You have recently been approached by ABC, Inc., a public company within your industry that wants to acquire your business. After a review of the business, ABC’s representatives indicate that they would be willing to pay $40 million for your company – in the form of ABC common stock. While considering this offer you are approached by XYZ Company, a private company in your industry. Following limited due diligence XYZ offers $30 million for your company – in the form of cash. Which offer is more attractive? The example is a simple demonstration of the proposition: “Price vs. Terms.”
This article addresses some of the issues that a seller of a company must consider when evaluating and negotiating the sale of a business. It is by no means an exhaustive analysis of the subject.
In terms of the example, several questions come to mind when evaluating the two offers. When examining the offer from ABC (public company), questions would include: “What is the track record of the company and how has its stock performed?” “What are the future prospects?” “Is there adequate liquidity in the company’s common stock?” “Are there any restrictions on the sale of the stock (e.g. lock up provisions, affiliate issues, registration, etc.)?” “Is the proposal for a fixed price or a fixed exchange ratio?” “What are the tax implications (e.g. triggering of Alternative Minimum Tax, holding period for capital gains treatment, etc.)?”
When examining the offer from XYZ (private company) fewer questions arise. If you are receiving all cash at closing, most questions center around the tax treatment of the consideration.
The decision to accept the stock of an acquirer is not insignificant. You share the same risk in the ability of management to effectively integrate the acquisition as the shareholders of the acquiring company. More times than not, the selling shareholder(s) will have a reduced role in the operations of the combined company. The seller should consider whether or not they are willing to be a shareholder in a company that they have little or no control over. If the acquiring company has a successful track record of integrating acquisitions and is significantly large relative to the seller, this risk is somewhat mitigated. If, however, the acquirer was formed for the purpose of consolidating a group of companies in a fragmented market, the execution risk can be significantly high. Most industry “roll ups” have failed to produce the expense leverage and revenue enhancement promised to the market. These shortfalls have resulted in stock prices that have tumbled from their highs to well below their IPO price. Many sellers saw the fruits of their labors evaporate as the share prices fell. Any company considering weighing an offer that includes stock in the consideration should do a great deal of due diligence on the acquirer. Remember that when accepting stock, you are buying as well as selling.
When accepting stock, the seller needs to understand any limitations on the ability to monetize this investment. Some restrictions may be market-based and others shareholder specific. An indicator of liquidity is the average weekly volume in the acquirer’s stock. If selling the company for $50 million in stock and the average volume in the stock is a few hundred shares, liquidity is likely limited. This limitation applies to anyone investing in the acquirer’s common stock. Other restrictions may relate specifically to the shares received by the seller’s shareholders. Sometimes an acquirer will require that key shareholders of the seller’s company enter into a lock-up arrangement that prohibits the sale of the stock received for a period of time. During this intervening period, there is no guarantee that the price of the acquirer’s shares will not decline, thereby reducing the value of the deal. If, by virtue of this transaction, the selling shareholder becomes a beneficial owner of 10%, or more, of the acquiring company, Securities and Exchange Commission (SEC) rules limit the amount of stock that can be sold for a period of one year from the closing date of the transaction. Again, value can be greatly diminished during this forced holding period.
Another issue of equal importance to the seller is whether or not the proposed offer is for a fixed price or a fixed exchange ratio. If the offer is for a fixed price, then regardless of the price of the acquirer’s stock, the seller will receive a number of shares equal to the price divided by the market value of the acquirer’s stock as of a pre-determined date. If the deal is for a fixed exchange ratio, then the seller will receive a fixed number of shares for each of its outstanding shares. In this case, if the price of the acquirer’s stock goes down from the date that a definitive agreement is entered into to the closing date, then the value of the consideration to the seller declines. Conversely, if the price of the acquirer’s stock goes up, then the value to the seller also increases. A tool often used to mitigate the price risk between the definitive agreement and the close is to place a floor and ceiling on the total consideration. The floor protects the seller from a free falling stock and the ceiling protects the buyer from paying excessively based on its fast rising stock.
These are but a few of the issues that a seller must deal with when considering an offer for their business. So, which offer is better – $40 million in stock or $30 million in cash. It depends.
For answers to this and other questions, or to discuss a potential transaction, please contact us at (901) 685-2120. We would be happy to discuss your particular requirements in confidence.
Reprinted from Mercer Capital’s Transaction Advisor – Vol. 3, No. 3, 2000.
Corporate mergers and acquisitions are typically announced in a press release that expresses the enthusiasm of both the purchaser and the target. Like any wedding, a deal is an event that results in a great deal of excitement on the part of both participants, as well as a great deal of speculation on the part of those familiar with the union about whether or not it is a wise decision. And, like many marriages between a man and a woman, a significant number of corporate marriages result in disappointment for all involved.
It is this disappointment to which we are referring when we talk about “bad deals”. A bad deal is a deal that does not meet the expectations of the parties due to an avoidable failure of pre-closing due diligence. While there are some deals that go bad due to some unavoidable or unforeseeable event, these are not the situations that this article will addresses.
So why do deals fail to meet the expectations of the parties? One of the big reasons is that in many cases, neither party goes into a deal with clear expectations about how it will work. This is an important but often overlooked aspect of the decision to buy or sell a business. While the parties to the transaction invariably have some expectations about what will happen after the deal, it is more rare for either party to have spent some time writing down a detailed list of post-deal expectations.
Formulating a detailed list of post-closing expectations allows the parties to the deal to expand the due diligence phase to test the likelihood that those expectations will be met. An example will help illustrate this point.
Suppose that Company P and Company T are distributors of competing products. Company T decides to buy Company P in order to expand its geographic coverage, increase its customer base, and realize cost synergies associated with a reduction in the size of T’s sales force and the elimination of T’s warehouse facility. While just this sentence gives us some idea of P’s expectations in the deal, it is best if the management of P specifically quantifies the anticipated benefits of the deal and tests those expectations in due diligence.
If P does not quantify those expectations and test them in due diligence, there is a great deal of room for things to go wrong. T’s customers, for example, might have a strong preference for the products that T currently distributes and might be unwilling to purchase the products that P distributes. T might be in a long-term lease on the warehouse facility that will result in significant cost should P wish to break the lease after the deal. T’s customers might be closely tied to T’s salespeople, some of whom P expects to eliminate, and others of whom might leave, taking customers with them. In addition, it could be the case that part of T’s competitive advantage came by offering quick delivery times, and the elimination of the T facility and the larger delivery area serviced by P results in those customers finding an alternate vendor.
So in just this very simple example, we see that there are several areas where our hypothetical merger might go bad. The key to a good deal here is for P to determine, to the extent possible, whether its post-deal expectations are realizable before closing the deal. This would include expanding the traditional due diligence process to include talking to salespeople and possibly customers in an attempt to determine realistically what will happen after the deal.
While the example above focused on the buyer, it is just as important for the seller to form concrete expectations about how the deal will work. If a seller receives an offer of $10.0 million for the business, that seller might think that the offer means that he will walk away from the deal with $10.0 million in cash in his pocket. That expectation needs to be tested very carefully by hiring experienced legal, accounting and tax advisors. The $10.0 million offer may well have been an offer for substantially all of the assets of the business and none of the liabilities of the business. Paying off the liabilities that are left behind, paying the corporate tax on any gains realized in the asset sale, and paying any income taxes that result from moving the cash from the deal from the corporate balance sheet to the personal balance sheet of the owner could take a significant bite out of the deal proceeds. Clearly, a seller who expects to walk away with $10.0 million only to find that the actual net proceeds from the deal are less than half that amount will be disappointed.
Too often, the parties to a deal press forward with a transaction without having formulated or discussed a clear picture of how things will work after the deal. If both sides just fill in any blanks with favorable assumptions, and this starts the deal down the road to failure. When we assist our clients in a transaction, we try to pin down their expectations, and we encourage them to test those expectations to the extent possible in due diligence. It is dangerous to assume that certain expenses will go away or that a selling shareholder will have a certain amount of influence over the operations of the combined company. These types of issues must be explored well before the closing in order to avoid post-closing disappointment.
Reprinted from Mercer Capital’s Transaction Advisor – Vol. 3, No. 3, 2000.
Convertible securities, comprising convertible debt and convertible preferred stock, represent a hybrid ownership interest combining features of both “straight” debt and common equity. Like fixed income securities, convertibles typically have periodic interest or preferred dividend payments, stated par values/liquidation preference amounts, maturity dates, and call dates. At the same time, convertible securities are exchangeable at some price or conversion ratio into the common shares of the issuing company.
Convertibles provide current income through scheduled interest or preferred dividend payments and a floor value through the par value or liquidation preference as well as additional appreciation potential through the common share conversion feature. For companies needing cash, convertibles offer a means to reduce current borrowing costs by “buying down” the interest or preferred dividend rate by offering the security holders the ability to profit from future appreciation in the issuer’s common stock. For classes of investors (such as leveraged employee stock ownership plans and owners of acquired companies) requiring downside protection and/or current cash flow exceeding whatever dividend the issuer is paying on its common shares, convertibles offer a means of meeting those objectives while still retaining a stake in any appreciation in the company’s common equity.
Given their hybrid nature, convertible debt and convertible preferred stocks are typically issued with coupon or dividend rates below the market yields for comparable “straight” bonds and preferred stocks. At the same time, convertibles are also commonly issued with “out of the money” exchange ratios; that is, the conversion price is set at a premium to the current market price of a common share.
For example, if the prevailing yield on medium grade corporate bonds is 8.0%, a convertible issue of comparable credit quality, maturity, and callability might be issued with a 5.0% coupon. If the issuer’s common stock was trading at $20.00 per share, the exchange ratio might be set at 40 shares per $1,000 par bond, or $25.00 per share. The investor thus trades coupon income for upside potential in the event of enhanced corporate performance or higher stock market multiples while the issuer trades potential future dilution of its common share values (in the event of conversion) for lower current financing costs.
Under current financial theory, in general, the minimum value of a convertible security should be the greater of its value as a pure fixed income security or its value as a common share equivalent. Thus, if the net present value of the coupon income and par value exceed the value to be realized by immediately converting the security to common stock and selling the shares at the current market price, the security would be expected to trade at a price not less than its value as a “straight” bond or preferred stock. Alternately, if immediately converting the security into common shares yields a value exceeding the present value of the scheduled cash flows, the security would be expected to trade at a price not less than that implied by the conversion ratio multiplied by the current common share price. Because of the hybrid nature of convertibles, they typically trade at some premium to the prices implied by their pure bond values or their conversion values.
From a valuation perspective, convertibles can be modeled in two ways: first, as a “straight” bond or preferred stock with an embedded option or warrant to purchase the issuer’s common stock at the conversion price; and, second, as a bundle of common shares carrying the right to additional current income over some time horizon. Thus, the bond value is enhanced by the value of the embedded warrant while the common share equivalent value is enhanced by additional current income.
If we add the assumptions of a seven year maturity and semi-annual coupon payments to the hypothetical 5%, $1,000 par bond convertible into 40 common shares currently trading at $20.00 per share, we can infer a market value under the model of a bond with attached call options. Discounting the coupon income and the par value at a market yield to maturity of 8.0% implies a bond value of $841.55. The embedded warrant can be valued using a standard option pricing model such as a variant of the Black-Scholes or Binomial models. Let us assume that the option pricing model calculates a value of $4.00 per warrant share, or $160.00 for the 40 common shares under option. The resulting total value of the convertible security is thus $1,001.55 per bond, approximating par.
The same hypothetical security can be valued as a bundle of common share equivalents with additional investor cash flows attached. Multiplying the 40 common shares per bond by the $20.00 per share market price implies a conversion value of $800.00. The present value of the right to receive semi-annual payments of $25.00 for seven years discounted at 8.00% annually is $264.08. The total value implied is thus $1,064.08, a modest premium to par. This example assumes no common dividend. If the common stock paid a dividend, then only then only the present value of the cash flows on the convertible in excess of the common dividend would be added to the current conversion value.
This hypothetical security would be expected to trade somewhere between par and 106% of par; that is, between the indicated value as a bond with attached warrants on common stock and the indicated value as a bundle of common share equivalents with additional current income.
The preceding example incorporated simple terms and assumptions. Most convertible issues include call features allowing the issuer to redeem the shares prior to maturity, thereby forcing the holders either to be cashed out or to exercise their conversion rights early. In theory to maximize the value of its common stock, the issuer should redeem the convertible as soon as the conversion price is “in the money” relative to the market price of the common stock; otherwise, common shareholders are diluted by the existence of a group of equityholders having both the right to extra cash flows and the right to require the company to issue to them common shares for consideration (i.e. the conversion price) at or below the current market price. The presence of a call or redemption feature complicates the modeling of the embedded warrant on the issuer’s common shares as well as the modeling of the scheduled cash flows of the convertible security.
Where the issuer’s common stock is closely held or the shares to be received in conversion are not to be registered and/or the convertible security is unregistered or otherwise not readily marketable, valuation becomes further complicated. It will likely be appropriate to apply a marketability discount to the common stock and to add an increment for illiquidity to the pricing yield for the fixed income component of the convertible. In valuing the embedded warrants, adjustments must be considered to reflect any lack of marketability in the common shares, non-transferability of the embedded warrants, the inability to separate the warrants from the fixed income component of the security (that is, the right to call the shares cannot be exercised without terminating the scheduled cash flows), and the potential dilution of common share values due to the issuance of new shares upon conversion.
If you wish to discuss an appraisal or structuring of convertible debt or convertible preferred stock please contact us at (901) 685-2120.
Reprinted from Mercer Capital’s Transaction Advisor – Vol. 2, No. 2, 1999.
The terms “Financial Buyer” and/or “Strategic Buyer” frequently arise in discussions about investment banking activities, particularly when discussing the sale of a business. This article describes some of the characteristics of each type of buyer, and briefly discusses potential situations in which one might be more appropriate than the other.
Financial buyers can generally be classified as investors interested in the return they can achieve by buying a business. They are interested in the cash flow generated by a business and the future exit opportunities from the business. They are typically individuals or companies with money to invest, and who are willing to look at many different types of businesses or industries. Their goals may include growing cash flow through revenue enhancement, expense reductions, or creating economies of scale by acquiring other similar companies. Their exit plans may include an IPO (initial public offering), where the business is “taken public” (hopefully at a higher multiple of earnings than paid at acquisitions), or selling the company at a future date.
Financial buyers will carefully scrutinize the financial statements of the company. Most are looking for a well-managed company with a history of consistent earnings, and preferably, earnings growth. The transactions of financial buyers are often leveraged. It is common to see financial buyers use as much as 80% or more debt to finance an acquisition. By using high leverage, the financial buyer is effectively partnering with someone who is willing to accept a level of return (a lending rate, perhaps augmented by “kickers” to augment returns) that is generally lower than that required by financial buyers.
In layman’s terms, financial buyers are buying exactly what the company has to offer. They are buying the expected future earnings of the company as they are perceived to exist at the time of the acquisition. While financial buyers may see the potential for expanding cash flow beyond what the company has achieved on its own, they are generally not willing to pay for that potential. They are much more likely to keep the current personnel in place than strategic buyers. However, if their intent is to grow the business and eventually sell to a strategic buyer, the retention of personnel may be temporary.
Strategic buyers are interested in a company’s fit into their own long-term business plans. Their interest in acquiring a company may include vertical expansion (toward the customer or supplier), horizontal expansion (into new geographic markets or product lines), eliminating competition, or enhancing some of its own key weaknesses (technology, marketing, distribution, research and development, etc.).
Strategic buyers are often willing and able to pay more for a company than financial buyers. There are two main reasons for this. First, strategic buyers may be able to realize synergistic benefits almost immediately due to economies of scale that may exist through the combined purchasing power of the new entity and the elimination of duplicate functions. The better the fit (i.e., the more realizable the synergies are), the more they will want the business and the greater the premium they will pay. Second, strategic buyers are generally larger companies with better access to capital. They often have another currency available to them in the form of stock. Strategic buyers often offer stock, cash, or a combination of the two in payment of the purchase price.
