Valuation Perspective: Management Prepared Financial Statement Considerations
February 28, 2024

By Cavin Armour and Kevin Zanni

Whether a valuation analysis is prepared for litigation purposes, financial reporting purposes, or taxation related purposes, management prepared financial projections are an important value component.

We recently read and discussed the HBK Master Fund L.P., et.al., v. Pivotal Software, Inc. (“HBK”),[i] Delaware Court of Chancery (the “Court”) decision among our Miller Cooper analyst team. We found the HBK case matter to be of interest because the Court decided the fair value of Pivotal Software, Inc. related to a dissenting shareholder squeeze-out transaction. For the Court to arrive at the fair value per share price of Pivotal stock, it considered several valuation related concepts and provided insightful commentary. In the following paragraphs, we discuss certain income approach valuation analysis components presented in HBK.

Discounted Cash Flow Method

According to the International Glossary of Business Valuation Terms, the income approach is defined as “a general way of determining a value indication of a business, business ownership interest, security, or intangible asset by using one or more methods that convert anticipated economic benefits into a present single amount.” The income approach is considered to be the most widely recognized approach to estimating the value of a privately held business.

The income approach discounted cash flow (“DCF”) method is based on the principle that the value of a business is determined from the present value of the future economic income to be enjoyed by the business owners. The DCF method encompasses the following analytical components: revenue analysis, expense analysis, investment analysis, capital structure analysis, residual value analysis, and present value discount rate analysis (including an analysis of business risk).

The DCF method is based on management prepared financial projections of future earnings. To prepare a financial projection, company management should consider the reasonableness of financial projection components. It stands to reason that using reasonable financial projection components will result in a supportable financial projection.

Financial Statement Projection Components

Financial projections can be used for a variety of purposes. That is, financial projections can be used for internal benchmarking, for making and measuring management performance goals, for capital providers interested in projected business performance, for transaction related purposes that are used to evaluate the internal rate of return in a business combination, etc.

To prepare financial projections, management should consider how its projections compare with the current state of the business operations. Typical financial projection components considered by management to develop financial projections include the following:

  • Base year metrics—Assuming the latest 12-month period serves as the base year for comparison, how does management project changes in the business from the base year?
  • Revenue forecasts or revenue growth rates—Are projected growth rates consistent and supported based on historical performance?
  • Gross margins—How do gross profit margin projections compare with history?
  • EBITDA/EBIT margins—Are earnings profit margin projections consistent with history? If projections indicate an increase or decrease, do benchmarked industry/guideline publicly traded companies support an increase or suggest a decrease in profit margins?
  • Depreciation and amortization (book and tax)—Depending on the assignment, the projections may need to be adjusted from a GAAP basis to a tax basis.
  • Capital expenditures—Management must consider and project regular capital expenditures needed for maintenance purposes and those required to achieve its financial projection growth objectives.
  • Debt-free net working capital requirements—Net working capital projections must consider how management intends to manage its inventory and receivables. In other words, does management expect for net working capital to increase at the same rate as revenue or at different rate.

After the financial projection has been provided to the analyst, the analyst will consider if the projection is reasonable and supported. There are certain procedures that analysts may use, and company management should be aware of, that can help an analyst determine if the financial projections are reasonable and supported.

 Testing Reasonableness of Management Projections

As cited in HBK, “Delaware law clearly prefers [discounted cash flow] valuations based on contemporaneous[ly] prepared management projections because management ordinarily has the best first-hand knowledge of a company’s operations.”[ii] To that end, Delaware case law has provided the following guidance that courts often consider when determining the reasonableness of management prepared financial projections:[iii]

  • Are financial projections prepared outside of the ordinary course of business?
  • Does the management team regularly prepare long-term financial projections?
  • Were the projections prepared by management with a motive to alter the projection to protect their job?
  • Were projections prepared by management during the time when litigation was likely to occur and, therefore, could impact the neutrality of financial projection?
  • Were projections based on speculative or arbitrary assumptions that are not supported by the evidence?
  • Was there an internal process in which the board of directors reviewed management projections and provided comments or asked questions?

In HBK, the Court discussed how the process used by management to develop its management projections can impact the Court’s confidence in the financial projections. In other words, the process used by management to prepare financial projections is considered by the trier of fact to determine the reasonableness of financial projections. For example, the court may consider if the management projections are based on a bottom-up approach or a top-down approach. The bottom-up approach is often preferred, but this approach requires more rigorous procedures than does the top-down approach.

