What You Need to Know about Measuring the Fair Value of Contingent Consideration

The stakes for a business combination are high. Each party must negotiate a price and deal terms that promote its own interests but accommodate the counterparty’s expectations. Reaching an agreement can be a lengthy process and may require incorporating special provisions to help close the deal. Contingent consideration is a common example of such a provision.

Measuring the fair value of contingent consideration (commonly referred to as an “earnout”) for financial reporting is a complex process – based on a number of variable inputs, unique risk profiles, and potentially complicated payoff structures.  Valuation professionals must be well versed in the concepts of fair value, probability, and risk.  Here’s what you need to know about what goes into that fair value measurement before it lands on your desk.

How Does an Earnout Differ from Other Purchase Price Adjustments?

While both purchase price adjustments and earnouts can affect the total consideration paid in a transaction, they differ substantially in terms of criteria and realization.  Common purchase price adjustments include adjustments for working capital, client consents, and indebtedness.  Purchase price adjustments, which are based on financial statement information, are observable and knowable at the closing date of the transaction, while earnouts are not.  Earnouts, on the other hand, are payments based on performance that occurs subsequent to the measurement date.   Although the eventual earnout payment cannot be known at the closing date, valuation specialists have developed techniques to enhance the reliability of fair value measurements.

What Criteria Must Be Established in a Fair Value Measurement?

The Purchase Agreement establishes the basic criteria, structure, and time frame for the earnout.  Based on these characteristics, the valuation professional must determine several inputs for his or her modeling.

Earnout Metric

The Purchase Agreement will define one or more performance metrics for the earnout.  A common example is EBITDA for the twelve-month period following the acquisition.  The future outcome(s) of the relevant metrics are used to determine the future payout.  For purposes of fair value measurement, valuation specialists may reference management projections, analyst expectations, and industry forecasts to model the expected payoff.

Volatility

Since the actual value of the earnout metric cannot be known with certainty at the measurement date, the expected value is paired with an estimate of expected volatility. While there are several ways to estimate expected volatility, the estimate should be reasonable in the context of the volatility observed for similar companies, the subject company’s fundamentals, and the characteristics of the specific metric.

Discount Rate

The appropriate discount rate may be estimated through a bottom-up approach, where beta is built up using earnout-related factors, or through a top-down approach, which starts with the beta implied by the equity discount rate for the company overall.  In the top-down approach, the valuation professional adjusts the company level beta up or downward for differences in risk between the metric and the company’s equity. The type of risk associated with the metric will affect the model that should be used to value the earnout.  The two broad categories of risk are:

• Diversifiable. Diversifiable or “unsystematic” risk is specific to the subject company and can be reduced through diversification. For example, the risk associated with occurrence of a nonfinancial milestone such as patent approval is considered diversifiable.
• Non-Diversifiable. Non-diversifiable or “systematic” risk is related to the risk inherent in the market. For example, the risk associated with achieving a financial target such as revenue growth is considered non-diversifiable.

Payoff Structure

The structure of the earnout reflects the provisions established in the Purchase Agreement.  Questions that a valuation specialist may ask include:

• Is the underlying metric risk diversifiable (unsystematic) or not (systematic)?
• Is the payoff structure linear or non-linear?
• If multiple periods are involved, are the periods dependent on, or independent of, the other periods?

The answers to these questions can help the valuation professional determine the structure of the payoff and whether a scenario based model or option pricing model is best suited to the fair value measurement of the earnout liability.

Term

The term over which the metric is measured is established in the Purchase Agreement.  The earnout may be determined after one period or over a multi-period time frame. Payments may be made throughout the earnout period, at the end of the earnout period, or at a later date. Additional time to payment may increase counterparty risk, or the risk that the Buyer will default on the earnout payment due.

Credit Risk of the Buyer

Earnouts typically represent a subordinate, unsecured liability for the Buyer.  Thus, risk should be considered for the Buyer’s ability to meet the earnout obligation, commonly called counterparty credit risk or default risk. A valuation professional will look for any mitigating factors that could reduce or eliminate this risk, including:

• Guarantee by a bank or third party
• Escrow account for full or partial funding of the earnout
• Earnout structured as a note to increase its security ranking

What Methods Are Used to Measure Fair Value?

The two primary methods used to measure fair value are the scenario based method and the option pricing method. Selection of the method and model most appropriate for a given situation will depend on to the structure and risk profile of the subject earnout.

Scenario Based Method

Under the scenario based method, valuation specialists apply probability weights to the relevant metrics, and then discount the corresponding payouts at an appropriate rate. This method is most appropriate when the underlying metric for the earnout has a linear payoff structure or the underlying risk is diversifiable. Models within this method can effectively conform to any distribution assumption. This method is intuitive and is likely to mimic how the parties to the transaction thought about the earnout. However, these models can be perceived as unreliable since the inputs are qualitative in nature.

Option Pricing Method

When applying the option pricing method, valuation specialists use models such as Black-Scholes to measure the fair value of a portfolio of financial instruments that replicate the potential payouts of the earnout structure. This method is best suited for earnouts with nonlinear payoff structures and metrics with non-diversifiable risk. A significant benefit to the method is that the use of historical data to estimate volatility, correlation, and the discount rate creates consistency among input assumptions. However, the complexity of the mathematics associated with the models is not well understood by those without financial expertise, rendering them much less intuitive.

Understanding the Differences

A simple example of an earnout that could be modeled with the scenario based method is as follows: a payment of 30% of the next fiscal year EBITDA. The payoff in this model is linear since it has a constant relationship with the relevant metric, meaning that a payout is due whether EBITDA is $1 million or $100 million (Example 1 below).

In contrast, an earnout with a threshold or cap is better suited to an option pricing method. For example, a payment of 30% of the next fiscal year EBITDA only if EBITDA meets or exceeds $50 million. The payoff is the same as the linear scenario after EBITDA reaches the threshold; however, the payoff is $0 for any value of EBITDA below that.

The second example can be modeled as a portfolio of options, where the threshold value of the metric ($50 million) acts as an effective strike price.

What Guidance Exists Regarding Fair Value Measurement of Contingent Consideration?

The measurement of contingent consideration has historically been a matter of considerable diversity in practice.  While some common practices have generally been followed, new guidance clarifies best practices.  A working group formed by The Appraisal Foundation issued a first exposure draft of new guidance regarding the measurement of contingent considerations in February 2017.  This guidance details the methods described above and best practices for their application. The exposure draft endorses the risk-neutral valuation framework as the preferred basis for fair value measurements.  A risk-neutral framework makes risk adjustments to the earnout metric to account for the unsystematic risk inherent in the metric. The guidance is expected to promote the consistency and reliability of fair value measurements.

What Are the Implications of Fair Value on Financial Statements?

Earnouts can act as a way to “bridge the gap” between what the Buyer wants to pay and what the Seller wants to receive. They can provide downside protection for the Buyer and upside potential for the Seller. These benefits contribute to the common use of earnout provisions in business combinations. However, the financial reporting consequences of an earnout may be counterintuitive once the transaction has closed and the Buyer becomes the owner of the acquired company.  Subsequent to this point, if the relevant metric exceeds initial expectations, the Buyer will report a loss on its income statement associated with remeasuring the contingent liability at its new, higher value. In effect, if business goes well, the Buyer will report a loss. In contrast, if business goes poorly, the Buyer will report a gain upon remeasurement of the contingent liability at its new, lower fair value. Sophisticated deal makers understand the short-term implications for the Buyer’s financial statements but remain focused on the long-term goal.

Conclusion

The uncertainty associated with contingent consideration means that the fair value of the earnout will rarely equal the amount that is actually paid out at the future payment date. While valuation professionals do not know what the future holds, they do have tools and techniques to reliably measure the fair value of the earnout liability as of the date of the transaction. While the nuances encountered in fair value measurement of earnouts can extend well beyond the scope of this article, we hope it provided some insight into what goes into the numbers before they reach your company’s accounting department.

The inclusion of an earnout in a transaction negotiation can serve various purposes.

• Bridge the differences in Buyer and Seller expectations
• Serve as a form of alternative financing and defer a portion of the purchase price
• Provide incentive for management to help the company meet post-transaction targets
• Shift and allocate risk between the various parties involved

The motivation behind an earnout can influence management’s choice of earnout structure in order to achieve the intended purposes.

Definition of Fair Value (ASC 820)

“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.”

Objective of Fair Value Measurement (ASC 820)

“To estimate the price at which an orderly transaction would take place between market participants under the market conditions that exist at the measurement date.”

Did You Know Your Family Business Was For Sale?

Successful businesses don’t have to go looking for potential acquirers – potential acquirers are likely to come looking for them.  Most of our family business clients have no intention of selling in the near-term, and yet they often receive a steady stream of unsolicited offers from eager suitors.  Many of these offers can be quickly dismissed as uninformed or bottom-fishing, but occasionally serious inquiries from legitimate buyers of capacity appear that require a response.

What Kinds of Buyers are There?

Buyers are generally classified into two categories.

• Financial buyers are groups like private equity funds that purchase businesses with a view toward earning a return on their investment over a finite holding period. These buyers generally use financial leverage to magnify their returns, and expect to exit their investment by selling the business to another buyer after three to seven (or maybe even ten) years.  While financial buyers may have specific plans for making the business run more efficiently and profitably, they are generally not anticipating significant revenue synergies or expense savings from wholesale changes to the business.  Rather, they tend to be more focused on incremental changes to boost value and clever financial engineering to be the principal engines driving their returns.
• Strategic buyers are competitors, customers, or suppliers of the business who have a strategic goal for making the acquisition. Such buyers certainly want to earn a return on their investment, but that return is expected to come from combining the target’s operations with their own, rather than through financial engineering.  In other words, strategic buyers look to long-term value creation through assimilating the target into their existing business, not a short-term return from buying low and selling high.  Strategic buyers may anticipate revenue synergies through the combination or may foresee the opportunity to eliminate operating expenses in either the acquired or legacy businesses to fuel cash flow growth.

Distinguishing between financial and strategic buyers is important for evaluating unsolicited offers, but we suspect that a more important distinction is that between motivated buyers and opportunistic buyers.  Successful family businesses will attract motivated buyers who have the capacity to pay an attractive price for the business, but should strive to avoid opportunistic buyers who are seeking to take advantage of some temporary market dislocation or cyclical weakness to get the business at a depressed price.

Evaluating Acquisition Offers

Evaluating acquisition offers is ultimately the duty of the board of directors, not the family at large.  Uncle Charlie may have strong opinions on the proposed deal, but if he is not a director, he does not have the responsibility or authority to respond to the offer.  That does not mean that the directors will not care about Uncle Charlie’s perspective.  As we’ve discussed in previous posts, it is critical for the board to understand what the business “means” to the family, and the meaning of the business to the family may well inform how the directors evaluate the offer.  For larger families, the prospect of receiving a potentially-attractive unsolicited acquisition offer underscores the value of a regular survey process, whereby the board and senior management periodically take the pulse of the family on topics at the intersection of business and family.

Family business directors should evaluate offers along several dimensions:

• Buyer Motivation. What has prompted the offer?  If it is a strategic acquirer, what sort of operational changes would be expected post-transaction?  Will a sale result in facility closures, administrative layoffs, or discontinuation of the business name?  Or, could the sale increase opportunities for employees and expose the brand to new markets?  If the suitor is a financial buyer, what sort of debt load will they place on the company post-acquisition?  Will the company’s ability to withstand normal economic downturns be compromised?  Will the buyer want members of the family active in senior management to continue to run the business?  The answers to these and similar questions should be considered in the context of what the business means to the family and help inform whether the offer should be entertained further.
• Buyer Capacity. Does the buyer have the financial capacity to actually execute the transaction if it is agreed to?  If external financing is required, will it be available to the buyer when needed?  Basic due diligence goes both ways.  Going through a lengthy negotiation and due diligence process only to have the transaction fall apart at the closing table due to lack of financing will leave a bad taste in the family’s mouth.
• Price & Transaction Structure. What seems on the surface to be an attractive price may, upon further examination, turn out to be a far less attractive transaction.  A sale of stock may have a lower nominal price than a sale of assets, yet result in higher after-tax proceeds.  A high nominal price may be subject to contingencies regarding future performance which cause the economic value of the offer to be far less.  Or, a high nominal price may be payable, in part, in shares of the buyer rather than cash – what is the family’s appetite for trading stock in the family business for stock in a different business over which they will likely have no control?  There are many other components of transaction structure, such as required representations and warranties or escrow provisions that can significantly influence how attractive an offer really is.
• Price is not everything. Just because the price is adequate and the terms are acceptable does not mean that the timing is optimal for a sale.  Directors should carefully weigh the potential outcomes for shareholders by deferring a transaction: Is the family better served by taking the bird in hand or waiting for more birds to materialize in the bush?  If the company is on a growth trajectory or has its own acquisition opportunities to pursue, it may command a larger multiple down the road.  Understanding the risks and opportunities associated with the timing of a transaction requires directors to be well-attuned to company, market, and industry dynamics.  Family directors-in-name-only are unlikely to have anything meaningful to add to such deliberations.
• Reinvestment Opportunities. Does the family have a plan for putting sale proceeds to work?  Once again, what the business “means” to the family comes to the fore.  Will proceeds simply be distributed to the various branches of the family, to use or invest as they see fit?  Or will proceeds be retained at the family level and redeployed in other assets for the benefit of the family?  If so, are there reinvestment opportunities available that will “fit” the cash flow needs and risk tolerances of the family?  Will such investments provide the same degree of family cohesion as the legacy business?  A sale of the family business may have unintended, and potentially far-reaching consequences for the family.

Responding to Acquisition Offers

Once the board has evaluated the unsolicited offer, there are essentially four responses to choose from:

• Reject the offer. If the directors conclude that the proposed price and/or terms are unattractive, or if the timing of a transaction does not align with the broader goals of the family, the board may elect simply to reject the offer.
• Negotiate with the potential acquirer. If the directors conclude that the timing is right and that the suitor would be an attractive acquirer, the board may elect to negotiate with the buyer with a view toward consummating a transaction.  If the perceived “fit” between the family business and the potential acquirer is good, proceeding directly to negotiating price and terms of the transaction may result in the quickest and smoothest path to close.  However, without any exposure to the market, there is a risk that the negotiated price and terms are not really optimal.  There is a reason private equity firms like to tout their “proprietary” deal flow to potential investors – direct negotiation with sellers presumably results in lower purchase prices than winning auctions does.
• Engage in a limited sale process. Given the potential for underpayment, directors may elect to discreetly contact a limited number of other potential acquirers to gauge their interest in making a competing bid for the business.  The benefit of doing a limited market check is that it can generally be done fairly quickly without “putting the company up for sale” with the attendant publicity that the family may not desire.  The initial suitor will, of course, generally prefer that even a limited sale process not be engaged in, and may seek some sort of exclusivity provision which precludes the seller from talking to other potential buyers.  Directors will need to consider carefully whether the potential benefits of a limited sale process will outweigh the risk that such a process will cause the initial suitor to rescind their offer and walk away.
• Engage in a full sale process/auction. Finally, the board may conclude as a result of their deliberations that the unsolicited offer signals that it is an opportune time to sell the business because pricing and terms are expected to be favorable in the market and the family’s circumstances align well with a sale.  In a full sale process, the company’s financial advisors will prepare a descriptive investment memorandum for distribution to a carefully vetted list of potential motivated acquirers.  After initial indications of interest are received, the universe of potential buyers is then narrowed to a manageable group of interested parties who are invited to view presentations by senior management and engage in limited due diligence with a view to making a formal bid for the business.  With the help of their financial advisors, the directors evaluate the bids with regard to pricing, terms, and cultural fit, selecting a company with which to negotiate a definitive purchase agreement and close the transaction.  A full sale process will likely involve the most time and expense, and may expose to competitors the family’s intention to sell, but carries with it the potential for achieving the most favorable price and terms.