In short, the strategic buyer is buying the company in light of how it will enhance their existing operations. They are often willing to pay for readily realizable synergies, and many times will pay for speculative synergies, particularly if the target company is being marketed to other competitors (through some type of “auction”). Strategic buyers are much less likely to retain all of the current personnel.
Believe it, or not, the answer to the question “which is right?” is not always as cut and dry as it might seem. Whether a strategic buyer or a financial buyer is right for a specific company depends largely on the seller’s goals in selling the business. Listed below are different scenarios discussing the seller’s goal and the type of buyer most appropriate.
This brief discussion is in no way intended to try to address all of the circumstances that may need to be considered in the prospective sale of a business. If you are a business owner who is considering the sale of your business please contact us at Mercer Capital to confidentially discuss your specific situation.
Reprinted from Mercer Capital’s Transaction Advisor – Vol. 2, No. 2, 1999.
Acquirers of non-financial services companies tend to focus on various definitions of cash flow and value. Because acquirers typically employ a different capital structure than the seller, value generally refers to the value of total invested capital (“TIC”), or the value of the firm’s operations before considering the capital structure. Value for equity holders is derived by subtracting the target’s capital structure debt (note: short-term working capital borrowings would not be considered capital; however, to the extent such borrowings exist, operating cash flow should be reduced for interest expense on revolver loans.)
Cash flow measures including earnings before interest, taxes, and depreciation/amortization (“EBITDA”), which is sometimes referred to as gross cash flow, represent a proxy for cash earnings before capital expenditures and debt service. Operating cash flow is generally defined as EBITDA less capital expenditures (in effect “cash EBIT”). Pricing multiples which are based upon cash flow (or earnings) measures before consideration of the capital structure, such as EBITDA and EBIT, refer to overall firm value, not the value of the residual equity. Net free cash flow represents residual cash flow available to common shareholders after capital expenditures, debt service requirements, and net working capital requirements have been met. While cash flow is an important consideration for any security analysts, LBO sponsors, private equity investors and other investors who typically use a large amount of debt to finance transactions are highly focused on these cash flow concepts rather than reported GAAP net income.
Reprinted from Mercer Capital’s Transaction Advisor – Vol. 1, No. 2, 1998.
Companies often use contingent consideration when structuring M&A transactions to bridge differing perceptions of value between a buyer and seller, to create an incentive for sellers who will remain active in the business post-acquisition, and other reasons. In the medical device industry, contingent consideration is most often used to manage risks related to the uncertainty of the future performance of development-stage technologies. Starting when SFAS 141R (now ASC 805) became effective in 2009, acquiring entities are now required to record the fair value of earn-outs and other contingent payments as part of the total purchase price at the acquisition date. This rule came into effect in the aftermath of the financial crisis when M&A activity slowed to a stand-still. Given the recent experience and continued expectation of increases in M&A activity in the medical device industry, a refresher on the new rules may be helpful for CFOs and controllers of companies contemplating acquisitions in 2011.
The Rules
ASC 805, the section of the FASB codification that addresses business combinations, requires that:
What is Fair Value?
In the case of contingent consideration, fair value represents the amount the reporting entity would have to pay a hypothetical counter-party to transfer responsibility for paying the contingent liability. This amount is basically the present value of the probability-weighted expected amount of the future payment.
Valuation Procedures
The complexity of the procedures necessary to estimate the future payment ultimately depends on the structure of the earn-out.
Valuation Inputs
For earn-out structures including milestone payments or tiered schedules, the fair value of the contingent payment is generally most sensitive to the estimate of the probability-weighted expected payment (rather than other inputs such as duration of contingency or discount rate). Developing reasonable estimates of the probability of future events is inherently difficult, but the use of decomposition and cross-checks will help improve the quality of these estimates. Decomposition is the process of breaking down a big event (such as FDA approval) into a series of smaller, more familiar pieces to make the probability estimate process easier. Cross-checks using aggregate industry information (such as the average length of time to receive PMA-path approval from the FDA) can be helpful to validate assumptions that by nature rely on judgment. Industry expertise can be extremely valuable when selecting a valuation specialist to help with estimating the fair value of contingent consideration. An expert will be able to decompose common pathways into a series of managable steps to estimate, will have familiarity with available industry data that can be used to help support assumptions, and will be able to effectively explain and defend the assumptions.
Role of a Valuation Specialist
In most cases, you or someone else in your company will likely be the individual most knowledgeable of the potential outcomes. The role of the valuation specialist is to integrate this information into the appropriate valuation model, test it for reasonableness, and to articulate the nuances of the inputs and valuation model in such a way that is clear for auditors and other third-party reviewers to understand. For simple situations it may not be necessary to bring in the outside help of a valuation specialist. For more complicated situations requiring multiple scenarios or Monte Carlo analysis, however, outside support may be necessary. If you have any questions regarding the valuation of contingent consideration or the impact of particular structures on financial reporting procedures, feel free to call or e-mail us to discuss in confidence.
Leverage – the favorite son of an efficient capital structure has become the bane of those who relied too heavily on easy flowing, low cost financing. As it turns out in this new economy, the malt flavored punch is proving just as toxic as that served to investors in real estate and virtually every other asset class on the planet. Now, with an almost unprecedented deleveraging of the economy, malt beverage distributors find themselves in a world where financial uncertainty is higher and growth is less visible than at anytime in living memory. Consequently, there have been fewer transactions, less available credit, and ultimately lower valuations for the entire distributor space.
We are not surprised given our wealth of transaction and valuation knowledge amassed from thousands of engagements across hundreds industry platforms and niches during decades of service to business owners and their advisors. The valuations implied by many transactions in the past decade simply never reconciled to the financial realities of the broader marketplace. Much of the guiding information communicated to distributors appeared, from a valuation perspective, to stretch the bounds of reasonable and sustainable expectation. Yet, these transactions helped establish unrealistic valuation norms through a dangerous cocktail of rules-of-thumb and excessive debt. Yes, there have been voices calling for a better understanding, but like the rest of the business world, times were just too busy and the perceived needs and opportunities too great to stand still long enough to hear the encroaching tidal roar. Now we find ourselves in the wake of that great flood with a house whose foundation may be compromised.
What can beer distributors learn from the postmortem? Lots. We submit that a more thorough and comprehensive understanding of business valuation concepts and vocabulary is required to better appreciate the lessons of this recent past, as well as to anticipate the future that will likely unfold for many beer distributors. Therefore, we respectfully offer (from a valuation perspective) the following valuation framework and observations for deciphering the past and anticipating the future.
Regardless of the industry space or business model one may own or manage, the talk at industry trade functions and the casual exchanges with colleagues and pundits often includes rumors about who recently sold their business and for what sum. Drink the malt industry brew and you are likely to witness at least one small fish morph into Moby Dick via a mistaken rule of thumb. This is not a unique phenomenon. Ask the car dealers, the bankers, the internet service providers (among others) about their former rules of thumb. Thankfully, the misfortune that engulfed those industries does not appear absolute for beer distributors, but the lessons are loud and clear. No business model is immune from the forces of market and financial evolution. Just when and who first described a transaction value of a malt beverage distributor using rules of thumb is difficult to pinpoint. But the first misuse of these rules surely occurred at the exact same moment.
What is a rule of thumb? WIKIPEDIA offers the following definition:
A rule of thumb is a principle with broad application that is not intended to be strictly accurate or reliable for every situation. It is an easily learned and easily applied procedure for approximately calculating or recalling some value, or for making some determination.
Those familiar with WIKIPEDIA know that it is a collaborative, web-based amalgam of its users’ and contributors’ collective wisdom. Consequently, anything found there is subject to constant review, revision and qualification. Too bad the same principle has not been true of the rules of thumbs for transacting a beer distributorship. From a business valuation perspective, we offer the following addendum to the definition of a rule of rule of thumb:
A business valuation rule of thumb is a simplified metric that converts a financial or operational measure of performance to a value for the subject business. Unless specifically qualified otherwise, a business valuation rule of thumb expresses the value of 100% of the tangible and intangible assets of the enterprise as such would be normally included in a transaction.
If you have a pulse, let alone a multi-million asset at stake, you should have many questions about the origin of any rule of thumb and the specific application of that rule to your business. Let us take this moment to introduce the basic representative equation of business value:
V = P x M
V= Value
P = A Measure of Profitability
M = Multiple (or Capitalization Factor)
Value is the product of some measure of profit times some multiplier of that profit. This formula appears relatively simple. However, the first mistake is taking this formula for granted. There are numerous underlying definitions and qualifications that must be understood for the results of this equation to be properly framed for the specific question being posed.
The most common rules of thumb for beer distributors use gross profit and/or case volume. Substituting these measures into the basic value equation results in the following equations:
Value = Case Volume x Multiplier
or
Value = Gross Profit x Multiplier
Simple enough, right? But wait. As beer distributors, don’t countless questions immediately spring to mind?
The combination of answers can result in a far more complicated assessment than the simplicity of the equation suggests. Referring back to the basic value equation, the same questions apply – the vocabulary is simply different and the interaction of the volume/profit measure and the multiplier are highly dynamic because each element of the equation can influence the appropriateness of the other. For example, the use of an adjusted or forward looking measure of case volume or gross profit (assuming growth is occurring) might require a modestly conservative view of the multiplier. Conversely, the use of a conservative volume or profit measure from an unfavorable year might suggest a slightly higher multiplier to capture the upside potential to right-size distributor performance in the market.
Given the prevalence of rules of thumb and reliance on a relatively small universe of advisors and brewery resources, it seems many beer distributors have had little interest in understanding the language and concepts of business valuation. Now that beer distributors are becoming less immune and less differentiated from other distribution platforms (economically that is), they are more curious about the basics of the valuation discipline than ever before. Let’s use the basic valuation equation and pose an abbreviated list of similar questions as noted above but use the vocabulary of a business valuation practitioner. The scope of possible questions and the responses to them include some potentially unfamiliar concepts to distributors and their shareholders but they are critical in order to understand the valuation placed on a given distributorship as a whole or for an ownership interest therein.
Regardless of the rules of thumb used to describe a transaction, these metrics (i.e. case volume or gross profit) can be translated into more meaningful financial expressions. These translations are useful because they can reveal important variables and identify potential sources for common valuation mistakes. Judging from the legacy of transactions represented on the balance sheets of a great many distributors, there has been rampant misunderstanding in determining how much to pay and what the consequent return on investment would be.
The most common (and most crude) distributor valuation rule of thumb is value per case. A common rule of thumb for the value of total assets for a domestic brew house distributor has been approximately ten times annual case equivalent volume (historically speaking). Referring to regularly compiled data reported by Risk Management Associates (“RMA”) and the National Beer Wholesaler Association (“NBWA”), we can make some basic assumptions about a “typical” beer distributor. Such a distributor (statistically) might have an annual case volume of 2.5 million, with net sales of $30-$35 million and a gross profit margin of approximately 25%. Many have a reported earning before interest, taxes, depreciation, and amortization (EBITDA) margin of approximately 5%, but in our experience, this can vary greatly. Often, the transactions between distributors are premised on adjustments to EBITDA on the order of 2%-5% of sales (shareholder compensation) increasing the adjusted EBITDA margin to approximately 8% (if not more). At this level of cash flow, a typical distributor would be expected to deliver $1.00 of EBITDA per case (+/- 8% EBITDA margin 0n net sales per case of approximately $13.50).
Based on the financial profile of a typical distributor, $10 per case translates to a total transaction value of $25 million. Based on an 8% EBITDA margin, the typical distributor would be producing on the order of $2.6 million in adjusted EBITDA. Based on a 25% gross margin, the same distributor reports $8.1 million in gross profit, corresponding to the other commonly used rule of thumb: three to four times gross profit. However, the gross profit rule of thumb implies multiples of EBITDA (10x in this example) that are higher than similar-sized transactions across numerous small-to-middle market sized companies in various industries (typically 5x EBITDA). There may be sound reasons to explain somewhat higher multiples than often exist for many other small-to-mid-market sized businesses, but such reasons should be compelling.
From a valuation perspective, only two underlying characteristics can explain a value at 10 or more times EBITDA: 1) exceptionally low risk, and/or 2) significant growth potential. In the malt beverage world, growth rates in volume and profit are typically limited to inflationary pricing growth and 1%+/- for population growth and other territory factors. Given the rarity of high growth as a supporting rationale for such high multiples, the only value attribute remaining is risk, uncommonly low risk. The assessment and quantification of risk is beyond the scope of this article. However, it should be obvious that the economics commonly applicable to a broad range of industries, some with attractive risk and growth attributes, simply do not correlate to the valuations often paid in beer distributor transactions, either for brand rights or for total assets. Accordingly, a rule thumb at 10 or 12 or higher times case volume seems questionable without unique circumstances. There are always exceptions, but they are few and far between. Ultimately, it is no surprise that recent transaction activity reflects lower valuation multiples than those of the last many years. What is surprising is that it took the worst financial crisis in 75 years to alter valuations in the malt distributor space.
Unfortunately, rules of thumb are not just the folly of the industry but can become habitual in the financial valuation arena as well. It is relatively easy for financial assumptions to become bogged down through the use of near universal assumptions regarding rates of return, capital structure assumptions, and growth rates. Through the years we have had the benefit of reviewing numerous appraisals. As with all analytical works, particularly those requiring elements of judgment, some of these reports have been sound and some, in our view, have been lacking in documentation, clarity, and/or reasonableness. Often, valuation issues emerge from a combination of almost ubiquitous assumptions concerning rates of return and growth rates that often do not reconcile to the transactions and realities of the market place.
A brief example involves the assessment of a near universal cost of capital on the order of 10% and extremely low growth rates. True, growth at the top line of the malt beverage industry is not sexy. That’s why the call of the day for brewers and distributors is consolidation, because defense of margin and prospective growth are largely reliant on increasing efficiencies. It’s true that margin pressures for distributors have been acute in recent years reflecting periods of unusual fuel costs, price competition, declining volumes, and other factors. Ultimately though, a 1%-2% growth rate for cash flow falls short of reconciling to the gross profit and case multiples of even some of the most conservative valuations. Yet in many valuations, 10% seems to be the universally adopted total cost of capital and low growth rates are predominant. The low growth treatments are not so troubling but there are exceptions based on the level of cash flow being used and the nature of the individual distributor being valued.
For example, low-volume growth in a highly leveraged distributor does not automatically equate to low-earnings growth since earnings can increase as debt is retired. Even flat to low growth in cash flow (EBITDA) can facilitate a healthy pace of loan repayment. Based on the realities of present value math, near term earnings growth via the amortization of debt can have a meaningful effect on value which under many valuation methods may best be captured through an appropriately higher growth rate in earnings than might be reasonable for revenue or cash flow.
The capitalization rate resulting from a 10% cost of capital and a 1% growth rate is 9% (10% less 1%% = 9%). The reciprocal of that capitalization rate is a cash flow multiplier of 11.1. Assuming a hypothetical norm of annual net cash flow (after taxes) on the order of $1 million (based on “normal” margins and normal cash flow sources and uses for a typical 2.5 million case house) the 11.1 multiplier explains only half of the valuation such a distributor’s total assets (warehouse, fleet, inventory, brand rights, etc.) would receive. In our example, that’s less than two times gross profit and less than five dollars per case. The primary financial reconciliation of historical deals and historical valuation norms includes a lower cost of capital or a higher growth rate for cash flow, or some combination of both. We’re not suggesting that a 25 multiplier of cash flow is typical, but in relation to $25 million valuation for a 2.5 million case wholesaler, that’s what it would take. Often net cash flow is somewhat higher than our example (via adjustments), and the use of a much higher debt structure in the deal provides the underpinning for the historical financings and valuations we have witnessed for brand and territory acquisitions. Tweaking the cash flow up by 20%, adjusting the capital structure to include more low-cost debt, and using a higher growth rate for net cash flow will collectively explain many of the historical deals. Ultimately, paying more to get a deal done equates to compromising the buyer’s rate of return on the investment.
