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

1. MAXIMIZING VALUE THROUGH KNOWLEDGE
Money for Nothing
Valuation of Distressed
Businesses and Assets
Georgia Society of
Certified Public Accountants
October 21, 2008
Michael S. Blake, CFA
October 16, 2008
770-432-0308
michael@adamscapital.com
600 Galleria Parkway, Suite 1850, Atlanta, GA 30339 www.adamscapital.com 1

2. Who is Adams Capital?
Boutique valuation services firm
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Founded by David P. Adams, III in 1995
•
Five financial professionals, including
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ASA, ABV, CPA, CFA, CFE, and J.D.
Participant in the GA Tech Co-op program
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40 hours of annual CPE per professional
•
High-end, service-oriented, entrepreneurial
•
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3. StartupLounge.com
501(c)(6) non-profit
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Co-founded by Scott Burkett and Michael Blake
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Key players: Stacy Williams, Charlie Paparelli,
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Jerry Recht, Anne Simons
Goal is to facilitate early-stage capital investments
•
in Georgia
Educating entrepreneurs (podcasts, PitchCamp)
–
“Safe” networking meetings for entrepreneurs
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(CapitalLounge)
“Safe” networking for angel investors (Angel Lounge)
–
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4. Why Distressed Asset Value is Important
We are seeing and will continue to see many
•
distressed businesses for the next 12-18 months
In particular, smaller businesses tend to under
•
value distressed assets
Tax and accounting implications
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Required for recapitalizations
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Required for bankruptcy court and/or settlement
•
negotiations
MAXIMIZING VALUE THROUGH KNOWLEDGE

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6. Definition of Fair Market Value
From IRS Revenue Ruling 59-60:
The price at which the property would
change hands between a willing buyer
and a willing seller when the former is
not under any compulsion to buy and
the latter is not under any compulsion
to sell, both parties having reasonable
knowledge of relevant facts.
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7. Value: What Someone is Willing to Pay?
Who is “someone” and what are their
•
circumstances?
Free to decide to buy/sell or not to buy/sell?
–
Is the asset made available to many buyers?
–
Could the buyer flip the asset at the same price quickly?
–
What was the second highest bid?
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Is the buyer knowledgeable and privy to all relevant
–
facts?
Were the terms of sale all cash?
–
Are non-financial drivers at work?
–
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8. Does Value Equal Price?
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9. Challenges of Valuing Distressed Businesses
Incomplete or fraudulent data
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Many conventional valuation models don’t
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work well
Track record breaks down
•
Fundamental assumptions must change
•
Fewer buyers
•
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10. Definition of a Distressed Business
The Insolvency Act 1986 (Section 123) sets
•
out two primary forms of validation.
Cash flow test. Where the business is unable to
–
pay debts as they fall due
Balance sheet test. The value of the business’
–
assets is less than its liabilities, taking into
account its contingent liabilities and
prospective liabilities.
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12. Signs of Distress
There are many, but some dead
•
ringers are
– Consistently accumulating debt
– Lengthening accounts payable
– Multiple creditor warning
letters
– High borrower interest rates
– High turnover in key
financial/accounting functions
– Revolving consultants
– Behind on payroll taxes
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13. Sources of Distress
Manageable Impact Unmanageable Impact
Loss of key customer Natural Disaster
Litigation/dispute event Negative regulatory shift
Event
Loss Competition intellectual property
Driven
Negative public relations event advance
Office or workplace incident Research & development failure of
Industrial accident key product
Discovery of fraud
Over-leverage Industry obsolescence
Cost structure Death of key person
Systematic Cash management Low-cost foreign competition
Defection of key employees Poor economic environment
Under-investment Financial market movements
Poor fit of management skill Unavailability of labor
Poor financial record systems Unavailability of capital
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14. Valuation of a Reorganizing Debtor
Principle set forth in 1941 U.S. Supreme
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Court Consolidated Rock case
Core question is earning capacity
•
Free the enterprise from the burden of past
•
errors, miscalculation, or disaster
Beware of Kool-Aid
•
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15. Market Approach
Can be useful for individual assets
•
Challenges
•
Frequently, no profit multiples available
–
Hard to identify comparable companies sold
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through an acquisition
Hard to identify guideline public companies
–
In distress, the assumptions of fair market value
–
are routinely violated
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16. Market Approach Techniques
Use forward EBIT/EBITDA multiples
•
Add restructuring costs back to forward
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EBIT/EBITDA multiples (EBITDAR?)
Use different multiples
•
Sales multiples
–
Cash flow multiples
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Production capacity
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Tangible asset value
–
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17. Market Approach Checklist1
Are guideline public companies truly representative of the
•
subject firm
What financial metrics will be used?
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Should the metric(s) be based on historical or projected
•
financial data?
Should any discounts or premiums for size, comparability,
•
or other factors be applied to a particular multiple?
What time frame for comparable M&A transactions and
•
other data should be reviewed?
Rule of thumb – at least 20% discount for distress
•
1 Powlen, David, Triple Trouble: Valuating Companies in Chapter 11, The Journal of Corporate
Renewal, October, 2008 (www.turnaround.org)
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18. Asset Approach
Can appraise value of individual assets
•
Tangible assets
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Intangibles
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Customer lists
•
Patents, trademarks, trade dress
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In-process research & development
•
Brand
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Copyrighted material
•
Web domain name
•
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19. Premises of Asset Value
Value in continued use; going concern
1.
Value in place; not a going concern
2.
Piecemeal value under orderly liquidation
3.
Piecemeal value under forced liquidation
4.
Bankruptcy courts generally have required the going concern premise since
1974.
MAXIMIZING VALUE THROUGH KNOWLEDGE

