Introduction A solvency opinion, or a fraudulent conveyance letter, usually requires the skills of a business valuation specialist. Such an appraiser must be able to work with a real property appraiser and a machinery and equipment appraiser, as appropriate, to incorporate the underlying asset values into the current financial analysis as well as into pro forma spreadsheets reflecting the term of the debt. Comment While at the time of this writing the perceived requirement for such studies has lessened, particularly being not “in fashion”, the fundamental financial need for such studies remains regarding the collateral and repayment capability information provided. THE SOLVENCY OPINION Fulfilled needs of the user / reviewer are as follows: 1. Independent comfort concerning the transaction. 2. Information which cannot be developed internally by the user / reviewer. 3. Potential for passing liability to a third party (the appraiser / service provider). 4. Possible additional protection if sued, by demonstrating prudence and due diligence. Concerns of the service provider generally involve professional ethics, reliance upon another party for basic data, and liability / exposure. Through the completion of an analysis, the business valuation specialist will be able to offer the following observations concerning the successor firm: 1. The firm will remain solvent, or not be insolvent, for the seven year term of the loan. o Thereby meeting its trade obligations. o Thereby fulfilling debt service obligations. o Not having unreasonably small capital. o Not being deemed to have been transferred at less than reasonably equivalent value for the debt obligation incurred. o The present fair salable value of NEWCO is greater than its liabilities, including organization costs. 2. The firm will be able to meet the ratio requirements contained in the loan agreement. 3. The equity will not be eroded during the term of the debt. 4. The Fair Market Value of the business enterprise is X. 5. The Fair Market Value of the tangible assets is X. 6. The Fair Market Value of the intangible assets is X, as required dependent upon #5 above. In order to fulfill these service requirements, usually the business, fixed assets and intangible assets must be appraised on a line item basis. Working capital adequacy tests and debt burden capacity review are an integral element of completing such an analysis. Always remember, the basic theory of appraising is to consider the Cost, Sales (Market) Comparison, and Income Capitalization Approaches to value. Also, what is the present value of future benefits, expressed in terms of money. Valuation of a Business Enterprise There are three general approaches to valuing a business, which are: 1. Capitalization of indicated earnings at a reasonable return on investment based on relative risk and current interest rates. 2. Comparison with price earnings ratios of publicly traded companies in the same or a comparable industry or comparison of known traded equities for companies in the same or comparable business. 3. Appraisal of all underlying assets, tangible and intangible, with adjustment for existing liabilities. Capitalization of Income Stream This method requires analysis of the earning power of the company and conversion of the earning power into value. The earnings stream is related to the rates of return expected in the current money market for various types of investment with consideration given to expected rates of growth, risk, and the potential time lag until a reasonable level of profit can be obtained. In practice, the relation of earnings power to reasonable return and translation into value in usually accomplished by relating the rate of return expected to a corresponding multiple of net after tax income such as is represented by the price earnings ratio often discussed in analysis of stock exchange traded equities. The rate of return used has a reciprocal or inverse relationship to the multiple (the price earnings ratio) used in capitalizing the income stream. In a more comprehensive analysis, the ratios or multiples used for converting earnings to value may be related to other forms of the income stream. A useful approach in such a study is a cash flow analysis which will indicate the amounts available for dividends or reinvestment after obligations to trade creditors, banks, bond holders, and other creditors are met. This analysis may take the form of a future projection or cash flow which can be discounted back to present value through the use of present worth discount factors. The discount factor selected should be based on a reasonable rate of return for an investment with determined similar risk. The future projection of earnings or cash flow may also be averaged out to represent a reasonable return on investment. The difference in use between the discounting process and the straight capitalization process is mainly dependent on the assumed future life of the investment. If it appears that the operation can continue on for a long period as a profitable business, the capitalization procedure is appropriate. If the life of the operation is limited by contract or by economics, the discounting procedure including analysis of assets expected to remain at the termination of the period may be preferable. The residual assets, will in such a case, also be discounted to derive present value. This is a critical point of departure which links the appraiser, who most often uses cash flow as a fundamental basis for determining value, to determining solvency. Combining this thought with the appraiser’s usual analysis of the tangible and intangible underlying assets to sustain this cash flow and cover debt repayment, results in a professionally complete solvency analysis. Comparison with Sales of Similar Interests In this second approach a search is made for other enterprises which are comparable in size, growth characteristics, product line, market area, profitability, and financial condition. Where such business are found and where their common stock is publicly traded in an established market, the prices for which such shares are traded can help to form a basis for valuation. Two important factors affect the reliance upon the analysis