The debate over how to build up a discount rate never loses its fizz, as a recent appeal from a bankruptcy court decision shows.
Small change, big effect:
The debtor was a closely held company that specialized in hydrographic surveying and navigational mapping—a niche business. Its five principal shareholders had unique qualifications and long-lasting relationships with the U.S. Army Corps of Engineers, which they used to obtain government qualification contracts. Eventually, 90% of the company’s revenues came from projects for the Corps. After bankruptcy, the debtor proposed a reorganization plan under which it would retain all of its 23 workers and not allow the appellants to acquire a majority interest in the business. The court’s plan approval turned on the valuation of the debtor’s equity interests.
The appellants’ financial expert said the company should be valued as a going concern. He used an income approach to determine “the earning capacity of the business” and a “build-up” discount rate of 18.44%, allocating only 1.5% of it to the company-specific risk. He did not believe the departure of any one of the five principal employees would seriously affect the company’s ability to preserve its contracts with the Corps. He concluded that the debtor was worth $960,000. The debtor’s rebuttal expert called the rate “way understated” and said the company-specific risk in this case was “major.” He gave an example of how “just a few tweaks in the discount rate … can make a huge difference in the valuation.” He said the opposing expert “failed to separate the value of the business from the value of the professional owners of the business” and also did not appreciate the difficulty of replacing key personnel given the principal shareholders’ unique technical skills. The rebuttal expert suggested the discount rate in this case could range from 40% to 75%.
Key role of principals:
The bankruptcy court acknowledged the impact of the discount rate on the valuation number and emphasized that a willing buyer assessing the debtor company would consider the key role the principal shareholders played in getting Corps contracts and the latter’s importance to the survival of the company. In the court’s view, “if you don’t have the employees and you don’t have the contracts, what have you got left?” Ultimately, the bankruptcy court arrived at a value of $200,000, without identifying the discount rate it applied or specifying the adjustments it made to the proposed valuation.
On appeal, the district court affirmed. The bankruptcy court did not unduly focus on the risk factors. And just because it did not give a mathematical formula for how it got to $200,000 does not mean it “pulled the number out of thin air,” the district court said. The bankruptcy court’s computed value aligned with the rebuttal expert’s proposed range of discount rates.
Find an extended discussion of Vision-Park Properties v. Seaside Engineering, 2014 U.S. Dist. LEXIS 41923
(March 27, 2014), in the June issue of Business Valuation Update;
the court’s opinion will appear soon at BVLaw.
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