Bringing Together the Right Team

There is a sharp experience imbalance in most transactions: buyers have often completed many transactions, while sellers may have never sold a business before.  As a result, sellers need to assemble a team of experienced and trusted advisors to help them navigate the unfamiliar terrain.  The transaction team will include at least three primary players: a transaction attorney, a tax accountant, and a financial advisor.

Definitive purchase agreements are long, complicated contracts, and an experienced attorney is essential to memorializing the substantive terms of the transaction in the agreement and ensuring that the sellers’ legal interests are fully protected.

Business transactions also have significant tax consequences, and the tax code is arcane and littered with pitfalls for the unwary.  Trusting the buyer to do your tax homework can be a very costly mistake.  An experienced tax attorney is essential to maximizing after-tax proceeds to the family.

The financial advisor takes the lead in helping the board evaluate unsolicited offers, setting value expectations, preparing the descriptive information memorandum, identifying a target list of potential motivated buyers of capacity, assessing initial indications of interest and formal bids, facilitating due diligence, and negotiating key economic terms of the definitive agreement.  My colleague Nick Heinz leads Mercer Capital’s transaction advisory practice, and Nick likes to say that his job in a transaction is to run the transaction on behalf of the company so the company’s management can focus on running the business on behalf of the shareholders.  Transactions can be time-consuming and mentally draining, and it’s simply not possible for company management to devote the necessary time to managing the transaction process and the business at the same time.  An experienced financial advisor takes that burden off of management.

When it comes to assembling the right team, business owners sometimes blanch at the cost.  However, the cost of a quality and experienced team of advisors pales next to the cost of fumbling on the transaction.  The family will only sell the business once, and there are no do-overs.  As we recently heard someone say, “Cheap expertise is an oxymoron.”

If you have recently received an unsolicited offer for your family business, or would like to discuss whether selling the business now is right for your family, please give us a call to discuss your situation in confidence.

A Taxing Matter for Family Businesses

Family business owners cite different motives for investing their time, energy, and savings to build successful businesses.  Some have entrepreneurial zeal, while others are creators who see problems in the world that they can solve.  Others are natural leaders who are inspired by the job opportunities and other “positive externalities” that successful enterprises generate for employees and the communities in which they operate.  But common to nearly all family business owners is the desire to provide financially for their heirs.  As a result, one of the most common concerns such owners cite is the ability to transfer ownership of the family business to the next generation in the most tax-efficient way.

The Internal Revenue Service defines the estate tax as follows: “The estate tax is a tax on your right to transfer property at your death.”  The amount of tax is calculated with reference to the decedent’s gross estate, which is the sum of the fair market value of the decedent’s assets less certain deductions for mortgages/debts, the value of property passing to a spouse or charity, and the costs of administering the estate.

As with all taxes, things are not as simple as they seem.  Before calculating the estate tax due, two adjustments are made.  First, all taxable gifts previously made by the decedent (and therefore no longer in the estate) are added to the gross estate.  Second, the sum of the gross estate and prior taxable gifts is reduced by the available unified credit.  The unified credit for 2018 is just over $11 million.  The following table illustrates the calculations for the taxable estate of an unmarried individual.

To complicate things a bit further, estates have benefited from the introduction of “portability” to the estate tax regime in 2011.  Portability refers to the ability of an individual to transfer the unused portion of their available unified credit to a surviving spouse.  The ultimate effect of portability is that for married family business owners, the total available unified credit is slightly more than $22 million.

Taxes are never fun, but what proves to be especially vexing about the estate tax for family business owners is that a substantial portion of their estate often consists of illiquid interests in private company stock.  Going back for a moment to our prior example, if the decedent’s assets consist primarily of a portfolio of marketable securities, it is relatively easy to liquidate a portion of the portfolio to fund payment of the tax.  If, on the other hand, the decedent’s assets are primarily in the form of shares in the family business, liquidating assets to pay the estate tax may prove more difficult (estate taxes are payable in cash and may not be paid in-kind with family business shares).  As a result, family businesses may be sold or be forced to borrow money to fund payment of a decedent’s estate tax liability.

Attorneys who specialize in estate taxes have devised numerous strategies for helping families manage estate tax obligations.  Strategies range from relatively simple, such as a program of regular gifts to family members, to complex, such as the use of specialized trusts.  While the finer points of various potential strategies is beyond the scope of this post, the concept of fair market value is essential to understanding and evaluating any estate planning strategy.

What is Fair Market Value?

As noted above, fair market value is the standard of value for measuring the decedent’s estate, and therefore, the estate tax due.  The IRS’s estate tax regulations define fair market value as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.”

So far, so good.

But how does all this work for a family business?  To understand the underlying rationale for much estate planning, we need to explore how the standard of value intersects with what is referred to as the level of value.  In other words, the fair market value of family business shares in an estate depends not just on the fundamentals of the business (expected future revenues, profits, investment needs, risk, etc.) but also on the relevant level of value.

If an estate owns a controlling interest in a family business (in most cases, more than 50% of the stock), the fair market value of those shares will reflect the estate’s ability to sell the business to a competitor, supplier, customer, or financially-motivated buyer such as a private equity fund.  In contrast, the owner of a small minority block of the outstanding shares of a family business has no ability to force the business to change strategy, seek a sale of the business, or otherwise unilaterally compel any action.  As a result, the owner of the shares is limited to waiting until the shareholders that do have control decide to sell the business or redeem the minority investor’s shares.  In the meantime, they wait (and, potentially, collect dividends).  If there is a willing buyer for the shares, they may elect to sell, but that buyer will be subject to the same illiquidity, holding period risks, and uncertainties, so the price is unlikely to be attractive.

Business appraisers often describe the levels of value with reference to a chart like the following:

The levels of value chart captures two essentially common-sense notions regarding value.  First, investors prefer to have control rather than not.  The degree to which control is valuable will depend on a whole host of case-specific facts and circumstances, but in general, having control is preferred.  Second, investors prefer liquidity to illiquidity.  Again, the magnitude of the appropriate marketability discount will depend on specific factors, but not surprisingly, investors prefer to have a ready market for their shares.  Fair market value is measured with respect to both of these common-sense notions.

Estate Planning Objectives

As a result, one objective of most estate planning techniques is to ensure – through whatever particular mechanism – that no individual owns a controlling interest in the family business at his or her death.  Of course, minimizing taxes is only one possible objective of an estate planning process, which might include asset protection, business continuity, and providing for loved ones.

Therefore, family businesses should carefully consider whether an estate planning strategy designed to minimize estate taxes will have any unintended negative consequences for the business or the family.

• For example, an aggressive gifting program that causes the founder to relinquish control prematurely may increase the likelihood of intra-family strife, or jeopardize the family’s ability to make timely strategic decisions on behalf of the business.
• Or, adoption of an unusually restrictive redemption policy in an effort to minimize the fair market value of minority shares in the company may lead to inequitable outcomes for family members having a legitimate need to sell shares.

In short, families should be careful not to let the tax tail wag the business dog.  Families should consult legal, accounting, and valuation advisors who understand their business needs, family dynamics, and objectives to ensure that their estate plan accomplishes the desired goals.

What Is Your Family’s Most Valuable Asset?

European investment banking icon Rothschild & Co. recently announced that 37-year old Alexandre de Rothschild will be taking the reins at the firm, succeeding his father at the bank’s May shareholders’ meeting.  The new chairman is a member of the seventh generation of the family.  While the future performance of the bank under the younger Mr. Rothschild will be the ultimate barometer of success, the Rothschild family clearly has fostered a culture of developing the next generation.  Few families have the long history of next-gen development that the Rothschild’s do, but it is a task that becomes more important with each successive generation.  The long-term health of any organization ultimately depends on the quality of the rising generation of leaders, and families are no different.

From our experience working with successful family businesses, talking with family business leaders, and reviewing relevant research, we’ve identified the following themes that are common to successful family businesses when it comes to developing the next generation of shareholders:

• Successful families recognize that each succeeding generation will be different, and that’s okay. As families mature and grow, succeeding generations naturally become more diffuse than their parents’ generation.  Family members move away, pursue careers and interests outside the family business, and have different personal and financial objectives.  While this increasing family diversity can be intimidating, successful families embrace the new experiences, opportunities, and challenges that this growth brings.  Imposing obligations on the next generation to do things just like grand-dad did, generally prove to be stifling and counter-productive (and, in all likelihood, contrary to grand-dad’s mindset when he was achieving his greatest business successes).  The differences between Boomers, Gen Xers, and Millennials are real and matter for family businesses.  Groups like the Center for Generational Kinetics publish fascinating research on the differences between generations and how to make those differences productive for your family and business.
• Successful families identify the core business and family attributes that the family wants to persist across generations. This is the counter-weight to the prior theme: families have “social ballast” that can help the business maintain its balance in the inevitable rough seas.  This “social ballast” comprises the core family and business attributes that maintain and preserve identity across generational changes.  The key is to identify the root causes of the family’s success.  Without saddling the next generation with a mandate to do things just like grand-dad did, can the family identify the core attributes underlying grand-dad’s success that can transcend generations?  For example, what are the two or three core attributes that make a Rothschild business a Rothschild business?  Identifying these attributes does not limit the next generation’s flexibility, but rather frees the next generation from having to develop – out of whole cloth – a framework within which to meet the unique family and business challenges with which it will be faced.
• Successful families acknowledge that experiences outside the family business promote development of next generation leaders. While growing up in the family business provides development opportunities that are not easily replicated, many successful families are recognizing the benefit of gaining professional experiences outside the family business.  Family employment policies often mandate that before becoming eligible to work in the business, family members must have three to five (or more) years of external professional experience.  Such policies have multiple potential benefits, not least of which is exposing the next generation to the ideas, processes, and strategies of other successful businesses.  As noted in the article linked above, the younger Mr. Rothschild spent the first five years of his career working at other financial firms before joining the family business.  Furthermore, even in the context of non-employee roles (shareholder, family council member, director), successful families value and encourage the “outside” experiences of the next generation.
• Successful families provide development opportunities for both employee and non-employee shareholders. Regardless of the current family composition, the likelihood that rising generations will include a mix of employee and non-employee shareholders is high.  Next generation development is not limited to future employees, but should include members of the rising generation that do not plan to work in the business.  Development opportunities include both education and service.  No one is born knowing what has made the family business successful, how to read the company’s financial statements, or how to think about the tradeoffs between current distributions and investment for future growth.  Successful families are intentional about providing ongoing education on these and other topics for the next generation.  With regard to service, rotating membership on a family council can create great opportunities for non-employee members of the next generation to actively contribute to the success of the family.
• Successful families allocate resources to fostering next generation innovations. The next generation is a natural source of innovation necessary to keep the family business relevant in evolving markets.  Successful families consider multiple potential strategies for accomplishing this goal.  Some families follow a corporate venture capital model, providing seed capital to fund new ventures headed by members of the next generation (subject, of course, rigorous vetting procedures).  If there is some organic connection between the proposed venture and the family’s core operations, such investments may be made by the family business itself.  If the proposed venture is a bit further afield, a holding company structure may be used to make the investment.  Or, if the risk-return preferences of various family members do not all accommodate venture investing, the family may explore setting up a captive venture fund in which family members may, but are not obliged to, invest.  Still, other companies view significant ongoing distributions as the seed money for the next generation to put into new ventures of their own choosing.
• Successful families use philanthropy as a tool in next generation development. Perhaps the most effective way to develop the next generation is to provide for active involvement in the family’s philanthropic efforts.  Having a voice in the family’s giving and other charitable activities can be a great way for the next generation of the family to develop a sense of the responsibility for managing and stewarding the wealth created by prior generations for the benefit of their communities and other worthy beneficiaries.  For many families, this is such an important component of developing the next generation that they include even teens and pre-teens in their philanthropic efforts.

At the risk of sounding overly sentimental, a family’s most valuable asset is its next generation.  If the current generation of business leaders is focused on the long-term sustainability and health of the family business, developing the next generation of family shareholders must be viewed as a strategic priority.

Orthopedics Overview

The worldwide market for orthopedic products in 2016 was estimated to be nearly $48.2 billion, an increase of 3.2% from 2015. Demographics will continue to be a key driver of industry expansion, with population growth and rapidly-growing international markets driving the need for musculoskeletal care. Increasing life spans, the increasing prevalence to remain active, and increasing obesity rates will impact the number of individuals with joints subject to degeneration, thereby increasing demand for orthopedic/joint replacement procedures.

Subspecialties

Orthopedic devices are commonly divided into several primary sectors that correspond to the major subspecialties within the orthopedic field. These subspecialties include:

• Large Joints: Implants, instruments, and surgical assistance systems to replace or revise failed knee and hip joints. Generally dominated by large medical device players (Zimmer, Stryker, J&J, Smith & Nephew).
• Spine: Implants and instruments and surgical assistance systems used in the treatment of degenerative disc disease, herniated discs, scoliosis, vertebral fractures, or other spinal conditions. Devices used include pedicle screws, plates, rods, interbody cages, artificial discs. Medtronic and J&J are market leaders, with other smaller players (Nuvasive, Globus Medical) controlling sizable share.
• Trauma: Implants and instruments for internal and external use (plates, screws, nails, pins, wires, staples, external fixators). May be referred to as fracture repair. Market led by large incumbents, some smaller players focusing on extremities.
• Arthroscopy/Soft Tissue Repair: Arthroscopy devices include arthroscopic visualization products, fluid management systems, manual instruments, and powered instruments, while soft tissue repair includes devices utilized in cruciate ligament, hip, meniscus, and shoulder fixation. Also referred to as “Sports Medicine.” Arthrex and Smith & Nephew have over 50% market share, with J&J and Stryker also controlling a large portion of the total market.
• Orthobiologics: Biologic products such as allograft tissue, synthetic bone grafts, autologous platelet/ plasma systems, and cell-based repair systems. Products utilized in other orthopedic segment settings. Low market concentration relative to other orthopedic segments.
• Extremity: Implants, instruments, and surgical assistance systems to replace or revise failed joints in the shoulder, elbow, wrist, ankle and digits. Market led by both large incumbents and small niche players, such as Wright Medical, Exactech, and Orthofix.

Product Segmentation

Knee, hip, and spine represent the largest medical device segment based on total revenue. These segments are generally controlled by larger, diversified industry participants who are able to leverage their size and efficiencies to capture market share at relatively lower costs. The remaining segments, particularly biologics, arthroscopy, and extremities are smaller pieces of the total market but represent growth opportunities for both small niche players and larger device manufacturers.

