First quarter M&A decreases in all but one valuation segment

“Although progress was made on many fronts in the first quarter of 2009, many acquirers determined that it was best to sit on the sidelines due to tight credit markets and the high levels of economic and market uncertainty,” says a new article by Mike Rosenthal of PCE Investment Bankers, which takes a first look at Q1 2009 M&A transaction data. “Deal activity dropped substantially during 1Q09,” Rosenthal adds. “When compared to transaction level in 4Q08 and 1Q08, the contrast is striking. Compared to 4Q08, transaction levels decreased at all valuation segments except deals with values above $250 million. The most dramatic decrease was in the $50 to $100 million valuation range, which dropped 52.1%. When 1Q09 is compared to 1Q08, deal activity is down at all levels, with the most significant decrease [again] taking place in the $50 to $100 million valuation segment. During this period, the number of transactions dropped by 70.4%.” A complete copy of State of the M&A Markets, First Quarter 2009 Update, is available here.

For another insiders’ take on the M&A landscape, take a look at Is Mergers & Acquisitions Deal-Making Dead, Dying, or Primed for Resuscitation? by Steven M. Levitt and Jaime Carvallo of Park Sutton Advisors in the April 2009 Business Valuation Update™.

Rethinking assumptions about discount and capitalization rates

The development of discount and capitalization rates was a subject of discussion and debate in the valuation community even before the current economic crisis. Although some practitioners advocate amendments to determinants of these rates, others believe it appropriate to “stay the course,” arguing that all recessions end and the economy is always in flux. In short, knowing how to develop informed, unimpeachable valuation decisions is becoming more and more difficult.

On Thursday, April 30 at 10:00am PT/1:00pm ET, Ron Seigneur, Stacy Preston Collins, and Donald DeGrazia will discuss these and other topics in Developing Discount and Capitalization Rates In a Troubled Economy: New and Emerging Views on Old Issues, a 100-minute teleconference hosted by BVR. Our panel of distinguished experts will cover risk-free rates, economic benefit streams, equity risk premiums, specific-company risk, cost of debt, capital structure, and leverage—all from the perspectives of ongoing valuation debates and how the economic crisis is affecting the valuation of businesses.

Teleconference attendees will receive access to extensive, ancillary reading materials created by BV thought leaders, as well as relevant economic data and a first look at Morningstar/Ibbotson’s Peer Group Builder. To register, find more information, or hear Ron Seigneur describe the program in his own words, click here.

New study counters thinking on S Corps as a tax loophole

The effective federal income tax rate—or the actual percent of net income that a firm pays as taxes—varies by its form of organization, according to Effective Federal Income Tax Rates Faced by Small Businesses in the United States. The new report from the Office of Advocacy of the U.S. Small Business Administration shows that overall, small businesses of all types pay an estimated average effective tax rate of 19.8%. Sole proprietorships face a 13.3% rate and small partnerships face 23.6%. In contrast, small Subchapter S corporations face a 26.9% effective tax rate. Although not directly comparable, small C corporations face an effective rate of 17.5%. (For the purpose of this study, the authors, Quantria Strategies, define a small business as a firm with less than $10 million in gross receipts).

Why the discrepancy for S corporations? A recent write-up in the Washington Wire, published by The S Corporation Association, an advocacy group, notes that “the tax treatment of S corporations at the federal level is mirrored on the tax treatment of partnerships. One possibility is that S corporations may tend to be older, more mature companies that were organized before the emergence of the Limited Liability Company.” In addition, they cite Quantria’s explanation that “the effective tax rate for C corporations does not include taxes paid by shareholders on dividends and capital gains.”

The progressivity of the tax code also affects effective rate calculations, as firms with less income face a lower statutory rate. The data reveal that nearly 60% of small sole proprietorships have a net income of less than $10,000, but only 3.1% have a net income of at least $100,000. On the other hand, more than 18% of small S corporations have a net income of at least $100,000. The authors primarily used data from the IRS Individual Statistics of Income Public Use File, 2004, as the basis for the study. A complete copy of the report is available here.

Should S Corp retained earnings be attributable to a minority owner’s income for child support determinations?

When the Wright’s marriage went wrong, the central issue in their divorce was whether the husband’s 25% interest in a Subchapter S corporation was sufficient to permit the court to consider the company’s retained earnings for purposes of determining child support. The court had met this issue before, when the parent/spouse was a sole or majority owner of an S corporation. Under those circumstances, it followed the majority rule:

The overwhelming majority of states…have held that when the parent is a minority shareholder in a closely held or subchapter S corporation, and therefore does not control the decision on the distribution of earnings, then the retained earnings of the corporation cannot be attributed to him/her as income.

In this case, the husband wanted the court to focus exclusively on his minority status, ignoring that he owned the business with his brother and another (unnamed) individual. He also wanted the court to use the $84,000 that he reported as adjusted income on his annual tax return as the basis for child support, overlooking the $340,000 that he reported on his schedule K-1. Adding final insult to income, he admitted that for each of the years of the marriage, the S Corp set aside approximately $50,000 in retained earnings attributable to his minority share. In the year the couple divorced, however, it set aside nearly seven times as much.

Given its prior decisions permitting a trial court generally to attribute the retained earnings of a closely held corporation to the parent shareholder, the Alabama Court of Appeals in Wright v. Wright, WL 724153 (March 20, 2009) upheld the trial court’s finding that the husband’s income exceeded the applicable guidelines and confirmed its award of $3,000 in monthly child support.

The court also considered the application of minority and marketability discounts to the husband’s share of the company—and in an interesting evidentiary twist, it also considered whether the husband/owner could give an opinion not only as to the value of the business (acceptable under the applicable rules) but also to rebut the opposing expert’s opinion. The trial court said that was the exclusive province of “dueling” experts—but the court of appeals took a wider approach, citing the “liberalizing” purpose of the rules. The full case abstract will make good reading in the forthcoming, June 2009 Business Valuation Update™, and the complete text of the court’s opinion will be available at BVLaw™.

What is your experience with income determinations in divorce? Like the experts in the Wright case, do you primarily focus on the valuation of a business, and only occasionally assist with income determinations as they arise? Or are income determinations more of a separate and discrete focus of the engagement and your practice? Please take a few moments to email the editor and we may publish your comments in future issues of the ‘Wire.

PCAOB offers new guidance on Fair Value

Staff Audit Practice Alert No. 4, issued last week by the Public Company Accounting Oversight Board (PCAOB), is intended to remind auditors of their responsibilities in conducting reviews of interim financial information and annual audits in light of the new, FASB Staff Positions (FSPs) related to fair value measurements and other-than-temporary impairments. The alert addresses three recently issued Financial Accounting Standards Board Staff Positions:

• FSP FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly;  
• FSP FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments; and  
• FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments.

Martin Baumann, PCAOB chief auditor and director of professional standards, explains, “the alert will be helpful to auditors as they conclude their work related to the first quarter of 2009 or prepare for the review of the second quarter and the audit of the financial statements, including the integrated audit.”

Real-world examples of non-compete and employment contracts

Non-compete and employment/consulting agreements with key personnel could have either a beneficial or an adverse effect, depending on the relationship between the cost and the value to the company. To find real-world examples, we scoured the Pratt’s Stats® database and found over 6,600 transactions with non-compete and/or employment/consulting agreement information (description and dollar value attributed to the agreement). The two lists with creative examples of each, Real-World Non-compete and Employment/Consulting Agreements from Pratt’s Stats, are now available for download at our Free Resources page.