted Economic Value $8,166.8
Rounded Value $8,200.0

Footnote(s):
[1] Remaining % Year 1 (Average) = [ 100% (Year 0) + __._% (Year 1) ] / 2, where __._% = 100% - __._% (Attrition Rate) ]
Remaining % Year 2 (Average) = [ __._% (Year 1) + __._% (Year 2) ] / 2, where __._% = __._% x (1 - __._%) (Attrition Rate) ]
[2] Tax Benefit Cash Flow Factor = 1 / [ 1 - Tax Rate x (( 1 - ( 1 / ( 1 + WACC )^15 )) / WACC ) / 15 ]

(4) Discount rate

(a) The rates of return for intangible assets are usually discerned after
deriving an appropriate weighted average cost of capital for the
entity and comparing the riskiness of the intangible asset to the risk
of the entity’s overall capital.

 Each class of tangible and intangible asset is assigned a

rate of return.

 Individual tangible assets will have a rate of return

lower than the WACC

 Individual intangible assets will likely have a rate

of return higher than the WACC

 After valuing each tangible and intangible asset the

valuer can reconcile his work by comparing a weighted
average return on the assets (WARA) to the WACC. The
two rates should approximate each other

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 Chapter 3. The Valuation of Intangible Assets iiBV 204: Advanced Topics in Business Valuation

 If the assignment is being performed as part of a

purchase price allocation after a transaction – and the
transaction price has been determined as the appropriate
indication of Fair Value – then the internal rate of return
(IRR) from the transaction can also be compared to the
WACC and WARA.

(b) Documentation requirements for the derivation of the discount rates:

 Rationale for market participant tax rate used to estimate

rates of return for each asset

 Rationale for the after-tax rates of return for each asset

used in the WARA

 Explanation of any discrepancies between the WARA,

IRR, and WACC

 All adjustments in the WARA calculation in the event of a

non-taxable transaction

(5) Contributory Asset Charges (CAC)

(a) The CAC is a charge that is assessed against the revenues of the
firm for the use of the all the other assets other than the asset being
valued. An example of a model to calculate the contributory asset
charge is shown below:

ABC Company
Contributory Asset Return Calculation
(000)
Required After-tax
Fair Value Required After-tax Required Cash Corresponding Cash Return as % of
Contributory Asset Estimate Return Estimate Return Revenue Level Revenue
Debt-free Net Working Capital $648.0 5.2% $33.7 $25,000.0 0.13%
Fixed Assets 3,505.0 6.2% 217.3 25,000.0 0.87%
Work Force 945.0 12.0% 113.4 25,000.0 0.45%
Non-Competition 250.0 13.0% 32.5 25,000.0 0.13%
Software 1,100.0 15.0% 165.0 25,000.0 0.66%
Trade Name 2,975.0 (3.0% on pre-tax basis) 1.95%

Total Contributory Asset Cash Return (as a % of Rev.) 4.20%

(b) In the above model, each of the Company’s assets has been valued
with the exception of the customer list. The required cash return of
each asset is calculated as a percentage of sales. These returns
are summed to a total of 4.2%. This CAC is deducted from ongoing

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revenues to isolate the remaining income which is attributable to the

customer list.

(c) Documentation Required for the CAC calculation

 Identification of all assets included in the CAC

 Working capital – level, required rate of return, the charge

and how calculated

 Land – FV, required rate of return, charge on land and

how calculated

 Other fixed assets

 Return ON fixed asset charge –

 Return OF fixed asset charge (e.g., depreciation,

amortization or in expense structure)

 Intangibles

 Each intangible asset and its required rate of

return is included (with the obvious exception of
the asset being valued)

 Royalty rate on the patent or trademark – if different from

the rate used to value trade name, explain. Rate should
be expressed net of taxes

 Assembled workforce

 Assumptions used to value assembled workforce

 Required rate of return

(d) Explanation of the number of years the CAC charges applied are
different from the economic life of the asset, and an explanation if
the CAC changes from year to year.

(e) Identification of all assets in valuation not included in CAC

(6) Tax amortization benefit (TAB)

(a) In jurisdictions where corporate taxes are assessed and where

identified intangible assets can be amortized for tax purposes (that
is, written off over a period of time), then the value of the intangible
asset should include the tax benefit from the amortization. The TAB

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 Chapter 3. The Valuation of Intangible Assets iiBV 204: Advanced Topics in Business Valuation

equals the present value of the taxes that will be saved over the
amortizable life of the asset.

(b) Appropriate when estimating the FV of an entity using an income

approach for a presumed taxable transaction. When a cost or
market approach is used the TAB is not appropriate: 1) under a non-
taxable transaction, and 2) when pre-tax costs are expended, or 3)
when the price paid reflects the full fair value of the entity.

(c) FV is not determined or affected by the taxable or non-taxable

nature of the transaction. The FV of the asset should include the
TAB if it is amortizable and tax benefits are to be had.

(d) CAC is generally based on FV of intangible assets inclusive of the

TAB because the resulting value would be the basis for economic
rent.

(e) If a pre-tax cost approach is used to estimate FV the addition of a

TAB is not considered appropriate, although the TAB is considered
appropriate with a cost savings method (which is a form of the
income approach).

(f) Documentation required:

 Understanding of the market participant’s tax jurisdiction

to determine:

 The appropriateness of the TAB

 The amortization method, whether a straight line

or accelerated method used

 Explanation for the number of years used in the

calculation (e.g., 15 years in the U.S.)

 The rationale for the market participant tax rate

 The rationale for the discount rate – could be the

discount rate used to estimate FV of the
intangible, or the WACC, or other

 Consideration of the TAB in either a taxable or

nontaxable transaction when doing a DCF or iRR

 The interaction with the WARA

 Foreign transactions and TAB

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 Chapter 3. The Valuation of Intangible Assets iiBV 204: Advanced Topics in Business Valuation

(g) An example of the TAB is shown in the case study at the end of this
chapter in connection with the trade name valuation.

B. Greenfield Method (IVS 210, prg.60.29)

(1) The Greenfield Method assumes that the asset being valued is the only
asset in the Company. Cash flow is projected which captures start-up
costs over a ramp-up period until the asset reaches a period of
stabilized cash flows.

(2) A Greenfield model is the same as an MPEEM model except that

instead of a CAC all the other assets are assumed to be bought, built, or
rented.

(a) The other assets are derived usually using the replacement cost
method.

(3) The Greenfield Method is often used for franchise rights and broadcast
rights.

C. Relief from Royalty Method

(1) The Relief from Royalty method depends on finding market evidence of
royalty rates on similar assets to the one being valued.

(a) The asset is valued based on the income that is saved by owning
the asset and not having to rent the asset from a third party

(b) The valuer usually bases the income saved on observed royalty
rates in the market on similar assets.

 Royalty rates can be found by researching filings of

public companies which may lease their trademarks or
trade names.

 Rates are usually researched on databases which are

made available by data providers.

(2) An example of a trade name valuation using the relief from royalty
method is shown below.

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 Chapter 3. The Valuation of Intangible Assets iiBV 204: Advanced Topics in Business Valuation

Sample Company
TradeName Valuation
In Thousands

20XX 20XX 20XX 20XX 20XX

TOTAL COMPANY REVENUES $100,000.0 $102,000.0 $105,060.0 $110,313.0 $113,070.8

Revenue Growth 20.1% 2.0% 3.0% 5.0% 2.5%
% of Revenues Related to Trade Name 40.0% 40.0% 40.0% 40.0% 40.0%

TRADE NAME ASSOCIATED REVENUES 40,000.0 40,800.0 42,024.0 44,125.2 45,228.3

FAIR MARKET ROYALTY RATE 2.5% 2.5% 2.5% 2.5% 2.5%

ROYALTY SAVINGS 1,000.0 1,020.0 1,050.6 1,103.1 1,130.7 Long-Term

TAXES 250.0 255.0 262.7 275.8 282.7 Growth Rate Perpetuity

AFTER-TAX CASH FLOW 750.0 765.0 788.0 827.3 848.0 3.0% 873.5

PRO-RATA ADJUSTMENT FACTOR 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

PRO-RATA AFTER-TAX CASH FLOW 750.0 765.0 788.0 827.3 848.0 873.5
Capitalization Rate 11.0%
Perpetuity Value 7,940.7
DISCOUNT RATE 14.0%
Time Remaining in 1st Period 1.0000
Years to Discount 0.5000 1.5000 2.5000 3.5000 4.5000 4.5000
PV FACTOR 0.9366 0.8216 0.7207 0.6322 0.5545 0.5545
PV CASH FLOW $702.4 $628.5 $567.9 $523.0 $470.3 $4,403.4

Sum of Interim Period Present Value $2,892.1

Present Value of Terminal Value 4,403.4

TOTAL PRESENT VALUE $7,295.4

Tax Benefit Cash Flow Factor [1] 1.128x

Economic Value $8,229.6

Rounded $8,230.0

Footnote(s):
[1] Tax Benefit Cash Flow Factor = 1 / [ 1 - Tax Rate x (( 1 - ( 1 / ( 1 + WACC )^15 )) / WACC ) / 15 ]
Assuming WACC = 12% and tax rate = 25%

(3) The above example is a valuation of a trade name using the relief from
royalty method. If the company did not own the trade name, it would
have to bear the cost of leasing the name from another owner. The
valuer estimated that 40% of Sample Company’s total revenue is
attributable to this particular trade name. He also determined that an
appropriate royalty rate is 2.5%.

(4) The annual savings from owning the name ($750,000 in year one,
$765,000 in year two, etc.) is brought to present value in a typical
discounted cash flow analysis at a 14.0% discount rate which is the risk
rate on the trade name.

(5) After calculating the TAB the value of the trade name is $8.23 million.

D. Profit Split Method

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(1) An alternative to the Relief from Royalty Method is the Profit Split
Method in which the licensor of the trade name or trademark receives a
percentage of profits, not sales.

(a) The licensee’s profit before royalties is analyzed.

(b) The profit split principle states that the royalty rate that a licensee is
willing to pay (that is, a royalty rate on sales) depends on the profits
that the licensee earns from licensing the trade name.

(2) The rule of thumb in the industry is that the profit split that the licensee is
willing to pay is between 20% and 33% of total profits.

(a) In the RFR example shown above, the $1,000,000 royalty rate would
be checked against the firm’s profits from the segment’s sales. If it
fell within the rule of thumb range, then there would be a greater
comfort level in the analysis.

(3) The profit split method has received the same criticism as any rule of
thumb over the years.

E. Some form of the income approach is most commonly used to value the
following assets:

(1) Trade names

(2) Customer lists

(3) Technology

(4) Licenses

(5) Non-competition agreements

4. Market Approach

A. Transaction method

(1) If an asset that is similar in nature to the subject intangible asset can be
found, the transaction is arms-length and sufficient data is available to
analyze the deal, then this approach might be applied.

(2) Since it is rare that such transactions can be found, the market
approach is seldom applied in the direct valuation of intangible assets.

(3) This method is sometimes possible when valuing internet domain

names since deal data on these assets can be found.

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 Chapter 3. The Valuation of Intangible Assets iiBV 204: Advanced Topics in Business Valuation

5. Cost Approach

A. The Cost Approach provides an indication of value using the economic principle
that a buyer will pay no more for an asset than the cost to obtain an asset of
equal utility, whether by purchase or by construction, unless undue time,
inconvenience, risk or other factors are involved (see IVS 105 pg.60.1 and
60.2).

(1) The cost approach is valid when the alternative income, market, or
hybrid approaches cannot be applied.

(2) The cost approach is most commonly used for the following intangible
assets:

(a) Internally developed software/technology

(b) Acquired software/technology

(c) Assembled workforce

B. Replacement Cost Method

(1) Considers the direct and indirect costs of replacing the utility of the
asset.

(a) Labor – all salaries, bonuses, etc. of internal and subcontracted

workers

(b) Materials

(c) Other overhead costs

(2) Technological and economic obsolescence should also be considered.

(3) A profit mark-up on the costs may be considered.

(4) Opportunity costs during period of replacement should be considered if

the asset cannot be replaced in a short period of time.

(5) See example in case study for software.

C. Reproduction Cost Method

(1) Reproduction cost considers the same process as the Replacement

Cost Method except that it produces an exact duplicate of the asset in
question. Since this is rarely the case, the more common cost method
is the Replacement Cost Method.

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Section D. Case Study – Wahmi Limited

Company Background

Wahmi Limited is an auto parts distributor and retailer which sells a broad range of aftermarket
automobile parts to auto part retail chains, auto repair shops and individual customers
throughout southern Europe, Eastern Europe and Turkey. The Company began operations in
1971 in Padua, Italy and has remained in the same location since that time. The company
distributes a wide range of engine, chassis, and add-on parts for several European makes
including Audi, Peugeot, Volvo, Opel, Renault, Skoda, Dacia, and Japanese carmakers such
as Toyota, Honda, and Nissan.

Since 1971, the company has been doing business as “Trazione” and is known in the market
as Trazione Company and Trazione Parts. Over nearly a half century in business the
Company has established its name as being a reliable supplier of quality aftermarket products.
Although its base customer list is comprised of company clients, about $10 million to $15
million of its annual revenues come from individual customers throughout Europe who either
make one-time purchases or return on an intermittent basis.

The Company markets its inventory primarily to retail chain stores which sell auto parts to
individuals as well as local repair shops. The company also sells directly to repair shops and
to individual buyers. Some of the retail chains and repair chains also buy direct from
manufacturers; Wahmi competes with manufacturers by focusing on speed and efficiency
which is a mandatory requirement for repair shops looking to turn around repair jobs in one to
two days.

Between 1971 and 2010, Wahmi printed and sold catalogues which it distributed to its
customer base. Repair mechanics could look up the needed part and place an order by phone
and the needed part was sent out via overnight or same day delivery service. The Company
also sold lines of personalized auto parts for do-it-yourselfers who worked on their own
automobiles.

In 2011, the company began a transformation to an online ordering system. Its entire
inventory was placed online so that customers could find and order the needed part with the
click of a button. All orders are shipped within 24 hours. The transformation took six years
and was only completed at the end of 2017.

The majority of Wahmi’s customer base is located in northeastern Italy. The Company’s
largest customers are autopart retail chain stores with multiple locations and three of the larger
repair shop chains in southeastern Europe. Wahmi supplies these customers with a relatively
large volume of mainstream parts. The bulk of the customer base is comprised of repair
shops which order parts on an as need basis. Often, Wahmi receives the order because other

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 Chapter 3. The Valuation of Intangible Assets iiBV 204: Advanced Topics in Business Valuation

local suppliers do not have the part. In all cases, Wahmi’s customers require the needed
inventory to be delivered within 48 hours and often within 24 hours after the order is placed.

Transaction

Effective December 31, 2017, Wahmi was purchased for €68 million euros by a larger
competitor in the market, WendeWerks, GmbH, a privately-owned company located in Graz,
Austria. The purchase price included the assumption of all Wahmi’s third party debt.

You have been retained to allocate the purchase price to the Company’s tangible and
intangible assets under IFRS 3, Business Combinations.

Assume the following facts:

• In your discussions with WendeWerks management and your review of the

transaction documents, you have identified the following intangible assets as
having potential value:

o Your support staff has completed due diligence on Wahmi’s tangible

assets and they have documented the following:

▪ Net operating working capital (current assets minus non-interest

bearing debt) represents Fair Value as is stated on the balance
sheet. Your staff considered the potential for an inventory step-
up but discovered that the firm moves inventory fast enough that
any step-up calculations would be immaterial.

▪ The fixed asset values expressed on the balance sheet also

reflect the fair value of the assets. Tangible asset appraisers
(real estate and machinery/equipment appraisers) were consulted
and expressed conclusions that the reflected values are
representative of fair value.

o Management provided prospective financial information (PFI) for the

Company. For the purposes of this assignment you will assume that the
PFI accurately reflects market participants’ expectations for the
Company’s performance going forward. However, take note of the PFI
component of the exercise instructions, below.

o Trade name – “Trazione” – Wahmi has been using this name since 1971
and the market identifies the Company’s products and services with the
trade name.

o Customer list – Wahmi’s Management was able to provide historical

sales information for the Company’s top 65 customers over the past five
years.

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o Software – the Company developed its own internal software as part of

its modernization effort which converted the Company from a catalogue-
based marketer to an online marketer. Management believes the
software is state-of-the-art and comprises a significant competitive
advantage over the company’s competitors.

o Assembled workforce is not a separable identified asset, but it is valued

separately since it must be included in the contributory asset charge.

o You have received an excel file labelled “Wahmi.Ltd” which contains the
Company’s financial spreadsheets, prospective financial information,
and basic model for valuing the identified intangible assets.