Major Companies & Market Shares

Five multi-national companies currently dominate the orthopedic industry, each with approximately $2 billion or more in annual sales and combined revenue of nearly $29 billion (59% total share). This represents a slight decline over the last several years, falling from 61% total market share in 2015 and 63% in 2014.

Global Trends

The worldwide orthopedics market is expected to grow at an annualized rate of 4.0% between 2016 and 2022, slower than the average growth expected for the medical device industry overall (5.1%). Certain challenges are expected to weigh on the orthopedic device market over the next several years. Increased competition between manufacturers for market share in a mature market will continue to put downward pressure on prices, along with new reimbursement regimes in the U.S. and in Europe.[1]

While overall orthopedic growth is projected to grow slower than other device segments, certain areas within orthopedics are expected to outperform over the next several years. The maturing hip (2.3%), spine (2.0%), and knee (3.7%) markets saw slower growth in 2016, while the extremities (8.0%) and arthroscopy / soft tissue segments (5.6%) realized more robust sales growth over the year. Momentum in these niche segments is expected to continue over the next several years as manufacturers look to diversify into these underserved and untapped device markets.

[1] Growth estimated per “EvaluateMedTech” utilizes sales data differing from total sales data cited previously. Growth rates utilized for perspective.

Is There a Ticking Time Bomb Lurking in Your Family Business?

Five Trends to Watch in the Medical Device Industry in 2018

Medical Devices Overview

The medical device manufacturing industry produces equipment designed to diagnose and treat patients within global healthcare systems.  Medical devices range from simple tongue depressors and bandages, to complex programmable pacemakers and sophisticated imaging systems.  Major product categories include surgical implants and instruments, medical supplies, electro-medical equipment, in-vitro diagnostic equipment and reagents, irradiation apparatuses, and dental goods.

The following outlines five structural factors and trends that influence demand and supply of medical devices and related procedures.

1. Demographics

The aging population, driven by declining fertility rates and increasing life expectancy, represents a major demand driver for medical devices.  The U.S. elderly population (persons aged 65 and above) totaled 49 million in 2016 (15% of the population).   The U.S. Census Bureau estimates that the elderly will roughly double by 2060 to 95 million, representing 23% of the total population.

The elderly account for nearly one-third of total healthcare consumption.  Personal healthcare spending for the population segment was $19,000 per person in 2012, five times the spending per child ($3,600) and almost triple the spending per working-age person ($6,600).

According to United Nations projections, the global elderly population will rise from approximately 610 million (8.3% of world population) in 2015 to 1.8 billion (17.8% of world population) in 2060.  Europe’s elderly are projected to reach nearly 29% of the population by 2060, making it the world’s oldest region.  While Latin America and Asia are currently relatively young, these regions are expected to undergo drastic transformations over the next several decades, with the elderly population expected to expand from approximately 8% in 2015 to more than 21% of the total population by 2060.

2. Healthcare Spending and the Legislative Landscape in the U.S.

Demographic shifts underlie the expected growth in total U.S. healthcare expenditure from $3.3 trillion in 2016 to $5.7 trillion in 2026, an average annual growth rate of 5.5%. While this projected average annual growth rate is more modest than that of 7.3% observed from 1990 through 2007, it is more rapid than the observed rate of 4.2% between 2008 and 2016.  Projected growth in annual spending for Medicare (7.4%) and Medicaid (5.8%) is expected to contribute substantially to the increase in national health expenditure over the coming decade.  Healthcare spending as a percentage of GDP is expected to expand from 18% in 2016 to nearly 20% by 2026.

Since inception, Medicare has accounted for an increasing proportion of total US healthcare expenditures.  Medicare currently provides healthcare benefits for an estimated 57 million elderly and disabled people, constituting approximately 15% of the federal budget in 2016.  Medicare represents the largest portion of total healthcare costs, constituting 20% of total health spending in 2015.  Medicare also accounts for 26% of hospital spending, 29% of retail prescription drugs sales, and 23% of physician services.

Owing to the growing influence of Medicare in aggregate healthcare consumption, legislative developments can have a potentially outsized effect on the demand and pricing for medical products and services.  Net mandatory benefit outlays (gross outlays less offsetting receipts) to Medicare totaled $588 billion in 2016, and are expected to reach $1.1 trillion by 2026.

The Patient Protection and Affordable Care Act (“ACA”) of 2010 incorporated changes that are expected to constrain annual growth in Medicare spending over the next several decades, including reductions in Medicare payments to plans and providers, increased revenues, and new delivery system reforms that aim to improve efficiency and quality of patient care and reduce costs.  On a per person basis, Medicare spending is projected to grow at 4.5% annually between 2016 and 2026, compared to 5.1% average annualized growth realized between 2000 and 2016.

As part of ACA legislation, a 2.3% excise tax was imposed on certain medical devices for sales by manufacturers, producers, or importers.  The tax had become effective on December 31, 2012, but met resistance from industry participants and policy makers.  In late 2015, Congress passed legislation promulgating a two-year moratorium on the tax beginning January 2016.  In January 2018, the moratorium suspending the medical device excise tax was extended through 2019.

3. Third-Party Coverage and Reimbursement

The primary customers of medical device companies are physicians (and/or product approval committees at their hospitals), who select the appropriate equipment for consumers (patients).  In most developed economies, the consumers themselves are one (or more) step removed from interactions with manufacturers, and therefore pricing of medical devices.  Device manufacturers ultimately receive payments from insurers, who usually reimburse healthcare providers for routine procedures (rather than for specific components like the devices used).  Accordingly, medical device purchasing decisions tend to be largely disconnected from price.

Third-party payors (both private and government programs) are keen to reevaluate their payment policies to constrain rising healthcare costs.  Several elements of the ACA are expected to limit reimbursement growth for hospitals, which form the largest market for medical devices. Lower reimbursement growth will likely persuade hospitals to scrutinize medical purchases by adopting i) higher standards to evaluate the benefits of new procedures and devices, and ii) a more disciplined price bargaining stance.

The transition of the healthcare delivery paradigm from fee-for-service (FFS) to value models is expected to lead to fewer hospital admissions and procedures, given the focus on cost-cutting and efficiency.  In 2015, the Department of Health and Human Services (HHS) announced goals to have 85% and 90% of all Medicare payments tied to quality or value by 2016 and 2018, respectively, and 30% and 50% of total Medicare payments tied to alternative payment models (APM) by the end of 2016 and 2018, respectively.  A report issued by the Health Care Payment Learning & Action Network (LAN), a public-private partnership launched in March 2015 by HHS, found that 29% of payments were tied to APMs, a 6% increase from 2015 to 2016.

While the shift toward value-based care is continuing, the pace could slow under the new administration.  In November 2017, the CMS partially canceled bundled payment programs for certain joint replacement and cardiac rehabilitation procedures.  However, indications are that the CMS supports value-based care and wants pilot programs to accelerate.  Ultimately, lower reimbursement rates and reduced procedure volume will likely limit pricing gains for medical devices and equipment.

The medical device industry faces similar reimbursement issues globally, as the EU and other jurisdictions face increasing healthcare costs, as well.  A number of countries have instituted price ceilings on certain medical procedures, which could deflate the reimbursement rates of third-party payors, forcing down product prices.  Industry participants are required to report manufacturing costs and medical device reimbursement rates are set potentially below those figures in certain major markets like Germany, France, Japan, Taiwan, Korea, China and Brazil.  Whether third-party payors consider certain devices medically reasonable or necessary for operations presents a hurdle that device makers and manufacturers must overcome in bringing their devices to market.

4. Competitive Factors and Regulatory Regime

Historically, much of the growth for medical technology companies has been predicated on continual product innovations that make devices easier for doctors to use and improve health outcomes for the patients.  Successful product development usually requires significant R&D outlays and a measure of luck.  However, viable new devices can elevate average selling prices, market penetration, and market share.

Government regulations curb competition in two ways to foster an environment where firms may realize an acceptable level of returns on their R&D investments.  First, firms that are first to the market with a new product can benefit from patents and intellectual property protection giving them a competitive advantage for a finite period.  Second, regulations govern medical device design and development, preclinical and clinical testing, premarket clearance or approval, registration and listing, manufacturing, labeling, storage, advertising and promotions, sales and distribution, export and import, and post market surveillance.

Regulatory Overview in the U.S.

In the U.S., the FDA generally oversees the implementation of the second set of regulations.  Some relatively simple devices deemed to pose low risk are exempt from the FDA’s clearance requirement and can be marketed in the U.S. without prior authorization.  For the remaining devices, commercial distribution requires marketing authorization from the FDA, which comes in primarily two flavors.

• The premarket notification (“510(k) clearance”) process requires the manufacturer to demonstrate that a device is “substantially equivalent” to an existing device that is legally marketed in the U.S. The 510(k) clearance process may occasionally require clinical data, and generally takes between 90 days and one year for completion.
• The premarket approval (“PMA”) process is more stringent, time-consuming and expensive. A PMA application must be supported by valid scientific evidence, which typically entails collection of extensive technical, preclinical, clinical and manufacturing data.  Once the PMA is submitted and found to be complete, the FDA begins an in-depth review, which is required by statute to take no longer than 180 days.  However, the process typically takes significantly longer, and may require several years to complete.

Pursuant to the Medical Device User Fee Modernization Act (MDUFA), the FDA collects user fees for the review of devices for marketing clearance or approval.  The current iteration of the Medical Device User Fee Act (MDUFA IV) came into effect in October 2017.  Under MDUFA IV, the FDA is authorized to collect almost $1 billion in user fees, an increase of more than $320 million over MDUFA III, between 2017 and 2022.

Regulatory Overview Outside the U.S.

The European Union (EU), along with countries such as Japan, Canada, and Australia all operate strict regulatory regimes similar to that of the FDA, and international consensus is moving towards more stringent regulations.  Stricter regulations for new devices may slow release dates and may negatively affect companies within the industry.

Medical device manufacturers face a single regulatory body across the EU.  In order for a medical device to be allowed on the market, it must meet the requirements set by the EU Medical Devices Directive.  Devices must receive a Conformité Européenne (CE) Mark certificate before they are allowed to be sold in that market.  This CE marking verifies that a device meets all regulatory requirements, including EU safety standards.  A set of different directives apply to different types of devices, potentially increasing the complexity and cost of compliance.

5. Emerging Global Markets

Emerging economies are claiming a growing share of global healthcare consumption, including medical devices and related procedures, owing to relative economic prosperity, growing medical awareness, and increasing (and increasingly aging) populations.  As global health expenditure continues to increase, sales to countries outside the U.S. represent a potential avenue for growth for domestic medical device companies.  According to the World Bank, all regions (except Sub-Saharan Africa) have seen an increase in healthcare spending as a percentage of total output over the last two decades.

Global medical devices sales are estimated to increase 6.4% annually from 2016 to 2020, reaching nearly $440 billion according to the International Trade Administration. While the Americas are projected to remain the world’s largest medical device market, the Asia/Pacific and Western Europe markets are expected to expand at a quicker pace over the next several years.

Bonus Items for 2018

The following is a (non-ordered) list of items likely relevant for the medical device and med tech industry over the shorter-term.

Tax Reform

Passage of tax reform legislation in late 2017 appears to have invigorated market participants across many sectors of the economy.  While the full effect of the new legislation will likely play out over the course of the rest of the year and beyond, the implications for valuation (multiples) are generally expected to be positive.  The effective tax rates for many multinational medical device companies were already below the new corporate rate.  Accordingly, reductions in overall tax burdens for device companies are likely modest.  A more immediate effect materialized in the form of a transition tax on corporate cash parked outside the U.S. (for example, Johnson and Johnson reported a one-time $13.6 billion charge related to the new tax law).  With a lower tax rate available on deemed repatriation, many corporations will likely have a more direct access to hitherto-unused overseas funds.

Innovation

Given the structural underpinnings (discussed in earlier sections), continued innovation is probably a low-risk bet vis-à-vis the medical device industry and is likely to materialize along three dimensions.  First, the traditional product pipeline nursed by the industry over the years is likely to continue turning out iterative and transformative changes to improve or create new devices (hardware).  Second, cost pressures as well as technological developments outside the industry will likely fuel new data analysis and tele-communication products and services (software) that augment or complement the traditionally product-only offerings of device and med tech companies.  Finally, business model innovations in response to the changing pricing and competitive landscape will become increasingly relevant, especially for the more mature devices.

M&A

The level of deal activity in the industry observed in 2017 will likely continue in 2018 as consolidation within certain sub-sectors could provide (a degree of) inoculation against the ravages of competitive forces.   Some potential acquirers will also be buoyed by the unlocking of the cash resources previously trapped overseas.  As in 2017, transaction motivations will likely mirror the three dimensions of innovation as firms pursue i) acquisition of complementary products, ii) access to newer higher-growth markets or segments, and iii) ability to address changes in the modes of care delivery that increasingly favor lower acuity settings over lengthy hospital stays.

Summary

Demographic shifts underlie the long-term market opportunity for medical device manufacturers.  While efforts to control costs on the part of the government insurer in the U.S. may limit future pricing growth for incumbent products, a growing global market provides domestic device manufacturers with an opportunity to broaden and diversify their geographic revenue base.  Developing new products and procedures is risky and usually more resource intensive compared to some other growth sectors of the economy.  However, barriers to entry in the form of existing regulations provide a measure of relief from competition, especially for newly developed products.

Benefits of a Financial Expert in Family Law: Why & When to Hire

Most family law attorneys do not have a background in finance or accounting, yet are often confronted with complex financial issues in divorce matters. The services of an experienced financial expert can be vital to you and your client in such matters.

In vetting financial experts, look for those who specialize in business valuation and forensic accounting. However, don’t pigeon-hole your expert. If your matter doesn’t require a business valuation or the tracing of dissipated assets, a financial expert can still be of great help to you in each phase of the process: discovery, deposition, and trial.

Beyond valuation, tracing, and testifying, below is a list of services a skilled financial expert provides to help you uncover and understand financial issues:

• Determine financial documentation requests for subpoena
• Examine submitted financial documents
• Evaluate the accuracy of previously mentioned documents
• Assess whether further support is necessary
• Assemble relevant information
• Quantify the financial elements of a case
• Identify and classify marital and nonmarital assets and liabilities
• Assist with interrogatory drafting
• Support deposition questionnaire drafting
• Attend depositions for real-time financial support

In financial situations that may be scrutinized by regulators, courts, tax collectors, and a myriad of other lurking adversaries, the financial, economic, and accounting experience and skills of a financial expert are invaluable.

To receive the highest benefit of financial expert services, hire the financial expert with ample time to assist with the various stages of the case and provide the expert access to pertinent documentation and information.

A competent financial expert will be able to define and quantify the financial aspects of a case and effectively communicate the conclusion.

For more information or to discuss your matter with us, please don’t hesitate to contact us.

Originally published in Mercer Capital’s Tennessee Family Law Newsletter, First Quarter 2018

The Important Role of Personal Financial Statements in Divorce

High dollar, contested divorce litigation engagements often involve complex financial issues. In turn, those financial issues usually include business valuations and voluminous amounts of documents and financial information. How does an attorney or business appraiser determine what is crucial to the case and what is secondary information? One such piece of financial information that varies wildly in its interpretation and importance to the case is a personal financial statement.