20. Dead or Alive
Value-destroying
firm
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22. Income Approach
• Capitalized earnings not generally usable
• Discounted cash flow is helpful
• Is flexible enough to factor in changing revenues
• Factor in changing cost structures
• Provides a time line continuity between past
performance and future expectations/goals
• Factor in impact of net operating loss tax benefits
• Factor in restructuring expenses
• Factor in additional risk and new capital structure
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23. Hard-to-Believe DCF
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24. Easier-to-Believe DCF
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25. What is Negotiable
• Debt holders and creditors become
stakeholders
• Opportunity to delay/defer expenses if
• You prove you’re likely to pay later
– Creditor doesn’t have a ready customer
Landlords
•
Service providers, including utilities
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Some tax obligations
•
Lenders
•
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26. Cost of Capital and Capital Structure
Cost of debt and cost of equity will increase with
•
distress
In current environment, debt may not be available
•
at any acceptable price
Lenders will frequently demand warrants for
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“upside”
Debt takes on characteristics of equity, and can in
•
effect become equity
Cost of capital and discount rate goes up, value
•
comes down
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27. Cost of Capital Shift
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28. How Debt Becomes Equity
Equity swaps
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Default clauses
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Convertibility
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Warrant coverage
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Equity Erosion
•
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29. Equity Erosion
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30. Capital Structure Considerations1
Who has control and leverage of firm policy?
1.
Is the composition concentrated or diffuse?
2.
Do any investors have veto capabilities?
3.
Who are the holders of the securities? (banks,
4.
individuals, venture capitalists, hedge funds,
friends & family)
Are they likely to have different objectives?
–
How do they impact the overall risk of the
5.
company?
1Lurvey, David et al., Hidden Treasures: Techniques for Valuing Distressed Enterprises, The Journal of
Corporate Renewal, October, 2008 (www.turnaround.org)
MAXIMIZING VALUE THROUGH KNOWLEDGE

31. Option Modeling – the 21st Century Approach
Option models don’t require a finite view or
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set of views of the future
Option models all have the following
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elements
Time to expiration (expected time to recover)
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Current price
–
Exercise price
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Holding return
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Volatility (variability of returns over time)
–
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32. Option Features and Value
Option Feature Value Impact
Time to expiration increases Increased value
Current price increases Increased value
Exercise price increases Increased value
Holding period return increases Decreased value
Volatility increases Increased value
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33. Volatility Examples
High Volatility Low Volatility
Lower upside
Higher upside
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34. Liabilities
• Liabilities must be re-valued because face value
has lost its meaning
• Likelihood of repayment
• Likelihood of partial payment
• Change in timing of payments
• Prospect of forgiveness
• Valuation of contingent liabilities
• Debt itself discounted due to default risk and
interest rate that is below market given the
company’s current condition
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35. Asset vs. Stock Sale
• Asset sales allow transfer of key sources of value
while leaving liabilities behind
• If prior to default, state and federal law (Section 544
of the Bankruptcy Code) can nullify the sale up to 6
years in arrears
• Sale intended to defraud, hinder or delay creditors
• Sale was less than fair market value, and seller was
insolvent at the time or sale rendered seller insolvent
• Value may be higher in bankruptcy in a Section 363
sale, which is approved by the court
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36. Insolvency
• Balance Sheet Test
• Is net equity (net tangible
equity) positive?
• Cash Flow Test
• Can company pay bills
as they are due?
• Thin Capital Test
Can the business operate
–
out of distress in the
future?
MAXIMIZING VALUE THROUGH KNOWLEDGE

37. Summarizing Thoughts
Distress adds uncertainty to the business and makes
•
valuation more challenging
Valuation tools work differently
•
Assumptions require close scrutiny
•
Option models can capture uncertainty more robustly
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Capital structure is critical
•
Distress and insolvency are related but different
•
Don’t forget about liabilities
•
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38. MAXIMIZING VALUE THROUGH KNOWLEDGE
Thank you for
your attention
Questions?
600 Galleria Parkway, Suite 1850, Atlanta, GA 30339 www.adamscapital.com 38