Exhibit 15.25 Optimum Software and Selected Merged and Acquired Companies Financial and Operating Ratio Comparison CygnaCom Symitar Bonson DOME Data Subject Fiscal Year Ended 12/31/20X2 12/31/20X1 12/31/20X3 12/31/20X1 11/30/20X2 Median 12/31/20X4 Comment Liquidity/Solvency Ratios Quick ratio 9.9 1.3 1.4 1.3 1.2 1.3 2.8 Above median Current ratio 10.0 1.4 1.7 2.1 1.5 1.7 3.3 Above median Accounts receivable to sales 22.5% 7.4% 55.2% 12.9% 32.1% 22.5% 17.9% Below median Current liabilities to net worth 11.2% 159.9% 136.5% 105.5% 174.5% 136.5% 43.7% Below median Turnover Sales to receivables 4.4 13.6 1.8 7.8 3.1 4.4 5.6 Above median Sales to working capital 3.2 15.6 2.9 4.0 6.6 4.0 4.4 Above median Sales to fixed assets 282.6 22.5 30.3 27.8 257.5 30.3 28.4 Below median Sales to total assets 2.8 3.5 1.1 1.9 2.0 2.0 2.7 Above median Debt/Risk EBIT/interest expense na 0.0 na na na na 79.4 NM Current liabilities to total debt 77.7% 100.0% 100.0% 76.7% 99.5% 99.5% 75.3% Below median Long-term debt to total assets 2.8% 0.0% 0.0% 13.5% 0.3% 0.3% 9.1% Above median Total debt to total assets 12.6% 61.5% 57.7% 57.9% 63.7% 57.9% 36.7% Below median Total debt to net worth 14.4% 159.9% 136.5% 137.4% 175.4% 137.4% 58.1% Below median Fixed to net worth 1.1% 40.1% 8.6% 16.1% 2.1% 8.6% 15.2% Above median Profitability Gross margin 35.5% 55.8% 29.2% 66.8% 33.9% 35.5% 49.8% Above median EBITDA to sales 27.4% 16.8% 10.1% 30.0% 9.8% 16.8% 30.8% Above median Operating margin 27.0% 15.3% 8.1% 28.3% 9.6% 15.3% 28.9% Above median Pretax return on assets 77.8% 56.5% 8.3% 53.7% 19.9% 53.7% 78.0% Above median After-tax return on assets 77.8% 55.6% 8.2% 36.4% 16.6% 36.4% 46.8% Above median Pretax return on net worth 89.0% 146.8% 19.7% 127.5% 54.8% 89.0% 123.3% Above median After-tax return on net worth 89.0% 144.5% 19.4% 86.5% 45.6% 86.5% 74.0% Below median Pretax return on sales 27.8% 16.3% 7.5% 28.4% 9.9% 16.3% 28.5% Above median After-tax return on sales 27.8% 16.0% 7.4% 19.3% 8.3% 16.0% 17.1% Above median 256 Working Capital Working capital to sales 31.4% 6.4% 35.0% 25.3% 15.1% 25.3% 22.9% Below median Net income to working capital 88.4% 249.6% 21.3% 76.4% 54.9% 76.4% 74.9% Below median Inventory to working capital 0.0% 16.4% 9.8% 61.9% 57.1% 16.4% 18.8% Above median Current liabilities to working capital 11.1% 276.3% 149.5% 93.1% 209.9% 149.5% 44.3% Below median Long-term debt to working capital 3.2% 0.0% 0.0% 28.2% 1.0% 1.0% 14.5% Above median Operating efficiency Operating expenses to gross margin 23.8% 72.6% 72.2% 57.7% 71.7% 71.7% 42.0% Below median Operating expenses to sales 8.5% 40.5% 21.1% 38.6% 24.3% 24.3% 20.9% Below median Depreciation to sales 0.4% 1.5% 2.0% 1.8% 0.2% 1.5% 1.9% Above median Total assets to sales 35.7% 28.9% 90.6% 53.0% 50.0% 50.0% 36.6% Below median Sales to net worth 3.2 9.0 2.6 4.5 5.5 4.5 4.3 Below median Sales to fixed assets 282.6 22.5 30.3 27.8 257.5 30.3 28.4 Below median Notes: When compared to the sample of guideline merged and acquired companies, Optimum Software has: • Higher than the median liquidity and solvency ratios as well as turnover ratios except for slightly lower than median fixed asset turnover • Debt and risk ratios below the median for the group indicating lower risk • Profitability above median with the exception of the after-tax return on net worth • Better than median operating efficiency and lower than median use of fixed and total assets 257 258 THE MARKET APPROACH Exhibit 15.26 Selected Merged and Acquired Company Method Pricing Multiples Company MVIC/Sales MVIC/EBITDA MVIC/EBIT MVIC/BVIC CygnaCom 2.58 9.41 9.29 8.02 Symitar 1.34 8.00 8.23 12.08 Bonson 1.75 17.30 23.14 4.56 DOME 2.14 7.14 7.53 7.28 Data 1.61 16.40 16.16 8.78 Mean 1.88 11.65 12.87 8.14 Median 1.75 9.41 9.29 8.02 Standard deviation 0.49 4.83 6.69 2.72 Coefficient of variation (1) 0.26 0.41 0.52 0.33 Notes: The sales, EBITDA, EBIT, and BVIC figures in the denominators of the multiples are for latest full year. (1) The coefficient of variation is computed as the standard deviation