The HBS Blog offers insight on Delaware corporations and LLCs as well as information about entrepreneurship, start-ups and general business topics.
There are various approaches to valuing companies. For privately-held companies that are established and generate income, normalized net operating cash flow is usually the starting point for valuation. All other qualitative issues related to the merits of a company, such as its market position, intellectual property, etc. can be factored in but the bottom line is that the more cash a company generates, the more it is worth. Business owners should understand that cash flow is not the same as the net income on your income statement. Normalized Net Operating Cash flow is derived by adjusting the income statement for certain items that are either non-cash related, or unusual or discretionary. This process of adjusting is called “recasting”. It takes an experienced analyst to do this correctly.
Normalized Operating Cash Flow: Normalized operating cash flow is the cash flow that can be expected of the company under “normal” circumstances. It excludes unusual and discretionary expenses, as well as non-cash items.
Adjusting the Income Statement: To calculate normalized operating cash flow, start with net income from the income statement. Then add back non-cash expenses such as depreciation and amortization, and discretionary items like interest (how a company is financed is a discretionary decision), charitable gifts, personal expenses, and rent that is greater than fair market rates. Non-recurring expenses such as a company move or unusual repair may also be added back. Adjustments can also be made for gains or losses on sales of assets and income or expenses not related to the operation of the business such as interest income.
Adjusting for Owners’ Compensation: Often owners compensate themselves more or less than “fair market compensation for owners’ work”, which is what the owner could expect to pay someone hired to perform the owner’s duties. The way to adjust for this is to add back the actual owners’ compensation, and subtract the fair market owners’ compensation.
Discretionary Cash Flow and EBITDA: After adding back the actual owners’ compensation (including other perquisites such as auto expenses, insurance, etc.) and the other adjustments mentioned above, the resulting figure is called Discretionary Cash Flow (DCF). It is one cash flow measure used in appraisals. After subtracting fair market owners’ compensation from the Discretionary Cash Flow, the second cash flow figure derived is Earnings Before Interest Taxes Depreciation and Amortization (EBITDA). EBITDA represents the normalized operating cash flow that can be expected from the business. By making these adjustments, companies can be using consistent measures of cash flow, whether it’s DCF or EBITDA.
Keeping Track of Expenses: Of course, this is all possible only if you have the ability to find all the adjustments to make. Some of them are automatic line items in most accounting systems, such as amortization, depreciation, and interest. Others, such as officers’ compensation, are available in others. Some may not be separately identifiable in any accounting system and must be tracked by either creating special accounts in your accounting system or by a manual method. Keeping track of your personal expenses in the company, as well as unusual or discretionary items, may be a worthwhile effort as it will help you enhance the value of your business in the long run.
After recasting the income statement with all adjustments to net income, the resulting normalized operating cash flow may be evaluated to determine the company’s worth. Companies with low net income but high debt service, equipment depreciation or other expenses may actually be worth more than they initially appear.
I get a kick out of seeing how people respond to various stressful circumstances. Not to be mean, mind you, but simply how they choose to confront a threat or a dilemma, or how they handle a tricky negotiation. Most people are rational and so there aren’t too many surprises. When rational meets irrational, or when irrational meets irrational, the ensuing conflict can be hilarious or horrifying. Most of the time though, it is just a matter of wondering who will do what next.
On a grand scale, this is known as the study of the conflict of strategy. It's mathematical sister is game theory; the stuff that A Beautiful Mind's John Nash won the 1994 Nobel in Economics for his work. Conflict strategy is about human behavior, bargaining and negotiation. In 1960, Thomas C. Schelling wrote The Strategy of Conflict: the book that practically became a handbook for diplomats and was routinely prescribed as a textbook for Political Science majors. Schelling was the 2005 Nobel Laureate in Economics. Although this book was intended to theorize international politics during the Cold War, the principles are as true as ever, and by reducing the players down to an individual or group level, Schelling makes large concepts fairly easy to comprehend.
I bring this book to your attention for its thorough and thoughtful analysis of negotiation and bargaining. Schelling's discussion about these is some of the most interesting theory reading I've ever done. Some of the scenarios include: How does one person make another person believe something? How does one convince someone else that they are not willing to pay more, or accept less, than stated? What are the costs of a stalemate? Might burning your bridges be in your best interest? What strategic role can communication play when bargaining? Should I get somebody to negotiate for me? These scenarios are paraphrased just to give you the gist; they are rather complex, but well and intriguingly presented.
