Improved Approach to Company Size Premiums
In an article in The Value Examiner, David H. Goodman addresses company-specific risk. Risk-premiums compensating for company-size have a long history in valuation and are widely used. They also have an equally long history of drawing criticism. The author introduces a novel approach to better substantiate this premium.
Background
Most valuations cover small businesses. Annual revenues of less than 3 million USD are common. However, the parameters for these valuations mainly come from the profitability data of large public companies. This raises comparability concerns, as small companies differ from larger listed companies. Substantially. Especially management capabilities are vastly different and more dependent. Small firms often rely on a small set of key personnel.
Empirically, the Implied Private Company Pricing Line (“IPCPL”) illustrates this. It shows that risk and market return are inverse to the size of a business. This relationship is not linear. Notably, businesses below an annual revenue of 1 million USD typically show extremely high profitability. Accordingly, valuators nee to adjustment for this bias.
Mitigation Strategies
Valuators typically address this by adding a Company-Specific Risk-Premium (“CSRP”) on the profitability derived from the public peer companies. In practice, we use different methods. For example, it is possible using empirical data to run probability-weighted cash-flow simulations. However, no single method to obtain a CSRP can claim universal acceptance. Furthermore, these approaches still involve large degrees of professional judgement. Virtually all methods also were criticized by courts, because they do not sufficiently explain how the numerical value was calculated.
Proposed Hybrid Approach
Goodman proposes a hybrid model to calculate a more substantiated CSRP for small, closely held companies. The model uses a modified version of the Risk-Rate Component Model (RRCM”) in connection with the Multi-Attribute Utility Theory (“MAUT”). From the RRCM, it draws the principal framework of using a variety of risk-attribute categories with individual weights. From the MAUT, it uses the techniques to transform qualitative analyses into quantitative results. These can then feed into the RRCM-framework.
In the model he uses for illustration, 36 individual attributes contribute to company-specific risk. It obtains the input values – and their weighting factors – from a Monte-Carlo simulation with 2’000 iterations. His result was a CSRP of 5 to 7 percent; higher and narrower than the often-used rule-of-thumb of 3 to 6. The results are dependent of the specific model and the individual simulation run. While this approach still involves a large degree of professional judgement when identifying the risk factors. The author considers this an improvement in terms of the explanatory value.
Our Views and Thoughts
The question of choosing a CSRP also arises in a transfer pricing context. International restructurings typically involve the cross-border transfer of businesses and business lines. Accordingly, they require a valuation to determine an appropriate arm’s-length price that the recipient is supposed to pay. This faces difficulties on two sides: On the one hand, applicable standards require reliable input data. On the other hand, tax administrations increasingly employ qualified valuators that can verify data reliability.
Regarding the former, valuations for tax purposes involve a high need for verifiable input. Under the standard set by the OECD, the taxpayers must “find a reasonable estimate of an arm’s length outcome based on reliable information” (para. 1.13 OECD TPG). Consequently, the OECD also advises against “rules of thumb”. Currently used CSRP tend to fit in this category.
Regarding the latter, the tax administrations of many developed countries employ valuation experts for general tax purposes. With increasing professionalization in TP, this also impacts restructurings. For example, the US Internal Revenue Service employs qualified economists in its Advance-Pricing-Agreement Program. Similarly, Germany’s Federal Central Tax Office employs certified valuators for examining transfer prices.
Under these difficult circumstances, Goodman’s proposed approach opens an opportunity for more reliable transfer prices. His method makes the determination of a CSRP more transparent. This will be helpful in any discussion with TP examiners, either in advance or during a tax audit.
Sources
The article “A Hybrid Approach to Determining Company-Specific Risk” by Goodman was published in The Value Examiner of July/August 2022 on pages 19 through 23.