divided by the mean. Exhibit 15.27 Guideline Merged and Acquired Company Method MVIC Multiple Adjustments Median Adjustment Adjusted Multiple Selected Pricing Multiple Pricing Multiple Factor Pricing Multiple Weight MVIC/Sales (1) 1.75 20.0% 2.10 45.0% MVIC/EBITDA (2) 9.41 15.0% 10.82 20.0% MVIC/EBIT (2) 9.29 15.0% 10.69 15.0% MVIC/BVIC (3) 8.02 10.0% 8.82 20.0% Notes: (1) Due to higher returns to sales compared to the guideline merged and acquired companies and lower risk, this multiple was adjusted upward by 20 percent. See Exhibits 15.23, 15.24, and 15.25 for details. Due to the relatively lower coefficient of variation, a weight of 45 percent was allotted to this multiple. (2) The subject company exhibited higher operating margins and superior asset turnover ratios compared to the guideline sample of merged and acquired companies. See Exhibits 15.23, 15.24, and 15.25 for details. Thus, these multiples were adjusted upward by 15 percent. A higher weight was assigned to the MVIC/EBITDA compared to MVIC/EBIT because of its lower coefficient of variation. (3) The subject company posted higher returns on assets. Also, the subject company exhibited superior asset turnover ratios. See Exhibits 15.23, 15.24, and 15.25 for details. This multiple was adjusted upward 10 percent and a weight of 20 percent was assigned because of its relatively lower coefficient of variation. Appendix: An Illustration of the Market Approach to Valuation 259 Exhibit 15.28 Guideline Merged and Acquired Company Method Weighting and MVIC Calculation Adjusted Subject Weighted Pricing Company Indicated Multiple Method Selected Pricing Multiple Multiple Fundamental Value Weight Value Guideline merged and acquired company data MVIC/Sales 2.10 $17,045,000 $35,725,161 45.0% $16,076,323 MVIC/EBITDA 10.82 $5,255,000 $56,878,852 20.0% $11,375,770 MVIC/EBIT 10.69 $4,925,000 $52,635,278 15.0% $7,895,292 MVIC/BVIC 8.82 $4,509,375 $39,764,813 20.0% $7,952,963 Guideline merged and acquired $43,300,347 company method MVIC Less: Market value of interest- $564,844 bearing debt (20X4) Equals: Indicated value of $42,735,503 common equity Note: See footnotes to Exhibit 15.27 for explanations of the adjusted pricing multiple and the multiple weights. Exhibit 15.29 Opinion of Value Derived from the Application of the Market Approach to Valuation Method Indicated Value Method Weight Weighted Value Guideline public company MVIC method $41,906,045 0.5 $20,953,023 Guideline merged and acquired company MVIC method $42,735,503 0.5 $21,367,752 Total $42,320,774 Note: Equal weight was assigned to each method in this case, but other weights may be appropriate. Chapter 16 The Asset-Based Approach Summary Adjusted Net Asset Value Method Excess Earnings Method (The Formula Approach) Steps in Applying the Excess Earnings Method Example of the Excess Earnings Method Reasonableness Check for the Excess Earnings Method Problems with the Excess Earnings Method Conclusion SUMMARY The asset-based approach is relevant for holding companies and for operating companies that are contemplating liquidation or are unprofitable for the foreseeable future. It should also be given some weight for asset-heavy operating companies, such as financial institutions, distri- bution companies, and natural resources companies such as forest products companies with large timber holdings. There are two main methods within the asset approach: 1. The adjusted net asset value method 2. The excess earnings method Either of these methods produces a controlling interest value. If valuing a controlling interest, a discount for lack of marketability may be applicable (see Chapter 18). If valuing a minority interest, discounts for both lack of control and lack of marketability would be appropriate in most cases. ADJUSTED NET ASSET VALUE METHOD The adjusted net asset value method involves adjusting all assets and liabilities to current val- ues. The difference between the value of assets and the value of liabilities is the value of the company. The adjusted net asset method produces