C Corp to S Corp Conversion

From February’s Axiom on Value

The Window to Elect S Corp Status for 2015 Closes March 15

Many business owners are completely focused on the day-to-day operation of their business.  For these owners, issues of ownership transition planning and optimal tax strategy at the owner’s exit are “nice to consider” but will be irrelevant if the company does not make it through next month’s payroll.  CPAs for these businesses try to educate their clients on the long-run implications of staying as a C corporation, the de facto structure when incorporating, but often run into a variant of “why bother? In the long run, we are all dead”.

The decision whether to elect S corporation is a complex one, and should only be done after reviewing with your advisors the pros and cons of both corporate structures.  However, we note that according to IRS statistics, most “small” businesses chose the S form at some point in their stage of development, so it is an issue worth serious consideration if the owner expects to sell the business, rather than close it down upon retirement.

 Major Difference in Taxes Paid in an Asset Sale between a C and S Corp

The primary reason to consider electing S corporation status is that there can be a significant difference in the taxes paid on the sale of a business in an asset transaction between an S corporation seller and a C corporation seller.  (If the buyer is willing to buy the corporate stock, then there may be little or no difference in taxes paid by sellers of a C or an S corporation).   In an asset transaction for a C corporation, the gains on tangible and intangible assets are taxed at the corporate capital gains rate, which is 35% at the federal level.  Then, when the corporation closes down, it will distribute the remaining cash as dividends, which in most cases are taxable at the individual level.  The effective tax rate can exceed 55% of the gain in the C corporation assets.

The asset sale of an S corporation after 10 years following the S election will be taxed at a much lower rate, since the capital gains are taxed at the individual capital gains rate, and there is no tax on distributions.

The 10 Year Window for the BIG Tax 

For companies that elect S corporation status, there is a 10 year window following the election when the C corporation tax structure will apply to the value created as a C corporation.  The IRS imposes a “Built-In Gain (BIG) tax on the gain in value of the company’s assets as of its conversion from C to S.  The gain in value over the value as a C corporation is taxed based on the S Corp rules.  Consequently, it is necessary to determine the value of the company and its tangible and intangible assets in their C status as of the conversion date.

If S Election is Made, a Business Valuation Should be Done

The valuation should be done using the conversion date as the effective date.  This valuation will be based on the financial statements of the business up to the conversion date, and on the outlook for the company as of the valuation date.

The valuation should determine the total fair market value of the business.  For larger companies, there should be an additional analysis to allocate the total asset value over specific tangible and intangible assets, in case there are sales of specific assets during the 10 year window.

This valuation will not be filed with the IRS upon its completion.  The valuation will stay with the corporation and its CPA for use in the tax calculations, if there is a sale of assets or the business during the 10 year window.  Having the valuation done just after the conversion date is the best way to maximize the rewards from building and operating a privately held business.

 S Corporation Basics (from IRS publications)

S Corporation Requirements

To qualify for S corporation status, the corporation must meet the following requirements:

– Be a domestic corporation
– Have only allowable shareholders
* May be individuals, certain trusts, and estates and
* May not be partnerships, corporations or non-resident alien shareholders
– Have no more than 100 shareholders
– Have only one class of stock
– Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).

Steps to Elect S Status:

Complete and file Form 2553:  No more than two months and 15 days after the beginning of the tax year the election is to take effect, or at any time during the tax year prior to the tax year the conversion is to take effect.

Is Investing in an Equity Tranche of a CLO Too Risky?

From November’s Axiom on Value:

By: Dr. Stanley Jay Feldman, Chairman, Axiom Valuation Solutions

John Roberts, Managing Director, Axiom Valuation Solutions

One of the more complicated investments to value is the lower end tranches of CLOs, collateralized loan obligations.  Axiom’s CLO model provides investors with accurate pricing of all CLO tranches including the equity tranche, which, as it turns out, is highly valuable in a low interest rate slow growth economic environment as we show below.

CLOs are an important part of the fixed income landscape primarily because they offer benefits that other structures do not.   CLOs offer investors an opportunity to invest in slices or tranches of the CLO that meet their particular risk appetites and yield objectives.  At the same time, CLOs contribute to a more liquid loan market since CLOs use the funds raised through issuance of securities (tranches) to fund the purchase of loans.  The basic CLO structure is shown below.

