On-Demand: Alternative Investments Year-End Audit Planning Webinar Series | Part I - Private Equity Valuation Considerations

Craig Ter Boss:Right. Thanks, Tony. I'm going to put up a couple slides, three or four slides, covering recent market trends. I think unfortunately the first couple slides might give people some agita. It reminds them of their 401k measuring from January of 2022 through September of 2022, both the Dow Jones Industrial Average, which is this slide, and the next slide, the S&P 500, has similar trends where the highs were in January and the actual low was September 30th. Now to be fair, prior to that, if we just take a step back and we look at from the beginning of '13, for the Dow Jones Industrial Average, it increased from that point about $13,400 to roughly $24,800 at the beginning of '18, so it's about an 85% return, and then it increased to $36,600 roughly at the beginning of 2022, which from the beginning of '13 gives you a total return of 173%. As I said, unfortunately earlier that slid from that $36,600 in the beginning of 2022 to roughly $28,700 at 9/30/2022, or a decrease of 21-1/2% for that nine month period.

Fortunately, for the Dow Jones, in October of 2022, it had its best month since 1976 where it increased back to $32,700 roughly, which is a 14% gain for that month, and that cut that loss of 21-1/2 of the nine months to roughly 10-1/2 for the 10 months. The S&P 500 had a similar trend in the beginning of '13, it was at $1,462 and then it increased to roughly $2,696 at the beginning of 2018 for a return of 84% and then it increased to $4,797 at the beginning of 2022. So the total gain from the beginning of '13 to the beginning of 2022 was roughly 228%. Similar to the Dow Jones, from January of 2022 to September of '22, it decreased roughly 25%, a little bit worse than the Dow Jones for that same period. Unfortunately for the S&P, the recovery in October was not quite as good. It had increased only 8% for that month and that cut the 10 month change down to negative 19%, so not quite as good, but still better than what was happening through 9/30.

Again, this just kind of summarizes that that we just discussed, but the next slide paints a little bit different picture in the fact that although they are down through 9/30, roughly 21 and 25%, you can see that, for example, certain of these, it's by industry. So the worst performing, you had IT and textiles, roughly almost 59% and 50% loss for the year, and then you had oil and gas up 33%, so it's kind of industry-specific for that. Now we're going to just shift a little bit to what's causing some of this loss in the equity markets. If we look at the inflation trends, it has increased from an average of 1.2 for 2020, then it increased to 4.7 for 2021 and was roughly a little bit over 8, 8.2% in October of 2022, which is a little bit below the median of that year of 8.3. To combat that inflation, the Fed increased interest rates several times in 2022 from almost zero to 3.75 to 4%, and a lot of people don't think they're done yet, maybe not in 2022, but early 2023.

A lot of what you read from the Economist is that they don't think that these hikes are really addressing what they feel these inflationary culprits, which is corporate pricing, energy costs and supply chain distributions. The Fed's actions, which are designed to mitigate the high rate of inflation, is obviously having a significant impact on mortgage rates. Through 2022, they increase consistently. In fact, as of October 31, 2022, the 30-year fixed mortgage rate was a little bit above 7%, which is more than double what it began at at 2022. These current rates, I believe, are around a 15-year high. That's obviously one of the issues. I know that that has had an effect on the multiples as of 9/30 and to be seen as of year-end audits. I'm going to turn it over to Bill to discuss about the market participant pricing.

William Johnston:Thank you, Craig. One thing I just wanted to mention about what you went through and everything that I think is worth pointing out is the data from 2013. The markets have had a great run. It's been a very strong, good, long run of going up every year basically, and so this is the first time in a while where things have dropped significantly. So I think showing that data and showing those trends, it puts it into perspective that this year is different than past years have been in terms of how you need to think about your valuation work.

Craig Ter Boss:Right, and I think COVID obviously played a part in the decrease, parts of 2020 in a little bit, but I think it recovered fairly quickly. I think that, as you pointed out, and it's a good point, that we're in for something that I don't think a lot of people have seen in 14, 15 years, at least, a decent bull run.

William Johnston:Yeah, that was a good point in terms of COVID. People thought we might have to, but the recovery was so fast that it didn't become as much of an issue. But here I think you have a much greater likelihood of it'll be long-term enough, you're going to have to take it into consideration, so that ties in nicely to what we're talking about. So just when you're doing work for financial reporting purposes, there's a whole framework for fair value and how you're supposed to approach valuation, and we have the definition here of fair value. A key thing is to just keep in mind that the pricing is basically what market participants would agree to at the measurement date, and it's really an exit price, not an entry price. In many cases, the actual transaction, what you bought it at and everything, would be the most reliable thing to consider.