a controlling interest value. The adjusted net asset value encompasses valuation of all the company’s assets, tangible and intangible, whether or not they are presently recorded on the balance sheet. For most companies, the assets are valued on a going-concern premise of value, but in some cases they may be valued on a forced or orderly liquidation premise of value. The adjusted net asset method should also reflect the potential capital gains tax liability 260 for appreciated assets. (This is discussed in Chapter 17.) In Dunn, 1 the Fifth Circuit Court of Appeals opined that the full dollar amount of the tax on the gains can be deducted “as a matter of law” from indications of value using the asset approach. As a result, this can be done as an adjustment to the balance sheet rather than a separate adjustment at the end. Exhibit 16.1 is a sample of the application of the adjusted net asset value method. In a real valuation, the footnotes should be explained in far greater detail in the text of the report. In- tangible assets are usually valued by the income approach. EXCESS EARNINGS METHOD (THE FORMULA APPROACH) The excess earnings method is classified under the asset approach because it involves valuing all the tangible assets at current fair market values and valuing all the intangible assets in a big pot loosely labeled goodwill. It is also sometimes classified as a hybrid method. The excess earnings method originated in the 1920s as a result of Prohibition. The U.S. government decided that the owners of breweries and distilleries that were put out of business because of Prohibition should be compensated not only for the tangible assets that they lost, but also for the value of their potential goodwill. Thus, the concept of the excess earnings method is to value goodwill by capitalizing any earnings the company was enjoying over and above a fair rate of return on their tangible as- sets. Thus the descriptive label, excess earnings method. The result of the excess earnings method is value on a control basis. The latest IRS pro- nouncement on the excess earnings method is Rev. Rul. 68-609. 2 Specifically, the Ruling states, “The ‘formula’ approach may be used for determining the fair market value of intangi- ble assets of a business only if there is no better basis therefore available.” Steps in Applying the Excess Earnings Method 1. Estimate net tangible asset value (usually at market values). 2. Estimate a normalized level income. 3. Estimate a required rate of return to support the net tangible assets. 4. Multiply the required rate of return to support the tangible assets (from step 3) by the net tangible asset value (from step 1). 5. Subtract the required amount of return on tangibles (from step 3) from the normalized amount of returns (from step 2); this is the amount of excess earnings. (If the results are negative, there is no intangible value and this method is no longer an appropriate indica- tor of value. Such a result indicates that the company would be worth more on a liquida- tion basis than on a going-concern basis.) 6. Estimate an appropriate capitalization rate to apply to the excess economic earnings. (This rate normally would be higher than the rate for tangible assets and higher than the overall capitalization rate; persistence of the customer base usually is a major factor to consider in estimating this rate.) Excess Earnings Method (The Formula Approach) 261 1 Estate of Dunn v. Comm’r, T.C. Memo 2000-12, 79 T.C.M. (CCH) 1337; rev’d 301 F.3d 339 (5th Cir. 2002). 2 See Chapter 22 for a full discussion. 