The last third of the book is directed more towards international politics and is a real playground for international relations junkies like myself. Some topics covered here are: Reciprocal Fear of Surprise Attack; Surprise Attack and Disarmament; Nuclear Weapons and Limited War. As large as these topics are, Schelling brings it down to a scale that is workable and applicable to many business situations. And that scalability, that ability to examine, analyze and disseminate the theory of the strategy of conflict are some of the major reasons that this book is so useful. The discussion of the theory provides for the analysis of both sides of a conflict and makes us aware that sometimes our greatest opponent may be ourselves.
If you got anything out of Sun Tzu's Art of War, or Nicolo Machiavelli's The Prince, you will come away from The Strategy of Conflict with a much deeper and thorough understanding of human behavior.
Let me start with full disclosure: This post is being written on a MacBook linked to a large Apple cinema display screen. This MacBook is the latest in a string of Apple computers I’ve owned over the last decade and a half. I also own an iPod and that little miracle, the iPhone. In fact, I have been using Apple products for so long that the other day, when writing a document on a PC using the Windows version of Word, I could not remember the keystrokes necessary to save the file.
While I am a fan of the elegant, intuitive, state-of-the-art products, I do not drink the corporate Kool-Aid; I have reservations about some of Apple’s anti-competitive corporate practices, and I am not a member of the Steve Jobs Cult of Personality, although I’m happy to acknowledge that he is clearly a brilliant and imaginative innovator.
What I am about to write may have Apple addicts shunning me the way the Amish community treats an apostate, but as a journalist and a media trainer, I have to say it: I can think of no better parallel to Apple’s opaque and evasive handling of the Steve Jobs health issue than the North Korean government’s communications about Kim Jong-Il’s August 2008 stroke.
While the “Great Leader” was being worked on by teams of Chinese doctors, the North Korean propaganda apparatus denied he had any health issues. Months passed before Kim made any public appearances at all. His most extensive (and totally controlled) exposure to the captive North Korean media came on April 5, nearly 8 months after the stroke, when he attended the launch of a multi-stage rocket that crashed into the Pacific instead of achieving its announced goal of placing a satellite in orbit. (This parallel can be taken too far. Apple has acknowledged its CEO’s health problems--to a degree--while North Korea continues to deny Kim had any health issues. In our free and open society, Apple is subject to criticism, even unfounded and baseless criticism like the witless, pointless online screed the New York Times published about the iPhone, while the North Korean media is so totally controlled, it broadcast patriotic music and claimed it was “beamed from space” by the satellite it failed to launch.)
While Apple generally enjoys glowing praise for its products (well-deserved in my opinion), the company’s media relations are aggressive and controlling. It has sued bloggers who have had the temerity to report on Apple’s future product plans -- threatening to take one of them all the way to the Supreme Court. At the same time it gains great traction by having its products in movies. Former Vice President Al Gore, a member of the Apple board of directors, ran his slideshow from an Apple laptop in the Oscar-winning documentary, “An Inconvenient Truth.” Apple products also show up on popular TV shows. The psychologist on HBO’s “In Treatment” uses a MacBook Pro; the widow of a 9/11 firefighter on “Rescue Me” accuses a teenager of stealing her iPhone; everyone on NBC’s “30 Rock” uses Apple computers and Tina Fey’s iPhone had a pivotal role in one plot turn -- she left it in a cab and the driver held it for ransom because there was a nude picture of her in its photo library. In these media appearances, Apple products define cool and cutting-edge. Scientists and artists love Apple’s computers. I do a lot of media training for NASA and when workshop participants haul their laptops out of their briefcases, MacBooks generally outnumber PCs by a ratio of four-to-one.
Now on to the CEO: Jobs, one of Apple’s founding fathers, was forced out of his own company in 1985. This was akin to the Continental Congress forcing George Washington from the Presidency. Jobs spent 11 years in the wilderness -- well, hardly the wilderness; he did start Pixar animation and NeXT computers. The Jobs legend has it that during his absence Apple nose-dived, but the real story is more nuanced. During those years Apple introduced the Powerbook, its first, groundbreaking laptop. It also brought out color computers, upgraded its operating system and adopted the RISC chip (Reduced Instruction Set Computing), a high-performance processor developed jointly by IBM, Motorola and Apple that gave Apple Power Macs impressive processing speed. Management also made a series of bad business decisions, yielding ever-increasing margins of the computer business to PC-based machines. Jobs returned in 1996 and under his guidance -- actually, under his vision -- the company enjoyed a sustained spurt of creativity and innovation, increased its market share and become quite profitable. It is no exaggeration to say that every other company in the computer and mobile phone business is playing catch-up. One indicator of that prodigious success: the announcement in April that iPhone customers had downloaded one billion applications from Apple’s Apps Store.
