Non-compete agreements are often implemented when a business is purchased to prevent the seller from competing with the purchaser. These agreements, referred to as Covenants Not to Compete, contain restrictions which often include a specified length of time and geographic area in which the seller is prohibited from competing with the purchaser. These agreements are considered intangible assets of the Company and need to be valued for purposes of allocating the purchase price of the Company.
One way a valuation analyst could value Covenants Not to Compete and other restrictive agreements is by using a “with or without” method. This method compares the value of the Company “with” the agreement in place – thereby assuming no competition from the seller and “without” the agreement in place – thereby assuming the seller competes with the Company. The “with” model is based on the Company’s projected net income over the period of the covenant. The method uses a discounted cash flow for the period of the covenant. See Table 1
The “without” assumes competition from the seller exists and uses projections based upon that assumption. In determining the projections, the analyst must understand:
- The relationships which exist between the seller and the customers;
- The ability for the seller to maintain those relationships beyond his/her affiliation with the Company;
- Whether or not the relationships also exist with key employees of the Company;
- Do barriers to entry exist which would limit the sellers ability to compete;
- The age, general ability and willingness of the seller to compete;
- The intention of the seller to remain in the geographic area;
- The ability of the Company to prevent a customer from leaving;
- The probability that competition will affect the Company.
The analyst will need to have extensive discussions with Company management to gain an understanding of the above factors. The projections will be subjective based upon the analyst’s understanding of the factors.
Once a value is determined “without”, the value of the covenant is the difference between the value “with” and “without” the covenant in place. See Table 2
A qualified valuation analyst should be consulted when a Covenant Not to Compete or any intangible assets need to be valued.
By Melissa E. Loughlin-Sines CPA, CFE, CVA, CFF, ABVPosted on July 22 2014 by admin
In recent years, the number of companies converting from C corporation status to S corporation status has increased dramatically. One of the main reasons is to avoid double taxation. C corporations are taxed at the corporate level for federal income tax purposes. Additionally, the C corporation shareholders are also taxed on any capital gains realized by the shareholder and on any dividend income distributed from the C corporation. However, the shareholders of an S corporation pay only one level of federal income tax. This is because the S corporation does not pay any federal income tax but rather passes it through to the S corporation shareholders.
If a company meets the eligibility requirements for conversion from a C corporation to S corporation (*) , the next step is to recognize that there is a number of potentially costly tax issues associated with the conversion. One of the primary tax implications is the Built-In-Gains (“BIG”) Tax, which applies if assets are sold or distributed within five years after the conversion (**). BIG Tax requires the corporation to measure the amount of unrecognized appreciation that existed at the time an S conversion was made. In order to do this, the fair market value of the corporation is measured at the effective date of the S election as compared to its tax basis. Fair market value is defined in Revenue Ruling 59-60 as follows (***):
The price at which the property would change hands between a willing buyer and a 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.
The amount of unrecognized gain is determined for each separate asset. This includes assets that are not reflected on the corporation’s balance sheet such as goodwill, patents and trademarks. The net of unrecognized built-in gains and built-in losses is the company’s unrecognized built-in-gain. Any of this built-in gain recognized during the five-year period beginning with the first day of the first tax year for which the corporation was an S corporation remains subject to corporate level tax at the highest rate of tax applicable to corporations (currently 35%).
In order to document the assets on hand and keep track of their future sale, a qualified appraisal to determine fair market value is essential. Statutory presumptions applicable to the built-in gains tax effectively require taxpayers to prove their case to the IRS’s satisfaction. All gains recognized by an S corporation during this recognition period are presumed to be recognized built-in gains, except to the extent the taxpayer establishes that a portion of the gain constitutes post-conversion appreciation or that the asset was not held at the beginning of the recognition period. Without a qualified appraisal, the corporation runs the risk of subjecting the entire gain from a sale to corporate level tax during the entire recognition period.
Understanding the potential tax consequences due to a conversion from a C corporation to an S corporation is extremely important and typically requires the involvement of a tax adviser, legal counsel and a business valuation professional.
