New Sanity Check Model
Provides Independent Validation of Indicated Values
Newly-minted valuation analysts may question the reasonableness of their conclusion of value. That is natural. In this article, the author introduces readers to the Hypothetical Willing Buyer-Willing Seller Sanity Check Model. This is a model developed by the author in connection with valuation of a 100% controlling interest.
Are you new to valuation and feel unsure about whether your conclusions of value are reasonable, or are you a seasoned valuation analyst looking for a better set of rules of thumb?Â If you have doubts from time to time about whether your indicated values are realistic, there is a tool that has been developed that might provide you with some reassurance as to the reasonableness of your indicated values when conducting calculations of value, conclusions of value, or business planning engagements.
This Excel-based modeling tool called the Hypothetical Willing Buyer-Willing Seller Sanity Check was developed by Garth Tebay, CPA, CFA, and MAFF, over many years of valuation practice, based on information that has been requested from potential buyers and lenders.Â This sanity check model consists of nineteen tests which use benchmarks obtained from private capital market sources; primarily Pepperdine Universityâ€™s annual Private Capital Markets Report.Â The model helps valuation analysts to identify valuation variables which may lack quantitative support, considers the viewpoints of both buyers and sellers, and incorporates current credit and equity market data available to and known by prudent, well-informed buyers.Â The model also addresses concerns of sellers of small companies, including sale prices of similar companies, proceeds available to maintain lifestyle or invest, and subjective factors that may influence the decision to sell.
The model is designed to test the valuation analystâ€™s 100% controlling-interest, marketable indication of value.Â Inputs to the model include this indicated value; non-operating assets that would not be transferred with the subject entity; the sources of funding to pay for the indicated value and the uses of this funding; discount rate; historical and post-purchase balance sheets; income and cash flow projections; and several other singular variables.Â Outputs from the model include easy-to-read â€śPassâ€ť/â€śFailâ€ť summary results for all nineteen tests, grouped by tests of interest to the seller and tests of interest to the buyer, and calculations and explanations for each test.Â There are four tests of interest to sellers and fifteen tests of interest to buyers and other parties who provide funding for deals.Â The summary reports are appropriate for inclusion within the body of a valuation report, whereas the detailed calculations could be included in appendices.
Tests that address the interests of sellers include an industry market multiple test; a return on investment test; a test to estimate the number of years for which the deal sale proceeds will fund the sellerâ€™s lifestyle; and an eighteen-question qualitative factors test.Â Tests that address the interests of buyers, banks, and other sources of capital to fund deals include: a debt service coverage ratio; a collateral coverage ratio; a debt to equity ratio; current ratio, quick ratio, and two fixed-charge coverage ratios; an internal rate of return on equity ratio; three debt multiple ratios; an industry market multiple test; a debt to tangible net worth ratio; and a goodwill valuation test.Â The test values are calculated from the inputs provided by the valuation analyst and are compared to benchmarks that can be updated annually when the new Pepperdine Private Capital Markets Report is released.Â This report can be obtained from https://digitalcommons.pepperdine.edu/gsbm_pcm_pcmr/10/.Â These benchmarks are, in many cases, broken down by factors such as industry, EBITDA size, and loan size.Â The benchmarks are compiled by Pepperdine from surveys administered to banks, mezzanine capitalists, angel investors, venture capitalists, business brokers, and other private capital funding sources.
Some tests, such as the buyerâ€™s internal rate of return on equity ratio, the buyersâ€™s goodwill valuation test, almost never pass on the first try.Â When a test does not pass, the valuation analyst must analyze the reason for the testâ€™s failure.Â The analyst should, at this point, reconsider key variables within the original development work.Â Often, fixed-asset and other balance sheet fair market values, the level of debt financing used to fund the deal, or the analystâ€™s discount rate require reconsideration andÂ adjustment.Â Examples of changes to other variables used to derive the original indicated value that could be considered include the weights applied to indicated values, normalization adjustment values, and completed-transaction market multiples.Â Once these adjustments are made, the indicated value that is being subjected to testing will adjust along with the adjustments to the other variables.Â The valuation analyst should, however, avoid manipulating the sanity check modelâ€™s input variables without first making corresponding changes to the underlying valuation model.
After making changes to the valuation model, an analyst may still find that some of the sanity check modelâ€™s tests fail.Â It is not mandatory for every test to pass; however, for those that fail, the analyst must be able to justify and defend the failed tests.Â For example, the sellerâ€™s test return on investment defines â€śreturnâ€ť as the sellerâ€™s gain on the sale of the subject interest plus the distributions made by the subject interest to the seller over the time period in which the seller held the subject interest.Â If the seller received no distributions throughout the holding period of the subject interest, the â€śreturnâ€ť on the sellerâ€™s invested capital may be so low that the test fails.Â The analyst cannot change the fact that no distributions were ever made; thus, the failure of the sellerâ€™s return on investment test can be easily defended by the analyst.
By forcing an analyst to compare the 100% controlling-interest, marketable indicated value of subject interests to published, independent, and timely benchmarks, the Hypothetical Willing Buyer-Willing Seller Sanity Check Model provides the analyst with a defensible, relevant set of sanity check tests that add value to the analystâ€™s indicated values and valuation reports.
Jill R. Christopher, DBA, CPA, CVA, CFE, James F. Dicke Professor of Accounting, James F. Dicke College of Business, Ohio Northern University. Dr. Christopher holds an endowed chair in accounting. She teaches undergraduate courses in financial and managerial accounting, and masters-level courses in forensic accounting, including a business valuation course which features high-impact learning through live-client valuation engagements. Her prior business experience includes public accounting, private accounting, and a manufacturing controllership position.
Dr. Christopher can be contacted at email@example.com.
Garth M. Tebay CPA, CVA, MAFF, CMAA, Managing Director of Value Defined, LLC, a valuation and litigation support service company serving attorneys, CPAs and business owners. Value Defined provides business valuation services for closely held business for transactional, litigation, tax, and financial reporting purposes. Value Defined â€™s litigation support services include expert testimony and reports of economic damages for a wide range of causes. www.valuedefined.comÂ
Mr. Tebay can be contacted at (419) 865-4478 or by e-mail to firstname.lastname@example.org.