But as time goes on from that date, you want to be thinking about an exit value concept and thinking about what a market participant would assume when they're purchasing the business, and there's lots of examples of that. But the key really there is to make sure that what your assumptions are consistent with a market participant, and that's again what this slide is covering. There's lots of examples. An example could be something as simple as you don't think labor pricing is going to increase as much as other may... You think it's only going to increase 3%, all the other market participants think it's going to increase 10% over the next year or two, and so that's something where the pricing could vary. You just want to make sure you're in sync there.

Craig Ter Boss: Bill, sorry to interrupt. Just a question. When they talk about an exit price, basically, are they saying that the price that you entered in, an entry price, may not be fair value? Is that because it's specific to you, not to a marketplace participant?

William Johnston:Yeah. Yeah, so good question. That's the exact content because things are negotiated all the time and at certain prices and everything like that. But the whole fair value is that you don't want to take unique things into consideration in terms of what the value is going forward. For example, if there's unique synergies from the transaction or things like that, you already have that investment, have that position, and the value is really based on what you'll sell it to a market participant for, not what your own assumptions are. That's the kind of situation where you have to make sure you're in sync.

Craig Ter Boss:Got it.

William Johnston:Another thing to just talk about is, so I've been doing this for a while. I've been through a lot of ups and downs with the economy and the markets and everything, and there was a lot of guidance put out by the FASB 2008, 2009, and I think we want to focus on what the most key points are, so we don't want to spend a lot of time rereading the quotes and everything. But during the Great Recession, the markets were to some extent disorderly, and so you had a lot of feedback from people at that point in time saying, "You can't use market pricing to come up with fair value." The FASB did listen to those complaints or comments and pretty quickly put some guidance out specifically on this, so there is specific guidance in considering whether or not markets might be disorderly.

A key focus on that is the volume, the amount of volume and activity in the market, and there are specific factors that the FASB puts out to consider that, like, say, you had a really wide bid ask price or something like that. However, and I'd be curious to hear what you think about this, Craig also, I do not consider it... While things are more volatile now, I don't look at this the same as the Great Recession and I consider the markets to be fairly orderly right now.

Craig Ter Boss:Yeah, I think just a couple things, just to give a little bit of history, and Tony and I have worked together for quite some time. I think at that point the FASB, which used to be, what, FAS 157, now 820, had just kind of rolled out at that point for, I believe it was audits ending 12/31/08. So the spring '09 when people were auditing their '08 results, you could see the market drop in the fall of '08 through the spring of '09. Going back many years, but I think a lot of what really the issue is a lot of liquidity in a lot of different markets evaporated overnight. You had the collapse of obviously some banks which provided liquidity in certain securities. You had real estate, you had all types of... not just equity markets but all types of markets where the liquidity just disappeared overnight, and I think that was one of the real issues where it had to be addressed, and I believe the FASB put out that point.

But I think now it's a little bit different. We talked about this a little bit before this webinar that prior to this, and I'm not going to use the word correction, but prior to this adjustment through the nine months, multiples in both private and public companies had increased a considerable amount in the last several years. Maybe it's a correction, but I don't know if I would consider disorderly. That's my opinion. I know, Tony, any...

Anthony Minnefor:I would agree with that. I agree.

Craig Ter Boss:Okay, good.

Anthony Minnefor:On this one.

Craig Ter Boss:Sorry. So we just want to cover, talk about a little bit about the most common approaches in valuing private equity investments. One is the market approach, which has two methods, and the other is the income approach, which has other methods, but I would argue the most common is the discounted cash flow. Let's just start with the market approach. The method is called the guideline company method, comparable company method. Obviously what it's called is the methodology's the same. Basically you're utilizing market comps in their multiples such as enterprise value to EBITDA or enterprise value to revenue and you're comparing it to a private company, a subject company that someone has made an investment in, to kind of gauge what the value is at a certain point in time.

I think the most common that I see is enterprise value to EBITDA, and EBITDA is earnings before interest, tax, depreciation and amortization. Another one that we saw, especially with growth companies that were not EBITDA positive, was enterprise value to revenue or some form of revenue, whether it was annualized recurring, billings or revenue as some definition, wasn't necessarily GAAP revenue. Then just want to touch base on what we've seen recently with COVID, and now what we're probably going to see at the end of 2022 is a term we call sharpening the pencil, where clients or people in the private equity industry might start looking a little bit deeper at the companies they used in the past to see if they're really affected the same by the market as their subject company.

