Intangible Value in a Practice

From both a valuation and brokerage standpoint, professional practices are significantly different from entities engaged in manufacturing, distribution, or retailing. A professional practice renders a service as opposed to producing, distributing, or selling a tangible product. The owner/practitioner level of a professional practice is always composed of at least one licensed individual who has demonstrated the requisite education and skill to practice in their specific field of endeavor. Major differences also exist in the nature of the operational assets necessary for the successful functioning of a professional practice. The professional practice is considerably more reliant upon intangible assets than are the other entity types.

What are intangible assets?

Intangible assets have the characteristic of property that is incorporeal, having no physical substance apparent to the senses. Intangible assets are not “purchased” per se, yet are often “acquired” over extended periods of time. Intangibles are not always readily identifiable. Specific intangibles are often difficult to precisely explain. As a result of these characteristics, intangibles are often overlooked in either the valuation of a practice or in a transfer price of an ownerhip interest in the practice.

A convenient classification of intangible assets is the following:

• Client and Patient Related
• Human Capital Related
• Goodwill and Client/Patient Related
• Intellectual Property Related
• Locations and Operations Related
• Governance and Legal Structure Related
• Marteting and Business Developmint Related
• Regulator Legal Related
• Financial Revenue Related
• Technology Related

The fact is, intangible assets are necessary to the successful operation of all professional practices.  Intangible assets materially contribute to the practice’s income and profits.  Pragmatically, intangible assets are often identified conceptually and valued as a composite figure.  Hence, there is little need to separately value each discrete intangible asset.  Composite valuation is the norm.  See pg. 8 and the Excess Earnings Method.

The Valuation Engagement

An engagement for services needs to be specific in regard to the following:  the client, the property (i.e., stock or ownership interest) being valued, the date at which time the property is to be valued, the purpose of the valuation, the applicable standard of value, the nature of the property (i.e., whether a controlling or a minority interest), the premise of value (i.e., whether the entity is, or is not, a “going concern”), and any limiting conditions.

In a litigation matter, an attorney should determine, at the outset, whether the valuator is to be used as an advocate (i.e., expressing the interests of the client) or as an expert (i.e., presenting an unbiased and independent opinion).  For the expert styled engagement, the attorney and not the attorney’s client, should engage the valuator to obtain the legal advantage of a “privileged” work product.

Fair Market Value

Fair Market Value (FMV) is the most commonly utilized standard of value.  The definition of FMV from Treasury Regulation 20.2031-1(b) is:

The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion; to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts.

The property can be any of the following: stock of a corporation, a partnership interest, an interest in a limited liability entity (e.g., an LLC or LLP), or ownership of a proprietorship.

It is imperative to understand the conceptual elements of the above definition.  A fundamental concept is that FMV is a hypothetical determination, whereas price is based upon an actual sale transaction.  Also critical to the understanding of FMV are the following conceptual underpinnings:

• the parties are considered hypothetical, meaning also that there is no identified buyer
• that both parties have reasonable knowledge of all of the material relevant facts
• that the parties are capable of consummating the transaction at current economic conditions
• that neither party is under any compulsion to purchase or sell
• that reasonable time is allowed for exposure of the property on an open market
• that the transaction is based on known or reasonably knowable events, but not on events unknowable at the date of valuation (i.e., subsequent events)

The term “value” has several meanings depending upon the legal or financial context of its use.  FMV should not be confused with other definitions or standards of value, such as:

Book Value	a financial accounting term, denoting assets less liabilities, generally stating assets at their conservative historical costs as opposed to their fair market values
Investment Value	the value to a specific investor that is determined with a prescribed or required rate of return on the investment.
Liquidation Value	the net value of the entity based on the sale of individual assets over a relatively short period of time, and the related extinguishment of debt.
Synergistic Value	the value to a strategic buyer, where such a buyer may benefit from economies of scale, elimination of duplicate functions, and/or expanded markets.
Intrinsic Value	the value a financial stock analyst would put on corporate stock, which may differ from its trading price.

Financial, Economic, and Industry Analysis
A practice valuation is based on the analysis of “all relevant factors.”  FMV, being a question of fact, will depend on the circumstances in each case.  The valuator must exercise judgment as to the degree of consideration to accord any specific factor.

As a starting point, IRS Revenue Ruling 59-60 indicates consideration should be given to eight factors:

• the nature of the practice and its history since its inception
• the economic outlook in general and the outlook of the specific industry in particular
• the book value of the stock and the financial condition of the practice
• the earning capacity of the company
• the dividend-paying capacity of the company
• the existing goodwill or other intangible value of the company
• the recent sales of stock and the size of the block to be valued
• the market prices of comparable companies engaged in the same or a similar line of
• practice having their stocks actively traded in an open market

In the broadest sense, the relevant categories that should be considered are practice, economic, and industry; and may also include legal, tax, personnel, and environmental, among others.

