Tax Treatment Complicates S Corp Valuation

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So-called “pass-through” entities — including partnerships, limited liability companies (LLCs) and S corporations — generally aren’t required to pay entity-level taxes. So, when it comes to valuing a small business structured as a pass-through entity for tax purposes, people often wonder: Would investors pay a premium for an interest in this business compared to an interest in an otherwise identical C corporation? And, if so, how much is this favorable tax treatment worth? This is the crux of the tax-affecting debate.

Much of the litigation regarding this issue comes from the IRS and tax courts. But a recent Tennessee Court of Appeals decision discusses this issue in the context of a shareholder buyout. (Raley v. Brinkman, No. 2018-02002, Tenn. App., July 30, 2020)

Pros and Cons of Pass-Throughs

For pass-through entities, all items of income, loss, deduction and credit pass through to the owners’ individual tax returns, and taxes are paid at the personal level. Distributions to owners generally aren’t taxable to the extent that owners have positive tax basis in the entity.

If a pass-through entity distributes just enough of its earnings to cover the owners’ tax liabilities, there may be little potential valuation difference at the investor level between the pass-through entity and a taxable entity, assuming similar tax rates at the entity and the investor levels. If the pass-through entity distributes larger amounts of earnings to the owner, the interest becomes potentially more valuable than an equal interest in a taxable entity, all other things being equal. If the pass-through entity distributes less than the tax liability amount, an interest in the taxable entity could potentially be more valuable in the hands of the owner.

Court Allows Tax Affecting

The tax-affecting issue took center stage in a recent buyout case involving two equal partners in a restaurant that generated roughly $3.4 million in gross annual income in 2016. When the owners disagreed about how to manage their business, a Tennessee trial court ordered a buyout of one owner’s interest at “fair value” under applicable state law.

The business operated as an LLC that elected to be treated as an S corporation for income tax purposes. The trial court allowed the buyout price to include a hypothetical 38% corporate income tax rate to the restaurant’s earnings. But the seller (plaintiff) appealed, arguing that tax affecting wasn’t appropriate for a pass-through business that wasn’t subject to entity-level tax.

The buyer (defendant) contended that tax affecting was appropriate because the income from an S corporation passes through to the owners’ individual tax returns and is taxed at the owners’ personal tax rates. He also argued that valuation experts commonly use after-tax income values to calculate the capitalization rate under the income approach.

The appellate court explained that the problem with using the income approach to value a pass-through entity is that it’s designed to discount cash flows of C corporations, which are taxed at both the entity and the shareholder level. Income from an S corporation is taxed only at the shareholders’ personal level.

Citing the landmark Delaware Open MRI Radiology Associates case, the appellate court concluded that declining to tax affect an S corporation’s earnings would overvalue it, but charging the full corporate rate would undervalue it by failing to recognize the tax advantages of S status. The court also determined that it was appropriate to use an after-tax earnings stream because the expert’s capitalization rate was based on after-tax values.

Finally, the appellate court cited the Estate of Jones. In this U.S. Tax Court case, the court concluded that the cash flows and discount rate should be treated consistently when valuing a pass-through entity.

IRS Job Aid Provides Insight

The debate over tax affecting pass-through entities has persisted for decades. To help clarify matters, the IRS has published a job aid entitled “Valuation of Non-Controlling Interests in Business Entities Electing To Be Treated As S Corporations for Federal Tax Purposes.” This document helps IRS valuation analysts evaluate appraisals of minority interests in S corporations for federal tax purposes.

However, the job aid provides useful guidance on the issue of tax affecting that may be applied more generally to all types of pass-through entities that are appraised for any purposes, not just for tax reasons. Business valuation experts may use this job aid as a reference tool to help support their decisions to apply tax rates to the earnings of pass-through entities when projecting future cash flows.

No Bright-Line Rules

When it comes to tax affecting pass-through entities, there’s no clear-cut guidance that prescribes a specific tax rate — or denies tax affecting altogether. Rather, tax affecting may be permitted on a case-by-case basis, depending on the facts and circumstances.

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Price-to-EBITDA Multiples Decline During First Quarter, According to DealStats

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The median price-to-EBITDA multiple among deals reported to DealStats fell slightly to 3.8 during the first quarter of 2021, down from 3.9 in the fourth quarter of 2020, suggesting transaction prices remain under pressure from the coronavirus pandemic.