Since Jobs was seen as the Apple’s savior, it was a shock to investors when, in 2004, he underwent surgery to remove a cancerous growth from his pancreas. Before the surgery, Jobs tried several months of holistic treatment, but during that period no announcement was made about the cancer. Because the Jobs cult of personality had led the public--and stockholders--to think Jobs was Apple Computer, the stock price is tied tightly to his continued run as CEO.
During 2008, Jobs, a vegetarian who was never particularly chubby, lost 30 pounds, giving rise to rumors that his pancreatic cancer had returned. For months, the company vehemently denied that he was seriously ill. Then Jobs cancelled his keynote address at the MacWorld conference in San Francisco. Initially, Apple claimed there was no new product big enough to warrant his appearance; then the story changed and Apple said Jobs was suffering a hormonal imbalance.
If this statement was supposed to quiet investor concerns about his cancer, it is likely Apple’s publicists slept through high school biology, missing the lesson about how the pancreas makes hormones, including insulin. Insulin regulates metabolism and an insulin imbalance can result in radical weight change. If someone who has had cancer of the pancreas has a hormonal imbalance, alarm bells should ring. At very least journalists should ask which hormone or hormones were out of balance. Business reporters appear to have slept through high school biology, too, and that vital question was either unasked or, if asked, unanswered. Very few stories on Jobs’ health made the direct connection between the pancreas, insulin and weight change.
Shortly after Jobs’’ non-appearance at MacWorld, there came an even more stunning announcement. Posting an online message, Jobs wrote the “hormonal imbalance” was “more complex” than first thought and he would take a six-month leave of absence from the company to concentrate on battling the problem. The company said Jobs would be actively involved in new product development during that time. That announcement resulted in an immediate seven percent plunge in Apple’s stock price.
Apple’s often contradictory and opaque handling of Jobs’ health issues finally forced journalists to do real reporting. Some of them actually read last week’s Apple Q-10 filing with the SEC, instead of just reprinting the company’s press release. Their big discovery? Apple had paid Jobs nothing in the first quarter of 2009 for use of his Gulfsteam V jet and only $4,000 for corporate travel on the plane in the last quarter of 2008. Compare that to $891,000 the firm paid him for the jet in Apple’s last corporate year. Business reporters took this to be an indication of how complete the leave of absence was and how uninvolved Jobs was with the company during the quarter. (Apple’s press release about the filing contains no reference whatsoever to Jobs.)
Which brings us to today -- Is there light at the end of the tunnel? I dusted off my old reporter’s hat and read the same 10-Q filing. In it Apple lists risks to its business plans. One of the risks: “Much of the company’s future success depends on the continued service and availability of skilled personnel, including its CEO, its executive team and key employees in technical, marketing and staff positions... The company’s CEO has taken a medical leave of absence until the end of June and has been involved in major strategic decisions during his leave. There can be no assurance that the company will continue to successfully retain key personnel.”
During an April 22 earnings conference call, Apple CFO Peter Oppenheimer was asked if Jobs would be returning at the end of June. His answer, opaque as always, is more instructive for what he didn’t say than what he did say: “We look forward to Steve returning to Apple at the end of June.” Anyone see the word “yes” in that answer? I thought not.
Minority Interests are Worth Less Than Control Interests. It is simply a fact that minority interests in closely held companies are worth less, pro rata, than control interests. Minority interests are usually considered to be 50% or less. In appraisal terms this is the difference between Fair Value, and Fair Market Value. To illustrate the point, what would, say, a 10% interest in a closely held C-corporation be worth if the owner decided to try to sell it to a public buyer? The appropriate value would be Fair Market Value. The answer: not much. It likely pays no dividend. The only chance to recover the principal investment is upon sale of the entire company, and the minority shareholder likely has no control in that regard. Therefore the Fair Market Value of the minority interest would reflect a fairly deep discount from Fair Value – perhaps as high as an 85% discount depending on the circumstances. The size of the discount is dependent upon the impairments to control of marketability contained in bylaws, shareholder’s/partnership agreements, buy-sell agreements, etc.
This fact can be used to advantage to reduce taxes in gifts or transfers of interests as a part of estate planning. However these discounted values must be supported by a qualified appraisal.
