Author: David E. Consigli

In performing a business valuation, deciding whether to use the weighted average cost of capital (WAAC) or a build-up method depends on the circumstances. Both methods are appropriate in valuing a business. 

The WAAC represents the rate of return an investor expects that includes all investors, debt, and equity. It can be useful when the company has:

1. A Complex Capital Structure and you need to distinguish the different rates of returns for costs of equity and several types of debt.
2. Consideration of an acquisition and the buyer expects to pay off the debt and equity and refinance the entire debt and equity structure.
3. The objective is to value the equity of a business. The value of the Market Value of Invested Capital (value of debt and equity) is appropriate when a company is highly leveraged to understand the equity separate from the debt holders.
4. Capital Projects are situations where the WAAC can provide answers to what could be available to finance capital projects. This would be based on debt capacity.

The Build-Up Method is another way to estimate the cost of capital when valuing a privately held business. It is commonly used for small, privately held companies and involves “building up” various risk premiums of market rates of returns. The Build-Up Method is appropriate when.”

1. Small privately held companies where market data may not be readily available.
2. When there is no comparable market data to determine beta or market risk premiums.
3. Unique risk factors that can be accounted for in a more customized risk premium addition.
4. Early-stage companies that do not have stable capital structures.

Some common mistakes when calculating the WAAC and the Build Up Method

WAAC

1. Using the historical cost of debt instead of current market cost of debt. If a buyer is going to retire the debt and refinance, they will want to know what the current debt structure looks like.
2. Failing to account for the tax deductibility for the interest expense.
3. Using the average tax rate vs the marginal tax rate can lead to incorrect calculations.

Build-Up

1. Using a risk-free rate that does not match the time horizon, for instance, using a 20-year bond when the investment horizon is 10 years.
2. Using a general equity risk premium when more specific content is available. 
3. Over reliance on subjective information without justification.

The choice of how a discount rate and/or capitalization rate is going to be calculated can be a difficult decision, but choosing an experienced business valuation analyst will go a long way.

 1 -Cost of Capital, 5th Edition, Shannon Pratt, p 544

In the process of valuing a business, especially in divorce, the business owner often comments “but the business is not worth anything without me.” This could be true, however, in the context of a divorce, in equitable distribution states this statement is false for the following reasons.

First off, the business is valued on the premise of going concern. This is the assumption that the business is going to continue to operate into the near future and has no intention of liquidating or curtailing its business operations. 

Secondly, there is the concept of value to the holder, especially for small businesses. Value to holder is the concept of the value of the business to the business owner (the holder). For example, if a sole proprietor earns $50,000 more than what he/she would be paid for a salary on the open market, that $50,000, using a multiple of five, would have approximately $250,000 in value to that sole proprietor. Even if there is no market for his/her business, it has value to him/her.

Both the previous situations enable the non-owner spouse to participate in an asset division of the privately held business.

There could be other factors involved. 

Personal Goodwill vs. Practice/Enterprise Goodwill

In Massachusetts, Personal Goodwill is not a divisible asset in a divorce. It is important to distinguish between personal goodwill and practice or enterprise goodwill.

Personal goodwill is the value of the business that is attributable to the skills, reputation, relationships, and expertise of an individual, usually and owner, of the business. This portion of the value can not be transferred to another individual. The lack of transferability is the key concept. Business owners think that it is just because they have good relationships and expertise that they have personal goodwill. This is often not the case. A business valuation expert has good relationships and expertise but that does not mean other business valuation experts do not have the same skills and the relationships could be transitioned in an orderly way once they feel comfortable with the new expert. 

A good example of personal goodwill is dental practice. Certain patients use the practice because of a particular dentist and would follow the dentist wherever he/she would go. Other patients go to the practice because it is convenient for them and is in a convenient location.

Practice/Enterprise Goodwill is the intangible portion of the value of a business. It is the total value less the value of the tangible assets (equipment, furniture, etc.). It is created through the business’s relationship with customers, location, brand recognition. This goodwill is tied to the business itself and not a particular individual.

There are many aspects of the division of assets that must be considered when a private business is involved. An experienced business valuation expert can not only navigate through these concepts but help explain them in a way to help the litigation process move forward.

There are approximately thirteen states that have legalized recreational use of cannabis. There are an additional twenty-two states which have legalized cannabis for medical use. Since cannabis is still illegal federally, the challenges of valuing these entities is challenging. Here are ten factors that affect the value of a cannabis entity. 