So again, EBITDA, which is earnings before interest, taxes, depreciation, amortization, it's a proxy for the profitability of cash flow of an operating business. The reason it's skews is because it excludes the impact of how a business is structured for tax purposes or how the company is financed. It makes these companies comparable with respect to the enterprise value, which is the value of both the equity and the debt holders to the debt holders. So your market cap is your equity and then obviously you have your debt valuation. Just want to cover some of the terms that we've seen over the last couple years. I think the most common, especially with mature companies in certain industries, is last 12 month EBITDA, referred to LTM EBITDA or sometimes trailing 12 months EBITDA.

This is just basically, again for certain companies that are more mature where the future growth is not expected to be wholly different than the past, they'll look at it, figure out what it is for the comps, whether it's three comps, five comps, eight comps, comparable companies, excuse me, and they'll apply it to that subject company. One of the things that we see a lot and we work with Tony and the audit teams is understanding sometimes when we have this adjusted EBITDA, which is your reported EBITDA, typically adjusted for non-recurring one-time or unusual items. It could be severance payments, it could be litigation expenses, it could be certain deal expenses. But I think the key point with this is when you use adjusted EBITDA for the subject company, you have to make sure that the comps are adjusted for the same similar adjustments or you're going to be matching the wrong multiple to the wrong EBITDA.

Another one that we have seen more in the last few years is Run-Rate EBITDA, and that's typically used for companies that have high growth rates. So quarter by quarter the growth is so high that the annual EBITDA for the 12 month doesn't really paint the picture of going forward. Sometimes you take that last quarter and you annualize it, you call it Run-Rate EBITDA, and the same concept is with adjusted, you have to look at the comps in the same way or you're going to be doing a mismatch. Pro-Forma or Next Twelve-Month EBITDA, another type of EBITDA that we've seen quite a bit. We've had a lot of private equity clients that they have a platform company, they're making a lot of acquisitions. I believe the rule under GAAP is you only recognize EBITDA and revenue or earnings and revenue from the point you acquire the company to year-end. Therefore reported EBITDA in those won't paint the true picture of what the go forward EBITDA is.

Lastly, we see this a lot with certain clients that have debt agreements where the EBITDA is defined by definition, and just to paint a little picture, and Tony, correct me if I'm wrong in this, EBITDA is a non-GAAP term?

Anthony Minnefor:It is a non-GAAP term.

Craig Ter Boss:Enterprise value's a non-GAAP term, yet they're all over. Every AICPA, public companies report EBITDA in their non-GAAP financial disclosures. Bill, I just want your opinion on this because I have my own, but typically we see operating income adjusted for depreciation, amortization, add backs, and then any non-cash. But I've come across where we've seen it built from the bottom from net income, including other income and expenses and going that way. Any thoughts on that of what you prefer, what you see, or what do you think is more appropriate?

William Johnston:Yeah, well my answer to that is an answer I would give to a lot of adjustments we make, which is that you can probably do it either way and get to the same answer. It's usually a little bit cleaner from a practical standpoint to work off of operating income. But if you do it right and build up from the bottom, then you should be able to do that and get to the right answer still. One thing I just also wanted to.... going through all your... I say EBITDA versus EBITDA. Everyone has a little bit different pronunciation for it, but the one thing somebody may be asking is, "Why are there so many EBITDAs on here?" I don't know about your thought, but my thought on that is because each valuation has its own unique circumstances, each of these companies is going to be different, and you can't apply a one size fits all approach. Especially in these times, you can't just always look at what the trailing 12-month EBITDA is.

It's going to vary by company and by industry, but you're really trying to drill down to what is the true kind of core EBITDA of the business and some of these measures will reflect that and some won't. The reason why you have so many of these is because in these more uncertain times on a going forward basis, you need to consider them in terms of your subject company.

Craig Ter Boss:Yeah. Yeah, Tony and I, we work a lot, my group worked a lot with Tony and his team, any audit team in understanding, for example, adjusted EBITDA, what adjustments are being made, how significant are they through the base EBITDA that you started with? And whether you use S&P Cap IQ or Thomson Wood or some service that gives you those multiples for the comps, did they make the same adjustments? The one that we use, you can click through and you can see the base EBITDA, you can see any adjustments they made by reading the MD&A or something similar to that. I call it an EBITDA bridge, I don't know if that's, again, it's a non-GAAP term, but it kind of gets us from reviewing a client, how they get from the reported EBITDA to the adjusted EBITDA.

The Run-Rate EBITDA, I would say for certain private equity clients that we had in certain growth areas, technology in particular, it made sense if you looked at the growth that the LTM EBITDA really did not tell how good the company was doing in the last couple quarters. The tricky part was getting the comparable companies, making sure they had the same growth rate as the subject company and making sure that the multiple is the appropriate multiple. If you think about it, if you're using Run-Rate EBITDA in a high growth company, which you're comparing it to multiples that do not have the same high growth rate, you're in essence using a multiple that you're overvaluing that investment.