What Recent Court Cases Have Shown: Cases brought to the Tax court in recent years have shed light on the relatively obscure subject of discounted values caused by reduced marketability and control for minority interests.
Prior to these cases, appraisers typically treated valuation of such discounts as a minor adjunct to the valuation of the basic (majority interest) position. Many either used “industry standards” for marketability discounts of, say, 35% without support, or they attempted to support these values with statistics from studies of restricted stock of public companies. The courts have rejected such valuations in closely held securities, and laid down some principles which, if adhered to in appraisals, should significantly limit the chances of litigation and in many cases, significantly increase the defensible size of the discount.
Full Analysis Required. Though the appropriateness of applying minority discounts has been universally accepted by the IRS and the courts, recent court decisions have shown a fair amount of disagreement over the means of quantifying them. IRS Revenue Ruling 77-287 deals with marketability discounts for “restricted securities,” but it is silent on “exempted securities,” which make up the vast majority of privately held securities.) The cases indicate a complete analysis is required to effectively defend the discount! The cases also clearly indicate that reliance on data from public company transactions is not appropriate for closely held, exempt, non-registered securities. (stocks, partnership interests, LPs, and LLCs are all securities under the law.)
Lack of Control Discounts, for small privately held companies are magnified in comparison with publicly held companies for a simple reason – in privately held companies the only practicable way to recover the investment is liquidation (sale) of the company. Without control, an investor does not have the right to exercise this option. Thus minority interests in closely held companies are very difficult to sell. In practice, appraisers have attempted to base discounts for lack of control on control premium studies of public companies. The two are not the same at all.
The case of Mandelbaum v. Commissioner, T.C.M 1995-255 sets forth basic factors which might comprise the discount, but this list was not exclusive, and other factors may apply and be considered as the situation dictates. It states that a complete analysis must be done which is relevant to the subject. In principle, the analysis must address all relevant factors. It includes but is not limited to issues such as private vs. public sales of stock, dividend policy, economic outlook, management, control issues and policies, voting rights, restrictions on transfer, redemption or “put” policy, etc.
Control Discounts as Applied to Family Members Owning Shares. IRS Revenue Ruling 93-12 holds that a minority discount will not be disallowed (emphasis added) solely because a transferred interest, when aggregated with interest held by family members, would be part of a controlling interest.
Conclusion: The courts have indicated that the appraiser must conduct a complete, defensible analysis of the applicable issues upon which to base his decision.
More Information. A white paper which provides more detail on minority and control discounts including court case references can be accessed at:
One thing everybody seems to have figured out by the time they call us is the name of their company. They may not know what type of entity they’ll form or where they’ll get the money to do it, but one thing they always know is the name of the company. Now, you may think you have the greatest name for the most spectacular notion ever contemplated in the history of the world, but here are some things you may want to consider before naming your new Delaware company:
1. The start will lead you to the end. What I mean is, start with the foundation of it all, the type of entity, and figure out whether you are going to form a Corporation or an LLC. Many states, including Delaware, will require an entity specific word, or words, to appear on the end, or within, the company name. Below are the acceptable endings in Delaware for Corporations and LLCs:
• Corporation endings - association, club, company, corporation, foundation, fund, incorporated, institute, limited, society, syndicate, and union. A name may include abbreviations, with or without punctuation, such as, Inc., Co., Corp., and Ltd.
• LLC endings -Limited Liability Company, LLC, and L.L.C.
2. Don’t red flag me!!! Be careful not to include a word that is restricted by the State. Though Delaware is one of the more lenient states when it comes to naming your company, it does place some restrictions on the use of particular words.
• Corporations may not use the words bank, university or college, without being subject to additional scrutiny by those respective Delaware State departments. Also, corporations may not include the word trust.
• LLCs, like corporations, may not use bank, university or college with the additional scrutiny; however, unlike the corporation the LLC may use the word trust. Also, an LLC name may not include Corporation, Corp., Incorporated or Inc.
3. Make sure the name’s available. There’s nothing worse than thinking you have all the details figured out only to find out that someone else beat you to it, so once you have the specifics of the name be sure to check its availability. Delaware requires that a name be distinguishable from any type of entity already on record. This means that two companies, regardless of entity type, may not have the same name unless given written consent by the previously formed entity, which almost never happens. To make sure your company name is available in Delaware, take advantage of Harvard Business Services free name check service, https://www.delawareinc.com/name-check/
Remember, these rules and restrictions apply to Delaware so if you will be doing business in a state, or states, other than Delaware, be sure to check name availability and word restrictions in those states before forming your company.