Exercise 1.

Exhibits 1 – 7 on the following pages (as well as in the excel file) reflect the following:

1. Historical balance sheets for Wahmi, Ltd. (Exhibit 2)

2. Historical income statements for Wahmi Ltd. (Exhibit 3)

3. Projected income statements for Wahmi, Ltd. (Exhibit 4)

4. Financial data for seventeen guideline public companies which are assumed to
represent the market participants for Wahmi’s industry. Most of the companies
are U.S. based and some are based in Europe. For the purposes of this
exercise assume that all companies are comparable to Wahmi regardless of
the country of origin. (Exhibit 5)

5. A spreadsheet which reflects the derivation of Wahmi’s WACC as well as the

derivation of individual returns for Wahmi’s tangible assets, which include net
working capital and fixed assets. (Exhibit 6)

6. A spreadsheet which reflects the raw data to determine the rates of returns for
each of the intangible assets that have been identified and will be valued as
part of this assignment as well as intangible assets that will be valued as part
of the contributory asset charge (Exhibit 6, continued), including:

a. Customer list

b. Trade name

c. Software

d. Assembled workforce

e. Goodwill

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7. A spreadsheet which contains the calculations for Wahmi’s internal rate of

return from the transaction. (Exhibit 7)

Given the information provided thus far, complete the following tasks:

• Review the historical financial information in Exhibits 2-3, noting historical

growth, profitability, capital structure, etc. Document your observations.

• As stated above, the PFI provided by management is assumed to be accurate

(Exhibit 4). Nonetheless, create a list of questions for management that you
would have about the PFI if this were a real-life assignment.

• Review the Market Participant Analysis in Exhibit 5 and make note of data that
you will need to reference in the ensuing analysis.

• The WACC and required rates of return have been provided in Exhibit 6.
Given the information you have been provided, fill in the discount rates in the
spreadsheet for Customer Lists, Trade Name, Software, Assembled
Workforce, and Goodwill in the yellow-shaded cells in the excel file provided in
the “Assumptions” tab.

• Fill in the desired trademark rate in the yellow shaded cell in the “Assumptions”
tab.

• Using the Goal-Seek Function, complete the Transaction Internal Rate of

Return analysis. The transaction amount was €68 million (remember that the
excel file is in thousands). The excel file as shown contains dummy values for
the firm. The prospective cash flows are correct.

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Exhibit 1
Wahmi, Limited
Intangible Asset Valuation
Summary of Values
(€ 000)

Tangible Asset Indicated Fair Value

Operating Working Capital

Fixed Assets

Intangible Asset Indicated Fair Value

Trade Name
Software
Assembled Workforce
Customer List
Goodwill

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Exhibit 2
Wahmi, Limited
Historical Balance Sheets
For the fiscal period ending December 31,
(€ 000)
CAGR Percent of Total Assets
2014 2015 2016 2017 2014 - 2017 2014 2015 2016 2017
ASSETS
CURRENT ASSETS
Cash € 1,061.3 € 1,357.2 € 1,180.4 € 967.5 -3.0% 4.7% 5.7% 4.7% 3.8%
Receivables 3,875.1 4,135.5 4,841.9 4,610.2 6.0% 17.3% 17.5% 19.4% 18.3%
Inventory 6,844.0 7,107.5 7,387.8 7,657.8 3.8% 30.5% 30.1% 29.6% 30.4%
Prepaid Expenses 765.0 1,129.5 1,237.7 1,871.3 34.7% 3.4% 4.8% 5.0% 7.4%
TOTAL CURRENT ASSETS 12,545.4 13,729.7 14,647.8 15,106.8 6.4% 56.0% 58.1% 58.7% 60.0%

NET FIXED ASSETS 9,467.0 9,650.0 10,156.0 10,005.0 1.9% 42.2% 40.8% 40.7% 39.7%

OTHER ASSETS
Deferred Financing Costs 397.8 265.2 159.0 71.0 -43.7% 1.8% 1.1% 0.6% 0.3%
TOTAL OTHER ASSETS 397.8 265.2 159.0 71.0 -43.7% 1.8% 1.1% 0.6% 0.3%

TOTAL ASSETS € 22,410.2 € 23,644.9 € 24,962.8 € 25,182.8 4.0% 100.0% 100.0% 100.0% 100.0%

LIABILITIES & EQUITY

CURRENT LIABILITIES
Accounts Payable € 4,335.3 € 4,397.6 € 3,277.7 € 3,618.0 -5.9% 19.3% 18.6% 13.1% 14.4%
Accrued Liabilities 2,814.4 2,267.1 1,712.6 1,290.2 -22.9% 12.6% 9.6% 6.9% 5.1%
Revolving Credit 1,883.6 1,100.8 1,838.9 2,015.0 2.3% 8.4% 4.7% 7.4% 8.0%
Current Portion of Long-Term Debt 3,029.8 2,797.3 2,680.6 2,148.0 -10.8% 13.5% 11.8% 10.7% 8.5%
TOTAL CURRENT LIABILITIES 12,063.1 10,562.8 9,509.8 9,071.2 -9.1% 53.8% 44.7% 38.1% 36.0%

LONG TERM LIABILITIES

Long-Term Debt 6,795.2 8,503.3 9,815.0 9,515.0 11.9% 30.3% 36.0% 39.3% 37.8%
TOTAL LONG-TERM LIABILITIES 6,795.2 8,503.3 9,815.0 9,515.0 11.9% 30.3% 36.0% 39.3% 37.8%

EQUITY
TOTAL EQUITY 3,551.9 4,578.8 5,638.0 6,596.6 22.9% 15.8% 19.4% 22.6% 26.2%

TOTAL LIABILITIES & EQUITY € 22,410.2 € 23,644.9 € 24,962.8 € 25,182.8 4.0% 100.0% 100.0% 100.0% 100.0%

Net Operating Working Capital € 4,334.4 € 5,707.8 € 8,477.1 € 9,231.1

Net OWC as % of Revenue 6.0% 8.3% 11.8% 12.5%

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Exhibit 3
Wahmi, Limited
Historical Income Statements
For the period ended December 31,
(€ 000)
Percent of Total Revenues
2014 2015 2016 2017 CAGR 2014 2015 2016 2017

NET SALES € 72,466.5 € 68,758.8 € 71,675.8 € 73,991.1 0.7% 100.0% 100.0% 100.0% 100.0%

COST OF GOODS SOLD 46,474.1 45,120.5 46,773.1 47,947.1 1.0% 64.1% 65.6% 65.3% 64.8%

GROSS PROFIT 25,992.4 23,638.3 24,902.7 26,044.0 0.1% 35.9% 34.4% 34.7% 35.2%

Labor and Other Employee Costs 7,904.8 7,373.9 7,187.0 7,491.6 10.9% 10.7% 10.0% 10.1%
Catalog and Postage Expense 4,519.8 1,429.3 685.2 112.1 6.2% 2.1% 1.0% 0.2%
Web & computer expense 1,299.0 2,915.8 4,122.2 4,988.6 1.8% 4.2% 5.8% 6.7%
Selling and Marketing Expenses 1,173.9 1,184.3 1,381.2 1,882.1 1.6% 1.7% 1.9% 2.5%
Occupancy Expenses 1,149.7 1,243.0 1,212.5 1,255.2 1.6% 1.8% 1.7% 1.7%
General and Administrative 3,099.6 2,908.1 2,685.4 2,718.1 4.3% 4.2% 3.7% 3.7%
OPERATING EXPENSES 19,146.9 17,054.5 17,273.5 18,447.7 -1.2% 26.4% 24.8% 24.1% 24.9%

Reported EBITDA 6,845.5 6,583.8 7,629.2 7,596.3 3.5% 9.4% 9.6% 10.6% 10.3%
Depreciation & Amortization 657.4 633.3 510.7 603.8 0.9% 0.9% 0.7% 0.8%

Reported EBIT € 6,188.1 € 5,950.5 € 7,118.4 € 6,992.5 4.2% 8.5% 8.7% 9.9% 9.5%

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Exhibit 4
Wahmi, Limited
Projected Income Statements
For the period ending December 31,
(€ 000)
2018 2019 2020 2021 2022

NET SALES € 78,301.0 € 82,230.0 € 86,305.0 € 90,705.0 € 95,200.0

COST OF GOODS SOLD 50,800.0 53,410.0 56,005.0 58,800.0 61,800.0

GROSS PROFIT 27,501.0 28,820.0 30,300.0 31,905.0 33,400.0

OPERATING EXPENSES 19,300.0 20,300.0 21,300.0 22,305.0 23,540.0

EBITDA 8,201.0 8,520.0 9,000.0 9,600.0 9,860.0

Depreciation & Amortization 700.0 700.0 800.0 800.0 800.0

EBIT € 7,501.0 € 7,820.0 € 8,200.0 € 8,800.0 € 9,060.0

Sales growth 5.8% 5.0% 5.0% 5.1% 5.0%

Gross profit margin 35.1% 35.0% 35.1% 35.2% 35.1%
EBITDA margin 10.5% 10.4% 10.4% 10.6% 10.4%
Operating margin 9.6% 9.5% 9.5% 9.7% 9.5%
Capital Expenditures € 400.0 € 400.0 € 500.0 € 650.0 € 790.0

EBITDA Calcs for Customer Relationships

Wahmi EBITDA € 8,201.0
Less : allocated depreciation 700.0
WAHMI EBIT 7,501.0
Add: Overhead to attract new customers 50.0 mgt estimate of €50 customer expense on new customers.
Wahmi Customer EBIT (for customer list) 7,551.0

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 Chapter 3. The Valuation of Intangible Assets iiBV 204: Advanced Topics in Business Valuation

Exhibit 5
Wahmi, Limited
Intangible Asset Valuation
Market Participant Analysis
($ in millions, except stock price)

Market Value Debt & Financial

Shares Preferred of Invested Preferred / Effective Tax Levered Business Risk EBIT
Guideline Company Stock Price Outstanding Equity Value L-T Debt Equity Capital MVIC Rate Beta Risk Index Index Margin

Advance Auto Parts, Inc. $95.80 73.860 $7,075.8 $1,043.0 $0.0 $8,118.8 12.8% 37.8% 0.70 0.64 0.06 7.4%
Autonation, Inc. 42.41 100.44 4,259.66 4,261.00 - 8,520.66 50.0% 38.5% 1.02 0.63 0.39 3.6%
Autozone, Inc. 511.63 28.030 14,341.0 4,924.0 0.0 19,265.0 25.6% 35.1% 0.51 0.42 0.09 19.3%
Copart, Inc. 31.97 230.330 7,363.7 640.5 0.0 8,004.1 8.0% 31.6% 1.04 0.98 0.06 32.6%
Group 1 Automotive 54.84 20.110 1,102.8 2,362.0 0.0 3,464.8 68.2% 35.2% 1.76 0.74 1.02 3.3%
Autoliv, Inc. 105.30 86.910 9,151.6 1,544.0 0.0 10,695.6 14.4% 30.1% 1.17 1.05 0.12 8.5%
BorgWarner, Inc. 44.76 211.060 9,447.0 2,220.0 0.0 11,667.0 19.0% 20.4% 1.94 1.63 0.31 12.4%
Eaton Corp. 71.04 444.800 31,598.6 8,277.0 0.0 39,875.6 20.8% 9.5% 1.39 1.12 0.27 11.6%
Gentex Corp. 17.94 285.550 5,122.8 186.0 0.0 5,308.8 3.5% 31.9% 1.35 1.32 0.03 29.9%
Genuine Parts Co. 83.30 146.830 12,230.9 875.0 0.0 13,105.9 6.7% 36.0% 1.07 1.02 0.05 6.8%
Lear Corp. 144.54 68.010 9,830.2 1,942.0 0.0 11,772.2 16.5% 27.7% 1.37 1.20 0.17 8.2%
Magna International, Inc. 47.76 372.530 17,792.0 2,582.0 0.0 20,374.0 12.7% 26.8% 1.45 1.31 0.14 7.5%
Modine Manufacturing Co. 16.10 50.120 806.9 511.0 0.0 1,317.9 38.8% 28.4% 1.20 0.83 0.37 4.4%
Standard Motor Products, Inc. 9.95 19.850 197.5 113.8 0.0 311.3 36.6% 31.0% 0.65 0.47 0.18 4.7%
Superior Industries Int'l, Inc. 14.90 24.900 371.0 0.0 0.0 371.0 0.0% 24.4% 0.63 0.63 0.00 4.9%
Tenneco, Inc. 52.68 53.200 2,802.6 1,384.0 0.0 4,186.6 33.1% 0.0% 1.79 1.20 0.59 4.9%
Visteon Corp. 112.10 31.170 3,494.2 382.0 0.0 3,876.2 9.9% 18.6% 1.08 0.99 0.09 8.3%

High $31,598.6 $8,277.0 $0.0 $39,875.6 68.2% 38.5% 1.9 1.6 1.0 32.6%
Low 197.5 0.0 0.0 311.3 0.0% 0.0% 0.5 0.4 0.0 3.3%
Mean 8,119.5 2,012.8 0.0 10,132.3 22.7% 26.6% 1.2 1.0 0.2 10.7%
Median 6,243.2 1,464.0 0.0 8,262.4 17.8% 29.2% 1.2 1.0 0.2 7.8%

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Exhibit 6
Wahmi, Limited
Assumptions
Summary of Values
(€ 000)

WEIGHTED AVERAGE COST OF CAPITAL REQUIRED RETURN ON WORKING CAPITAL

Risk-Free Rate [1] 2.1% Enter Base Rate Proxy [7] 4.4%
Business Risk Index [2] 1.00 Risk Premium 3.0%
Market Risk Premium [3] 5.5% Pre-Tax Required Return 7.4%
Size Risk Premium [4] 5.0% Taxes -1.8%
Company Specific Risk Premium 0.0% REQUIRED RETURN ON WORKING CAPITAL 5.6%
Unlevered Cost of Equity 12.6%
% Debt Capital [5] 20.0% REQUIRED RETURN ON FIXED ASSETS
% Equity Capital 80.0% Enter Base Rate Proxy [8] 5.5%
Tax Rate [6] 24.0% Risk Premium 4.0%
Levered Cost of Equity 13.6% Pre-Tax Required Return 9.5%
Pre-tax Cost of Debt 7.7% Taxes -2.3%
WEIGHTED AVERAGE COST OF CAPITAL 12.1% REQUIRED RETURN ON FIXED ASSETS 7.2%

Tangible Assets

NORMAL NET WORKING CAPITAL [9] € 10,198.60

NORMAL LEVEL OF FIXED ASSETS [10] € 10,005.00
CORRESPONDING REVENUE LEVEL € 78,301.00

Footnote(s):
[1] Utilized the long term treasury yield on German bonds at measurement date .
[2] Based on the average business risk index as observed in the market participant group.
[3] Utilized the long horizon expected equity risk premium as presented in Duff & Phelps Risk Premium Study and in Aswath Damodaran analysis
[4] Based upon the Duff & Phelps size risk premium study.
[5] Based upon a review of the capital structure composition of the market participant group.
[6] Based on Italian statutory corporate tax rate.
[7] Based upon the Baa Composite yield (4.39%) at the measurement date as presented in Reuters.
[8] Utilized the bank prime rate and the Baa corporate composite rate at the measurement date .
[9] Normal net working capital = net working capital prior to the transaction. No inventory step-up was deemed required.
[10] Normal level of fixed assets equals balance sheet book value as determined by tangible asset appraisers.