William Johnston:That's a good point. One other example I thought of while you were talking about that too is we do the same thing that you mentioned, but we also have to be careful. Certain industries, the revenue can be seasonal, so that's a case where you want to make sure you're not applying the run rate over a short period of time where either sales are lower or higher than other quarters and everything too. So one other thing to think about if you're doing that is looking at seasonality also.

Craig Ter Boss:Yeah, that's a good point. Yeah, yeah.

William Johnston:I tend to see the run radio even in subscription-based businesses as a-

Craig Ter Boss:Yeah, right, right, that's true. In the Pro-Forma EBITDA, we did see a lot of that in the last couple years because there were so many acquisitions that were being made, that to look at it clean, you kind of had to look at it, not just going forward, but even historically a lot of clients would roll back to show that growth as what's organic and what's through acquisitions. That's extremely helpful, not just on a go forward basis, but just looking at it historically to make sure that it makes sense, whatever they're using for the next 12 month.

So as mentioned earlier, there was a period where a lot of the growth equity, private equity, especially in the technology sector, where there was a lot of emphasis on growing and not as much on profitability, so we did see revenue multiples there because of the negative earnings. Obviously you can't do an EBITDA multiple, but I get a little hesitant with the revenue multiples when they're in industries where it's slow and steady growth and basically what we see is that the profitability issue for the subject company is not as great as the comparable companies, so that's one knock against the revenue multiples that ignores the difference of profitability. Bill and I were talking about this earlier, usually that's not how deals are evaluated, it's usually multiples of EBITDA or projected EBITDA, and again it's really difficult to compare by industry and it's also difficult based on the growth stage of the company, more mature versus in high growth.

One thing I did over the years find interesting in the high growth is that a lot of clients would peel back the different types of revenue, non-recurring versus recurring, subscription-based versus non-subscription-based and apply different multiples to those revenue streams. But a lot of times we would just get that one multiple and apply it to the market comp. So it's a little bit difficult because you had to obviously make sure the comparables had the same type of revenue. I think that again when we talk about the sharpening the pencil, in the next slide, I think you'll start seeing that. But just any comments on the enterprise valued revenue?

William Johnston:Well, yeah, just to add to what you were saying, Craig, is I've had situations where... Like Craig said, we're talking more companies that are already profitable and established. If you've got some kind of tech company, earlier stage company, then it is common to look at a revenue multiple. But when you're looking at these more traditional companies, I've had situations where all the comps had double the profit and the whoever in question would think that you could use the same revenue. But if your profit is half all the comparables, you can't just use their revenue multiple because you can just go ahead and look and there is a correlation between profitability and value. A pretty common thing I see is that you have to look at what the actual profitability is and then that's why if you have measures of profitability, it's really just better to use those in those kinds of cases.

Craig Ter Boss:Right. Right. Sharpening the pencil is actually a term a client said to me several years ago and it kind of stuck in my mind. And as discussed a little bit earlier that as things decrease as we saw, at least for the first nine months, we don't know where the year-end's obviously going to be yet. But what happens is these multiples, you can see sometimes in certain sectors and industries you see high margin multiples are very different than low margin multiples and size, the difference, the larger companies might have a different multiple than the mid-cap companies and obviously the type of revenue. I think that in the past several years, the difference between those type of multiples wasn't that great. But if you peel back a certain... just happened to be looking at home building multiples versus construction and engineering multiples, for several years they were fairly close.

Then the last year the home buildings have decreased a considerable amount where the construction and engineering has kind of held its own. So in that case you might see a client that's in the construction and engineering and not as much home building, maybe put less weight on that, sharpen the pencils and see that. I think anytime you change your methodology or your comparable companies or the criteria, how you select those, it should be documented, should be part of your valuation policies and procedure. Then you should document it and make sure obviously your auditors are aware of it, but also just that you have in your records or your minutes or whatever your valuation committee meeting.

William Johnston:If I could just chime in on that quick, I think this sharpening the pencil when you have... We're talking about hard to value securities here and they're even harder to value right now, given what's going on in the market. I think that my experience is this. What Craig just covered is one of the most important things. If you're in a traditional market that's going up every year, you already have an anchor in terms of what you're originally paid for it. It's not as necessary to drill down and look at each comparable more closely and everything. But in this case, you really get a lot by singling out which comparables are more similar.