According to the latest edition of DealStats Value Index, the four-quarter average EBITDA (earnings before interest, taxes, depreciation and amortization) multiple for the year ending in March 2021 was 3.9, the lowest such average since the period ending in the third quarter of 2016.

EBITDA measured as a percentage of net sales fell to 10 percent in the first quarter of 2020, due at least in part the ongoing economic toll of the pandemic and resulting restrictions. The reduction also reflects a longer-term trend of lower margins. EBITDA margins for transacted businesses have fluctuated between roughly 10.5 percent and 12 percent since late 2018, according to DealStats. From 2015 to 2018, they generally moved between 11 percent and 14.5 percent. DealStats does not indicate if the EBITDA margin metric is a median or an average.

Transaction reporting appears to have slowed with the pandemic. Of 15 sectors tracked by DealStats, just three met the minimum of 10 reported transactions during the first quarter required for the inclusion of sector-specific multiples.

DealStats is a database of private-company transactions maintained by Business Valuation Resources. The database is used by business appraisers when applying the market approach to valuation. Multiples such as sale price-to-EBITDA can be derived from transactions involving similar businesses and used to estimate the value of a company, subject to adjustments for unique characteristics of the business being valued.

Advent’s William Quackenbush Awarded FASA Designation

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William Quackenbush, director of Advent Valuation Advisors, has been elected into the College of Fellows of the American Society of Appraisers and awarded the coveted Fellow Accredited Senior Appraiser (FASA) designation. Fellowship is the highest honor bestowed by the Society on a member and recognizes the professionalism and invaluable contributions the member has made.

Earning the FASA makes Bill one of a small, select group of members that currently hold this honor. A member since 1998, he had previously been designated as an Accredited Senior Appraiser (ASA) within the business valuation discipline of the Society.

“Your exemplary service and dedication have helped ASA maintain its position of leadership among professional appraisal organizations around the world,” said Lorrie Beaumont, ASA, International President of the American Society of Appraisers. “Your commitment to excellence in your practice and in every task you have undertaken on behalf of the Society has contributed to the advancement of the valuation profession in the minds of those who use, practice and regulate appraisal services.”

Bill is the founder and current director of Advent Valuation Advisors, a national business valuation and financial advisory services firm with offices in Newburgh, Poughkeepsie and Manhattan. He has been a contributing author or technical reviewer of several books on business valuation and business valuation-related topics and has been a frequent speaker on business valuation-related issues to professional associations.

“The team at Advent is thrilled to see Bill honored for his exceptional and wide-ranging contributions to the business valuation profession,” said Lorraine Barton, Partner of Advent Valuation Advisors. “This prestigious designation recognizes Bill’s years of dedication to his craft, his clients and his colleagues.”

Bill has served as the Chair of the Business Valuation Committee (BVC) of the American Society of Appraisers and many functional committees of the organization. He has been a course developer and is currently an instructor and Vice Chair of the Board of Examiners. He has taught business valuation internationally and for the Big Four accounting firms for over 15 years.

Bill remarked, “The American Society of Appraisers has been the leader in the advancement of the business valuation profession. My work with the Society has been and continues to be immensely rewarding. I am honored to have been elected into the College of Fellows and to join those who have contributed so much to the profession.”

How Reasonable is Your Owners’ Compensation?

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There are many factors to consider when determining reasonable owners’ compensation. Photo by Matthew Henry from Burst

For most privately held businesses, owners’ compensation is one of the largest expenses on the income statement, especially when all the related perks and hidden costs are calculated. Compensation should accurately reflect what others would receive for similar duties in a similar setting. Reasonable compensation levels are important not only for state and federal tax purposes, but also to get an accurate estimate of the fair market value of the business.  

Total Compensation Package

Before compensation can be assessed as reasonable, all components of the package must be calculated, including:

  • Direct salaries, bonuses and commissions,
  • Stock options and contingent payments,
  • Payouts under golden parachute clauses,
  • Shareholder loans with low (or no) interest and other favorable terms,
  • Company-owned or leased vehicles and vehicle allowances,
  • Moving and relocation expenses,
  • Subsidized housing and educational reimbursements,
  • Excessive life insurance or disability payments, and
  • Other perks, such as cafeteria plans, athletic club dues, vacations and discounted services or products.