Basic CLO Structure

A CLO operates like any other business: It owns assets, in this case bank loans, and funds the purchase of these assets with debt and equity. The debt stack is made up of a series of securities (X thru C) that have priority claims on the cash flows generated by the assets.  Securities with the highest priority claims (X-A) are paid interest and principal first, and hence are rated highly, while those securities that are at the lower end of the debt stack (B-C) have a lower priority claim on the cash flows and as a result face the possibility that interest and principal will not be paid as expected.   The subordinated notes are equivalent to equity since it receives cash flow only after X thru C is paid. In cases where issuing firms default on their loans, promised cash flows  to all but the least risky tranches are at risk of not being fully paid.   Since the equity tranche only receives residual cash flow, its value in large measure is a function of the probabilities associated with loans in the CLO portfolio defaulting, dollar size of the defaults, size of the recovery value associated with defaults and the timing of these recovery payments.   

Using Axiom’s CLO model, the chart below shows the payment to equity under the base case and three default scenarios.   Keep in mind that even though there is a default, in most cases, a large percentage of the principal is subsequently recovered.  The analysis assumes a 70% recovery rate, which is the average recovery of principal for bank loans.  The recovery occurs subsequent to the default date.

Equity Payout at Different Default Rates

In this example, the par value for the equity tranche is $35,000,000.  In the base case scenario, the equity holder would receive over $60,000,000 for a six year investment period.  If, however, the default rate for the collateral loans was 1% per year (cumulative 6%), the equity holder would only receive $54,000,000.  At a 2% per year default rate, the equity holder would receive $47,000,000, and at a 5% per year default rate, the equity holder would receive less than par or about $28,000,000.

Based on the weighted average credit rating of the CLO loan portfolio, the cumulative six year default rate for six years is about 12% based on a recent S&P study on loan defaults.   Our analysis indicates that the equity tranche is reasonably well protected since even at a 2% annual default rate (12% cumulative), cumulative payments to the equity tranche exceed par value.

Valuing a Startup as an Exercise in Quantum Physics

It seems to be clear, therefore, that Born’s statistical interpretation of quantum theory is the only possible one. The wave function does not in any way describe a state which could be that of a single system; it relates rather to many systems, to an ‘ensemble of systems’ in the sense of statistical mechanics. (Albert Einstein, on Quantum Theory, 1936)

The value of a startup and the character of a wave function in quantum theory are similar in that neither is best described by one value but reflect an ensemble of values for which there is a central tendency. Valuing a startup business is not only difficult and complicated but there are many factors that more often than not lead to significant miscalculation.  What we know is that there is no valuation model that is designed to address the spectrum of risks, and of course opportunities, that characterize startups as a group.

Axiom works with startups all the time, and the valuation framework most often used is  discounted cash flow. The accompanying assumptions typically include a  rapid growth phase  to reflect the “market opportunity” and a very high cost of capital, to reflect the myriad of undefined risks expected to be encountered, which is then used to discount the expected super growth in free cash flow.  The values that result from using this approach may pass the proverbial “smell test” but given the undisclosed trajectories that a startup can take, it is virtually impossible for early stage investors to use the business plan valuation as  anything more than a hope and a prayer. On the other hand, early stage investors that are considering investing in the startup generally have a good idea of whether the business model makes sense and also whether the commercial market is large enough to support some level of activity that the startup represents.  With this in mind,  investors proceed by first giving the business plan valuation a significant haircut and then determine what percentage of the startup they need to own to produce the desired rate of return. The end result is that the entrepreneur gets some financial capital but at a very stiff price.

In order to properly value a startup  that will yield higher business values and financial terms from investors that are likely to be less oppressive, entrepreneurs need to recognize two fundamental factors. First, they need to transparently incorporate, but not limited to, the factors noted below.

  1. There are a multitude of risks, including not getting to market on time,  the product/service does not function as anticipated, operating expenses are greater than expected, and efficiencies of scale do not develop as anticipated (meaning that expense levels are far higher than anticipated and the investment required to sustain commercial viability is greater than expected).
  2. Sales may be greater or less than expected and customer segments may not be as receptive as originally thought, while others may be more receptive but in order to take advantage of these developments costly modifications of the product or service are required.

