Acquisition Advisors | Case Study: Valuing a New Venture and Minority Interest
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12 May Case Study: Valuing a New Venture and Minority Interest

The majority owner of a business was presented with a new business opportunity that was not exactly related to that of his core business. He had lots of questions and asked for our help. This case study will walk you through the simple analysis that we facilitated.

The Case: Tim Frame owns 80 percent of Frame Services, Inc., a business that provides medical billing for doctors’ offices. Scott Hope owns 20 percent. Through a personal relationship, Tim has been presented with an opportunity to provide pension administration and actuarial services for a large insurance company. The proposed contract is for four years and will pay $350,000 per year. There are also circumstances that make it extremely unlikely that the contract will extend beyond the four-year term.

Tim wants to set this contract up separate from Frame Service, Inc. and he wants to own 100 percent of it. So, Tim turns to us for assistance.

Question 1: Does Scott have a right to 20 percent of the new venture or not? What are the issues here? In other words, does Scott need to be bought out at all?

Answer: This may be more of what we call a soft issue, meaning it has more to do with the relationship between Tim and Scott than a legal issue. What is the understanding between Tim and Scott?

We must also “drill down” into how this opportunity really arose. Meaning, from where did this “personal” relationship come. Did it develop through the business of Frame Services? Sure, the new opportunity is a service not performed by Frame Services, but carving it out into a new entity or venture and excluding Scott from ownership might not sit well with Scott. It could create problems between Tim and Scott. It could even lead to a lawsuit.

Following lengthy discussions, we agreed that Scott should be considered a 20 percent owner in the to-be-established venture.

Question 2: What is the net cash that will be received from the project?

Answer: The agreement will pay $1,400,000 in four equal payments to be received at the end of each of the first four years. Tim explains that this is the net cash he estimates from the project. In other words, he estimated the annual cost of the project and subtracted them from estimated annual revenue to arrive at $350,000 in net cash per year.

Tim did not estimate income taxes, however, so in talking to Tim and his accountant we estimate the annual taxable income to also be $350,000. We established a tax rate of 30 percent (state and federal), yielding after-tax cash of $245,000 per year [$350,000 x (1 – tax rate)].

Question 3: What is the value of the new opportunity? Tim should get a handle on this before he accepts the project regardless of the situation with Scott.

Answer: The value of the opportunity is based on the net cash that will be derived from it. However, a dollar held today is more valuable than a dollar received in the future. Why? First of all, a dollar held today can be invested to earn more money. Secondly, there is a risk that the dollar will never be received. After all, what if the person who is supposed to pay the dollar fails to do so?

So, to compare apples to apples, we value all things in terms of present value (i.e. dollars today). Doing so allows us to directly compare the value of, say, $100 today, $200 paid over the next three years and $1,000 over the next 15 years.

Tim’s opportunity promises annual after-tax cash of $245,000 over four years, but there is no guarantee. For starters, the proposed agreement states that Tim’s customer will be obligated to pay only “as long as the services are provided in a satisfactory manner.” Sounds like something that could be open to interpretation and potentially provide the customer with an “out.”

Aside from this, the company is large but it will not provide information about its financial condition. We pulled a Dun and Bradstreet (D&B) report on the company and found no cause for concern, but D&B is not always up to date and even the most seemingly stable business can run into problems, e.g. Enron and  WorldCom.

In summary, to compensate for the time value of money and risk (combined), we chose a discount rate of 20 percent. As such, we “discount” at 20 percent per year the payments expected to be received in the future.  Here is the calculation:

000’s Q0 Q1 Q2 Q3 Q4 Qs 5 thru 16 Total
Revenue $0.00 $87.50 $87.50 $87.50 $87.50 $87.50 $1,400
Expense ($7.50) ($9.00) ($9.00) ($9.00) ($9.00) ($9.00) ($144)
Op. Profit ($7.50) $78.50 $78.50 $78.50 $78.50 $78.50 $1,256
Tax ($3.00) $31.40 $31.40 $31.40 $31.40 $31.40 $502
Net Profit ($4.50) $47.10 $47.10 $47.10 $47.10 $47.10 $754
NPV $481.90

Note: Discount factor rates are found in the backs of most finance textbooks, on the Internet, and are included in A Concise Overview of Business Valuation (see www.TheBusinessOwner.com)

In summary, we estimate the project to be worth $634,060.

Question 4: If Scott has a right to 20 percent of the new venture and Tim wants to buy him out, what would be a fair price?

Answer: Now that we have estimated the value of the entire project, we’re within reach of placing a fair value on Scott’s 20 percent interest. Clearly, we could simply multiply $634,060 times 20 percent to obtain $126,812. One could argue compellingly that this is the value of Scott’s share. However, one could also argue that Scott is in a weak position to bargain because his ownership interest is too small to really influence the business or dictate when and if profits are distributed. Also, Tim is really the only buyer for Scott’s shares. Legally, Tim could choose to not distribute profit to shareholders, not to employ Scott, and not to buy Scott’s interest. For reasons such as this, minority interests trade at a discount.

Value of 20% Ownership Position
Value of 100% $634,060
Times 20% Minority Ownership .20
$126,812
Less Minority Discount @35% 0.65
Net Value of 20% $82,428

In conclusion, we suggest that Tim use $126,812 as the maximum he would be willing to pay for Scott’s 20 percent of the new venture. A 35 percent minority discount would also be fair, placing the value at $82,428.

This article was written by the experts at Acquisition Advisors, all rights reserved. Acquisition Advisors is the M&A firm of choice for buyers and sellers of mid-size U.S. companies. They can be reached at 918-748-7995 or visit www.AcquisitionAdvisors.com for more information.

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