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Elastic demand allows interpretation of “fair value” in California Corporations Code Section 2000.
Bob Bruns
Premier Business Advisors
www.pmbizbrokers.com
Combining simple market demand with expected benefits allows interpretation of a confusing “fair value” definition.
Introduction
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Section 2000 of the California Corporations Code defines fair value in a way that is very difficult for an appraiser to reconcile. Many appraisers have struggled with the meaning of the statute with respect to traditional methods of valuation. The purpose of this article is to introduce a single element into the appraisal process, the demand curve, which allows the statute to be interpreted completely and in accordance with the wishes of its authors. The demand curve is a well known and accepted part of marketing theory, and its addition to traditional valuation techniques results in an equitable measure of the compromise in value necessary when one or more parties moves from an on-going concern.
California Corporations Code §2000
California Corporations Code §2000 describes how a corporation should be valued to avoid dissolution brought about by actions defined in sections 1800 or 1900. It defines “fair value” as:
The fair value shall be determined on the basis of the liquidation value as of the valuation date but taking into account the possibility, if any, of sale of the entire business as a going concern in a liquidation.
For an appraiser this definition seems difficult, as the parts of it conflict with appraisal standards.
Liquidation value as of the valuation date is held to be that of a piecemeal sale of the assets of the corporation. So the meaning of the phrase: The fair value shall be determined on the basis of the liquidation value as of the valuation date is simply the value of the assets as if sold in a manner consistent with the order of the court.
The second clause in the fair value definition is much harder to interpret: but taking into account the possibility, if any, of sale of the entire business as a going concern in a liquidation.
Taking into account the possibility, if any, of sale
The possibility of selling any business is related to the properties of the business and its asking price. Obviously some businesses are simply not transferable, for example, those businesses that rely heavily on the efforts of a single individual or the special talent of a small group. Businesses that require little to start up, in terms of cost or time, may also have limited possibilities for sale. Some examples of businesses that are hard to sell are professional services businesses, such as legal offices and accounting offices, or trade businesses that rely on specialty contractor licenses.
Businesses that are more easily exchanged are ones that are transferable, appeal to a broad base of buyers, and require some sort of initial investment or time to start. Examples of businesses that enjoy a high probability of sale are franchises, restaurants, gas stations with convenience stores, and most manufacturing businesses.
The desirability of a business also depends on the asking price for the assets or stock in that business. Asking too much for a business will inhibit offers being made on it. There are two reasons for this: first is that an overpriced business may not be attractive compared with other offerings. The internet has made it possible for a buyer to comparison shop businesses with respect to their financial performance prior to contacting the owner or broker for more information. For example, a search for a restaurant on the web site www.bizbuysell.com might reveal over 300 businesses for sale in Massachusetts, and about one half of these will have figures for both asking price and cash flow. The value of any business and its desirability is proportional to its cash return and its perceived risk. Searching on web listing services has helped to define the range where the asking price, cash flow, and risk are right.
Even if a buyer is interested in a particular business, pricing too high may inhibit an offer. Often a broker will hear “I don’t want to make an offer because I am afraid of insulting the seller.” The perception is that the seller is being unreasonable in his/her desires and that a low offer will create conflict. In fact, another good reason that too high a price may not elicit an offer is that it is cheaper to start such a business than to buy it – this perception is one that always affects the psychology of the buyer.
Of the entire business as a going concern in a liquidation
The court has already ordered a liquidation as part of the process: a hypothetical buyer would take this into account when making an offer for the business as an ongoing concern perhaps avoiding paying any premium in the absence of other potential suitors knowing that the alternative is the lower liquidation value. This would taint the sale process and tend to drive the price down. Conversely, buyers might be attracted to businesses where liquidation had been ordered, looking for bargains. One might consider the public nature of the court order to be, in effect, another channel for marketing of the business, thus potentially increasing the buyer pool and also increasing the chance of a sale. It is not clear how this clause is intended to affect the value. The following analysis makes this clause entirely irrelevant under any of the above scenarios.
