Financial valuation Applications and Models phần 7 pot

ACCOUNTING STANDARDS AND ESOPs WITH DEBT The AICPA issued a Statement of Position (SOP) 93-6, Employers’ Accounting for Employee Stock Ownership Plans, with an effective date for financial statement presentation of accounting years beginning after December 15, 1993. Existing ESOPs will apply this approach to all new acquisitions of shares but not to refi- nancing of old acquisitions, since prior ESOP transactions are allowed to retain their prior accounting treatment. Balance Sheet Issues and the Leveraged ESOPs Under SOP 93-6, a company’s direct and indirect loan arrangements for the ESOP loan should be shown as an obligation (liability) of the company with a contra account as a reduction in the equity section termed “Unearned ESOP Shares.” These unearned ESOP shares are known as suspense shares representing the pledged ESOP shares. As the ESOP debt is repaid, the suspense shares are released and are allo- cated in a way that may not necessarily be proportionate to the debt reduction. Dividends on allocated shares and released but unallocated shares are charged to retained earnings. In cases where there has been an increase in the market value of the stock over that of suspense shares, the increase is added to paid in capital. No financial statement consideration is given to the future tax benefits derived by the income tax deductibility associated with the repayment of the ESOP debt principal. The plan buys shares of stock from treasury, new issues of the sponsoring com- pany, existing shareholder(s), or any combination of the three. Repayment generally occurs not less frequently than quarterly. The sponsoring company makes repay- ment of the loan to the ESOP as a tax-deductible plan contribution. In the case of a direct loan, the plan pays the lender directly from the funds contributed to it by the sponsoring company for the purpose of loan repayment. In the case of an indirect loan, the company pays the lender directly and accounts for the transaction as a plan contribution, thereby eliminating the need to contribute to the plan. Then the plan repays the sponsoring company. SOP 93-6 requires the sponsoring company to record the transaction as a treas- ury stock acquisition for both direct or indirect loans used to purchase stocks held by shareholders in the open market. A subsequent issue of the shares to the ESOP is recorded by relieving the treasury stock account of the acquired shares and creat- ing a contra equity account, “Unearned ESOP Shares.” Should the ESOP acquire new issue (unissued) shares from the company, the company will increase the com- mon stock account at the current value of the shares with a corresponding entry to the “Unearned ESOP Shares” account. Earnings per Share Issues Dividends on released common shares constitute an exchange of ESOP shares for compensated services (earned). As such, they are considered outstanding for earn- ings-per-share calculations. However, shares that are not to be released (suspense shares) are not considered “earned” and are not outstanding in the earnings-per- share calculations. Dividends on convertible preferred stock issued to an ESOP will affect earn- ings-per-share calculations since they can be paid on allocated or unallocated shares 604 VALUATION ISSUES IN EMPLOYEE STOCK OWNERSHIP PLANS and are recorded differently by the company on leveraged ESOP shares depending on that allocation. In essence, the sponsoring company has control of dividends on the unallocated shares. Thus, when dividends paid on unallocated shares are used for debt service, the liability for the debt or accrued interest is charged and if added to participant accounts, they are charged as compensation expense. In both instances payment of dividends on unallocated shares requires no accounting adjust- ments to the net income in the earnings-per-share calculation. Dividends paid on allocated shares added to participant accounts are no dif- ferent from any other dividend on convertible stock and are included in the EPS cal- culation using the if-converted method. If the dividends on the allocated shares are used for debt service, net income in the EPS calculation may need reduction. Statement of Income Issues for the Leveraged ESOP There are two primary issues relative to income statement presentation for leveraged ESOPs: 1. The measurement of compensation expense associated with the ESOP plan 2. The period with which that expense is to be associated Each accounting period has a different compensation expense, which fluctuates with the market price of the shares to be released. The average value of compensation expense for the year is used, since the stock is considered earned throughout the year. This treatment differs in nonleveraged plan accounting, since compensation expense is equal to the cash paid for the shares committed at the date of the commitment. Dividends and the Leveraged ESOP For financial statement purposes, dividends are chargeable to retained earnings and not compensation expense with one exception. In the case where dividends are paid on unallocated shares arising from prepayment of debt, they will be treated as com- pensation expense. If they can be used to satisfy an obligation of the plan, the pay- ment will no longer have the