In addition, owners’ compensation may be buried in such accounts as management and consulting fees, rent expense and noncompete covenants.

IRS Guidance

The IRS has published a guide titled, “Reasonable Compensation: Job Aid for IRS Professionals.” IRS field agents use this guide when conducting audits to help determine what’s reasonable and how to estimate an owner’s total compensation package.

The IRS is on the lookout for C corporations that pay employee-shareholders excessive salaries in place of dividends. This tactic lowers the overall taxes paid, because salaries are a tax-deductible expense and dividends aren’t.

Owner-employees of C corporations pay income tax on salaries at the personal level, but dividends are subject to double taxation (at the corporate level and at each owner’s personal tax rate). If the IRS decides that a C corporation is overpaying owners, it may reclassify part of their salaries as dividends.

For S corporations, partnerships and other pass-through entities, the IRS looks for businesses that underpay owners’ salaries to minimize state and federal payroll taxes. Rather than pay salaries, S corps are more likely to pay distributions to owners. That’s because distributions are generally tax-fee to the extent that the owner has a positive tax basis in the company.

The IRS job aid lists several sources of objective data that can be used to support compensation levels, including:

  • General industry surveys by Standard Industry Code (SIC) or North American Industry Classification Systems (NAICS),
  • Salary surveys published by trade groups or industry analysts,
  • Proxy statements and annual reports of public companies, and
  • Private company compensation reports such as data published by Willis Towers Watson, Dun & Bradstreet, the Risk Management Association or the Economic Research Institute.

“Reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances,” states the IRS job aid.

Compensation Benchmarks

Beyond IRS audits, the issue of reasonable compensation may become an issue in shareholder disputes, marital dissolutions and other litigation matters. When valuing a business for these purposes, a company’s income statement may need to be adjusted for owners’ compensation that is above or below market rates.

Courts often rely on market data to support owners’ compensation assessments. But it can be a challenge to find comparable companies — and comparable employees within those companies. The five areas that courts consider when evaluating reasonable compensation are:

  1. The individual’s role in the company,
  2. External comparisons of the salary with amounts paid to similar individuals in similar roles,
  3. Character and condition of the company,
  4. Potential conflicts of interest between the individual and the company, and
  5. Internal inconsistency in the way employees are treated within the organization.

Owners can control compensation, and that creates an inherent conflict of interest when estimating what’s reasonable. External comparisons are key to supporting compensation levels. Business valuation experts typically interview owners to get a clearer picture of their experience, duties, knowledge and responsibilities.

Get It Right

For more information about reasonable owners’ compensation, please contact the business valuation professionals at Advent Valuation Advisors. We can help estimate total compensation levels, find objective market data and adjust deductions that are above or below market rates.

Prep Your Business Before You List It

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Make your business sparkle – and tidy up the books, too – to help ensure a successful sale. Photo by Verne Ho on Unsplash

The COVID-19 pandemic has put unprecedented stress on private business owners. Some are now considering selling their businesses before Congress has a chance to increase the rates on long-term capital gains. Before putting your business on the market, it’s important to prepare it for sale. Here are six steps to consider.

1. Clean Up the Financials

Buyers are most interested in an acquisition target’s core competencies, and they usually prefer a clean, simple transaction. Consider buying out minority investors who could object to a deal and removing nonessential items from your balance sheet. Items that could complicate a sale include underperforming segments,nonoperating assets, andshareholder loans.

Sales are often based on multiples of earnings or earnings before interest, taxes, depreciation and amortization (EBITDA). Do what you can to maximize your bottom line. That includes cutting extraneous expenses and operating as lean as possible.

Buyers also want an income statement that requires minimal adjustments. For example, they tend to be leery of businesses that count as expenses personal items (such as country club dues or vacations) or engage in above-or below-market related party transactions (such as leases with family members and relatives on the payroll).

2. Highlight Strengths and Opportunities

Private business owners nearing retirement may lose the drive to grow the business and, instead, operate the company like a “cash cow.” But buyers are interested in a company’s potential. Achieving top dollar requires a tack-sharp sales team, a pipeline of research and development projects and well-maintained equipment. It’s also helpful to have a marketing department that’s strategically positioning the company to take advantage of market changes and opportunities, particularly in today’s volatile market conditions.