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 Chapter 3. The Valuation of Intangible Assets iiBV 204: Advanced Topics in Business Valuation

Exhibit 6 (continued)
Wahmi, Limited
Assumptions
Summary of Values
(€ 000)

Intangible Assets

CUSTOMER LISTS
Revenue Projection € 78,301.0
EBIT Margin 9.6%
Tax Rate 24.0%
Discount Rate
Attrition Rate 5.9%
Growth Rate 3.0%

TRADE NAME
Revenue Allocation 100.0%
Royalty Rate
Tax Rate 24.0%
Discount Rate
Long-term Growth Rate 3.0%

SOFTWARE
Tax Rate 24.0%
Discount Rate

WORKFORCE INTANGIBLE
Required Return

GOODWILL
Required Return

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 Chapter 3. The Valuation of Intangible Assets iiBV 204: Advanced Topics in Business Valuation

Exhibit 7
Wahmi, Limited
Transaction Internal Rate of Return
(€ 000)

2017 2018 2019 2020 2021 2022 Perpetuity

REVENUE € 73,991.1 € 78,301.0 € 82,230.0 € 86,305.0 € 90,705.0 € 95,200.0 € 98,056.0

OPERATING INCOME 6,992.5 7,501.0 7,820.0 8,200.0 8,800.0 9,060.0 9,609.5

TAXES 1,800.2 1,876.8 1,968.0 2,112.0 2,174.4 2,306.3

NET INCOME 5,700.8 5,943.2 6,232.0 6,688.0 6,885.6 7,303.2

PLUS (MINUS):
Dep. & Amort. 700.0 700.0 800.0 800.0 800.0 0.0
Net Working Capital Additions (517.2) (471.5) (489.0) (528.0) (539.4) (342.7)
Capx (400.0) (400.0) (500.0) (650.0) (790.0) 0.0

FREE CASH FLOW 5,483.6 5,771.7 6,043.0 6,310.0 6,356.2 6,960.5

As % of Rev. 7.0% 7.0% 7.0% 7.0% 6.7% 7.1%

PRO-RATA ADJUSTMENT FACTOR 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

PRO-RATA AFTER-TAX CASH FLOW € 5,483.6 € 5,771.7 € 6,043.0 € 6,310.0 € 6,356.2 € 6,960.5
Capitalization Rate 6.0%
DISCOUNT RATE 9.0% Perpetuity Value 116,008.2
Time Remaining in 1st Period 1.0000
Years to Discount 0.5000 1.5000 2.5000 3.5000 4.5000 4.5000
PV FACTOR 0.9578 0.8787 0.8062 0.7396 0.6785 0.6785
PV CASH FLOW € 5,252.31 € 5,071.84 € 4,871.77 € 4,666.99 € 4,312.99 € 78,717.15

Sum of Interim Period Present Value € 24,175.9

Present Value of Terminal Value 78,717.2
Market Value of Invested Capital € 102,893.0

Assumptions
Revenue Growth 5.8% 5.0% 5.0% 5.1% 5.0% 3.0%
EBIT Margin 9.6% 9.5% 9.5% 9.7% 9.5% 9.8%
Tax Rate 24.0% 24.0% 24.0% 24.0% 24.0% 24.0%
Dep & Amort. (% of rev.) 0.9% 0.9% 0.9% 0.9% 0.8% n/a
Net Working Capital (% of rev.) 12.0% 12.0% 12.0% 12.0% 12.0% 12.0%

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 Chapter 3. The Valuation of Intangible Assets iiBV 204: Advanced Topics in Business Valuation

Exercise 2.

Complete the trade name valuation by determining the appropriate royalty rate for the
‘Trazione’ trade name given the market evidence in Exhibit 8 below and what you know about
the Company. Enter the royalty rate in the appropriate cell in Exhibit 6 – Assumptions. Also
insert the appropriate discount rate. The trade name valuation in Exhibit 9 will automatically
be completed.

Exhibit 8
Wahmi, Limited
Guideline Royalty Rates
Trademark Related Licensing Agreements

Business Name/Description Product or Service Licensed Royalty Range Upfront Fees/Comments

AAF MSQuery, Inc. "McQuay" trademark 2.0% to 5.0% In connection with sale and marketing
of HVAC products.
Goodyear Tires Use of "Goodyear" name 3.5% Licensee is independent chaing of tire
retail stores and repair shops
Cable and Wireless Plc Trademark and logo 8.0% Licensee Hong Kong
Telecommunications Ltd.
Carnival Corp. "Carnival" trademark 1.0% Licensee is Carnival hotels & casinos.
Royalty is greater of $100,000 or 1%
of revenues.
Casino Magic Corp. "Casino Magic" trade name and service marks 2.0% Licensee is Casino Magic Neuquen
S.A.
Century 21 Real Estate "Century 21" trademark 3.0% Exclusive use in connection with home
improvements.
Rock Auto Parts Use of "Rock Parts" trade name and mark 3.0% Licensee is subsidiary retal chain
HFS Inc. "Avis" trademark 3.0% Base rate of 3.0% plus 1.0%
supplemental.
KPMG Peat Marwick, LLP "KPMG" name 5.0% Licenses is KPMG BayMark, LLC an
investment bank
Lufthansa German Airlines "DHL" trademark 0.8% Licensee DHL Airways Inc.
Minnegasco Utility's name 1.0% Licensed to affiliate.
Nextel "Nextel" brand name 1.0% 0.5% first year, 1.0% thereafter.
Southwestern Bell Telephone "Southwestern Bell" name 5.0% Licensed to affiliate.
SUSA Partnership, LP "Storage USA" trademark 5.0% Operation of self-storage facilities.
Washington Natural Gas Company Washington's name 1.5% Licensed to affiliate.
Western Union Corp. "Western Union" trade and service marks 5.0% Licensee is Financial Services, Inc.

Average = 3.2%
Median = 3.0%

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Exhibit 9
Wahmi, Limited
Trade Name Valuation
(€ 000)

2018 2019 2020 2021 2022

TOTAL COMPANY REVENUES € 78,301.0 € 82,230.0 € 86,305.0 € 90,705.0 € 95,200.0

Revenue Growth 5.0% 5.0% 5.1% 5.0%
% of Revenues Related to Trade Name 100.0% 100.0% 100.0% 100.0% 100.0%

TRADE NAME ASSOCIATED REVENUES 78,301.0 82,230.0 86,305.0 90,705.0 95,200.0

FAIR MARKET ROYALTY RATE

ROYALTY SAVINGS #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! Long-Term

TAXES #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! Growth Rate Perpetuity

AFTER-TAX CASH FLOW #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! 3.0% #VALUE!

PRO-RATA ADJUSTMENT FACTOR 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

PRO-RATA AFTER-TAX CASH FLOW #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
Capitalization Rate #VALUE!
Perpetuity Value #VALUE!
DISCOUNT RATE
Time Remaining in 1st Period 1.0000
Years to Discount 0.5000 1.5000 2.5000 3.5000 4.5000 4.5000
PV FACTOR #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!
PV CASH FLOW #VALUE! #VALUE! #VALUE! #VALUE! #VALUE! #VALUE!

Sum of Interim Period Present Value #VALUE!

Present Value of Terminal Value #VALUE!

TOTAL PRESENT VALUE #VALUE!

Tax Benefit Cash Flow Factor [1] 1.122x

Economic Value #VALUE!

Rounded #VALUE!

The trade name valuation is completed automatically in the excel spreadsheet once the
variables are entered. The tax amortization benefit is also automatically calculated. The
actual tax benefit can also be expressed as follows:

Mechanics of the Tax Amortization Benefit

Present Value
Year $ Amortized Tax Saved at 14.0%
1 € 1,227.5 € 294.6 € 262.8
2 1,227.5 294.6 234.4
3 1,227.5 294.6 209.1
4 1,227.5 294.6 186.6
5 1,227.5 294.6 166.4
6 1,227.5 294.6 148.5
7 1,227.5 294.6 132.4
8 1,227.5 294.6 118.1
9 1,227.5 294.6 105.4
10 1,227.5 294.6 94.0
11 1,227.5 294.6 83.9
12 1,227.5 294.6 74.8
13 1,227.5 294.6 66.7
14 1,227.5 294.6 59.5
15 1,227.5 294.6 53.1
Present Value of Tax Shield = 1,995.8

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 Chapter 3. The Valuation of Intangible Assets iiBV 204: Advanced Topics in Business Valuation

Exercise 3.

Complete the software valuation using the replacement cost method as contained in Exhibit 10
(see tab “E10.Software” in the excel file). Assume the following facts:

• There are four programmers needed to complete the software asset. The two
lead programmers are paid 145,000 euros per year in addition to a 21,000
bonus each, the third programmer is paid 100,000 euros plus a 17,500 bonus,
and the fourth programmer is paid 75,000 euros per year with a 15,000 bonus.
The rest of the data has been entered.

Exhibit 10
Wahmi, Limited
Internally Developed Software
Cost Approach
(€ 000)

Employee Costs Contractor Costs

Estimated Estimated
Average Replacement Man Total Average Replacement Man Total
Annual Cost New Years to Employee Annual Cost New Years to Contractor
Personnel Salary Bonus (RCN) Re-create Cost Salary (RCN) Re-create Cost

Programmer 1 € 0.0 3.0 € 0.0 € 150,000.0 € 150,000.0 2.0 € 300,000.0

Programmer 2 0.0 3.0 0.0 125,000.0 125,000.0 2.0 250,000.0
Programmer 3 0.0 3.0 0.0 0.0 0.0 0.0 0.0
Administrative support 0.0 0.5 0.0 0.0 0.0 0.0 0.0

Exhibit 10
Wahmi, Limited
Internally Developed Software
Cost Approach
(€ 000)

Total Costs Obsolescence Factor Economic Life

One Time Adjusted Replacement

Personnel Costs Total Costs Factor Total Cost New Remaining Cost

Programmer 1 € 265,000.0 € 565,000.0 10.0% € 508,500.0 10.0 yrs 8.0 yrs 80.0% € 406,800.0
Programmer 2 0.0 250,000.0 10.0% 225,000.0 10.0 yrs 8.0 yrs 80.0% 180,000.0
Programmer 3 0.0 0.0 10.0% 0.0 10.0 yrs 8.0 yrs 80.0% 0.0
Administrative support 0.0 0.0 10.0% 0.0 10.0 yrs 8.0 yrs 80.0% 0.0

TOTAL REPLACEMENT COST 586,800.0

TAX SAVINGS 0.0% -

AFTER-TAX REPLACEMENT COST 586,800.0

Tax Benefit Cash Flow Factor [1] 1.122x

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 Chapter 3. The Valuation of Intangible Assets iiBV 204: Advanced Topics in Business Valuation

Analysis of the assembled workforce

The Assembled Workforce calculations have been completed and entered into the
spreadsheets below. The assembled workforce is not a separable, identified asset. It is
considered part of the final goodwill asset. However, for purposes of the Contributory Asset
Charge (CAC) it must be separately valued since it has a different rate of return than goodwill
and is included as a separate asset in the CAC calculation. The Assembled workforce is
calculated from the perspective of having to replace the existing workforce. The model below
is an example of the replacement cost method. All hiring costs, incremental salaries and
bonuses, training costs and unproductive ramp-up inefficiencies are captured in the
calculations below.

Exhibit 11
Wahmi, Limited
Assembled Workforce Analysis
Cost Approach
(€ 000)
Clerk &
Employee Classification/Grade Executive Managerial Automotive Shipping

Average Compensation/Employee
Total Base Salary € 782,226 € 647,837 € 1,023,235 € 568,818
Number of Employees (FTE) 6.0 12.0 42.0 25.0
Base Salary 130,371 53,986 24,363 22,753
Bonus/Other 28,682 4,859 0 0
As % of Base Salary 22.0% 9.0% 0.0% 0.0%
Total Compensation 159,053 58,845 24,363 22,753
Benefits/Other 31,289 12,957 5,847 5,461
As % of Base Salary 24.0% 24.0% 24.0% 24.0%
Fully Burdened Total Compensation 190,342 71,802 30,210 28,213
Fully Burdened Compensation/Hour 92 35 15 14

Incremental Compensation Cost

Base Salary 130,371 53,986 24,363 22,753
Incremental Base Salary 15,000 5,000 7,500 5,000
As % of Base Salary 0.0% 0.0% 0.0% 0.0%
New Hire Base Salary 145,371 58,986 31,863 27,753
Bonus/Other 35,000 5,000 0 0
As % of Base Salary 24.1% 8.5% 0.0% 0.0%
New Hire Total Compensation 180,371 63,986 31,863 27,753
Benefits/Other 31,289 12,957 5,847 5,461
As % of Base Salary 21.5% 22.0% 18.4% 19.7%
New Hire Fully Burdened Total Compensation 211,660 76,943 37,710 33,213
Fully Burdened Compensation/Hour 102 37 18 16
Incremental Total Compensation € 21,318 € 5,141 € 7,500 € 5,000

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 Chapter 3. The Valuation of Intangible Assets iiBV 204: Advanced Topics in Business Valuation

Exhibit 11
Wahmi, Limited
Assembled Workforce Analysis
Cost Approach
(€ 000)

Interviewing/Recruiting Cost Executive Managerial Clerk & Shipping

First Round Interview

Number of Candidates 8.0 5.0 5.0 3.0
Total Interviewing Time 1.0 1.0 1.0 0.5
Total First Interview Time 8.0 5.0 5.0 1.5
Interviewer's Cost/Hour € 60.00 € 60.00 € 60.00 € 60.00

Second Round Interview

Number of Candidates 2.0 3.0 3.0 2.0
Total Interviewing Time 3.0 2.0 1.5 1.0
Total Second Interview Time 6.0 6.0 4.5 2.0
Interviewer's Cost/Hour € 60.00 € 50.00 € 25.00 € 25.00

Total Interviewing Time 14.0 11.0 9.5 3.5

Blended Cost/Hour 60.00 54.55 43.42 40.00
Total Interviewing Cost 840 600 413 140

New Hire Base Salary 145,371 58,986 31,863 27,753

Headhunter Fee as % of Hiring Base Salary 25.0% 0.0% 0.0% 0.0%
Headhunter Fee 36,343 - - -

Interviewing/Recruiting Costs
Interviewing Costs 840 600 413 140
Headhunter Fees 36,343 - - -
Other Costs - - - -
Total Interviewing/Recruiting Costs € 37,183 € 600 € 413 € 140

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 Chapter 3. The Valuation of Intangible Assets iiBV 204: Advanced Topics in Business Valuation

Exhibit 11
Wahmi, Limited
Assembled Workforce Analysis
Cost Approach
(€ 000)

Training/Productivity Costs Executive Managerial Clerk & Shipping

Internal Training Time 80.0 40.0 20.0 16.0

Instructor Cost/Hour € 30.00 € 20.00 € 12.00 € 8.00
Total In-House Training Cost 2,400 800 240 128
Outside/Formal - - - -
Total Training Costs 2,400 800 240 128

Fully Burdened Compensation 211,660 76,943 37,710 33,213

Average Unproductive Factor 75.0% 50.0% 25.0% 25.0%
Loss of Productivity/Year 158,745 38,472 9,427 8,303
Loss of Productivity/Week 3,053 740 181 160
Number of Weeks to Full Productivity 8.0 6.0 2.0 1.0
Total Productivity Costs € 24,422 € 4,439 € 363 € 160

REPLACEMENT COST SUMMARY

Incremental Compensation Costs € 21,318 € 5,141 € 7,500 € 5,000

Interviewing/Recruiting Costs 37,183 600 413 140
Training/Loss of Productivity Costs 24,422 4,439 363 160

Total Cost/Employee 82,923 10,180 8,275 5,300

Number of Employees (FTE) 6.0 12.0 42.0 25.0

REPLACEMENT COST/EMPLOYEE GRADE € 497,541 € 122,163 € 347,554 € 132,492

TOTAL REPLACEMENT COST € 1,099,750

TAX SAVINGS 24.0% 263,940

AFTER-TAX REPLACEMENT COST 835,810

Tax Benefit Cash Flow Factor [1] 1.122x

Economic Value €937,550

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 Chapter 3. The Valuation of Intangible Assets iiBV 204: Advanced Topics in Business Valuation

Analysis of the Contributory Asset Charge

The Contributory Asset Charge is shown below in Exhibit 12 (also see excel file, tab
“E12.Cont.Asset.Ch”). This calculation equals the after-tax return that is required for all assets
in the business other than the customer list, including working capital, fixed assets, the trade
name, software, and assembled workforce. These returns will be deducted from total income
to isolate the customer list returns in the following exercise.

(FV of Asset x after-tax return) = Required Cash Return on Asset;

(Required Cash Return/Revenue) = Net profit margin on asset

The sum total of each net margin of each individual asset equals the CAC. The CAC is
deducted from total revenue to determine the profit which is attributable to the sole remaining
asset which is the customer list.

Exhibit 12
Wahmi, Limited
Contributory Asset Returns
Summary of Values
(€ 000)

Fair Value Required After-tax Required Cash Corresponding Required After-tax Cash
Contributory Asset Estimate Return Estimate Return Revenue Level Return as % of Revenue
Debt-free Net Working Capital [1] € 10,198.6 5.6% € 572.8 € 78,301.0 0.7%
Fixed Assets [1] 10,005.0 7.2% 722.4 78,301.0 0.9%
Work Force 937.6 12.1% 113.2 78,301.0 0.1%
Tradename [2] 20,700.0 2.3%
Software 1,784.0 15.0% 267.6 78,301.0 0.3%

Total Contributory Asset Cash Return (as a % of Rev.) 4.4%

Footnote(s)
[1] Working capital and fixed assets are valued based on their balance sheet reported amounts.
[2] Tradename required after-tax cash return as a % of revenue = fair market royalty rate * (1 - tax rate), or 3.0% * (1 - 24%)

The return on sales that is attributable to the aggregate assets (other than the customer list) is
therefore equal to 4.4%.