One just little example I wanted to give, sometimes we have situations where we go beyond looking at financial metrics, we look at specifics. One is a company that's in the leisure and entertainment business and the conditions required us to look at it more in depth. One of the things we noticed was who their customers were, so some of these had customers that most of them were local or regional and then some of them, a lot of their customer base, their visitors, were national and international. So you can have different sort of trends going on there and you can see what the pricing's different. But our experience has been that looking at how the companies that are most similar have been performing recently within your comp set is one of the more important things you should be doing.

Craig Ter Boss:Yeah, that's a good point. When you're talking about that, I was thinking of you have a client that has an investment in the apparel industry and that obviously you have luxury apparel, you have basic apparel, various different... within each sector and each industry. Sometimes people hit these, use services and they have quick comps and that. One thing I've found helpful was looking at analysts' reports on certain of those companies and seeing what the analyst thinks are the... I'm going to say true comps, but more comparable. It's interesting because they definitely dissect why they think it is and add a little bit and maybe take that sector, that industry and bifurcate it into two or three different stratas. I find it helpful, and as opposed to sometimes what we see with these fairness opinions where it lists 40 transactions and 1,520 comps to say it's fair, I find the analyst report's a little bit more helpful.

William Johnston:Yeah. Couple other quick examples are sometimes we'll look at our comps. One, some have much greater online sales versus retail sales. Some you look and some of them more of a manufacturer versus a distributor. Those are just more examples of things, specifics about the companies that may help you identify which ones are best.

Craig Ter Boss:Right.

Anthony Minnefor:Right.

Craig Ter Boss:Another market approach, sometimes called precedent transaction approach, M&A transaction approach, is using multiples from M&A transactions and applying it to the subject company. I think here, this time, at the last nine months, 10 months kind of, I want to say it changes the way that we look at it personally, the way I personally look, and then Tony and I have talked about this. When you have an environment that's so different than when transactions were happening two years earlier, nine months earlier, 10 months earlier, and not only that, just the comparables in that, one of the biggest things that Bill and I were talking about that we see is this historical data versus forward-looking estimate.

Getting data on these transactions is fairly difficult and typically the way I see it is it's typically against historical data, the multiples that have come out from that, and you don't really know what the forward-looking... Every once in a while you get lucky and they tell you what they think the next year's going to be, so you kind of do have a forward-looking estimate, but I would say 90% of them do not. Is that your experience, Bill? Or is that-

William Johnston:Yeah, that's my... probably at least 90%. Another way of saying what you're saying, you and I have talked about this a number of times, is in most cases you have no idea what the buyer's expectations are, so it's already challenging to use this approach because usually the buyer thinks, "Okay, well, I might be able to eliminate these costs going forward. I might be able to increase revenue." There's lots of different ways they might want to do that and you don't know what they're thinking usually, and that has a significant impact. Sometimes information is limited and to look at the historical. Then now in this market where it's volatile and it's going to be based more on expectation of future performance, it just makes that issue even more of a thing to consider because of how the approach is.

Craig Ter Boss:Right. I think just want to ask you a question and get your thoughts on this. When we talk about this market participant, one of the things, at least with the private equity investments, when you look at certain transactions, you see who the seller is and you see who the buyer is. So couple things. One is you have strategic buyers and you have financial buyers, which sometimes have very different viewpoints on a subject company as considering synergies, considering certain expenses or costs that I may already have as a strategic buyer that a financial buyer doesn't have, that they can't eliminate. I think that it's kind of that, "Who is the market participant?" Is that a fair point?

William Johnston:Sure. Now, that's a great question. Then also you have platform acquisitions and you have add-ons and those can be looked at a little bit differently, and you have strategic versus financial buyers. That is definitely something that needs a fair amount of consideration, everything. There is to some extent guidance in the fair value framework about that and how to consider that. But from a... Give a little bit more practical viewpoint based on the guidance and the work that we've done is, that it's usually best to be anchored as a starting point based on the most recent transaction, the most recent acquisition, and was that entity a strategic buyer or a financial buyer?

Then the presumption is, starting out, that that's what you would want to consider going forward. However, that doesn't mean that's what you should assume, but you have market evidence of who the buyer was. Sometimes, for various reasons, sometimes it's tax reasons. We have to think about this more in terms of how we would do the modeling. Something else you can do, if you aren't totally comfortable about your assumption there, is you can run a search for transactions in the industry and see who the most common buyer was if you're struggling with that issue. But we're usually anchored in the who the buyer was most recently and then that's the presumption, but then go through our points to make sure that that makes sense.

Craig Ter Boss:Right. I think, Tony, just let me know if you agree with this statement though, but I would say that the last several years, the use of earnouts has increased a considerable amount, and so I guess that plays kind of in the picture of what service are you using to come up with these multiples of the comps and the M&A transactions? Does it assume the earnout from day one?