What Is a Personal Financial Statement?

Depending on the jurisdiction, most family law attorneys are familiar with documents often referred to as Sworn Financial Affidavits, Asset/Liability Statements, Marital Balance Sheet or Divorce Financial Statements that are included with the filing of the divorce case.

A personal financial statement is a similar document that is typically submitted to a bank or lending institution for the purpose of securing financing by representing an individual or couple’s financial position or net worth. In other words, it’s an asset and liability statement with estimates of value for each item akin to a balance sheet. Therefore, the couple’s or individual’s net worth is the sum of all assets, less the market value of all liabilities. For most liquid assets, such as cash/bank accounts, and investment/retirement accounts, the values can easily be obtained from the most recent account statement. Market value estimates for other assets, such as residential and personal real estate, can be obtained from recent appraisals, recent purchases, property tax assessments, and/or realtor websites. If the individual or couple owns a business, there generally is an estimate of value assigned to that asset. Since a business represents a non-liquid asset, the source of that value estimate can vary widely.

Below, is a common example of a personal financial statement:

Generally, the following items are excluded from a personal financial statement:

Leased/Rented Items: These assets are excluded since they are not actually owned by the couple or individual. However, if the couple owns a piece of property that is rented to someone else, it would be included as an asset. Further, some personal financial statements include a summary of all forms of income and expenses, often expressed in the form of monthly or yearly amounts, if the personal financial statement is used to obtain credit or to show the couple’s or individual’s overall financial position in addition to their net worth.

Personal Property: Refers to items such as furniture and household goods. Generally, the value of these items is not readily known and they are generally not considered for credit as they are unable to easily be sold. If there is any personal property with significant value, such as jewelry, cars, antiques or collectibles, their value might be included with an appraisal as the source of value. Family law attorneys will note that values for personal property are also generally not listed on divorce filings. Opinions on value can widely vary and often the true value to an individual may be rooted more in sentimental reasons than actual value. Unfortunately, the allocation of value to these items or the selection as to who ends up with each item can be one of the last and most challenging aspects to settling a case.

Why Is a Personal Financial Statement Important?

Family law attorneys, financial experts and business appraisers should ask for personal financial statements as part of their discovery or information request process. If one exists, how important is this document and how much weight should be given to it? Here’s where there are different views of the same document.

One view of a personal financial statement is that no formal valuation process was used for business assets; so at best, it’s a thumb in the air, estimate of value of the business. Did the business owner complete the form without consulting any external data or did the business owner recently conduct a business valuation on the business or consult with a business appraiser? Chances are the spectrum of possibilities is generally closer to the former than the latter, but it might bear to ask questions regarding the circumstances of the personal financial statement.

Another view is that the individual or couple submitting the personal financial statement is attesting to the accuracy and reliability of the financial figures contained in that document under penalty of perjury. Further, some would say the business owner is the most informed person regarding his/her business, its future growth opportunities, competition, and the impact of economic and industry factors on the business.

With such considerations, how do family law attorneys and business appraisers use personal financial statements? Dismiss them and throw them out? Use them as a gold standard and forego a formal business valuation? As usual, the two adages “it depends” and the “truth lies somewhere in the middle” are both probably accurate in this situation. Personal financial statements can be helpful in some cases or they can lack third party independent analysis as to the value of the business assets in other cases.

Do You Like Surprises?

Attorneys and business appraisers do not want to be surprised by not knowing about information or documents that exist. Therefore, ask for personal financial statements. They should then be used as another data point along with the other indications of value that a business appraiser is considering, such as an asset value, income value, market value, recent transactions within the Company’s stock, etc.

As with recent transactions within the Company’s stock or other market indications of value such as prior company transactions or contemplated sales/mergers, consideration should be given to the following factors: First, what is the timing of submission for the personal financial statement or data point to either the date of filing or date of trial. In other words, a recently submitted personal financial statement or data point is more relevant than one from five or ten years prior. Second, what was the context, relevance and motivation involved in the event? Why was the personal financial statement submitted or did the event represent an arm’s length transaction between two unrelated parties, as opposed to family members. Finally, do the values submitted in the personal financial statement or other data points caused by events represent elements of fair market value or do they reflect strategic value. A recent issue of Family Law Valuation and Forensic insights, covers the definitions of some of these standards of value in the overall context of understanding and defining the assignment.

If the value indicated for the business by the personal financial statement falls within a reasonable range of the estimates from the other methodologies, it could probably be given more weight. Be cautious if the value indicated for the business by the personal financial statement is materially higher or lower than a reasonable range indicated by the other methodologies. In which case, it may require the business appraiser to ask more questions regarding the thought process behind the estimate in the personal financial statement or why conditions might have changed drastically from the submission to current day.

Conclusion

Bottom line, ask for personal financial statements, review them, but consider them along with other factors and methodologies before concluding on a value for the business. These documents can be helpful in the divorce process, but don’t let them become the smoking gun by not asking for them or by not being aware that they exist.

Observations of New Tax Reform Law on Personal Goodwill in Family Law Cases

Most professionals have seen countless reports of the 2017 Tax Cuts & Jobs Act (TCJA) on national news and been bombarded with requests to discuss the impact and various changes in the new law.  For the family law community, obvious takeaways are the change in the deductibility, or lack thereof, in alimony payments after 2018, elimination of personal exemptions, and expanded use of 529 plans to include secondary and lower-level education expenses.  Can a provision in the TCJA actually provide some insight into the presence of personal goodwill?

Personal Goodwill Under Tennessee Law

Under Tennessee case law, personal goodwill is not a divisible marital asset.  As discussed in the seminal case Koch, the Court reiterates the findings and definition of personal goodwill provided by the Wisconsin Court of Appeals in Holbrook.  Holbrook describes personal goodwill as follows:

“The concept of professional goodwill evanesces when one attempts to distinguish it from future earning capacity. Although a professional business’s good reputation, which is essentially what its goodwill consists of, is certainly a thing of value, we do not believe that it bestows on those who have an ownership interest in the business, an actual, separate property interest. The reputation of a law firm or some other professional business is valuable to its individual owners to the extent that it assures continued substantial earnings in the future. It cannot be separately sold or pledged by the individual owners. The goodwill or reputation of such a business accrues to the benefit of the owners only through increased salary.”

Section 199A of the TCJA and Personal Goodwill

So, what does personal goodwill have to do with the TCJA?  Upon closer examination of the provision for a Section 199A deduction, some individual’s trusts and estates could be eligible for a 20% deduction on certain pass-through income.  However, there are special limitations that apply to “specified service businesses.”  According to the TCJA, “specified service businesses” are defined as follows:

A specified service trade or business means any trade or business involving the performance of services in the fields of health, law, accounting, actuarial sciences, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities.

Sound familiar?  Both the Holbrook and “Specified Service Businesses” definitions have some common elements including reputation and skill of the employee.  Under the TCJA, can tax returns now be used to assist attorneys and business appraisers to determine if the presence of personal goodwill exists?  In other words, if an individual fails to qualify for a Section 199A deduction because of the “specified service businesses” limitation, does that illustrate that personal goodwill is present?

We think the Section 199A provision and a person’s deductibility or exclusion of this deduction can provide another data point for attorneys and appraisers in determining whether personal goodwill is present.  As with any thorough analysis of personal vs. enterprise goodwill, other important factors to consider are:

1. Size of business and number of owners/practitioners
2. Presence/lack of covenants not to compete
3. Dependence on owner(s) for selling feature with Company’s products
4. Presence/lack of ancillary income

Conclusion

The 2017 Tax Cuts & Jobs Act may assist attorneys and appraisers in determining if personal goodwill is present via the Section 199A deduction.

As we’ve pointed out, this deduction/exclusion is just one of several data points that should be considered. It should also be noted, that determining whether personal goodwill is present or not is only the first step to an analysis. If personal goodwill is present, the second step is to determine or assign value to the personal goodwill. In other words, a company’s value could be comprised of both enterprise and personal goodwill. A qualified business appraiser is necessary to make this determination and to provide an allocation of the goodwill.

Originally published in Mercer Capital’s Tennessee Family Law Newsletter, First Quarter 2018

Management Succession in Family Businesses

Next Man (or Woman) Up?

Perhaps no group is as proficient at the art of clichéd answers as football coaches. When confronted with the season-ending injury of a star player, the coach will inevitably stare stoically into the camera and solemnly declare “Next man up.” Whether the coach truly believes that the replacement player will be adequate, the cliché is intended to convey the idea that the coach has created such a “culture of success” that the “Process” (two of the newer clichés) that the team’s performance will be unaffected.

From the perspective of family business, “Next Man or Woman Up” is one approach that the board of directors can take to management succession. Perhaps for some family businesses, management succession is as simple as pulling the next available candidate from the management depth chart. But we suspect that approach falls short for most family businesses. The combination of business growth, generational dynamics, and intra-family relationships that make family businesses unique precludes one-size-fits-all solutions to management succession. The primary questions associated with management succession are (1) Who will be the next leader of the business? and (2) How will the transition occur?

First Question: Who?

In our experience, many succession struggles are rooted in a failure to distinguish between being a good family member, a good employee, and a good business leader. The combination of native ability, education, character, social IQ, technical skills, and strategic savvy necessary to run a large business successfully is rare. The often-unspoken assumption that, since Dick has been a good son, or Jane a good daughter, that he or she is entitled to run the business when his or her turn comes up is unfair to the shareholders and employees of the business, not to mention Dick or Jane. While there are abundant examples of capable and energetic second, third or later generation family members that are great business leaders, it is a mistake to think that management of the business should simply be a matter of inheritance.

The second common myth is that since Bill and Suzie have demonstrated themselves to be great employees (in whatever functional area) that they will, therefore, be great leaders. Being good at one’s job does not guarantee success as the leader of a family business. Further, as companies grow, new challenges may require a different set of leadership skills than were required in the prior generation. The skills and personality traits that made Uncle Phil the ideal leader of the business twenty-five years ago may be different from what Cousin Carlton needs to possess for success in the same role today.

If the family has successfully distinguished family membership from family business management, it may be easier for the board to cast a wider net to find the best candidate to assume leadership of the business. Having an “outside” CEO does not mean the company has ceased to be a family business any more than hiring the first non-family employee on the shop floor did. Rather, it simply means that the directors have fulfilled their responsibilities to shareholders, employees and the community by seeking the right candidate for the job. Family members are by no means ruled out from consideration, but directors must acknowledge that the requisite skills may not reside in the family. And that’s okay. Having “professional” management may actually help family cohesion – and therefore business sustainability.

In many cases, the combination of outside perspective and family loyalty that make a successful leader can be found among the family’s in-laws. Such “married-ins” are often sufficiently removed from family dynamics that they can see business issues for what they are, uncolored by what may be decades’ worth of emotional baggage. At the same time, their membership in the family may give a head-start in aligning economic incentives. In other words, “married-ins” will likely have plenty of skin in the game.

Second Question: How?

In the long run, management succession is inevitable: the proportion of managers that are eventually replaced is 100%. In the short run, however, there are generally three circumstances giving rise to management succession.

1.     Planned Retirement: When the senior executive is approaching a natural retirement age, the directors should identify potential candidates to replace the retiring leader. With a multi-year planning horizon, the board can give due consideration to family candidates, develop mentoring opportunities for those candidates, and evaluate the performance of those candidates in areas of increasing responsibility. If it becomes apparent that no family candidates represent the right fit for the job, the board can extend the search to include existing non-family employees and non-employees.

The appropriate retirement age for family business executives is a vexing issue. There simply is no one-size-fits-all for when a successful family business leader should step away. In our practice, we have seen examples of departures that – in hindsight – were premature, because the designated replacement was not yet ready to assume leadership. Perhaps more commonly, we see examples of businesses that plateau and stagnate because an aging senior executive refuses to move out of the corner office.

2.     Performance-Driven Transition: We wrote in a previous post about the unique challenges associated with management accountability in family businesses. If the directors determine an existing senior executive is not generating acceptable results, it may be appropriate to seek a replacement. Family dynamics can make this an extremely difficult decision, and the prospect that such a decision may be in the best interest of the principal stakeholders (family shareholders, employees, local community, customers, suppliers, etc.) is one good reason to include qualified independent non-family members on the board. The independent directors can provide an objective assessment of managerial performance uncolored by internal family dynamics. If a performance-driven transition is necessary, the ultimate replacement should not be selected hastily; the long-run health of the business may be better served by a deliberate selection process, during which an experienced executive can manage the company on an interim basis.

3.     Unexpected Vacancy: Finally, management succession may be forced upon the company because of an untimely illness, death, or other unforeseen circumstances. No business is immune to such circumstances, which underscores the need for directors to proactively think about management succession, even when the current leader is successful and expected to have a lengthy remaining tenure. When tragedy strikes, selecting the next leader should still be considered a measure-twice, cut-once project, with the long-term health of the organization taking precedence over the short-term desire to fill the position.

As noted in the Harvard Business Review, recent research by Stephanie Querbach, Miriam Bird, and Nadine Kammerlander offers some interesting insights into best practices for management succession in family businesses. After studying over 500 management successions, they concluded the likelihood that successor-managers would be able to implement needed changes and improve the long-term sustainability of the family business was linked to three strategies: (1) limiting the power of the outgoing CEO subsequent to his or her retirement, (2) crafting a formal agreement regarding the how and when of power transfer, and (3) selecting a non-family successor. Of course, these observations reflect probabilities – they’re not absolute prescriptions for how every succession should occur. But they do provide a somewhat counter-intuitive perspective on the topic that family businesses would do well to consider.

In the end, every management succession plan will be as unique as the family business it is designed for. But one constant for all family businesses is that now is the time to begin thinking and planning. “Next Man Up” may work in football, but your family business deserves better than that.

Father Knows Best? Management Accountability in Family Businesses

One of the greatest sources of strife in family businesses is ill-defined roles.

• What does a good shareholder do?
• What is expected of a family business board member?
• How will the performance of management be evaluated?

Management accountability is hard for any company; effective management accountability within a complex web of family relationships can be an order of magnitude more difficult. Since some family members may fill multiple roles, clear and appropriate expectations paired with measurable outcomes are foundational to a management accountability structure that promotes business sustainability and family cohesion.

Who Sets Expectations?

Management accountability is an element of overall corporate governance. In family businesses, corporate governance and family governance can sometimes be hard to separate, but working to distinguish between the two pays dividends for both the business and the family.

The first step for many families in developing more formal governance is moving strategic business deliberations from the dining room to the board room. In the first generation, it is common for the board to consist only of mom and dad. As the business matures, the natural result of such arrangements is that the board meets continually, but never effectively. What works for the bootstrapping startup does not work for the established multi-generation family business. Formalizing the board governance process may be as simple as scheduling regular meetings, establishing appropriate sub-committees, and preparing real agendas which are distributed to members in advance of meetings. The addition of one or more independent directors may be appropriate for some companies. Independent directors with industry expertise and relevant experience can provide fresh perspective to deliberations and model how to provide frank feedback unencumbered by family baggage. The appointment of independent directors also signals that the board’s job is company oversight, not to serve as the final arbiter for non-business family disputes.

