by Kevin Jennings | Jun 27, 2016 | All Blog Entries, Corporate, Employee Compensation, ESOP, Succession Planning
Valuations frequently assume a third party will purchase a business and primarily run it unchanged. This does not mean a buyer will continue to pay expenses or a level of expense not considered typical. Non-operating assets are typically excluded from a valuation, too. Normalizing adjustments take the atypical expenses or portion of expense (or income) out of the mix.
Non-operating and one-time items include but are not limited to gains and losses from the sale of assets, income and expenses related to investments and legal settlements. Expenses related to layoffs are an example of operating but non-recurring expenses generally removed. If an income source or expense is not related to ongoing operations, it is subject to adjustment.
Discretionary adjustments look to income sources or expenses over which an owner has a choice. Compensation paid to owners and officers as well as rent paid to related parties are frequent candidates for a discretionary adjustment. Rent paid to a related party is often based on the cash flow requirements of that related party. For a property with no mortgage, for instance, below market rent may be paid. This is an example of how adjustments can work as a reduction of expense or an addition to expense.
Various authoritative sources report officer/owner compensation based on industry type, size and location. These sources can form the basis for this adjustment. Real estate appraisals are frequently used as the source for an adjustment to market rent.
Controversy exists over whether to include “discretionary” adjustments when valuing a minority interest. Opponents say no, correctly stating a minority owner has no control over these discretionary expenses. Proponents argue these adjustments should always be considered. Shareholders of publicly-traded companies will invest elsewhere if they deem company management is overpaying executives, for example, resulting in a lower return on their investment. A growing lack of investor interest leads to a decline in share price.
Proponents point to the derivation of yields used when calculating value based on cash flow. These yields are often based on data from public equity markets. As investors price shares and the related returns based on how well management is running the company, a perceived overpaying of expenses will lead to lower share prices and returns.
by Kevin Jennings | Jun 3, 2016 | All Blog Entries, Corporate
The Financial Accounting Standards Board (“FASB”) released the Accounting Standards Codification Topic 805 (“ASC-805”) in July 2009. ASC-805, as amended, is the authoritative source for GAAP concerning business combinations.
A business combination is the transfer of ownership rights of a business to another entity in exchange for consideration. Consideration is the sum of the assets transferred by the acquirer plus the liabilities of the acquiree assumed by the acquirer plus equity issued by the acquirer. Regardless of when the consideration and the interest in the business are transferred, the acquisition date is the date that the acquirer obtains control of the business.
Proper calculation of the consideration and identification of the assets purchased and liabilities assumed are the first steps in determining fair value of intangibles. Part of the consideration may be contingent on future events. Contingent consideration is reported on the acquirer’s balance sheet at fair value. If the contingent consideration may be owed to the acquiree, it is included in determining goodwill. If consideration may be returned to the acquirer, it will be recorded as an asset.
All identifiable assets and liabilities acquired are recorded at fair value. ASC 820, Fair Value Measurement, defines fair value as “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”
Identifiable assets include identifiable intangibles. The intangibles in question vary depending on the transaction. The intangible asset must have either contractual or legal rights or is separable (can be transferred as a separate asset or in conjunction with related assets and liabilities). Examples include, but are not limited to, trademarks, patents, customer lists and licenses.
Goodwill equals consideration minus the fair value of tangible assets minus the fair value of identifiable intangible assets. When the value of the transferred consideration is less than this net value, the acquiring company realizes a bargain purchase. It reports the gain in the year of acquisition.
Identifiable intangible assets are typically amortized over their respective useful life. Goodwill is not amortized but is tested annually for impairment.
by Kevin Jennings | May 27, 2016 | All Blog Entries, Corporate
Allocation of goodwill to personal goodwill can alter individual tax liability on the sale of a company. Personal goodwill should be valued by a third-party valuation firm. It should be clearly identified in the purchase price agreements and agreed to by the acquirer.