The above Revenue Ruling is a required consideration in gift and estate tax matters and has been widely recognized as appropriate in a number of other non-tax valuation contexts (e.g., divorce, buy-sell, etc.).

Financial, Economic, and Industry Analysis

A practice valuation is based on the analysis of “all relevant factors.”  FMV, being a question of fact, will depend on the circumstances in each case.  The valuator must exercise judgment as to the degree of consideration to accord any specific factor.

As a starting point, IRS Revenue Ruling 59-60 indicates consideration should be given to eight factors:

• the nature of the practice and its history since its inception
• the economic outlook in general and the outlook of the specific industry in particular
• the book value of the stock and the financial condition of the practice
• the earning capacity of the company
• the dividend-paying capacity of the company
• the existing goodwill or other intangible value of the company
• the recent sales of stock and the size of the block to be valued
• the market prices of comparable companies engaged in the same or a similar line of
• practice having their stocks actively traded in an open market

In the broadest sense, the relevant categories that should be considered are practice, economic, and industry; and may also include legal, tax, personnel, and environmental, among others.

The above Revenue Ruling is a required consideration in gift and estate tax matters and has been widely recognized as appropriate in a number of other non-tax valuation contexts (e.g., divorce, buy-sell, etc.).

Approaches and Methods

Valuations can theoretically be divided into three general categories of approaches: asset, income, and market.  Hybrid approaches and industry approaches may be separately classified, as these often do not fall clearly within any of the general categories.

Succinct explanations of the three general categories are the following:

asset approaches	• analyze the current value of the underlying component assets and liabilities incorporating previously unrecorded assets and contingent liabilities.
income approaches	• focus on the benefit stream (e.g., revenues, earnings, or cash flows) and the capitalization or discounting of that stream.
market approaches	• analyze transactions of the company’s stock and/or multiples of other similar entities or transactions.

Asset Methods

Adjusted Asset Method   (a.k.a., Asset Accumulation Method, Adjusted Net Asset Method)

Assets and liabilities are divided into their individual components and adjusted to their current values.  Unrecorded assets and unrecorded liabilities are also adjusted to their current values.  Intangibles are often among the more material unrecorded assets.  Intangible assets include the following: goodwill, patents, contract rights, going concern value, etc.

The utility of this asset method is that it often establishes a “floor value,” below which a going concern should not be valued.  Its weakness, in most instances, is that a moderately profitable entity will often yield a higher value from either the income or the market approaches.  It is often appropriate for valuing “asset holding” companies, which are entities with nominal net profits and which own appreciated assets (e.g., real estate).

Assets such as real estate, uniquely constructed machinery or equipment, and certain intangibles may require an independent appraisal by a specialist for that type of asset.

 

Liquidation Method

For the financially distressed company, assets are recorded at their liquidation values, assuming either a reasonable time for disposal or a quick sale scenario.  Liabilities are recorded at either their book values or a negotiated payoff amount.  An estimate is also needed for the overhead operating costs likely to be incurred during the liquidation process.  Certain intangibles, such as goodwill, often have little or no value, since separation from the operating company as a whole is meaningless in this valuation scenario.  Other intangibles, such as patents, trademarks, and copyrights, may be salable or have an assignable royalty value.

The liquidation method is not utilized for “going concern” entities (i.e., those entities with reasonable profits and/or positive financial operating characteristics). 

Income Methods

Capitalized Income Method   (a.k.a., Capitalized Earnings Method) 
                        
This method is calculated by dividing a single “economic benefit” by a capitalization rate.  The capitalization rate is a discount rate less the expected long-term growth rate.  The discount rate for a closely-held entity may be determined referentially from the alternative returns available from the public stock market, plus an increment for the additional risk of the subject entity.

The economic benefit may be expressed as net earnings, pre-tax earnings, EBIT, EBITDA, or cash flows.  The economic benefit should be adjusted for extraordinary items and may be adjusted for other normalized items.  Common normalization items are excessive compensation and owner perquisites.

It is imperative that the economic benefit stream be appropriately matched with the formulated discount rate.  For example, a discount rate formulated for application to a net earnings benefit stream should not be applied directly to a cash flow benefit stream.

The strength of this method is that it relies upon the actual historical performance of the subject entity.  Its weakness is that the method does not specifically address the expected future performance of the entity.

Discounted Earnings Method  (a.k.a., Discounted Future Earnings Method)

This method involves projecting economic benefits over a period of future years and discounting each year’s projected benefit stream to its present value.  The present values are summed and combined, if appropriate, with a terminal value.  The discount rate may be determined referentially from the alternative returns available from the public stock market, plus an increment for the additional risk of the subject entity.

This method is considered the most theoretically appropriate due to its focus on the future benefits that a hypothetical buyer might expects to receive.  Its weakness is that it relies upon an expectation of future benefits, as opposed to the known historical benefits.