characteristics of a dividend. Additionally the financial statement presentation affects the income statement of the company as compensation expense, not as a charge against retained earnings on the balance sheet. Accounting Standards and ESOPs with Debt 605 The company measures compensation expense on the basis of the fair value (an accounting term sometimes considered synonymous with fair market value) of the shares to be released, which can cause some dra- matic fluctuations in recorded compensation expense. ValTip Valuation Impact Financial statement presentation for leveraged ESOPs under SOP 93-6 remains con- troversial. While SOP 93-6 attempts to address financial reporting inconsistencies with leveraged and nonleveraged plans found in the superceded SOP 76-3, it does not create a clear picture for valuation purposes and presents several issues that must be reconciled as follows. There are no real generally accepted accounting procedures (GAAP) differences between SOP 76-3 and SOP 93-6 and, thus, no valuation adjustments warranted for a nonleveraged ESOP. However, for a leveraged ESOP, the difference between the two is significant. Prior to the enactment of SOP 93-6, neither “suspense shares” nor “fair value” compensation expense required differentiation of the proper accounting period for share allocation. Treatment in SOP 93-6 results in fluctuations of compensation expense based entirely on estimates of a nonexisting market where hypothetical willing buyers and sellers are used to match employee-earned services with an esti- mated value of shares. In addition, prior to SOP 93-6, the number of shares out- standing did not depend on whether shares had been released during debt repayment and classified as “allocated” shares. Instead, it follows an economic rationale of ownership with debt as collateral rather than a debt controlling the ownership relationship. Armed with a clear understanding of the financial presentation requirements of GAAP, the analyst may find it difficult to support certain provisions of SOP 93-6 in the valuation of leveraged ESOPs without economic and monetary adjustment. By not considering adjustments, the value indication could result in a material mis- statement, an unsupportable valuation conclusion, and possible breach of the “ade- quate consideration” rules promulgated by the DOL. In a leveraged ESOP valuation, while the loan is made with the company as guarantor or the maker of the ESOP loan, the economic realities of the transaction cannot be ignored. In most leveraged transactions involving ESOPs, the plan is a pledgor of the shares that come from purchases from shareholders. It is not unusual for lenders to require the ESOP shares as collateral acquired from the seller. When the sponsoring company uses proceeds for non-operating purposes, the share pro- ceeds from the sale (perhaps in the form of qualified replacement property in the case of qualified tax-deferred gains under provisions of the IRS), sponsoring com- pany business assets, and the sponsoring company (along with a personal guarantee of an officer of the sponsoring company or the selling shareholder or both) may be a condition of the loan. If the ESOP loan were buying new issues of the sponsoring company, the com- pany would be the recipient of the proceeds of the loan, thereby increasing company assets and cash flow for reinvestment in corporate growth. In essence, these valuation adjustments may be considered: • Fluctuating compensation expenses based on unallocated suspense shares as period charges using estimated “fair values” should be adjusted to their original cost and allocated as an expense at that time and as the principal of the debt is reduced. • All shares of stock owned by the ESOP, whether held as suspense, unallocated shares, or allocated shares, may be considered outstanding to capture the fully dilutive effect. 606 VALUATION ISSUES IN EMPLOYEE STOCK OWNERSHIP PLANS VALUE FOR ESOP SHARES The characterization of the premise of value for all ESOP transactions of employer securities, where no public market exists, is the responsibility of the Plan trustee. The appraiser’s responsibility is to maintain adherence to the promulgations of the Internal Revenue Service and Department of Labor specific to the valuation. In most cases, the value will be that of a noncontrolling, nonmarketable, (minority) interest. (Special consideration is given to extraordinary liquidations, sales or mergers of the company that are outside the discussion in this chapter.) There are circumstances whereby the ESOP shares will be treated as in a “con- trol position.” The DOL has established criteria that: • Establishes the importance of differentiating a minority and control interest • Scrutinizes whether or not the seller of the shares of stock would be able to obtain a control premium from an unrelated third party with regard to the block of securities being valued • Establishes the importance of the ESOP maintaining actual control in both form and substance, which has passed to the ESOP or will be passed to the ESOP within a reasonable period of time, pursuant to a binding agreement in effect at the time of sale • Establishes the requirement for a reasonable assumption that the ESOP’s control will not dissipate within a short period of time