Recent Tax Court decisions in Bross Trucking, Inc., T.C. Memo. 2014-107, and Estate of Adell, T.C. Memo. 2014-155 continue to show the Tax Court does differentiate between personal and corporate goodwill. The personal goodwill concept is typically associated with the landmark case Martin Ice Cream Co., 110 T.C. 189 (1998).
In Martin Ice Cream, the United States Tax Court decided that the majority shareholder’s relationships with his clients were not owned by the corporation as the shareholder did not have either an employment agreement with the Company nor a covenant not to compete. Therefore, the goodwill associated with this was not the asset of the Company but an asset of the shareholder himself.
Personal goodwill is dependent on the personal characteristics of the business owner. Personal relationships, ability, personality, and reputation of a shareholder-employee key to the business’ success must be defined and supported.
Quantifying the proportion of personal versus business goodwill is often based on factors associated with the shareholder-employee such as these:
- Age and health
- Demonstrated earning power
- Community reputation for judgment, skill and knowledge
- Comparative industry success
- Nature and duration of person’s role in creating company profits
- Personal relationship with customers
- Importance to developing new business
- Personal involvement in solving client problems
- Critical role in financial/operational decisions
- Direct impact on profitability
- Personal knowledge, experience, known-how and abilities
A vital test is whether the individual holds the right to sell the goodwill. It must be the shareholder’s asset that was not previously transferred to the corporation. Evidence of such transfers include employment agreements and non-compete agreements.
Multiattribute Utility Model
The Multiattribute Utility Model (“MUM”) is a commonly-used tool to allocate goodwill between personal goodwill and enterprise goodwill. It calls for the analyst to identify key attributes of goodwill and segregate them between personal and enterprise goodwill. Attributes span industries.
To each attribute, a weight of importance (with 1 as the lowest and 5 the highest) is assigned. Attributes include those above and are fine-tuned for each situation. An attribute is weighted based on the importance of the attribute to the person and enterprise. The weights determine the allocation between personal and corporate goodwill.
As with any valuation, each allocation of weight must be supportable. Our philosophy at JBV is if you can’t support it, don’t state it.
At JBV, we are here to assist you.
by Kevin Jennings | May 6, 2016 | All Blog Entries, Corporate
Owners of small businesses enter into buy/sell agreements with their partners to protect their interests in their largest investment, their business. The presence of such an agreement is essential to ensure a clean succession and to protect heirs. We applaud the efforts, but not always the process or results.
Much time is spent agonizing over details. Elaborate definitions of earnings are created; multipliers are agreed upon; the requirement for discounting is debated. All these factors, and others, are agonized over. Countless hours spent and professional fees incurred to arrive at a plan deemed acceptable to all, a daunting task.
Creating a hard-and-fast formula for a buyout can be a mistake. Businesses evolve. Products change, services are added or deleted. The nature of the business itself can change.
The lifetime of a small business can span many years or even several decades. The nature of our economy, and our society, has changed significantly over these periods. Not long ago, a garment manufacturer designed, manufactured and distributed their products from their own facility in the U.S. Today, they are, in essence, distributors. While they design and distribute, manufacturing takes place overseas. With smaller companies, these contract manufacturers are not captive to them, adding a layer of complexity and cost.
Industries have changed in other ways. SEC regulation of hedge funds, the emergence and disappearance of Blockbuster in a matter of a few decades are milestone changes in industries that just recently started. The onslaught of iTunes, Spotify and Pandora in the music industry has led to the virtual end of sales of albums. Uber threatens to end the taxi and limo industry as we know it. Just two examples of major upheavals in traditional industries we never considered would change. Formulas set even just a few years ago may no longer be relevant.
A better and more cost-effective solution for a buy/sell is to appoint a valuation firm to handle the project. A baseline valuation is performed which is then updated every one, two or three years. In some cases, no update to the baseline valuation occurs until a triggering event happens. In either case, appointing a firm that all partners agree to can avoid dissension at a critical and often emotional time.
Designing a buy/sell should be an integral part of an operating agreement. An attorney and a tax specialist ought to be consulted.
