Q: We operate under an LLC form. We are in the service business and need to finance our startup accounts receivable. The owner of the LLC is contemplating giving an interest in the LLC for a cash infusion to finance the accounts receivable. The annual sales are $15 million and the accounts receivable are $1.5 million.
What are the various valuation techniques to determine the size of interest in the LLC for the $1.5M?
A: LLC valuation techniques (and those of privately held firms in general) take on a variety of forms. Each company and valuation interest is unique, which requires a close examination of the facts by a financial economist.
In general, there are three common techniques for valuing privately held businesses: market multiples of historical financial information, discounted cash flows, and reference to other sales/bids/offers of the company or its interests. For each of these methods, certain adjustments may be required, including the key person discount, the control premium, and the marketability discount. There have been many articles and books written on these concepts, including by me, which I will briefly summarize below.
The market multiple approach begins by computing the ratios of price to earnings, equity, revenue, or some other financial item of publicly traded companies with similar operations and risks to the company at issue. These ratios are then multiplied by the corresponding item of the company at issue. This can be done for the trailing twelve months of financial data or a longer historical time period to “flush out” the effect of business cycles. The resulting valuation would be classified as “minority, publicly traded” in that it reflects what minority shareholders would pay for a publicly traded company.
The discounted cash flow approach calculates the present value of a company by discounting its forecasted future earnings (income) with an appropriate discount rate. Earnings can be defined in a number of ways, although it should reflect the cash flow accruing to the company’s shareholders. The discount rate accounts for the time value of money/opportunity costs and specific investment risk. Like the market multiple approach, this approach also yield a minority, publicly traded value.
In addition to the mathematical approaches described above, a good valuation must consider direct market evidence. This could include offers to buy the company or its interests, bids to sell the company or its interests, and actual sales of portions of the company. As a general rule, only transactions that occur BEFORE the valuation date are explicitly relevant, but transactions that occur shortly after the valuation date can serve as a check of reason. For example, if the company successfully undertakes an IPO two months after the valuation date, then its initial market capitalization should be considered. The type of valuation produced by this approach is dependent on the type of transaction in that some transactions are in a public (private) market and some transactions involve a minority (majority) stake in the company.
The key person discount reflects the fact that the departure (or death) of a key person in a business may have a significant effect on its future prospects. This can be especially relevant when buying out an important partner in a business or in an estate tax valuation. Such adjustments are typically in the form of discounts (lowering the firm value), but the departure of a poorly performing key person may induce a premium to be added.
The control premium reflects the fact that a shareholder with majority interests in a company has the opportunity to make all decisions and potentially receive fringe or direct benefits. In this way, the value of a single share of stock is less than the implied “price per share” paid for a controlling interest. Some valuation methods produce a controlling price, while others produce a minority price. Adjustments are required if the methodology does not match the size of the block being valued.
The marketability discount accounts for the fact that privately held companies and their interests are more difficult to sell than publicly- traded companies. The discounts typically applied here are smaller for controlling interests because such an owner would have the potential to take the company public (the costs of going public are less than the typical marketability discounts applied to minority interests). This adjustment may have the most variability, as the different companies can have very different levels of illiquidity based on partnership agreements, size of company, and state laws.
Without actually reviewing the financial materials of your company, it is premature to suggest which methods would be most appropriate in your case. However, it will be important to include the $1.5 million cash infusion on the financial statements of the company before valuing it. A valuation of the company with this cash will determine what portion of the company could be purchased with $1.5 million. This $1.5 million will likely translate to a minority interest in the company, and this must be considered when comparing it to values held by the controlling interests.
Brian C. Becker, Ph.D.
Senior Vice President, Criterion Finance LLC
See previous “Ask the Experts” columns:
Accounting for purchase of receivables from a company undergoing Chapter 11.
Fiduciary responsibility for self-directed 401(K)s
Combining Chinese Subsidiaries into One
U.S.-U.K. Tax Treaty
Paperwork for Customers in Tax-Free States
Licensing Fees in Japan
Buy-out Legal Fees and Treasury Stock
A Merger Accounting Scenario
A FAS 133 Example
Recognizing Upfront Fees
Proving Tax-exempt Status
The ABCs of OECD
Credentials for Credit
Big Five Audits and Venture Funding
GAAP for Private Firms
Insurance for E- business Infrastructure
401(k) Brokerage Links
Navigating the Rough Waters of Sales Tax
Ask the Experts is a weekly column that aims to help finance executives like you find answers to difficult questions.
Submit your questions by E-mailing them to [email protected]. Unfortunately, we cannot answer all questions individually.
While we will enlist professionals to try to answer your questions, Ask the Experts is meant only to create a dialogue on the topics. Consult legal or financial professionals before acting on any of the advice given by our expert panel.