subsequent to acquisition • Requires that the valuation report include all relevant factors considered in the determination of the applicability of a control concept. Adjustments for Lack of Control An ESOP should not pay more for shares of stock in the sponsoring company than any other hypothetical buyer would at the same point in time, given the same rele- vant facts. Determining the degree and extent of control purchased or exercised by the ESOP is a significant challenge for the analyst. The Department of Labor considers control as determined not only by the size of the block of shares held by the ESOP, but also by the prerogatives those shares give to the plan in both form and sub- stance. The DOL makes a clear distinction between numerical and actual control when the ESOP owns, or can reasonably expect to own, more than 50 percent of the spon- soring company’s common stock. While the DOL acknowledges that a control pre- Value for ESOP Shares 607 ESOP valuations are usually that of a noncontrolling interest, unless compelling requisite relevant factors and empirical evidence are avail- able to support a control value. ValTip mium may be applicable in certain instances, it stresses that there must be com- pelling evidence of actual control in addition to numerical control, which must or will pass to the ESOP, and that control will not dissipate over time. In a private company setting, a minority interest adjustment sometimes is taken as a discount from control value of the sponsoring company. In most cases, the adjustment results in a minority interest that is worth less than its proportionate share of the value of all the outstanding shares. The magnitude of a minority inter- est adjustment depends on the shareholder’s inability to exercise any or all of the rights typically associated with the ownership of the shares. This adjustment should take into account the full definition of fair market value, including the assumption of a hypothetical buyer and seller outside the set- ting of the ESOP. The philosophy behind and quantification of a minority interest adjustment is crucial in the valuation of closely held stock for purposes of ESOP transactions of the sponsoring company shares. A minority interest discount is a reduction to the initial indicated value due to a lack of control prerogatives such as declaring dividends, liquidating the company, going public, issuing or buying stock, directing management, and setting management’s salaries. Quantifying the amount of minority interest adjustment rests with the facts and circumstances of the engagement and a good-faith interpretation of the relevant facts, including a close analysis of the DOL-proposed regulations. While the ESOP may transact a larger block of stock as a percentage of the company, the participants will generally transact in a small holdings of minority interests. The analyst should search for verifiable exchanges/sales of the spon- soring company stock within a reasonable period of time prior to the valuation date. Voting and Other Rights of the ESOP Shareholders Voting rights need to be “passed through” to the ESOP beneficiaries only on issues that require majority stockholders to vote. In public companies, voting rights are passed through to plan participants as with other shareholders. In private compa- nies, ESOP participants must be able to direct the plan trustee on the voting of allo- cated shares regarding such issues as mergers, liquidation, and recapitalization. In cases where a vote pass-through is required, appropriate information on the issues must be provided, just as it would be provided to other shareholders. Participants in an ESOP do not have rights to the sponsoring company’s financial statements, stock record books, or information on salaries. Disclosures of these items are at the discretion of the sponsoring company. However, as a practical matter, summary financial information often is made available to the plan trustee. 608 VALUATION ISSUES IN EMPLOYEE STOCK OWNERSHIP PLANS When valuing a minority block of stock of a closely held corporation, no range of discounts is universally applicable in all circumstances. ValTip Adjustments for Lack of Marketability Marketability adjustments are intended to reflect hypothetical buyers’ concerns regarding the absence of a ready and available market when they decide to sell. In contrast to shares of stock in public companies that have an active market, owner- ship interests in closely held companies are typically not readily marketable. Therefore, often it is appropriate to apply an adjustment in the form of a discount to the value of closely held shares to reflect the reduction in value due to lack of marketability. The magnitude of the discount for ESOP company shares is measured on the basis of the effects of such factors as: • Restrictions on transfer • Buy-sell agreement or bylaws • Prospect of a public offering or sale of the company • Viability and strength of the put right and the capacity to acquire shares • The market available that may be interested in purchasing shares • Dividend yields in distributions When referencing publicly traded securities in valuing a minority position in a closely held ESOP corporation, an adjustment for the lack of marketability of the pri- vately-held interest may