The Fair Commission Model of Goodwill: A New Business Appraisal Approach

Mike Sack Elmaleh

Accounts Payable: Amounts owed by a firm for goods and services previously rendered.

Accounts Receivable: Amounts owed to a firm for goods and service previously rendered.

Accrual Basis of Accounting: A system of recording and reporting transactions in the accounting statements of a firm where revenue is recorded when earned and expenses recorded when incurred irrespective of the timing of cash payments.

Amortization: A method of recording and allocating as an expense the value of an intangible asset such as goodwill usually over a period of fifteen years.

Anchoring: A cognitive bias in which a person assesses the value of a measurement based on an arbitrary number.

Asset Method: An appraisal method in which the equity value of a firm is deemed to be the sum of the values of the assets, both tangible and intangible, owned less the value of the liabilities.

Attrition Rate: The rate at which customers,clients or patients (CCPs) stop patronizing a firm.

Bias: When an appraiser applies appraisal methods and judgments in a manner to systematically push the equity value in one direction.

Bernoulli Probability Distribution: A discrete probability distribution used to model infrequently occurring events.

Beta: A measurement used in portfolio theory and many variants of the income method to quantify the risk of owning an equity. When applied to publicly traded securities, Beta measures the degree to which a security’s price moves with the market as a whole.

Business Brokers: Professionals who for a fee facilitate the sale of closely held firms.

Buyout Period: In equity transfer agreements the period of time the buyer makes payments to the seller.

Buy Sell Agreements: agreements that commit one partner or partners to acquire the equity of another partner in the event of disability, retirement or death.

C Corporations: Under the IRS code, a category of business where income is taxed once at the corporate level and again when income is distributed to shareholders.

Calibrated Estimates: A system of assessing the upper and lower bounds of a measure such that the actual value will fall within these bounds at least 90% of the time.

Capitalization Rate: A rate used to convert a series of future income or cash streams to a present value. In the application of the income method the rate is the risk adjusted discount rate less the assumed growth rate.

Cash Basis of Accounting: A system of recording and reporting transactions in the accounting statements of a firm where revenue is recorded only when cash is collected from customers or clients and expenses recorded only when cash is paid to vendors.

Closely Held Firms: Any firm whose equity shares are not listed or traded on a regulated public stock exchange.

Compete or Buy(COB): A comparative advantage measure applicable to buyers who are currently competitors with the subject company (SC). When the buyer operates with a capacity constraint the COB measures the difference of the expected future discretionary earnings (DE) from acquiring the SC and the DE from continuing to compete with the SC.

Computer Simulations: A computer based system of generating multiple forecasts based on the assignment of probability functions to key variables.

Confidence Intervals: A method of estimating the range of values for a measurement based on sample data.

Consolidators: Larger regional or national firms who purchase the equity of smaller local firms.

Continuation Agreements: Agreements between professionals to insure that the practice of one will be continued in the event of the disability or death of the other.

Continuous Variables: Measurements that can take on any real numbered value.

Customer, Client or Patient (CCP) base: the set of CCPs who regularly and repeatedly patronize an SC.

Depreciation: A method of recording and allocating as an expense the value of a tangible asset such as equipment or furniture over its useful life.

Descriptive Appraisal Theory: those appraisal methods that simply describe how the equity of closely held firms are exchanged. Market methods and rules of thumb are descriptive. Income methods are not.

Differential Compensation: A comparative advantage metric that forecasts the difference between the wages an employee buyer could make remaining an employee and the DE that could be realized if the buyer acquired the SC.

Discount for Lack of Control: A discount applied to the equity of an owner with less than 50% of the total equity. The discount is applied on the theory that such minority owners have less timely access to the economic benefits of the SC than do majority owners.

Discount for Lack of Marketability (DLOM): A discount applied to the appraised value of equity in a closely held firm to reflect the comparative illiquidity relative to publicly traded equity.

Discounted Future Cash Flows Method: An appraisal method in which a forecasted future cash flow is converted to a present value by applying a risk and growth adjusted discount rate.