262 THE ASSET-BASED APPROACH Exhibit 16.1 Adjusted Net Asset Value for XYZ Company 6/30/94 Adjusted As Adjusted $$$ Assets: Current Assets: Cash Equivalents 740,000 740,000 Accounts Receivable 2,155,409 2,155,409 Inventory 1,029,866 200,300 a 1,230,166 Prepaid Expenses 2,500 2,500 Total Current Assets 3,927,775 200,300 4,128,075 Fixed Assets: Land & Buildings 302,865 (49,760) b 253,105 Furniture & Fixtures 155,347 (113,120) b 42,227 Automotive Equipment 478,912 (391,981) b 86,931 Machinery & Equipment 759,888 (343,622) b 416,266 Total Fixed Assets, Cost 1,697,012 (898,483) 798,529 Accumulated Depreciation (1,298,325) 1,298,325 c 0 Total Fixed Assets, Net 398,687 399,842 798,529 Real Estate—Nonoperating 90,879 43,121 d 134,000 Other Assets: Goodwill, Net 95,383 (95,383) e 0 Organization Costs, Net 257 (257) e 0 Investments 150,000 20,000 d 170,000 Patents 0 100,000 e 100,000 Total Other Assets 245,640 24,360 270,000 Total Assets 4,662,981 667,623 5,330,604 Liabilities and Equity: Current Liabilities: Accounts Payable 1,935,230 1,935,230 Bank Note, Current 50,000 50,000 Accrued Expenses 107,872 107,872 Additional Tax Liability 0 267,049 f 267,049 Total Current Liabilities 2,093,103 267,049 2,360,151 Long-Term Debt 350,000 350,000 Total Liabilities 2,443,102 267,049 2,710,151 Equity: Common Stock 2,500 2,500 Paid-in Capital 500,000 500,000 Retained Earnings 1,717,379 400,574 g 2,117,953 Total Equity 2,219,879 400,574 2,620,453 Total Liabilities and Equity 4,662,981 667,623 5,330,604 Notes: a Add back LIFO reserve. b Deduct economic depreciation. c Remove accounting depreciation. d Add appreciation of value, per real estate appraisal. e Remove historical goodwill. Value identifiable intangibles and put on books. f Add tax liability of total adjustment at 40% tax rate. g Summation of adjustments. Source: American Society of Appraisers, BV-201, Introduction to Business Valuation, Part I from Principles of Valuation course series, 2002. Used with permission. All rights reserved. 7. Divide the amount of excess earnings (from step 5) by a capitalization rate applicable to excess earnings (from step 6); this is the estimated value of the intangibles. 8. Add the value of the intangibles (from step 7) to the net tangible asset value (from step 1); this is the estimated value of the company. 9. Reasonableness check: Does the blended capitalization rate approximate a capitalization rate derived by weighted average cost of capital (WACC)? 10. Determine an appropriate value for any excess or nonoperating assets that were ad- justed for in step 1. If applicable, add the value of those assets to the value determined in step 8. If asset shortages were identified in step 1, determine whether the value esti- mate should be reduced to reflect the value of such shortages. If the normalized income statement was adjusted for identified asset shortages, it is not necessary to further re- duce the value estimate. Example of the Excess Earnings Method Assumptions: Net tangible asset value $100,000 Normalized annual economic income $ 30,000 Required return to support tangible assets 10% Capitalization rate for excess earnings 25% Calculations: Net tangible asset value $100,000 Required return on tangible assets 0.10 × $100,000 = $10,000 Excess earnings $30,000 – $10,000 = $20,000 Value of excess earnings $20,000/0.25 = $ 80,000 Indicated value of company $180,000 Reasonableness Check for the Excess Earnings Method If 16.7 percent is a realistic WACC for this company, then the indicated value of the in- vested capital meets this reasonableness test. If not, then the values should be reconciled. More often than not, the problem lies with the value indicated by the excess earnings method rather than with the WACC. Normalized income $30,000 Indicated value of company 0.167 or 16.7%= Excess Earnings Method (The Formula Approach) 263 Problems with the Excess Earnings Method Tangible Assets Not Well Defined • Rev. Rul. 68-609 does not specify the appropriate standard of value for tangible assets (e.g., fair market value [FMV] on a going-concern basis or replacement cost); although some type of FMV seems to be implied, some analysts simply use book value due to lack of ex- isting asset appraisals. • It is not clear whether clearly identifiable intangible assets (e.g., leasehold interests) should be valued separately or simply left to be included with all intangible assets under the head- ing of goodwill. • Rev. Rul. 68-609 does not address when or whether asset