3. Downplay (or Eliminate) Risks

It’s no surprise that businesses with higher risks tend to sell for lower prices. No company is perfect, but industry leaders identify internal weaknesses (such as gaps in managerial expertise and internal control deficiencies) and external threats (such as increased government regulation and pending lawsuits). Honestly disclose shortcomings to potential buyers and then discuss steps you have taken to mitigate risks. Proactive businesses are worth more than reactive ones.

4. Prepare a Comprehensive Offer Package

Potential buyers will want more than just financial statements and tax returns to conduct their due diligence. Depending on the industry and level of sophistication, they may ask for such items as:

  • Marketing collateral,
  • Business plans and financial projections,
  • Fixed asset registers and inventory listings,
  • Lease documents,
  • Insurance policies,
  • Franchise contracts,
  • Employee noncompete agreements, and
  • Loan documents.

Before you give out any information or allow potential buyers to tour your facilities, enter into a confidentiality agreement to protect your proprietary information from being leaked to a competitor.

5. Review Deal Terms

Evaluate different ways to structure your sale to minimize taxes and maximize selling price. For example, one popular element is an earnout, where part of the selling price is contingent on the business achieving agreed-upon financial benchmarks over a specified time. Earnouts allow buyers to mitigate performance risks and give sellers an incentive to provide post-sale assistance.

Some buyers also may ask owners to stay on the payroll for a period of time to help smooth the transition. Seller financing and installment sales also are commonly used.

6. Hire a Valuator

A fundamental question buyers and sellers both ask is what the company is worth in the current market. To find the answer, business valuation professionals look beyond net book value and industry rules of thumb.

For instance, a business valuation professional can access private transaction databases that provide details on thousands of comparable business sales. These “comparables” can be filtered and analyzed to develop pricing multiples to value your business.

Alternatively, a valuation expert might project the company’s future earnings and then calculate their net present value using discounted cash flow analyses. These calculations help buyers set asking prices that are based on real market data, rather than gut instinct. However, final sale prices are influenced by many factors and can be higher or lower than a company’s appraised value.

They can also estimate the value of buyer-specific synergies that result from cost-saving or revenue-boosting opportunities created by a deal. Synergistic expectations entice buyers to pay a premium above fair market value.

Planning for a Sale

Operating in a sale-ready condition is prudent, even if you’re not planning on selling your business anytime soon. Our experiences in 2020 have taught us to expect the unexpected: You never know when you’ll receive a purchase offer, and some transfers are involuntary.

The professionals at Advent can help you prepare for a sale whether in 2021 or beyond.

© 2021, Powered by Thomson Reuters Checkpoint 

Divorce Case Highlights Value of Goodwill

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Photo by Nosiuol on Unsplash

While not a New York case, a recent divorce case in Delaware Family Court sheds new light on an old precedent for the treatment of enterprise goodwill in a sole proprietorship.

The couple in A.A. v. B.A. married in 1979 and divorced in February 2017, but the case lingered, with a decision regarding the valuation of the husband’s financial advisory practice, a sole proprietorship, coming in October 2020.

Both spouses hired experts to value the business. The experts reached widely divergent conclusions, with the husband’s expert valuing the business at $255,000, while the wife’s arrived at a value of $3,488,0000 to $3,500,000.

The court rejected the report by the husband’s expert, taking issue with both its failure to consider the business’s goodwill and its reliance on a flawed asset approach.

“From the outset, husband’s expert’s opinion was limited by his belief that Delaware law was settled that there could not be good will in a sole proprietorship,” reads the decision.

The husband’s expert had relied on a 1983 Delaware Supreme Court decision. In E.E.C. v. E.J.C., (457 A. 2d 688, Del. 1982), the court had rejected the consideration of goodwill in the valuation of a sole practitioner’s law practice. According to the decision in A.A. v. B.A., the husband’s expert took that oft-cited decision as an indication that Delaware case law does not permit the use of goodwill in valuing sole proprietorships under any circumstances.

The court rejected this premise: “The court notes that husband’s business in the present case is not a law firm and the practice and means of generating income are different. The court does not read E.E.C. as stating every sole proprietorship in every case has no professional good will.”

The court agreed with the wife’s expert, who assigned 5 percent of the total goodwill to the husband based on the value of his noncompete agreement, and the remaining 95 percent to the business. The court said both experts agreed that, if the husband could transfer goodwill such that he could transfer to a buyer his client base and stream of income, or even 95 percent of his stream of income, he could receive about $3.5 million for the business.

