BV practitioners ‘split’ on applying an S corp premium
More than half (54%) of respondents to last week’s poll on valuing pass-through entities (PTEs), such as S corporations, say they do not apply a “premium” to account for the difference between the data on publicly traded C corps, from which they derive the cost of capital, and the subject PTE, to which they will apply it. “I consider actual taxes/tax rate paid by the entity,” said one respondent, who reflected the consensus of this camp. “No phantom imputation.” Others said the driving question is: “What do buyers do?” Commented one, “Our position is that in the real world, buyers tax affect an investment … in terms of using after-tax cash flows as the metric for value.”
At the same time, just under one-third (29%) of those who do not apply a PTE premium adjust the discount rate instead. “This seems to be where the new Fannon/Sellers paper is going,” said one, “but there is no definitive way to determine how big an adjustment should be made.” (Another respondent believes this is the way the IRS is going, too.) “Interestingly,” noted another:
When I had my report reviewed to obtain my ASA in 1994, I prepared a DCF on which I did not tax affect but rather adjusted the discount rate.… The report was rejected on that basis; I still believe today that you cannot adjust the discount rate and get an adequate answer.
Among the 46% of survey participants who still apply an S corp premium, by far the most commonly used models were the ones by Van Vleet (checked off by 31%) and the Delaware Chancery (20%). “Yes, Fannon and others have provided sound and better analyses to do this,” commented one, “but so far, all the tax-affecting analyses still contain many assumptions and are too complex for everyday use.” Most business appraisers make “countless” assumptions, this commentator added, and “don’t consider tax affecting any more serious of an assumption than the company-specific premium, the WACC weightings, the discounts, etc.” We’ll have more from the survey results next week.
Taking a current look at an ongoing controversy: On Thursday, May 10, join Eric Barr (Fischer Barr & Wissinger) for The Pass-Through Premium: A New Perspective on an Old Issue, which takes a fresh look at how entity structure, applicable tax rates, and business performance impact the credibility of an ultimate value conclusion.
DOL resists pressure on fiduciary redraft
The Financial Services Institute and Financial Services Roundtable are pressuring the U.S. Department of Labor (DOL) to release a “progress report” on its redrafting of the rule that would redefine “fiduciary” under the Employee Retirement Income Security Act (ERISA), citing a list of criteria that federal legislators laid out for DOL to follow in its reproposal. (As a reminder, last October, the DOL decided to withdraw its original draft, which would have amended the rule to include business appraisers as ERISA fiduciaries.)
According to a recent report by AdvisorOne, however, the DOL’s Employee Benefits Security Administration (EBSA) will not be releasing a “progress report” before it releases the fiduciary reproposal. “Our reproposal, when complete, will provide ample opportunity for public comment, both on the proposed rule itself and on our assessment of its likely effects,” a DOL spokesperson told AdvisorOne. According to the EBSA’s most recent (fall 2011) regulatory agenda, it planned to release its reproposed rule amending the definition of an ERISA fiduciary sometime this month.
New deadline to participate in BV salary survey
During these past few weeks, many BV practitioners have let us know that they wanted and intended to participate in the Borrowman Baker/BVR 2012 BV Salary Survey, but fell behind because of the busy season and were worried there might not still be time. We heard them—and have just extended the deadline for participation to Friday, June 1. Participants now also have the option to complete the survey without ordering the final survey (receiving instead an option to buy on publication).
The Borrowman Baker/BVR Survey will deliver top-quality, BV-specific compensation data that hiring partners and their firms need to stay competitive in the race for talent. Click here to go to the Welcome Page and get started.
Total beta is still an ‘excellent’ reference point
“I completely agree: Investors in private companies are somewhere in between” completely diversified and undiversified investors, says Pete Butler (Valtrend), responding to Aswath Damodaran’s comments in the BVWire last week. “Thus, you can't use beta (totally diversified) by itself and you can't use total beta (completely undiversified) by itself,” Butler says. “Both, however, are excellent reference points for a private company's cost of capital.”
That’s why (after informal consultation with Damodaran just over two years ago now), Butler and Gary Schurman (Applied Economics) developed a "private company beta" calculation using modern portfolio theory to account for partial diversification for the "somewhere in between" investor, says Butler, citing question 46i of the FAQs to the Butler Pinkerton Calculator (modified for clarity here):
- We have done more than just qualitatively consider the ramifications of diversification; we have developed an Excel spreadsheet to assist appraisers in making informed, quantitative decisions related to the question of diversification. Please click here to access the spreadsheet now.
- Although somewhat subjective, the assumptions of this spreadsheet have as their ultimate goal to price risk depending on the level of diversification the analyst believes is appropriate for the average investor in the [subject] buyer pool.
In the past, when BV appraisers assigned a company-specific risk premium to their discount rate, “what level of diversification did they have in mind?” Butler asks. “Total beta/private company beta brings the debate front and center, to where it should be—on how to use it—and not whether it has a math or logic problem, which is where, in my opinion, ‘total beta has taken on a life of its own.’"