The additional value push under many historical valuations came from buyers giving their sellers most, if not all, of the synergies of the deal. In the eyes of many strategic buyers are operational and financial enhancements that can increase value. Many of these synergies are limited for financial buyers. Additionally, and perhaps questionable, is the assumption that the IRS will help buyers pay for part of their bite at the apple. The booking of a transaction facilitates a purchase price allocation that provides for favorable tax treatment, namely the amortization of distribution rights over a 15 year period. The most valuable asset for most beer distributors is distribution rights. Using our $25 million example deal, it might not be unusual to see $15 to $20 million in booked distribution rights. Over a 15 year period this can shelter upwards of $1.3 million in annual earnings from income tax. Using typical tax rates, this equates to $500,000 annually in saved taxes for 15 years that can be used to service debt. Until recently, lenders were too happy to oblige and distributors seemingly used this source of cash flow to over-borrow and thus to overpay. However, the notion of a 40% break on the rights portion of the deal and the reality of the time value of money simply don’t reconcile. In truth, the present value of this tax benefit is only about half of the perceived $7 million benefit implied by common observation (40% of the rights). So, not only were buyers dealing away an inflated perception of the tax benefit, perhaps they were giving it all away. Based on our $25 million deal, we would estimate this misunderstanding to explain a portion of the over-valuation in many deals, albeit, a strategic buyer’s compulsions often result in making compromises to get a deal done.
It is important to understand that our perspectives on value are steeped in the concept of fair market value. Fair market value is a concept of financial value in a rational and hypothetical world without unique compulsions for either buyers or sellers and where both are imbued with equal knowledge and negotiating power. In the strategic world, there is often an exception to the fair market value concept. People do things because they are uniquely inclined to do.
While the observations in this piece may seem adverse to the interests of distributors who are seeking to maximize their valuations – fear not. The world has simply changed, and while valuation expectations should be reined in a bit, understanding the financial and financing realities of this market are key to positioning your business for its best result in the market. There are still many valuable franchises in this space. In addition to optimizing your distributorship’s sales and operations, you should seek feedback on the state of your valuation so that expectations may be better aligned with emerging market conditions. Feel free to contact me with your questions and/or comments.
Originally published September 2009.
In recent years, valuation issues have become increasingly important for start-up companies due to changing IRS and financial reporting rules, as well as increasing regulatory and shareholder scrutiny, which together compound potential troubles for start-up companies. In the past, industry specific start-up “rules of thumb” may have been sufficient to serve as reasonable basis for any valuation concern (e.g. the “Silicon Valley Rule” that the value of a common share is equal to 1/10 of the value of the preferred share pricing in most recent capital round). While the simplicity of such rules can be appealing, the scrutiny of the IRS, SEC, and your auditors in combination with the potential liability associated with misreporting make it critical that value be determined and articulated in a credible fashion.
Valuation for start-up enterprises can be a tricky proposition. Regardless of industry, start-ups generally share a common set of operational characteristics and valuation needs that are distinct from mature firms. Because both the subject enterprise and valuation purpose are misfits within the context of typical valuation work, typical valuation practices are generally not applicable for start-up companies. Combined with the unique market dynamics and regulatory environment associated with the medical device industry, medical device start-ups present a unique set of valuation considerations.
Below, we will discuss common circumstances that give rise to the need for a valuation, basic valuation concepts, and specific valuation considerations relevant to medical device start-up companies.
The day-to-day activities of start-up companies, being in a formative phase, require significantly more attention from senior management than mature firms. As a result, many start-up company founder/managers can overlook pending valuation issues for more immediate operational concerns.
For start-ups, valuations are most often needed for employee stock option or equity compensation compliance purposes. For financial reporting purposes, SFAS 123R requires that employee stock option compensation be recorded as an expense at the fair value of the option grant as of the grant date. The issuance of IRS 409A has created tax implications for non-qualified deferred compensation plans, which includes the issuance of stock options and stock appreciation rights to employees at a discount. Given the severity of the tax implications, the rule effectively requires non-public companies that issue stock options or other forms of equity as compensation to obtain an independent, contemporaneous valuation of the relevant securities.
Other common valuation circumstances for start-ups involve advisory services and fairness opinions related to additional fundraising or exit events on behalf of company management for both planning purposes and to fulfill a fiduciary duty to shareholders. There is also a growing trend in venture capital funds obtaining independent valuation opinions or reviews of internal valuations related to compliance in reporting fund investments at fair value.
Through casual observation, the value of an enterprise seems like an easy concept with a single definition. In reality, the appropriate definition of value varies depending on the circumstances surrounding each valuation engagement. The actual analytical framework for determining value is only developed once these aspects are defined. The following concepts are vital to understanding what is meant by “value” and are essential in defining an engagement with a valuation specialist.
The standard of value establishes the particular definition of value used in a specific engagement. Identification of the appropriate standard of value is the first step of every valuation. So, what are the most common standards of value for start-up companies?
Fair Market Value is the most common standard of value used in business appraisals and is the standard used for 409A compliance related to equity compensation. Fair market value is defined by Revenue Ruling 59-60 as “the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.” A significant body of application guidance has been generated over the years through a variety of professional standards, government regulations, and court cases.
Fair Value can have one of two distinct meanings, depending on the situation. For start-up company valuation, fair value most commonly refers to the standard defined by FASB in SFAS 157 for financial statement reporting purposes. Here, fair value is “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.” This definition of fair value is the relevant standard of value for valuations involved in SFAS 123R compliance for employee stock option compensation reporting.
In other circumstances, fair value can refer to the statutory standard of value applicable to cases involving dissenting minority shareholders with respect to corporate reorganizations or recapitalizations covered by the various state statutes. It may also have a specific meaning for divorce or under the securities laws for a given state. These statutory definitions of fair value (which are unrelated to the definition of fair value for financial statement reporting), however, are not commonly relevant in start-up company valuation.
Many start-up managers and venture fund managers often pragmatically observe that fair market value and fair value are different than the real world where buyers and sellers are very specific people who are individually motivated, uniquely informed, and are using something other than 100% cash to transact.
Investment Value is the value to a specific investor based on their particular investment requirements and opportunities. This value reflects the knowledge, expectations, synergies, and economies of scale of the particular investor. Investment value is generally used when valuation or investment banking professionals are advising their clients as to the merits of executing a specific transaction such as raising additional equity capital, selling the business, or completing an IPO. Investment value answers the questions – what’s it worth to them? Or what’s it worth to me?
A word of advice concerning who you choose to value your medical device start-up: associated with nearly every industry are niche consultants who sometimes practice valuation without the requisite command of how value is defined for a given circumstance and correspondingly how such value should be developed. Likewise, there are many valuation specialists without specific experience with the unique dynamics of the medical device industry. Given the incremental valuation complexities particular to medical start-up enterprises, it is important to remember that industry knowledge and valuation knowledge are not synonymous—and both are important.
There are three general approaches to determining business value – asset, income, and market. Under each approach there are specific ways to determine value that are commonly referred to as methods. As a general rule every valuation should consider each of these approaches. Ultimately, the conclusion of value will reflect consideration of one or more of these approaches (and perhaps various underlying methods) as being most indicative of value for the subject ownership interest.
The Asset Approach
The asset approach determines the value of the subject business by examining the cost that would be incurred by the relevant party to reassemble the company’s assets and liabilities. For start-up companies, the asset approach is generally inappropriate to apply unless the start-up is in a very early stage of operational development such that there has been no intellectual property or other intangible value developed internally. The asset approach can provide meaningful valuation benchmarks for start-ups that have recently completed fund-raising rounds.
The Income Approach
The income approach is based on the idea that the value for a given enterprise is created by the expectation of future cash flows and thus focuses on the capacity of a start-up company to generate future economic benefits. The mechanics of an income method require an estimate of future cash flows and an appropriate discount rate with which to determine the present value of future cash flows.
Methods under the income approach are wide ranging but typically fall into one of two categories: 1) single period capitalization of income; or 2) discounted future benefits. By nature, income expectations for medical device start-up companies are often characterized by a period of anticipated operating losses and increasing capital needs, followed by an expected payoff in the form of proceeds from an IPO, strategic acquisition, or other exit event. Accordingly, single-period capitalization of income methods and conventional applications of discounted future benefits methods are rarely appropriate to use.
The Market Approach
The market approach compares the subject to similar businesses, business ownership interests, or other assets that have been recently transacted. Market methods include comparison of the subject interest with valuation metrics implied by investments in publicly traded companies and those implied by transactions involving controlling interests in similar companies. Consideration of prior completed financing rounds or other transactions in interests of a start-up is also a method under the market approach.
Guidance in SFAS 157 suggests that the market approach is the preferred approach when appropriate data is available in sufficient quantity and quality. Most start-ups are not near IPO or acquisition, however, so there is generally not sufficient information to implement the market approach to determine the enterprise value for start-up enterprises with the exception of the occasional very late stage start-up.
Prior financing rounds can provide meaningful indications of value for a particular equity class in a start-up, but differences in rights and preferences between various classes of equity create difficulties in translating value of one equity class (e.g., preferred stock) to another (e.g., common stock). Generally, medical device start-ups are funded by one or more financing rounds subsequent to the company’s initial formation, and thus are capitalized by several classes of equity—which complicates the determination of enterprise value based on a given share value. However, such per share pricing information from capital rounds provides helpful valuation anchors in the form of upper or lower boundaries for enterprise value, and can credibly substantiate the reasonableness of valuation conclusions.
Ultimately, the value of a start-up company is a function of:
For medical device start-ups, exit events generally take the form of a strategic acquisition or an IPO. In either case, exit value will be driven by the relevant market characteristics combined with the expected impact the company will have on that market. At any given point in time, the probability of achieving successful exit and the expected time period necessary to achieve a successful exit will be a function of the development stage of the company as well as certain key indicators such as management quality.
Market Characteristics. All companies operate within a given market and this context is perhaps the most significant factor in the exit valuation of a medical device start-up. Even if a start-up has everything else in place, 100% market share of nothing is still nothing.
Market dynamics within the various medical device segments tends to share the same broad contours. The most significant market factor to consider for a medical device start-up is the absolute size and growth prospects for the pertinent market. Relevant measures in evaluating a particular medical device market often include the number of physicians performing procedures, the number of procedures performed in a given year, and the reimbursement rate per procedure.
Most new medical devices tend to be improvements on devices used in existing procedures, and thus have a readily-defined market at the start of the device development process. Less frequently, new devices offer revolutionary solutions for which there are no existing markets. Developing expectations of market characteristics in this situation is more difficult, but such products typically command far greater market impact.
Market Impact. Market impact can be defined as the market share that, if development efforts succeed, a medical start-up would likely command. Market impact is driven by the disruptive potential of the new technology and management’s ability to develop the technology, execute the business plan, and fully realize the new technology’s disruptive potential.
Other than the disruptive potential of the new technology itself, strategic acquirers in the medical device space commonly consider a variety of factors in evaluating the potential market impact of a new device:
Stages of Development. The value of a given start-up is largely related to its level of operational development. Most medical device start-ups tend to follow similar patterns in operational development regardless of industry segment. Loosely speaking, medical device start-ups often follow the following development pattern:
Since the development of start-up enterprises is measured by the passing of various milestones, the meeting of milestones (or the lack thereof) contributes significantly to the valuation of a start-up. Passing certain milestones create a bigger impact on value than others; examples of such milestones include the completion of the initial round of financing, proof of concept, regulatory approval, delivery of product to customers, and profitability.
With the passing of each milestone, the level of uncertainty associated with the start-up decreases and thus drives value upwards. Generally, meeting later-stage milestones generates greater increases in value than that of earlier-stage milestones.
Key Indicators. Compared to mature enterprises, financial information for start-up companies is less frequently available and typically of lower quality. Due to this relative lack of information, qualitative factors such as the quality of the management team, clinical advisory team, and venture capital investor group become an important consideration, especially in the valuation of early-stage start-ups.
Mercer Capital has valued a number of start-up enterprises in the medical device space over the years and we have witnessed many of the hardships and successes of such companies. We hope this introductory primer helps you better shop for business valuation services and understand valuation mechanics. We encourage you to extend your business dialogue to include valuation – sooner or later circumstances requiring independent valuation will arise, and early awareness will minimize the likelihood of potentially unpleasant surprises.
Over the last decade there have been hundreds of transactions in the beer distribution space. The impetus for consolidation has come from the top-down strategy of the breweries and the bottom-up ambition of distributors. Like a great many things before the onset of the financial crisis, the underlying strategies compelling distributor consolidation and deal pricing made better sense then.
During the last 10 years, major changes have occurred in the financial reporting process. The movement of financial reporting from a system of almost purely historical cost to one more focused on market value is now well established. In 2001 and 2002, the Financial Accounting Standards Board (FASB) enacted new rules concerning the manner in which business combinations must be accounted for. At that time, the use of the “pooling-of-interests” method was abandoned in favor of the “purchase method.” The purpose for the change was multi-faceted, but the overriding goal was to promote a more relevant accounting representation of the economics of a given transaction and its composition, namely the value of the intangible assets acquired in a transaction. To the degree a buyer in a merger paid consideration in excess of the net tangible asset value of the seller (inventory, fleet, and warehouse), such excess is required to be booked as specific intangible assets, whether definite-lived or indefinite-lived in nature, with the residual amount recorded as goodwill. For beer distributors, the value of “brand distribution rights” generally falls into the category of an indefinite-lived intangible asset. The exercise of assigning fair value to the assets acquired in an acquisition is referred to as purchase price allocation, the process for which is defined under Statement of Financial Accounting Standard (SFAS) 141R. Based on surveys of financial data published by the National Beer Wholesalers Association and Risk Management Associates, the average beer distributor has approximately one-quarter to one-third of its total assets booked as a “distribution rights” intangible.
Prompted by tightening credit and compounded by disconnects between buyers and sellers on deal valuations, consolidation has slowed and deal flow will likely remain modest as distributors digest emerging news concerning brewery strategies on distribution. Given the gloomy economic outlook and increased uncertainty in the market today, the carrying value of “distribution rights” could require restatement. Under SFAS 142, the carrying value of an indefinite-lived intangible asset or goodwill cannot exceed its “fair value.” Carrying values must be subjected to periodic tests for impairment. Should such distribution rights fall short of fair value as defined under SFAS 142, then the asset is considered impaired and must be written down to its fair value. Just as fair market value has a specific meaning under the tax code, fair value has specific meaning for financial reporting purposes and is defined in SFAS 157, Fair Value Measurements. The nuances of the numerous FASB pronouncements applicable to beer distributors is beyond the scope of this article; however, since distribution rights often represent the majority of value acquired in a transaction, SFAS 142 is a particularly relevant and timely pronouncement.
Auditors are increasingly requiring their clients to obtain an independent valuation analysis to determine if the carrying values of intangible assets are free of impairment. Keep in mind that SFAS 142 does not require the restatement of the carrying value unless the asset is determined to be impaired (again, worth less to a market participant than reflected in the financial statements). For beer distributors, fair value accounting procedures have become compulsory and likely represent an opportunity for distributors to reform their thinking about the valuations that should govern future strategic decisions, as well as influence shareholder expectations.
If your distributorship has grown via acquisition and the legacy of those deals resides on your balance sheet as a large distribution rights asset, the value of that asset may be impaired. The reality is that numerous advisors in the deal market are on the record proclaiming that the rules of thumb have changed and the financial realities of the market represent lower cash flow multiples. Lenders echo this new reality with less favorable credit terms and with requirements that buyers bring equity to their deals. Those distributors paying big multiples for territory and brand rights who have not markedly improved the margins, market share, and/or operations of their predecessors likely face the challenge of testing these assets for impairment. Beer distributors are main street players in their regional economies and communities. However, Wall Street realities and accounting requirements are knocking at the door.
This is not to say that most transactions in the beer distribution space were bad deals or lacked a sound economic rationale. Most beer distributors are savvy operators and who relied upon the financial feedback of their breweries concerning territory and brand acquisitions. Like many business platforms in the world today, the rules are simply different, or least more stringent, than before. The nature of change in so many markets is exactly the purpose behind enhanced financial disclosure and reporting rules. Many distributors could care less what the financial statements say, particularly as a result of accounting rules that may lack a certain operative and intuitive sense. However, auditors have a keen interest in compliance with the pronouncements that govern the accounting function, not to mention the financial opinions that lenders rely on. Shareholders also need to understand and reconcile the economics of past transactions.