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 Chapter 3. The Valuation of Intangible Assets iiBV 204: Advanced Topics in Business Valuation

Exercise 4. Valuation of the Customer List

This exercise includes three tabs in the excel file:

• Exhibit 13. Revenues by Customer

• Exhibit 14. Attrition Estimate

• Exhibit 15. Customer List

Using the information in Exhibit 12 (CAC) and Exhibits 13 and 14, complete the yellow shaded
cells in Exhibit 15, Customer List. The two variables that need to be entered include the
contributory asset charge and the attrition estimate.

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 Chapter 3. The Valuation of Intangible Assets iiBV 204: Advanced Topics in Business Valuation

Exhibit 13
Wahmi, Limited
Revenues by Customer
(€ 000)

12/31/2013 12/31/2014 12/31/2015 12/31/2016 12/31/2017

Customer 1 € 8,147.5 € 8,249.1 € 8,414.5 € 8,512.2 € 8,600.8
Customer 2 7,777.3 7,518.6 7,605.3 7,598.0 7,815.1
Customer 3 5,948.0 6,855.3 6,752.2 6,419.5 6,653.2
Customer 4 4,917.4 5,013.5 5,009.3 5,551.2 5,216.0
Customer 5 3,918.5 4,002.3 4,189.0 4,089.3 4,159.0
Customer 6 3,908.4 4,187.2 4,186.0 4,216.2 0.0
Customer 7 2,611.0 2,900.0 3,008.0 2,915.0 3,050.5
Customer 8 1,556.9 1,956.2 2,850.0 3,201.8 3,359.6
Customer 9 0.0 0.0 621.0 1,774.1 2,926.3
Customer 10 1,422.0 0.0 0.0 0.0 0.0
Customer 11 1,189.0 987.0 1,096.0 0.0 0.0
Customer 12 1,086.3 1,288.5 985.0 956.1 156.8
Customer 13 998.0 995.0 655.9 615.9 0.0
Customer 14 951.2 948.7 755.0 715.8 722.8
Customer 15 0.0 0.0 0.0 701.0 705.2
Customer 16 0.0 22.0 148.3 189.2 699.2
Customer 17 950.1 1,080.3 1,186.0 1,212.1 1,414.4
Customer 18 929.0 944.0 1,245.0 1,308.4 1,209.5
Customer 19 918.4 821.3 255.0 486.1 0.0
Customer 20 877.2 50.2 89.3 0.0 0.0
Customer 21 851.2 655.1 701.2 548.1 559.5
Customer 22 0.0 0.0 858.1 257.6 528.8
Customer 23 800.8 129.8 156.3 229.2 288.6
Customer 24 751.8 0.0 0.0 0.0 0.0
Customer 25 706.5 1,099.5 885.3 649.5 654.4
Customer 26 664.2 758.6 269.5 317.7 321.8
Customer 27 0.0 255.0 159.5 305.2 333.2
Customer 28 608.5 699.9 709.6 855.3 828.9
Customer 29 0.0 0.0 214.0 0.0 801.0
Customer 30 587.6 678.2 715.6 679.1 798.5
Customer 31 555.3 594.5 665.8 159.8 0.0
Customer 32 501.9 422.0 487.9 333.6 685.5
Customer 33 458.2 319.5 0.0 0.0 0.0
Customer 34 0.0 451.0 0.0 298.2 569.2
Customer 35 0.0 0.0 0.0 158.3 497.7
Customer 36 422.5 29.6 0.0 0.0 0.0
Customer 37 348.8 0.0 0.0 0.0 0.0
Customer 38 333.7 318.9 415.9 214.9 547.6
Customer 39 292.6 588.4 669.5 671.9 698.8
Customer 40 246.5 648.5 714.4 717.8 798.5
Customer 41 222.1 298.5 316.9 399.2 509.5
Customer 42 209.9 152.2 189.5 98.5 487.5
Customer 43 0.0 124.0 299.8 326.3 397.7
Customer 44 0.0 0.0 100.5 199.7 380.2
Customer 45 197.8 122.5 156.2 198.3 201.5
Customer 46 192.8 296.5 154.3 164.5 218.8
Customer 47 185.3 288.2 150.0 128.3 178.9
Customer 48 0.0 111.0 222.3 383.1 490.0
Customer 49 179.9 215.6 222.2 233.6 299.0
Customer 50 0.0 0.0 0.0 0.0 643.1
Customer 51 160.5 178.5 187.6 198.2 228.0
Customer 52 154.6 166.2 174.6 0.0 0.0
Customer 53 141.3 128.5 145.2 0.0 0.0
Customer 54 140.2 89.0 0.0 0.0 0.0
Customer 55 135.5 0.0 0.0 0.0 0.0
Customer 56 0.0 587.5 0.0 288.8 456.2
Customer 57 130.9 158.6 66.3 0.0 0.0
Customer 58 129.8 0.0 0.0 0.0 0.0
Customer 59 124.4 255.0 259.3 269.3 312.7
Customer 60 0.0 109.6 108.6 102.5 0.0
Customer 61 0.0 65.5 121.4 89.5 65.3
Customer 62 120.2 198.5 201.5 272.7 377.0
Customer 63 119.2 129.6 134.8 189.6 157.9
Customer 64 111.1 201.0 205.9 297.5 301.0
Customer 65 105.5 89.0 0.0 0.0 0.0

Total € 58,997.3 € 59,432.7 € 60,090.3 € 60,697.7 € 61,304.7

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 Chapter 3. The Valuation of Intangible Assets iiBV 204: Advanced Topics in Business Valuation

Exhibit 14
Wahmi, Limited
Attrition Calculation
(€ 000)

12/31/2013 12/31/2014 12/31/2015 12/31/2016 12/31/2017

Customer 1 € 8,147.5 € 8,147.5 € 8,147.5 € 8,147.5 € 8,147.5
Customer 2 7,777.3 7,777.3 7,777.3 7,777.3 7,777.3
Customer 3 5,948.0 5,948.0 5,948.0 5,948.0 5,948.0
Customer 4 4,917.4 4,917.4 4,917.4 4,917.4 4,917.4
Customer 5 3,918.5 3,918.5 3,918.5 3,918.5 3,918.5
Customer 6 3,908.4 3,908.4 3,908.4 3,908.4 0.0
Customer 7 2,611.0 2,611.0 2,611.0 2,611.0 2,611.0
Customer 8 1,556.9 1,556.9 1,556.9 1,556.9 1,556.9
Customer 9 0.0 0.0 0.0 0.0 0.0
Customer 10 1,422.0 0.0 0.0 0.0 0.0
Customer 11 1,189.0 1,189.0 1,189.0 0.0 0.0
Customer 12 1,086.3 1,086.3 1,086.3 1,086.3 1,086.3
Customer 13 998.0 998.0 998.0 998.0 0.0
Customer 14 951.2 951.2 951.2 951.2 951.2
Customer 15 0.0 0.0 0.0 0.0 0.0
Customer 16 0.0 0.0 0.0 0.0 0.0
Customer 17 950.1 950.1 950.1 950.1 950.1
Customer 18 929.0 929.0 929.0 929.0 929.0
Customer 19 918.4 918.4 918.4 918.4 0.0
Customer 20 877.2 877.2 877.2 0.0 0.0
Customer 21 851.2 851.2 851.2 851.2 851.2
Customer 22 0.0 0.0 0.0 0.0 0.0
Customer 23 800.8 800.8 800.8 800.8 800.8
Customer 24 751.8 0.0 0.0 0.0 0.0
Customer 25 706.5 706.5 706.5 706.5 706.5
Customer 26 664.2 664.2 664.2 664.2 664.2
Customer 27 0.0 0.0 0.0 0.0 0.0
Customer 28 608.5 608.5 608.5 608.5 608.5
Customer 29 0.0 0.0 0.0 0.0 0.0
Customer 30 587.6 587.6 587.6 587.6 587.6
Customer 31 555.3 555.3 555.3 555.3 0.0
Customer 32 501.9 501.9 501.9 501.9 501.9
Customer 33 458.2 458.2 0.0 0.0 0.0
Customer 34 0.0 0.0 0.0 0.0 0.0
Customer 35 0.0 0.0 0.0 0.0 0.0
Customer 36 422.5 422.5 0.0 0.0 0.0
Customer 37 348.8 0.0 0.0 0.0 0.0
Customer 38 333.7 333.7 333.7 333.7 333.7
Customer 39 292.6 292.6 292.6 292.6 292.6
Customer 40 246.5 246.5 246.5 246.5 246.5
Customer 41 222.1 222.1 222.1 222.1 222.1
Customer 42 209.9 209.9 209.9 209.9 209.9
Customer 43 0.0 0.0 0.0 0.0 0.0
Customer 44 0.0 0.0 0.0 0.0 0.0
Customer 45 197.8 197.8 197.8 197.8 197.8
Customer 46 192.8 192.8 192.8 192.8 192.8
Customer 47 185.3 185.3 185.3 185.3 185.3
Customer 48 0.0 0.0 0.0 0.0 0.0
Customer 49 179.9 179.9 179.9 179.9 179.9
Customer 50 0.0 0.0 0.0 0.0 0.0
Customer 51 160.5 160.5 160.5 160.5 160.5
Customer 52 154.6 154.6 154.6 0.0 0.0
Customer 53 141.3 141.3 141.3 0.0 0.0
Customer 54 140.2 140.2 0.0 0.0 0.0
Customer 55 135.5 0.0 0.0 0.0 0.0
Customer 56 0.0 0.0 0.0 0.0 0.0
Customer 57 130.9 130.9 130.9 0.0 0.0
Customer 58 129.8 0.0 0.0 0.0 0.0
Customer 59 124.4 124.4 124.4 124.4 124.4
Customer 60 0.0 0.0 0.0 0.0 0.0
Customer 61 0.0 0.0 0.0 0.0 0.0
Customer 62 120.2 120.2 120.2 120.2 120.2
Customer 63 119.2 119.2 119.2 119.2 119.2
Customer 64 111.1 111.1 111.1 111.1 111.1
Customer 65 105.5 105.5 0.0 0.0 0.0
Total € 58,997.3 € 46,209.9

Estimated Compound Annual Loss Rate -5.9%

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 Chapter 3. The Valuation of Intangible Assets iiBV 204: Advanced Topics in Business Valuation

Exhibits 13 and 14 determine an estimation of customer attrition. Management provided

historical sales by customer for the Company’s top 65 customers between 2013 and 2017.
That information is contained in Exhibit 13. Exhibit 14 isolates only the customers that existed
in 2013. The model reflects the 2013 sales amount for each year in which that customer
bought goods from the company.

For example, Customer #1 purchased €8,147,500 of goods from Wahmi in 2013 and the
customer bought goods all five years. Exhibit 14 attributes €8.147 million in sales to that
customer in all five years of the study (even Customer #1 bought higher amounts of goods in
ensuing years) since the model is measuring customer activity in ensuing years relative to
2013. If the customer left the company, then the sales level is reduced to zero as is the case
with Customers #10 and #11.

Also, customers that did not exist in 2013 but came in to the company in later years are
attributed zero sales in all years since the objective of the model is to measure customer
attrition in 2017, relative to the customers that existed in 2013.

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Exhibit 15
Wahmi, Limited
Customer List Valuation
MPEEM
(€ 000)

BASE YEAR CUSTOMER CASH FLOW ANALYSIS

CUSTOMER REVENUE ESTIMATE € 78,301.0

EBIT 9.64% 7,551.0

TAXES 24.0% 1,812.2

AFTER-TAX INCOME 5,738.8

AFTER-TAX CONTRIBUTORY ASSET RETURNS #VALUE!

CUSTOMER CASH FLOW #VALUE!

ATTRITION RATE
GROWTH RATE 3.0%

Total Remaining Discount PV Present Discounting

Year Cash Flow Remaining % Cash Flow Rate Factor Value Period

1 #VALUE! #VALUE! #VALUE! 14.0% 0.9366 #VALUE! 0.5000

2 #VALUE! #VALUE! #VALUE! 14.0% 0.8216 #VALUE! 1.5000
3 #VALUE! #VALUE! #VALUE! 14.0% 0.7207 #VALUE! 2.5000
4 #VALUE! #VALUE! #VALUE! 14.0% 0.6322 #VALUE! 3.5000
5 #VALUE! #VALUE! #VALUE! 14.0% 0.5545 #VALUE! 4.5000
6 #VALUE! #VALUE! #VALUE! 14.0% 0.4864 #VALUE! 5.5000
7 #VALUE! #VALUE! #VALUE! 14.0% 0.4267 #VALUE! 6.5000
8 #VALUE! #VALUE! #VALUE! 14.0% 0.3743 #VALUE! 7.5000
9 #VALUE! #VALUE! #VALUE! 14.0% 0.3283 #VALUE! 8.5000
10 #VALUE! #VALUE! #VALUE! 14.0% 0.2880 #VALUE! 9.5000
11 #VALUE! #VALUE! #VALUE! 14.0% 0.2526 #VALUE! 10.5000
12 #VALUE! #VALUE! #VALUE! 14.0% 0.2216 #VALUE! 11.5000
13 #VALUE! #VALUE! #VALUE! 14.0% 0.1944 #VALUE! 12.5000
14 #VALUE! #VALUE! #VALUE! 14.0% 0.1705 #VALUE! 13.5000
15 #VALUE! #VALUE! #VALUE! 14.0% 0.1496 #VALUE! 14.5000

TOTAL PRESENT VALUE #VALUE!

Tax Benefit Cash Flow Factor [2] 1.122x

Economic Value #VALUE!

Rounded Value #VALUE!

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 Chapter 3. The Valuation of Intangible Assets iiBV 204: Advanced Topics in Business Valuation

Reconciliation of Values

After valuing the customer list, the valuer has assigned values to all of the Company’s tangible
and identifiable intangible assets. The only asset that has not been directly valued is the
remaining goodwill. By definition the goodwill equals the Fair Value of the firm (in the case the
fair value equals the transaction price) less the value of each tangible asset and each
identified intangible asset.

In addition to calculating goodwill value in this way, the valuer should perform a check to his
analysis by calculating the weighted average return on assets (“WARA”). This calculation is
shown in Exhibit 16 (see excel file, tab E16.WARA).

Exhibit 16
Wahmi, Limited
Weighted Average Return on Assets
(€ 000)
Required After-tax Return Contribution to Weighted
Asset Fair Value % of Total Assets Estimate Return
Debt-free Net Working Capital € 10,198.6 15.0% 5.6% 0.8%
Fixed Assets 10,005.0 14.7% 7.2% 1.1%
Trade Name 20,700.0 30.4% 14.0% 4.3%
Software 1,784.0 2.6% 15.0% 0.4%
Work Force 937.6 1.4% 12.1% 0.2%
Customer List 14,130.0 20.8% 14.0% 2.9%
Goodwill 10,244.8 15.1% 16.0% 2.4%

BUSINESS ENTERPRISE VALUE € 68,000.0 100.0% WARA 12.0%

WACC 12.1%

TRANSACTION IRR 12.1%

The fair value amount of €68 million is entered into the business enterprise value cell and the
goodwill amount is calculated by subtracting all the valued assets. The goodwill amount
equals 68 million less the other values.

The percentage weight of each asset is then calculated as a percentage of business

enterprise value (BEV). The required after tax rate of return for each asset is then multiplied
by the weight to determine the portion that each weight has in the total value. The summed
weights equal the WARA.

If the valuation was completed with a consistent assessment of risk for each asset and no
errors were made in calculation, then the WARA, the WACC and the IRR should approximate

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each other. The amounts do not have to equal, but there should not be a material difference
since each of the metrics indicates the same variable, Wahmi’s cost of capital.

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Section E. Chapter Review Questions

1. Sample Company has the following assets with the following returns. You are valuing
Sample’s customer list.

Required
Asset Fair Value Return
Net working capital $ 2,400,000 5.5%
Fixed Assets 8,750,000 6.5%
Software 2,300,000 13.5%
Trade name 7,100,000

Additional information
Trade name royalty rate 3.00%
Tax rate 25.00%
Company revenue 35,000,000

What is Sample’s contributory asset charge given the above information?

