Valuation Report

Business Valuation Trends and Strategies Summer 2013

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Valuation Concepts

AICPA Issues Updated “Cheap Stock Guide”

C Corp vs. S Corp: Should You Convert?

How to Avoid Divorce Double Dipping

methods that can be used to allocate value to a company’s common stock when its total equity value is less than the liquidation preference of its preferred stock.

Why the Update?Since the original guide was issued in 2004, there have been many changes in generally accepted accounting principles (GAAP) related to valuation. These include ASC 718 (formerly FAS 123R), which requires fair value-based valuation for share-based payments, and ASC 820 (formerly FAS 157), which standardizes fair value measurement across GAAP.

Changes in the tax code such as IRC 409A have also focused more attention on “cheap stock” valuations. Further, valuation practice has advanced significantly. The goal of the update is to reflect and clarify how these changes and advancements impact these spe-cific types of valuations.

What’s New?Key changes to the guide include:

• Discussions regarding the treatment of debt and the effects of leverage.

• The relevance of ASC 820 and AICPA valuation standard SSVS 1.

• How to apply SEC and FASB guidance.

• New cost of capital tables and studies.

In addition, the updated guide has new chapters that address:

• Adjustments for lack of control and marketability.

• How to infer across the capital structure from transactions in only one part of the capital structure.

• Common valuation questions.

These changes and advancements impact all three equity value alloca-tion methods described in the guide: the current value method (CVM), the option pricing method (OPM) and the probability weighted expected return method (PWERM).

Which Is Most Appropriate?The updated guide clarifies that while the CVM may be the most obvious equity value allocation method, it is often not the most appropriate. This is because managers and investors base their decisions on the company’s expected future equity value, but the CVM allocates the company’s current equity value. For early stage compa-nies with complex capital structures, this frequently implies (incorrectly) that the company’s common equity has no value.

To address this problem, the guide describes the PWERM and OPM valua-

The Basics of Valuation Standards

Continued on page 3

In 2012, the AICPA’s Financial Reporting Executive Committee

released for comment an updated working draft of its practice aid titled “Valuation of Privately Held Company Equity Securities Issued as Compensation.”

Also known as the “Cheap Stock Guide,” it is of particular interest to those who value, audit, manage or invest in early stage companies that have issued both preferred and com-mon stock, resulting in a complex capital structure. The guide describes

2Valuation Report Summer 2013

Technical Topics

Double Dipping in Divorce

court cases. While the concept itself is widely recognized, it is not fully endorsed by all courts. And because divorces are handled differently by different jurisdictions, there’s not one rule that courts always follow.

Of course, each case should be decided based on its particular facts and circumstances. But most valuation analysts would argue that the interplay of income for support and business valuation should be considered in a divorce settlement. n

Interested in learning more about double dipping? We’re always happy to talk to you about valuation issues.

Dissolving a marriage is never easy. But when one spouse owns a busi-

ness, equitable division of assets can be even more complicated. One of the valuation issues that often arises is “double dipping.”

Double dipping occurs when the recipient of spousal support “dips” twice into the same asset — once in the equitable distribution calculation and again when it comes to spousal support. Here’s how it plays out:

When a couple is getting divorced, a valuation analyst is often called on to assess the value of the business and make a determination of the spouses’ earnings as a basis for calcu-lating spousal support payments. The problem arises when the business val-uation uses a different amount of fair market value compensation than is used by the courts for purposes of determining spousal support. To avoid double dipping, the spousal support calculations must be based on the same compensation assumptions as the business value.

A Case in PointSay Mr. Jones owns a business with earnings of $300,000 and pays himself $150,000 in salary. In the course of the business valuation, the valuation ana-lyst determines that reasonable com-pensation for Mr. Jones would actually be $100,000. (Note that it is not unusual for business owners to pay themselves higher-than-market salaries as they dis-tribute profits to themselves in the form of compensation.)

Double dipping occurs when the recipient of

spousal support “dips” twice into the same asset — once in the equitable distribution calculation

and again when it comes to spousal support.

For valuation purposes, this $50,000 difference is added back into the company’s earnings, resulting in a new adjusted earnings amount of $200,000 ($300,000 earnings minus $100,000 fair market compensation). For the purposes of this example, assume that the earnings are then capitalized by 3X. With- out a reasonable compen- sation adjustment, the value of the company is $450,000. With the adjustment, the value is $600,000.

Clearly, using the adjusted reason- able compensation figure substantially increases the value of the business. When it comes time to divide the value of the business, most experts would say that the adjusted value of $600,000 is the figure that should be used because it represents the fair market value of the company.

What About Support?If the court uses the actual salary of $150,000 rather than the adjusted reasonable compensation amount of $100,000, the soon-to-be-ex-Mrs. Jones gets a substantial bonus. Her support isn’t being calculated on the same compensation amount used in the business valuation.

Remember, the $150,000 has already been included in the busi- ness valuation and is being equitably divided through her share of the business. If her support is calculated using the unadjusted compensation amount, she is double dipping into the business.

This inconsistency has been the central issue in several important

3Summer 2013 Valuation Report

Tax Tips

Should You Convert from a C to an S Corporation?circumvent corporate level taxes by converting to an S corp before a sale, Congress added the built-in gains tax in 1986. Any S corporation that previ-ously operated as a C corporation is subject to this corporate-level tax on appreciation in the value of assets held on the day a corporation con-verts to S status.