Anthony Minnefor:Service may not get into that level of granularity.

Craig Ter Boss:Right, or they might just automatically assume that it's going to be there. I think some of them do that, and I don't know if anyone's ever gone back to look to see how many earnouts have really been earned. I don't even if you can do that.

William Johnston:That's a great question, and we didn't plan this ahead of time, I swear, but I was actually a subject matter expert in a working group that put out all the guidance for contingent consideration earnouts, and also we do a lot of earnout valuations. The only thing I wanted to add to what you were saying is from taking a very deep technical dive into those, what we've discovered is that overall they're usually worth less than management often thinks they're worth from having done the modeling. Not always, but more often than not, and so that is something. Then also as time goes on, the earnout value can go lower or higher. Then like Craig's mentioned a few times, whatever you're looking at, you want to make sure you're comparing apples to apples in terms of what you're including, what you're not including.

Craig Ter Boss:Right. Yeah. I think for the M&A transactions, if you just look at the technology industry, for example, the slide that we showed several slides ago, market caps are down 59%, I believe the number was, roughly. So now how do you use the M&A approach from transactions in early 2022 to 2021 where there're clearly going to be 40, 50% higher multiples, the M&A, than the guideline company, so that's-

William Johnston:Yeah, that's a great point. Actually, as you know, when you actually do the analysis, there aren't countless acquisitions in, say, a six month period of time to bring in. Because you can't go back too far with those, you're forced in most cases to have a very small number of transactions, so that just weakens that method even further.

Craig Ter Boss:Just to recap, just on the market approach, just some questions that we kind of threw out there and just want to discuss a little bit is, again, as we just had, should the weighting of the methodology of the market approach be less than in prior periods? We'll talk about the Discounted Cash Flow income approach next, but taking right there that maybe the M&A approach isn't as relevant compared to the guideline company approach in certain industries or certain multiples. One of the things that Tony and I have stressed with clients over the years is other than with the comparable companies, provide factors, "When you made this investment, what comps did you look at? Why did you look at those comps, the stage of development, the size, growth? Are those still appropriate five years later, three years later?" And understanding those and how they're considered today in this environment.

William Johnston:If I could add one other thing. We're sort of finishing up the market approach part. One other thing that I often say with clients, et cetera, is, "When the market is down, you have to acknowledge that the market's down." But one thing also, when we're looking at a control level valuation, if you're looking at public comparables, you can consider applying control premiums to the value and an argument can be made, it has to be thoughtful and supportable. But an argument can be made that if the market is down and the owner or the most recent buyer wouldn't sell at that pricing, then maybe some kind of at least partial compensation or accounting for that needs to be taken into consideration. One way you could consider that is your control premium or how you're accounting for control using a market approach, so that's one consideration in these times that you could think about.

Craig Ter Boss:Right, right. Good point. Yeah. When the AICPA came out with their private equity and venture capital guide, one of the terms that was in there quite a bit that we had been hearing for quite a few years prior to that was calibration. I think I mentioned it to Tony when it first came out and we had already been doing that with a lot of audit clients and just basically linking the original investment thesis to each, whether we look at it on an annual basis, every six months. We have some clients we look at 6/30, 9/30 and 12/31, valuations and we just calibrate from that original investment thesis to the prior periods. One thing, if you're using industry-specific data, whether it's one rate 4-Wall EBITDA, how does it tie back to those prior periods and can that information be determined from the comparable companies?

Bill and I, you and I talked about this a little bit, about this 4-Wall EBITDA and that's something after 2008, 2009, we noticed a lot of. We had a client that had grocery stores and they were looking at it from a financial buyer's viewpoint and a strategic buyer's viewpoint. For the strategic buyer, another grocery store chain that would buy them, they already have all the corporate overhead, they already have that, so they looked at the EBITDA within the store. So if they were going to sell 100 stores in a certain geographic area to a strategic buyer, this is the price that they felt they would get, which is different, which was a different price that they would get from a strategic buyer who doesn't have all that over overhead, et cetera. Have you run into that? I mean, I ran into it a lot in but recently I have, yes.

William Johnston:What's good about that example is you touch on two, not one, good points about doing something like that. Number one, I do believe that if people in the space, whether they're financial or strategic, look at certain industry-based measures and that's a common way of looking at valuation or measuring performance, that's important that you include that and consider that. Because those are basically market participants and also there's has to be a reason why they're doing it. It probably adds a lot of value in everything, so I think that that is a very important thing. Another point that you brought up about that, that is very important, is what would a market participant assume? If there are duplicative costs that don't need to be... I would say that's the most common set of adjustments that we look at is what kind of expense savings would you get and things that are overhead that are duplicative might not be applicable. I think that was a good measure you picked because it highlights a couple of things.