Misassessed assets

The court also took issue with the husband’s expert’s asset approach, which did not consider income earned but not yet paid to the business as of the separation: “Husband continued to run the business and the value receive[d] by husband through receivables, work in process or residual commission tails was well beyond the amount placed on it by husband’s expert. This would probably explain why the husband himself placed a value of $10 million on the business in his financial statements.”

The decision notes that, between the date of separation and late 2019, the husband extracted more than $4 million from the business, including commissions for work done during the marriage. This included a $600,000 commission received in 2018 that had been in the making for perhaps three years, according to the husband’s testimony.

The wife’s expert used a weighted combination of the income approach (capitalized income method) and market approach (transaction and guideline public company methods). The court relied on the wife’s expert, determining that the business’s value was $3,488,000.

The case is A.A. v. B.A., CN16-05018 (Del. Fam. Oct. 9, 2020). Read the decision here.

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If you require assistance with the valuation of your business in a matrimonial matter, please contact Advent for trusted guidance.

How Much is that Donated Stock Worth?

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A valuation may be necessary if you’ve donated stock in a private company. Photo by Sarah Pflug from Burst

Philanthropic business owners may have made last-minute gifts of stock to charities at the end of 2020. Others plan to make donations in 2021. How much is that stock worth? Donations of publicly traded stocks are relatively easy to value, but private equity interests are typically more complicated to value.  

Deduction Requirements

Qualified charitable donations can help lower your taxable income as well as support worthwhile causes. However, not all donations are tax deductible. Individuals can deduct them only if they itemize.

In addition, charitable contributions must be made to qualified organizations. You can determine whether an organization is qualified by going to the IRS Tax Exempt Organization Search (formerly Select Check).

Depending on the amount of the donation, to claim the tax break you’ll have to:

  • File Form 8283 Section B for a donation valued at more than $5,000,
  • Obtain an independent appraisal within 60 days of the date of the gift (before or after) if the stock is valued at more than $10,000, and
  • Attach the appraisal to your tax return if the shares are deemed to be worth more than $500,000.

Fair market value (FMV) is the appropriate standard of valuation for these donations. Under IRS Revenue Ruling 59-60, FMV represents “The amount at which the property would change hands between a willing buyer and willing seller, when the former is not under any compulsion to buy, and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”

If you put a restriction on the use of the property you donate, the FMV must reflect that restriction.

Business Valuation Report

Appraisals for donations valued at more than $10,000 must be written. Abbreviated calculations or letter formats may cost less, but they may also raise a red flag with the IRS. Moreover, valuators’ reports typically serve as their direct testimony if a return ends up in U.S. Tax Court.

According to IRS Publication 561, Determining the Value of Donated Property, qualified appraisals must include the following items:

  • Detailed descriptions of the donation, including dates of the contribution and valuation as well as terms of any agreements relating to the use, sale or other disposition of the property,
  • Statements that the appraisals were prepared for income tax purposes,
  • FMV on the date of contribution,
  • The methods used to value the business interest, such as the cost, market or income approach, and
  • Any specific data the appraiser used to determine FMV, such as comparable sales transactions.

Business valuation reports should identify the appraisers’ firms and list their qualifications, including background, experience, education and memberships in professional appraisal associations.

Always use an appraiser who has earned an appraisal designation from a recognized professional organization and who meets IRS requirements for education and experience. The IRS specifically prohibits do-it-yourself valuations by the donor, recipient or related parties.

It is important to note that you are not permitted to take a charitable deduction for business valuation or appraisal fees. In previous years, those fees may have qualified as miscellaneous deductions, subject to the 2 percent-of-adjusted-gross-income limit. However, starting in 2018, that tax break has been temporarily suspended through 2025 under the Tax Cuts and Jobs Act.

Forewarned Is Fair Warned

The IRS has cracked down on charitable contributions in recent years. The bigger your deductions, the more stringent the substantiation rules are — and the more likely the IRS is to audit them. Hire an experienced business valuation professional to help ensure your deduction survives IRS scrutiny.

Please contact the professionals at Advent Valuation Advisors if you have any questions regarding the valuation of a stock donation or other business valuation matters.