Discount Rate: A rate used to convert a series of future cash flows or income streams into a lump sum present value. The rate may reflect expected inflation, opportunity cost and/or risk.

Discrete Variables: Measurements that can take on only integer values.

Discretionary Earnings (DE): A measure of the economic benefit available to the owner of an SC or buyer. DE reflects the cash available to the SC owner or buyer after all necessary and ordinary expenses have been paid to third parties. This measure differs from free cash flow in that DE includes an allowance for owner compensation.

Due Diligence: The investigative process buyers and SC owners engage in before an equity exchange.

Earn Out Sales: A form of deferred equity sales contract where the proceeds paid by the buyer are contingent on the future earnings of the SC.

Earnings Per Share: Net income divided by the number of common shares outstanding.

Elastic and Inelastic Demand: The degree to which customer demand is impacted by rising prices or lower disposable income.

Enterprise Goodwill: The intangible asset derived from the future DE from an SC’s transferable CCP base.

Excess Earnings Method: An appraisal method that values enterprise goodwill as the capitalized portion of net income that are considered in excess of “normal”. This is also called the treasury method.

Exit Planning: A formal plan of ownership succession often calling for senior employees to acquire the equity of retired owners.

Fair Market Value: The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms-length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.

Fixed Costs: Expenses that do not vary with the revenue. Also known as overhead expenses.

Forecasts: Predictions of future economic performance.

Free Cash Flow: A measure of economic performance based on the net cash flow available to the owners of a firm. Free cash flow does not include cash payments to the owner for their services to their firm.

Generally Accepted Accounting Principles (GAAP): The accounting rules utilized by publicly traded equity markets, regulatory authorities and major lending sources.

Gross Profit: The difference between gross revenue and the direct costs associated with providing services.

Gross Revenue: The revenue collected from services before direct or fixed expenses.

Guideline Public Company Method (GPC): A market method in which an appraiser utilizes the earnings per share of a publicly traded company or group of publicly traded companies to assign a value to an SC’s equity.

Hurdle Rates: A minimum rate of return deemed necessary to attract an investor to acquire a control position in the equity of a SC.

Hypothetical Buyers: An amorphous term utilized in current appraisal practice to encompass passive investors and exclude synergistic investors.

Income Methods: Appraisal methods that convert projected future earnings of an SC into a present value utilizing risk adjusted discount and capitalization rates.

Intangible Assets: Any non-tangible asset. The important examples are enterprise goodwill, trademarks, patents and copyrights.

Inter-Quartile Range: The difference between the 75th and 25th percentiles of sample values.

Investment Buyers: Non-synergistic buyers who will not play an active role in the operation or management of the SC.

LLCs, LLPs: Limited liability corporations and partnerships. These are forms of business organization that combine features of limited liability corporations with features of partnerships and proprietorships. For tax purposes these are usually treated as pass through entities.

Marginal Benefit: The just sufficient amount of additional compensation and/or profit necessary to induce an investor to accept the responsibility and risk of investing in an SC.

Market Methods: Appraisal methods that utilize either historical data from publicly or privately traded firms to appraise the value of a SC’s equity.

Maximum Competitive Advantage: A metric that forecasts the present value of the expected DE from the SC’s transferred customers or clients over the period of time they continue to patronize the SC. Expected attrition is accounted for in the computation.

Mean: A statistical measure of central tendency based on an arithmetic average.

Median: A statistical measure of central tendency based on the 50th percentile. 50% fall above and 50% fall below the median value.

Net Income: The difference between gross profit and all other expenses incurred by the SC.

Net Tangible Assets: The difference between tangible assets and liabilities of an SC.

Non-Compete Agreements: Agreements between employer and employees prohibiting the employees from leaving and serving clients or customers of the employer. Such agreements are also customarily included in equity exchanges between the seller and buyer of an SC.

Non-Controlling Interests: Any equity interest less than 50% of the total.

Normal Probability Distribution: A symmetrical bell shaped probability distribution that describes many natural distributions of characteristics.