By Cindy Andresen, ASA
(*) Eligibility requirements can be found in IRC Section 1361 and the corresponding Regulations.
(**) Before 2009, the BIG tax applied to gains recognized during the first 10 years after the S election was effective. In 2009 and 2010 this was shortened to 7 years and temporarily shortened to 5 years in 2011. The American Taxpayer Relief Act of 2012 extended the 5 year recognition period to 2012 and 2013. H.R. 4453 would amend the Internal Revenue Code to make permanent a 5 year recognition period, retroactive to January 1, 2014.
(***) Source: Sec. 2.02, Revenue Ruling 59-60, 1959-1 C.B. 237, Internal Revenue Service.
Sources: Tax Implications of Converting from a C-Corporation to a S-Corporation, by Nicholas P. Hoeft, November 2011
The Tax Adviser, Now is the Time: Converting a C Corporation to an S Corporation or LLC, by Michael F. Lynch, J.D., CPA, David B. Casten, J.D., LL.M., CPA, and David Beausejour, J.D., CPA, August 1, 2012
The Tax Adviser, The S Corporation Built-In Gains Tax: Commonly Encountered Issues, by Kevin D. Anderson, CPA, J.D., March 1, 2012Posted on July 15 2014 by admin
I am often asked to review the provisions in a buy/sell agreement related to the question as to how value is determined. This sometimes occurs when there is a triggering event. Unfortunately, in those circumstances, we simply determine value based on the agreement. Sometimes the resulting value is favorable to one party to the detriment of another. Other times the language of the agreement is subject to interpretation resulting in unnecessary disputes and possibly litigation. There are advantages, disadvantages and pitfalls to avoid in drafting these agreements.
I reviewed a recent agreement that defined the purchase price for triggering events to be determined pursuant to a formula. The benefit to a formula driven approach is simplicity (as long as the formula is well-defined) and valuation certainty. The challenge with a formula approach is that, while the formula may reflect a fair price at the date of the agreement, it may also become quickly out of touch with actual value for a future transaction.
Another agreement had a defined value agreed on by the shareholders with periodic updates required. However, updates are frequently not performed. In addition, it should be clear whether the agreement requires a determination of value of the enterprise or value of the minority interest to be valued.
Certain terms have specific meanings in the finance, accounting and valuation literature, and care should be taken in selecting those terms to avoid misinterpretation or unintended results. Some common terms include:
- “fair market value”
- “fair value”
- “book value”
- “net book value”
- “net income”
- “generally accepted accounting principles”
- “accounting principles consistently applied”
An alternative to a formula approach is a process-driven value determination. As an example, the agreement might provide that the value is to be determined by a qualified appraisal performed by a qualified appraiser. The appraiser could be pre-selected or agreed on by the parties upon a triggering event. If the parties could not agree on the appraiser to be selected, a mechanism could be created to determine the appraiser to be retained. Periodic appraisals could also be performed with either named appraisers or through a selection process.
Other considerations include the options/rights of the parties and the terms of payment for any purchase of equity interests in the Company on a triggering event. Care should be taken that the terms of payment are aligned with the cash flow requirements of the business and the estate planning requirements of the parties.
These are just some of the basic considerations for a properly aligned buy/sell agreement. Now might be a good time to revisit your buy/sell agreement and consider updates.
By Steve Koons, CPA, ABV, CFF, ASAPosted on July 1 2014 by admin
“The Obama administration has begun trying to relax some of the post crisis efforts to tighten mortgage-lending standards over concerns that the housing sector … is struggling to shift into higher gear.” – Wall Street Journal, June 16, 2014 edition
Prospective home buyers may be getting some great news in the near future that may enable them to quality for a residential mortgage. As a frame of reference, regulators in 2013 issued a proposal related to down payments required by lenders that included two options.
Option 1: Eliminate the down payment requirement in favor of mortgage-lending rules that require banks to verify a borrower’s ability to repay a loan. (*)
Option 2: Increase the down payment requirement to 30%.
With the exception of the Securities and Exchange Commission (SEC), most agencies, under pressure from lawmakers, the housing industry and consumer groups, endorsed the first option. They argued that a significant down payment requirement could harm the fragile housing market.
