The overriding objective of a business valuation is to parallel the thought process that hypothetical investors would use in determining the suitability of acquiring an interest in the firm in question. As such, there are two general areas of analysis. The first is to determine the economic returns that are likely to accrue to the investor as a result of ownership and “convert” those returns into a value estimate. The second area of analysis evaluates how the market prices similar firms.

Market pricing reflects the consensus of investors who are comparing a particular investment to similar firms in the marketplace in terms of risk and return. Valuation multiples are then created, which are applied to the earnings of the subject company.

The business valuation community has developed two general methods to capture these concepts: the Discounted Cash Flow method and the Guideline Public Company method.

Using this method, the analyst looks at the subject company as an investment and values the stream of investment returns that the subject is projected to generate. This starts with an analysis of the subject company’s revenue-generating capability, as a function of both its internal capacity and the size and level of competition present in the external marketplace.

The costs and expenses associated with the production of the projected revenue are then estimated based on the analysis of historical trends and other information. Working capital infusions and fixed asset additions are also projected at levels necessary to sustain operations. This leads to a computation of net cash flow, which is the investor’s source of return over time.

Converting the future stream of investor cash flow to present value is accomplished by using a discounted rate of return. This takes into account the subject company’s risk levels as well as the known rates of return available on investments of various levels of risk. Using the discounted rate of return, present value factors are computed for each year and multiplied against the projected cash flow for each year. The summation of these figures equals the value of the investment under the Discounted Cash Flow method.

The strength of the Discounted Cash Flow method is that the specific investment attributes of the subject company are directly incorporated into the valuation model. The weakness of this method is that it might be difficult to prepare reliable long-term projections for the business enterprise.

Using this method, the appraiser identifies companies in the same or similar business as the subject company for whom transaction data is publicly available. These companies are analyzed and the transaction pricing data is related to various indications of current and historical earnings, revenue, book value and other statistics, so an array of multiples can be developed.

Once a degree of comparability is established, appropriate multiples are selected and applied to the subject company’s earnings, revenue, book value, etc. This leads to an indication of the value that might be expected to be paid for the subject company if it were exposed to the same economic conditions as the comparative companies.

The Guideline Public Company method’s strength is that it relies on “live” external data and the application of multiples to create actual, verifiable valuation figures. Its weakness lies in the compromises that must be made when establishing whether a group of companies is truly comparable or not.

The valuation of closely held securities requires the assessment of the degree of marketability of the shares in question. With most closely held securities, there is an absence of marketability when compared to public company stock. In fact, there is a large body of research that supports the notion that the impediment in marketability of closely held securities has a significant impact on value. Therefore, discount for lack of marketability (DLOM) is the amount or percentage deducted from the value of an ownership interest to reflect the lack of marketability.

As a holder of either fractional or 100 percent control, the shareholder can control the selection of directors and shareholder voting. As such, with a controlling interest, there is an enhanced certainty regarding the use of cash flows of the Company. This enhances value, and such interests might be valued at a premium above a minority interest in the same company.

The majority of our valuation projects include the preparation of a detailed report in full narrative form; however, that isn’t always the case. Because companies vary in terms of complexity and breadth of industry coverage, it is difficult to estimate accurate costs without knowing more specifics. Please contact us at 630.443.9933, and we can give you a better idea of approximate costs after obtaining more information from you.

In the case of a leveraged buyout, the company pays the principal back in after-tax dollars. In an ESOP situation, the benefit is the principal payments become tax deductible to the company. This ultimately results in savings of 35 percent to 40 percent of the overall transaction cost. On the selling shareholder side, the main benefit is the possible tax deferral on the sale of the securities. A seller can elect 1042 tax deferral if the company is a C Corporation and the transaction size is at least 30 percent of the outstanding securities.

In most cases, ESOP shares do not usually get distributed to employees out of the ESOP. They are held and controlled by a trust established for the benefit of the plan participants, and therefore the trustee votes the shares. Under certain circumstances involving the sale or liquidation of the Company, the ESOP trustee is required to “pass-through” the vote to the participants.

ESOP Trustees are appointed by board resolution. Of course, in a controlling interest ESOP, the board is ultimately controlled by the trustee’s vote because the trustee elects directors. This seems circular and sometimes ends up being just that in practice. However, existing directors might have staggered terms, and therefore it is possible that not all directors will be subject to reelection at any given point in time. When a controlling interest ESOP is established, an agreed-upon board structure can be put in place that balances the corporate governance objectives of the Company, ESOP trustee and non-ESOP shareholders.

In the case of an ESOP, there is an enhanced degree of marketability as a result of the statutory put option granted to ESOP participants. This becomes effective at the time they are eligible to receive benefits under the ESOP. In the view of most ESOP valuation practitioners, this enhancement either totally or substantially reverses the typical DLOMs applied in closely held valuation situations.