The ultimate demand for a business opportunity
Ultimately the desirability of a business is defined by a demand curve as it is for any other goods for sale. According to the law of demand “the lower the price of a good, the larger the quantity consumers wish to purchase.” It is reasonable to modify this law, based on the prior argument, to substitute “the quantity that consumers wish to purchase” with “the probability that the business will sell.” In general the higher the price, the less the probability of a sale and the longer the time required for that business to sell.
For any business one might develop a demand curve based on price. For a business which there is considerable demand, the elasticity of demand would be lower, that is to say that the business would have a good chance of selling even if the asking price were at or above the Fair Market Value of the business. For businesses that are in lower demand, pricing substantially above Fair Market Value may not only mean that the probability will be lower, or zero, but the time required to obtain an offer will be substantially lengthened if an offer is obtained at all.
Simply put: The higher the business is priced, the longer it will take to sell, and the less likely a sale will be.
Development of a hypothetical business sale demand elasticity and sale probability curve.
For a “typical” business we, as business brokers, can make certain assumptions about the demand curve. Statistically only about 30% of all businesses for sale ever sell, and those that do require an average of six months from listing to completion of the sale process. Most businesses are overpriced; some would say that 70% are priced above their fair market value. It is probable then that most businesses which are suitably priced for sale sell for near their Fair Market Value in an average of six to seven months.
For the purpose of this discussion I will develop a hypothetical company, Sheet Metal Inc. for which the principles of establishing a Section 2000 value will be derived.
Sheet Metal, Inc. is a California corporation established in 1965. It has grown each year and by 2006 had annual revenue of $8,000,000 and an EBITDA of $650,000. The owners of the corporation were brothers, having each inherited half of the company stock from their late father’s estate. Brother John ran the company as the president, and Carl served as the operations manager, supervising 90 employees. The company continued to be successful selling custom and semi custom sheet metal components in the construction and air conditioning trades. Much of the equipment used in the shop had no book value, but was still in use. Some of the equipment was old: in fact some of the fabrication equipment had been in use since the company was founded. It was still in good working order and would continue to serve the needs of the factory into the foreseeable future.
At the end of 2006, Carl had grown tired of the day to day operations and wanted to sell. Carl left and a foreman was promoted to run the factory. Although John wanted to buy Carl out, they could not agree on a price. The Fair Market Value of the business was appraised at $3.0 million and a business broker agreed that he could probably sell the business for this price. It was the perfect company to sell. It had goodwill, because was producing an income stream in excess of ordinary earnings for its asset base. Its longevity and consistency meant that bank financing was available for a new buyer, or even for John to buy Carl out, as the company had little debt. Because of its excellent long term return and reputation in the market, it was a desirable candidate for a financial buyer.
John and Carl’s disagreement about the buyout price cuts to the heart of the intent of the Section 2000 code. Carl argued that the company should be sold for its highest value and the proceeds split 50/50. John argued that Carl’s presence was not required to maintain the company’s profitability because it was he who dealt with customers and Carl had already been replaced. John argued that the goodwill was his and he did not want to sell; his income would certainly drop if he did, and at age 45 he wished to continue working the business until retirement. Besides, there was no excess cash in the coffers: everything had been paid to the owners at the end of the year. John offered to prorate the liquidation value of the assets; about $1 million. Carl wanted half of the Fair Market Value of the going concern, $3.0 million. Try as they might, they could not agree on a compromise, and the negotiation was taking its toll on the brothers, their wives and children, and the rest of the family. At stake to either brother was $1,000,000.
Finally, Carl filed an action under Chapter 18 of the California Corporations Code and petitioned the court for involuntary dissolution of the business. He reasoned that forcing liquidation at least assured him of some return from his inheritance.
John filed an action under Section 2000 to avoid dissolution and appraisals were ordered by the court to find the “fair value” as defined by the statute.
By traditional appraisal standards, it is clear that the Fair Market Value is not correct, because it is does not use the liquidation value as a basis.
Liquidation value is not correct either, because it does not take into the account the possibility of a sale of the entire business as a going concern (in liquidation.)
The last part of the statute, in a liquidation, is satisfied simply by the fact that the court has already ordered a liquidation as part of the process. In the subsequent analysis, the fact that the liquidation is publicly known and the hypothetical sale may be tainted has no (or very little) effect on the final determination of value.