A. 27.5%

B. 5.1%

C. 20.6%

D. 5.9%

2. You are valuing the trade name for Cowboy Jeans, an American-based manufacturer
of pants and casual clothing. Royalty rate research has uncovered the following data:

Business Product Licensed Royalty Rate

Apple Computer Mac trade name 7.0%
The Gap The Gap apparel trademark 4.0%
Coca-Cola Coke trade name 9.0%
Disney Mickey Mouse cartoon image 6.5%
Abercrombie & Fitch A&F apparel trademark 3.0%
Izod Lacoste polo shirts Alligator trademark 3.5%
Mercedes Benz Mercedes trademark 8.0%
Bostonian shoes Bostonian tradename 3.0%
Alibaba Alibaba name 10.0%
Average 6.0%
Median 6.5%

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What would be an appropriate royalty rate for Cowboy Jeans?

A. 3.4%

B. 6.0%

C. 10.0%

D. 6.5%

3. Which of the following intangible assets is an example of a contractual type of asset?

A. Customer list

B. Net working capital

C. Non-competition agreement

D. Trade name

4. Which of the following statements best describes the tax amortization benefit?

A. The value a long term leasehold interest where market lease rates have
increased above the contractual rent being paid by the lesee

B. The present value of the tax amortization from the identified intangible asset
over its tax life

C. The present value of a lease amortization over the life of the lease contract

D. The present value of the tax savings on the amortization from the identified
intangible asset over its tax life

5. A company’s annual customer attrition rate is 6.0%. The Company’s annual growth
rate is 3.5%. Assuming that the prior year’s cash flow attributable to its customer list
was $100,000, the cash flow in the first year of the forecast would equal:

A. $97,000

B. $100,395

C. $97,290

D. $94,000

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Chapter 4. Advanced International Cost of Capital

Section A. Introduction

iiBV 202 introduced the topic of estimating the cost of capital for developing and undeveloped
countries. Basic underlying international macroeconomic principles were discussed as well as
several general models for deriving the cost of equity. This chapter takes a closer look at four
models for developing the cost of equity in developing economies. Three sources provide the
annually updated information that is needed to use these models:

• 2016 International Valuation Handbook; Guide to Cost of Capital , Duff &

Phelps, Wiley, 2016 (referred to throughout this chapter as “the Handbook”)

• 2016 International Valuation Handbook: Industry Cost of Capital, Duff &

Phelps, Wiley, 2016

• [email protected]

These texts are not required for the student in this course. The classroom material and the
examination are based on the material in this outline. However, it is highly recommended that
the valuation practitioner obtain a copy of the two texts above for reference in practice. The
Damodaran website contains the research from Aswath Damodaran, Ph.D. from New York
University. This information, as well as excerpts from the Duff & Phelps Guide, are needed for
using the Damodaran model which is one of the models discussed below.

Four Models were selected for further analysis in this Chapter:

• Relative Volatility Model

• Erb-Harvey-Viskanta Country Credit Rating Model

• Country Yield Spread Model

• Damodaran Model

All four international cost of capital models covered in this chapter were introduced in iiBV 202,
The Income Approach. Although the models have been discussed, the information that is
needed to actually apply the models was not discussed. This chapter reviews the information
sources that allow the valuer to actually use these models.

In the development of a cost of equity outside North America, it is best practice to use as many
of these models as data sources and practicality allow. After reviewing the relevance and
limitations of each model the valuer can then decide on an appropriate cost of equity.

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Section B. Review

1. Capital Asset Pricing Model

A. The modified capital asset pricing model is shown below:

Ke = Rf + β(ERP) + Α
Where:

Ke = Cost of equity
Rf = Risk-free rate
β= Beta (systematic risk)
ERP = Equity risk premium
A= Alpha (size and specific risk)

(1) The CAPM estimates the cost of equity.

(2) The above model is the modified CAPM, which estimates the cost of
equity for a single stock.

(a) The original CAPM excluded the Alpha variable since it did not
include unsystematic risk. The original CAPM was derived to
assess the cost of equity for a portfolio of stocks in which all
unsystematic risk was assumed to be diversified away.

B. Risk-free rate (Rf)

(1) The yield to maturity on a country’s long-term government bond is used

as a proxy for the risk-free rate.

(2) The risk-free rate should capture the long-term inflation in the subject
country’s economy. If a developed country’s government bond is
applied in the valuation of a subject company in a developing economy,
then the inflation differential must be captured elsewhere.

(3) If, for example, a U.S. government bond is used, the valuer should be
aware that he is building a discount rate based in U.S. dollars.

C. Beta (β)

(1) The beta is a proxy for systematic risk. Systematic risk represents risk
that cannot be diversified away. Natural disasters, civil unrest, climate
change are all examples of systematic risk.

(2) A stock’s beta represents the volatility of the stock’s excess returns in
relation to the excess returns in the stock market.

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(3) A beta above 1.0 indicates a greater degree of volatility relative to the
market and a beta below 1.0 indicates a lower degree of volatility.

(4) The beta is multiplied by the equity risk premium in the CAPM.

D. Equity risk premium (ERP)

(1) Represents the premium that an investor requires for investing in a

portfolio of large publicly held stocks above the return on a developed
country’s yield on its long-term government bonds.

(2) In the past most practitioners used the arithmetic average of historical
returns on the market over a period of time (the most common time
period in U.S. measurements was 1926 to the measurement date).

(a) The Dimson Marsh and Staunton studied measure the ERP from
1900 to the present.

(3) Best practice today requires the use of forward-looking models such as
the supply side models or IRR models available from Damodaran or
Duff & Phelps.

E. Size risk premium (part of Alpha)

(1) Size risk is specific to the subject company and therefore part of
unsystematic risk.

(2) Studies have consistently shown that the smaller a company is the
greater its risk. For smaller companies, a size premium is added to the
CAPM to capture this risk.

(a) The size risk though has not been measured to exist in other
countries with the same consistency as in the United States. This is
not to say that the size premium does not exist – it is just difficult to
measure. See Section G of this chapter.

(3) The Duff & Phelps Risk Premium Study breaks the U.S. market down
into eight different definitions of size (market value of equity, book value,
total assets, market value of invested capital, sales, average historical
EBITDA, average historical net income, and # of employees).

(a) Total market returns for each size definition are broken down by size
into 25 portfolios with size premiums measured for each portfolio.

(b) The subject company’s size risk premium should be derived from as
many of the eight size definition studies as feasible.

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(c) There are two size premium studies published by Duff & Phelps.
The original study is relevant for the U.S. market.

 There is a separate study based on the research of

Professor Erik Peek of the Rotterdam School of
Management at Erasmus University. This study provides
the size premium over the risk-free rate under seven
different size definitions. This study is discussed further
below in Section G.

F. Specific risk premium (part of Alpha)

(1) There are no quantitative models which objectively measure specific risk
(above size risk). The specific risk premium is a subjective premium
which is based on the valuer’s professional discretion.

(2) There is potential that the valuer may double count risk factors if a
specific risk adjustment is made above a size risk premium.

(a) Example: A valuer derives the cost of equity as follows:

19.05% = 2.5% + 1.10(5.5%) + 7.0% +3.5%

(b) The size risk is 7.0% based on the size premium studies. The
valuer justifies the specific risk premium of 3.5% by saying it is risk
due to lack of management depth, lack of access to capital markets,
and lack of geographic diversification.

(c) The valuer could be criticized for double counting since the support
used to justify the specific risk are all size factors that would
normally be captures in the size premium of 7.0%.

(3) Accounting guidance frowns on specific risk adjustments that are not
based on objective facts.

2. Country Risk

A. Country risk is attributed in large part to an undeveloped or developed

economy’s isolation from global markets. The more isolated the country is from
global markets, the greater the volatility of its markets. This volatility causes
higher variability in earnings, which is the equivalent of risk. This segmentation
of a country from global markets is traced to factors in three areas:

(1) Financial

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(a) Currency risk – risk of a detrimental change in exchange rate will

lower the returns when profits are converted back to the investor’s
home currency.

 Currency risk is usually captured by building anticipated

exchange rate fluctuations into the forecasted cash flow
rather than a separate currency risk premium in the
discount rate.

(b) Leverage

(2) Economic

(a) Inflation rate – Global inflation has increased to approximately 3.5%

as of 2017, the highest rate in five years. However, some countries
due to a variety of economic factors are well above the average.

(b) Government debt to GDP ratios – The higher the ratio, the riskier the
economy. As the amount of the debt increases a larger portion of
the government budget goes to debt service and less is devoted to
the public good.

 Economists generally agree that debt to GDP ratios

above 80% place a country in an increasingly precarious
position.

 The chart below shows that some of the world’s largest

economies have debt/GDP ratios in a high risk range.
This can lead to higher inflation and a devalued currency.

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20 Largest Economies by GDP

Inflation Rate Debt/GDP
Country @ 2017 Ratio
Japan 0.6% 248.0%
Italy 1.3% 133.0%
United States 1.9% 106.0%
Spain 1.9% 99.0%
France 1.2% 97.0%
Canada 1.8% 91.0%
U.K. 2.7% 89.0%
Brazil 3.8% 74.0%
Germany 1.6% 71.0%
Netherlands 1.1% 68.0%
India 3.9% 67.0%
Mexico 5.7% 54.0%
Switzerland 0.5% 46.0%
China 1.9% 44.0%
Australia 2.2% 37.0%
South Korea 1.9% 36.0%
Turkey 10.3% 33.0%
Indonesia 4.3% 27.0%
Russia 4.1% 18.0%
Saudi Arabia 1.1% 6.0%
Sources: The Economist
2016 International Valuation Handbook

(3) Political

(a) Corruption

(b) Government expropriation of assets

(c) Military conflict

(d) Rule of law

(e) Terrorism

B. One common approach in the international models is to first measure the cost
of equity for a developed country and then add a premium for the subject
company’s country.

(1) The valuer must remember to match the discount rate currency with the
cash flow currency in the numerator of the DCF model.

(2) If the model develops the risk-free rate, beta, and ERP based on a
developed economy’s metrics and adds a country risk premium relative
to the developed economy, then the cash flows must be forecast in the
developed economy’s currency.

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3. Although many of the models are theoretically sound they are difficult to apply since
they require inputs of information which either does not exist or is too costly for the
valuer to accumulate.

A. Some models require the local country to have a well-developed and diversified
stock market from which information can be derived. Most developing and
undeveloped nations do not have such markets.

B. Other information, such as an individual company’s exposure to the local

market relative to other companies can be difficult to obtain.

Section C. Relative Volatility Model (RVM)

1. This model was developed in various forms at the Massachusetts Institute of

Technology by Professor Donald Lessard and by analysts at Goldman Sachs and Bank
of America.

2. Similar to the reasoning used by other models the RVM develops a cost of equity
based on a developed economy’s metrics and inserts a factor to recognize the
additional risk of operating in a developed or undeveloped economy.

3. The model is presented as follows:

Kel = Rfd + (βd x ERPd x RV) + Α

Where:

Kel = Cost of equity in local country

Rfd = Risk-free rate for developed economy
βd = Beta from developed economy
ERPd = Equity risk premium for developed economy
RV = Relative Volatility
A = Alpha (size and specific risk) for subject company

Notes: Duff & Phelps data has options for United States
or Germany as the developed economy

A. The resultant cost of equity in the local country captures the risk of the local
country but is expressed in the currency of the developed country since the
variables (risk-free rate, beta, equity risk premium) are derived from the
developed market.

B. The relative volatility (RV) variable can be thought of as an adjustment to the

beta. It represents the incremental risk of investing in the local country by

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measuring the relative volatility of the local market against the developed
country’s market.

(1) It is calculated as the ratio of the annualized monthly standard deviation

of the local country’s equity returns on the market relative to the
annualized monthly standard deviation of the developed country’s equity
returns.

(2) The model uses trailing 60 months of equity returns to measure monthly
standard deviation. The standard deviation from the local market is
divided by the standard deviation of the developed market to arrive at
the RV factor.

C. Limitations of the Model

(1) If the local country’s stock market is not well-diversified (most

developing country’s stock markets are not well-diversified), then the
volatility of that market might not reflect country risk, but the risk of the
industry or industries that dominate that stock market.

(2) If the subject company is a large company with access to global

markets, then the country risk may not be relevant since the subject can
mitigate the risk by shifting production elsewhere.

4. RV Model adapted for industry risk

A. The original RV model shown above measures country risk relative to a

developed economy, either the U.S. or Germany, as exemplified below.

(1) Since only country risk is captured, the valuer must still account for the
subject company industry, size, and specific risk.

B. The model can be adapted to capture not just country risk, but industry risk as
well to include some or all of the risk of the subject company.

(1) Industry betas are available to measure some of the specific company
risk. The model would be adapted as follows:

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Kel = Rfd + (βdi x ERPd x RV) + Α

Where:

Kel = Cost of equity in local country

Rfd = Risk-free rate for developed economy
βdi = Industry beta from developed economy
ERPd = Equity risk premium for developed economy
RV = Relative Volatility
A= Alpha (size and specific risk) for subject company

Notes: Industry betas for world, Eurozone, European

Union, and United Kingdom are available from
International Valuation Handbook; Industry
Cost of Capital, Duff & Phelps

(2) The only change in this model relative to the base model is the βdi
variable, which represents the industry-specific beta from the developed
economy.

(3) Industry betas can be found in a variety of sources. For the regions
noted above, one suggested source is:

(a) Duff & Phelps, “2016 International Valuation Handbook, Industry

Cost of Capital”, Wiley, 2016

 This source provides betas by industry for the world, the

United Kingdom, the Eurozone, the European Union, in
euros, pounds and dollars

(b) Duff & Phelps, “2016 Valuation Handbook – Industry Cost of Capital,
Wiley, 2016

 This source provides betas by industry for the U.S. in

dollars

5. Duff & Phelps data support

A. Duff & Phelps publishes the RV factors relevant to the United States market
and the German Market in its International Valuation Handbook.

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Duff & Phelps RV Factors relevant to the United States and Germany -Selected Countries
as of March 31, 2016
U.S. RV German RV S&P Sovereign MSCI Market
Country Factor $ Factor € Credit Rating Classification
Bahrain 1.2 0.8 BB Frontier
Croatia 1.0 0.5 BB Frontier
Czech Republic 1.6 0.9 AA- Emerging
Egypt 2.3 1.5 B- Emerging
Jordan 1.3 0.9 BB- Frontier
Kuwait 1.0 0.7 AA- Frontier
Oman 1.0 0.8 BBB- Frontier
Qatar 1.4 1.0 AA Emerging
Russia 2.1 1.3 BB+ Emerging
Saudi Arabia 1.5 0.9 A-
Serbia 2.0 1.1 BB- Frontier
United Arab Emirates 2.5 1.6 AA Emerging
‘ Source: 2016 International Valuation Handbook; Guide to Cost of Capital, Duff & Phelps

(1) If the U.S. factor is used then the rest of the model’s variables should be
expressed in U.S. metrics and the cost of equity would be relevant to
dollars.

(2) If the German factor is used then the rest of the model’s variables
should be expressed in German metrics and the cost of equity would be
relevant to euros.

B. The difference in relative volatility factors reflects a potential limitation in the

model, as noted above. Many of the emerging countries are less volatile than
the German market, as per the RV factors; if the model were applied, then the
cost of equity would be lower for the subject company in, say, Croatia, than the
same company in Germany.

(1) This is unlikely the case. It is more likely that the Croatian market is not
active or diverse enough for a valid comparison.

(2) Conversely, the emerging market might be dominated by a single

industry which is not volatile.

6. Example

A. A valuer is deriving a cost of equity for a auto parts manufacturer in Serbia.

The valuer operates in Germany and is developing a cost of equity in euros.
He consulted the 2016 International Valuation Handbook and determined that
the beta for auto components manufacturers (GIC 251010) for the Eurozone, in
euros, was 1.5. The cost of equity is therefore derived as:

= 3.0% + (1.5 x 5.0% x 1.1)

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= 11.25%

(1) In this example, the 3.0% represents the German risk-free rate, the 1.5
is the industry beta for auto parts manufacturers in the Eurozone, the
5.0% is the ERP in Germany, and 1.1 is the RV factor for Germany.

(2) The 11.25% is the derived cost of equity assuming the following:

(a) It is from a German investor’s perspective and the cash flows are in
euros.

(b) The cost of equity captures the country risk of operating in Serbia.

