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Three Factors Driving Value (and Risk) in Craft Breweries

craft beer flightThe Craft Beer industry is one of the fastest growing alcoholic beverage segments in the United States. According to IBISWorld the industry has experienced annualized revenue growth of 19.0% in the five years leading up to 2014, reaching an estimated $4.2 billion in 2014. Industry market research predicts that over the next five years the industry will grow by an annualized rate of 7.4%, reaching $6.0 billion by 2019. American consumers who might have traditionally preferred a light lager from a national brand are increasingly demanding pale ales, porters, saisons, and wheats – beers largely produced by local craft breweries. Consumers are attracted to industry’s products for their attention to detail, wide range of beer styles and overall freshness.

When determining the value of a craft brewery, the basic valuation approaches are the same as those we typically use for valuing operating companies, though the analysis should put additional weight on industry-specific factors including:

  • – Distribution Strategy
  • – Ownership Type
  • – Business Results by Style of Beer

Distribution Strategy

The distribution strategy is a key business driver. Whether selling in the taproom, self-distributing, or utilizing a third party distributor nationally or internationally, it is prudent to bear in mind the complex and evolving laws governing these strategies which may affect the company’s risk profile. Additionally, any plans for growth must consider where and to whom the beer will be sold. The proposed Craft Beverage Modernization and Tax Act may have positive implications for craft brewers who are distributing their products.

Ownership Type

Small businesses are often owned and operated by the same people; however, it is common in the craft brewing industry to have investors who back a brewer. These structures highlight what is typically called “key-man” risk.

What would happen to the company if the brew master or a key relationship manager were to become ill or voluntarily withdraw from the business? This factor affects the risk of the business.

Business Results by Style of Beer

There are many types of beer available for brewing (and drinking) and choosing which beers to focus on is a major business decision for the craft brewery.

Beer styles are all over the map and consumers’ tastes are constantly evolving. The types of beers brewed have wide sweeping impacts on the business. Ingredients have varying costs and different styles are popular with different consumers at different times.

Currently, for example, there is a hop shortage which is increasing the cost of certain hop varieties. This represents a problem when the IPA, a beer known for its “hoppiness” represents 27.4% of the total craft beer consumption in the States.

 

 

 

 

 

 

 

 

 

Understanding which beers are most popular or most profitable is a big part of the financial analysis portion of the business valuation.

Quist Valuation works with businesses in a variety of industries. We see many similarities across diverse businesses. However, we also know that risks value drivers can be unique to specialized industries like the craft brewing industry. We attend dozens of specialized training events and webinars to ensure that our team knows the factors that drive your business valuation.

When valuing interests in holding companies, appraisers typically incorporate the asset-based approach. The asset-based approach considers the value of the subject company’s assets and liabilities in order to arrive at the value of equity. The net asset value (“NAV”) method is one method under the asset-based approach where the appraiser determines the fair market value of each asset on the company’s balance sheet as well as any intangible assets that may not be listed. The resulting total fair market value of the company’s total asset base is reduced by the fair market value of its liabilities. The resulting value is considered to be the fair market value of the company’s total equity. Because an investor would need to force the sale of all assets in order to achieve this level of value, the NAV method is considered to be on a control (can force sale) marketable (can achieve the fair market value of the assets upon sale) level of value. This is in contrast to a liquidation value or “fire sale” value where all assets are liquidated as quickly as possible for whatever price might be achieved.

When valuing controlling interests, the NAV method is an insightful look at what it would take to recreate the owner’s position. If an investor could purchase all of the same assets, she may be able to replicate the subject business. However, it is challenging to apply the NAV method to minority interests. A minority interest holder cannot force the company to sell its assets. Further, even if the asset is sold, the minority interest holder cannot compel the company to distribute the proceeds from that sale to the shareholders. These hurdles prevent the minority interest holder from accessing any value that the underlying assets may represent.

In order to account for the risks of the minority interest holder, discounts for lack of control (DLOC) and discounts for lack of marketability (DLOM) are typically applied to the NAV derived under the asset-based approach. Using closed-end mutual funds (CEFs) and registered limited partnerships (RELPs), the appraiser can determine an appropriate DLOC. Various methods such as Restricted Stock Studies or a Mandelbaum factor analysis are then employed to estimate the DLOM.

The problem with the NAV method in minority interest valuations is that the DLOC and DLOM are not observable. An appraiser can make informed estimates of the discounts required to provide fair returns to shareholders; however, moving from the control, marketable indication to a non-marketable, minority indication requires the appraiser’s judgement.

Solution 1 – Market Approach

One way to address the problems with the DLOC is to consider the market approach. The Guideline Transaction method under the market approach considers the prices paid by investors to acquire interests in similar companies.