However, about two weeks ago the Wall Street Journal reported that the SEC is contemplating the approval of a policy whereby (1) regulators would not require a down payment; and (2) banks and other issuers of mortgage-backed securities will no longer be obligated to retain a portion of the credit risk on their books. SEC Chairman Mary Jo White has agreed to essentially adopt the revised mortgage rule without down payments as long as regulators agree to frequently reevaluate the rule to ensure it is imposing restraint on the mortgage-backed securities market.
The aforementioned policy is consistent with the Obama administration’s recent initiatives to begin relaxing some of the post 2008 financial crisis efforts to tighten mortgage-lending standards over concerns that the housing sector, traditionally an engine of economic recovery, is struggling to shift into higher gear.
It is my personal opinion that applicants for home mortgages should be required to put down at least a 10% down payment and have a minimum credit score of 660 because these criteria enable lenders and regulators to predict the ability of the borrower to pay back a home loan. (**) I strongly support the American dream of home ownership, especially for young families, but not at the cost of rekindling another financial crisis for this country. What are your thoughts? Please share them with me at firstname.lastname@example.org.
By Gary Ringel, CGREA
(*) Rules promulgated by the Consumer Financial Protection Bureau.
(**) Mortgage lenders generally will follow the Freddie Mac standards when making their loan and interest rate decisions. Potential borrowers with a credit score around the 660 level will probably be offered standard loan products and interest rates. Borrowers with higher credit scores will be offered a wider selection of types of loans and will be offered lower interest rates.
Dodd-Frank Wall Street Reform and Consumer Protection Act
June 16, 2014 edition of the Wall Street Journal
Appraiser News Online published by the Appraisal Institute
As a forensic accountant, I was recently involved in the mediation process of a very complex divorce case. Due the nature of the case, preparing for trial would be a long and expensive process for my client. In addition, in order to resolve the issues satisfactorily for both parties, a creative, and somewhat nontraditional, approach was needed.
A forensic accountant can be a valuable asset in the mediation or arbitration process. The parties will have a better chance of settling the case if they are well prepared and have a good understanding of the financial aspects of the case. Forensic accountants can prepare schedules and documents to support a position, as well as provide a comparative analysis of the two opposing positions to help the parties understand where they may be in agreement and where they are in dispute.
After many years of being involved in litigation support services, I have seen first-hand that the litigation process can be extremely wearing, as it becomes an emotional and financial drain on the parties. Some of the reasons that I have seen parties look for alternative solutions are as follows:
- Mounting attorney and expert fees associated with the case;
- Numerous delays caused by the court docket or other issues;
- Risk of an unsympathetic or unsophisticated jury, that may not understand the complexities of the case;
- Sensitive or embarrassing personal or business information (such as cheating on taxes);
- Emotional strain on the parties, their families and/or employees and business associates.
These factors combined with the possibility of losing their case in court may cause clients to be open to an alternative resolution. Two of the most popular alternatives are mediation and arbitration. Mediation allows the parties involved to air their differences in a more relaxed environment. Both parties will generally describe their version of the dispute to a mediator. The mediator does not make any decisions, but acts as a bridge to help the parties discuss their differences, see both sides of the issue(s) and come to a voluntary settlement. One of the benefits of mediation is that it can often foster a creative solution that both parties feel is acceptable. However, due to the voluntary nature of mediation, a highly controversial issue often will not be resolved in mediation.
Arbitration involves a forced settlement in a less formal environment than a courtroom. The arbitrator will objectively listen to the explanation of both parties before making a decision on the issue, similar to a judge. The decision may be binding or non-binding. Arbitration is beneficial when there is a highly contentious or emotional issue, but is generally not as likely as mediation to please both sides.
A forensic accountant can be extremely beneficial in preparing the parties and attorneys for mediation and arbitration. In addition, the forensic accountant may attend the conference/hearing, or be available by phone to assist in explaining a financial issue when needed. Furthermore, if the parties do not come to a settlement, then the forensic accountant will be in a situation to assist in preparing for trial.