Mercer Capital has a combination of industry, valuation, and financial reporting expertise that is uncommon in the beer distribution space today. Distributors face rising scrutiny with lenders and auditors because historical valuation metrics simply do not translate to today’s transaction environment. Last, but certainly not least, is a challenging world of expectations for many distributors and owners who could face strategic attrition and/or outright termination as brewery strategies surface and evolve. In this environment, what is the fair value today of yesterday’s transactions and how can this new reality be turned into the power of information for better reasoned decisions tomorrow? For a confidential assessment of your strategic and financial reporting needs, call me at 901.685.2120.
The market downturn of 2008 left a myriad of battered stocks in its wake. In such a difficult investment environment many investors flocked to the safe haven of so-called “recession proof” stocks. Historically, beverage stocks have been thought of as recession proof stocks.
In the case of soft drink manufacturers and distributors, the thinking is that despite hard times consumers can’t give up drinking (although they do have the option of cheaper alternatives, such as water). However, changes in consumer behavior within the soft drink segment often occur at the margin, according to Pepsi CEO, Indra Nooyi. For example, consumers may be more deliberate to stock up on soft drinks at the supermarket, where prices are lower, in order to avoid impulse purchases at convenience stores and other on-premise consumption outlets, where prices are higher. Additionally, in an economic downturn consumers become much more conscious of the products already in their pantry, using every last item before making a trip to the store to re-stock. Nevertheless, households in budget mode generally look to first cut bigger ticket items, such as vacations, furniture, and even cell phones, offering soft drink manufacturers at least some reprieve.
Along a different line, the alcoholic beverage industry is often thought of as recession proof for more somber reasons. It is commonly thought that drinking offers an outlet or escape from the stresses of tough economic times, which might include unemployment, foreclosure, precipitously declining retirement accounts, etc. The beer industry in particular is often viewed in this light, while some portions of the wine and liquor segments are considered (and priced) more as luxury goods, making them somewhat more optional in the household budget.
Unfortunately, in a severe market downturn, such as the one experienced in 2008 and continuing on into 2009, it seems no stock is immune, and beverage companies were no exception, with stocks across segments of the industry falling to multi-year low valuation multiples. All three segments (as tracked by Mercer Capital’s indices) reported median P/E valuation multiples representing double digit percentage declines from 2005 levels. Wineries and distillers saw the largest decline in P/E ratios, followed by soft drinks and then brewers. Perhaps it was best put by Peter Cressy, CEO of The Distilled Spirits Council of the United States (DISCUS), when he stated that “Contrary to popular belief, the entire beverage alcohol sector is recession-resistant, not recession-proof.”
So, is it possible to spin any of this in a positive light? In fact, there is a silver lining to plummeting valuation multiples (and these days a silver lining is about all you can hope for). No owner of a privately held business wants the value of their company to decline, especially not at the pace or to the levels experienced in the past 18 months. However, owners of wineries, beverage manufacturers, beverage distributors, distilleries, or any other company within the beverage industry could actually benefit from the current level of valuation multiples.
Over the life of a business, any number of transactions in the stock will, and eventually must, take place. For example, the gifting of shares to younger generations, contributions to charitable or family trusts, the granting of employee stock options, and others are all more efficient to the tax payer if done at lower stock valuations (i.e., lower valuation multiples). As an added bonus, any transfers done now help to ease a shareholder’s estate tax burden later. Estate planning, succession planning, and operational requirements within the distribution world are linked together making the execution of any one plan a multi-faceted exercise. As with any transaction or transfer, finding mutually agreeable and financially credible solutions can be challenging. Figure One provides a comprehensive list of conditions and circumstances for which a valuation may be required or is advisable.
Perhaps it is proverbially chaste to remind oneself that tomorrow is not a better day to do something that could better be done today. From the perspective of strategic and ownership planning, the insult on top of the injury of today’s markets and valuations will occur in the future when many look back at this time and realize they did not take advantage of a life time opportunity (at least the best so far in living memory). One could argue that it is a buyer’s market – possibly so, if your business is not well positioned and operationally optimized to receive its highest value. We would argue that the current economic climate has more likely given rise to a paradigm of more rational pricing for both buyers and sellers, one that looks more like that of other distribution platforms we have seen in our practice over many years. This new reality is a big part of the current discussion in early 2009, particularly in malt beverage distribution.
Mercer Capital has a combination of industry, valuation, and financial reporting experts that are uncommon among the pre-existing expertise in the beverage industry. For a confidential assessment of your strategic, valuation, and financial reporting needs, contact myself or Tim Lee by calling 901.685.2120.
Prepared by an independent financial advisor, a fairness opinion is just that – an opinion that a proposed transaction is fair (or not) from a financial point of view, to shareholders of a company (either all or a certain specific group of shareholders). A fairness opinion can assist corporate directors and/or ESOP trustees in making or approving decisions concerning strategic and financial events. A fairness opinion can also instill confidence among stakeholders that an action has been thoroughly vetted for its effects on the ESOP and/or the sponsoring company. These opinions can aid in substantiating that decision makers have adhered to the business judgment rule.
The prudent answer is yes. Despite out belief that transactions affecting or potentially affecting an ESOP should include a fairness opinion, such opinions are rare. Some business owners and trustees believe that fairness opinions are time-consuming, costly, uncommon, unnecessary, or excessive for many transactions. Perhaps, in some circumstances, a fairness opinion could be viewed as nonessential. However, every ESOP installation and every ESOP termination, and virtually every significant corporate (or strategic) event in an ESOP sponsoring company would be better served to include a fairness opinion rendered from the financial perspective of the ESOP and its trustee.
That an ESOP transaction or significant corporate event that affects the shareholders or participants of an ESOP company requires a fairness opinion is not specifically codified. Nonetheless, obtaining the service can be a vital, virtually obligatory exercise for any prudent decision-maker, particularly one carrying the burden of a fiduciary obligation to ESOP participants.
No. A valuation of the transacting interests may be an essential underpinning for a fairness opinion but it is not the only substance of a fairness opinion. Fairness opinions frequently contain additional disclosures, observations, and assessments concerning the circumstances of, alternatives to, and other key factors surrounding a transaction.
In many cases a fairness opinion reaches beyond the instant economics of a transaction to examine the specific terms and context of a transaction. Valuations are often based on the standard of “fair market value” and are constructed using reasonable assumptions and reflections of a hypothetical and rational universe. When an actual transaction arises between specific parties, the situation often includes attributes specific to the parties and the circumstances – in other words, the real world versus the hypothetical world. A well-crafted fairness opinion reaches beyond the hypothetical to examine and document these real world considerations.
The following is a list (non-comprehensive) of the types of events that could give rise to the need for a fairness opinion. A good rule for decision makers concerning the assessment of need for a fairness opinion is if you suspect that any aspect of a transaction is potentially controversial, then an assessment of fairness to the party in question should be considered. The responsibilities and obligations inherent in the ESOP trustee role is serious business.
Absolutely. Based on Mercer Capital’s experience, events that are potentially controversial, involve a conflict of interest, or involve decisions and actions other than in the ordinary course and timing of business may require a fairness opinion. As with the previous list of events, the following is not all-inclusive. Additionally, most of the following conditions relate to the sale of an ESOP company or the installation of an ESOP.
Despite the breadth of the above events circumstances, there are many other situations which likely accompany ESOP transactions and transactions of ESOP owned companies. Your transactions should be thoroughly reviewed from the financial perspective of the ESOP. The transaction process, evolution, negotiations, and other factors that comprise the event (and any circumstances) should be systematically analyzed and documented within the fairness opinion.
The fairness opinion is a brief document, typically in letter form. However, the supporting work behind the fairness opinion letter can be substantial. This supporting work is often reported and documented in the form of a fairness memorandum that incorporates all material factors, conditions, circumstances, and other considerations which were analyzed, assessed, and disclosed in the development of the opinion. The fairness opinion letter typically makes the affirmative statement that the proposed transaction is fair from the financial perspective of the ESOP.
In the case of a new ESOP or the sale of an ESOP owned company, the fairness exercise virtually always includes a valuation to determine if the ESOP is paying or receiving adequate consideration for the interests it is buying or selling. Generally, the purpose of the valuation is to develop the fair market value of the ownership interest to be transacted. The fairness memorandum also includes all relevant disclosures concerning the transaction, alternatives and potential consequences related to action or inaction regarding the pending transaction, and other assessments that may be specifically requested by the trustee.
In our experience as financial advisors to ESOP trustee, and as an ESOP-owned company, every ESOP situation usually has unique circumstances that require specific assessment. For a confidential discussion about your specific ESOP situation, please contact a Mercer Capital valuation professional.
The establishment of an Employee Stock Ownership Plan (“ESOP”) is a complex process that involves a variety of analyses, one of which is an appraisal of the Company’s shares that will be held by the plan. The process of a business valuation is often new and challenging to first-time clients, so we thought it would be helpful to provide elaboration on Mercer Capital’s valuation process to make the experience less intimidating.
Part of the establishment process is a feasibility analysis to determine whether the company is a good and appropriate candidate for an ESOP. Typically the company engages a number of advisors who coordinate to assist the company and its shareholders in making this determination. A firm that specializes in ESOP implementation is generally hired, as well legal counsel (if the ESOP service firm does not have internal legal resources), an accounting firm, a banker (if there are plans to leverage the ESOP), and an independent Trustee.
An appraisal firm is hired and works with the company and its team of professional advisors to determine the characteristics of the stock held by the Plan and to place a value on the shares. If the company is undecided about whether a plan will actually be implemented and is in the discovery phase of the process, the valuation firm may initially be retained to provide a limited appraisal or valuation calculations and at a later time prepare an appraisal in accordance with the Employee Retirement Income Security Act, the Department of Labor and the Internal Revenue Service guidelines as well as Uniform Standards of Professional Appraisal Practice (“USPAP”).
However, whether the initial estimate of value is a limited appraisal, valuation calculations or a stand-alone appraisal, if the ESOP is eventually implemented there are certain procedures and requirements necessary to develop and prepare a fully documented appraisal that is in compliance with USPAP. The following discussion will provide an overview of the steps necessary to prepare an appraisal.
During the initial introduction, professionals of Mercer Capital will request certain descriptive and financial information (usually recent audits and marketing brochures) to help define the scope of the business in the context of an ESOP appraisal. Defining the project is a critical phase of the valuation, and can be accomplished with telephone and personal visits with the company and its professional advisors, as required.
Once the valuation project has been defined, an Engagement Letter is issued setting forth the key elements of the appraisal assignment. Typical elements included in the letter are the name of the client (usually the Trustee of the Plan), the official name of the entity to be appraised, its state of incorporation or organization, its principal business location and the specific business interests to be appraised. Additionally, the letter will indicate the appropriate standard of value (fair market value), the premise of value (controlling or nonmarketable minority interest), the effective date of the appraisal, and the type of report to be produced. There are three scopes of work, including appraisals, limited appraisals and calculations as defined by the Business Valuation Standards of the American Society of Appraisers.
The Engagement Letter will provide a descriptive project overview, outline the qualifications of the appraiser and set forth the timetable and fee agreement. Accompanying the Engagement Letter is a comprehensive checklist request for information which is forwarded to the company. The information requested includes the company’s historical financial statements and detailed operating and structural information about the business, and the market in which it operates.
Upon execution of the Engagement Letter by the responsible party, including a response to the checklist request for information, Mercer Capital will begin its preliminary analysis of the company, including research and review of appropriate industry data and information sources. As securities analysts, we recognize that an appraisal of common stock represents an assessment of the future at a current point in time. Yet, most of the information available to the analyst is historical information. The future will likely change relative to the past, and we know that management will be largely responsible for making that future happen.
Accordingly, upon review of the checklist and industry information, we will schedule an on-site appointment with management to discuss the operations of the business. Normally, one or two business valuation professionals will visit with management at the headquarters location to:
The Company visit provides an important perspective to the business valuation, since it puts the analyst in direct contact with the individuals responsible for shaping the future performance of the Company. In a very real sense, management’s input will shape the investment decisions to be made by the appraiser in reaching a conclusion of value.
Following the Company visit, the analysis is completed, making specific documented adjustments discussed with management, in context with more subjective conclusions involving the weighting of some factors more than others. Prior to sending a draft report, the valuation analysis and report will be thoroughly reviewed by other in-house analysts to ensure that the initial conclusions are well- reasoned and supportable.
The client’s review of our draft report is an important element in the process. We believe it is important to discuss the appraisal in draft form with management and the Trustee of the ESOP (if one has been appointed at the time of our analysis) to assure factual correctness and to clarify any possible misunderstanding from our company interview.
Upon final review, the valuation report is signed by the major contributing appraiser, and is reproduced in sufficient number for the Plan’s distribution or documentation requirements.
If you are considering an ESOP, or have one already in place, and would like to discuss any valuation issue in confidence, please give us a call. We know that most companies do not run their businesses to be able to immediately respond to an appraiser’s inquiries, but our depth of experience will lead you easily through the valuation process.
ESOP valuation is an increasing concern for Trustees and sponsor companies as many ESOPs have matured financially (ESOP debt retired and shares allocated), demographically (aging participants), and strategically (achieved 100% ownership of the stock).
Given these and other evolving complexities (including the proposed DOL regulation which would designate ESOP appraisers as fiduciaries of the plans they value), it is sometimes necessary or advisable for ESOP Trustees and the Boards of ESOP companies to change their business valuation advisor.
This article addresses why a Trustee or sponsoring company might or should opt for a new appraisal provider, as well as what criteria, questions, and qualities drive the process of selecting a new appraiser.
There are potentially many circumstances and/or motivations that can compel an ESOP Trustee to seek a new valuation advisor.
Some appraisals may subtly (or unintentionally) rely on the upper end of the range of valuation assumptions, thereby compounding a series of seemingly reasonable control treatments or adjustments into an unsupportable valuation conclusion.
Over-valuation can also result from a failure to reasonably modify or abandon control-style treatments over time due to changes in market evidence, economic/financial cycles, or changes in company performance and/or outlook. Has the company’s management and/or non-ESOP shareholders lived up to their end of the bargain by modifying their compensation to comply with valuation treatments applied to develop transaction pricing? If not, how has the appraisal treated the issue?
When the decision has been made to select a new qualified appraiser, it is appropriate for the Trustee to begin an orderly process of interviewing more than one potential valuation expert in order to make an informed decision.
Therefore, Trustees and/or sponsoring companies should consider the following:
The Trustee has a role to play in providing pertinent information to the prospective appraisal firms such that they can understand the proposed project and provide a comprehensive proposal of services. As such, the Trustee should provide the following information to the appraiser candidates:
The Trustee’s selection decision should be based on the overall qualifications of the business appraisal firm. Discussion of the probable valuation outcome during the selection phase could be misleading or taint the process. In cases where a new appraiser serves as a review resource to the Trustee, there could be situations when differences of treatments and methodologies are discussed, as well as the impact that valuation modifications or additions would have on an appraisal issued by the previous appraiser. In such cases, the new appraiser has the burden of independence and credibility and Trustees have the obligation of obtaining the best information and not a predetermined outcome from a change in the appraisal firm. As stated previously, shopping the valuation for a targeted treatment or result is a dangerous endeavor.
The selection process should also be reasonably documented so that the questions of “why was a change necessary?” and “how was the selection process undertaken?” can be answered by the Trustee.
There are risks involved when making the decision to select a new appraiser, including a change in valuation methodology, a possible meaningful change in share value, and the perceived independence of the Trustee (and appraiser) from the perspective of regulators and/or plan participants. Some Trustees are simply averse to the potential backlash or complications that can arise from changing appraisers. However, in many situations, a change is needed and prudent and a lack of change can be viewed as creating or worsening a valuation issue.
The selection process should serve to ensure that the change in appraisers minimizes or mitigates the negative impact on the ESOP, and the ESOP participants (or that a change is accompanied by necessary, long-term considerations, even if a change in the valuation provider results in a meaningful near-term impact on the ESOP) and should be rigorous enough to withstand scrutiny from government regulators and plan participants.
Given the economic uncertainties in recent years, the continuing globalization of markets, the evolution of valuation science, and the growing concern for DOL compliance, Trustees must retain the right and conviction to source valuations from providers that can properly develop and defend their appraisal results.