be appropriate, since the shareholders have no access to an active public market for their investment. Further, shareholders cannot force registra- tion to create marketability. Without market access, an investor’s ability to control the timing of potential gains and losses and to minimize the opportunity cost associated with alternative investments is impaired. Given two investment instruments identical in all other respects, the market will typically accord a considerable premium to one that can be liquidated into cash instantly, especially without risk of loss in value. For this reason, an investment in a privately held company usually is adjusted to a lesser stock price than an otherwise comparable investment in a publicly traded entity. Shares of ESOPs are subjected to much the same lack of marketability as non-ESOP shares. The only difference is the required put right provisions, which can substantially reduce this discount. For private stock, several types of empirical studies including restricted stock studies and pre-initial public offering studies, and certain models can be used to indicate the adjustment for marketability. See Chapter 8 for more detail concerning these studies and models. Repurchase Requirement: How to Deal with It An ESOP repurchase requirement is a right or claim made by a plan participant to the sponsoring company to convert vested ESOP shares to cash upon the partici- pant’s departure from the plan. This conversion right of the ESOP participant is a plan requirement that obligates that sponsoring company to repurchase the stock at fair market value from terminating participants. Value for ESOP Shares 609 A put right is the legal right, not the requirement, of a participant, under certain circumstances of plan termination, to convert sponsoring company stock held in individual accounts to cash under a detailed, time-specific formula. ValTip There is no Accounting Standard requirement to accrue a repurchase liability for the ESOP plan shares on sponsoring company financial statements or to include such in a financial statement footnote disclosure, even though the estimated amount of liability may, in some cases, be material. If the stock held by an ESOP participant is not readily tradeable, the IRS requires the company to provide the participant with the right to demand that the sponsoring company repurchase the participant’s stock under a fair valuation for- mula within a definitive time period. Under this IRS Tax Code section, the ESOP participant who has terminated by reason of death, disability, or retirement, has two 60-day windows for the company to repurchase ESOP shares. Those two 60-day window periods are: 1. Immediately after the distribution 2. One year later, allowing for the next valuation of the shares to have taken place For the participant who leaves the plan for reasons other than death, disability, or retirement, the repurchase obligation can be delayed until the end of the fifth year following the year the participant terminates with the company. The repurchase can be paid in a lump sum or can be paid out over an extended period of time and is based on the fair market value of the shares at the time of distribution. In most cases, ESOP participants tender their shares under the put right. In the case of C corporations, participants have the option to keep the shares after leaving the plan and the company. However, the company can place limits on what the ter- minated participant can do with the shares and also retains the option to buy back the ESOP shares. This ensures that former plan participants will not transfer the shares outside the company. The majority of ESOP shares tend to be repurchased in a lump sum. Either the sponsoring company will purchase the shares as treasury stock or make contributions to enable the ESOP to make the repurchase. It is also possible that the ESOP itself may use its available funds to make the acquisition. ESOP trust agreements basically specify three ways for shares of the sponsoring company stock to be purchased: 1. The ESOP may purchase the shares using pooled funds residing in the plan at the time the participant requests liquidation of his or her account. 2. If the ESOP does not have available funds, the sponsoring company may make a cash contribution to the plan to acquire the shares from the participant. (The shares of stock held in the plan and those held outstanding by the company are identical as before the purchase. Only the assets held in the plan have changed. This repurchase method is often referred to as recirculation of the shares.) 