(c) The industry risk for auto parts manufacturing in the Eurozone is
captured; if there are factors which make this industry more or less
risky in Serbia relative to the Eurozone, they would need to be
accounted for.

(d) Specific company risks due to size and other factors have not
theoretically been captured. In reality, they may have been captured
in the industry beta and RV factor above, but they have not been
specifically addressed.

Section D. Erb-Harvey-Viskanta Country Credit Rating Model

1. The model develops country risk premiums in a 2-step process:

A. Country credit ratings are regressed against country market returns. For those
undeveloped or developing countries without market returns, their credit rating
can be entered into the regression to derive the implied returns.

B. Country risk premiums for any country relative to any other country can be
derived by subtracting one country’s return from the other.

2. STEP A:

A. Each country’s credit rating is based on information from Institutional Investor, a

bi-annual publication of country credit ratings.

(1) Institutional Investor bases its CCRs on input from international bankers,
money managers, and securities firms which rank each country on a
scale of 0 to 100 with 0 being the riskiest and 100 being the safest.

B. Each country’s market returns (to the extent they exist) are regressed against
the country credit rating as per the following regression model:

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Kel = α + β x [natural log(CCR L)] + ε

Where:

Kel = Cost of equity in local country

α = Regression constant
β = Regression coefficient
CCRL = Country credit rating of local country
ε= Regression error term

(1) The model works as follows:

(a) All available country credit ratings (i.e. 0 to 100 for each country)
from 1979 through 2016 are matched with each country’s following
monthly equity returns (for example, a CCR for Saudi Arabia for
January, 1980 would be matched with the Saudi Arabian equity
return for February of 1980, etc.). As of 2016, this resulted in 20,477
matched monthly pairs.

(2) The model regresses all the country credit ratings for all countries in a
given month against all equity returns for countries in the following
month. The regression inputs are as follows:

(a) The natural log of the CCRs is the independent variable.

(b) The equity returns is the dependent variable.

(c) The latest CCR for the country whose cost of equity is being sought.

(3) The Model uses the predictive ability of the regression model to predict
the expected rate of return. The example below is for demonstration
purposes as to how the regression works. The data used is not actual
CCR data.

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Sample Regression Analysis

(for demonstration purposes - not actual data)

Y - Dependent X - Independent
Variable Variable

Country Credit Predicted

Equity Returns Rating Equity Return Residual

Country A 8.1% 88.9 7.5% 0.01

Country B 14.0% 58.2 13.5% 0.01
Country C 13.0% 61.1 12.9% 0.00
Country D 9.2% 79.5 9.4% (0.00)
Country E 13.4% 60.2 13.1% 0.00
Country F 16.5% 41.0 16.8% (0.00)
Country G 11.5% 66.3 11.9% (0.00)
Country H 8.8% 81.1 9.0% (0.00)
Country I 8.9% 82.1 8.9% 0.00
Country J 9.4% 76.9 9.9% (0.00)
Country K 13.0% 64.9 12.2% 0.01
Country L 10.5% 70.0 11.2% (0.01)
Subject Country 75.0 10.2%

Intercept 0.25
Coefficient (0.002)

R-Squared 0.97 R-Squared is interpreted as the proportion of the variance

in MVIC/Sales attributable to the variance in EBIT/Sales

(4) The subject country’s CCR can be entered into the regression to derive
the predicted equity return.

(5) In this example, the equity returns are expressed in a specific currency,
say the U.S. dollar. Therefore the 10.2% equity return would represent
the cost of equity of the subject country from the perspective of a U.S.
investor.

Regression Results
0.2
0.2 41

0.1 58
60
61 65
0.1 66
70
Multiple

0.1
7780
82
81
0.1 89

0.1
0.0
0.0
0.0
0 20 40 60 80 100
Dependent Variable

Country Credit Ratings

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(a) The regressions are repeated for each of the 56 country

perspectives presented in the Handbook (data on equity returns is
taken from the MSCI Global Equity Indices, which includes a total of
72 countries).

3. STEP B:

A. Once total equity returns are found for each country, relative country risk
premiums can be derived by subtracting any country’s return from any other
country’s return.

4. Country Risk Premium Data

A. The Erb-Harvey-Viskanta country risk premiums can be used in the context of a

CAPM.

B. Data is presented from the perspective of 56 different countries providing

country risk premiums for 179 countries.

(1) This country risk premium data presents the risk of investing in 179
countries from the perspective of investors in each of 56 other countries.
In other words, there are 56 sets of country risk premium data, one for
each country perspective (approximately half of the total Handbook is
comprised of this premium data presentation).

(2) The data is presented quarterly by the Handbook. For each quarter,
each country’s base cost of equity capital is presented. To determine
the relevant cost of equity, one merely adds or subtracts the premium to
determine the appropriate return for the investment in question.

(3) An example for one of the 56 countries presented in the Handbook,

Saudi Arabia, is shown below. This sampling includes 7 countries – the
actual data set includes 179 countries (that is, an investment in 179
different countries from the perspective of an investor in Saudi Arabia):

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Base Cost of Equity

12/31/2015 3/31/2016
Saudi Arabia = 10.3% 10.6%

Investor Perspective: Saudi Arabia

Country Risk
Country Premium 3/31/16
Albania 7.5
China (0.8)
Eqypt 10.1
Hungary 2.8
Latvia 0.6
Russia 3.5
Spain 0.7
Source: 2016 International Valuation Handbook

(4) The base cost of equity for Saudi Arabia (prior to consideration of
unsystematic risk) was 10.6% as of March 31, 2016 (this variable is
provided in the Handbook). Therefore, for an investor in Saudi Arabia
developing a cost of capital for an investment in Russia, a country risk
premium of 3.5% would be added to the capital asset pricing model to
capture the risk of investing in Russia relevant to Saudi Arabia. The
cost of equity inclusive of the Russian country risk would therefore be
14.1% (10.6% + 3.5%).

(a) If the Saudi investor were making an investment in China, the cost of
equity would be 9.8%, or [10.6% - (-.8%)].

(5) Remember that the model renders the cost of equity prior to
consideration of the subject company’s risk. The country risk premiums
when added to the country cost of equity render a cost of equity for
investing in that market as a whole, not for an investment in a specific
company or industry in that market.

C. If the valuer concludes that the country’s original cost of equity (i.e. the 10.6%
above) is different than the cost of equity published in the Handbook, then the
authors recommend adding the assigned premium to the valuer’s cost of equity.

(1) For example, assume the valuer concludes that the appropriate cost of
equity for Saudi Arabia is 12.0%, not the 10.6% shown above. If valuing
a Russian investment from the perspective of a Saudi investor, then
they would use a cost of equity equal to 15.5% (12.0% + 3.5%).

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5. As discussed, the above model captures country risk from the perspective of an
investor in one identified country. It does not capture industry risk, company size risk,
or other specific risks of a subject company.

(1) Industry risk and specific risk must be separately dealt with by the
valuer.

(2) Industry risk in the home country can be estimated using the Industry
Cost of Capital Handbook. The valuer would add the industry premium
to the home country cost of equity and then proceed to capture the
country’s cost of capital as described above.

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Section E. Country Yield Spread Model

1. The country yield spread model adds a country risk premium to the CAPM based on
the difference in yield on the long term sovereign bond of a developed economy versus
the yield on a long term sovereign bond of an emerging economy. The model is shown
below:

Kel = Rfd + (βd x ERPd) + CRP

Where:

Kel = Cost of equity in local country

Rfd = Risk-free rate for developed economy
βd = Beta from developed economy
ERPd = Equity risk premium for developed economy
CRP = Country Risk Premium

A. The result of the above equation is a cost of equity for a company in a

developing economy (i.e. “local country”) but expressed in terms of a developed
country’s cash flows; therefore it would be used to discount future cash flows
that are stated in the developed economy’s currency.

B. The CRP represents the country risk premium which is measured as the yield
spread between the developed country’s government bond and the emerging
economy’s bond of an equal maturity.

(1) This concept works only if the emerging economy has government
bonds of the same maturity that are expressed in the same currency as
the developed economy.

(a) For example, if the model is developed in U.S. dollars, the emerging
country must offer bonds denominated in dollars.

(b) If the model is developed from a German perspective, the emerging

country must have bonds expressed in euros.

2. The Handbook provides a methodology for applying the model in circumstances where
the emerging economy either: a) has no bonds expressed in dollars or euros; or 2) the
emerging economy has no bonds.

A. Four levels of countries (or economies) are referenced in this model:

(1) Tier 1 countries – These are the developed countries with AAA credit
ratings. Each of these countries has sovereign bonds and a sovereign
credit rating.

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(2) Tier 2 countries – These countries are developing economies that have
sovereign bonds denominated in the currency of a Tier 1 country.

(3) Tier 3 countries – These are developing countries that do not have
publicly-traded sovereign bonds traded in dollars or euros but they do
have an S&P sovereign credit rating.

(4) Tier 4 countries – These countries have neither publicly-traded

sovereign bonds in dollars or euros nor an S&P sovereign credit rating.

B. The original country yield spread model works easily with Tier 1 and Tier 2
countries. Additional steps though are necessary to make the model work with
Tier 3 and 4 countries.

(1) Tier 3 countries

(a) D&P conduct a regression using the observed Tier 2 country risk
premiums as the dependent variable and the numerical equivalent of
that country’s S&P sovereign credit rating as the independent
variable. The regression equation is used to estimate a Tier 3 CRP
using its S&P sovereign credit rating. A similar concept was used in
the Sample Regression Equation applied above in the Country
Credit Rating Model.

(2) Tier 4 countries

(a) For Tier 4 countries, the Handbook uses Euromoney Country Risk
Score (ECR scores) which are available through subscription from
the provider (the Handbook provides the regression results). The
Tier 2 CRPs are entered as the dependent variable and are
regressed against the Tier 2 countries’ ECR score. Since ECR
scores are produced for all countries, the subject country’s ECR
score can be entered into the regression model to obtain its implied
country risk premium.

3. The data sets for the Country Yield Spread Model are presented in the Handbook
under Data Exhibit 2. Country risk premiums are presented for 188 countries from two
perspectives:

A. A U.S. investor investing in any of the 188 countries

B. A German investor investing in any of the 188 countries

C. For each country, the country risk premium, the Tier method used to derive the
country risk premium and the S&P credit rating is shown.

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4. Example

A. A German investor is valuing a company located in Argentina. The cash flows

will be expressed in euros but the valuation must capture the risk of the
operations in Argentina relevant to Germany.

(1) The valuer consults the Handbook’s cost of equity for Germany, which is
shown in the Germany section under Data Exhibit 4. As of March, 2016,
this cost of equity was 6.5%.

(a) Note that the valuer can develop his or her own cost of equity based
on alternative German macro variables and proceed with the
following steps. If there is a material difference between the valuer’s
cost of equity and the one shown in the Handbook, the valuer should
understand the variance.

(2) Under the Germany section of Data Set 2, the CRP for Argentina is
30.3%. Note that the information shows that the Tier 3 method was
used to derive the premium, meaning that Argentina did not have
publicly-traded sovereign bonds, but did have an S&P credit rating that
could be used in the Tier 3 regression.

(3) The cost of equity is therefore 36.8% (6.5% + 30.3%). (note that
Argentina has been plagued by government corruption, high
unempoyment, and has one of the highest inflation rates in the world,
which explains its relatively high required rate of return).

(4) This cost of equity does not include subject company size or specific risk
or industry risk. Those must be calculated separately.

5. Limitations of the Country Yield Spread Model

A. The model’s key assumption is that the country’s sovereign debt risk is an
adequate proxy for that country’s business risk.

(1) One of these variables is a debt measurement and the other is an equity
measurement.

(2) There are instances when a country’s sovereign debt is affected by

macroeconomic variables that do not have the same affect on business
cash flows.

B. If the valuer captures some or all of the country risk in the cash flow projection
then the risk will be double counted.

C. The model may not yield relevant results during periods of global economic
crises.

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D. As is true with other models this model may be less relevant with a multi-
national company that can shift production to safer countries at will.

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Section F. The Damodaran Model

1. Aswath Damodaran is a Professor of Finance at New York University. He is an

authoritative figure in the field of finance and business valuation. His research,
valuation models, and the data needed to deploy his models available on his website:

http://pages.stern.nyu.edu/~adamodar/

2. Damodaran’s Original Model

A. The original Damodaran model applies a country risk premium, calculated

either with credit default swaps or through the difference in sovereign bond
yields. The model is shown as follows:

KL = RfUS + βUS(ERPUS) + λ(CRP)

Where:
KL = Cost of equity in local country
RfUS = U.S. Risk Free Rate
βUS = U.S. Beta
ERPUS = U.S. Equity Risk Premium
λ= Company's exposure to local country risk
CRP = Country Risk Premium
= Country Default Spread x (σstock/σbond)
σStock = standard deviation of local country's stock market
σBonds = standard deviation of local country's bond market

(1) A beta is applied to the U.S. equity risk premium which conforms to the
original capital asset pricing model.

(2) The country risk premium is multiplied by lambda (λ) which represents
the subject company’s exposure to the local country risk. Although this
variable makes logical sense, it is difficult to measure. Damodaran
recommends the following:

(a) Lambda is a relative variable. The country’s exposure to country

risk is measured relative to the average company’s exposure in the
country. At least three factors, according to Damodaran, affect this:

 Revenue from the country

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 Location of facilities

 Level of usage of risk-management products

(b) If the average company derives 75% of its revenues from the
country, then the local company’s revenue percentage would be
measured relative to the 75%.

 While this is conceptually understandable it would be

very difficult to document and difficult to deploy especially
if other criteria are brought into the calculation.

3. A commonly applied adaption of Dr, Damodaran’s model for international cost of

capital is as follows:

KL = RfUS + δ(CDSL - CDSUS) + (ERPUS) + Alpha

Where:
KL = Cost of equity in local country
RfUS = Risk-free rate of developed market

σe
δ=
σb
Where:
σe = Standard deviation of the equities market
σb = Standard deviation of the bond market

CDSL = Credit default swap spread on local government bond

CDSUS = Credit default swap spread on developed country government bond
ERPUS= Equity risk premium in the developed market
Alpha = Unsystematic risk (size and specific risk)

A. Credit Default Swaps (CDS)

(1) A credit default swap is a derivative instrument on debt securities. It can

be thought of as an insurance contract in which one party obtains
insurance against the default of a debt security.

(2) If the loan defaults or experiences other types of credit problems, the
buyer of the CDS receives the face amount of the security.

(3) The buyer of the CDS does not actually have to own the debt security
(called a “naked CDS”). Anyone who bets that a debt security will
default can acquire a CDS on that security.

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(4) The market for credit default swaps is mostly unregulated.

(5) The Credit Default Swap Spread

(a) The CDS spread is expressed in percentage terms and is equivalent

to the insurance premium on the debt.

(b) It represents the annual amount the buyer of the CDS must pay as a
percentage of the ‘insured’ amount (i.e. the face value of the debt
security) to the seller of the CDS.

(c) Example:

 Debt security = £100,000,000

 CDS spread = 1.25%

 Annual payment made by the CDS buyer = £1,250,000

(6) The CDS spread therefore represents a market perception of the

underlying riskiness of a debt security.

(a) Credit default swaps on most government bonds are traded on

markets around the world.

(b) Analysts are therefore able to compare the CDS spreads on different
government long term bonds as a comment on the country risk of
the government selling the bonds.

(c) Example

 Suppose the 5-year CDS spread for an Egyptian

government bond is 8.01% and the spread for a U.S.
bond is 0.50%. The country risk spread is the difference
between the two spreads, or 7.51%.

B. The Delta variable (δ)

(1) Damodaran recognizes that the CDS market is a debt market and
therefore not equivalent to the equities market. Debt securities are
inherently less volatile than the equities market.

(2) The delta variable represents an adjustment to the CDS spread to make
it relevant to the cost of equity.

(3) Damodaran measures the relative volatility of the debt securities market
to the volatility of the equities market by dividing one into the other. The
result is the delta adjustment to the CDS spread.

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(a) Damodaran updates the delta variable on his website each year.

(b) As of 2017, the delta variable equaled 1.23x.

C. The valuer still needs to account for the equity risk premium and the alpha, or
the risk factors specific to the subject company.

(1) If the risk-free rate is taken from the U.S. economy, then the equity risk
premium should be taken from there as well.

(2) The specific risk is a matter of the valuer’s professional judgment

D. It is important to remember that the cost of equity that results from

Damodaran’s model should be applied to cash flows that are in the developed
economy’s currency. In this case, that would be dollars.