Originally published in Mercer Capital’s Value Matters(TM) 2011-01, released March 2011
For many business owners, the investment in their company is their most significant asset. Shareholders of closely held businesses, particularly those on the crest of the baby boom wave, are rigorously searching for exit plans to diversify their portfolios and to plan for the next stage of life. It certainly helps if the exit plan is aligned with a compelling estate and tax strategy. In this era of challenging credit conditions and economic uncertainty, interest in Employee Stock Ownership Plans (“ESOPs”) is rising as sellers come to understand the varying opportunities related to transaction financing and to potential tax benefits accorded qualified sellers to ESOPs. One such potential benefit for selling shareholders is the 1042 rollover.
Internal Revenue Code Section 1042 provides beneficial tax treatment on shareholder gains when selling stock to an ESOP. Given certain conditions, capital gains tax can be deferred allowing the full transaction proceeds to be invested in Qualified Replacement Property (“QRP”). Long-term capital gains are recognized upon the liquidation of QRP securities at a future date after a required minimal holding period. If the QRP is not liquidated and becomes an asset of the seller’s estate, it enjoys a stepped up basis and avoids capital gains completely.
In order for the sale of stock to qualify for a 1042 rollover, several requirements must be met:
Qualified replacement property is defined as stocks and bonds of United States operating companies. Government securities do not qualify as replacement properties for ESOPs. The seller must invest in these properties within a 15 month period beginning three months prior to the sale and ending 12 months after the sale. The money that is invested can come from sources other than the sale, as long as that amount does not exceed the proceeds. However, not all of the proceeds have to be reinvested. If the seller chooses to invest less than the sale price, then he or she will have to pay taxes on the amount not invested in QRP. In order to meet the 30% requirement, two or more sellers may combine their sales, provided that the sales are part of a single transaction. The sponsor Company must be a C Corporation for selling the shareholder to qualify for a 1042 rollover.
The shares sold to the ESOP can not be allocated to the ESOP accounts of the seller, the relatives of the seller (except for linear decedents receiving 5% of the stock and who are not treated as more-than-25% shareholder by attribution), or any more-than-25% shareholders.
The current federal capital gains tax is 15%, but if no legislative action is taken, on January 1, 2011, the federal (long-term) capital gains tax will revert to 20%, making the 1042 rollover option more attractive and beneficial to business owners. If an owner with a $2,000,000 basis sells his or her shares for $5,000,000 and realizes a capital gain of $3,000,000, he or she would defer or save $450,000 in capital gains taxes under today’s tax structure. Given no legislative action and a 2011 reversion to previous capital gains rates of 20%, a seller would defer or save $600,000 in federal capital gains tax on the sale as shown below.
If legislative action is taken that results in an even higher capital gains tax rate, a 1042 rollover becomes even more attractive.
Leveraging the sale of stock to the ESOP can provide further financial benefit to the company and its shareholders. Sellers often use all or part of their replacement property as collateral for loans used to finance ESOP purchases. Financing costs are significantly lower for corporations that borrow to purchase owner’s stock for ESOPs than for conventional stock redemption because the corporations are able to deduct the principal and interest payments on the loan when used to purchase ESOP stock. If a corporation is in the 34% tax bracket and borrows $5,000,000 to purchase the ESOP stock, it would save $1,700,000 in federal income taxes. Combined with the $450,000 in savings with the current capital gains tax rate, the federal tax savings would be $2,150,000 or 43% of the selling price. If capital gains tax rates revert to the previous rate of 20%, the total federal tax savings would be $2,300,000 or 46% of the selling price.
Although S Corporations are allowed to have ESOPs, the 1042 rollover option is not available to the shareholders. In most cases, there is a 25% limit on tax-deductible contributions made by employers to ESOPs. C Corporations do not have to count interest payments on ESOP loans as part of the 25% limit, but S Corporations do. There is no required length of time during which a corporation must have C status to receive the benefits of the 1042 rollover, which means that an S Corporation can change its status and receive the differed tax benefits without delay. However, this change in status can have negative tax effects that would cancel out any benefits gained from the 1042 rollover status due to different accounting methods, so a change in status may not always be the best option.
Given the corporate development criterion of most strategic and financial buyers in the markets today, relatively few small-to-medium sized business owners can achieve an exit via a transaction with an external buyer. Throw in the difficulties of financing acquisitions and many shareholders of successful and sustainable businesses may be locked out of certain exit strategies. Increasingly, sellers to ESOPs are financing their own transactions. Before the financial crisis struck, many ESOPs sellers found that continuing business involvement and loan guarantees were required by ESOP lenders. The realization: seller financing in today’s market represents little incremental risk and time than in previous more favorable markets. True, many valuations may be lower than a few years back, but most good ESOP candidates have likely fared better than the markets as a whole. Absent the need for lump sum liquidity, and given a strong and early start to longer-term exit planning, seller-financed ESOPs may be a viable and preferable path for many closely held business owners.
Confused? We’re alluding to taxes – in the context of a nation whose thirst for government spending had been both red and blue in the past ten years and shows little sign of being quenched. The likely result, relentless tax pressures even if significant belt tightening occurs. For those business owners committed to the long-term success of their businesses, concerned about the fate of their employees, and who have a desire for favorable tax treatment in the course of achieving succession and exit planning, the ESOP is a viable alternative. As taxes went down in previous years, so it seems they are going up. As ESOP formation waned in a previous market where external exit opportunities abound and have now collapsed, ESOP formation appears primed to go up. ESOPs represent one of the few exit plans that can be timed and entered into without a change of control. In an increasingly uncertain world, throw in a healthy dose of tax advantages for qualified sellers and it is hard not to view the ESOP with increased interest.
Mercer Capital has over 35 years of experience providing ESOP valuation services and is employee-owned, giving us a unique perspective. For more information or to discuss a valuation issue in confidence, give us a call at 901.685.2120.
Article originally appeared in the September/October 2010 issue of Value Matters(TM).
ESOPs are a recognized exit planning tool for business owners, as well as a vehicle for employees to own stock in their employer company. However, most business owners and their advisors are unfamiliar with how an ESOP works. The mechanics of an ESOP can vary somewhat, but there is a basic common functionality to all ESOPs. Below, we discuss the mechanics of leveraged and non-leveraged ESOPs.
Most ESOPs are leveraged and involve bank financed purchases of either newly issued shares, or more often, the stock of a selling shareholder. The Company funds its ESOP via annual contributions as a qualified retirement plan and the plan effectively uses those funds to repay the debt used for the purchase.
Leveraged ESOPs tend to be more complicated than non-leveraged ESOPs. A leveraged ESOP can be used to inject capital into the Company through the acquisition of newly issued shares of stock. Figure 1 illustrates how the initial leveraged ESOP transaction typically works.
Subsequent to the initial transaction, the Company makes annual tax deductible contributions to the ESOP, which in turn repays the loan. Stock is allocated to the participants’ accounts — just as it is in a non-leveraged ESOP — enabling employees to collect stock or cash when they retire or leave the Company. ESOP participants have accounts within the ESOP to which stock is allocated. Typically, the participant’s stock is acquired by contributions from the Company — the employees do not buy the stock with payroll deductions or make any personal contribution to acquire the stock. An exception to this norm could involve roll-overs of participant’s funds from alternative qualified plans sponsored by the Company. Plan participants generally accumulate account balances and begin a vesting process as defined in the plan. Contributions, either in cash or stock, accumulate in the ESOP until an employee quits, dies, is terminated, or retires. Distributions may be made in a lump sum or installments and may be immediate or deferred. The typical annual flow of funds for a leveraged ESOP is illustrated in Figure 2.
Although non-leveraged ESOPs have certain tax advantages to selling shareholders, they generally tend to be an employee benefit, a vehicle to create new equity, or a way for management to acquire existing shares. The Company establishes an ESOP and either makes annual contributions of cash, which are used to acquire shares of the Company’s stock, or makes annual contributions in stock. These contributions are tax deductible for the Company. As in a leveraged ESOP, the employee/participant vests according to a schedule defined in the plan document, and stock accumulates in the account until the employee/participant leaves the Company or retires. At that time the participant has the right to receive stock equivalent in value of his or her vested interest. Typically, ESOP documents contain a provision called a “put” option, which requires the plan or the Company to purchase the stock from the employee after distribution if there is no public market for it, thus enhancing the liquidity of the shares. Figure 3 illustrates a non-leveraged ESOP.
As ESOP participants roll out of the plan at termination or retirement, the ESOP or the Company purchases the employee’s plan shares based on the terms specified in the plan document. Plan design and administration are crucial to a successful ESOP experience and require the participation of specialized financial and legal advisors.
As with all qualified retirement plans, there are rules and requirements pertaining to annual contribution limits, vesting, share allocation, plan administration, and other functional aspects which are beyond the scope of this overview.
Sellers of stock to an ESOP may enjoy certain tax benefits related to their sale proceeds, and the Company (the sponsor) may enjoy tax benefits related to its contributions to the ESOP. Thus, ESOPs are often postured by business advisors as a tax advantaged exit strategy. Please refer to other articles on Mercer Capital’s website or contact me or Tim Lee for more information.
Mercer Capital is itself an employee-owned firm. We value scores of ESOPs annually and provide fairness opinions and other valuation services on a regular basis to many other plans. To discuss a valuation issues in confidence, give me a call at 901.322.9716.
Reprinted from Mercer Capital’s Value Matters (TM) 2009-03, published March 31, 2009.
The Employee Stock Ownership (ESOP) appraisal utilizes the same tools and techniques of any fair market value appraisal assignment, but with an added emphasis on analyst expertise in understanding the market, the economy, and the underlying business model for the subject company. The ESOP appraisal has the added sensitivity of the Plan participants and trustees who don’t like to see the value of allocated shares reflect a decline on the annual plan account statements, especially if it’s at redemption time.
We all recognize that in the real world, stocks frequently do decline in value, and closely held ESOP shares should be no exception. However, the appraiser of ESOP shares is in a unique position to interpret market, industry, and company performance in the context of a fair market value appraisal. This analysis is even more important for a cyclical company, where sales and earnings declines are expected but seldom forecast. As appraisers, we frequently utilize the tool of average or weighted average earnings in context with a specific company risk premium and earnings growth rate to develop a capitalization rate, or multiple of ongoing earnings. For an annual ESOP appraisal update, the use of average or weighted average earnings can work against the reality of the situation, and it is here that the analyst must have a firm grasp on the underlying trajectory of earnings as the subject company
navigates through the down cycle, in anticipation of the expected, but unknown, upside.
Consider the case of Cyclical Growth Company, Inc., (“CGC or the “Company”), a large manufacturer of industrial products, subject to normal business cycle fluctuations. The eight year summary of operations shown in Figure One reflects the peak of the last cycle and the recovery to date in 2006.
During the period 1999 – 2001, earnings are advancing but not at an accelerating rate, and appear in line with management’s expectation of a long term growth rate approximating 5%. With the benefit of hindsight, we know that 2001 was the peak of the cycle, we just don’t know that for the 2001 appraisal.
Accordingly, a reasonable derivation of the capitalization factor by means of the Adjusted Capital Asset Pricing Model during this time period may include using a 3% specific company risk premium and a 5% sustainable growth rate in earning power. As shown in Figure Two, this results in a multiple of earnings at 7.90x for 2001, applicable to ongoing earnings power.
When applied to the ongoing earning power of CGC, based on 5-year average earnings, a value of $21.75 per share is indicated. Again, this was the peak of the cycle, we just don’t know that yet.
By 2002, it is evident that this is the first year of the downturn. As shown in Figure One, earnings approximate one-third of prior levels and sales are down substantially. The Company is able to maintain about the same gross margin as in the prior year, but the cut in SG&A expenses is not enough to avoid an operating margin at about half of the peak (2001) year, although profitability is maintained. Specific company risk has not changed, although interest rates are now lower in the recession. Since the length and depth of the downturn are unknown, and the average earnings analysis has produced ongoing earnings of $2.5 million (versus reported earnings of $1.2 million), it may still be reasonable to expect a long term growth rate of earnings at 5%, resulting in only a modest decline in value compared to 2001.
By 2003, it is clear that the recession and decline in sales and earnings are for real. Reported earnings are now about half of 2002 and approximate about 16% of the peak (2001) year, although still profitable. The length and depth of the recession are still unknown, but recent history tells us that recessions are shorter than expansionary phases. The 5-year average earnings analysis still provides some moderation to ongoing earnings (now assuming a reasonable recovery). With the specific company risk premium unchanged, and given the underlying growth rate of earnings approximating 5%, it may now be feasible to assume that with earnings acceleration upon the recovery, the long term growth rate of earnings for the determination of a single-point capitalization rate may be 7%. This results in a higher multiple on lower earnings, which is exactly what the market would typically do if the Company were publicly traded.
By 2004, the sales decline has now ended, but profitability has not fully recovered, as the Company has maintained sales with lower margin products, and boosted SG&A expenses back to the 2002 – 2001 level. The operating margin at 3.6% is the lowest in the last six years, and earnings at $620,000 matches 2003’s performance, Management may have a feel for a prospective, but undefined recovery at this point, but we will not know that this is the nadir of the cycle until we can look back on it. Given the relatively low ongoing earnings based on the 5-year average earnings analysis, in context with a prospective, but undefined recovery, it may be reasonable to boost the growth rate of earnings to 8% for 2004, anticipating a recovery by 2005.
By 2006, the recovery is clearly in place, with sales and earnings greater than expected. The gross margin has improved to its highest level, exceeding the peak in 2002 – 2001. Operating expenses have increased too, with additional catch-up bonuses to employees who sought to maintain market share in the recession. The operating margin now approximates the peak in 2001. Earnings are at the highest level ever, at $4.3 million. With the Company clearly beyond the recession, it may be time to modify the average earnings analysis to a 3-year average, which picks up the two recovery years, but tempers that with the last diminutive year of the recession. From this recovery earnings level, the earnings growth rate as a component of the capitalization rate is no longer 8%, but can reasonably be expected to achieve the 5% projected by management.
During the economic cycle described, the Company has experienced significant changes in financial performance. While consistency is important in an ESOP appraisal, the analyst need not be crucified on the cross of consistency. Given the modest changes in interest rates, and a constant specific company risk premium, the key variables here involve the growth rate of earnings and the average earnings base (ongoing earnings) to which the capitalization multiple is applied. It is at this decisive analytical juncture that the seasoned analyst has an edge: experience counts. Experience with the variance of market cycles and the nature of equipment manufacturers during different phases of the economic cycle, in context with the legacy experience in the analysis of the Company and its management all comes together to provide an analytical perspective allowing the adjustment (and defense!) of key benchmarks in the multiple and the ongoing earnings to which it is applied. A summary of the capitalization of earnings approach since the peak in 2001 is shown in Figure Two.
In the case of Cyclical Growth Company, Inc., the analysis has reflected the reality of the marketplace at key junctures in the economic cycle. While the future is uncertain during the freefall part of the cycle, the averaging of earnings provides some moderation to the decline (assuming, of course, that earnings actually will recover). Moderating the growth rate at the proper time, based on experience, assigns a higher multiple to lower earnings, which is exactly what the public market does. Finally, with the recovery in place, a re-adjustment of the growth rate of earnings and the averaging process results in a reasonable assessment of the future at the valuation date. From the ESOP participant’s point of view, the per share value declined only modestly over three years, but not nearly as severely as the decline in earnings for those years, and the value upon recovery exceeds the prior peak in 2001.
If you need the experience of a seasoned analytical team to define and defend the appraisal of your ESOP, or for other business valuation resources, please give us a call at Mercer Capital to discuss your specific requirements in confidence.
Reprinted from Mercer Capital’s Transaction Advisor, Vol. 10, No. 2, September 2007.
Webster’s dictionary defines a "fable" in several ways: 1. a feigned story or tale, intended to instruct or amuse; 2. a fictitious narration intended to enforce some useful truth or precept; 3. the plot, story or connected series of events forming the subject of an epic or dramatic poem; 4. any story told to excite wonder; 5. fiction, untruth, falsehood. The title of this article is a play on the venerable Aesop, whose musings turn out to be highly relevant to world of ESOP oversight and valuation. Mercer Capital renders services for ESOP fiduciaries that cannot remotely be characterized as fable. In over twenty years of providing valuation services in connection with ESOP installations, plan year updates and plan terminations, we have assisted many victims of bad advice and misinformation.