Second, and most importantly, entrepreneurs need to understand that the factors noted above, along with others, will likely combine in unexpected ways that will lead to sales and expense trajectories that the entrepreneur has not anticipated but will nevertheless be expected to cope with. Each of these outcomes is associated with a different business value which means that a startup is really not characterized by one value- the business plan value- but rather a distribution of values which reflect the market place the business will develop in.

The question then becomes how do these factors combine? Is there a logic that may provide guidance?  For startups, more so then for established firms, there are many more known unknowns and this along with the plethora of unknown unknowns makes placing a final and precise value on a startup almost an exercise in futility.  However, all hope is not lost once we are willing accept the view that we do not know what trajectory the startup will take and certainly we generally know almost nothing about when the startup will become commercially viable.  If we consider the various factors that govern a startup and assume they will randomly combine over a future time period, then we can study what the valuation implications of these combinations are.  If we randomly combined the factors described in 1 and 2 above, for example, what would this tell us?

First and foremost it would generate a distribution of firm values and the associated probabilities of achieving these values.  The strength of this analysis is not in simply understanding the valuation  implications if specific things go awry but rather what happens if some things go right and others  do not since inevitably this will be the case.  In the end, we do not really know how future values of various valuation drivers  might combine in ways that may be detrimental to the startup or enhance its prospects. What we do know is that there are series of events that could occur and we want to know how these in combination will impact the prospects of the startup and its value.

The Exhibit below is constructed based on 27,000 valuations which are produced by randomly combining the multitude of paths that numerous variables that drive valuation can take. The startup is an Axiom client selling its unique products and related services to an energy-related business client base.

Probability Density Function

The founder was in the midst of his first capital raise and was receiving feedback that the value he placed on the firm was too high.  Given this feedback and accompanying term sheets that were hard to fully come to grips with, he turned to Axiom for help to better understand what the value of the firm really is and how to use what he learned to negotiate terms that are more consistent with the firm’s central tendency value.

There are two vertical lines indicating the value assigned by the entrepreneur in the business plan and the value implied by a VC investor group’s term sheet.   Based on Axiom’s analysis, the central tendency of the firm’s value distribution is in the neighborhood of $12 million.

So what is the value of this startup?   The answer is the value is likely to be between $10.5 and $13.6 million since this range covers a significant portion of the value distribution.   The eventual transaction value is based on a multitude of factors but two that are critical are:  level of investor competition and liquidity in the market for startups.

From October’s Axiom on Value

The Benefits of Offshoring Intellectual Property: Minimizing Taxes and More

From August’s Axiom on Value:

Given the current debate on the implications of corporate inversions — the acquisition of a U.S. company by a foreign firm resulting in the U.S. company moving to a low tax jurisdiction — one is reminded that there are significant business and tax minimization strategies that closely-held private firms can utilize if they have intellectual property (IP) and currently do, or expect to do, significant business outside of the U.S.

The effective corporate tax rate can be reduced by as much as 50%.  The extent of tax reduction depends on the facts and circumstances, but whatever these happen to be, owners usually reap a sizeable benefit.  Keep in mind that IP includes more than patents and trademarks. It includes know-how and business secrets that are the basis of a commercial venture.

There are at least two significant benefits associated with transferring IP to a foreign company that is domiciled in a low tax haven such as Ireland:

  1. Significant reduction in the corporate tax burden.  For example, if the foreign company is domiciled in Ireland, the marginal tax rate on profits attributed to that company based on transferred IP would be 12.5% versus the expected 40% combined Federal and state tax rate.
  2. Cost sharing between the U.S. parent and the foreign host related to improving the IP.  For example, if the transferred IP are databases and associated applications, then costs of any improvements can be funded by the U.S. parent (high tax haven) and the foreign company.

The key to implementing this strategy is determining the  value of the IP being transferred and the associated stream of royalty payments that would emerge if the agreement were arm’s length between two unrelated parties.

Axiom Valuation Solutions has valued many types of IP which were eventually transferred to a foreign host.   Based on this experience, we have identified four major drivers:

  1. Determination of the fair value of the U.S. company (pre-transfer)  and each of its identified intangible assets including the IP to be transferred;
  2. Expected revenue generated by the foreign company;
  3. The target rate of return that the sponsor would require in order to enter an agreement with an unrelated party; and
  4. Expected non-U.S. revenues.