Normalizations: Adjustments made by appraisers to the financial statements of SC’s to insure that only ordinary and necessary expenses are reflected in the computation of DE.

Normative Appraisal Theory: Any appraisal method or theory which develops criteria for what constitutes a fair and rational price for the equity of an SC. Both the income and the Fair Commission Model normative while rules of thumb and market methods are not.

Opportunity Cost: The amount of cash foregone by embarking on an investment option.

Ordinal Scales: Measures that indicate variations in degree or intensity but lacking in an objective or operationally defined unit.

Overhead: See fixed costs.

P Values: Statistical measures of the degree to which variables are related to one another.

Pass Through Entities: Any form of business where income is taxed only at the level of the individual owners.

Pepperdine Private Cost of Capital Surveys: Surveys of private lenders, venture capitalists and others active in lending and investing in closely held firms designed to ascertain required levels of return.

Personal goodwill: The value of a customer base that includes repeat customers who would be unwilling to transfer to a new owner.

Present Values: The conversion of expected future cash flows to a lump sum value utilizing discount rates.

Price Earnings Ratio: The price of a common share of publicly traded stock divided by its earnings per share.

Probability Distribution Functions: Functions that describe the expected frequency of events or characteristics of a population.

Reference Prices: Previous prices consumers use to gauge the fairness of current prices.

Reference Points: Levels of DE or salary that buyers utilize in deciding how much to bid on the equity of an SC.

Referral Sources: Satisfied CCPs of an SC who recommend the firm to potential new customers or clients. Other sources can include other professionals such as lawyers, bankers or insurance brokers.

Replacement Costs: The current cost of constructing or replacing an asset. The metric is often used as an upper bound value in appraisals.

Responsibility Premium: The level of DE a buyer requires in exchange for assuming the responsibilities of servicing an SC’s customer base.

Restricted Stock Studies: Surveys of publicly traded shares subject to special liquidation restrictions. These studies are often invoked to justify the use of discounts for lack of marketability.

Revenue: Gross proceeds before expenses.

Risk: Any event that can cause a sudden and significant decline in gross revenue and DE.

Risk Premiums: Adjustments to discount rates to reflect the levels of risk associated with investing in an SC.

Rules of Thumb: A simple formula used to convert an SC’s revenue to a value of its equity.

S Corporation: A corporation whose earnings are taxed directly to the equity owners.

SC = Subject Company: The closely held firm whose equity is being appraised.

SDE = Sellers Discretionary Earnings: A measure of the economic benefits of owning an SC. It is the difference between gross revenue and all necessary and reasonable expenses, both fixed and variable, that must be paid to non-owners.

Satisficing: The tendency of survey respondents to rush through questions without providing thoughtful responses.

Subject Matter Experts: Individuals with the expertise and experience necessary to provide reliable estimates of key measures.

Succession Plan: An agreement usually between senior employees and current equity owner’s to transfer control equity on the retirement, disability or death of the equity owner.

Sunk Costs: Investments in assets such as specialized expertise that cannot be recovered except by use in the operation of a service firm.

Survival Curves: Functions that describe the decline of a population of interest over time.

Sustainable Capacity: An efficient level of operation crafted to the expected size of a firms long term customer base.

Synergistic Buyers: Buyers who will utilize their skill and expertise in the full time management of an SC.

Tangible Assets: Cash, accounts receivable, inventory and fixed assets.

Terminal Value: The present value of all future cash flow streams derived by taking an estimate of the typical earnings and dividing by a risk adjusted capitalization rate.

Transactional Data Bases: Databases reflecting sales of closely held firms developed from data provided by business brokers.

Transactional Data Base Methods: An appraisal approach that relies on data from sales of closely held firms reported by business brokers.

Triangular Probability Distribution: A probability distribution utilized in simulations where certainty about the range of values is better understood than the full shape of the curve.

Variable Costs: Costs that vary directly with the amount of revenue.

Variance: A statistical measure that describes the dispersion of sample data.

Variation: Ordinary and non-extreme fluctuations of key measures.

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