4. An example of the application of the Damodaran model is shown below. These costs
of equity are for selected countries from the Damodaran website as of August 31,
2017.

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Damodaran Model: Derivation of Cost of Equity for Companies in Selected Countries

Moody's U.S. CDS Spread Country Risk U.S. Alpha
Rating Rf rate (Local-U.S.) δ Premium ERP Raw Ke (example) Ke
Country a b c d e f g h i
(c x d) (b + e + f) (g + h)
Australia Aaa 2.47% 0.00% 1.23 0.00% 5.69% 8.16% 2.00% 10.16%
Brazil Ba2 2.47% 3.47% 1.23 4.27% 5.69% 12.43% 2.00% 14.43%
China Aa3 2.47% 0.70% 1.23 0.86% 5.69% 9.02% 2.00% 11.02%
Croatia Ba2 2.47% 3.47% 1.23 4.27% 5.69% 12.43% 2.00% 14.43%
Egypt B3 2.47% 7.51% 1.23 9.24% 5.69% 17.40% 2.00% 19.40%
France Aa2 2.47% 0.57% 1.23 0.70% 5.69% 8.86% 2.00% 10.86%
Greece Caa3 2.47% 11.55% 1.23 14.21% 5.69% 22.37% 2.00% 24.37%
Jordan B1 2.47% 5.20% 1.23 6.40% 5.69% 14.56% 2.00% 16.56%
Kuwait Aa2 2.47% 0.57% 1.23 0.70% 5.69% 8.86% 2.00% 10.86%
Oman Baa1 2.47% 1.84% 1.23 2.26% 5.69% 10.42% 2.00% 12.42%
Philippines Baa2 2.47% 2.20% 1.23 2.71% 5.69% 10.87% 2.00% 12.87%
Poland A2 2.47% 0.98% 1.23 1.21% 5.69% 9.37% 2.00% 11.37%
Russia Ba1 2.47% 2.89% 1.23 3.55% 5.69% 11.71% 2.00% 13.71%
Saudi Arabia A1 2.47% 0.81% 1.23 1.00% 5.69% 9.16% 2.00% 11.16%
Serbia B1 2.47% 5.20% 1.23 6.40% 5.69% 14.56% 2.00% 16.56%
Spain Baa2 2.47% 2.20% 1.23 2.71% 5.69% 10.87% 2.00% 12.87%
Turkey Ba1 2.47% 2.89% 1.23 3.55% 5.69% 11.71% 2.00% 13.71%
United Arab Emirates Aa2 2.47% 0.57% 1.23 0.70% 5.69% 8.86% 2.00% 10.86%
United Kingdom Aa1 2.47% 0.46% 1.23 0.57% 5.69% 8.73% 2.00% 10.73%
United States Aaa 2.47% 0.00% 1.23 0.00% 5.69% 8.16% 2.00% 10.16%
Vietnam A2 2.47% 5.20% 1.23 6.40% 5.69% 14.56% 2.00% 16.56%
Source: http://pages.stern.nyu.edu/~adamodar/

Column a Moody's rating on government debt. For countries with no Moody's rating, Damodaran uses S&P. If country has no
government debt, he applies the average CDS spreads per rating.
Column b The model calls for a developed country risk-free rate. In this example, the U.S. risk-free rate as of 8/31/17 was used.
Column c Damodaran provides this data which is the country CDS spread less the U.S. CDS spread.
Column d This is the delta variable, which represents as of 2016-17, the volatility of the equities market over the debt market.
This metric is updated and provided by Damodaran on the website.
Column e The country risk premium is the CDS spread multiplied by the delta variable.
Column f The equity risk premium from a developed economy. Damodaran's calculated U.S. ERP is used here.
Column g This is the cost of equity prior to adjustment for unsystematic risk. It equals the risk-free rate, plus the country risk
premium, plus the U.S. ERP.
Column h The valuer must insert any size or specific risks that are appropriate for the subject company. An example of 2.0%
was applied here for expositive purposes.
Column i The final cost of equity equals the unadjusted cost of equity plus alpha.

5. Limitations of the adapted Damodaran Model

A. The model shown above is an example of a build-up model. It is not a

derivation of the CAPM since there is no beta applied to the ERP.

B. Research suggests that the credit default swap spreads are not purely the
market’s perception of country risk.

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(1) As stated above, the risk of government debt does not equal country
risk.

(2) CDS spreads may fluctuate due to short-term market manipulations.

These are not solely a market comment on country risk.

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Section G. Special Topics

The following sections address three topics of interest to international valuers. These topics
are not directly tied to each other but are presented here since they are relevant to the
development of the cost of capital in an international environment. The final three topics in the
Chapter are:

• Size risk premium studies outside the United States

• Total beta and the industry risk premium

• How to use the International Valuation Handbook; Industry Cost of Capital

1. Size Risk Premium Studies Outside the United States

A. The size risk premium was presented in iiBV 202 as an element of

unsystematic risk in the capital asset pricing model. The size premium is
quantitatively measured by comparing returns on the market for eight different
definitions of size.

(1) This study is based on the United States market and does not
necessarily apply to markets outside the United States.

(2) Similar studies have been done on markets outside the United States
but have been hindered by several factors:

(a) Very few markets have the historical data and the diversification
which make the U.S. studies more robust.

(b) There is a lack of integration in some stock markets outside the

United States; if multiple markets are studied this presents
measurement problems.

(c) In a stand-alone market, investors do not have the same

opportunities for diversification wherein a small stock’s risk can be
mitigated by larger stocks in the portfolio. Therefore, smaller
companies in segmented markets might see higher required rates of
return relative to similar small companies in a large market like the
United States.

B. The only comprehensive study (outside the United States) of company size in
relation to market returns has been conducted by Professor Erik Peek at the
Rotterdam School of Management at Erasmus University.

(1) Professor Peek has stratified market returns by size on the stock
markets in the following European countries between 1990 and 2015:

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(a) Austria, Belgium, Denmark, Finland, France, Germany, Greece,

Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal,
Spain, Sweden, Switzerland, and the United Kingdom

(2) Although the studies have shown a statistically significant size effect,
the effect was not uniform throughout the markets studied.

(a) The size effect was limited to the smallest companies and was not
uniform throughout the portfolios, as was seen in the U.S. studies.

(b) The size effect was not uniform throughout the 17 European
countries in the study.

(3) The Handbook provides the results of Professor Peek’s work in the
context of two sets of size premium data:

(a) Premia over the Risk-Free Rate

 In these studies, the valuer would not use the CAPM, but
rather a build-up model to develop the cost of equity.
The size premium is added to the risk-free rate. The
ERP is already included in the added premium.

(b) Premia over the CAPM

 In these studies the size premium is added as part of a

traditional capital asset pricing model.

(4) The size studies include 7 different size definintions:

(a) Market capitalization

(b) Book value of equity

(c) Market value of invested capital

(d) Total assets

(e) Sales

(f) Number of employees

(g) Size factor

(5) Each size definition includes 16 different size portfolios. The valuer
would consult the appropriate portfolio(s) relevant to the subject
company and apply the Smoothed Adjusted Risk Premium to either the
Build-up Model or the CAPM, whichever is being used.

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(6) The valuer should note that although there is convincing evidence that a
size risk premium exists in the European markets, there is statistical
noise in these studies, so much so that best practice in Germany
requires valuers to ignore adding a size risk premium.

(7) It goes without saying that if the valuer is considering a size premium
outside the context of the two studies that are available (in the United
States and Europe) the size premiums contained therein may be
considered but not taken as direct evidence of a size premium in the
local market.

2. Industry Risk Premium and Total Beta

A. Most valuers outside the United States rely on the CAPM to develop a cost of
equity. Within the United States a significant number of valuers use the Build-
up Method, which was discussed in iiBV 202. The build-up method develops a
cost of equity by adding the risk-free rate, the equity risk premium, the size risk
premium and specific risk. There is no separate consideration of the beta or
systematic risk in the original build-up model.

B. There is a form of the build-up model in which a variable called the “full
information beta” is used to derive an industry risk premium. The industry risk
premium is added to the other variables to come up with the cost of equity as
per the following formula:

Ke = Rf + ERP + SP + IRP

Where:
Ke = Cost of equity
Rf = Risk-free rate
ERP = Equity risk premium
SP = Size premium
IRP = Industry risk premium

C. Full information beta

(1) Many publicly-held guideline companies are discarded from the market
approach since, although they have sales in the subject industry, those
sales are only a small part of the overall operation. Some of these
excluded companies may actually be market leaders in the subject
industry.

(2) The full information beta develops a beta using all the betas from public
companies with segment sales in the industry (regardless of how small
those segment sales may be to the entire company). The betas are

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weighted according to the relative market capitalization to the total

industry capitalization) and are applied as the dependent variable. The
sales of the companies are applied as the independent variable.

D. The Industry Risk Premium

(1) The industry risk premium is a measure of systematic risk in the subject
industry which is applied to the regular equity risk premium, as follows:

(a)

IRP = (βi x ERP) - ERP

Where:
IRP = Industry risk premium
βi = Full information beta for industry
ERP = Equity risk premium

(b) The industry risk premium equals the full information beta multiplied
by the ERP, minus the ERP. This variable can be added if the
analyst is using the build-up model.

 If the industry beta is below 1.0, then the industry risk

premium will be negative.

(c) A separate size or specific risk premium can be added if appropriate.

(d) The industry risk premium cannot be used in the capital asset pricing
model.

(2) Example: A valuer is using the build-up model to derive a cost of equity
for a company involved in the oil and gas field service industry. The
following information has been developed:

(a) U.S. risk-free rate = 2.5%

(b) U.S. ERP = 5.0%

(c) Size premium relevant to the subject = 2.0%

(d) Full information beta for oil/gas field = 1.36

(e) The cost of equity = 11.3%

 2.5% + 5.0%+2.0% + [(1.36*5.0%) – 5.0%]

 The IRP = 1.8%

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E. The Industry Risk Premia are calculated by Duff & Phelps and presented in the
U.S. version of their Valuation Handbook. The text provides the full information
beta and the industry risk premia (calculated with both an historical ERP as well
as a supply-side ERP) for approximately 270 different industries. As of 2018,
there is no separate calculation of an industry premium in the International
version.

3. The International Valuation Handbook; Industry Cost of Capital

A. As of 2015 a new resource is available for developing growth rates and the cost
of capital by geographic region and by industry around the world, 2016
International Valuation Handbook, Industry Cost of Capital (Duff & Phelps,
published by Wiley).

(1) This text provides the following data by industry, by region:

(a) Financial ratios

 Return on assets

 Return on equity

 Dividend yield

 Liquidity ratios

 Profitability ratios

 Leverage ratios

 Growth rates

(b) Betas (levered and unlevered)

(c) Valuation multiples

 Price/sales

 Price/earnings

 Market/book

 Enterprise Value/Sales

 EV/EBITDA

(d) Cost of equity

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(e) Cost of debt

(f) Weighted average cost of capital

(2) Each of the above metrics is broken down into the following 5
categories:

(a) Median

(b) GICS composite

(c) Large composite

(d) Small composite

(e) High financial risk

(3) Regions covered – the following regions are covered in the text through
three currencies, euros, pounds and dollars. That is, each region has
three sections, one for each currency.

(a) World

 Includes companies in the MSCI (Morgan Stanley Capital

International Index) investable market index that meet the
text’s requirements. The regions included in the 2016
Handbook come from the following regions:

 European Union – 15.8%

 United States – 23.9%

 Asia – 40.7%

 Other – 19.7%

(b) European Union

 Austria, Belgium, Cyprus, Estonia, Finland, France,

Germany, Greece, Ireland, Italy, Latvia, Lithuania,
Luxembourg, Malta, Netherlands, Portugal, Slovokia,
Slovenia, Spain, Bulgaria, Croatia, Czech Republic,
Hungary, Poland, Romania, Sweden, Denmark, United
Kingdom

(c) Eurozone

 Includes the 19 countries that have adopted the euro:

Austria, Belgium, Cyprus, Estonia, Finland, France,

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Germany, Greece, Ireland, Italy, Latvia, Lithuania,

Luxembourg, Malta, Netherlands, Portugal, Slovokia,
Slovenia, Spain

(d) United Kingdom

(4) Industries Covered

(a) For each of the twelve sections (that is, one section for each of the 3
currencies in each of the 4 geographic regions), the data outlined
above is presented for 70 to 90 industry categories.

 The text used the Global Industry Classification Standard

(GICS) codes. These codes range from a two-digit broad
categories (e.g., consumer supplied) to an 8-digit specific
category (soft drinks).

(5) Applications of the Text

(a) Financial analysis of the subject company – as discussed in iiBV

201, a key determinant of the valuer’s risk and growth assessment is
a comparison of the subject company to industry financial ratios.
The financial ratios broken down by industry provide a barometer for
comparison.

(b) If the valuer defines an industry group as the ‘market participants’

then the capital structure ratios could potentially be used as a
subject company’s target capital structure.

(c) Levered and unlevered betas by industry can be used in the

development of a subject company’s cost of equity.

(d) Analyst’s growth estimates by industry can provide a basis for

supporting growth in a discounted cash flow analysis.

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Section H. Chapter Review Questions

1. A valuer is appraising a Jordan-based pharmaceutical company for a U.S. investor.

The following information is available to develop a cost of equity using the relative
volatility model:
U.S. risk-free rate 4.0%
Company beta 1.2
Pharma industry beta 1.1
U.S. ERP 5.0%
RV factor 1.3
Alpha 3.5%

The appropriate cost of equity to apply to the cash flows is:

A. 11.15%

B. 7.15%

C. 15.3%

D. 12.5%

2. In the above question, the discount rate that is derived should be applied to which of
the following cash flows?

A. The Jordanian company’s projected cash flows expressed in U.S. dollars

B. The Jordanian company’s projected cash flows expressed in Jordaniain dinars

C. The Jordanian company’s projected cash flows expressed in dollars, but

adjusted downward to account for the relative risk of Jordan to the U.S.

D. The Jordanian company’s projected cash flows expressed in dinars, but

adjusted upward to account for the relative risk of Jordan to the U.S.

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3. One relative weakness of the size premium studies conducted by Professor Peek on
the European market as compared to the size premium studies done in the United
States is:

A. The European markets are older than the U.S. market and therefore contain
outdated information.

B. The unification of all the separate European markets into a single Eurozone
stock market skews the data.

C. The European stock markets do not enjoy the same level of integration as
exists in the United States market.

D. The European stock markets trade under different currencies which renders the
return information less meaningful.

4. Which of the following is a criticism of the Country Yield Spread Model?

A. The sovereign yield spread is an equity risk measurement and the CAPM
requires a debt risk measurement.

B. Debt premiums are not the equivalent to a volatility measurement.

C. Most country’s have sovereign bonds denominated in U.S. dollars, but the
bonds are not rated by a rating agency.

D. If the valuer has captured the country risk in the cash flow projection, then
applying a country risk premium would double count the risk.

5. A valuer is considering using the following model to apply in his valuation of a company
in Turkey for an investor in the United Kingdom:

KL = RfUS + δ(CDSL - CDSUS) + (ERPUS) + Alpha

One limitation of this model is:

A. The δ factor represents the subject company’s relevant exposure to the country
risk, which is a very difficult variable to measure efficiently.

B. The credit default swap spreads do not necessarily represent the market’s
comment on country risk.

C. The risk-free rate and ERP are based on United States metrics while the credit
default metrics are based in the local country’s metrics.

D. Alpha has already been captured in the CDS measurement.

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Chapter 5. Saudi Valuation Market
Section A. Saudi Valuation Market Overview

1. Macroeconomic Profile

A. As was discussed in BV 201, the macroeconomic and microeconomic

environments of the subject company should be assessed for their contribution
to the company’s overall risk profile.

(1) This part of the analysis should not be a mere list of macro and micro
variables of the subject country’s economy.

(2) The data should be discussed in light of how it affects the sales growth
potential and operating risk of the subject business.

(a) The economic profile should therefore focus on those issues which
pose opportunities and challenges to the country and the companies
that operate within the country.

B. Macroeconomic Challenges to the KSA economy

(1) Population profile

(a) The shape of the population’s age demographic might indicate a risk
factor. KSA’s population is youthful by world standards, with 44.5%
of the population under the age of 25 years.

 A young population could pose a risk if there are not

enough jobs available to bring them into the workforce.

 Conversely, a population with an disproportionately older

population could pose a risk since there may not be a
sufficient number of younger people in the workforce to
support the old age population in terms of healthcare and
other social welfare support payments.