A ‘great facts’ FLP case
During the 1990s, the decedent executed a will that made specific gifts of real estate and stock to each of her three grown children, dividing any residual equally among them. Over time, the value of the bequests changed, and the assets became exposed to greater liability—but by then, the decedent was suffering from Alzheimer’s. Without knowing the contents of the will, the three children (who all managed the family businesses) agreed to divide their mother’s estate equally and petitioned the probate court to become her co-guardians. When they discovered the unequal bequests—which would require the recipients to issue disclaimers to effectuate an equal division—the children approached an estate planning attorney.
Ultimately, the attorney’s plan called for the decedent to establish a family limited partnership (FLP) for each child, funded with an equal amount of assets, and a corporation to act as general partner (GP), for which it received a market-determined management fee. Importantly, the decedent retained sufficient funds to pay her personal expenses. Equally important: The children continued to actively manage the businesses and observe all partnership formalities, including crediting the decedent’s contributions to her capital account. When she died in 2005, the IRS asserted a deficiency of over $2.2 million, arguing that her gross estate should include the value of the FLP assets. The Tax Court disagreed. “The decedent’s primary motives were to ensure effective property management and equal distributions among the children—not minimization of tax consequences,” the court held. Further, the nature of the assets in this case “would lead any prudent person to manage [them] in the form of an entity.” Read the complete digest of Estate of Kelly v. Commissioner,T.C.Memo 2012-73 (March 19, 2012) in the next Business Valuation Update; the Tax Court’s opinion will be posted soon at BVLaw.
IASB/FASB issue progress report on convergence
The International Accounting Standards Board and the Financial Accounting Standards Board have just posted their joint progress report on their convergence activities. “The boards are close to completing the MoU [Memorandum of Understanding] program,” according to the report:
Most of the short-term projects identified for action have been completed or are close to completion and one has been determined to be a lower priority. Of the longer-term projects, several have been completed and there are three of the originally identified projects for which the boards have yet to finalize the technical decisions—leases, revenue recognition, and financial instruments.
For more information about convergence between IFRS and U.S. GAAP, click here.
Last chance to comment on AICPA working drafts
Valuation specialists, BV appraisers, and other interested parties still have until May 24 to comment on two working drafts by the AICPA’s Financial Reporting Executive Committee (FinREC):Testing Goodwill for Impairment and Assets Acquired to Be Used in Research and Development Activities.
The AICPA is looking for feedback to further inform the development of these guides, which FinREC will issue as final once it has received, considered, and appropriately acted on all the input. The committee will also keep all comments confidential (without posting them on the AICPA website). If you would like to provide comments, please e-mail them to Yelena Mishkevich at email@example.com.
Dorrell publishes third in series of DOJ bulletins
Darrell Dorrell (Financial Forensics) has just written the third in a series of practice bulletins for the U.S. Department of Justice (DOJ), “Financial Intelligence: People and Money Techniques to Prosecute Fraud, Corruption, and Earnings Manipulation, Vol. 60, No. 2 (March 2012).
“These bulletins are technical resources used by DOJ attorneys when prosecuting civil and criminal matters on behalf of the U.S.,” Dorrell explains. His first two bulletins for the DOJ are: “Financial Forensics I—Counterterrorism: Conventional Tools for Unconventional Warfare,” Vol. 53, No. 2 (March 2005), and “Financial Forensics II—Forensic Accounting: Counterterrorism Tactical Weaponry,” Vol. 53, No. 3 (May 2005).
New software for VC/PE shareholder data
Shareholder InSite and Quist Valuation have just launched a new software package, “Shareholder InSite,” that allows venture capital and private equity investors to model and analyze the status and performance of their investments, as well as to track, administer, and report shareholder data.
“With growing SEC scrutiny and regulations, investors and CFOs in their portfolio companies face additional pressure to make financial data more accurate, tied to source documentation, and securely available to all stakeholders,” say the co-developers in a recent release. “Shareholder InSite platform helps meet compliance imperatives through a stable, secure, and scalable platform for both shareholder administration and investment/security analysis.” Tours of the new solutions are available online.
More ‘don’t miss’ CPE in May
Catch Mark Dietrich and attorney J.D. Epstein tomorrow, May 3, as they discuss the potential implications of the Supreme Court challenge during the AICPA-sponsored webinar: "Healthcare Reform and the Supreme Court: What Are the Possible Outcomes?"
And don’t miss Lost Profits Issues Unique to Government Contracts, Part 10 of BVR’s Online Symposium on Litigation & Economic Damages, featuring attorney Daniel Johnson (McKenna Long & Aldridge) and appraiser Patrick McGeehin (FTI Consulting). Still one of the largest employers in the construction, defense, and other industries, the U.S. government, its contractors, and their subcontractors and competitors represent a huge field of claimants and defendants whose lost profits challenges carry many pitfalls and opportunities. Join Johnson and McGeehin May 15 for this in-depth look at what every economic damages expert should know.
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