In recent years, Mercer Capital has seen a significant increase in the scrutiny of process and the propriety of conduct concerning ESOPs and their fiduciaries. In turn, Boards of Directors and ESOP Trustees (both inside and third party) are seeking more skilled and experienced service providers to enhance their understanding of the valuation process and to improve the credibility of their valuations. If you are an ESOP Trustee or a Board member of an ESOP-sponsor company, the ante for prudent decision-making continues to rise rapidly.
There are many reasons that ESOP valuation is an increasing concern for sponsor companies. Much has been written concerning Enron and other egregious cases of corporate malfeasance. As if greed was not bad enough to bring the hammer down, the demographic tsunami of plan participants requiring diversification or retirement is contributing to an inescapable tide of emerging liability issues. Compounding these concerns are the competing liquidity needs of non-ESOP shareholders who may be calling on finite resources to address their own needs. Last, but certainly not least, the economy is yawing and pitching in a storm of cyclical and fundamental waves which we have arguably never experienced. In the midst of all this turbulence, a strong dose of examination is required:
Revisiting some of Aesop’s fables, we can find many relevant morals concerning the structuring and planning of an ESOP.
This brief article cannot possibly provide a complete inventory of items and issues that may be important to assessing the health of an ESOP or the prudence of its sponsor company and fiduciaries. If your answers to some of the above questions have you concerned or curious, take action to prevent or correct potential problems. Mercer Capital has been providing valuation services on behalf of ESOP Trustees for over twenty years. Contact us to discuss a valuation need in confidence.
Reprinted from Mercer Capital's ESOP Valuation Advisor- Volume 13, No 1, 2004.
Many of Mercer Capital’s clients have recognized the value of employee ownership in terms of employee loyalty and motivation as well as the numerous tax advantages to the business and maintain an Employee Stock Ownership Plan (“ESOP”). During the first part of 2001, we have performed hundreds of appraisals for purposes of establishing the value of shares held by ESOPs, proposed ESOP transactions as a result of mergers and acquisitions, and many other purposes. The most interesting development in the ESOP arena, however, is the increasing number of S corporations establishing ESOPs and ESOP-owned C corporations electing to convert to subchapter S status.
Although the provisions of the Small Business Protection Act of 1996 (the “Act”) enabled trusts such as an ESOP to be an S corporation shareholder, the Act included numerous provisions that presented significant barriers for S corporations to sponsor an ESOP. In 1997, however, Congress amended the Act to correct technical flaws relating to ESOPs. Most importantly, the revisions to the Act exempt ESOPs from the unrelated business income tax (“UBIT”), making ESOP ownership much more appealing. The revisions also allow S corporations to require cash distributions rather than stock distributions to departing employees to prevent potential disqualification of the subchapter S status (for example, an IRA is not a qualified S corporation owner, and an employee’s placing of S corporation stock in her IRA would result in the termination of S status under the Internal Revenue Code).
The valuation on S corporation stock is fundamentally identical to the valuation of an interest in a C corporation. However, a number of valuation approaches require the tax-effecting of earnings/distributions, an adjustment that will convert S corporation operations to a C corporation equivalent basis.
For example, the market approach to valuation includes a variety of methods that compare the subject company with transactions involving similar investments, including publicly traded guideline companies. A direct comparison between an S corporation and a publicly traded C corporation, however, is impossible, as demonstrated in the example in Table 1 top of page 2.
The S corporation’s hypothetical value based on $100 in pretax income and an after tax valuation multiple of 6x is $600, versus the C corporation’s value of $360. Say your company operated as a C corporation in 1998, operated as an S corporation during 1999, and operations were absolutely identical in both years. I am sure that you would agree that your Company’s value (everything else being equal) did not increase more than 65% simply because of the conversion to an S corporation. The flaw in the above analysis is, of course, the application of an after-tax multiple (which is commonly based upon publicly traded C corporations) on S corporation earnings. In order to allow for a meaningful comparison between your S corporation and the publicly traded C corporations, it is necessary to adjust the S corporation’s income for corporate taxes. On a C corporation equivalent basis, net income in the above example is $60 ($100 of taxable income tax-effected at an assumed tax rate of 40%), resulting in a value of $360 for the enterprise.
A similar adjustment is necessary when comparing a C corporation’s dividends with an S corporation’s distributions. C corporation shareholders pay income taxes at their applicable tax rate on dividends received. The S corporation shareholder, however, is responsible for the taxes on his or her share of the company’s income, whether a distribution occurred or not. As a result, it is necessary to convert distributions from an S corporation to a C corporation equivalent basis before any valuation inferences can be drawn. (For a more detailed description, please call us for a copy of “Converting Distributions From ‘S’ Corporations and Partnerships to a ‘C’ Corporation Dividend Equivalent Basis,” by J. Michael Julius, 1996).
The above examples illustrate that an S corporation’s value cannot be derived simply by applying after tax valuation multiples to S corporation net income or distributions. Similarly, we pointed out that there is no S corporation premium resulting simply from the conversion to a subchapter S corporation. If there is no increase in value as a result of conversion, however, what triggered the recent surge in conversions to S corporations?
The key incentive for ESOP ownership of an S corporation appears to be the fact that distributions to the ESOP are tax exempt. The higher the ESOP’s ownership stake in the company, the less taxes are paid. If the ESOP is the sole owner of the S corporation, the organization pays no income tax. While we demonstrated that an S corporation’s value does not differ from its C corporation peer, this ability to retain, accumulate, and reinvest significant amounts of cash can increase value over time as the operations and earnings grow. During the past year, some of our clients have been able to significantly expand their operations by using the incremental cash flow that resulted from their conversion to an S corporation.
At the same time, there are some potential disadvantages to the S corporation ESOP. First, a Section 1042 “Rollover” (the deferred recognition of gain on the sale of stock to an ESOP) is not available to S corporations. Second, contribution limits for S corporations to pay ESOP debt are limited to 15% of payroll (but increases to 25% if the ESOP contains money pension purchase provisions). Third, S corporations can only have one class of stock, and any distributions must be made pro rata. Since most S corporations distribute an amount at least equal to the shareholders’ tax liability and the ESOP has no tax obligation, funds that could be available for reinvestment have to be distributed to the ESOP. However, these funds could be used for a variety of purposes, including ESOP debt retirement, additional stock purchases, or payments to terminated employees.
C corporations with ESOPs desiring conversion to S status must also consider the following:
ESOP ownership in S corporations can create significant advantages for employers and employees. Employee ownership creates incentives for employees to contribute to “their” company’s success and motivate stakeholders to take an active part in the operations of the organization. Business owners have the opportunity to share the successes of their business with employees and reward loyal, long-time employees for their contributions to the business. While employee ownership provides many intangible advantages as compared to more traditional ownership structures, the ability of ESOPs to own a stake in an S corporation may very well be one of the most financially rewarding changes in tax legislation.
Reprinted from Mercer Capital’s ESOPVal.com, Volume 10, Number 1, 2001.
Mercer Capital has been engaged periodically by the U.S. Department of Labor (DOL) to review an historical ESOP transaction and offer our comments regarding the appropriateness of (1)Valuation and (2) Procedural Prudence. While these are two different and distinct areas, the DOL is interested in pursuing both. Violations of procedural prudence can influence the business valuation process and its determination of adequate consideration for ESOP shares.
Proposed regulations for the Department of Labor relating to the adequacy of consideration paid in ESOP transactions have been outstanding since May 1988. Pending their finalization, many appraisal firms, including Mercer Capital, are operating as if they were final. In essence, the proposed regulations incorporate the guidelines of Revenue Ruling 59-60 and add other specific requirements for the appraisal of employers’ securities for ESOP purposes.
We do not provide legal advice, and would look to legal counsel to interpret the standards of fiduciary responsibility in the pension plan context, a primary objective of the Employee Retirement Income Security Act of 1974 (ERISA). Nonetheless, a few general guidelines, based upon our experience, will highlight the need for professional advisors in the establishment and maintenance of an ESOP.
Does the valuation follow the basic guidelines of revenue Ruling 59-60, which sets the standard for Fair Market Value?
Does the valuation properly account for the degree of control to be purchased or sold by the ESOP: a minority or controlling interest?
Does the math check out?
Does the appraisal make sense?
Does that complex discounted cash flow model tucked in the back, and upon which substantial weight was placed, make sense when comparing future growth rates of sales, earnings and margins with historical results? Does the model reasonably reflect the risks of achieving those results? Are the reasons which support the model adequately disclosed in the text?
Do the guideline companies appear reasonably comparable to the subject company, or has the appraiser used multi-billion dollar sales companies in comparison to a $10 million family enterprise? Is the “fundamental discount” so large as to put the whole guideline approach into question?
Business valuation is an art as well as a science, and sometimes a company appraisal will not fit the normal standard to which the appraiser is comfortable. Appraisers and fiduciaries need to review appraisal reports to ensure that the premise, format and standard match the unique circumstances of the ESOP company.
Have fiduciaries reviewed and critiqued an independent appraisal report? As stated in Donovan v. Cunningham (716 F.2d 1455 (1983)), “An independent appraisal is not a magic wand that fiduciaries may simply wave over a transaction to ensure that their responsibilities are fulfilled. It is a tool and, like all tools, is useful if used properly. To use an independent appraisal properly, ERISA fiduciaries need not become experts in the valuation of closely held stock – they are entitled to rely on the expertise of others. However, as the source of the information upon which the experts’ opinions are based, the fiduciaries are responsible for ensuring that that information is complete and up-to-date.”
Have fiduciaries acted in good faith? There is a clear conflict of interest between the selling, controlling shareholder, who may also be President of the company, and the ESOP. This conflict should be mitigated by the input of other professional advisors.
Have the fiduciaries negotiated independently on behalf of the ESOP, in terms of transaction price, loan requirements and the structure of the deal?
Is there only one person who controls the whole process? There is an inherent conflict of interest if only one person is selling the shares, hiring the appraiser, providing the appraiser with company information and negotiating with the lending authority.
Did the appraiser receive full and adequate information? Most of what an appraiser can analyze is historical information, from which he can make a judgment about the future, based upon management performance. The appraiser must be advised how the future may change relative to the past, and how management will deal with or implement that change.
Are there clear lines of communication with responsible fiduciaries? Do they know their responsibilities and is it documented? Do the fiduciaries have the capacity to review the independent appraiser’s report and determine its adequacy?
Has the ESOP purchased or sold its shares for “adequate consideration” and can the reasonableness of that determination be validated by more than waving the appraisal report over the transaction?
Based on our experience, ESOP transactions are not always challenged by the DOL just because a participant complained. The DOL has periodically undertaken targeting initiatives to probe for violations of ERISA relating to whether ESOPs were independently valued, and whether that valuation supported the standard of adequate consideration.
If you would like to discuss a prospective ESOP transaction with us in confidence, please give us a call.
Reprinted from Mercer Capital’s ESOPval.com – Vol. 9, No. 2, 2000.
An ESOP is an employee benefit plan designed with enough flexibility to be used to motivate employees through equity ownership. Therefore, according to theory, ESOPs implicitly enhance productivity and profitability and create a market for stock. This enhances shareholder liquidity and provides a vehicle for the transfer of ownership, which can assist in the transition from an owner/management group to an employee-owned management team.
Although ESOPs have been in use for a number of years – and with each new tax law undergo some changes – their basic structure and benefits have stood the test of time. ESOPs deserve to be examined and considered for potential application. Here is a brief and basic description of ESOPs, a simplified overview of the two types of ESOPs and a summary of the benefits of employee ownership to employees, shareholders and employers.
An ESOP is an employee benefit plan which qualifies for certain tax-favored advantages under the Internal Revenue Code (“Code”). In order to take advantage of these tax benefits, it must comply with various participation, vesting, distribution, reporting and disclosure requirements set forth by the Code. These requirements are designed to protect the interests of the employee owner. ESOPs are also subject to the regulations set forth in the Employee Retirement and Income Security Act of 1974 (“ERISA”) which essentially created a formal legal status for ESOPs and must meet the employee benefit plan requirements of the Department of Labor.
A company establishes an employee stock ownership trust and makes yearly contributions to the trust. These contributions are either in new or treasury stock, cash to buy existing shareholder stock or pay-down debt used to acquire company stock. Regardless of the form, the contributions are tax-deductible.
Employees or ESOP participants have accounts within the ESOP to which stock is allocated. Typically, the participant’s stock is acquired by contributions from the company – the employees do not buy the stock with payroll deductions or make any personal contribution to acquire the stock. Plan participants generally accumulate account balances and begin the vesting process after one year of full time service. Contributions, either in cash or stock, accumulate in the ESOP until an employee quits, dies, is terminated, or retires. Distributions may be made in a lump sum or installments and may be immediate or deferred.
ESOPs are of two varieties: leveraged and non-leveraged. Each of the ESOPs has different characteristics.
FunCo, Inc. establishes an ESOP and makes annual contributions of cash, which are used to acquire shares of the company’s stock, or makes annual contributions in stock. These contributions are tax deductible for the company. As shares are allocated to participants’ accounts based on a value determined by an independent appraisal, employees begin to acquire an equity ownership in the business.
The employee/participant begins to vest according to a schedule incorporated into the ESOP document, and stock accumulates in the account until the employee/participant leaves the company or retires. At that time, the participant has the right to receive stock equivalent in value to his or her vested interest. Typically, ESOP documents contain a provision called a “put” option, which require the Plan or the company to purchase the stock from the employee after distribution if there is no public market for it, thus enhancing the liquidity of the shares.
Non-leveraged ESOPs, although they have certain tax advantages, generally tend to be an employee benefit, a vehicle to create new equity, or a way for management to acquire existing shares.
Leveraged ESOPs tend to be more complicated than non-leveraged ESOPs. However, they provide a company with tax-advantages by which it can generate capital or acquire outstanding stock. A leveraged ESOP may be used to inject capital into the company through the acquisition of newly issued shares of stock.
FunCo establishes an ESOP. A bank or other lending institution lends money to the ESOP which acquires company stock. The company makes annual tax deductible contributions to the ESOP, which in turn repays the loan. Stock is allocated to the participants’ accounts – just as it is in a non-leveraged ESOP – enabling employees to collect stock or cash when they retire or leave the company.
The advantages and benefits of an ESOP are numerous and varied depending on whether you are the employee/participant, an existing shareholder, or an employer.
An ESOP can provide an employee with significant retirement assets if the employee is employed by the company for a significant period of time and the employer stock has appreciated over the years to retirement. The ESOP is generally designed to benefit employees who remain with the employer the longest and contribute most to the employer’s success. Since stock is allocated to each employee’s account based on a contribution by the company, the employee bears no cost for this benefit.
Employees are not taxed on amounts contributed by the employer to the ESOP, or income earned in that account, until they actually receive distributions. Even then, “rollovers” into an IRA or special averaging methods involved in the income calculation can reduce or defer the income tax consequences of distribution.
When the employee’s participation in the ESOP ends, they are entitled to their share of the “vested” benefit according to a schedule incorporated into the ESOP document. Distributions may be made in stock or cash. However, a “put” option, which requires the Plan or the company to acquire stock distributed to participants, may provide cash for their shares. This is especially valuable to participants in privately held companies where there is no market for the company stock.
An ESOP can create a market for the stock of a privately held company. The ESOP provides a ready, current market for the stock of outside shareholders providing liquidity not otherwise available. This feature may be used by participants, beneficiaries, major shareholders or estates of deceased shareholders.
The ESOP leveraging provides a way for a selling shareholder to receive cash, rather than incur the risk of a deferred payment arrangement.
Subject to certain conditions and regulations, the Code makes provision for special tax incentives for certain sales of stock to an ESOP. This would enable a shareholder of a closely held company to sell stock to an ESOP, reinvest the proceeds in other qualified securities and defer taxation on any gain resulting from the sale.
