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How Minority Shareholders Can Protect Themselves
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If you are considering investing in a private firm, it s vital that you protect the value of your investment before you sign your contracts There are certain rights that will protect your investment They are: Limit the compensation to the control shareholder for management of the firm Otherwise, the control shareholder can render your stock worthless or close to it by sucking all the value out by paying him- or herself enough compensation to eliminate all or most of the net income Drag-along right of sale This is a right that gives the minority shareholder the right to sell at the same price as the control shareholder Otherwise, the latter can sell his or her stock, leaving the minority shareholder still illiquid Provide a mandatory buyout at Fair Market Value, assuming arm s length compensation to the control owner Make sure you have the right to register stock in the event of the company making an initial public offering (IPO) This is a right that would primarily come to play in the event of good news The first three items are to protect against disaster, while this one is intended to maximize your value for an exit via an IPO
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PART ONE Business Valuation
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This chapter has presented most of the conceptual groundwork in business valuation We covered: 1 How to define the valuation assignment, which involves: a Defining the business interest b Specifying the effective date of the valuation c Specifying the purpose(s) of the valuation d Specifying the standard of value 2 The levels of value a How to value control interests b How to value minority interests 3 How a prospective minority investor in a business can protect him or herself In the next chapter we will cover how to value a business as of a future date, and how to manage your business to maximize its value in the future
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Increasing the Value of Your Business
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To this point, we have examined how to value a business as of
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a current date Now we ll discuss what creates value Understanding the philosophy of value, you can manage your business to maximize the price for which you can sell it at some time in the future whether one year or 30 years from now Obviously, this chapter will be more useful to those who have more time to manage their businesses in order to maximize value before the sale, but it s still valuable for those with only one year to retirement and sale If you plan on selling or giving your business to your children, it is vital that both you and they understand the principles involved in increasing the value of your business For this reason, most readers should find this the most important chapter in this book
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Let s go back to Billabong Boomerangs and assume that economic net income last year was $1,190,476 Connie Billabong forecasts a Payout Ratio of 80 percent and constant growth in cash flows of 5 percent Forecast economic cash flow next year is $1,190,476 105 80% $1 million Referring to Table 61 in 6, for an assumed Fair Market Value of $5 million
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PART ONE Business Valuation
(A14), the discount rate would be 212 percent (B14), and the Gordon Model multiple (GMM) would be 68 (K14)1 We can calculate the FMV as $1 million 68 $68 million The calculated FMV is reasonably consistent with the assumed FMV, so we will stick with that as our valuation as of today Now let s ask what we think Billabong Boomerangs will be worth five years from now with the information we have today Assuming we are at time zero now, we have already forecast economic cash flows for Year One as $1 million Therefore, we need to roll forward our forecast to Year Six, since we want our valuation to be effective as of the end of Year Five even though our information about the firm is only current as of now, ie, time zero Assuming the 5 percent per year growth is correct, Connie should forecast economic cash flow in Year Six of $1,000,000 1055 $1,276,000 (rounded to the nearest thousand) The 276 percent increase in cash flow after five years will push up the valuation of the firm by at least that much In fact, it pushes it up a little more, since the valuation will be closer to $10 million (Table 61, A13) than $5 million (A14) Thus, the appropriate discount rate is lower, and the GMM is higher We use a GMM of 71 (K13) Our valuation as of the end of Year Five will be $1276 million 71 $90 million The compound annual growth rate ( compound growth, or CAGR) in Fair Market Value over the five years is 586 percent, which is higher than the 5 percent forecast growth in economic cash flows This means that $68 million 105865 $90 million The CAGR is higher than the forecast growth in economic cash flows because the growth of the company will put it in a new size category, which should give it additional stability and less risk hence the lower discount rate and the higher GMM
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