The Guideline Transaction method uses the same CEF and RELP information as utilized in the NAV method to calculate pricing multiples. The derived price-to-NAV multiples reflect the amount that investors paid to acquire minority interests in similar companies, relative to their NAVs. Using this pricing data, the appraiser can select an appropriate price-to-NAV multiple that applies to the subject interest. The resulting indication of value is on a marketable, minority basis.

While both the NAV method and Guideline Transaction method utilize the same CEF and RELP data, changing the presentation allows Quist to better defend the implied DLOC against the IRS for the simple reason that the Guideline Transaction method concludes on a marketable, minority basis and arguments that need to be made when utilizing the NAV method in regards to the degree in which minority interest holders have the ability or lack of ability to liquidate the underlying assets of the entity, to influence management, and to determine the timing and amount of distributions is moot.

Solution 2 – Income Approach

In order to bolster the conclusions of the asset-based and market approaches, Quist considers the benefits that the minority investor receives from holding the investment. The benefits of ownership are based on what an investor will receive and when they will receive it. Under the income approach, the discounted cash flow method (“DCF”) discounts a series of future income streams based on a multi-period forecast. The cash flows for holding companies are typically low and the timing of any dispositions is typically unknown. We can view various scenarios under the DCF method (perpetual, 5-year and 10-year holding periods, to name a few) to determine whether the investor will earn an appropriate internal rate of return. The indication of value resulting from the DCF analysis is based on the present value of the benefits received by the minority shareholder. Therefore, the resulting indication of value is on a marketable, minority basis.

Reconciliation

After considering the three approaches to valuation – asset-based, market and income – Quist will consider the merits of the approaches and conclude on a weighted indication of value on a marketable, minority basis. However, further adjustment needs to be made for minority interests in private holding companies because the shares are not freely traded.

Applying and Defending the DLOM

Various methods for estimating the DLOM have been used. Typically, the appraiser looks at studies of observable discounts and makes qualitative and quantitative comparisons to the subject interest. Based on a number of factors, the appraiser uses judgement to select the appropriate DLOM.

What is often missing from the traditional DLOM analysis is a test of its applicability to the subject interest. A benefit of the DCF method is that it can be a tool for performing a test of the DLOM. Applying a DLOM reduces the price an investor would pay for the minority interest. Using this lower purchase price and the cash flows determined in the DCF analysis, we can calculate the internal rate of return (“IRR”) of the investment. Comparing the IRR before and after the application of the DLOM illustrates the increase in rate of return that the subject investor would receive on the non-marketable investment. This increase can be compared to other studies which further defend our clients from IRS challenges. With these alternative valuation methods, we, at Quist, are armed and ready to defend DLOC and DLOM discounts.

Quist is on the forefront of integrating these alternative valuation methods when valuing holding companies. The industry is at a tipping point and moving away from what is “traditional” and familiar to these alternative valuation methods that consider specific attributes such as distributions, leverage, historical performance and liquidation horizon. Since the asset-based approach does not quantify future benefits or income generating ability, it is important to consider these alternative valuation methods. Being able to quantify the DLOC and DLOM through the lens of what a hypothetical investor would require in additional return on investment for the risk being borne is a valuable tool in defending our clients from IRS challenges.

Brand ValueI was recently asked by a prospective client to discuss how Quist Valuation thinks about brand in a valuation engagement:

  1. What are the dimensions of brand value?
  2. How do we consider the stages of brand development?
  3. What approaches are used to measure brand value?

A company’s “brand” encompasses a variety of concepts: it is your trademark, your trade name, the quality of your product, your technology, your reputation. A brand consists of more than a bundle of tangible, functional attributes; its intangible, emotional benefits, along with its “identity,” frequently serve as the basis for long-term competitive differentiation and sustained loyalty. How you manage those brands is an essential piece of building value for your organization.

Brands are far too important to be left to brand people and marketers. It is the responsibility of the CEO to nurture the brand.” – David J. Haines, Chairman of Grohe, the leading global provider for sanitary fittings.

Brand value is important in many of the businesses we work with. Identifying and quantifying intangible assets driven by brand value are the purpose in many of our valuation assignments. In fact, approximately 20 percent of our work is for Purchase Price Allocations (PPAs) – projects that quantify the portion of the price paid for a target company that relates to trade names/trademarks, customers, technology, employees, and hard assets. Even when the allocation of tangible and intangible assets is not the objective, the strength of a company’s brand value is critical for determining the reasonableness of 1) growth rates (i.e. strong brand value helps penetrate new markets and maintain current sales); 2) margins (i.e. strong brand improves the value of the product and results in greater pricing power); and 3) risk (i.e. strong brand value can increase switching costs for customers or facilitate the expansion of product offerings).