An ESOP is mandated by law to invest contributions primarily in employer stock. It is also the only qualified employee benefit plan which is permitted to borrow funds on employer credit in order to acquire employer stock. These differences provide significant flexibility for a company using an ESOP as a corporate finance tool and make possible the accomplishment of corporate objectives not available through other methods.
As a corporate finance technique, the ESOP can be used to raise new equity to refinance outstanding debt or to acquire assets, or outstanding stock, through leveraging with third party lenders. Since contributions to an ESOP are fully tax-deductible, an employer can fund both the principal and the interest payments on an ESOP’s debt service obligations with pre-tax dollars. Dividends which are used to repay a loan may also be deductible.
Another major benefit to both employer and shareholder is the positive impact that results when employees have an equity ownership in the company. This results in improved productivity, profitability and overall corporate performance.
An ESOP is an attractive employee benefit and corporate financing tool; its structure can range from simple to very complex. Its feasibility should be considered by competent lawyers, accountants, and administrators to ensure tax deductibility compliance with the Internal Revenue Service regulations and to meet the employee benefit plan requirements of the Department of Labor.
Reprinted from Mercer Capital’s Bizval.com – Vol. 9, No. 2, 2000.
The responsibilities and duties of trustees for qualified employee benefit plans (ESOPs, profit-sharing plans, 401(K)s, etc…), which invest in employer securities are becoming increasingly important. In light of current trends toward more complex ESOP matters, (i.e. mergers and acquisitions of ESOP companies, plan terminations and amendments, maturing plans and the resulting repurchase obligation, and increasing shareholder litigation), trustees need to clearly understand their responsibilities and liabilities. Recognition of this fact is leading to the use of a variety of financial advisors, including Trustees, who are independent to the plan, and have the expertise and knowledge base required to engage in complex transactions.
Fiduciary responsibilities with respect to the purchase and allocation of employer securities as well as the proper maintenance and administration of the plan are set forth in the Employee Retirement Income Security Act of 1974 (“ERISA”). Actions of Trustees of Employee Stock Ownership Plans are also subject to review by the Department of Labor (“the DOL”); therefore, these duties should also be considered in light of the Proposed Regulations Relating to the Definition of Adequate Consideration (Federal Register 29 CFR Part 2510, May 17, 1988) when stock transactions occur. While these regulations are still outstanding in their proposed form, most ESOP trustees, counsel and valuation practitioners still look to these regulations for guidance in determining the value of employer securities.
To summarize, actions with respect to a plan by its Trustee(s) under ERISA, must be discharged solely in the interest of the participant and beneficiaries: 1) for the purpose of providing benefits to participants and their beneficiaries; 2) with the care, skill, prudence and diligence under the circumstances that a prudent person acting in the same capacity with such matters would use under similar circumstances; and, 3) in accordance with the document governing the plan insofar as the documents are consistent with ERISA. In addition, the Trustee must avoid either direct or indirect transactions between the Trustee and another party in interest to the plan.
The DOL recognizes that ERISA regulations are broad, and allows the fiduciary some degree of latitude as long as transactions are conducted in good faith. A fiduciary is generally considered to have acted in good faith if the valuation of employer securities is arrived at subject to a thorough examination of all the relevant factors to the transaction, or if the fiduciary relies on a valuation of the employer security by an appraiser independent of all the parties to the transaction.
In other words, the scope of the Trustee’s responsibility would require that a plan fiduciary either be an expert in stock appraisals, or exercise sound judgment in the selection and assessment of the qualifications of an independent appraiser. Since it is neither practical, nor likely, that most plan Trustees will be thoroughly familiar with business appraisal, the key element of the valuation process from the Trustee’s standpoint is to be confident the appraisal firm selected to perform the valuation is well qualified and independent. Qualifications can be based upon a variety of factors including independence, academic and professional credentials, involvement in professional organizations, and related ESOP appraisal experience (See “Questions to Ask Your Appraiser in the Fall, 1998 issue of ESOPVal.com).
Section 409(a) of ERISA stipulates that a fiduciary who has breached fiduciary obligations be personally liable to make good plan losses which result from the breach, restore plan profits which have been made through the use of assets of the plan by the fiduciary, and be subject to any remedial relief the court deems appropriate. Case studies indicate that the liability for breach of fiduciary duty has usually been limited to restitution (although in egregious cases penalties have been more severe), and provided the courts can determine the Trustee acted in good faith, the Trustee is not obligated to guarantee the outcome of its decisions. The potential for greater monetary penalties may increase the risk factors for all involved. The selection of a qualified appraiser whose appraisal can withstand rigorous scrutiny will assist in minimizing the potential penalties and personal liabilities of plan Trustees.
Mercer Capital is one of the largest ESOP appraisers and one of the largest independent valuation firms in the nation. We have worked with clients in over five hundred industry categories and provided independent valuation services for many personal and corporate purposes, including employee benefit plans. Give us a call if you have any questions or if we can help you in any way.
Reprinted from Mercer Capital’s ESOPVal.com – Vol. 9, No. 1, 2000.
After years of experience listening to and working with clients and their financial advisors, as well as preparing hundreds of appraisal reports, we have learned a few general and often overlooked simple truths about ESOP appraisals. We share the following six observations in hopes that they will broaden your perspective of business valuation and possibly provide you with some “tips” to assess future appraisals you may review.
Remembering these common sense yet important points should give you a feel for the general perspective and tone the business appraiser is trying to create. If our perceptions have prompted questions, contact one of our professionals. We will be happy to discuss any valuation issues with you in confidence.
Reprinted from Mercer Capital’s ESOPval.com – Spring/Summer 1997.
The complexity of transactions involving the use of Employee Stock Ownership Plans (ESOPs) and the rising sensitivity to fiduciary responsibilities has led many plan fiduciaries to seek the advice of independent financial advisors when important transactions occur. Examples include unleveraged purchases and sales of stock, leveraged purchase of shares, the use of hybrid securities, and multi-investor buyouts. This article describes the role and qualifications of the financial advisor, the primary factors in the development of financial advisory opinions, and some practical issues related to the decision by the trustee to hire an advisor.
ESOPs have been part of the corporate finance scene for more than twenty years. While the level of activity in the public markets has abated in recent years, transactions continue to occur in the less visible venue of the closely held company. Improving corporate profitability and greater availability of bank loans has lead to a resurgence in transactions. Notwithstanding the relative degree of complexity of a given transaction, consideration should be given to the use of an independent financial advisor.
Over the years, a number of refinements and changes have occurred in the role of the various players in completing a transaction involving an ESOP. The Department of Labor (DOL), as the government agency responsible for monitoring compliance with the Employee Retirement Income Security Act of 1974 (ERISA), the Internal Revenue Service (IRS), and state and federal courts have increasingly focused on the role of the fiduciary in ESOP transactions. For example, the IRS periodically tightens up its procedures with new announcements such as Announcement 92-182 – Employee Plans Examination Guidelines and Announcement 95-33-Examination Guideline on Leveraged ESOPs.
A 1993 federal district court case, Reich v. Valley National Bank of Arizona, more commonly known as the “Kroy case,” further heightened the potential responsibilities of the plan fiduciary and the financial advisor. A discussion of Kroy is outside the scope of this article, but suffice it say that it is essential that ESOP fiduciaries and advisors must understand its implications.
The effect of all of this has been to clarify and often increase the responsibilities of plan fiduciaries, because they are obligated to act prudently and solely in the interest of the plan participants. One way to meet those responsibilities is to use an independent financial advisor to address questions of adequate consideration and fairness.
A transaction involving an ESOP can have the following participants to the purchasing and selling parties:
It may well be in smaller deals that several of the above roles are filled by the same person or entity. However, this duplication of roles raises the fiduciary’s risk profile, particularly if the ESOP was later determined to be inadequately represented. A distinction should be drawn between an independent appraiser and an independent financial advisor. Although this role may be the same individual or company, the appraiser makes an independent determination of the fair market value of the company’s shares and the financial advisor assesses the overall fairness of the transaction, including the pricing and terms. This article attempts to focus on the overall broader responsibility of the financial advisor (whether or not the advisor is an appraiser also) rather than discussing each consultant and their individual roles and responsibilities.
The financial advisor acts as a financial consultant to the fiduciary. The role and responsibility of the financial advisor can be categorized as follows:
Documentation of the opinions is particularly important because some of them are required by law. The relevant factors in reaching the conclusion of value and fairness should be carefully articulated and supported.
The qualifications of the financial advisor are very important. Specific factors to consider include:
The financial advisor should be familiar with a wide range of valuation techniques, including those considered most accepted and utilized in the industry. Knowledge of the financial markets and accepted valuation techniques is also very important. “Rules of thumb” and other more generalized methods of valuation are likely to prove less useful in a complex ESOP transaction.
The determination of fair market value of the stock is a crucial question because it is required; yet it is sometimes the easiest portion of the assignment. Fairness can be a much more difficult concept, particularly when a leveraged transaction is involved. It is vitally important that the ESOP and its participants be treated equitably in relationship to other shareholders. The test of financial fairness can be divided into two broad categories: (1) valuation and (2) allocation of equity among the owners.
The issue of valuation arises from ERISA’s mandate that the ESOP cannot pay more than adequate consideration for the securities it acquires or sell securities for less than adequate consideration. It can however, pay less and sell for more. As part of the test of adequate consideration, the financial advisor must determine the fair market value of the securities. It is incumbent upon the appraiser to look at valuation from the perspective of the interest being sold (or bought) as well as the structure of the transaction.
The fairness of the transaction from a financial point of view requires an analysis of fair market value in the context of the transaction, as well as the overall treatment of the ESOP in relationship to other participants in a deal. Major questions often relate to allocating equity when shares are purchased in a multi-investor buyout, or to allocating the sales proceeds when the consideration paid includes cash, stock, notes receivable, contingent deferred payments, and non-compete or employment agreements.
The allocation of equity can be a very complex process in a multi-investor leveraged ESOP. Transactions involving cash equity at the time of the purchase by the ESOP are much more straightforward because all of the parties are purchasing their securities with the same “currency.” The use of debt instruments adds substantial complexity because equity interests must be allocated appropriately.
The various methods of equity allocation have not been fully agreed to in the financial, regulatory, and legal communities; therefore the reader should be aware of possible philosophical differences that can lead to radically different conclusions.
The issue of the fairness of a transaction to all of the parties involved is often addressed by obtaining a fairness opinion from the financial advisor to the transaction. While a fairness opinion is not required in every transaction, there are certain situations in which ESOP fiduciaries and participants would benefit from an independent opinion of the transaction. The fairness opinion, which is a document that states whether or not a proposed transaction is fair from a financial viewpoint, provides a safe harbor to the ESOP fiduciary from charges of uninformed decision-making, violations of the business judgment rule, and conflicts of interest. It also, more importantly, protects the rights of the participants and enables the fiduciary to negotiate the best possible deal for the ESOP. Its purpose is to provide an objective standard against which directors, shareholders, fiduciaries, and other interested parties may measure proposals and opportunities presented to the company. 1 The facts of a particular proposal may lead the parties involved to believe that an analysis of other alternatives should be considered. Circumstances in which it would be prudent to obtain a fairness opinion include:
The scope of a fairness opinion analysis is broad and extends beyond the rigid or “canned” analysis of a computer-generated financial model. The financial advisor is retained to assist the fiduciary in determining whether an offer is made to the shareholders at a fair price — a determination that requires an examination of the present and future prospects for the company; the existence of other alternatives; the ability to obtain financing to complete the transaction; and the overall effect of a proposal on employees, customers, suppliers, creditors, and the community in the case of small, closely held companies.
The fairness opinion document is generally a short document, typically a letter, but may vary in length and detail and is dependent on the complexity of the transaction, the financial advisor, and the needs of the fiduciary. Generally the document is a letter addressed to the fiduciary that outlines the major considerations of the opinion, describes the due diligence process including all of the documents reviewed, and offers the advisor’s opinion of the fairness of the transaction from a financial viewpoint. While the document itself may be short, the supporting documentation is substantial, and reflects the degree to which the proposed transaction was analyzed.
Evaluating the financial aspects of a tender offer or the acquisition of shares by an ESOP is a challenging and complex task. The expert retained to render a fairness opinion must be aware of IRS and DOL regulations, ERISA provisions, specific plan provisions, accepted investment analysis practices, the specific facts and circumstances surrounding the transaction, and furthermore must sometimes be willing to protect the interest of the ESOP participants through active negotiating of terms and pricing.
The authors’ experience as financial advisors to ESOP fiduciaries has led to a number of practical observations. Following are useful considerations for a fiduciary when the ESOP is the purchasing entity.
Following are comments from the perspective of representing the ESOP in a sale situation.
Regulatory, legal and business trends are all moving toward increased responsibilities for ESOP fiduciaries. Fiduciaries must demand quality work from ESOP financial advisors and be in a position to recognize pitfalls before they occur. At the same time, it is important for the fiduciaries to recognize that financial advice can be of great benefit in starting transactions and providing comfort as they perform their fiduciary responsibilities.
Reprinted from Mercer Capital’s ESOPval.com – Spring/Summer, 1996. It also appeared in the Summer, 1996 (Volume 8, No. 2) issue of the NCEO’s Journal of Employee Ownership Law and Finance.
Peter A. Mahler, Esq., of Farrell Fritz, P.C., in New York, reviewed a statutory fair value case issued in New York on April 25, 2011 (via New York Business Divorce):
An epic corporate governance and stock valuation battle between rival siblings, fighting over a Manhattan real estate portfolio worth upwards of $100 million, generated an important ruling last week by New York County Supreme Court Justice Marcy S. Friedman. Justice Friedman’s decision in Matter of Giaimo (EGA Associates, Inc.), 2011 NY Slip Op 50714(U) (Sup Ct NY County Apr. 25, 2011), and the underlying, 184-page Report & Recommendation by Special Referee Louis Crespo dated June 30, 2010, are must reading for business appraisers, attorneys and owners of closely held real estate holding corporations who are involved in, or who are contemplating bringing or defending against, a ”fair value” proceeding under New York’s minority shareholder oppression or dissenting shareholder statutes.
The case involved two C corporations that collectively owned 19 residential apartment buildings, most or which are located in Manhattan’s Upper East Side. The companies are EGA Associates, Inc. (“EGA”) and First Avenue Village Corp (“FAV”).
The stock in the corporations was owned equally by three siblings, Edward, Robert and Janet. Edward’s will provided that his stock be divided equally between his surviving siblings at his death; however, Janet claimed that shortly prior to his death in 2007, Edward sold one share of each corporation to her, giving her control of both corporations at just above 50% of the shares.
Robert filed suit to invalidate the sale of the shares, and simultaneously, Robert sought judicial dissolution of the corporations (EGA and FAV). Janet elected to purchase Robert’s shares under Section 1118 of the Business Corporation Law in New York, and the matter was referred to a Special Referee to determine the fair value of the shares of the two corporations.
An 18-day trial occurred in January, February and early March of 2009. The Special Referee issued a report of more than 180 pages on June 30, 2010. Justice Friedman’s opinion was issued April 25, 2011.
Counsel for Robert Giaimo was Philip H. Kalban of Putney, Twombly, Hall & Hirson LLP, New York City. Having attended a substantial portion of the trial, it is clear to me that Robert was well-represented in this matter. I asked Phil to read this to help ensure the factual accuracy of my comments. However, I am responsible for the content in this article.
The Special Referee first determined the market values of the various apartment buildings, siding mostly with Robert’s real estate appraiser, but making adjustments in the appreciation rates that lowered value overall. There were two important valuation issues and some related issues pertaining to Edward’s estate (and that of the siblings’ mother, as well). The two important valuation issues are:
Janet’s counsel (and business appraisal experts) argued that the entire BIG should be applied as a liability in determinations of net asset value. Robert’s counsel argued that none of the BIG should be considered as a liability, but his business appraisal expert testified as to appropriate methods for partial consideration if the court determined that a BIG deduction was appropriate.
The court agreed with the special referee’s application of a so-called “Murphy Discount,” which was decided while the Special Referee was preparing his report (Matter of Murphy (United States Dredging Corp.), 74 AD3d 815 (2d Dept 2010)). The concluded BIG liability was about 50% of the combined embedded gains in the two corporations.