© 2021, Powered by Thomson Reuters Checkpoint 

Manufacturers More Susceptible to Fraud

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Manufacturing is among the industries most susceptible to fraud, with a median fraud-related loss of $198,000, according to the 2020 Report to the Nations. Photo by Laurel and Michael Evans on Unsplash

When fraud strikes manufacturers, the effects can be devastating. The median fraud loss in the manufacturing sector, one of the industries most affected by fraud, was $198,000, according to the 2020 Report to the Nations published by the Association of Certified Fraud Examiners (ACFE). That’s significantly higher than the median fraud loss for all industries ($150,000).

Here are some other key findings from the latest biennial ACFE report:

Common Fraud Schemes

Over the years, the ACFE has identified three methods of occupational fraud:

  1. Asset misappropriation. In these schemes, dishonest employees access and misuse assets for their personal gain. For example, they might steal company funds, inflate expense reports or engage in fake billing scams.
  2. Corruption. This is abuse of business privileges enabling an employee to gain a direct or indirect benefit. Examples include bribery and manipulation of conflicts of interest.
  3. Financial statement fraud. Here, the employee intentionally causes a misstatement or omission of material information in financial reports. For example, a fraudster might record fictitious revenues, understate expenses or inflate assets.

According to the 2020 Report to the Nations, asset misappropriation occurred in roughly 86 percent of the cases. Though misappropriation schemes are the most frequent fraud technique, they resulted in the lowest median loss ($100,000). Conversely, financial statement fraud took place less frequently (in 10 percent of cases), but it had the highest median loss ($954,000).

For manufacturers, the most common fraud schemes include:

  • Corruption (50 percent),
  • Billing schemes (23 percent),
  • Theft of non-cash assets, such as inventory or fixed assets, (23 percent), and
  • Inflated expense reimbursements (20 percent).

The total adds up to more than 100 percent because incidents may involve more than one type of fraud scheme.

The median loss from corruption crimes was $200,000. This could help explain why the median fraud loss for manufacturers was higher than the overall median for all industries.

Methods of Detection

More than 40 percent of the frauds in the 2020 report were unearthed by tips. About half of those tips came from employees. But customers and suppliers can also be valuable sources of fraud tips. Other common methods of detection include internal audit (15 percent of cases) and management review (12 percent of cases).

The ACFE concludes: “When fraud is detected proactively, it tends to be detected more quickly and thus causes lower losses, while passive detection results in lengthier schemes and increased financial harm to the victim. Anti-fraud controls such as account reconciliation, internal audit departments, involved management review, and active cultivation of tips are all tools that can lead to more effective detection of occupational fraud.”

While the median duration of a fraud is 14 months, averages differ based on the type of fraud. Usually, non-cash, cash on hand, skimming and corruption fraud is caught in less than 24 months. Billing, expense reimbursement, register disbursements, check and payment tampering, payroll and financial statement frauds typically take about two years before being discovered. Naturally, the longer fraud goes undetected, the larger the financial loss.

Profile of Perpetrators

The 2020 report shows that higher-ups are responsible for larger crimes. Although owners or executives perpetrated only 20 percent of the frauds in the study, the median loss in those cases amounted to $600,000 — much higher than losses caused by managers and mid-to-lower-level employees. This is attributed mainly to wide-ranging access to funds. Similarly, frauds committed by long-time employees resulted in greater losses than ones caused by relative newcomers.

Age and gender were also among the most significant factors. More than half of the perpetrators (53 percent) were between the ages of 30 and 45, but median losses trended higher for older fraudsters. Also, males committed 70 percent of the frauds and the median loss for male perpetrators ($150,000) was almost double the median for females ($80,000).

Methods of Prevention

Manufacturers are less likely to incur fraud losses if they learn how to identify potential fraud risk and adopt an effective system of internal controls for combatting fraud.
In particular, the ACFE recommends keeping an eye out for employees who engage in one or more of the following high-risk behaviors:

  • Living beyond their means (42 percent of cases),
  • Exhibiting financial difficulties (26 percent of cases),
  • Having unusually close association with a vendor or customer (19 percent of cases),
  • Displaying excessive control issues or an unwillingness to share duties (15 percent of cases),
  • Being unusually irritable, suspicious or defensive (13 percent of cases),
  • Reflecting shrewd or unscrupulous behavior (13 percent of cases), and
  • Being recently divorced or experiencing family problems (12 percent of cases).