Craig Ter Boss:Yeah, I think in that situation what we did is we went back and we said, "Okay, well was that part of your original investment thesis?" And it was. It was that potentially they were going to take that supermarket chain and break it up and sell it into various pieces to other, not one strategic, but a few strategic buyers. So that did tie in and that's who they felt the market participant was in that situation.

William Johnston:If I could take it one step further, what we would do push on and will accept either way, depending on what the fact pattern is, is what we push harder on is if the client says that none of the costs will carry over, we sometimes do accept that, but we ask questions like, "Well, if none of the costs carry over, how are you able to incorporate this in on a going forward basis without any additional cost? Were you running at excess capacity or something? What allows you... " So we do accept that fact pattern, but we push harder if it's all of the costs versus some of the costs.

Craig Ter Boss:Right. Just the last point on this is, on the mark approach again, if you're going to, whether it's change the criteria for selecting the comps or change the waiting between the various approaches, I think clearly it should just be documented and the rationale as to why. Okay, Bill, if you don't mind, can you take the lead on the income approach and-

William Johnston:Sure. Two things. One is going to cover what's on this slide, but I did want to make one separate point about the income approach, and by income approach, like Craig said, there's different forms of that, but the one we think about most of the time with that is the DCF, Discounted Cash Flow, approach. There are cases where we have clients that don't use this approach or aren't as big a fan of using this approach. It could be they think market multiples are the best way to do it. It could be a cost benefit consideration if you think you can get to a supportable answer with the market approach and everything. But I do want to be a champion here of doing a DCF, especially in this kind of market because when you're selecting multiples using a market approach, while you can account for all these factors by looking at things, what's different about the DCF is you can incorporate all of these things specifically into your model that you're dealing with and see what the actual impact is.

If you have higher inventory levels, if you have higher wages, but you think after a year or two they're going to taper back down, if you have higher price increases and you think it's going to... If you have a period of time where you think you need to recover to get back to the normal level, those can all be reflected in that. I would want to give a shout out to using this approach because especially if you're in a situation where you think it's more challenging to do a valuation and you don't feel as good about your market approach and the multiples and what you've done there, I would recommend doing a DCF because first of all it's a second method so it corroborates and supports where you're coming out. But it also can reflect these factors.,And I don't know, Craig, if you wanted to add anything to that.

Craig Ter Boss:Yeah, I believe again the FASB says you should consider all methods and there's a cost benefit analysis. I would say my experience is that most clients in the private equity for the more mature industries and clients use the Discounted Cash Flow, whether as an independent from the market approach or a sanity check for the market approach. I would say the high growth, we tend not to see it as much. Tony, you agree with that or-

Anthony Minnefor:They're projecting losses in those cases.

Craig Ter Boss:Yeah, projecting loss in many cases or-

Anthony Minnefor:At least for security.

Craig Ter Boss:The fund thinks that the management's projections are too aggressive and they're not sure. But I have seen it used more since the AICPA guide came out a few years ago and so I have seen a pickup in it, whether it's a sanity check or an independent, but there are definitely a lot of clients in certain industries where, or situations where, it is the appropriate method and they do utilize it.

William Johnston:Yep. I think if you're in a situation, so there's obviously a lot of considerations, technical and practical, what approaches you use and everything. But I would just go back then. If you're in a situation where you're not doing a DCF or your DCF is simpler and you find it more challenging to come up with the right position, that's where considering doing something more in-depth and using that approach will be helpful. Going to the bullet points here, the key point of this slide is you're doing an income approach, you're doing a DCF, you want to make sure that your approaches are consistent. So if you're making a certain assumption about using a lower or higher multiple based on, like, say you think your company's going to outperform the comparables from a growth standpoint, well, you would expect then that to be reflected in your DCF or profitability or other issues.

When you're doing a DCF or you're doing a market approach, one interesting thing, and I do it regularly, and we will show exhibits for this, is you compare your company to all the comparables and you show history every year of profitability of growth, things like that. Then in lots of cases these comparables will forecast out going forward, so you can look at the whole... Say you had a comparable that was growing 30% a year and then they projected to grow 15% in the future and your company was only growing 5% over that period and you project the same growth, that will shed some light into what you're doing, so there's a lot of different ways.

Also what you can do if you're doing a DCF is you can look at your... Some people... That's basically the value of the business after the forecast, let's say it's a five year projection period after the five years, you want to at least do a sanity check. We use a commonly used formula, the Gordon growth method, to calculate a horizon value, but however you calculate that horizon or terminal value, you want to make sure it's reasonable compared to what you're assuming for your multiples in the market.