A second common step is to establish a family council. While all family councils are unique, the principal role of the family council is to provide a forum for group decision-making on non-business family matters. Many family councils also provide opportunities for education regarding the business and collect input from family members about business decisions including distribution policy, capital structure, and capital budgeting (i.e., reinvestment). This input is valuable to the board, but is not binding; the board has sole responsibility for business oversight.

A parallel governance structure like that illustrated above helps to clarify that management (whether comprising family members or non-family professionals) is accountable to the board of directors, who in turn owes a fiduciary duty to the shareholders. As a result, the board of directors has the authority and responsibility to establish expectations for management, assess performance, and determine whether remedial actions are appropriate. In other words, the CEO is accountable to the board of directors and not her obstreperous second cousin.

How Should Expectations Be Set?

One reason successful family businesses remain privately-held is that such businesses can more easily avoid the “short-termism” perceived to afflict public markets, where success or failure might judged by next quarter’s earnings release. Since family businesses are free from the constraints of the quarterly reporting treadmill, management expectations should reflect the long-term goals that will promote the sustainability of the business and the financial success of the family.

Developing a so-called “balanced scorecard” to evaluate management performance can help promote a long-term perspective that aligns management accountability with the overall health of the company. As developed by Professor Robert Kaplan of the Harvard Business School, a balanced scorecard can help to promote management accountability by focusing on four key elements of business success.

• Customer perspective: How do customers see the business?
• Internal business perspective: What must the business excel at?
• Innovation and learning perspective: Can the business continue to improve and create value?
• Financial perspective: How does the business look to shareholders?

Notice that the financial perspective is only one component of the balanced scorecard. To be sure, if management succeeds with regard to the other perspectives, financial success should follow. The idea is to take a broader view of corporate health, balancing traditional financial metrics with a few measurable operating metrics that will reveal whether the company is engaging in the activities that will promote the long-term sustainability (and financial performance) of the business.

The essence of a balanced scorecard – or any other management accountability tool – is pairing observable measures with business-specific goals under each perspective. Metrics that are not correlated to the company’s strategies won’t get traction, and goals that can’t be measured won’t be achieved. To be useful as a management accountability tool, the selected metrics should describe processes or outcomes over which management has at least some degree of control. For example, revenue per day of operation and number of rainout days are both measures that contribute to the financial success of a theme park, but only one is subject to management influence.

Making Accountability Work

Managing the family business is not a birthright, nor is it a responsibility that must be borne simply because of one’s birth. It is a job, and the associated compensation and financial incentives should reflect market conditions. The hardest part of a management accountability system is deciding what to do when clearly-communicated goals are not met. An ill-conceived accountability framework that does not have the support of all the major stakeholders can – in the end – create more problems than it solves.

Goals may fail to be met for multiple reasons:

•  The goal was unrealistic. In retrospect, it may be obvious that no management team could have delivered the specified results.
• Management performed unsatisfactorily. Given the available resources and prevailing market conditions, management simply failed to meet expectations.
• Market or other forces outside of management’s control negatively affected the business. Going back to our prior example, the theme park may have suffered through an abnormally rainy summer.
• The business strategy proved to be ineffective and needs to be revised. Management has executed the plan flawlessly, but the plan did not accurately reflect the customer, supplier, technological, or competitive forces shaping the industry.

The reasons for failure are not always easy to discern. If the goals were unrealistic, management accountability should look different than if management performed unsatisfactorily. If the business strategy proved to be ineffective, who was responsible for developing the strategy? If the board supported, or perhaps even mandated, the strategy, to what degree should management be accountable for its failure? Evaluating management performance requires both strong nerves and the ability be flexible when warranted. A seasoned, independent outside voice on the board can be especially valuable when poor performance needs to be evaluated.

Conclusion

Management accountability in family businesses is hard. Overlooking the failures of a favored relative and magnifying minor faults because of a strained family relationship are both ever-present temptations. In the end, management is accountable to the board of directors, not the family at large. Management performance should be evaluated relative to a set of clearly-defined and measurable objectives that further the long-term health and sustainability of the company. Evaluating management performance when goals are not met is difficult, but failing to evaluate performance (and thereby letting problems fester) is not a responsible course of action.

Fairness When the Price May Not Feel “Right”

Viewed from the prism of “fairness” in which a transaction is judged to be fair to shareholders from a financial point of view, many transactions are reasonable; some are very fair; and some are marginally fair. Transactions that are so lopsided in favor of one party should not occur absent a breach of corporate duties by directors (i.e., loyalty, care and good faith), bad advice, or other extenuating circumstances. Obtaining competent financial advice is one way a board exercises its duty of care in order to make an informed decision about a significant corporate transaction.

The primary arbiter of fairness is the value of the consideration to be received or paid relative to indications of value derived from various valuation methodologies. However, the process followed by the board leading up to the transaction and other considerations, such as potential conflicts, are also important in the context of “entire” fairness.

A tough fairness call can occur when a transaction price appears to be low relative to expectations based upon precedent transactions, recent trading history, management prognostications about a bright future, and/or when the value of the consideration to be received is subject to debate. The pending acquisition of commercial finance lender NewStar Financial, Inc. (“NewStar”; Nasdaq-NEWS) is an example where the acquisition price outwardly seems to be low, at least until other factors are considered.

NewStar Example

On October 16, 2017, NewStar entered into a merger agreement with First Eagle Holdings, Inc. (“First Eagle”) and an asset purchase agreement with GSO Diamond Portfolio Holdco LLC (“GSO”). Under the merger agreement, NewStar will be acquired by First Eagle for (a) $11.44 per share cash; and (b) non-transferable contingent value rights (“CVR”) that are estimated to be worth about $1.00 per share if the transaction closes before year-end and $0.84 per share if the transaction closes in 2018. The CVR reflects the tax benefit associated with the sale of certain loans and investments at a discount to GSO for $2.37 billion.

Also of note, the investment management affiliate of First Eagle is majority owned by an entity that is, in turn, partially owned by Corsair Capital LLC, which is the largest shareholder in NewStar with a 10.3% interest.

Acquisition Price

As shown in Figure 1, the acquisition price including all of the CVR equates to 83% of tangible book value (“TBV”), while the market premium is nominal. Although not relevant to the adequacy of the proposed pricing, NewStar went public in late 2006 at $17.00 per share then traded to around $20 per share in early 2007 before sliding to just about $1.00 per share in March 2009.

“Feel” is a very subjective term; nonetheless the P/TBV multiple that is well below 100%, when combined with the nominal market premium, feels light. NewStar is not a troubled lender. Non-performing assets the past few years have been in the vicinity of 3% of loans, while net charge-offs have approximated 1% other than 2015 when losses were negligible. Further, the implied haircut applied to the loans and investments that will be acquired by GSO is modest.

Transaction Multiples

While the P/TBV multiple for the transaction is modest, the P/E multiple is not at 26.5x (the latest twelve month (“LTM”) earnings) and 18.4x (the consensus 2018 estimate). The P/E could be described as full if NewStar were an average performing commercial bank and very full if it was a typical commercial finance company in which low teen P/Es are not unreasonable.

What the P/TBV multiple versus the P/E multiple indirectly states is that NewStar has a low ROE, which has been less than 5% in recent years. The culprit is a highly competitive market for leveraged loans, a high cost of funds absent cheap bank deposit funding and perhaps excess capital. Nonetheless, management’s projections incorporated into the recently filed proxy statement project net income and ROE will double from $20 million/3% in the LTM period ended September 30 to $41 million/6% in 2020.

In spite of a doubling of projected net income, the present value (assuming NewStar is worth 18.4x earnings in 2020 discounted to September 30 at a discount rate of 13%) is about $507 million, or about the same as the current transaction value to shareholders. Earnings forecasts are inherently uncertain, but one takeaway is that the P/TBV multiple does not appear so light in the context of the earnings forecast.

Additional perspective on the transaction multiples is provided in Figure 2 in which NewStar’s P/TBV multiple based upon its public market price consistently has been below 100% the last several years while the P/E has been around 20x or higher due to weak earnings.

Performance and Timing

As for the lack of premium there outwardly did not appear to be wide-spread expectation that a transaction was imminent (as was thought possible in 2013 when Bloomberg reported the company was shopping itself). There were no recent media reports; however, the shares fell by 17% between May 2–May 19 following a weak first quarter earnings report. The shares subsequently rebounded 19% between June 6–June 14. Both the down and then up moves were not accompanied by heavy volume. Trading during most of this time frame fell below the approximate 100 thousand daily average shares.

Measured from June 14–October 17, the day after the announcement, NewStar’s shares rose about 10% compared to 8% for the SNL Specialty Finance Index. Measured from May 19, when the shares bottomed following the weak first quarter results the shares rose 34% compared to 12% for the index through October 17. The market premium relative to recent trading was negligible, but it is conceivable some premium was built into the shares for the possibility of a transaction given the sharp rebound during mid-June when negotiations were occurring.

Other Support for the Transaction

Further support for the transaction can be found in the exhaustive process that led to the agreements as presented in the proxy statement. The proxy confirmed the Bloomberg story that the board moved to market the company in 2013. Although its investment bankers contacted 60 potential buyers, only two preliminary indications of value were received, in part because U.S. banking regulators tightened guidelines in 2013 related to leverage lending by commercial banks. The two indications were later withdrawn.

During 2016 discussions were held with GSO regarding a going-private transaction, in addition to meetings with over 20 other parties to solicit their interest in a transaction. By the spring of 2017, consideration of a going-private transaction was terminated. Discussions then developed with First Eagle/GSO, Party A and Party B that eventually led to the announced transaction. Given the experience of trying to sell NewStar in 2013 and go private in 2016, the board elected not to broaden the marketing, calculating the most likely bidders would be alternative asset managers (vs. banks with a low cost of funding).

Fairness considerations about the process were further strengthened through a “go-shop” provision in the merger agreement that provided for a 30-day “go-shop” period in which alternative offers could be solicited. If a superior offer emerged and the agreements with First Eagle and GSO were terminated a modest termination fee of $10 million (~2.5%) would be owed. Conversely, if NewStar terminates because GSO cannot close, then a $25 million termination fee will be owed to NewStar.

The go-shop provision was activated, but to no avail. More than 50 parties were contacted and seven other unsolicited inquiries were received. NewStar entered into confidentiality agreements with 22 of the parties, but no acquisition proposals were received.

Financial Advisors

Other elements of the agreements that are notable for a fairness opinion include the use of two financial advisors, financing, and director Thornburgh, who was recused from the deliberations given his association with 10% shareholder Corsair, which holds, with Blackstone, a majority interest in First Eagle. Financing was not a condition to close on the part of the buyers because GSO secured $2.7 billion of debt and equity capital to finance the asset purchase. First Eagle will use excess funds from the asset purchase and existing available cash to fund the cash consideration to be paid at closing to NewStar shareholders. While two financial advisors cannot make an unfair deal fair, the use of two here perhaps gave the board additional insight that was needed given the four-year effort to sell, take the company private, or affect some other corporate action to increase value.

The Lesson from the NewStar Example

While the transaction price for NewStar seems low, there are other factors at play that bear consideration. When reviewing a transaction to determine if it is fair from a financial viewpoint, a financial advisor has to look at the entire transaction in context. Some shareholders will, of course, focus on one or two metrics to support a view that is counter to the board’s decision.

Conclusion

Every transaction has its own nuances and raison d’etre whether the price “feels right” or not. Mercer Capital has significant experience helping boards sort through valuation, process and other issues to determine what is fair (or not) to shareholders from a financial point of view. Please call if we can help your board make an informed decision.

Originally published in Bank Watch, December 2017.

2018 Trends to Watch in the Banking Industry: Acquire or Be Acquired Conference Recap

For those readers unable to escape the cold to attend Bank Director’s Acquire or Be Acquired (AOBA) conference in Scottsdale, AZ, we reflect on the major themes: bank M&A and scarcity, tax reform and valuation, and FinTech. For those unfamiliar with the three-day event, over 1,000 bankers, directors, and advisors gather to discuss pertinent industry issues.

Bank M&A and Scarcity

There are fewer than 5,500 banks today, which is roughly half from only 10 years ago when we first attended AOBA. This scarcity was top-of-mind for several panelists who noted variations on the same theme: Scarcity matters to both buyers and sellers as the number of banks dwindles at a rate of 3-4% per annum.

Unlike the 1990s and even the pre-crisis years when a seller could expect multiple offers, banks that sell today often have just one or two legitimate suitors. In our view, this means that sellers need to think more strategically about their valuation today and prospectively if their most logical suitor(s) is acquired. Even if the logical acquirer is unlikely to be acquired, board planning for some institutions should consider the potential to strike a (cash) deal with a credit union. For buyers, scarcity may translate into less desirable banks in targeted markets. If so, scarcity may mean greater emphasis on expansion through lift-outs from other banks, or even a push into non-traditional bank acquisitions/investments such as wealth management that could serve as a nucleus around which traditional banking services are bolted. One key question to watch: Will scarcity impact the pace of consolidation and the valuation of transactions? The short answer is seemingly “yes,” but rising acquisition valuations over the past couple of years correspond to the rising value of acquirers’ publicly traded shares.

Tax Reform and Valuation

The banking sector was revalued higher in the public markets following the November 2016 elections, reflecting four attributes that would favor banks: regulatory reform, tax reform, faster GDP growth, and therefore, higher interest rates. While the impact (thus far) of regulatory reform and higher interest rates is limited, passage of the Tax Cuts and Jobs Act of 2017 is a highly tangible benefit for banks and customers. With the stroke of a pen, ROE for many banks will rise to or above the institution’s cost of capital, returning to pre-financial crisis levels. However, tax reform is not a cure for strategic issues such as whether FinTech may radically disrupt the “core” in the deposit relationship between customers and their banks.

One panelist summed up the debate by noting that management teams who achieve a 10-15% increase in earnings and ROE in 2018 from tax reform are not geniuses; rather, they are around to cash the check. The real winners, as it relates to tax reform, will be banks that leverage the enhanced cash flows to make optimal capital budgeting and strategic decisions. Bankers will have to allocate the additional earnings before some of it is competed away among investments in staff, technology and/or higher dividends, share repurchases and acquisitions. Perhaps in the ideal world, the incremental capital to be created would be used to support faster loan growth, but few at the conference indicated their institution had seen an increase in loan growth as a result of tax reform.

A related theme that emerged in several sessions was the dichotomy in valuations between the “haves” and “have-nots” along key metrics such as size, profitability, core deposits, location, management team, and operating strategy/niche. This divergence could widen further following tax reform as the “haves” effectively take their higher cash flows and reinvest/deploy them more profitably than the “have-nots.” Ultimately, these strategic decisions and the trajectory of the bank’s performance will drive whether tax reform leads to sustainably higher bank valuations, likely varying case-by-case. For those interested, we discuss implications of tax reform for banks in greater detail here.