3. The sponsoring company may purchase the stock as a treasury redemption pur- chase. The number of shares outstanding and the amount of cash expended in the transaction will be reduced proportionate to the value of the overall com- pany on an aggregate minority interest basis. This repurchase method is often referred to as redemption of the shares. Special situations apply to S corporation repurchases of shares. Since S corpo- rations are pass-through entities, the pro rata share of ownership earnings and prof- its passed to an ESOP is not subject to income tax. In addition, dividend 610 VALUATION ISSUES IN EMPLOYEE STOCK OWNERSHIP PLANS distributions received by an ESOP on allocated shares are considered plan earnings that are allocated to participants based on accumulated account balances. When these dividend plan earnings are used to repurchase shares from departing ESOP participants, the repurchased shares will be allocated proportionately only to those participants who received the dividend. This differs from using company contribu- tions to repurchase stock where repurchased shares are allocated based on eligible annual compensation. The size of the repurchase obligation changes over time. Leverage, vesting, underlying stock value, age of participants, company-specific personnel turnover, and amount of available liquidity in the ESOP must all be considered to determine the existence, size and effect of the liability. For valuation purposes, the materiality of the sponsoring company obligation will depend on several factors, including the company’s: • Ability to borrow money • Availablity of continued operating income of the size and timing to meet normal participant attrition • Adequacy of cash reserves that could be used to buy departing participant shares The contemplated liquidation or sale of the sponsoring company or the termi- nation of the ESOP itself would be considered an extraordinary event that should not be factored into a typical repurchase obligation study. The ESOP plan was created for the ongoing benefit of the employee partici- pants for their retirement. Assuming that the analyst determines that a material repurchase obligation exists and assuming that repurchase amounts can be calcu- lated with reasonable accuracy and reasonable economic certainty, a valuation adjustment may be warranted and a liability account established to reflect the obli- gation as a liability of the sponsoring company. Before making this modification, the analyst must consider the ESOP’s ability to meet the obligation with its funds. This adjustment can extend to the sponsoring company’s balance sheet and be included in its cash flows. The principal questions are: • How to quantify the repurchase obligation • Where to consider its impact in the valuation To answer these questions, it is important to consider how many shares the ESOP holds in the sponsoring company. The smaller the percentage of ESOP stock Value for ESOP Shares 611 It can be difficult to forecast repurchase obligations much farther than a few years and to estimate the present value of future repurchase obli- gations. ValTip ownership in the sponsoring company, the lower will be the effect on value of the repurchase obligations. As stock ownership by the ESOP grows and the repurchase obligation grows with it, the potential drain of cash flow can negatively effect stock value since the cash flow set aside to satisfy the put requirement could have been used in growing the business, reducing debt, or other critical business purposes. The put right provision was established to provide plan participants some assurance that they would be able to sell their shares at retirement. In most cases, this right reduces the amount of adjustment for lack of marketability, since the put provision does provide a ready market for the ESOP shares. Some analysts even eliminate the discount. WRITING A VALUATION CONCLUSION The valuation process is not complete until a written report is furnished to the trustee. The DOL states or implies that the valuation report must contain: • A full description of the asset being valued • A statement(s) of conclusion of the asset’s value • A statement(s) of the purpose of the valuation • A statement(s) of the effective date of the valuation • A statement(s) of the approaches and methods considered • A statement(s) of the relevance of each methodology employed • A statement(s) of any restrictions or other limiting condition(s) • A statement(s) of the factors considered in the formulation of the conclusion of value • A written assessment of all relevant factors, including those factors cited in Revenue Ruling 59-60 • A statement that all rules of the proposed DOL regulations have been met • A written assessment of all relevant factors concerning any marketability adjust- ment(s) and that the put option rights were considered • A written assessment of all relevant factors concerning any control or minority interest adjustment(s) • A summary of the qualifications of the appraiser(s) • Signatures of the appraiser(s) and the date the report was signed • Statement of independence 612 VALUATION ISSUES IN EMPLOYEE STOCK OWNERSHIP PLANS To comply with the requirements of the Department of Labor, the ana- lyst’s conclusion of fair market value must be presented in a written document. ValTip A per share value can be extracted simply by dividing the outstanding (consid- ering unallocated or effects of dilution) shares of the company into the aggregate company value. The plan administrator can determine the appropriate reporting of these shares. The report should be written to the plan trustee who retains the analyst. It does not matter whether the plan or the sponsoring company pays for the valuation serv- ices, and the trustee does not have to use the analyst’s value estimate. Rather, it is the plan trustee’s responsibility to render the final conclusion. The analyst’s task is to offer to the trustee a professional estimate of the fair market value of the ESOP shares. INFORMATION SOURCES IRC § 401(a)(14) IRC § 401(a)(28)(B) IRC § 404(a)(9)(A)-(B) IRC § 404 IRC § 409(h)(1)(B) IRC § 409(h)(4) IRC § 409(o)(A) IRC § 409(o)(1)(B) IRC § 411(a) IRC § 411(d)(6)(I) IRC § 415 (c) IRC § 501 IRC § 512 IRC § 1042 IRC § 1361 IRC § 4975 Revenue Ruling 59-60 Revenue Ruling 77-287 Priv. Ltr. Rul. 8644024 (August 1, 1986) Priv. Ltr. Rul. 19934006 (May 21, 1999) Priv. Ltr. Rul. 9619065 (February 12, 1996) Information Sources 613 The valuation generally is made on at least an annual basis and may be used in several scenarios over which the analyst has little or no control. ValTip [...]