in the comparative market approach: 1) degree of comparability between the companies, and 2) weight to be accorded the evidence developed through this method of valuation. These factors impose difficulties, but when comparative companies are found, shares for which market prices are not readily determinable can be valued based on the price earnings ratios of the comparable companies. This method is preferable to selecting a price earnings ratio (or earnings multiplier) based only on assessment of risk and judgment as to the requirement for return on investments. The capitalization factors used may be based on various forms of the income stream such as net income, pretax income, operating income or cash flow, and on income adjusted for interest expenses to give comparison on a debt free basis. Value of Underlying Assets A third approach to value, which is often neglected, yet which is particularly germane to the topic is an analysis and valuation of the underlying assets of a closely held corporation. This method can be important in a valuation of closely held corporate securities and it may act as a check on the two previously discussed methods. It attempts to find the cost of reproducing the business enterprise and impels the individual responsible for the valuation to attempt to identify each element of value in the business, including those which do not contribute to current earnings or profitability. Tangible assets which make up a business normally consists of such elements as inventories, current assets, land, buildings, plant construction, machinery, and all equipment related to the ordinary function of the operation. Intangible assets may consist of patents, licenses, leasehold interest, investments, personnel assemblage, management skills, know how, reputation, market position, copyrights, mineral rights, and any other element which provides the company with rights or advantages of an intangible nature. A knowledgeable individual should make a technical study of the assets to evaluate adequacy of the facilities for the operation. Any future capital outlay required to continue or expand business is extremely important as are physical properties with saleable value in the current market but which currently add nothing to operations or earnings, e.g. a large tract of recreation land being held as an investment. The financial condition or solvency of the company and the adequacy of working capital are pertinent considerations. As a review, business enterprise or capital stock valuation can utilize a variety of value indications. 1. Under the market approach, multiples may be selected based upon the stock market or the sale price of a similar business. These may include: o capitalization of after tax income, o capitalization of earnings before depreciation, interest and taxes less long term debt, o a multiple applied to revenue, and o a multiple applied to book value or book adjusted for difference between market and book on certain selected assets. 2. Approaches which arrive at value from estimation of future income benefits. o Discounted present worth of relevant cash flow. o A loan equity capitalization procedure. 3. The cost approach is usually not utilized in valuing the business, yet one can develop a cost to replace as a somewhat theoretical procedure. Valuation of Intangible Assets The sum of the normal working capital requirement and underlying tangible and intangible assets cannot exceed the business enterprise value, in a going concern. Notice the statement is qualified by saying “a going concern”. It is correct that break-up value of a single entity may result in additional value, analogously to the break-up value of a conglomerate. The fundamental concept in the valuation of intangible assets is that the actual value of the assets to the enterprise is the present value of future benefits of ownership. These benefits must be reduced to a stream of income or relief from payment that can be anticipated over a reasonable period of time and capitalized at a rate commensurate with the degree of uncertainty in forecasting the income. As an overview, the steps in appraising intangible assets are: • Search out and identify • Segregate the intangibles • Assign the proper income segments to each intangible • Capitalize this income to establish the present value A basic list of intangible assets are as follows: 1. Patents 2. Patent Applications 3. Unpatented Technology 4. Project Agreements 5. License Agreements 6. Processes 7. Formulations or Recipes 8. Trade Secrets 9. Technological Support Items 10. Catalogs 11. Training Courses 12. Computer Software 13. Management Information Systems 14. Data Banks and Libraries 15. Non-Compete and Employment Agreements 16. Distributorships 17. Sales Routes 18. Customer Lists, Mailing Lists, Subscription Lists 19. Copyrights 20. Agency and Regulatory Approvals 21. Leasehold Interests 22. Easements 23. Permits 24. Air Rights 25. Water Rights 26. Mineral Rights 27. Favorable Financing 28. Tax Loss Carry Forward 29. Contracts Implied or Written 30. Trademarks or Trade Names 31. Going Concern Value and Goodwill As an aside, certain categories of intangible assets have statutory lives, the economic life can be ascertained with “reasonable certainty” (key for tax amortization), while some have indeterminate lives. From a lending perspective, certain intangibles, e.g. patents, trade names, customer lists and licenses may have value separate from the business. Again remember, any appraiser must be prepared to answer the questions, were the Cost, Sales (Market) Comparison, and Income Capitalization Approaches to value considered, and what is the present value of the future benefits currently drawing income from the rights of ownership or use of the asset. Valuation of Tangible Assets The valuation of tangible assets usually is based upon a Fair Market Value determination of land, land improvements, buildings and structures, machinery and equipment, furniture and fixtures, utilities and specialty assets (dies, jugs, molds, etc.). Consideration is given to asset physical deterioration / depreciation, functional (technology and productive) obsolescence, and economic obsolescence. The study should consider excess