FinTech

While FinTech wasn’t even on the agenda when we first made the trip to Scottsdale for AOBA in the mid-2000s, it was all over this year’s schedule. One panelist humorously compared bankers’ reactions to FinTech with the “Seven Stages of Grief” noting that bankers seemed to have finally progressed beyond the early-stages of anger and denial toward the latter-stage of acceptance. Bankers are considering practical solutions to incorporate FinTech into their strategic plans. Sessions included panel discussions on the nuts and bolts of structuring FinTech partnerships and creating value through leveraging FinTech to enhance profitability. (For those interested in FinTech, learn more about our book on the topic.) Niches of FinTech that garnered particular attention included digital lending, payments (both consumer and business), blockchain, and artificial intelligence. AI in particular was top-of-mind, and one panel noted it as an area of FinTech offering strong potential for banks in the next few years.

We look forward to discussing these three themes with clients in 2018 and monitoring how they evolve within the banking industry over the next few years. As always, Mercer Capital is available to discuss these trends as they relate to your bank – feel free to call or email.

Originally published in Bank Watch, February 2018.

Diversification and the Family Business

The following is an installment in our series “What Keeps Family Business Owners Awake at Night”

Consider the following perspectives on diversification and risk:

“Diversification is an established tenet of conservative investment.” – Legendary value investor Benjamin Graham

“Diversification may preserve wealth, but concentration builds wealth.” – Legendary value investor Warren Buffett

The appropriate role of diversification in multi-generation family businesses is not always obvious. One of the most surprising attributes of many successful multi-generation family businesses is just how little the current business activities resemble those of 20, 30, or 40 years ago. In some cases, this is the product of natural evolution in the company’s target market or responses to changes in customer demand; in other cases, however, the changes represent deliberate attempts to diversify away from the legacy business.

What is Diversification?

Diversification is simply investing in multiple assets as a means of reducing risk. If one asset in the portfolio takes a big hit, it is likely that some other segment of the portfolio will perform well at the same time, thereby blunting the negative impact on the overall portfolio. The essence of diversification is (lack of) correlation, or co-movement in returns. Investing in multiple assets yields diversification benefits only if the assets behave differently. If the correlation between the assets is high, the diversification benefits will be negligible, while adding assets with low correlations results in a greater level of risk reduction.

To illustrate, consider a family business deciding which of the following three investments to make:

There is no unambiguously correct choice for which investment to make. While the capacity expansion project offers the highest expected return, the close correlation of the returns to the existing business indicates that the project will not reduce the risk – or variability of returns – of the company. At the other extreme, the warehouse acquisition has the lowest expected return, but because the returns on the warehouse are essentially uncorrelated to the existing business, the warehouse acquisition reduces the overall risk profile of the business. The correct choice, in this case, should be made with respect to the risk tolerances of the shareholders and how the investments fit the strategy of the business.

Diversification to Whom?

Business education is no less susceptible to the lure of fads and groupthink than any roving pack of middle schoolers. When I was being indoctrinated in the mid-90s, the catchphrase of the moment was “core competency.” If you stared at any organization long enough – or so the theory seemed to go – you were likely to find that it truly excelled at only a few things. Success was assured by focusing exclusively on these “core competencies” and outsourcing anything and everything else to someone who had a – you guessed it – “core competency” in those activities. Conglomerates were out and spin-offs were in. With every organization executing on only their core competencies, world peace and harmony would ensue. Or something like that.

I don’t know what the status of “core competency” is in business schools today, but it does raise an interesting question for family businesses: whose perspective is most important in thinking about diversification? If the relevant perspective is that of the family business itself, the investment and distribution decisions will be made with a view to managing the absolute risk of the family business. If instead the relevant perspective is that of the shareholders, investment and distribution decisions are properly made with a view to how the family business contributes to the risk of the shareholders’ total wealth (family business plus other assets).

Modern finance theory suggests that for public companies, the shareholder perspective should be what is relevant. Shareholders construct portfolios, and presumably the core competency of risk management resides with them. Corporate managers should therefore not attempt to diversify, because shareholders can do so more efficiently and inexpensively. In other words, corporate managers should stick to their core competencies and not worry about diversification.

That’s all well and good for public companies, but for family businesses, the most critical underlying assumptions – ready liquidity and absolute shareholder freedom in constructing one’s portfolio – simply does not hold. Family business shares are illiquid and often constitute a large proportion of the shareholders’ total wealth. Further, as families mature, shareholder perspectives will inevitably diverge.

For example, consider two cousins: Sam has devoted his career to managing a non-profit clinic for the underprivileged, and Dave has enjoyed an illustrious career with a white-shoe law firm. Both are 50 years old and both own 5% of the family business. Sam’s 5% ownership interest accounts for a significantly larger proportion of his total wealth than does Dave’s corresponding 5% ownership interest. As a result, they are likely to have very different perspectives on the role and value of diversification for the family business. Sam will be much more concerned with the absolute risk of the business, whereas Dave will be more interested in how the business contributes to the risk of his overall portfolio.

We wrote in a previous post about the four basic “meanings” that a family business can have. What the business “means” to the family has significant implications for not only distribution and reinvestment policy, but also the role of diversification in the business.

So how should family businesses think about diversification? When evaluating potential uses of capital, family business managers and directors should consider not just the expected return, but also the degree to which that return is correlated to the existing operations of the business. Depending on what the business “means” to the family, the potential for diversification benefits may take priority over absolute return. There are no right or wrong answers when it comes to risk tolerance, but there are tradeoffs that need to be acknowledged and communicated plainly. Family shareholders deserve to know not just the “what” but also the “why” for significant investment decisions.

To Invest or Not to Invest, That is the Question

The following is an installment in our series “What Keeps Family Business Owners Awake at Night”.

Successful family businesses are built over time, and building well requires investment. Since a given dollar of cash flow generated by a business will either be returned to capital providers or reinvested in the business, a company’s reinvestment policy is essentially the inverse of its distribution policy: businesses that reinvest heavily will make modest distributions, while those that emphasize large distributions will have less available for reinvestment in the business.

Cash distributed leaves the business, providing current returns to investors, while reinvested funds remain in the business with the expectation that the retained capital will generate returns which contribute to capital appreciation. In other words, the tradeoff between current return and capital appreciation is rooted in the corresponding tradeoff between distribution and reinvestment.

For a family business, investment can take different forms.

• Capacity maintenance and modernization. Tangible assets wear out, and technological advances can render existing assets inefficient relative to available replacement assets. It may be possible to defer certain expenditures with few observable consequences in the short-term, but the bill always comes due eventually. While investments in capacity maintenance and modernization are not always the most exciting, successful family businesses recognize their priority for long-term sustainability.
• Capacity Expansion. In our experience, businesses are either growing or dying – holding steady is nearly impossible over the long-term. Investments in capacity expansion help keep family businesses on a growth footing. Depending on the company’s circumstances, growth investments may involve penetrating new geographic markets, introducing new product lines, or research to develop products for an unmet market need.
• Acquisitions. Rather than building incremental capacity, managers and directors of a family business may determine that it is more efficient to assimilate existing industry capacity through an acquisition. Acquisitions offer the opportunity to “hit the ground running” with a built-in customer base, workforce, tradename and other intangible assets that typically accrue slowly over time. On the other hand, acquisitions present integration and culture challenges (and the risk of overpayment) not relevant to other forms of investment. For perspective, during the most recent year, the companies in the S&P 600 small cap index spent $24.2 billion on acquisitions, compared to $28.7 billion on capital expenditures, with nearly 40% of the companies having completed at least one acquisition.
• Diversification. Acquisitions are often classified as either vertical (purchase of a supplier or customer) or horizontal (purchase of a competitor). Both types of acquisitions have some organic connection to the existing business. Sometimes, however, family businesses make investments that are unrelated to legacy operations. It is not uncommon for family businesses to make investments for the sake of diversification, particularly as the business matures and the number of shareholding generations increases.

One of my favorite Seinfeld moments (among many) is set at the car rental counter, where an exasperated Jerry explains to the uncomprehending agent the difference between taking a reservation and holding a reservation. Taking the reservation is easy, but holding the reservation is what really matters. In the same way, investing for growth is easy: there are plenty of equipment dealers eager to sell shiny new machines and investment bankers who can’t wait to describe an exciting acquisition target. But making good investments – those for which the tradeoff between current returns and capital appreciation worthwhile – is considerably harder. So, what are the marks of a good investment?

• Market opportunity. A good investment addresses an identifiable need in the market. Further, given the competitive environment in the relevant markets, the identified need can be met profitably. In other words, management should have a simple and straightforward answer to the threshold question: Why does this make sense?
• Strategic fit. Family business managers and directors should also have a concise and credible answer to the natural follow-up question: Why does this make for us? In other words, how does the proposed investment complement the company’s corporate strategy? If it extends or deviates from the current strategy, why is the strategy adjustment appropriate? As we described in the context of distribution policy, the business can have a variety of potential “meanings” to the family – does the proposed investment cohere with the “meaning” of the family business?
• Financially vetted. A thorough capital budgeting process will involve calculating relevant return measures (internal rate of return, net present value) to assess whether the investment opportunity is likely to increase or decrease the value of the company. Of course, figures lie and liars make spreadsheets. For a proposed investment that addresses a real market opportunity and is a strategic fit for the company, the financial vetting process should be geared to answering another vital question: What financial results are necessary for this investment to be good for us? Has management assembled a compelling case for the expected returns, or is the investment more of a “trust me” exercise?
• Plan for monitoring. The most often neglected component of the capital budgeting process is establishing a feedback mechanism for the investment. Too often, capital investments simply melt away into the general corporate asset pool, with no reliable means of evaluating whether the investment generated an appropriate return. In other words, how will we know if this investment was, in fact, good for us? The ability to evaluate past investments is critical to making better investments in the future.

All family businesses need to evaluate how they are investing for future growth. Managers and directors must navigate carefully between the risks of depressed future returns through over-investment (i.e. empire building) and losing existing competitive advantages through insufficient reinvestment. The long-term sustainability of the family business depends on it.

Dividend Policy and the Meaning of Life (Or, At Least, Your Business)

The following is an installment in our series “What Keeps Family Business Owners Awake at Night”

Our multi-generation family business clients ask us about dividend policy more often than any other topic. This should not be unexpected, since returns to family business shareholders come in only two forms: current income from distributions and capital appreciation. For many shareholders, capital appreciation is what makes them wealthy, but current income is what makes them feel wealthy.

In other words, distributions are the most transparent expression of what the family business means to the family economically. Knowing what the business “means” to the family is essential for promoting positive shareholder engagement, family harmony, and sustainability. The business may “mean” different things to the family at different times (or, to different members of the family at the same time). In our experience, there are four broad “meanings” that a family business can have. These “meanings” are not mutually exclusive, but one will usually predominate at a given time. As discussed below, the “meaning” of the business has implications for the role of distributions.

• Meaning #1 – The family business is an economic growth engine for future generations. For some families, the business is perceived as a vehicle for increasing per capita family wealth over time. For these families, distributions are likely to take a backseat to reinvestment in the business needed to fuel the growth required to keep pace with the biological growth of the family.
• Meaning #2 – The family business is a store of value for the family. For other families, the business is perceived as a means of capital preservation. Amid the volatility of public equity markets, the family business serves as ballast for the family’s overall wealth. Distributions are generally modest for these families, with earnings retained, in part, to mitigate potential swings in value.
• Meaning #3 – The family business is a source of wealth accumulation. Alternatively, the business may be perceived as a mechanism for accumulating family wealth outside the business. In these cases, individual family members are expected to use distributions from the business to accumulate wealth through investments in marketable securities, real estate, or other operating businesses. Distributions are emphasized for these families, along with the (potentially unspoken) expectation that distributions will be used by the recipients to diversify away from, and limit dependence on, the family business.
• Meaning #4 – The family business is a source of lifestyle. Finally, the business may be perceived as maintaining the family’s lifestyle. Distributions are not expected to fund a life of idle leisure, but are relied upon by family shareholders to supplement income from careers and other sources for home and auto purchases, education expenses, weddings, travel, philanthropy, etc. These businesses typically have moderate reinvestment needs, and predictability of the dividend stream is often more important to shareholders than real (i.e., net of inflation) growth in the dividend. Continuation of the dividend is the primary measure the family uses to evaluate management’s performance.

From a textbook perspective, distributions are treated as a residual: once attractive reinvestment opportunities have been exhausted, the remaining cash flow should be distributed to the shareholders. However, at a practical level, the different potential “meanings” assigned to the business by the family will, to some degree, circumscribe the distribution policy alternatives available to the directors. For example, eliminating distributions in favor of increased reinvestment is not a practical alternative for family businesses in the third or fourth categories above, regardless of how abundant attractive investment opportunities may be.

The following table illustrates the relationship between “meaning” and distribution policy:

The textbook perspective on distribution policy is valid, but can be adhered to only within the context of the “meaning” assigned to the family business. In contrast to public companies or those owned by private equity funds, “meaning” will generally trump dispassionate analysis of available investment opportunities. If family business leaders conclude that the “meaning” assigned to the business by the family does not align with the optimal distribution policy, the priority should be given to changing what the business “means” to the family. Once the change in “meaning” has been embraced by the family, the change in distribution policy will more naturally follow.

A distribution policy describes how the family business determines distributions on a year-to-year basis. A consistent distribution policy helps family shareholders understand, predict, and evaluate distribution decisions made by the board of directors. Potential family business distribution policies can be arrayed on a spectrum that ranges from maximum shareholder certainty to maximum board discretion.

Family shareholders should know what the company’s current distribution policy is. As evident from the preceding table, knowing the distribution policy does not necessarily mean that one will know the dividend for that year. However, a consistently-communicated and understandable distribution policy contributes greatly to developing positive shareholder engagement.

So what should your family business’s distribution policy be? Answering that question requires looking inward and outward. Looking inward, what does the business “mean” to the family? Looking outward, are attractive investment opportunities abundant or scarce? Once the inward and outward perspectives are properly aligned, the distribution policy that is appropriate to the company can be determined by the board and communicated to shareholders.

Through our family business advisory services practice, we work with successful families facing issues like these every day. Give us a call to discuss your needs in confidence.

Making Shareholder Communication a Family Business Priority

The following is an installment in our series “What Keeps Family Business Owners Awake at Night”

Communication determines the success of any relationship, and the relationships among shareholders of multi-generation family businesses are no exception.  In the early years of a family business, communication is generally informal (and continual), since the dining room often doubles as the board room.  As the business and family grow, the shareholder relationships become more complicated, and formal communication becomes more important.

For a multi-generation family business, communication is not optional.  A failure to communicate is a communication failure.  When communication is lacking, the default assumption of shareholders – especially those not actively involved in the business – will be that management is hiding something.  Suspicion breeds discontent; prolonged discontent solidifies into rancor and, in some cases, litigation.

In light of the dire consequences of poor communication, how can family business leaders develop effective and sustainable communication programs?  We suggest that public companies can provide a great template for multi-generation family businesses.  It is perhaps ironic that public companies – to whom their shareholder bases are largely anonymous – are typically more diligent in their shareholder communications than family businesses, whose shareholders are literally flesh and blood.  While public companies’ shareholder communications are legally mandated, forward-thinking public companies view the required shareholder communications not as regulatory requirements to be met, but as opportunities to tell their story in a compelling way.