... in a divorce litigation will often comply with both USPAP and the ASA separate business valuation standards The IBA and NACVA also have developed business valuation standards that require compliance from their members See Chapter 10 for additional information on standards ValTip Noncompliance to standards does not necessarily invalidate the valuation report for the court (that decision is up to the... 16 Valuation in the Divorce Setting ivorce valuations are completely state specific and are dependent on the specific facts and circumstances of each case This chapter presents some general, but important concepts, and also references certain state specific cases where an important issue was addressed For additional information on some of these issues see Chapter 17, Valuation of Small Companies, and. .. amount of value instead of a range of value PROFESSIONAL STANDARDS IN A DIVORCE SETTLEMENT The role of professional standards in divorce valuations is increasing in importance as judges and attorneys become more sophisticated and knowledgeable about the business valuation profession Experienced attorneys often look for accredited valuation analysts, and many judges give more credibility to their opinions... Ownership ESOP Valuation: Expert Guidance for Companies, Consultants and Appraisers, 2nd ed (Oakland, CA), pp 1–203 The National Center for Employee Ownership Leveraged ESOPs and Employee Buyouts, 4th ed (Oakland, CA), pp 1–259 Principles of Appraisal Practice and Code of Ethics, rev ed (Washington DC: The American Society of Appraisers, 1994) Standards Board of the Appraisal Foundation Uniform Standards... of these entities in accordance with the standards for business valuation and the local law DIVORCE VALUATION AND BANKRUPTCY Because of the liquidity myth, business interests valued in a divorce setting sometimes end up being valued again in a bankruptcy court This section deals with the correlation between value in the divorce proceeding and a possible later valuation in the bankruptcy court Liquidity... a 6 Id at p 10 626 VALUATION IN THE DIVORCE SETTING covenant and using those factors to construct a model to determine covenant value In Thompson v Commissioner, T.C Memo 19 97- 2 87 (June 24, 19 97) , the Tax Court concluded to the value of a noncompete agreement, using an 11-factor “economic reality test.” These factors included probability of competition, length of the covenant, and ability of the individual... Companies, and Chapter 18, Valuation of Professional Practices D STANDARDS OF VALUE IN DIVORCE It is incumbent on the analyst to know what standard of value is appropriate in the valuation of a business or business interest in a divorce Since this may vary from state to state and from jurisdiction to jurisdiction, the analyst should be aware of the terminology used in the jurisdiction and how that terminology... relating specifically to business valuation It had appointed a task force to develop standards, which should be promulgated by 2003 Once promulgated, it is anticipated that certified public accountants who prepare business valuations for use in a divorce litigation will follow those standards Those currently performing business valuations must abide by the appropriate general standards of the AICPA See Chapter... general standards of the AICPA See Chapter 10 for additional information on standards OTHER STANDARDS The American Society of Appraisers (ASA), Institute of Business Appraisers (IBA), and the National Association of Certified Valuation Analysts (NACVA) have all developed standards to be followed by their members The ASA standards are detailed enhancements to USPAP, which the ASA had previously adopted... finding must be upheld In Moretti v Moretti, 76 6 A.2d 925 (R.I 2001), the trial court held, in part, that the value of the landscaping business owned by the husband included goodwill The husband appealed the decision, arguing that the trial court erred in its finding that goodwill is included in the value of the business The Supreme Court of Rhode Island remanded the case in order for the trial court . studies and pre-initial public offering studies, and certain models can be used to indicate the adjustment for marketability. See Chapter 8 for more detail concerning these studies and models. Repurchase. Value—Liquidation 6 17 GOODWILL—THE BATTLEGROUND FOR DIVORCE VALUATIONS Goodwill has become the battleground for divorce valuations in the 2000s. How much and what goodwill will be included in a divorce valuation. App. 3d 1044 (1 974 )). 5 Robert E. Kleeman, Jr., R. James Alerding, and Benjamin D. Miller, The Handbook for Divorce Valuations (New York: John Wiley & Sons, Inc., 1999), p. 79 . APPLYING THE