write-ups should be tax affected. Most appraisers will include built-in capital gains, however, if assets are adjusted upward to reflect their fair market value. Definition of Income Not Specified Rev. Rul. 68-609 3 says the following: The percentage of return on the average annual value of the tangible assets used should be the percentage prevailing in the industry involved at the date of valuation, or (when the industry percentage is not avail- able) a percentage of 8 to 10 percent may be used. The 8 percent of return and the 15 percent rate of capitalization are applied to tangibles and intangibles, re- spectively, of businesses with a small risk factor and stable and regular earnings; the 10 percent rate of re- turn and 20 percent rate of capitalization are applied to businesses in which the hazards of business are relatively high. The above rates are used as examples and are not appropriate in all cases. In applying the “formula” ap- proach, the average earnings period and the capitalization rates are dependent upon the facts pertinent thereto in each case. 4 • Practice is mixed. Some use net cash flow, but many use net income, pretax income, or some other measure. • Since some debt usually is contemplated in estimating required return on tangible assets, returns should be amounts available to all invested capital. • If no debt is contemplated, then returns should be those available to equity. • The implication of the preceding two bullet points is that the method can be conducted on either an invested capital basis or a 100 percent equity basis. Capitalization Rates Not Well Defined • Rev. Rul. 68-609 recommends using rates prevalent in the industry at the time of valuation. 264 THE ASSET-BASED APPROACH 3 For a reference to the valuation of intangible assets see Robert F. Reilly, and Robert P. Schweihs, Valuing Intangi- ble Assets (New York: McGraw-Hill, 1998). 4 Rev. Rul. 68-609. For a full discussion, please see Chapter 22. • Required return on tangibles is controversial, but usually a blend of the following: • Borrowing rate times percentage of tangible assets that can be financed by debt • Company’s cost of equity capital • No empirical basis has been developed for estimating a required capitalization rate for ex- cess earnings. The result of these ambiguities is highly inconsistent implementation of the excess earnings method. CONCLUSION Within the asset approach, the two primary methods are the adjusted net asset value method and the excess earnings method. Under the adjusted net asset value method, all assets, tangi- ble and intangible, are identified and valued individually. Under the excess earnings method, only tangible assets are individually valued; all the intangibles are valued together by the cap- italization of earnings over and above a fair return on the tangible assets. Once indications of value have been developed by the income, market, and/or asset ap- proaches, the next consideration is whether to adjust these values by applicable premiums and/or discounts. In valuations for tax purposes, the premiums and/or discounts often are a bigger and more contentious money issue than the underlying value to which they are applied. Premiums and discounts are the subject of Chapters 17, 18 , and 19. Conclusion 265 [...]... income and guideline public company meth24 Estate of Klauss v Comm’r, T.C Memo 2000-191, 79 T.C.M (CCH) 2 177 Payne v Comm’r, T.C Memo 1998-2 27, 75 T.C.M (CCH) 2548 26 Estate of Desmond v Comm’r, T.C Memo 1999 -76 , 77 T.C.M (CCH) 1529 25 Conclusion 281 ods in valuing a paint manufacturing company’s stock, the court applied a 20 percent discount for marketability to the result of the market approach and. .. (June 1 977 ), pp 381–385 d Robert E Moroney, “Most Courts Overvalue Closely Held Stocks,” Taxes (March 1 973 ), pp 144–155 e J Michael Maher, “Discounts for Lack of Marketability for Closely Held Business Interests,” Taxes (September 1 976 ), pp 562– 571 d William F Pittock and Charles H Stryker, “Revenue Ruling 77 - 276 Revisited,” SRC Quarterly Reports (Spring 1983), pp 1–3 g Willamette Management Associates... interests in a 27- unit Burger King chain. 