1. Section 280E of the Internal Revenue Code-Section 280E was introduced in the U.S. tax code in 1982 when a business engaged in illegal drug trafficking attempted to deduct ordinary business expenses on a tax return. Under Section 280E any business engaged in illegal substances can only deduct the cost of goods sold and not ordinary business expenses. This means that expenses such as rent, utilities, wages that are not related to cost of goods sold. This results in a significant impact on profit margin.
2. Branding-Companies that have a strong position in the market on their brand will have higher valuations.
3. Consistent earnings-Companies that have strong and consistent earnings and revenues will be less risky and result in higher valuation. Strong forecasts of consistent revenues and earnings for start up entities will result in higher values.
4. Innovation-Companies that can adjust to customer demands and continue to adapt to customer demand and preferences will generate consistent customer satisfaction and will result in higher values.
5. Compliance-The cannabis industry is highly regulated. The companies that adhere to these regulations and compliance will result in higher values.
6. Geographic presence-Like many other businesses being in areas where demand is high and it is socially acceptable will be valuable for the business.
7. Collaboration-There are vendors, suppliers and consultants who are specialized in the cannabis industry. Working with these specialists allows the cannabis business to be more efficient and results in higher profits and value to the company.
8. Production and supply management-For companies that manufacture cannabis products, efficient production strategy and supply chain management are important for cost efficiencies and higher profits and value.
9. Public Perception-Investor sentiment including favorable industry outlook, media coverage and public support go a long way to adding value to a cannabis business.
10. Team-having a strong management team with experience and a strong track goes a long way to the value of the business.

Though the cannabis industry is ever growing, many of the factors that increase value are concepts that have been around a long time. The tax consequences of Section 280E make many of these concepts even more crucial to establishing a strong valuable business.

Cannabis companies can be valued differently for a variety of reasons, similar to companies in any other industry. Here are some factors that can influence the valuation of cannabis companies:

1. Market Position and Branding: Companies with a strong market position and well-established brands tend to have higher valuations. Brand recognition, customer loyalty, and a positive reputation can contribute significantly to a company’s value.
2. Revenue and Earnings: Financial performance is a crucial factor in determining a company’s value. Cannabis companies that demonstrate consistent revenue growth, profitability, and strong financial management are often valued more highly.
3. Regulatory Environment: The regulatory landscape for cannabis varies widely across regions and countries. Companies operating in areas with favorable and stable regulations may be more highly valued due to reduced risks and obstacles.
4. Product Diversity and Innovation: Companies with a diverse product portfolio and a focus on innovation may be valued higher. The ability to adapt to changing consumer preferences and introduce new and unique products can set a company apart in the competitive cannabis market.
5. Geographic Presence: The geographic scope of operations can impact valuation. Companies with a widespread presence in markets with high demand for cannabis products may be valued more than those confined to smaller or less lucrative regions.
6. Production Capacity and Supply Chain Management: Companies with efficient production capabilities and a well-managed supply chain may be valued higher. This is especially important in the cannabis industry, where cultivation, processing, and distribution efficiency can significantly affect costs and profits.
7. Partnerships and Mergers: Strategic partnerships, collaborations, or mergers can influence a company’s valuation. Aligning with established industry players, securing distribution agreements, or engaging in mergers and acquisitions can boost a company’s perceived value.
8. Market Sentiment: Public perception and investor sentiment play a role in the valuation of cannabis companies. Positive media coverage, public support, and a favorable industry outlook can contribute to higher valuations.
9. Legal and Compliance Factors: Companies that adhere to legal and regulatory requirements are likely to be more valued. A strong commitment to compliance and risk management can reduce legal uncertainties and contribute to a positive valuation.
10. Management Team: The expertise and experience of a company’s management team can influence its valuation. A strong leadership team with a successful track record can instill confidence in investors and stakeholders.

It’s important to note that the cannabis industry is still evolving, and factors influencing valuations can change rapidly as the regulatory environment, consumer preferences, and market dynamics evolve. Additionally, investor perceptions and market trends can also impact how cannabis companies are valued.

Section 280E is a provision in the United States Internal Revenue Code that specifically deals with the taxation of income derived from the trafficking of controlled substances. It was added to the tax code in 1982 as a response to a case involving a drug dealer who attempted to deduct ordinary business expenses on their federal income tax return.

Under Section 280E, businesses engaged in the illegal trafficking of controlled substances, as defined by the Controlled Substances Act, are not allowed to deduct normal business expenses, except for the cost of goods sold (COGS), when calculating their federal taxable income. This means that such businesses cannot take deductions for expenses like rent, utilities, wages, and other typical operating costs that are deductible for legal businesses.

While the provision was initially intended for illegal drug trafficking, it has had a significant impact on state-legalized marijuana businesses in recent years. Even though marijuana is legal for recreational or medicinal use in some states, it remains illegal at the federal level. As a result, marijuana businesses are subject to Section 280E, facing limitations on the deductions they can claim, which can significantly impact their overall tax liability.