I know what Robert’s expert concluded, because I was that expert.
No minority interest discount was applied in Giaimo, and no marketability discount was applied, either. The Mahler blog post summarizes the marketability discount issue:
As to DLOM, Justice Friedman states her disagreement with Mercer’s position, upon which Referee Crespo relied, that the valuation of a business as a going concern at a financial control level of value is inconsistent with a marketability discount. Justice Friedman finds Mercer’s position contrary to applicable precedent, particularly the Court of Appeals’ 1995 Beway decision (Matter of Friedman [Beway Realty Corp.], 87 NY2d 161) likewise involving a real estate holding company in which the court expressly upheld application of DLOM in fair value proceedings. Justice Friedman rejects Referee Crespo’s effort in his Report to distinguish Beway on the ground that, unlike in Giaimo, the properties held by the subject realty company in that case had mortgage financing.
Justice Friedman nonetheless finds that Referee Crespo’s decision not to apply a DLOM “is appropriate on this record.” Noting that fair value is a question of fact for which there is no single formula for mechanical application, she essentially finds that the subject corporations’ shares are readily marketable, stating as follows:
As discussed more fully below, in determining the built-in gains tax issue, the Referee specifically made a finding of fact, which is amply supported by the record, that the availability of similar properties on the open market is limited and that a buyer would accordingly buy the properties that EGA and FAV own through the corporations. This finding of the marketability of the corporations’ shares is as relevant to the determination as to whether to apply a discount for lack of marketability as it is to whether to reduce the value of the corporations by embedded taxes. The court accordingly holds that the Referee’s award on the DLOM should be confirmed.
This was an excellent result for Robert as the shareholder being forced to sell his shares. The decision affirms that no marketability discount should be applied, but for reasons other than stated initially by me. I stated that the valuation of a business as a going concern at the financial control level of value is inconsistent with the application of a marketability discount. At trial, I discussed this issue at some length and supported that testimony with the now familiar levels of value chart and references to articles and texts. The levels of value chart is placed below for reference.
Visually, the application of a marketability discount lowers the conceptual level of value from marketable minority (left) or financial control/marketable minority (right) to the nonmarketable minority level of value. This is clearly a minority interest level of value and does not represent a proportionate share of the value of an entire business as a going concern.
We know that the court did not apply a marketability discount as in Beway. The rationale was also provided by Mercer based on two factors:
In other words, I testified, first, that there was no reason to apply a marketability discount in a going concern appraisal at the financial control level. However, the additional arguments regarding the state of the Manhattan real estate market and exposure to market only further supported the first position, which Justice Friedman did not accept. She did accept the real estate market and exposure to market arguments. Perhaps she took this position because it was not necessary for her to tackle the precedent issue in Beway directly.
The result in Giaimo was clearly a determination of fair value at the financial control level of value, with no minority interest and no marketability discounts applied. This was a good result from an economic viewpoint if fair value is to be considered to be the value of a corporation at the financial control level of value.
However, the marketability discount issue from Beway still lives on to rise up another day.
Mercer did not simply disagree with the Beway decision (Matter of Friedman [Beway Realty Corp.], 87 NY2d 161). Beway states, in part (emphasis added):
A minority discount would necessarily deprive minority shareholders of their proportionate interest in a going concern, as guaranteed by our decisions previously discussed.
and,
Likewise, imposing a minority discount on the compensation payable to dissenting stockholders for their shares in a proceeding under Business Corporation Law Section 623 or 1118 would result in minority shares being valued below that of majority shares, thus violating our mandate of equal treatment of all shares of the same class in minority stockholder buyouts.
This guidance, as I read it from a valuation perspective, suggests that control shares of the same class as those minority shares being purchased pursuant to Section 1118 or 623 should be treated the same as the minority shares. This provides affirmation that the value called for in Beway is a controlling interest indication of fair value. The guidance of Beway couldn’t be clearer at this point. But to drive home the point, read the following series of paragraphs [bold emphasis added, italics in text of decision]:
Thus, we apply to stock fair value determinations under section 623 the principle we enunciated for such determinations under section 1118 that, in fixing fair value, courts should determine the minority shareholder’s proportionate interest in the going concern value of the corporation as a whole, that is, “`what a willing purchaser, in an arm’s length transaction, would offer for the corporation as an operating business’” (Matter of Pace Photographers [Rosen], 71 NY2d at 748, supra, quoting Matter of Blake v Blake Agency, 107 AD2d at 146, supra [emphasis added]).
Consistent with that approach, we have approved a methodology for fixing the fair value of minority shares in a close corporation under which the investment value of the entire enterprise was ascertained through a capitalization of earnings (taking into account the unmarketability of the corporate stock) and then fair value was calculated on the basis of the petitioners’ proportionate share of all outstanding corporate stock (Matter of Seagroatt Floral Co., 78 NY2d at 442, 446, supra).
Imposing a discount for the minority status of the dissenting shares here, as argued by the corporations, would in our view conflict with two central equitable principles of corporate governance we have developed for fair value adjudications of minority shareholder interests under Business Corporation Law §§ 623 and 1118. A minority discount would necessarily deprive minority shareholders of their proportionate interest in a going concern, as guaranteed by our decisions previously discussed. Likewise, imposing a minority discount on the compensation payable to dissenting stockholders for their shares in a proceeding under Business Corporation Law §§ 623 or 1118 would result in minority shares being valued below that of majority shares, thus violating our mandate of equal treatment of all shares of the same class in minority stockholder buyouts.
A minority discount on the value of dissenters’ shares would also significantly undermine one of the major policies behind the appraisal legislation embodied now in Business Corporation Law § 623, the remedial goal of the statute to “protect minority shareholders ‘from being forced to sell at unfair values imposed by those dominating the corporation while allowing the majority to proceed with its desired [corporate action]’” (Matter of Cawley v SCM Corp., 72 NY2d at 471, supra, quoting Alpert v 28 William St. Corp., 61 N.Y.2d 557, 567-568). This protective purpose of the statute prevents the shifting of proportionate economic value of the corporation as a going concern from minority to majority stockholders. As stated by the Delaware Supreme Court, “to fail to accord to a minority shareholder the full proportionate value of his [or her] shares imposes a penalty for lack of control, and unfairly enriches the majority stockholders who may reap a windfall from the appraisal process by cashing out a dissenting shareholder” (Cavalier Oil Corp. v Harnett, 564 A2d 137, 1145 [Del]).
Furthermore, a mandatory reduction in the fair value of minority shares to reflect their owners’ lack of power in the administration of the corporation will inevitably encourage oppressive majority conduct, thereby further driving down the compensation necessary to pay for the value of minority shares. “Thus, the greater the misconduct by the majority, the less they need to pay for the minority’s shares” (Murdock, The Evolution of Effective Remedies for Minority Shareholders and Its Impact Upon Evaluation of Minority Shares, 65 Notre Dame L Rev 425, 487).
We also note that a minority discount has been rejected in a substantial majority of other jurisdictions. ”Thus, statistically, minority discounts are almost uniformly viewed with disfavor by State courts” (id., at 481). The imposition of a minority discount in derogation of minority stockholder appraisal remedies has been rejected as well by the American Law Institute in its Principles of Corporate Governance (see, 2 ALI, Principles of Corporate Governance § 7.22, at 314-315; comment e to § 7.22, at 324 [1994]).
It should be clear that New York statutory guidance is clear in not applying a minority interest discount. However, there is other guidance in Beway that adds confusion to the mix and, effectively, applies an “implicit minority discount.” In discussing the application of a marketability discount, the Court stated:
McGraw’s technique was, first, to ascertain what petitioners’ shares hypothetically would sell for, relative to the net asset values of the corporations, if the corporate stocks were marketable and publicly traded; and second, to apply a discount to that hypothetical price per share in order to reflect the stock’s actual lack of marketability.
Note that the valuation date in Beway was in 1986 (for further reference, see Statutory Fair Value: #6 Applicability of Marketability Discounts in New York on www.ValuationSpeak.com). The appellate decision in Beway was rendered in December 1995. Valuation theory and concepts have evolved considerably since 1986 or 1995. But we only need to look at the evidence to realize what happened in Beway. Kenneth McGraw was an expert for the corporation in Beway. The technique he applied was clearly a minority interest technique. Application of a marketability discount based on reference to restricted stock studies derives a shareholder level value and presumes the inclusion of any minority interest discount. This was apparently not evident to the Court in Beway. The valuation industry was developing rapidly during the 1980s and 1990s. The level of value charts that are so ubiquitous today were first published in 1990, and did not receive wide distribution immediately. Perhaps the court was not presented with this visual, conceptual device.
It should be clear, however, that the application of a marketability discount very clearly moves the valuation from marketable minority/financial control (enterprise levels representing values of entire corporations) to the nonmarketable minority level of value, which clearly is a minority interest value. Application of a marketability discount in a fair value determination, where fair value is interpreted as a proportionate share of the value of the business at the financial control level and as a going concern, clearly has the effect of imposing an unwarranted minority interest discount by another name. This is, again, contrary to guidance of Beway.
Mandating the imposition of a ‘minority discount’ in fixing the fair value of the stockholdings of dissenting minority shareholders in a close corporation is inconsistent with the equitable principles developed in New York decisional law on dissenting stock holder statutory rights.
Partial Consideration of Built-In Gain Liability
The Mahler blog post summarized the result in Justice Friedman’s opinion:
Justice Friedman next turns to Janet’s argument that Referee Crespo erred by not calculating the BIG discount at 100% assuming liquidation upon the valuation date. Janet argued that the Manhattan trial court was bound to follow the Manhattan (First Department) appellate court’s ruling in Wechsler v. Wechsler, 58 AD3d 62 (1st Dept 2008), a matrimonial “equitable distribution” case in which the court applied a 100% BIG discount, rather than the Brooklyn (Second Department) appellate court’s Murphy decision upon which Referee Crespo relied. Justice Friedman notes that the Murphy decision expressly distinguishes Wechsler on grounds equally applicable in Giaimo, namely, there was no issue presented or expert testimony in Wechsler about reducing the BIG taxes to present value. ”Given the lack of precedent in this [First] Department on the issue of whether the BIG should be reduced to present value,” Justice Friedman writes, “the support for that approach in the Second Department, and the factual support in the record for the 10 year projection, the Court does not find that the Special Referee committed legal error in following the present value approach.”
Justice Friedman rejected Robert’s contention that there should be no BIG deduction, stating that Robert relied largely on cases from other states that refuse to consider the BIG unless the corporation was actually undergoing liquidation at the valuation date.
These cases treat an assumed liquidation as inconsistent with valuation of the corporation as an ongoing concern. While the reasoning has much to recommend it, New York follows the contrary view that it is irrelevant whether the corporation will actually liquidate its assets and that the court, in valuing a close corporation, should assume that a liquidation will occur.
Some additional background is appropriate. First, both experts for Janet concluded that 100% of the embedded BIG liability should be considered (i.e., deducted) in their determinations of net asset value. I concluded that 40% of the BIG liability should be considered as a liability. This conclusion was supported by a series of calculations and market evidence regarding the 2007 market for apartment buildings in Manhattan.
I wrote an article in 1998, following the issuance of the Davis case in U.S. Tax Court. The article, “Embedded Capital Gains in C Corporation Holding Companies,” was published in Valuation Strategies, November/December, 1998.
An important conclusion of the article was that, in fair market value determinations involving C corporation asset holding companies (like EGA and FAV), the usual negotiations between hypothetical buyers and sellers would result in a conclusion of consideration of 100% of the BIG liability. This is true when buyers have the choice of buying assets inside a corporate wrapper and purchasing identical assets in “naked form,” or without any issues of BIG. The article shows that the only way that buyers can get equivalent investment returns between the two choices, buying an asset in a corporate wrapper that has embedded BIG and purchasing the “naked asset,” is by charging the full amount of the embedded capital gain. And the article makes no assumption about the potential ability of a buyer to convert the C corporation to an S corporation and hold for ten years until the embedded BIG “goes away.” Simply put, buyers who have the alternative choice of acquiring identical “naked assets” won’t agree to that concept.
Janet’s counsel cross-examined me fairly hard on this issue, attempting to show that I was inconsistent between the article and the treatment in Giaimo. However, a critical assumption is made in reaching the article’s conclusion of charging 100% of the embedded BIG in C corporation asset holding companies:
When analyzing the impact of embedded capital gains in C corporation holding companies, one must examine that impact in the context of the opportunities available to the selling shareholder(s) of those entities. One must also consider the realistic option that potential buyers of the stock of those entities must be assumed to have – that of acquiring similar assets directly, without incurring the problems and issues involved with embedded capital gains in a C corporation.
At the valuation date, the market for comparable Manhattan apartment buildings was very tight. There had been only a handful of transactions in the market, which consisted of many thousands of buildings, in the last year. Brokers we spoke with indicated that because of the nature of the market, and because EGA and FAV owned multiple properties each, there would likely be competitive bidding that would enable the stock of the corporations to be sold with a sharing of the BIG liability. In other words, comparable “naked assets,” i.e., apartment buildings in Manhattan outside corporate wrappers like EGA and FAV, were not available. The Special Referee was convinced by this evidence that there was sufficient liquidity as a result that no marketability discount should be applied (see discussion of the marketability discount above).
Having reached this conclusion, the question became one of how much “sharing” of the BIG liability would be appropriate in a determination of statutory fair value. Recall that we were instructed by counsel that fair value should be determined as the functional equivalent of fair market value on a financial control basis.
Based on the court’s analysis in Murphy, I presented an analysis based on the facts of the Giaimo case with the following assumptions.
Given these assumptions, the present value of the expected future embedded capital gains tax represented 49.4% of the embedded BIG at the valuation date. Just to be clear, that means that for each dollar of embedded capital gain, the analysis suggests reducing net asset value by 49.4 cents. My conclusion, based on this analysis and others presented in court, was that the liability should be 40 cents of each dollar of BIG.
The Special Referee concluded that the appropriate BIG should be about 50% based on an analysis similar to that outlined above. Expected growth was 3% per year (not compounded), for ten years, and with a 10% discount rate.
This finding was affirmed by Justice Friedman’s opinion.
Justice Friedman agreed with the conclusion of no marketability discount in Giaimo, but she reached that conclusion without tackling the problem of the unclear and misguided (by faulty valuation evidence) conclusion regarding the applicability of marketability discounts in statutory fair value determinations. The application of a marketability discount in a statutory fair value determination in New York would have the economic effect of imposing, albeit implicitly, an undesired minority interest discount. I’ll be careful with terminology here. In the fifth post in the statutory fair value series on ValuationSpeak.com (The Implicit Minority Discount), we talked about an “implicit minority discount” in Delaware, which is a different concept entirely.
Since I know that my writings on fair value are being read with interest by an increasing readership, let me go back to my comments in the first post I wrote in the statutory fair value series on ValuationSpeak.com where I said:
At the outset of this series of posts on statutory fair value, let me be clear: I am agnostic with respect to what fair value should be in any particular state. That is a matter of statutory decision-making and judicial interpretation. As a business appraiser, what I hope is that the collective (statutory and judicial) definitions of fair value are clear and able to be expressed in the context of valuation theory and practice.
In my experience, disagreements over the applicability (or not) of certain valuation premiums or discounts provide the source of significant differences of opinion between counsel for dissenting shareholders and, unfortunately, between business appraisers. Because fair value is ultimately a legal concept, appraisers should consult with counsel regarding their legal interpretation of fair value in each jurisdiction.
I was not “for” or “against” a marketability discount in Giaimo. I was “for” the determination of fair value as the functional equivalent of fair market value at the financial control level of value (and on a going concern basis). My engagement instructions from counsel called for this determination. I am “for” clear judicial guidance for fair value determinations that is consistent with prevalent valuation and financial theory. I hope that debate over this continuing series on statutory fair value will help this process along in New York and other states, as well.
The Special Referee’s determination of the BIG liability was clearly in line with both the precedent treatment in Murphy and the economic reality of the marketplace for apartment dwellings in Manhattan at the valuation date.
It remains to be seen if there will be an appeal in the matter.
This article originally appeared on the blog www.ValuationSpeak.com.