Through the end of 2013, the tax applies to any built-in gain resulting from the sale of assets owned at the time of the conversion during the first five years after the S corp elec-tion is effective. In the absence of Congressional action, this period will revert to 10 years beginning in 2014.

The Role of a ValuationHaving a valuation performed at the time of the S election is helpful for sev-eral reasons. First, if the company is sold before the end of the recognition period, a valuation can provide valu-able support to limit the amount of built-in gains subject to the tax. Second, a tax rule limits the amount of gain subject to the built-in gains tax to the net unrealized built-in gain. A valuation

tion methods. PWERM estimates stock value based on an analysis of a variety of future exit scenarios — including an IPO, merger, sale, dissolution or con-tinued operation — weighted by their probability of occurrence. The OPM treats securities as call options on the company’s equity value, with strike prices determined by the characteris-tics of the various classes of securities.

The updated guide also describes a new hybrid method that adds OPM calculations to the PWERM method when exit scenarios include significant risks of an inability to achieve an IPO or obtain additional financing.

While this guide is “non-authoritative,” it is an important resource for valuation

can help determine if the corporation has a net unrealized built-in gain in its assets on the date of conversion and prove its case to the IRS.

If your company is a C corp, it’s wise to talk with your CPA about your exit strategy and discuss whether conversion to an S corp might make sense now while the five-year window is still in place. While the built-in gains tax can be extremely costly, proper planning may allow your company to reduce the tax, or at least plan the timing of when it would be due. n

Considering a conversion to an S corp? Call us first to discuss the move in more detail.

If your company is a C corporation, you may be considering a switch

of corporate status to avoid double taxation. As a reminder, C corps are taxed twice — once at the corporate level, and then again at the individual level, as shareholders pay taxes on their dividends.

To avoid this and other issues, some owners choose to convert from a C to an S corporation, which gener-ally doesn’t pay corporate income tax. Rather, with an S corp, the taxable income of the corporation “passes through” to the tax returns of its individual stockholders.

Issues to ConsiderIf you are considering this switch, there are several issues to consider:

• Net operating loss carryovers: If the C corp has any net operating loss carryovers or other tax attributes, they generally don’t carry over to S corpo-ration status. And S corps can’t use built-up net operating losses to offset future income.

• State income tax treatment: Some states recognize S corp status, but not all do. Similarly, not all states allow composite tax returns for shareholders. If yours is a multi-state corporation, this can create complications. It still may make sense to become an S corp in some states, but it’s important to discuss this issue with your CPA.

• Basis: If an S corp has losses, share-holders can only use them to offset gains to the extent that the sharehold-ers have basis in the corporation. If the company doesn’t have losses, basis isn’t an issue. If the company does have losses, a C corp may be a more favorable entity choice because it allows more opportunities to carry forward or carry back losses.

• Built-in gains tax: To ensure that C corp shareholders couldn’t

“Cheap Stock Guide” UpdatedContinued from page 1

To avoid double taxation, some owners choose to convert from a C to

an S corporation, which generally doesn’t pay corporate income tax.

analysts, audi- tors, managers and investors involved with privately held, early-stage companies. Because these valu- ations are complex, it’s important to work with a valuation analyst who is well versed in the nuances of the up- dated guide. n

We can help you with all types of busi-ness valuations, including valuations of early stage companies with complex capital structures.

This publication is distributed with the understanding that the author, publisher, and distributor are not rendering legal, accounting, tax, or other professional advice or opinions on specific facts or matters and, accordingly, assume no liability whatsoever in connection with its use. The information in this publication is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed in this publication. © 2013

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4Summer 2013 Valuation Report

The Basics: Valuation Standards at a Glance

Every business valuation has a pur-pose, and that purpose determines

which standard of value should be used. Before the engagement even begins, the client and analyst must agree on what they’re after. In other words, the valua-tion analyst’s job is to determine what the business is worth to whom and under what circumstances.

For example, if a business is being sold, its value may be different than if it is being assessed for estate planning purposes. Some standards are mandated while others just make more sense in certain situations. Here’s a quick review of three common valuation standards:

• Fair Market Value – The most com-mon standard, fair market value is used

in almost all state and federal tax mat-ters. It is defined by the AICPA as the “price, expressed in cash equivalents, at which property or business would change hands between a hypothetical willing and able buyer and a hypo-thetical willing and able seller, acting at arm’s length in an open and unre-stricted market, where neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”

• Investment Value – This standard assumes that certain synergies exist between buyer and seller. It’s typically defined as the value of a business or property to a specific buyer. For example, a buyer may have specific

expectations for an acquisition, like gaining a competitive edge or increas-ing geographic penetration for the company’s products or services. If the target company meets those specific criteria, it is worth more to that buyer.

• Fair Value – This standard is generally used in cases of dissenting stockholders’ disputes and financial reporting. In stockholders’ disputes, many states define fair value as “the value of the [dissenter’s] shares imme-diately before the effectuation of the corporate action to which the dissenter objects.” For financial reporting, fair value is defined as an “exit value,” or the proceeds expected from the sale of the asset. n