Business valuations are often completed to satisfy a company’s tax reporting requirements. There are a plethora of tax-related reasons to value a company or legal entity, including gift and estate tax purposes, the sale or transfer of an equity interest, “C” to “S” corporation conversions, cancellation of debt analyses (IRC Section 108), business restructurings, and merger and acquisition purposes. Given the ever-increasing complexity of domestic and international tax laws, a number of issues must be addressed or considered when completing a valuation analysis for tax reporting purposes. The following list represents a “Top Ten” list of common issues encountered in tax-related valuation engagements.
The purpose of a valuation engagement dictates the requirements as it pertains to the appropriate standard of value. The appropriate standard of value from a U.S. tax law perspective is “Fair Market Value,” which is defined as the price at which property would exchange between a willing buyer and a willing seller, when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both having reasonable knowledge of the relevant facts (Rev. Rul. 59-60, 1959-1 C.B. 237).
For financial reporting purposes, the standard of value is “Fair Value”, which is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (FASB ASC 820-10-20). Although there are specific (and often subtle) differences between the Fair Market Value and Fair Value standards, often the value of an asset valued under these premises of value are very similar, but in certain cases may differ materially.
Fair Market Value and Fair Value are two of the most common valuation premises, however, there are several other standards of value that may be appropriate to consider given the circumstances surrounding a valuation analysis. For instance, one may consider investment value (the value based on a specific investor’s assumptions, which may include revenue enhancement synergies and/or cost synergies upon combination), among others. The assumptions used to value an asset or equity interest under this standard of value is typically dramatically different than otherwise. The generally accepted view is that Fair Market Value should exclude such synergistic benefits. However, courts in certain situations have contemplated the available universe of buyers and the potential impact from a valuation perspective. Careful consideration and analysis should be performed with respect to consideration of such factors when determining value. Correspondingly, if you are relying on a prior analysis or work, it is critical that you confirm that the valuation analysis was prepared under the exact same premise required.
Depending on the purpose of the valuation, the appropriate conclusion may be either an asset value or an equity value. For situations where an equity value is needed (either the entire equity value of a business or a specific ownership interest in the equity), the valuation process may begin with determining the enterprise value of the business (i.e., net working capital plus tangible and intangible assets). The enterprise value of the business is correspondingly equal to the total invested capital (i.e., debt plus equity capital) of the business (see the table below in this regard). In order to value the equity of the company, enterprise value is estimated first and then total debt and other liabilities are subtracted.
Some valuation engagements require the conclusion to be an asset value. An example in this regard is a valuation completed for purposes of a Subchapter C to Subchapter S conversion. For this analysis, the appropriate conclusion is total asset value (which is generally equal to enterprise value plus current and long-term non-debt liabilities). Given the different requirements, it is critical that company management consult its tax and valuation advisors to ensure the output of a valuation analysis is consistent with the respective tax requirements.
The highest and best use of an asset or business must be considered when estimating value under the Fair Market Value premise of value if the subject interest is controlling in nature. In broad terms, highest and best use is determined based on the use of the asset by market participants that maximizes the value of such asset, even if the intended use of the asset by the business is different than a general market participant. For example, a real property asset may be used for manufacturing purposes by its owner, but a market participant may maximize value by redeveloping the property for residential use. Further, the valuation of a business requires an investigation into “the possibility that the business enterprise may have a higher value by liquidation of all or part of the business than by continued operation as is.”1 In situations where a business is not generating a sufficient return on its underlying assets, a hypothetical orderly liquidation value may be a more appropriate method to value the business as compared to a going concern value.
Commonly, companies are engaged in business transactions with related parties. These transactions not only include the purchase and transfer of goods, but can also include payments for services provided such as building rent, royalties, and licensing fees associated with the use of intangible assets, and an allocation of corporate overhead expenses. Accordingly, it is important to examine related party transactions to confirm market rates. For example, in situations where a royalty rate charged for the use of a technology asset is significantly divergent with a market royalty rate charged for comparable technology (based on market observations), an adjustment is made to incorporate a market rate when performing the valuation.
The assets of many companies include ownership interests in other related or unrelated entities. Typically, the balance sheet values of these investments do not reflect Fair Market Value when the ownership interest is a minority interest. Investments that represent an ownership interest of 50% or lower are either recorded on the balance sheet at historic cost or accounted for by the equity method of accounting. Both of these methods may not reflect Fair Market Value. Whether or not the Fair Market Value of these investments should be computed as part of a valuation analysis largely depends on the materiality of the investment relative to the value of the subject company as a whole (as well as the estimation of the potential magnitude of the difference between book value and Fair Market Value).