While the actual shape of the demand curve is not known, we shall assume it is a line (although this simplification may not be correct for most businesses and is used here for simplicity) The slope of the curve will vary according to the desirability of the business. For example: gas stations with convenience stores are very popular businesses, and the demand curve might shift to a lesser slope: the chance of selling such a business at Fair Market value is greater than 50%, it might be closer to 80 or 90 percent. A business with little desirability might have a steeper slope, meaning that the business is less likely to sell. No studies have been published correlating desirability, pricing and the chance that the business will be sold. The slope of this demand curve will make a substantial difference in the conclusion of a Section 2000 appraisal: The more likely the chance of a sale, the more the probability of a sale, the more the Fair Market Value should be considered in the value. Other factors in a business would also help determine the slope and shape of this line. A business would be more likely to sell if it is growing, has good supplier relationships, a strong and increasing market, barriers to entry from competition, and a good track record.
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Figure 1. Demand curve as a function of asking price
Figure 1 shows the demand curve for our hypothetical business, Sheet Metal Inc. A fair place to start with the demand curve is the aggregate demand curve for all businesses, recognizing that only about 40% of all businesses priced fairly sell at or close to Fair Market Value. Arguments for decreasing the slope because of high buyer demand might be that the business:
- Has a good historical income stream.
- Is well established and has a loyal customer base.
- Has many machines: high barrier to entry for competitors.
- Has financing available to buyers.
Arguments for decreasing the slope and making it less likely to sell are:
- The size of the company may limit the number of potential buyers: In general, companies this large have fewer buyers than businesses in the sub $1million price category.
- Buyers may be concerned if the business is tied to a cyclical industry, such as construction, especially if the growth has been tied to external factors in the customer base, such as the availability of credit.
Because of the above favorable factors, the chance of selling Sheet Metal Inc. was estimated to be 50% at Fair Market Value. The demand curve or demand line says that there is a 100% probability of selling the business at the asset value, a 50% probability of selling the business at Fair Market Value, and only a 13% chance of selling at a price 50% over fair market value. These values are consistent with generally accepted percentages in the business brokerage industry.
What is the value of a “probability?” The decision tree
We have now determined both a Fair Market Value (FMV) of Sheet Metal Inc, and an asset or liquidation value of $3.0 million and $1 million respectively.
The probability of sale, (P), has been defined over a range of possible sales values. At liquidation value, P is 100%, which means that the business has a 100% chance of selling at the liquidation value. For our example, P = 0.5 at Fair Market Value. The probability of a sale decreases as the price goes up, such that P = 0.13 at Price = 150% of Fair Market value:
The Expected Monetary Value (EMV) of an investment is what a risk neutral investor would be willing to pay for that investment given that the probabilities of all potential outcomes are known. In this case, the only two possible outcomes are:
- Sell as an on-going concern.
- Liquidate the assets.
A decision table can calculate the expected monetary value given the probabilities of a sale at a given price:
“Given a decision table with conditional values (payoffs) and probability assessments for all states of nature, it is possible to calculate the expected monetary value for each alternative…”
Thus, if there is a 50% chance of selling the company for $3,000,000 and therefore a 50% chance that the company will not sell, but will sell for an asset value of $1,000,000, the expected value is:
EMV = P(Asking Price) + (1-P)(Liquidation Value)
EMV = 0.5(3,000,000) + 0.5(1,000,000) = $2,000,000
At 150% of FMV the chance of selling is only 13% (there is an 87% chance that the business will not sell and will have to be liquidated for its asset value), and therfore the expected value is:
EMV = 0.87(1,000,000) + 0.13(4,500,000) = $1,437,000.
The expected monetary value of an investment with multiple probable outcomes is sometimes shown as a “decision tree.” “Any problem that can presented in a decision table can be graphically illustrated in a decision tree.”
The above two examples can be graphically illustrated as shown in the following figure:
Figure 2. Decision trees illustrating the mathematics of Expected Monetary Value (EMV)
Conclusion: Combining for Section 2000 value
Calculating the Expected Monetary Value (EMV) for all points along the demand curve results in the following graph:
Figure 3. The results in graphical form, the center curved line with the flat top is the Section 2000 value.