In 45 percent of the cases in the 2020 report, the fraudster had a record of other work misconduct issues, such as bullying, absenteeism or tardiness. Furthermore, the report stated that lack of internal controls contributed to almost one-third of frauds. Be aware that annual financial statement audits aren’t specifically designed to detect fraud. Your management team is responsible for the internal controls it employs.

Smaller firms face different challenges in preventing fraud and implementing anti-fraud controls than larger entities. The most common anti-fraud controls — external audit of financial statements and code of conduct — were evident in 56 percent and 48 percent of small businesses with fewer than 100 employees, respectively, compared to 92 percent and 91 percent for larger companies.

Fortunately, fraud prevention measures don’t necessarily require you to spend an arm and a leg. For instance, a manufacturing firm might adopt a written code of conduct, require its managers to review procedures and institute anti-fraud training for all employees. In addition, you may rely on external consultants to perform independent fraud testing, when appropriate, to address these concerns.

Final Thoughts

In the current business environment, manufacturing firms must reevaluate internal controls, policies and operating procedures, training assessments and risk identification. Since the situation remains fluid, your company should be prepared to react quickly to minimize potential losses. If you suspect suspicious activity, a forensic accountant can help evaluate the situation.

Advent Valuation Advisors has extensive and varied experience in detecting fraud. Please contact us with any questions.

© 2021, Powered by Thomson Reuters Checkpoint 

Buy-Sell Agreements Vital in the Age of COVID

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A smartly crafted buy-sell agreement can spare you and your business from complications down the road. Photo by Marcelo Dias from Pexels

When a business is owned by more than one person, it’s generally advisable for the owners to enter into a contractual agreement that prescribes what will happen if an owner dies, becomes disabled, retires or otherwise leaves the company.

Some market analysts predict that the COVID-19 crisis may trigger an increase in buyouts. For example, some struggling owners may decide to throw in the towel after months of teetering on the verge of bankruptcy. Or squabbling partners may disagree about the future of the business and decide to part ways.

So, now is a good time for owners to draft or update a buy-sell agreement. Here’s a look at common valuation issues and potential pitfalls to avoid.

Valuation Considerations

“Buy-sells,” as they’re often called, may be standalone agreements or a provision within a broader agreement (such as a partners’ or shareholders’ agreement). To avoid misunderstandings and delays when redeeming a departing owner’s interest, a buy-sell should address the following key elements:

  • Appropriate standard of value (such as fair market value or fair value)
  • Definition of the standard of value
  • List of applicable valuation adjustments and discounts
  • Relevant method of quantifying valuation adjustments and discounts
  • Effective date of the valuation (for example, the year-end nearest the triggering event)
  • Buyout terms (including who will buy the interest and how payments will be made), and
  • Appraisal/redemption deadline (for example, within 30 or 90 days of the triggering event).

The buy-sell should also specify the parties’ preferred method of appraisal. Examples include a fixed price, a prescribed formula or the use of credentialed business valuation professionals.

In some cases, the owners agree to use the company’s CPA firm to perform an independent valuation of the departing owner’s interest. Other buy-sells require two outside appraisals: one for the buyer and another for the seller; the value of the departing owner’s interest is then determined by averaging the results of the two conclusions.

Potential Pitfalls

Ambiguous or outdated buy-sells can cause problems when it’s time for a buyout. For example, an agreement containing undefined valuation terminology — such as “earnings” or “value” — may be subject to different interpretations.

Likewise, the use of a prescribed formula that’s based on a simplistic industry rule of thumb might cause problems when a buyout happens several years after the agreement was executed. Industry and economic conditions may have changed, or the company’s product or service lines might have evolved.

For instance, some companies have pivoted during the COVID-19 crisis to take advantage of new market opportunities, automate certain processes, or minimize face-to-face interactions with customers.

Fixed valuation formulas that were valid before the pandemic may no longer be relevant in the new normal. This underscores the importance of creating a “living” buy-sell that’s reviewed and updated regularly to stay current.