The Cost of Illiquidity in the Syndicated Loan Market

From July’s Axiom on Value:

Here we will address the issue of measuring liquidity in the syndicated loan market. The chart below measures the illiquidity of a set of syndicated loans in terms of the difference in yields to maturity. The difference is the YTM of the loan at the valuation date and the YTM of the loan if it were trading in a liquid market.  The latter YTM is generated using Axiom’s Credit Rating and Pricing Platform which has been shown to produce unbiased and accurate estimates of fixed income securities.

Yield Du to Liquidity Adjustments

As can be seen, the average adjustment in yield is between 3% and 5% which reflects the fact that investors require a sizeable liquidity premium for investing in an illiquid asset. However, for any given syndicated loan, the liquidity premium could be much higher than the average. The reason relates to a number of factors including but not limited to the following:
• The number of investors in the syndicate.
• Club deals are generally more illiquid than larger syndicates.
• Less familiar names underwritten by single investors are likely to have a larger liquidity premium than the average and the Club deal.

New Opportunities for Business Borrowers, The Bank Monopoly is Ending

From June’s Axiom on Value:

The bank monopoly on business lending is eroding, creating new opportunities for business borrowers to tap into the global pool of capital. Because banks have been focusing on strengthening their balance sheets and improving capital ratios, they are increasingly reticent to extend credit to businesses that are of lower credit quality but nevertheless credit worthy.  Credit funds and BDCs (Business Development Companies) have filled some of the void by directly underwriting loans, while the proliferation of capital raising platforms like FINEX  (https://fnex.com/) are presenting unique opportunities for business borrowers. These platforms connect business borrowers with new and non-traditional lenders including high net worth individuals looking for higher yielding credit worthy investments in a low interest rate environment.

In order to increase the probability of accessing debt capital on fair terms, borrowers need to provide potential lenders with a credit risk assessment in much the same way public firms hire a credit rating agency to rate a bond before it goes to market.  While such an analysis is not mandatory, Axiom’s experience working with lenders indicates that business borrowers are well served if they can formulate their own expectations as to firm credit risk and make it clear to prospective lenders the basis of this assessment. In this way, borrowers are well positioned to compare and contrast offers, while lenders will be able to initially assess the credit risk of the client and, based on this and other information they may require from the borrower, make a determination as to whether to make an offer.

For any given credit risks assessment, the terms of the offer to lend will cover three variables:

•          rate charged or coupon rate

•          maturity or tenor

•          call provisions

The rate on the loan is the base rate plus a spread or margin. The greater the credit risk, the greater the credit spread and hence the greater the cost of debt.   As an example, if the tenor of the loan is five years and Axiom’s credit rating is 13 which is equivalent to an S&P credit rating of B, then the rate on the loan would be 7% – 5 year Treasury rate or base rate of 1.73% plus a 5.27% spread, which is market spread for five year B rated credits at the time the analysis was done.   Keep in mind that the 5.27% spread reflects two factors – the credit risk of the business issuing the debt (corporate credit risk) plus the credit risk of the loan being issued which reflects what a borrower would recover if the firm defaulted.   Depending on the debt structure of the firm, the credit risk of the debt being issued could be very much higher than the corporate credit risk.

Finally, most loans have a penalty if the loan is paid off prior to maturity.  One way to reduce the interest on the loan for any given credit risk is for the borrower to give up the right to prepay the loan.  Loans have other requirements also known as covenants.  Covenants are guidelines that, if violated, may result in the loan being called by the lender. More typically covenant violations result in the borrower paying additional fees and the coupon is reset to a higher level.  Two common covenants are the leverage ratio (Debt/EBITDA) and the coverage ratio ([EBITDA-CAPX]/ Interest expense).   Like anything else, covenants are negotiable.

Business Valuation 101: The Five Myths of Valuing a Private Business

From May’s Axiom on Value:

As you work tirelessly to meet the everyday challenges of running your own business, you may wonder why you should be interested in a column on valuing your business. After all, valuation is something you will be concerned about some time in the future when there is “need” for a valuation. If you feel like this and you stop reading, you will be missing an opportunity to insure that your business will survive and prosper.