Market Methods

Guideline Publicly Traded Method

With this method the subject company is compared to a multiple (commonly the P/E* ratio) of a similar publicly traded company, preferably within the same industry.  Because the publicly traded entity is determined from a “market,” its P/E is considered relevant.  The P/E may be adjusted and the adjusted P/E applied to the subject company’s Earnings to compute the subject entity’s Price (i.e., the FMV of the subject).

The weakness is the subjective adjustment of the P/E ratio (i.e., of a public company’s performance to that of the closely held company).  The strength of this method is that it relies upon “market” derived public company multiples.

*P/E refers to the Price/Earnings ratio, in which the Price is the Trading Price of an entity, and the Earnings are the Net Income of the entity.

Market Transaction Method

Proprietary databases of actual sales of entities within the same industry are available to the valuation professional.  These databases are typically organized by Standard Industrial Code for matching to the subject company.  These databases contain information about actual sale transactions.  Typically, the Price to Earnings information in the database is applied to the subject company’s Earnings to compute the Price (i.e., the FMV of the subject).

The strength of this method is its reliance upon actual sale transaction data of similar entities.  The weakness is that there is often insufficient detail in the database for further comparison to the subject.

Prior Stock Sales

Sales of the subject company stock may be a highly useful indicator of FMV.  The sale should be recent and represent an arm’s-length transaction.  The more frequent these transactions occur, the more likely they will constitute a valid substitute “market.”

The  fact is that upon close scrutiny many of these transactions fall short of being true arm’s-length transactions for the following reasons, among others: they are determined to be intra-family favorable succession transfers, or there is an element of compulsion in the sale.  When, however, these transactions are indeed arm’s-length and otherwise approximate FMV, they are relevant indicators of FMV.

Hybrid and Industry Methods

Excess Earnings Method  (a.k.a., Treasury Method, Formula Method)

The IRS explained the use of this valuation method in its Revenue Ruling 68-609.  Due to the use of both assets and earnings of the subject entity, it is often classified as a hybrid method.  The method computes “excess earnings” above a reasonable return on net tangible assets.  The excess earnings are capitalized to yield the value of the intangibles.  The intangibles are added to the net tangible assets to yield the value of the subject entity.

This method has numerous variations due to the lack of specificity within the Revenue Ruling itself.  The method utilizes two often subjectively determined capitalization rates.  Its strength is the use of both the assets and the earnings stream of the subject entity.  See page 12, following, for a website reference to the IRS Revenue Ruling 68-609.

Gross Revenue Multiplier Method

Certain practices, particularly professional firms, are often valued using the P/G* ratio from a database of similar companies.  The subject company’s Gross Revenues are multiplied by the P/G database ratio to determine the Price (i.e., the FMV of the entity).

This revenue method benefits from a relatively straight forward computation.  This method should, however, not be utilized without further corroborating valuation analysis.

* P/G refers to the Price/Gross ratio, in which the Price is the Sales Price of the company in the database, and Gross is the Gross Revenue of the company in the database.

Industry Rules of Thumb

Certain industries have simplified valuation formulas.  These formulas may or may not be accurate when applied to a specific subject entity.  An example is in the nursing home industry, where a dollar amount per bed is applied to the total number of beds in the facility.

The industry method benefits from a straight forward application of a formula.  Reliance upon an industry formula should not, however, be made without further corroborating valuation analysis.

Risk & Risk Quantification

In certain valuation methods, an analysis must be made of “risk” as it affects the subject company.  Further analysis must be made of the risk of the industry and economy within which the company operates.

Risk is defined as the likelihood of not receiving a particular benefit stream.  Risk is relative.  It is relative to a comparable investment with similar risk characteristics. 

For instance, and as a purely hypothetical presentation, consider the following relative risks:

Investment Alternatives	Return (%)	Comment
US Treasury Bill	3.5	Low Risk – Federally insured (short-term)
US Savings Bond	4.5	Low Risk – Federally insured (long-term)
Corporate Bond	5 to 7	Low Risk – Bonds are paid before shareholders
In summary, the lower the risk, the lower the expected return, due to the low uncertainty of not receiving the expected return.  Inversely, the higher the risk, the higher the expected return, due to the greater uncertainty of not receiving the expected return. One of the challenges in performing a valuation analysis is to relate the overall economy and its trends, the industry and its trends, and the subject company’s strengths and weaknesses to a quantified overall risk.

Large Public Stock                    7 to 12            Medium Risk
Small Public Stock                    10 to 15           Medium High Risk

Low Grade Corporate Bond     13 to 18            High Risk – Sometimes includes junk bonds
Initial Public Offering                14 to 22            High Risk – Most never live up to expectations

Subject Company Stock            -?-                    High Risk – However, must be determined

The risk from a publicly traded stock market is a “discount rate,” which may be used directly in certain valuation methods, or adjusted and then utilized in other valuation methods.  The key is to match the direct rate or the adjusted rate to an appropriate valuation method.