One More Word of Caution

During a buyout, the buyer is typically either the company or the remaining owners. The seller is usually either the departing owner or the departing owner’s heirs. Because the buyer controls how financial results are reported after the seller leaves the business, the seller should be wary of the potential for financial misstatement. Financial statements often are used to value the departing owner’s interest. So, the buyer has an incentive to understate revenue and assets or overstate expenses and liabilities. These manipulations can lower the buyout price, unless adjustments are made to the company’s financial statements.

Outside Expertise

There is no one-size-fits-all buy-sell agreement. The input of a business valuation professional when drafting or updating a buy-sell can help achieve the owners’ buyout objectives and reduce disputes when and if the agreement is triggered. If you have any questions, the professionals at Advent Valuation Advisors are here to help.

For more information on buy-sell agreements, read our previous blog post here.

Lawsuit Turns on Credibility of Valuations

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A shareholder dispute involving a Nassau County business was decided based on the relative merits of two experts’ valuation reports. Photo by Matthew Henry from Burst

What makes the difference between your company being valued at $30 million or $6 million?

Sometimes, it comes down to which valuation expert’s report the judge finds more credible.

That’s what the owners of Kraus USA, Inc., a Long Island business selling fine plumbing fixtures, learned earlier this year. Sergio Magarik sued his co-owners, Michael Rukhlin and Russell Levi, in 2015, seeking to dissolve the company. (Read the petition here.) The respondents elected to buy out his interest in the company, and as a result, various claims and counterclaims were discontinued, leaving but one matter to be determined by the court: the value of Magarik’s shares. 

This required a determination of the fair value of the company as of September 20, 2015, the day before the petition was filed. Kraus is an internet-based business that sells faucets, sinks, plumbing fixtures and related items, primarily through third-party retailers. Its products are manufactured in China. The company grew rapidly, from $21 million in sales in 2012 to $36 million in 2015, but had negative cash flow and a significant amount of debt. Magarik owned 24 percent of the company, Levi, 51 percent and Rukhlin, 25 percent.

The trial included testimony from the three owners, Kraus’ controller and the valuation experts for each side. Each expert prepared a valuation based on an income and a market approach to value. Magarik’s expert arrived at a value of about $30 million for Kraus, the average of his discounted cash flow income approach ($21.9 million) and guideline public company market approach ($38.8 million).

The valuation echoed projected earnings prepared months earlier by Kraus’ controller in connection with a loan application in which Kraus’ owners represented that the company was worth more than $30 million. 

The respondents’ expert estimated Kraus was worth $6.05 million, about one-fifth the amount of the other expert’s estimate. He presented an income approach based on capitalization of earnings ($6.16 million) and cash flow ($5.9 million and $6.1 million). His market approach, a “merged and acquired company method” method relying on Pratt’s Stats database (now DealStats) for comparable transactions, resulted in a range of values from $5.3 million to $6.1 million. 

Justice Vito DeStefano found that Magarik’s expert did not sufficiently account for the level of competition Kraus faced or its lack of cash flow, and that it overestimated the value of the Kraus brand, which Kraus did not actually own. 

“The court does not accept the valuations provided by petitioner’s expert … as they exceeded the true value of the business, were based on income projections that were unrealistic and optimistic and not based on appropriate comparable businesses. Moreover, the two valuations provided were vastly disparate from each other, underscoring mistaken premises and assumptions.”

“In reality,” the justice wrote, “the value of the business was never $30 million and the projections contained in the loan application were never realized.” Justice DeStefano accepted the $6.05 million valuation presented by the respondents’ expert, which he found to be “supported by the credible evidence which demonstrated a successful and growing business that was not especially liquid.” (Read the decision here.) He applied a 5 percent discount for lack of marketability – less than the 25 percent DLOM sought by the respondents. The petitioner had not applied a DLOM.

The resulting value of Magarik’s 24 percent interest was calculated to be $1,379,400. Justice DeStefano added interest of 9 percent dating back to the filing of the petition, and gave Kraus two years to make the payment, in deference to the company’s cash flow difficulties.

For more on the two valuations, you can read the parties’ post-trial memoranda here and here. The case is Sergio Magarik v. Kraus USA, Inc., Michael Rukhlin and Russell Levi, Index No. 606128-15, Nassau County Supreme Court.

The decision in Magarik underscores the importance of securing a credible, defensible business valuation. The professionals at Advent Valuation Advisors offer a full range of business valuation and litigation support services. If you have any valuation needs, the professionals at Advent are here to provide a credible valuation.