There are probably only a handful of family businesses for which shareholder communication needs to be as frequent and detailed as that required by the SEC.  The structure and discipline of SEC reporting is what needs to be emulated.  For family businesses, the goal is to communicate, not inundate.  At some point, too much information can simply turn into noise.  Family business leaders should tailor a shareholder communication program along the following dimensions:

• Frequency. Public companies communicate results quarterly.  Depending on the nature of the business and the desires of the shareholder base, less frequent communication may be appropriate for a family business.  The frequency of communication should correspond to the natural intervals over which (1) genuinely “new” information about the company’s results, competitive environment, and strategy is available, and (2) shareholders perceive that the most recent communication has become “stale”.  As a result, there is no one-size-fits-all frequency; what is most important is the discipline of a schedule.
• Level of detail. Public company reports are quite detailed.  Family business leaders should assess what level of detail is appropriate for shareholder communications.  If the goal is to communicate, the appropriate level of detail should be defined with reference to that which is necessary to tell the company’s story.  The detail needs to be presented to shareholders with sufficient supporting context regarding the company’s historical performance and conditions in the relevant industries and economy.  A dashboard approach that focuses on key metrics, as illustrated below, can be an effective tool for focusing attention on the measures that matter.

• Format/Access. The advent of accessible webcast and data room technology makes it much easier for family businesses to distribute sensitive financial information securely.  Use of such platforms also provides valuable feedback regarding what is working and what is not (since use of the platform by shareholders can be monitored).  Some families may have existing newsletters that provide a natural and existing touchpoint for communicating financial results.
• Emphasis. The goal of shareholder communication should be to help promote positive shareholder engagement.  To that end, the emphasis of the communication should not be simply the bare reporting of historical results, but should emphasize what the results mean for the business in terms of strategy and outlook for the future.  It is probably not possible to re-tell the company’s story too many times.  Shareholders that are not actively involved in the business will be able to internalize the company’s strategy only after repeated exposure.  What may seem like the annoying repetitions of a broken record to management will for shareholders be the re-exposure necessary to “own” the company’s story.

Shareholder communication is an investment, but one that in our experience has an attractive return.  To get the most out of the investment, family business leaders must provide the necessary training and education to shareholders so that they will be able confidently to assess and interpret the information communicated.  With that foundation in place, a structured communication program can go a long way to ensuring that family shareholders are positively engaged with the business.

Through our family business advisory services practice, we work with successful families facing issues like these every day. Give us a call to discuss your needs in confidence.

It’s Tax Time: Implications of Tax Reform for Banks

A Memphis establishment long has used the slogan, “It’s Tax Time (… Baby),” in their low budget television advertising. After listening to early fourth quarter earnings calls, banks – and especially their investors – appear to be embracing this slogan as well. Four investment theses undergirded the revaluation of bank stocks after the 2016 presidential election: regulatory reform, higher interest rates, faster economic growth, and tax reform. One year later, regulatory reform is stymied in Congress, and legislative efforts appear likely to yield limited benefits. Short-term rates have risen, but the benefit for many banks has been squashed by a flatter yield curve and competition for deposits. Economic growth has not yet translated into rising loan demand.

Fortunately for bank stock valuations, the tax reform plank materialized in the Tax Cuts and Jobs Act of 2017 (the “Act”).¹ The Act has sweeping implications for banks, influencing more than their effective tax rates. This article explores these lesser known ramifications of the Act.²

C Corporations & The Act

In 2017, the total effective tax rate on C corporation earnings – at the corporate level and, assuming a 100% dividend payout ratio, at the shareholder level – was 50.5%. Under the Act, this rate will decline to 39.8%, reflecting the new 21% corporate rate and no change in individual taxes on dividends. For a hypothetical bank currently facing the highest corporate tax rate, the Act will cause a 40% reduction in tax expense, a 22% increase in after-tax earnings, and a 269bp enhancement to return on equity (Table 1).

The benefit reduces, however, for banks with lower effective tax rates resulting from, among other items, tax-exempt interest income. Continuing the example in Table 1, which assumed a 35% effective tax rate, Table 2 illustrates the effect on banks with 30%, 25%, and 20% effective tax rates.

Since investors in bank stocks value after-tax earnings, not surprisingly banks with the highest effective 2016 tax rates experienced the greatest share price appreciation in 2017. Table 3 analyzes share price changes for publicly-traded banks with assets between $1 and $10 billion.

Implications

The preceding tax examples distill a nuanced subject into one number, namely an effective tax rate. The implications of the Act for banks, though, spread far beyond mathematical tax calculations. We classify the broader implications of the Act into the following categories:

1. “Allocation” of Tax Savings
2. Lending
3. Miscellaneous

Implication #1: “Allocation” of Tax Savings

We know for certain that the tax savings resulting from the Act will be allocated among three stakeholder groups – customers, employees, and shareholders.³ The allocation between these groups remains unknown, though.

Customers

Jamie Dimon had a succinct explication of the effect of the Act on customers:

And just on the tax side, so these people understand, generally, yes, if you reduce the tax rates, all things being equal, to 20% or something, eventually, that increased return will be competed away.⁴

The logic is straightforward. The after-tax return on lending and deposit-taking now has increased; higher after-tax returns attract competition; the new competitors then eliminate the higher after-tax returns. Rinse and repeat. One assumption underlying Mr. Dimon’s statement, though, is that prospective after-tax returns will exceed banks’ theoretical cost of capital. If not, loan and deposit pricing may not budge, relative to the former tax rate regime. Supporting the expectation that customers will benefit from the Act is the level of capital in the banking industry searching for lending opportunities.

Renasant Corporation has noted already potential pressure on its net interest margin.

Not sure [net interest margin expansion is] going to hold. We’ll need a quarter or 2 to see what competitive reaction is to say that we’ll have margin expansion. But we do think that margin at a minimum will be flat and would be variable upon competitive pressures around what’s down with the tax increase.⁵

Employees

An early winner of tax reform was employees of numerous banks, who received one-time bonuses, higher compensation, and upgraded benefits packages. With falling unemployment rates, economists will debate whether employers would have made such compensation adjustments absent the Act. Nevertheless, the public nature of these announcements, with local newspapers often covering such promises, will create pressure on other banks to follow suit.

Generally, bank compensation adjustments have emphasized entry level positions. An open question is whether such benefits will spread to more highly compensated positions, thereby placing more pressure on bank earnings. For example, consider a relationship manager who in 2017 netted the bank $100 thousand after considering the employee’s compensation and the cost of funding, servicing, and provisioning her portfolio. Assuming that customers do not capture the benefit, the officer’s portfolio suddenly generates after-tax net income of $122 thousand. The loan officer could well expect to capture a share of this benefit, or take her services to a competitor more amenable to splitting the benefit of tax reform.

Shareholders

Mr. Market clearly views shareholders as the biggest winner of tax reform, and we have no reason to doubt this – at least in the short-run. Worth watching is the form this capital return to shareholders takes. With bank stocks trading at healthy P/Es, even adjusted for tax reform, banks may hesitate to be significant buyers of their own stock. Instead, some public banks have suggested higher dividends are in the offing. Meanwhile, Signature Bank (New York), which has not paid dividends historically, indicated it may initiate a dividend in 2018. In the two days after the CEO’s announcement, Signature’s stock price climbed 8%.

Table 4 compiles announced expenditures by certain banks on employees, philanthropy, and capital investments. Click to view Table 4.

Some public market analysts have “allocated” 60% to 80% of the tax savings to shareholders, with the remainder flowing to other stakeholders. Time will tell, but banks will face pressure from numerous constituencies to share the benefits.

Implication #2: Lending

The Act potentially affects loan volume with future possible effects on credit quality.

Volume

Looked at most favorably, higher economic growth resulting from the Act, as well as accelerated capital expenditures due to the Act’s depreciation provisions, may provide a tailwind to loan growth. However, some headwinds exist too. Businesses may use their tax savings to pay down debt or fund investments with internal resources. The Act eliminates the deductibility of interest on home equity loans and lines of credit, potentially impairing their attractiveness to consumers. Last, the Act disqualifies non-real estate assets from obtaining favorable like-kind exchange treatment, potentially affecting some types of equipment finance.

Quality

While we do not expect the Act to cause any immediate negative effects on credit quality, certain provisions “reallocate” a business’ cash flow between the Treasury and other stakeholders (e.g., creditors) in certain circumstances:

1. Net Operating Loss (“NOL”) Limitations. Tax policy existing prior to the Act allowed businesses to carry back net operating losses two years, which provided an element of countercyclicality in periods of economic stress. The Act eliminates the carryback provision. Further, businesses can apply only 80% of future NOLs to reduce future taxable earnings, down from 100% in 2017, thereby potentially pressuring a business’ cash flow as it recovers from losses. As a result, less cash flow may be available to service debt.
2. Interest Deductibility Limitations. The Act caps the interest a business may deduct to 30% of EBITDA (through 2021) and EBIT (thereafter) for entities with revenue exceeding $25 million.⁶ Assuming a 5% interest rate, a business’ debt must exceed 6x EBITDA before triggering this provision. Several issues arise from this new limitation. First, community banks may have clients that manage their expenses to achieve a specified tax result, which could face disallowed interest payments. Second, in a stressed economic scenario, cash flow may be diverted to cover taxes on nondeductible interest payments, rather than to service bank debt.
3. Real Estate Entities. The Act appears to provide relatively favorable treatment of real estate managers and investors. However, banks should be aware that the intersection of (a) the interest deductibility limitations and (b) the Act’s depreciation provisions may affect borrower cash flow. Entities engaged in a “real property trade or business” may opt out of the 30% interest deductibility limitation. However, such entities (a) must depreciate their assets over a longer period and (b) cannot claim 100% bonus depreciation for improvements to the interior of a commercial property.

Banks should also prepare for reorganizations among business borrowers currently taxed as pass-through entities, especially in certain service businesses not qualifying for the 20% deduction described subsequently. From a tax planning standpoint, it may be advisable for some business clients to reorganize with certain activities conducted under a C corporation and others under a pass-through structure.

Implication #3: Miscellaneous Considerations

Additional considerations include:

Effect on Tangible Book Value

Table 5 presents, for publicly traded banks with assets between $1 billion and $5 billion, their net deferred tax asset or liability positions as a percentage of tangible common equity. Table 5 also presents the number of banks reporting net DTAs or DTLs.

From a valuation standpoint, we do not expect DTA write-downs to cause significant consternation among investors. If Citigroup’s $22 billion DTA revaluation did not scare investors, we doubt other banks will experience a significant negative reaction. In Citigroup’s case, the impairment has the salutary effect of boosting its future ROE, as Citigroup’s regulatory capital excluded a large portion of the DTAs anyway.

Regulatory Capital⁷

The Basel III capital regulations limit the inclusion of DTAs related to temporary differences in regulatory capital, but DTAs that could be realized through using NOL carrybacks are not subject to exclusion from regulatory capital. As noted previously, though, the Act eliminates NOL carrybacks. Therefore, certain banks may face disallowances (or greater disallowances) of portions of their DTAs when computing common equity Tier 1 regulatory capital.⁸

Business Investments

An emerging issue facing community banks is their relevance among technology savvy consumers and businesses. Via its “bonus” depreciation provisions, the Act provides tax-advantaged options for banks to address technological weaknesses. For qualifying assets – generally, assets other than real estate and, under the Act, even used assets – are eligible for 100% bonus depreciation through 2022. The bonus depreciation phases out to 0% for assets placed in service after 2026.⁹

Mergers & Acquisitions

Our understanding is that the Act will not materially change the existing motivations for structuring a transaction as non-taxable or taxable. With banks accumulating capital at a faster pace given a reduced tax rate, it will be interesting to observe whether cash increases as a proportion of the overall consideration mix offered to sellers.

Permanence of Tax Reform

One parting thought concerns the longevity of the recent tax reforms. The Act passed via reconciliation with no bipartisan support, unlike the Tax Reform Act of 1986. As exhibited recently by the CFPB, the regulatory winds can shift suddenly. Like the CFPB, is tax reform built on a foundation of sand?

S Corporations & The Act

At the risk of exhausting our readership, we will detour briefly through the Act’s provisions affecting S corporations (§199A). While the Act’s authors purportedly intended to simplify the Code, the smattering of “lesser of the greater of” tests throughout §199A suggests that this goal went unfulfilled.

Briefly, the Act provides that shareholders of S corporations can deduct 20% of their pro rata share of the entity’s Qualified Business Income (“QBI”), assuming that the entity is a Qualified Trade or Business (“QTB”) but not a Specified Service Trade or Business (“SSTB”).¹⁰ That is, shareholders of QTBs that are not SSTBs can deduct 20% of their pro rata share of the entity’s QBI.¹¹ Simple.

The 20% QBI deduction causes an S corporation’s prospective tax rate to fall to 33.4%, versus the 44.6% total rate applicable in 2017, thereby remaining below the comparable total C corporation tax rate (Table 6).

S corporations should review closely the impact of the Act on their tax structure. The 2013 increase in the top marginal personal rate to 39.6% and the imposition of the Net Investment Income Tax on passive shareholders previously diminished the benefit of S corporation status. The Act implements a $10 thousand limit on the deductibility of state and local taxes, which may further diminish the remaining benefit of S corporation status. While we understand this limitation will not affect the deductibility of taxes paid by the S corporation itself (such as real estate taxes on its properties), it may reduce shareholders’ ability to deduct state-level taxes paid by a shareholder on his or her pro rata share of the S corporation’s earnings. S corporations also should evaluate their projected shareholder distributions, as S corporations distributing only sufficient amounts to cover shareholders’ tax liability may see fewer benefits from maintaining an S corporation election.¹²

Conclusion

For banks, the provisions of the Act intertwine throughout their activities. Calculating the effect of a lower tax rate on a bank’s corporate tax liability represents a math exercise; predicting its effect on other constituencies is fraught with uncertainty.¹³ We look forward to discussing with clients how the far reaching provisions of the Act will affect their banks, clients, and the economy at large. It will be Tax Time for quite some time. As always, Mercer Capital is available to discuss the valuation implications of the Act.

This article originally appeared in Mercer Capital’s Bank Watch, January 2018.