At JBV, we are here to assist you.
by Kevin Jennings | Apr 27, 2016 | All Blog Entries, Corporate, Employee Compensation
We continue our series of articles on compensation with this blog on IRS Section 83(b) elections.
A section 83(b) election allows an employee or contractor to include in taxable income the fair market value of property they received for the performance of services before they are truly entitled to that property. With small businesses, this often occurs with restricted shares granted to employees or contractors that vest over time. The election does not apply to stock options.
Without the election, with shares that have yet to vest and which the recipient can’t transfer, the fair market value of those shares is included in income when either the shares are theirs or the shares become transferable. Generally, that means as the shares vest.
The 89(b) election allows the recipient to recognize all the income associated with all the shares at the date of grant, presumably at a lower value. For tax purposes, all shares are treated as if they are fully vested.
If share value is expected to rise over the vesting period, electing 83(b) is a smart choice. The election starts the clock for capital gain recognition should the shares be sold or transferred in the future. It also determines that taxable basis for these shares when later sold or transferred.
Electing 83(b) should not be considered a slam-dunk. Even with a start-up, shares have value. This may be influenced by venture capital investments or other equity funding occurring at the same time as the restricted shares grant. And it is quite possible that when the shares do vest, their value may be lower than at the time of grant. Lastly, an employee who leaves prior to the completion of the vesting period will have paid taxes on compensation never fully received.
An 83(b) election is smart if the amount of income reported at grant is small, the share value’s growth prospects are moderate to high and the risk of share forfeiture through employee termination is very low.
An 83(b) election must be supported by a valuation of the shares in question. JBV has significant experience and expertise in that area.
A tax specialist should assist with the election to avoid any tax consequences.
At JBV, we are here to assist you.
by Kevin Jennings | Mar 7, 2016 | All Blog Entries, Employee Compensation, ESOP
Stock options and stock ownership plans are a popular and effective method of incentivizing employees, often at a low cost to both the employer and the employee. Several types exist, including non-qualified stock options, incentive stock options, employee stock ownership plans, phantom stock, stock appreciation rights and more. In this second of a series of articles, we will look at Phantom Stock Options and Stock Appreciation Rights.
Phantom Stock Options and Stock Appreciation Rights
Under traditional stock option plans, an employee can become an owner of the company. Often, a business owner does not wish to pass along ownership. But s/he does want to incentivize key employees. Phantom stock options (“mirror stock” or “shadow stock”) and stock appreciation rights (SARs) both provide these features.
As with other stock plans, a set of milestones can be established. The “shares” are “issued” when the milestone is reached.
Phantom stock plans are tied to long-term company performance. There are advantages to both the employer and employee traditional stock plans don’t offer. Employees do not need to invest any money. Nor are they subject to corporate governance issues that may arise. They cannot be asked to personally guarantee company obligations. Most importantly, if they wish to sell shares under a traditional plan, their options may be limited. Typical smaller businesses are not traded and often do not hold any defined means for redeeming shares. This issue is not relevant for a phantom plan.
For an employer, the shares are “phantom”, the employee is NOT an owner. These employees hold no authoritative input in the management of the business. Yet, the employee can be incentivized through additional value added to the business, much like an owner. Administratively, these plans are much less complex than traditional stock option plans.
For the employer and the employee, the exercise of the option becomes an immediate taxable event. The employee reports it as ordinary income; the employer as a deduction.
With a SAR, many of the same advantages exist as with phantom stock. The key differences are in the exercise of the option and the amount of the award. A SAR can be exercised at the employee’s discretion once the vesting schedule is met. A phantom plan calls for exercise at the time the vesting schedule is met. A SAR awards the employee the amount equal to the difference between the FMV of the underlying stock at the exercise date and the grant date. The recipient of phantom options receives the full value of the share.
An attorney and a tax advisor should design the plan with your guidance to avoid any legal or tax consequences.
At JBV, we have valued many stock option plans, from ESOPs to phantom stock and SAR plans to ISOs and more. We are here to assist you.