Understanding the factors that determine the value of any business will pay tangible dividends by focusing you on ways to increase your firm’s short and long-run profitability. Moreover, if you choose to sell your business at some point in the future, this knowledge will assist you in positioning your company to receive the highest price. Therefore, there is no time like the present to begin to understand what a business valuation is, under what circumstances a valuation is customarily completed, and the critical issues to watch out for when events dictate that you undertake a business valuation.

What is a Business Valuation?

We first turn to the central issue—What is a business valuation? To answer this question, consider the following example. You own IBM stock and you want to know how much it is worth. Well, all you have to do is pick up the business section of the daily newspaper or go to any financial website, locate the stock tables and multiply IBM’s closing price by the number of shares you own. Through this simple exercise, you have valued your IBM shares or what you would receive in cash if you sold your shares at the closing price.

In concept, valuing your private business is the same as valuing IBM stock. But, because your firm is private, there is no stock table that you can conveniently turn to. No need to worry, however, because there is a pseudo-science, or some say an art form, that provides the foundation for skilled business appraisers to estimate what your business is worth. The problem is that the valuation process is often viewed as a “black box.” As a result, a whole mythology has grown up around valuation of private businesses. To help de-mystify the valuation process, let me introduce you to my top five myths about valuing a private business and explain how to avoid the pitfalls these myths present.

Top 5 Business Valuation Myths

Myth 1: Valuing a private business should only be done when the business is ready to be sold or a lender requires a valuation as part of its due diligence process.

Although the business sales and lending processes generally require that valuations be completed, if these events represent the first time an owner has a valuation completed, then you can be sure critical business and estate planning issues have not been addressed. If the business is to have a life beyond that of its current owners, then effective planning for ownership transition requires a regular valuation of the business.

Ownership transition may include gifting some percentage of ownership shares to family members during the owner’s life, thus reducing any tax on the owner’s estate at death. If a firm has several owners, a buy-sell agreement with accompanying life insurance should be in place so that if an owner dies, the remaining owners have sufficient funds to purchase the deceased owner’s interest at an agreed upon value. The buy-out value under these agreements should be updated regularly to reflect the firm’s financial progress over time and the valuation approach used should be one of several acceptable to the IRS.

Myth 2: Businesses in my industry always sell for two times annual revenue (the revenue multiple). So why should I pay someone to value my business?

The short answer is that data on selling prices indicate that revenue multiples within an industry are generally all over the lot. These rules of thumb used by business brokers, the individuals who often facilitate private business transactions, are median multiple values. The median value indicates that half of the revenue multiples are below the median value and half are above. Thus, the median value is just a convenient midpoint and does not represent the revenue multiple for any actual transaction. Unless the firm that is being valued is truly a median firm, then using the industry rule of thumb for this purpose is clearly wrong.

For example, according to a well- known source for business transaction data, Pratt’s Stats, recent revenue multiples for firms in the auto parts industry ranged from a low of .98 to a high of 8.3 with a median of 2.9. If you were valuing your firm for sale and your annual revenue were $100,000, then the value of your business could be as low as $98,000, as high as $830,000, or somewhere in between. Where your firm lies along this continuum is obviously of the utmost importance and can only be determined by a valuation approach that incorporates academically validated methods with industry-specific valuation factors. Myth 4 below discusses the legal and tax implications of assigning a value to your firm that is outside a permissible range.

Myth 3: A local competitor sold his business for three times revenue six months ago. My business is worth at least this much!

Maybe yes and maybe no. What happened six months ago is not really relevant to what something is worth today. What your business is worth today depends on three factors: 1) how much cash it generates today; 2) expected growth in cash in the foreseeable future; and 3) the return buyers require on their investment in your business. First of all, unless your firm’s cash flows and growth prospects are very similar to the competitor firm, that firm’s revenue multiple is irrelevant to valuing your firm. Moreover, without getting into the nuances of finance, even if the competitor firm was equivalent to yours in every respect and both firms were sold today, if interest rates were higher today than 6 months ago, the firms would likely sell for less than three times revenue. Conversely, if rates were lower today than six months ago, the firms may be worth more than three times revenue. In short, the value of your business, like the value of IBM stock, is likely different today than six months ago because economic conditions have changed.