For example, in the bottom-up approach, the Company will combine individual revenue and profit center projections to prepare the Company’s consolidated financial projections. From the profit center perspective, financial projections are prepared based on current customer revenue projections combined with the expectation of new customers revenue contributions. Projected costs to service revenue are identified and projected with due consideration for the cost relationship with revenue, with inflation, or as a fixed cost that is not variable.

The top-down approach starts with aggregate assumptions regarding the entity and allocates those assumptions across the entity. In a top-down approach, the forecaster may project an overall entity growth rate without consideration of specific profit center contributions. In this manner, the forecaster makes revenue projections based on historical growth, industry related growth expectations, or inflationary expectation. Costs are projected based on the relationship with revenue—that is, as a percentage of revenue.

According to the Court, management prepared projections based on the bottom-up approach are considered to be more reliable than management projections based on the top-down approach.

 Fair Value Guidance for Testing Management Projections

Because financial projections are by nature imprecise, the assumptions that underpin the projections must be reasonable and supportable. For an analyst, professional judgement is required to determine if the management prepared financial projections are reasonable.

To evaluate management prepared financial projections, analysts often consider financial reporting guidance. Financial reporting guidance provides best practices that are used to evaluate management prepared financial statements (“FV Guidance”).[iv]

To test for reasonableness, FV Guidance requires an analyst to consider factors that include the following, among others:

  • Frequency of preparation. If a designated group of management regularly prepares forecasts, those forecasts are likely to be more consistent and meaningful compared to circumstances when management does not regularly prepare forecasts.
  • Comparison of prior forecasts with actual results. If prior forecasts exist, an analyst will test against actual results. This type of analysis will provide insight as to how management’s forecasts tend to be optimistic, conservative, or just generally inaccurate. Many external influences might make forecasting difficult, and an inaccurate forecast does not necessarily indicate that management’s process in preparing forecasts is deficient.
  • Mathematical and logic check. Financial projections should be checked for accuracy. Common errors include (1) use of inaccurate cell references in applying functions (such as growth rates), (2) simple summation errors (including use of inaccurate cell ranges), (3) use of improper functions, and (4) use of improperly specified “macros” in the context of the use of spreadsheet analyses.

Valuation analysts and auditors follow FV Guidance as a means to test for reasonableness of management projections. As management prepares its financial projections, it is recommended that management consider the analyst review of financial projections and how management can best support its financial projections.

 Summary and Conclusion

It is common for company management to prepare financial statement projections. Management prepared financial projections are used for valuation projects prepared for litigation purposes, for financial reporting purposes, and for taxation related purposes. Financial projections can also be used for internal benchmarking, for making and measuring management performance goals, for capital providers interested in projected business performance, for transaction related purposes that are used to evaluate the internal rate of return in a business combination, etc.

Because financial projections are by nature imprecise, the assumptions that underpin the projections must be reasonable and supportable. For an analyst, professional judgement is required to determine if the management-prepared financial projections are reasonable.

In HBK, the Court adjusted a DCF analysis prepared by the respondent’s expert. One of the issues addressed in HBK was the reasonableness of financial projections. In a DCF analysis, the financial projections are the primary value driver. Therefore, in HBK, the Court provided guidance as to recommended procedures used to test financial projections for reasonableness.

FV Guidance is another source of financial statement best practice guidance. Company management should be aware that financial statement projections prepared based on a bottom-up approach, in the ordinary course of business, and that maintain consistency between historical performance and projected performance are generally preferred. As management prepares its financial projections, it is recommended that management consider the analyst review of financial projections and how management can best support its financial projections.

Cavin Armour is a Valuation Analyst. He can be reached at carmour@millercooper.com.

Kevin Zanni, ASA, CVA, CBA, CFE is a Principal and the Director of Valuation Services. He can be reached at kzanni@millercooper.com.

 

[i] HBK Master Fund, L.P., and HBK Merger Strategies Master Fund, L.P, v. Pivotal Software, Inc., 2023 Del. Ch Lexis 322; 2023 WLS 5199634.

[ii] Doft & Co., v. Travelocity.com Inc., 2004 WL 11152338 at *5 (Del. Ch. May 20, 2004).

[iii] Many of the following bullet points were provided by the case matter LongPath Cap., LLC v. Ramtron Int’l Corp., 2015 WL 4540443, at *10 (Del. Ch. June 30, 2015), and at HBK, 2023 WL 5199634, at 72-73.

[iv] See the Application of the Mandatory Performance Framework for the Certified in Entity and Intangible  Valuations Credential, Corporate and Intangibles Valuation Organization, LLC, 2017, at 5-9.