assets or operating capacity, as well as possibly a highest and best use study of the real property. THE FRAUDULENT CONVEYANCE LETTER Below is a sample fraudulent conveyance letter. Generally, as a condition of closing, a financing transaction, after giving effect to the consummation of the financing transactions (New Financing) as disclosed to Southeast, that the Present Fair Salable Value of the assets of the Company exceeds its Stated and Identified Liabilities, and New Financing. Further, we have been requested to ascertain the Fair Market Value of the business enterprise. For the purpose of this report, the following terms are defined: 1. Present Fair Salable Value: The amount at which the assets of the Company, valued on an in use basis in their entirety, would exchange, within a reasonable period of time, between a willing buyer and a willing seller, each having reasonable knowledge of all relevant facts, with neither being under duress to buy or sell. Our opinion of Present Fair Salable Value is subject to the following conditions: o The aggregate assets of the Company are represented by the total business enterprise, and o The Operating Entity of the Company would be sold in the aggregate to a common buyer, but not under conditions of a forced liquidation, nor will the underlying assets of the Operating Entity be sold separately in a piecemeal disposition. 2. Stated Liabilities: The recorded liabilities of the Company. Such information has been provided to us by an officer of the Company responsible for financial and accounting matters. 3. New Financing: The indebtedness being incurred or guaranteed by the Company under borrowings from the Bank under the Credit Agreement. In expressing its opinions, Southeast has relied on information and analyses furnished by and/or discussions held with the Company, its counsel and investment banks, for which Southeast does not assume any responsibilities for the sufficiency and accuracy of the information, which Southeast has reviewed and which has been the subject of discussions and inquiry but not exhaustive examination. Such data has been accepted as reasonably reflecting the transaction, the Company’s financial condition and its past and future operations. An investigation was not made concerning any possible or potential contingent liabilities of the Company. All items generally considered subject to audit pursuant to generally accepted auditing standards and in conformity with generally accepted accounting principles have been relied upon without review, check or verification. Southeast has performed certain analyses, studies and investigations more fully described herein in support of its opinions. Our opinion is subject to the following assumptions and limitations: 1. The financing of the Transaction will be consummated pursuant to the terms and conditions described in the Financing Agreement, Financing Proposal and Letter of Intent. 2. From and after the date of the Acquisition, the Company’s business will be conducted, in all material respects, in the manner described in our discussions with management, and as reflected in the Memorandum and the Financial Projections. 3. The Financial Projections and Pro Forma Balance Sheet were reasonably prepared, reflecting the best available estimates and judgments of management at the time of preparation as to the Company’s future operating and financial performance. 4. The amounts and terms of the obligations of the Company, including stated liabilities and identified contingent liabilities, are assumed to be only those as set forth in the Financial Projections and the Pro Forma Balance Sheet of the Company. 5. Material changes in the industry or in market conditions which might affect the Company from and after the Acquisition date, and which are currently unforeseen, are not taken into account. Southeast has reviewed the unaudited, internal financial statements of the Company. Such areas of investigation have included: • An industry overview, • Inquiries as to the effect of future economic trends on the industry and the Company, • Business data, information and asset valuations made available to or prepared by Southeast, • Inquiry and discussion regarding various internal analyses, models and other data generated by the Company, and • Agreement (“Letter of Intent”). Southeast has, to the extent necessary, discussed Company financial and operating matters with management. This review included, but was not limited to, discussions of basic assumptions made in the preparation of the forecast relating to the type of business, geographic markets, capital facilities, and working capital requirements, among other factors. We have accepted the forecasts as prepared by the Company’s management and believe that the review we have conducted and the analyses and procedures we have undertaken are those generally considered appropriate for the purpose of expressing the opinions stated herein. Based upon the foregoing and such other matters as we consider relevant and subject to the foregoing qualifications, it is our opinion that, as of the date hereof and after giving effect to the financing to be incurred in connection with the acquisition: • The Present Fair Salable Value of the assets of the Company as set forth in the Recapitulation of Conclusions, exceed the total Stated Liabilities and New Financing by $X. • The Fair Market Value of the business enterprise is $X. This letter is solely for the information of and assistance to the parties to whom it is addressed in conducting their investigations with regard to those issues generally considered attendant to matters of fraudulent conveyance and tangible net worth in connection with the proposed Stock Purchase Agreement and the Credit Agreement. Any other uses are expressly prohibited and neither this letter nor any other of its parts may be circulated, quoted or otherwise referred to for any other purpose without the written consent of Southeast, the exercise of which will be at the sole discretion of Southeast not unreasonably withheld. If given, such consent shall not be without sufficient review by Southeast as to the precise language of such disclosure and the time and place of its potential release.