17 The court rejected in total the Service’s valuation Besides rejecting his methodology, the court noted that he had represented he possessed certain qualifications and credentials to perform business valuations, which he did not, in fact, have The taxpayer’s appraisal used a multiple of earnings before interest, taxes, depreciation, and amortization (EBITDA) and applied... Restricted Stock Studies 2 87 IRS Recognition of Discounts for Lack of Marketability: Revenue Ruling 77 -2 87 In 1 977 , the Service officially recognized the factors in the SEC Institutional Investors Study as being relevant in quantifying discounts for lack of marketability One of the concluding paragraphs of Rev Rul 77 -2 87 contains the following language: The market experience of freely tradable securities of the... restricted securities, and thereby significantly reduced the average discount that the market requires for holding restricted securities.8 5 Rev Rul 77 -2 87, section 6.04 Id., section 4.02 (a) and (b) 7 Id., section 6.02 8 Shannon P Pratt, Business Valuation Discounts and Premiums (New York: John Wiley & Sons, Inc., 2001): 82 6 288 DISCOUNTS FOR LACK OF MARKETABILITY Restricted Stock Studies Subsequent to the... discounts used by the experts and tried to find a middle ground between the immediate sale and the 10-year holding period The court concluded that a 24 percent discount for the trapped-in capital gains was reasonable 6 Estate of Welch v Comm’r, T.C Memo 1998-1 67, 75 T.C.M (CCH) 2252 Id 8 Estate of Borgatello v Comm’r, T.C Memo 2000-264, 80 T.C.M (CCH) 260 (2000) 172 , 175 , 242 7 270 ENTITY-LEVEL DISCOUNTS... Long-Term Study (1980–1996)” (Chapter 5) in Robert F Reilly and Robert P Schweihs, eds., The Handbook of Advanced Business Valuation (New York: McGraw-Hill, 2000) c Bruce Johnson, “Restricted Stock Discounts, 1991–1995,” Shannon Pratt’s Business Valuation Update (March 1999): 1–3; “Quantitative Support for Discounts for Lack of Marketability,” Business Valuation Review (December 1999): 152–155 d Kathryn F... assets and liabilities are among the most difficult to value simply because of their nature The challenge lies in estimating just how much may be collected or will have to be paid out, and thus in quantifying any valuation adjustments 23 Knight v Comm’r, 115 T.C 506 (2000) 280 ENTITY-LEVEL DISCOUNTS Concept of the Contingent Liability Discount In real-world purchases and sales of businesses and business. .. Columbia Financial Advisorsd Number of Transactions Average Price Discount (%) 1 979 –April 1992 1980–1996 1991–1995 1996–April 19 97 >100 53 72 23 23.0 27. 1 20.0 21.0 Notes: Lance S Hall and Timothy C Polacek, “Strategies for Obtaining the Largest Valuation Discounts,” Estate Planning (January/February 1994), pp 38–44 b Robert P Oliver and Roy H Meyers, “Discounts Seen in Private Placements of Restricted Stock:... the International Glossary of Business Valuation Terms (see Appendix B) as the ability to quickly convert property to cash at minimal cost The benchmark for marketability for business valuation is the market for active, publicly traded stocks The holder can have the stock sold in less than a minute at or near the price of the last trade, and have cash in hand in three business days Discount for lack . 12.08 Bonson 1 .75 17. 30 23.14 4.56 DOME 2.14 7. 14 7. 53 7. 28 Data 1.61 16.40 16.16 8 .78 Mean 1.88 11.65 12. 87 8.14 Median 1 .75 9.41 9.29 8.02 Standard deviation 0.49 4.83 6.69 2 .72 Coefficient of. and acquired company data MVIC/Sales 2.10 $ 17, 045,000 $35 ,72 5,161 45.0% $16, 076 ,323 MVIC/EBITDA 10.82 $5,255,000 $56, 878 ,852 20.0% $11, 375 ,77 0 MVIC/EBIT 10.69 $4,925,000 $52,635, 278 15.0% $7, 895,292 MVIC/BVIC. Expenses 1 07, 872 1 07, 872 Additional Tax Liability 0 2 67, 049 f 2 67, 049 Total Current Liabilities 2,093,103 2 67, 049 2,360,151 Long-Term Debt 350,000 350,000 Total Liabilities 2,443,102 2 67, 049 2 ,71 0,151 Equity: Common