The 1042 tax deferral is a special incentive for sellers of stock to an ESOP. It allows a qualifying seller to defer recognition of the capital gain on the sale to the ESOP trust under certain circumstances. The gain is deferred because the basis in the stock sold to the ESOP is carried over and becomes the basis that is allocated to the portfolio of reinvestment securities. Gain will be triggered (and taxes owed) if and when the reinvestment securities are sold. If a portion of the portfolio is liquidated, gain will be triggered only on that portion. Note that gain will be measured all the way back to the prior basis in the stock sold to the ESOP trust. Thus, the holding period becomes an important part of the reinvestment strategy.

The qualification for the tax deferral provided under section 1042 is based on certain criteria relating to the nature of the ESOP transaction as well as the nature and ownership of the securities themselves. The tax code and regulations spell out the details, but the following comments enumerate the general concepts:

• First, the tax deferral is only available if, immediately following the ESOP transaction, the ESOP trust holds at least 30 percent of the stock of the company.
• Second, the Company must be a C-Corporation at the time of the transaction.
• Third, the shares sold to the ESOP must be held by the seller for at least three years prior to closing.
• Fourth, the seller must obtain a document from the Company referred to as a “Statement of Consent.”
• Fifth, the seller must make appropriate filings with the Internal Revenue Service as the Qualified Replacement Property (QRP) is assembled during the allowed reinvestment window. The reinvestment window is defined as the 15-month period beginning three months prior to the closing of the ESOP transaction and ending twelve months after closing. These filings are referred to as “Statements of Purchase” and must be prepared and notarized within 30 days of each security purchase.
• Sixth, the seller must only reinvest his or her proceeds into QRP, which is generally defined as stocks and bonds of domestic operation corporations. This definition excludes many investments such as government securities, mutual funds, REITs and foreign-controlled stocks. Care should be taken in the selection of QRP investments.
• Seventh, the seller must file a “Statement of Election” with his or her tax return filed for the year the ESOP transaction is completed, regardless of whether the full 12-month post-closing reinvestment window is completed or not.

Each year, the Company will make a contribution to the ESOP trust to provide the funding necessary for the ESOP to make the loan payment on the ESOP financing. This will “release” a number of the shares and make them available for allocation to the employees. The allocation is based on the relative payroll of the participants in the plan, which means that an employee earning $50,000 per year will generally receive twice the shares of an employee earning $25,000 per year. Allocations in ESOPs are generally subject to similar limits regarding allowable compensation and top-heavy testing, as with 401k plans.

Generally, ESOPs are set up to allow all full-time employees over the age of 21 to participate. A company can choose to exclude a collective bargaining group, however.

Shares are allocated based on W2 wages. The individual W2 compensation is divided by the total eligible employee W2 compensation. For instance, if a company had total eligible payroll of $1,000,000 and the individual’s W2 compensation was $40,000, the individual would receive four percent of all the shares allocated in that given year.

In all ESOP situations, the company has ongoing administration in two areas. By law, the company must be valued every year by an independent appraiser to determine the fair market value of the shares held by the ESOP. In addition, the plan needs to be administered. This usually takes the form of an independent administration firm that gathers participant information and develops the participation statements.

Yes. Most of our private sale transactions are for companies larger than $5 million. While many of our clients are located in the Midwestern United States, we do work with companies nationwide and are willing to evaluate a variety of situations.

We begin by trying to understand who might have a strategic interest in the Company. Sometimes this group includes competitors, vendors, customers or other firms seeking to expand vertically or geographically into the business. Prairie has access to numerous sources of information about public and private companies to assist in this research. Secondly, we will identify whether there are financial buyers who seek to add the Company to their portfolios.

A thorough understanding of the Company is required, so the process begins with the collection and analysis of the Company's financial and descriptive data. This leads into two parallel phases: buyer identification, and the preparation of the descriptive memorandum and other informational documents.

Once the seller has approved the buyer list, "blind" contact is made. If the prospective buyer is interested, a non-disclosure agreement is entered into. Interested parties are then sent descriptive materials and given a deadline for their initial written expressions of interests. Once obtained, the prospects are screened further and those that are deemed probable buyers are scheduled for due diligence. We attempt to schedule the due diligence meetings in a non-disruptive fashion and within a narrow overall timeframe.

After this, a deadline is set for the delivery of letters of intent from multiple parties. The letters of intent are compared and presented to the seller and negotiating points are reconciled. Once a single buyer is identified, the buyer's letter of intent is signed and the formal documentation and closing process is undertaken.

Our general response is to expect the process to take between six and twelve months. However, there are exceptions on both ends of that range.