In tabular form, the results are:
Figure 4 . The same results in tabular form
The combination of the demand curve with the probability of sale has created an expected value which is insensitive to asking price. This is clearly shown in the graph, where a large flat spot is developed between an asking price of $2,000,000 (well below Fair Market Value) and $4,000,000 (well above Fair Market Value). In fact the Expected Monetary Value, which could also be described now as the value taking into account the possibility, if any, of sale of the entire business as a going concern varies only ± 7.1% with a 100% variation in asking price!
If we also consider that any hypothetical buyer would know that liquidation was imminent if an offer was forthcoming, we can assume the following:
- The buyer will use the forced liquidation as a bargaining position in negotiation.
- The buyer will not pay more than Fair Market Value.
These constraints can also be satisfied by considering only the points below Fair Market Value. The fact that the Expected Monetary Value curve is symmetrical means that mathematically this consideration has no meaning.
It is therefore possible to consider the average EMV over a suitably wide range of asking prices to be a reasonable value for Section 2000 appraisal. The average EMV through the range of $2mm to $4mm in sales price is:
Sheet Metal Inc., Section 2000 value = $1,875,000
Note that this value lies between the liquidation value and the Fair Market Value, as we would expect. The value becomes higher as either the goodwill value of the company in question becomes higher in relation to its assets or it is more desirable and therefore easier to sell (the probability of a sale is higher).
Steps to calculating the Section 2000 value using this method
- Calculate the Fair Market Value.
- Calculate the liquidation or asset value.
- Make a demand curve: Find at least one point where the probability of the sale can be determined, i.e. “There is a 45% chance that this business will sell for its Fair Market Value.” Then draw a line that passes through this point and the point at the asset value (the business can be liquidated if it doesn’t sell).
- For each point where a probability is known from the demand curve, calculate the Expected Monetary Value (EMV) using the probability of sale for several points along the demand line. Find the “flat spot” in the EMV curve, and in a reasonable range, calculate the average EMV. This is the “Section 2000” value, as it fulfills all of the requirements of the statute, most importantly the taking into account the possibility, if any, of sale of the entire business as a going concern in a liquidation.
Conclusion:
Section 2000 of the California Corporations Code defines “fair value” in a way that is very difficult for an appraiser to reconcile. Many appraisers have struggled with the meaning of the statute with respect to traditional methods of valuation. However, the statute’s wording “but taking into account the possibility, if any, of a sale…” allows the appraiser to build a demand curve for the business which takes into account this possibility over a range of expected values. Combining this with the expected monetary value allows the appraiser to develop a value which satisfies all the conditions of §2000, is well defined, and is insensitive to the range of values at which the subject company might be offered for sale. It also satisfies the requirement that the company is sold “in liquidation” as the hypothetical buyer is able to pay less than Fair Market Value; with the resultant §2000 value being unchanged. For any business, the demand curve is the key element for determining the §2000 value. Its shape and slope will differ for every business, and in the absence of real data, are reliant on educated adjustments to known data about the business sales marketplace.
About the author:
Bob Bruns
Premier Business Advisors, Fair Oaks, CA
www.pmbizbrokers.com
Bob Bruns has an engineering degree from Colorado and an MBA from Golden Gate University. He has been a business broker and appraiser for three years and in the prior 20 years of executive experience worked at several small to mid-sized high tech firms. He has worked on both ends of the acquisition business, steering transactions from $100K to over $87mm. He is a member of the Institute of Business Appraisers and the International Business Brokers Association and has offices in both Reno, Nevada and Fair Oaks, California. He is the holder of 13 US patents and is licensed as a broker in both Nevada and California. His personal pages can be found at www.bobbruns.com. In his spare time he enjoys backpacking, white-water kayaking, rafting and hang gliding. For small business owners interested in packaging, valuing and selling their own businesses, Mr. Bruns has developed an interactive web site at www.BizValPro.com His email is bbruns@pmbizbrokers.com and his cell phone number is (916) 801-7640.
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