We have extensive experience with brand value in the food products industry. Our clients have included national and international producers of health food products, bread, coffee, cheese and beer. Some of these companies held portfolios of localized brands while others have international recognition. One area of the food industry that has seen significant growth and a run up in valuation in recent years is the natural and organic food sector. We are fortunate to be headquartered in Boulder, Colorado a hub for the natural foods industry. While the natural and organic foods segment still makes up a small percentage of the overall food industry, it has become an ever-increasing crowded market where competitors can make unsupported claims about food safety, nutrition and health. As such, building trust with the consumer is an important factor in growing brand value. This uncertain landscape is a benefit to participants that can establish and communicate value through their trademarks, trade names and packaging. Nutritional education and the messaging of a company’s vision and mission communicated through social media are important drivers of growing brand awareness.

Obviously, branding is not limited to food products. It is a key part of any business that sells a product that can be confused with its competitors. A company can leverage its brand to show many attributes including: longevity, reliability, quality and value. In many cases, the strong performance of a single branded product allows the company to market related products. We have seen this strategy play out in many industries including ski and cycling clothing, western-wear clothing and sports clothing technology. Beyond traditional consumer brands, brand value is used to sell tools, equipment and specialty chemicals.

There are generally three ways to determine the value of a brand:

  1. Assess the cost to build and replace the brand;
  2. Assess the cost to buy the brand; and
  3. Assess the additional profit earned by using the brand.

For brand value, the second and third methods are generally preferred. We have a database of licenses that we query for license agreements related to similar products. These arm’s length agreements allow us to determine what rate a participant will pay to use the trademark or trade name associated with a brand. We can also determine how the business is improved by the brand by considering the profit margin earned with the brand compared to industry profit margins. In practice, the consideration of brand value also manifests in the selection of a comparable market multiple to apply to the company and in the determination of an appropriate discount rate to apply to the company’s projected cash flow streams.

Brand is an essential piece of determining a company’s overall Strategic Value. Here at Quist Valuation, we look at five main drivers to business value: 1) Financial Value; 2) Strategic Value; 3) Organizational Value; 4) Customer Value; and 5) Employee Value.

Strategic Value considers industry dynamics such as barriers to entry, capital intensity, industry concentration, regulatory environment, and industry life-cycle. It takes into account an entity’s competitive position and brand recognition, and it measures an entity’s growth opportunities and how it responds to external factors. A well thought out and written business plan that includes a company’s brand strategy can really add to the strategic value of a company. The ability to clearly articulate a company’s vision and cause increases its value proposition to the consumer. With these strong messages, stronger pricing power, brand loyalty, and higher switching costs can drive revenue growth, profit margins and reduce risk.

One of the most common issues we see in the registered investment advisory world is the discrepancy in understanding the different levels of value and how they coincide with various valuation approaches. For example, a controlling shareholder that is selling the business to a single controlling buyer faces an entirely different set of valuation metrics than an employee buying a 10% stake. In fact, where most mistakes with valuation methodology and logic occur are in simply matching valuation methodologies with the transaction.

Take the simple example of two identical RIAs with $300 million AUM. A single owner owns one and the other has four equal owners. Does the sum of the value of the four individual owner’s interests equal the value of the 100% owner? Conceptually, it seems obvious that if you were going to sell the firm then it doesnʼt matter how many owners there are; however, if you are going to sell 25% of the firm then the other ownership matters a great deal. The reason for the difference being that the 25% owner just simply doesnʼt hold the same power to influence management, pay dividends, approve a material long-term lease, or approve/block a merger agreement. As such, the cash flows potentially available to this 25% owner might be severely restricted.

So imagine buying into an investment advisory firm and owning a 25% interest. The founder, who has been running the firm like his own personal checkbook, owns the remaining 75%. He shows you the profits that the company can generate or even profits they generated in the prior year of $400k. However, after you buy-in, he starts compensating himself at double the rate as before and taking bonuses, joins a country club, and leases a new car through the company. Now the $400k in profits is $100k, and he decides to reinvest the profits back into the company’s growth. As you can quickly see, the value of your interest is nowhere near the same pro rata share as is his. This is why value is rarely a single point estimate but rather will work up and down a continuum based on the rights of the buyers and sellers.

If you want to maximize the value of your interest, whether you are a controlling shareholder or a minority shareholder, then simply negotiate to protect your rights and preferences. Items like rights of first refusal, buy/sell agreements, restrictive covenants, and liquidation preferences all enable minority shareholders to protect themselves. Now, the difficult part is often matching the valuation methodology to the level of rights held.

So, if you have some aspects of control and no ability to sell your shares, your interest is worth one value; however, that same interest might be worth a whole lot more to you if you could sell at anytime to anyone. Navigating these waters is why simply applying a market multiple ensures one outcome, a winner and a loser – you just wonʼt know which one you are until its too late.