End Notes

1. Lest we be accused of imprecision, the Act’s formal name is “An act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018.”
2. Before proceeding, we include the de rigueur disclaimer for articles describing the Act that Mercer Capital does not provide tax advice and banks should consult with appropriate tax experts.
3. We recognize that some of the tax savings may be invested in capital expenditures or community relations, but these expenditures ultimately are intended to benefit one of the three stakeholder groups identified previously.
4. Transcript of J.P. Morgan Chase & Co.’s Fourth Quarter 2016 earnings call.
5. Transcript of Renasant Corporation’s Fourth Quarter 2017 earnings call.
6. Floor plan financing is exempt from this provision.
7. See also Federal Reserve, Supervisory & Regulatory Letter 18-2, January 18, 2018.
8. Generally, DTAs are includible in regulatory capital up to a fixed percentage of common equity Tier 1 capital.
9. In addition, §179 allows entities to expense the cost of certain assets.  The §179 limit increases from $500 thousand in 2017 to $1 million in 2018.  The Act also expands the definition of assets subject to §179 to include all leasehold improvements and certain building improvements.
10. We recognize that the risk of exploding heads is acute with reference to §199A.  Therefore, we avoided discussion of the limits on the 20% deduction relating to W-2 and other compensation, “qualified” property, and overall taxable income, as well as the various income thresholds that exist.  Suffice to say, §199A is considerably more complex than we have described.
11. It does not appear that banks are SSTBs (and, thus, banks are eligible for the 20% deduction), although the explanation is mind numbing.  An SSTB is defined in §199A by reference to §1202(e)(3)(A) but not §1202(e)(3)(B).  Existing §1202 provides an exclusion from gain on sale to holders of “qualified small business stock.”  However, §1202(e)(3)(A) and §1202(e)(3)(B) disqualify certain businesses from using the QSB stock exclusion.  Banks are specifically disqualified from the QSB stock sale exclusion under §1202(e)(3)(B).  Since §199A’s definition of an SSTB does not specifically cite the businesses listed in §1202(e)(3)(B), such as banks, §199A has been interpreted to provide that banks are not SSTBs.  Interested in more SSTB arcana?  Architects and engineers are excluded specifically from the list of businesses ineligible for the 20% deduction, apparently speaking to the lobbying prowess of their trade groups (or their ability to build tangible things).
12. We are not aware that the Act limits the increase in an S corporation shareholder’s tax basis arising from earnings not distributed to shareholders.  However, the tax basis advantage of S corporation status typically is secondary to the immediate effect of an S corporation election on a shareholder’s current tax liability.
13. To be fair, we should limit the “math exercise” comment to C corporations; the S corporation provisions in §199A undeniably are abstruse.

The Valuation Implications of the 2018 Tax Reform

Significant Corporate Changes

Corporate valuations are a function of expected cash flows, risk, and growth. While the reduction in tax rates triggers the most obvious revision to expected cash flows, other provisions of the bill may also significantly influence cash flows for individual companies.

Tax Rate
Corporate tax rate reduced to 21% from 35%

Deductibility of Capital Investment
Through 2022, companies will be able to deduct capital investment as made rather than over time through depreciation charges

Deductibility of Interest
Interest expense deduction limited to 30% of EBITDA through 2021, and 30% of EBIT thereafter

Foreign Income
U.S. taxes due only on U.S. income, with one-time tax to allow repatriation of existing foreign retained earnings

NOL Carryforward Limitations
Max out at 80% of taxable income for year, no expiration

Like-Kind Exchanges
Changes to availability

The Impact on Valuation

Enterprise Valuation

Does a lower corporate tax rate make corporations more valuable, all else equal? Yes. Will all else always be equal? No. Appraisers will need to carefully consider the effect of the new tax law not just on rates, but on growth expectations, reinvestment decisions, the use of leverage, operating margins, and the like for individual companies.

Pass-Through Valuation

What effect does the new tax law have on the value of minority interests in pass-through entities, all else equal? It depends. The resulting differential between corporate and personal rates and the availability of the QBI deduction may cause some business owners to re-evaluate the merits of the S election. The ultimate effect on valuation will depend on the subject company’s distribution policy, the length of the expected holding period, and the perceived risk associated with the S election.

Word to the Wise

These significant changes should be evaluated on a company-by-company basis to determine what effect, if any, the changes will have on expected cash flows. Appraisers with deep experience in the relevant industry are best positioned to evaluate the potential effects.

Download the full presentation here.

How to Promote Positive Shareholder Engagement

The following is an installment in our series “What Keeps Family Business Owners Awake at Night”

Based on discussions with family business leaders from across the country at the most recent Transitions conference, we wrote an article addressing themes among attendees, and we continue the discussion in this article. One challenge noted by leaders of multi-generation family businesses was how to promote positive shareholder engagement.

Why is Shareholder Engagement Important for Family Businesses?

As family businesses mature into the third and subsequent generations, it becomes less and less likely that extended family members will be both shareholders and active participants in the business. As families grow numerically, they tend to become more geographically dispersed. Lack of professional involvement in the business, combined with geographic separation, can result in family shareholders feeling disconnected and becoming disengaged from the family business. A successful multi-generation family business can promote healthy family cohesion, but when shareholders are not positively engaged, the business can quickly turn into a source of stress and family strife.

Some families choose to eliminate the existence of disengaged shareholders by limiting share ownership to those members that are actively involved in the business. While this may be an appropriate solution for some families, it can have the unintended consequence of creating distinct classes of economic haves and have-nots within the family. When that occurs, the business quickly ceases to be a center of family unity.

For most businesses, there simply is no necessary link between share ownership and active involvement in the company. If public companies can function well with non-employee owners, surely it is possible for family businesses to do so as well. But to do so, family businesses will need to be diligent to promote positive shareholder engagement.

What are the Marks of an Engaged Shareholder?

It might be tempting to label non-employee shareholders as “passive”, but we suspect that term does not do justice to the ideal relationship between the company and such shareholders. “Actively non-controlling” hits closer to the mark but doesn’t exactly trip off the tongue. If “passive” is not the ideal, the following characteristics can be used to identify positively engaged shareholders.

• An appreciation of what the business means to the family. Engaged shareholders know the history of the family business in its broad outline. Few things promote a sense of community like a shared story. A successful family business provides a narrative legacy that few families possess. Engaged shareholders embrace, extend, and re-tell the story of the family business.
• A willingness to participate. Full-time employment is not the only avenue for participating in the family business. Engaged shareholders understand their responsibility to be active participants in the groups that are appropriate to their skills, life stage, and interests, which may include serving as a director, sitting on an owners’ council, or participating in a family council.
• A willingness to listen. Positively-engaged non-employee shareholders recognize that there are issues affecting the family business, the industry, and the company’s customers and suppliers of which they are unaware. As a result, they are willing to listen to management, regardless of whether management consists primarily of non-family professionals or their second cousins.
• A willingness to develop informed opinions. A willingness to listen does not mean passive acceptance of everything management is communicating. A competent and confident management team recognizes that non-employee shareholders have expertise, experiences, and insights that members of management lack. Engaged shareholders acknowledge their responsibility to develop and share informed opinions, not just gut reactions or prejudices.
• A willingness to consider perspectives of other shareholder groups. Engaged shareholders do not seek the benefit of their own branch of the family tree to the detriment of the others. Multi-generation family businesses inevitably have distinct shareholder “clienteles” with unique sets of risk tolerances and return preferences. Privileging the perspective of a single shareholder clientele is a sure way to promote discord.
• A commitment to deal fairly. Fairness needs to run in both directions: non-employee shareholders should not be penalized for not working in the business, and shareholders that do work in the business need to be fully and fairly compensated for their efforts. Fairness also extends to distribution and redemption policy, both of which can be used to this disadvantage of one group within the family. Engaged shareholders are committed to fair dealing in transactions with the business and within the family.

How to Develop an Engaged Shareholder Base?

The family business leaders we spoke with at the conference were eager to share and learn best practices around promoting shareholder engagement. The “how” of shareholder engagement is closely related to the characteristics of engaged shareholders noted above.

• Develop mechanisms for appropriate involvement. Not everyone can have a seat at the board, but family and owner’s councils can be great ways to broaden opportunities and prepare family members for greater involvement.
• Emphasize the privilege/responsibility of being a shareholder. This will look different for every family, but a visible commitment to charitable contributions and service opportunities can be a powerful signal to the family that being a shareholder involves a stewardship that transcends simply receiving dividends.
• Basic financial education. Family members will have many different talents, interests, and competencies. Offering rudimentary financial education (i.e., how to read a financial statement, and understanding how distribution policy influences reinvestment) can empower the healthcare professionals, educators, and engineers in the family to develop and communicate informed opinions on family business matters.
• Actively solicit shareholder feedback. While it is true that the squeaky wheel gets the grease, it is often the un-squeaky wheels that have the most valuable insight. Periodic shareholder surveys can be an effective tool for promoting positive shareholder engagement.
• Demonstrate a commitment to fair dealing. Shareholders who are also managers in the business need to be wary of the tendency to pursue empire-building activities at the expense of providing appropriate returns on the shares in the family business.

Most of the intra-family shareholder disputes we have seen (and we have witnessed too many) are ultimately traceable to shareholders that over time became disengaged from the business. Family business leaders who focus on positive shareholder engagement today can prevent a lot of grief tomorrow.

Through our family business advisory services practice, we work with successful families facing issues like these every day. Give us a call to discuss your needs in confidence.

What Keeps Family Business Owners Awake at Night?

We recently attended the Transitions West conference hosted by Family Business Magazine. The event brought together representatives from nearly 100 family businesses of all sizes. Through the educational sessions and informal conversations during breaks, we came away with a better appreciation of the joys, stresses, privileges, and responsibilities which come with stewarding a multi-generation family business.

While every family is unique, a few common themes and/or concerns stood out among the attendees we met:

• Shareholder engagement: How many of your second cousins do you know? As families grow into the fourth and fifth generations, common ownership of a successful business can serve as the glue that holds the family together. However, as the proportion of non-employee family shareholders increases, maintaining productive shareholder engagement grows more challenging.
• Communication: Effective communication is a critical for any relationship. Multi-generation family businesses are complex relationship webs. Identifying best practices for communicating effectively with family shareholders was a common objective for conference attendees.
• Distribution policy: Hands down, the most frequent topic of conversation was establishing a distribution policy that balances the lifestyle needs and aspirations of family shareholders with the needs of the business.
• Investing for growth: The flip-side of distribution policy is how to invest for growth. Can the family business keep up with the biological growth of the family? Is that a desirable goal? Regardless of the selected goal, family business leaders are concerned about identifying and executing investments to support the growth of the family business.
• Diversification: A striking number of the family businesses represented at the conference had diversified rather far afield from the legacy business of the founding generation. What are the marks of effective diversification for a family business?
• Management accountability: Evaluating managerial performance is never easy; adding kinship ties to the mix only makes things dicier. The family business leaders we spoke with were eager to develop and implement effective management accountability structures.
• Management succession: Whether it comes simply through age or as a result of poor performance, management succession is somewhere on the horizon for every family business. By our unofficial count, most of the family businesses in attendance were still led by a family member (often enough by so-called “married-ins”). A meaningful minority, however, had professional (i.e., non-family) management teams.
• Next Gen development: Rising generations are naturally more diffuse than prior generations, with regard to geography, interests, skill sets, and desires. Family leaders were interested in identifying appropriate pathways for next generation leaders to engage, learn, and grow in their contribution to, and impact upon, the family business.
• Generational transfer/estate planning: Attendees were keenly interested in tax-efficient techniques for transferring ownership of the family business to succeeding generations. While certainly important, there may be unanticipated pitfalls if estate and other taxes are the only factors considered when transferring wealth.
• Evaluating acquisition offers: There’s a definite selection bias at a family business conference: attendees are necessarily shareholders of family businesses that have not been sold. Even if the family does not plan to sell, credible acquisition offers at what appear to be attractive financial terms need to be assessed. Family business representatives were interested in learning how best to evaluate and respond to such offers.
• Share redemption/liquidity programs: There are many reasons family members may want to sell shares: desire for diversification, major life changes (such as divorce), funding for estate tax payments, starting a new business, or funding other major expenditures. What is the best way to provide liquidity to family shareholders on fair terms without sparking a run on the bank?

Through our family business advisory services practice, we work with successful families facing issues like these every day. Give us a call to discuss your needs in confidence.

The Importance of Size, Profitability, and Asset Quality in Valuation

The question for most financial institutions is not if a valuation is necessary, but when it will be required. Valuation issues that may arise include merger and acquisition activity, an employee stock ownership plan, capital planning, litigation, or financial planning, among others. Thus, an understanding of some of drivers impacting your bank’s value is an important component in preparing for these eventualities.

Data Analysis & Quantitative Factors Affecting Your Bank’s Value

Determining the value of your bank is more complicated than simply taking a financial metric from one of your many financial reports and multiplying it by the relevant market multiple. However, examination of current and long term public pricing trends can shed some light on how certain quantitative factors may affect the value of your bank.

To analyze trends, we focus our discussion on P/TBV ratios since this is one of the most commonly cited metrics for bankers. While all banks can be affected by overall macroeconomic trends like inflation rates, employment rates, the regulatory environment, and the like, we explore relative value in light of three factors we consider in all appraisals – size, profitability, and asset quality.

Size

Size differentials generally encompass a range of underlying considerations regarding financial and market diversity. A larger asset base generally implies a broader economic reach and oftentimes a more diverse revenue stream which can help to mitigate harmful effects of unforeseen events that may adversely affect a certain geographic market or industry. Furthermore, larger banks tend to have access to more metropolitan markets which have better growth prospects relative to more rural markets. Figures 1 and 2 on the next page illustrate that, to a point, larger size typically plays a role in value, as measured by price / tangible book value multiples. The sweet spot for asset size seems to be between $5 and $10 billion in total assets. Banks in this category traded at the highest P/TBV multiple as of September 30, 2017 and have generally outperformed all other asset size groups over the long term.

Profitability

To examine how profitability affects the value of your bank, we compare median P/TBV multiples for four groups of banks segmented by return on average tangible equity (Figures 3 and 4 on the prior page). A bank’s return on equity can be measured as the product of the asset base’s profitability (or return on assets) and balance sheet leverage. Balancing these two inputs in order to maximize returns to shareholders is one goal of bank management. A bank’s return on equity measures how productively the bank invests its capital, and as one would expect, the banks with the highest returns on equity trade at the highest P/TBV multiple.

Asset Quality

Inferior asset quality increases risk relative to companies with more stable asset quality and may limit future growth potential, both of which may negatively impact returns to shareholders. In addition, it makes sense that a bank with high levels of non-performing assets might trade below book value. Book value of the loans (or other non-performing assets) may not reflect the true market value of the assets given the potential for greater losses than those accounted for in the loan loss reserve and the negative impact on earning potential. Figure 5 illustrates how pricing is affected by higher levels of non-performing assets. As shown in Figure 6, P/TBV multiples plummeted at the start of the economic recession and have yet to recover to pre-crisis levels.

Conclusion

Size, profitability, and asset quality are factors to consider in your bank’s valuation. From an investor’s perspective, your bank’s worth is based on its potential for future shareholder returns. This, in turn, requires evaluating qualitative and quantitative factors bearing on the bank’s current performance, growth potential, and risk attributes.

Mercer Capital offers comprehensive valuation services. Contact us to discuss your valuation needs in confidence.

This article originally appeared in Mercer Capital’s Bank Watch, November 2017.

How to Value an Early-Stage FinTech Company Webinar Recording

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Do you have a clear picture of your company’s value and do you know if you are creating value in your early-stage FinTech company?

Hidden behind the veil of the private market, an early-stage FinTech company’s value can seem complex and obscure. However, it doesn’t have to be that way. Entrepreneurs and investors benefit from a clear picture of company value. Measuring value creation over time is vital for planning purposes, and an awareness of valuation drivers can propel the company to higher growth.

The knowledge gleaned from the valuation process provides insights and identifies key risk and growth opportunities that can improve the company’s strategic planning process–a process that might build to a successful liquidity event (sale or IPO) or the development of a stable company that can operate independently for a long time.

For investors, entrepreneurs, and potential partners, this webinar identifies the key value drivers for an early-stage FinTech company.