Myth 4: How much a business is worth depends on what the valuation is used for!

The value of a business is its fair market value (FMV). According to the Internal Revenue Service, the FMV is what a willing buyer will pay a willing seller when each is fully informed and under no pressure to act. While there may be a FMV range, the wider the assigned valuation range is, the less reliable is the valuation and the more likely it becomes that the valuation will face greater scrutiny from potential buyers or the IRS.

Consider the example of a parent selling a business to a child. The incentives to assign a low valuation under these circumstances are significant. Given that the parent pays taxes on the difference between the value of the stock sold to the child and its value on the firm’s books (book value equity), establishing a low value on the firm’s stock results in the parent minimizing the capital gains tax owed to the IRS. The child, on the other hand, has to come up with less money, because the sales price of the business is much lower than its FMV. These types of transactions are common and the IRS is always looking for abuses. Alternatively, an owner of a business may make a charitable contribution of company stock. In this case, there is a significant incentive to place the highest possible value on the donated shares, because this will result in the largest charitable tax deduction. If the value of the donated shares is outside the FMV range, an IRS audit may well be in the donor’s future.

Myth 5: Your business loses money, so it is not worth much.

Most private businesses appear to lose money. Appearances, however, are often misleading. Not long ago, a friend of mine was considering buying an auto parts business in California. The asking price was approximately $950,000 and, according to the firm’s tax return, it hardly made a profit. Like many businesses of this type, this business was generating a great deal of cash, but this cash was masquerading as legitimate expenses. One expense category really stood out—payments to officers. This payment included the owner’s wage of $80,000 per year and a bonus of $150,000 that the owner paid himself at the end of year. The $80,000 wage is what the business would have to pay a stranger to do the same job as the owner. This was a real expense. The $150,000, on the other hand, represents what finance people call a return to capital. It is the cash the business generated and it is this cash that determines the value of the business.

Unlike public companies, the separation between ownership and management does not really exist in a private firm. Thus owners have some discretion over how they categorize cash flow generated by the business. Quantifying the size of these discretionary expenses is often a critical determinant of the firm’s value. As such, owners should keep a tab on what these discretionary expenses may be so that, when they are ready to sell the business, they can document these facts to the buyer. By doing so, the seller increases the buyer’s confidence that the business does legitimately generate the cash the seller claims and, accordingly, increases the buyer’s willingness to pay the asking price for the business.

In the final analysis, there are many important reasons that business owners should know the value of their businesses long before they decided to sell. By understanding the basics outlined above, you should be able to successfully plan the financial future of you and your family by understanding the value of your most important asset—your business.

Maximizing the Rate of Return on Your Next Acquisition: Why the Allocation of the Purchase Price Should Be Done Before the Deal Closes

From April’s Axiom on Value:

When an acquisition (stock or asset deal) is completed, the purchase price needs to be allocated to the assets purchased.  In our experience, the allocation exercise is typically done after the deal is completed.  A typical allocation table is shown below.

axiom on value1

Notice that in this case the portion that is goodwill is quite large at about 30%. From a post-acquisition perspective the tax benefit (assuming an asset deal or a stock deal with a 338 election) associated with goodwill is no different than the tax benefit associated with the customer list, for example- one fifteenth is amortized for tax purposes. Hence, the usual view is that the allocation of purchase price between purchased intangible assets and goodwill has no cash flow implications. This is often not the case.

Here is the reason. Goodwill is the value the buyer expects to produce in excess of what could be produced by the assets alone. Now in most cases goodwill can be divided into two components. The first is seller goodwill or goodwill that the seller would be expected to produce if the business remained on is historical trajectory. This goodwill includes but is not limited to additions to the customer base for example and/or strategies designed to reduce historical customer loss rates. What the buyer should not pay for is buyer goodwill. Following the example used here, buyer goodwill would equate to additions to the customer base above what the selling entity would be expected to generate on its own. Hence, the minimum purchase price should include the standalone value of the assets purchased plus seller goodwill. Any increment in the purchase price above this level gives rise to buyer goodwill. While competitive conditions and capital availability may result in a market participant paying up, the only way to know the potential extent of the over-payment is to conduct an allocation of the expected purchase price to the assets purchased.