Craig Ter Boss:The terminal value typically makes up 75% or more of the total value, so if someone just slaps on 10 times EBITDA without considering the things that you mentioned, it could obviously skew the answer. I think the biggest thing that we talk to with clients is the overall risk, "Is it reflected in the projections? Is it reflected in the discount rate? Is it reflected in both?" But I think reconciling the terminal value to the actual market of what's going on at that point in time is very critical in that approach.

Anthony Minnefor:How about we recap things and then hopefully take a question from the audience?

Craig Ter Boss:Sure, sure. Just some key takeaways. I think mentioned before the concept of calibration, which you're linking the current value to any prior analysis and initial investment thesis and what has changed, not just showing numeric differences, just qualitative factors as to what's changed over that, which is also obviously in the second point. One of the things is be careful not to provide subsequent events that only support your position and kind of minimize events that do not. I'm sure, Bill, you've run into this, "Well, it's after the valuation date. We'll consider next time," when it doesn't support it. And then other times when it's does support it, they'll say, "Well, a month later, like October of '22, the market's back up." So that's that.

The biggest thing that I would say is when you reconcile, whether you're using the market approach, guideline company market approach, precedent transaction and the DCF, when you weight it and you reconcile it, forget about the weighting, just are there any outliers in there and did you address it? So you don't want the range to be so vast between the three approaches without some type of acknowledgement. Then the biggest thing is with your valuation policy and procedure, are they transparent? Is there consistently in the application of these policies and procedures and did you document any divergence from them, as we mentioned several times?

William Johnston: If I could just make one other point.

Craig Ter Boss:Sure.

William Johnston:Being neck-deep in this all day every day, a couple of takeaways I would just give is number one, maybe most importantly, you can't use the same mindset this year that you did in previous years. This is a different world, a different market. You have to think about things differently, it's not as straightforward. To just second point, put that a different way, the times are more complicated, the hard to value securities are even harder to value, these level three assets, and so you don't want to oversimplify your valuation approaches in a time where it's most important to take into consideration the complexity of what you're dealing with right now. Those are additional takeaways I have.

Anthony Minnefor:I would just add, just listening to the two of you discuss the market approach, this is a year for really doing a refresh on your comp set and really scrutinizing them and removing the outliers and just taking a refreshed look at, I think, would be very important and useful.

Craig Ter Boss:Yeah, and I don't think that warrants a change in methodology, in my opinion.

Anthony Minnefor:No. It's easy to carry forward-

Craig Ter Boss: It's just a refresher.

Anthony Minnefor:the comp set from one year to the next and companies change, industries change. Let's take at least one quick question here. We have a few from the audience, so I'll start with, "How should we evaluate a company that's performing well in 2022 with modest growth but has comps that are down to 20 to 30%? It seems counterintuitive to mark down an investment, though that's what the math is showing." Which one of you would like to take that one?

Craig Ter Boss:I'll start and Bill, you can edit. That's fine. I would argue one of the reasons we always talk about those qualitative factors is for this reason, and tying it, calibrating it back to the original investment thesis. If you had a plan for your original investment thesis and you're carrying on that plan and again peeling back those comps, what's affecting them, it should not or does not affect you, then I wouldn't mathematically just say, They're down 20, 30%, I must be down 20, 30%." That's why we talked about the Discounted Cash Flow might be more weighting towards that because that would, my opinion, flesh out those differences. I think it's kind of combination of what we've said, looking at the Discounted Cash Flow a little bit more appropriately, weighting it differently and then maybe looking at taking a harder look at your comps to see if they're really, truly what's affecting them, is, or should affect them.

William Johnston:Yeah, yeah, so I agree and to put that a different way, I think for myself, the whole key takeaway from all of this isn't what is the value going to be. That's going to vary from case to case and the facts and circumstances and the story. The key takeaway is to not oversimplify it. If in the most recent periods you've kept it the same without doing additional looking at things, like Craig gave a good example of, you wouldn't want to do that before going through that process. On the flip side, it would be a mistake for a valuation firm or anybody to go in saying, "Oh gee, well, the comps are down 20 or 30% and that means we're down 20 or 30%." The key here is you have to dig into things a little more deeply to support what your position is.

Anthony Minnefor:Craig, Bill, great comments. We're a little bit over the hour now, so I just want to thank you both for a very thoughtful discussion, and to the audience, thank you for joining us today and we look forward to you joining us on November 30th for our discussion on venture capital valuation considerations. Thank you.

Craig Ter Boss:Yep. Thank you.

William Johnston:Thank you.

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