Companies comprised of multiple legal entities often provide financing through intercompany borrowings. Specifically, one legal entity will provide a loan to another legal entity, and the entity providing the funds will record a note receivable on its balance sheet. Over time, due to declining financial performance of the payor, there may be a low probability of the loaning legal entity collecting its receivable (as the other legal entity may not have the wherewithal to repay the loan). As such, it is important to closely analyze the financial condition of the opposite party in such loan scenarios to ensure that there is economic value associated with the note receivable. If the related entity does not have the wherewithal to repay the loan, the note should be marked down to the amount that could be repaid (if any). Further consideration should be given with respect to the legal aspects of such notes and whether other entities may be responsible with respect to the payment of the loan or if other assets may be attached as collateral.
Commonly, companies with complex legal entity structures incorporate a cash pooling system to manage the funding requirements of the company as a whole. In a typical cash pooling structure, either the overall parent company or a legal entity that is specifically designated as the finance entity will manage the daily working capital requirements of all of the participating legal entities. Each legal entity regularly transfers (or “sweeps”) all or a portion of its surplus cash to a single bank account and, when necessary, withdraws funds from the bank account to fund operating expenses or other expenditures. This type of funding scenario is popular because it serves to reduce external borrowing as loss generating entities are able to fund operations through the cash generated by profitable entities. Furthermore, the parent company or finance entity can utilize economies of scale to negotiate more favorable lending rates with banks when external borrowing is necessary or desired.
In a valuation analysis, the treatment of a cash pool liability or asset is often not a straight forward decision. With respect to cash pool assets, the valuation issue is similar to that described above for related party notes receivable. When a company (or legal entity) has a cash pool liability recorded on its balance sheet, the critical issue to solve in a valuation analysis from a legal perspective is to determine whether to treat the liability as debt or equity. Although “black and white” rules for making this determination do not exist, guidance is provided within IRC § 385 (Treatment of Certain Interests in Corporations as Stock or Indebtedness) as well as prior court cases. Specifically, IRC 385 lists the following factors to consider:
i. Whether there is a written unconditional promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in money or money’s worth, and to pay a fixed rate of interest
ii. Whether there is subordination to or preference over any indebtedness of the corporation
iii. The ratio of debt to equity of the corporation
iv. Whether there is convertibility into the stock of
v. The relationship between holdings of stock in the corporation and holdings of the interest in question
vi. Effect of classification by issuer
The factors addressed in various historical court cases have been similar to guidance provided by IRC 385. Overall, the courts have concluded that no one specific factor in and of itself determines whether an interest is debt or equity. Rather, the facts and circumstances need to be considered collectively prior to making that determination.
If a legal entity owns net operating loss (“NOL”) carryforwards, it is important to carefully analyze the specific terms and conditions associated with the NOL carryforwards to ensure they are properly incorporated in a valuation analysis. Examples of important factors to consider include expiration dates, limits on use (e.g., Section 382 limitations), and general rules regarding which legal entities are allowed to utilize the NOLs.
In certain circumstances, the weighted average cost of capital, or discount rate, utilized in the valuation of a legal entity may be calculated for the entity being valued on a stand-alone basis. As a result, the concluded discount rate may likely be different than the parent company’s overall discount rate. Some reasons that contribute to differences in the discount rate include: company size, industry risk, and capital structure. If the legal entity is significantly smaller than the overall parent company, a larger risk factor related to size may be appropriate. Further, the operations and markets served by the legal entity may not be consistent with the parent company’s other divisions and business units, and thus, the selection of an appropriate beta may change. Finally, the capital structure conclusion should reflect optimal industry levels and also consider the legal entity’s specific borrowing capacity.
An additional issue to consider when calculating an appropriate discount rate is the location of the legal entity’s business operations. Investors require investment returns by considering the risk associated with the location of the legal entity’s operations as opposed to the location of the legal entity’s capital sources. Political, economic, and financial risks, in addition to industry operating risks and risks specific to the subject legal entity should be considered in measuring an investor’s required return on the entity’s projected cash flows.
In a tax valuation, it is important to consider the fact that intangible assets are often legally owned by a separate legal entity that is specifically designated for intellectual property management. In this instance, a valuation expert needs to investigate legal entity ownership of intangible assets and ensure the valuation analysis reflects such ownership. That is, even though the economic cash flows associated with an intangible asset may be generated by the operations of one entity, the legal owner of the intangible asset needs to be compensated such that the overall value of the intangible asset resides at that entity.
In preparing a valuation analysis for tax purposes, care must be given with respect to the 10 factors/issues mentioned above. This “top ten” list certainly does not capture every possible valuation issue to contend with, but it does reflect several issues that are commonly encountered. The bottom line is that these issues (and others depending on the facts and circumstances) need to be considered and properly accounted for in order to prepare a bullet proof valuation analysis that will withstand scrutiny in tax court.