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2018 Perspectives

Why Are Firms Valued Lower When Selling Internally Versus Externally?

I’ve spoken with countless, exasperated A/E firm owners over the years who’ve asked me why their firm’s internal valuation doesn’t reflect a number similar to what they believe they can reasonably expect from an external sale. Most, but not all of the time, they’re first generation owners who are not sure why they’re expected to sell shares internally at a discount to what they might receive on a pro rata basis if their company were to sell to an outside acquirer.

Understanding the various levels of value can go a long way in helping guide expectations for firm owners and potential owners alike, and in this perspective, I’ll provide a fundamental explanation of each level of value with the hope of demystifying some common misconceptions.

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A firm’s valuation will vary significantly based on the level of the interest being valued. The differences in levels reflect the risk of achieving two things: expected cash flows and expected growth.

Starting with the highest level of value – control – a controlling interest stake affords its ownership the right to exert control over key business decisions that it believes will allow it to improve earnings and increase growth prospects. As such, there is a premium associated with what an acquirer believes it will be able to generate in terms of future cash flows and top-line growth that is represented in a control premium paid to gain those future benefits. When AECOM acquired URS in 2014, it paid $56.31 per share, a number that represented a 19% premium over the trailing 30-day average closing URS share price. This premium was what AECOM paid to gain control of URS.

The level immediately below control is marketable minority, which is the most straightforward level of value. When you purchase shares of AECOM, you become a minority shareholder of AECOM; those shares are unrestricted, which means that you have the ability to monetize those shares quickly at a marginal cost in an open market with multiple buyers and sellers. What you don’t have as a minority interest owner, however, is the ability to make any business decisions on behalf of AECOM. This lack of influence over a Company’s decision-making process is reflected in the discount for lack of control (“DLOC”). We often see DLOCs in the range of ~10% to ~30% with our clients.

But the level of interest relevant for almost all privately-held companies, especially those that have an internal market for shares – the non-marketable minority interest – dictates that yet one more discount be considered. Unlike your shares in AECOM, owners of non-marketable minority interests aren’t able to quickly convert their shares to cash without risking a significant loss in value. Publicly-traded stocks aren’t subject to this holding-period risk, while privately-held company shares are, since there is no readily available market in which shares can be transacted. Additionally, a blockage discount is a byproduct of the illiquidity associated with this level of interest. This discount may further decrease value based on whether the block of shares being transacted is so great that in order for a timely transaction to occur, the price of the shares must be discounted.

These inherent restrictions associated with a privately-held ownership interest dictate that there be a discount to reflect the illiquid nature of such an interest. This discount is known as the discount for lack of marketability (“DLOM”). DLOMs for firms (non-ESOP) we work with are generally between ~20% to ~40%.

 

Final Thoughts

While the basic tenets of the various levels of value apply to almost all firms, there are two types of firms I encounter regularly for which additional consideration and planning are required to ensure successful transitions, internally or externally. The first type are the firms who buck industry performance trends…in a good way, that is. Regardless of what’s occurring in local, national or global economies, their profit margins are consistently high during a downturn and even higher when the economy is booming. These firms usually see a smaller gap between what they might transact at internally versus what they might command in an external acquisition.

The other type of firm is one that relies on a material portion of its revenues from set-aside contracts. These firms, regardless of whether they’re performing below, at, or above industry medians, can quite often trade at a higher price internally than they could reasonably expect to get from an acquirer.

There is no “one size fits all” approach to determining and applying discounts or premiums. Although all shareholders benefit from the various perquisites of ownership, the extent of such benefits can vary widely, especially based on what level of value best represents their ownership interest.

The Tax Cuts and Jobs Act and Your Firm’s Value

On December 22nd, the Tax Cuts and Jobs Act (TCJA) was officially signed into law.  Among the sweeping changes were substantial reductions in the corporate tax rate from a top marginal rate of 35%, to a flat 21%, along with an elimination of the corporate alternative minimum tax (AMT).  This time last year we theorized about what a potential corporate tax rate cut might mean for company valuations.  But now theory has become reality, with major implications for A/E firms across the U.S.

At the simplest level, profitable firms could see an increase in after-tax earnings of approximately 22%. The tables below illustrate the change in effective combined federal and state corporate tax rates for hypothetical firms in Iowa (one of highest corporate tax states), and in Wyoming (a state with no corporate income tax).

Estimated Combined Corporate Income Tax Rate Prior to TCJA


Estimated Combined Corporate Income Tax Rate After TCJA


Note that the above analysis assumes a C-corporation tax structure. The effective tax analysis for pass-through tax entities, including S-corporations and LLCs is much more complex, and will be the subject of a future Perspective.

All other things being equal, increased after-tax earnings would naturally lead to a commensurate increase in enterprise value (the value of a firm before consideration of its debt and cash balances), but business valuation is a bit more complex, and other factors, such as cost of capital, public company valuation multiples, and longer term economic trends must be considered.

With respect to the cost of capital, the TCJA puts limitations on the deductibility of interest expense. However, given that the typical firm in the A/E industry is lightly leveraged, this is unlikely to be a factor in most cases. The larger consideration will be whether baseline interest rates will increase in 2018, and by how much. In the latest meeting of the Federal Reserve’s Open Market Committee, the target range for the federal funds rate was increased by 0.25%. Inflationary concerns could spur further interest rate hikes in 2018, with the ultimate effect being a higher cost of capital, slightly offsetting the impact of increased earnings on company values.

As it relates to publicly traded firms, the perfect market theory would suggest that the cash flow impact of the TCJA is already accounted for in current market pricing. This seems to be supported by the broad expansion of the U.S. stock market over the past year. The Dow Jones Industrial Average has increased from 18,259 on November 7th, 2016 (immediately prior to the election), to 24,754 on December 22nd, (the date of the tax bill signing), which equates to an increase of 35.6%. Given that estimates for the Dow’s earnings per share for 2018 over 2017 suggest growth of only 11%, the market is clearly counting on significant incremental earnings benefits from the TCJA.

With respect to the narrower sector of publicly traded companies in the A/E industry, as the chart below indicates, these firms also saw stock price growth over the last year, with much of it coming in the final quarter of the year, which corresponds with the negotiation and eventual passage of the TCJA. The firms shown below include Tetra Tech (TTEK), AECOM (ACM), Stantec (STN), Jacobs Engineering (JEC) and NV5 Global (NVEE). We note that these firms have varying concentrations of earnings in the U.S., and therefore some will benefit more than others from a lower U.S. corporate tax rate.

AEC Publicly Traded Companies Share Price Trends

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The impact of longer term operational and economic trends is more difficult to gauge. Some lingering questions include:

  • Will the tax cuts spur an increase in economic growth as intended?
  • Will further economic growth, combined with already low unemployment rates put significant upward pressure on wages (and downward pressure on operating profits)?
  • If the next big legislative initiative is infrastructure, how will this impact A/E firm outlooks?

So in short, most firms should expect a material positive impact on their fair market value as a result of the TCJA. If you establish your firm’s value through the use of a professional business appraiser, he or she should be accounting for the impact of TCJA. If you are using another method to establish your firm’s value, such as a simple formula, this might be good time to re-assess that formula.