 KSA’s population graphic is compared to that of the U.S.

and Japan below:

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(b) KSA’s population, relative to the U.S. and Japan is significantly

younger.

 KSA’s median age is 30.2, compared to 37.8 in the U.S.,

and 46.1 in Japan.

 With declining opportunities in the energy sector, the

country is under pressure to diversify the economy to
allow multiple career paths for younger generations.

 Higher youth unemployment yields higher country risk

since unemployed youth are at greater risk of drifting into
socially unacceptable behaviors.

(c) KSA’s total population is 33.5 million as of 2018. Relevant

population metrics include the following:

 The unemployment rate is 5.6%. This rate excludes

women. If women of working age are included, the
unemployment rate is 25.0%.

 The workforce participation rate is 54.8%. The

participation rate is the number of people of working age
who are employed or are seeking work. KSA’s rate is low
by worldwide standards. Other selected rates include:
 United Kingdom 78.7%
 Kuwait 77.8%
 United States 62.7%
 European Union 58.2%
 Turkey 53.3%

 About 36.0% of the population are non-Saudis, many of

whom are foreign nationals who came to KSA to work.

 Foreign workers are mostly employed in

agriculture, cleaning, and domestic services
occupations.

 Total population is forecast to grow to approximately 36

to 37 million by 2022.

(d) Saudization Program (Nitaqat Program)

 The Saudization Program was initiated in KSA in 2003 to

alleviate the unemployment problem among Saudi

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citizens by replacing foreign nationals in many industries

with Saudi nationals. Under the program, companies
were assigned quotas for hiring Saudi citizens. Quotas
are based on the size of the company’s workforce and
the type of industry.

 This program was unpopular in the private sector

as Saudi citizens were difficult to recruit and
required higher compensation.

 Some employers in KSA tried to evade the quotas.

 The Program was updated in 2017 to become

more stringent with higher quotas. Employers
must now hire more Saudi nationals before
becoming eligible for Block Grants to bring in
foreign workers.

 The Saudization Program is intended to alleviate

the high percentage of unemployed youth in the
country by replacing foreign workers with Saudi
nationals.

(2) Gross Domestic Product (GDP)

(a) The Saudi economy is heavily influenced by a single sector, energy.

The country has 16% of the earth’s oil reserves.

 Oil constitutes 42.0% of GDP.

 Oil represents 87.0% of the KSA governmental revenues.

 Oil represents 90.0% of KSA export

(b) There are eleven other sectors in the KSA macroeconomy, several
of which show room for future growth.

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KSA GDP by Economic Sector

Soci al s ervices, 1.9%
Govt s ervi ces, 13.9%
Fi nance/Insurance,
3.5% Oi l , 44.3%

Rea l estate, 5.0%

Tra ns portation, 5.8%

Whol esale/retail,
9.0%

Conts truction, 4.7%

Agri cul ture, 2.3%
Util ities, 1.3%
Non-oil manuf, 8.3% Non-oil mining, 0.4%

(c) The reliance on oil for government budgets, employment, and

disposable income adds volatility to GDP and the nation’s
macroeconomic well-being.

 The lack of diversity affects employment opportunity,

disposable income and the health of the stock market.

 According to the International Monetary Fund (IMF), the

Saudi economy needs an oil price per barrel at $73.00
(U.S.) to break even. Other oil producing economies have
a more forgiving breakeven price:

 Kuwait = $46.50

 Qatar = $46.80

 Only Bahrain and Oman have higher breakeven

points than KSA among middle eastern producers.

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 As of early 2018, crude oil prices were in the $63.00 price

per barrel range, up slightly relative to the prior year, but
still approximately $10.00 below KSA’s breakeven point
given government spending levels.

 The volatility issue in KSA is graphically presented in

world oil prices over the past 45 years:

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 Oil prices collapsed in 2015 from $96.29 per barrel to

$49.49 per barrel. This caused a shock to the KSA
economy.

 In early 2018, prices increased to $66.85, but the

IMF predicts that prices will remain in the $55.00
to $65.00 range for the foreseeable future.

 This means that KSA will need to further curtail

government spending (or increase non-oil
revenues) in order to lower its breakeven point by
approximately another $10.00 per barrel.

 The government recognized this fact several

years ago and is engaged in a comprehensive
effort to make this happen.

(d) KSA’s annual GDP growth was impressive over the past ten years
as oil prices fueled macroeconomic activity. With the decline in oil in
recent years, GDP has also declined.

KSA Gross Domestic Product in U.S.$

900.0
800.0
700.0
600.0
500.0
400.0
300.0
200.0
100.0
0.0

Source: Statistica

 KSA’s GDP is expected to increase over the next five

years for the following reasons:

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 KSA is easing social and economic restrictions

which should encourage greater foreign
investment and domestic consumption.

 Woman are allowed to drive which will

lower household spending on outside
transportation.

 The government is taking steps to

encourage higher foreign investment in
local companies.

 Domestic and foreign investors will be

allowed to invest in ARAMCO, the Saudi
national oil company.

 A value-added tax (VAT) will be instituted which

will diversify the government’s reliance on oil and
alleviate the recent decline in government
spending.

 The general strategy of diversifying away from oil

into other economic sectors (technology,
healthcare, life sciences, services) is expected to
have a positive effect on GDP growth.

(3) Taxation

(a) Value-added Tax (VAT) – as of 2018 KSA imposed a 5.0% VAT on

consumer items such as food, clothing, electronics, gasoline,
telephone and electric bills and hotel bills.

 Some large expenses are exempt from the tax, including

rent, property sales, medications, airline tickets, and
tuition costs

 Sales tax on several products had already been

introduced prior to 2018, including a 50% tax on soft
drinks and a 100% tax on tobacco and energy drinks.

 Although the tax will affect consumption, the VAT is still

significantly less that many other countries such as in the
European Union, where the VAT is as high as 20.0% in
some countries.

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 The VAT had been recommended to the gulf countries by

the IMF as a way to diversify government revenues away
from oil income.

(b) Corporate income tax

 Non-Saudi investors are liable for a 20% tax on the

company’s net adjusted profits. Saudi investors are
exempt from this income tax.

 If a company is owned 90% by a Saudi citizen

and 10% by a non-Saudi, and the company earns
1,000,000 riyals in net adjusted profits, then
100,000 riyals (10%) is subject to the 20% tax
(20,000 riyals of tax).

 Zakat tax – Saudi citizens though are not completely

exempt from tax. The Zakat is an Islamic assessment on
corporate income of Saudi citizen investors. In the
example above, the remaining 800,000 riyals would go
into the basis on which the Zakat is assessed. This basis
is taxed at a 2.5% rate.

 Energy taxes – Activities in natural gas and hydrocarbons

are subject to different tax rates.

 Natural Gas Investment Tax (NGIT) – the tax rate

is based on the internal rate of return of the
natural gas project. The tax rate is 30% if the IRR
is 8.0% or less. The NGIT is progressive, with a
top rate of 85% if the IRR is 20% or higher.

 Income from oil and hydrocarbon production is

taxed at a rate of 50% to 85%.

 Withholding taxes:

 Dividends – 5.0% withholding tax is levied on

dividends paid to non-Saudis.

 Interest – 5.0% withholding tax is levied on

interest paid to non-Saudis.

 Royalties – 15.0% withholding tax is levied on

royalties paid to a non-resident.

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 Technical – 5% withholding tax is levied on

technical service fees paid to non-Saudis.

 Capital Gains Tax – a 20.0% capital gains tax is levied on

the sale of shares in a company by a non-Saudi investor.
Shares of companies traded on the Saudi stock
exchange are exempt from this tax.

2. KSA Market Transactions:

A. The business valuation profession in KSA is evolving. Demand for business

valuations typically comes from:

(1) Mergers & acquisitions – 34%

(2) Private placements – 33%

(3) Shareholder disputes – 23%

(4) Financial reporting – 5%

(5) Legal settlements – 5%

B. Key industrial sectors in which valuations are being conducted in KSA:

(1) Healthcare – 18%

(2) industrial manufacturing - 15%

(3) F&B – 12%

(4) Retail – 9%

C. The percentage of companies being valued by sizes

(1) Valuations > SAR 250 Mn is 33%

(2) Valuations between SAR 100- 250 Mn is 48%

(3) Valuations between SAR 20-100 Mn is 19%

(4) Valuations < SAR 20 Mn is difficult to estimate

D. It is estimated that approximately 1,000 - 1,500 valuations were undertaken in

KSA annually.

(1) 38% of the valuations were for companies more than SAR 250 Mn,

(2) 35% were for companies between SAR 100 Mn - 250 Mn and

(3) 27% were for companies between SAR 20 Mn -100 Mn

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E. There are approximately 140 to 160 successful transactions in KSA during 2016:

(1) Approximately 20% were valued above SAR 250 Mn,

(2) 32% between SAR 100 and SAR 250 Mn,

(3) 48% between SAR 20 and SAR 100 Mn.

F. The total size of transactions in KSA varied between SAR 24 Bn to SAR 28 Bn

annually and these include M&A, minority investments and IPO activities.

G. Cross border transactions are few and form a small portion of the valuation
exercises done in KSA (3% of KSA valuations). Few large corporate firms
undertake cross border valuation and transactions (e.g., Savola and STC). Such
firms typically acquire strategic assets in different geographies outside KSA. Few
large multinational investment banks with global networks also undertake cross
border transactions. However the number of such transactions is small.

H. Public Offerings:

(1) The KSA’s capital markets have seen 45 Initial Public Offerings (IPOs)
between 2010 and 2014 and approximately SAR 56 Bn of funds were
raised by the IPOs.

(2) The annual number of IPOs taking place in KSA varied between 6 and 12
during 2010 and 2014. The annual amount of capital raised through public
offerings varied due to the differences in size of transactions.

(a) IPO applications are coming from the following commercial sectors:

 Industrial manufacturing – 27%

 Financial services – 26%

 Healthcare – 10%

 Retail – 5% 6%, 10%, and 5% of the IPO applications in

KSA

(3) In 2014, the IPO of NCB was worth approximately SAR 22.5 Bn and was
the second largest public offering in the world. This large transaction
indicates the strong fundamentals of an attractive investment climate and
demand for valuation and transaction services in KSA

I. Merger & Acquisition Activities:

(1) Between 2010 and 2014 there were 126 announced M&A transactions in
KSA. The annual number of announced M&A transactions varied
between 17 and 37 transaction during 2010 – 2014.

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(2) Of the 126 M&A transactions, the size of transactions was disclosed in 75
transactions. Between 2010-2014 approximately SAR 22.2 Bn worth of
M&A transactions were disclosed.

(3) Industrial manufacturing, F&B, financial services, construction and real

estate were the key sectors that comprised 20%,13%, 9%,7%, and 6% of
the total M&A transactions in KSA.

(4) Some of the largest M&A declared M&A transactions in KSA between
2010 and 2014 included:

(a) Acquisition of 50% of Aujan Industries Company shares by Coca

Cola U.S. for SAR 3.7 Bn in 2012.

(b) Acquisition of an interest of 12% in Mobile Telecommunications

Company Saudi Arabia by Mobile Telecommunications Company
Kuwait for SAR 2.8 Bn.

J. Asset Management:

(1) The number of investment funds in KSA has increased from 359 funds in
2011 to 578 funds in 2014.

(a) The number of public placement funds declined from 272 funds in
2011 to 263 funds in 2014, however the number of private
placement funds increased from 87 funds in 2011 to 315 funds in
2014.

(b) Total AUM of funds increased from SAR 99,131 Mn in 2011 to SAR
162,088 Mn in 2014 at a CAGR of 18%.

(2) In 2013, approximately SAR 2,790 Bn of private equity funds were raised
in MENA region and approximately 66 investments of a total value of SAR
2.7 Bn were invested by private equity funds in MENA region.

(3) KSA is an attractive market for private equity funds in KSA and attracted
approximately 12% of the private equity investments in MENA region.

(4) Financial services, real estate, healthcare and manufacturing were some
of the key sectors in which private equity funds were invested in KSA.

3. Valuation market characteristics

A. Full businesses refers to valuation of 100% of equity of the business being

valued. It is the most common type of valuation requested by clients (73% of
valuation market).

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B. Shares of business valuation is done to value a subsidiary of a business or a

minority stake, this is undertaken for fund raising or divestments (23% of
valuation market).

C. Valuation of tangibles assets are carried out when a company is going for a
liquidation or when the assets it holds on books are non cash-generating assets.
The work is usually conducted by specialized asset appraisal companies (3% of
valuation market).

D. Intangible assets are not physical in nature, such as intellectual property,

goodwill, trademarks and brands. Goodwill is added to the balance sheet due to
premiums paid on net assets of acquired businesses. Valuation of tangible and
intangible assets as a standalone transaction is very low in KSA (1% of valuation
market).

E. Commonly Applied Valuation Methods and Information Sources

(1) The DCF method is the most common valuation approach and given
73% weight by valuers and other approaches including market multiples
and asset based approaches were given 23% and 4% weights by
valuers respectively.

(a) Sources of Information Used for Industry Benchmarks include:

 Government agencies publish economic and industry

performance indicators such as SAMA, MOL, MOH and
others.

 Economist Intelligence Unit has the most sector coverage

and is used by firms to get an understanding of the sector

 International agencies (e.g., IMF, WHO and the World

Bank) also publish macroeconomic indicators for sectors
and countries.

 Local investment banks have their own research

departments and produce reports for their subscribers.

(b) Sources of Information

 Damodaran produces well researched information on:

 Estimates for betas for different industries for developed

and emerging markets.

 Country and market risk premiums for major

countries including KSA.

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 Market multiples for major industries.

(c) Stock exchange websites, such as Tadawul that have information on

listed companies.

4. Valuation challenges in the Saudi Market:

A. Difficulties in data collection.

B. Lack of comparable companies.

C. High expectation on valuations by clients.

D. Lack of industry knowledge.

E. Lack of knowledge on valuation.

F. Inadequate Accounting Systems.

5. Valuation Body in the Kingdom:

A. Saudi Authority for Accredited Valuers (Taqeem) is the government body

responsible for the valuation profession in the Kingdom.

B. Taqeem has been dedicated to deliver the following roles:

(1) Organize the valuation profession and establish the necessary

standards for valuation procedures.

(2) Develop the valuation profession and raise the level of practitioners
professionally and ethically.

(3) Qualify and accredit professional valuers to practice valuation in all

sectors.

(4) Increase the public trust in the valuation profession and lift the
profession to the ranks of other prestigious professions.

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Section B. How does the KSA Macroeconomy affect the Subject Company:
Questions to ask:

1. How will the VAT tax affect demand in the subject company?

2. Is the subject company affected in any way by the price of oil?

3. How will levels of government spending affect the subject company?

4. How does the Saudization Program affect the subject company?

5. How should corporate taxes be handled in a valuation?

6. Is the company worth more to a Saudi investor than a non-Saudi investor?

7. How is the Zakat tax handled in a business valuation?

8. If a comparable company traded overseas is taxed at a 25% rate and a Saudi company
is taxed at a 2.5% rate, should the market multiple from overseas be adjusted?

9. How will the subject company’s demand be affected by the younger population as it
moves into its peak consumption years?

10. How would the subject company be affected if the government opens up more to
multinational companies and foreign investment?

11. Will the increase in the number of automobile drivers affect the subject company?

12. If the number of foreign workers declines (in favor of Saudi employees) will the subject
company be affected?

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Section C. Chapter Review Questions

1. Which of the following statements is true about population demographics in KSA?

A. Saudi Arabia has a citizen population of 33 million, but if non-Saudis are

included, the population increases to 62 million.

B. The Saudi birth rate is highest amoung all Asian nations.

C. Relative to other nations, Saudi Arabia has a youthful population with a median
age of about 30 years.

D. Approximately two-thirds of Saudi citizens are employed by the KSA

government.

2. All else being equal, would a Saudi investor pay more or less for a KSA company than
a non-Saudi investor?

A. He would pay the same since all equal fractional interests in a company must,
according to valuation principals, be worth the same.

B. He would pay more since his net after tax equity cash flow would be higher than
a non-Saudi investor with the same fractional interest.

C. He would pay less since Saudi citizens are taxed at a higher rate than non-
Saudi investors.

D. He would pay more since the investment is located in Saudi Arabia.

3. The objective of the Saudization Program is which of the following:

A. Increase foreign investment in KSA companies

B. Increase the number of IPOs on the Tadawul

C. Lower the restrictions on foreign workers entering KSA

D. Lower the unemployment rate among Saudi citizens

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