By Julia Allen Miessner, CPA/CFFPosted on June 17 2014 by admin
The Association of Certified Fraud Examiners (ACFE) has released its bi-annual “Report to the Nations on Occupational Fraud and Abuse”. The study, issued since 1996, looks into the costs, schemes, perpetrators and victims of occupational fraud. Occupational fraud is “the use of one’s occupation for personal enrichment through the deliberate misuse or misapplication of the employing organization’s resources or assets.” (*)
The 2014 study is based upon 1,483 cases of occupational fraud reported by Certified Fraud Examiners (CFEs) from all around the world with nearly half of the cases (646) occurring in the United States. I always find this survey to be very interesting and it provides great insight into what is happening all around us. I have outlined some of the most interesting statistics below.
- The median loss across all 1,483 schemes was $145,000 with 54.4% of all cases resulting in losses of less than $200,000.
- More than 21% of cases resulted in losses in excess of $1,000,000, up slightly from the 2012 survey.
- Occupational Fraud falls into three major categories:
- Corruption, which includes conflicts of interest, bribery, illegal gratuities and economic extortion
- Asset Misappropriation, which includes thefts of cash, receipts or other assets such as inventory, fraudulent disbursements or misuse of inventory or other assets
- Financial Statement Fraud, which includes overstatements or understatements of assets, revenues, expenses, and/or liabilities
- Consistent with the 2010 and 2012 surveys, asset misappropriation accounted for the majority of cases of fraud in the 2014 survey (85.4%).
- The median loss from asset misappropriation schemes was $130,000.
- Financial statement fraud occurred most infrequently (9%) but resulted in the highest median loss ($1,000,000).
- Nearly one quarter of all the cases lasted less than 7 months with median losses of $50,000.
- Those cases lasting more than 5 years (8.8%) resulted in median losses of $965,000.
- The median loss for organizations with less than 100 employees was $154,000, up from $147,000 in 2012.
- The median loss for organizations with greater than 10,000 employees was $160,000, up from $140,000 in 2012.
- Just over 60% of all cases were referred to law enforcement for criminal prosecution.
- Civil suits against the perpetrator were brought in only 22.2% of the cases.
- Victim organizations had no recovery of losses in 58.4% of the cases.
Fraud is all around us and cannot and should not be ignored. Management must be ever aware of its possibility and continually assess the risk of its occurrence in their organizations.
The complete 2014 Report to the Nations can be found on the Association of Certified Fraud Examiner’s website at www.acfe.com.
By Melissa E. Loughlin-Sines CPA, CFE, CVA, CFF, ABV
(*) 2014 Report to the Nations on Occupational Fraud and Abuse, Association of Certified Fraud ExaminersPosted on June 10 2014 by admin
In October 2010 the Department of Labor (DOL) proposed a regulation that would classify business appraisers who perform appraisals for Employee Stock Ownership Plans (ESOPs) as ‘fiduciaries’ under ERISA. In September 2011, the DOL withdrew its proposed regulation. The DOL has indicated it intends to re-propose the rule after this year’s mid-term elections. The issue has resurfaced again as the DOL believes that conflicts of interest and problematic appraisals are commonplace.
According to an article published by the Business Valuation Committee of the American Society of Appraisers, the DOL has the following primary areas of concern (*) :
- Company Projections. The DOL perceives that ESOP advisors (including trustees and appraisers) often rely on overly aggressive company projections without an adequate investigation of the credibility and reliability of such projections.
- Conflicting Roles. The DOL perceives that an ESOP appraiser who conducts the ‘ESOP feasibility study’ and is subsequently retained by a trustee to prepare an appraisal related to the stock purchase may taint the impartiality of the appraiser.
- Control Premiums. The DOL perceives a problem when a party sells stock to an ESOP at a ‘control price’ and then fails to transfer sufficient control to the ESOP (e.g. the seller maintains control of the company board of directors).
- Seller Financing Issues. The DOL perceives an issue where ESOP transaction seller financing – which is frequently structured with a lower interest rate than could be obtained from an arm’s length lender – is ‘discounted’ below its face value due to its below-market terms.
- Internal Inconsistencies. The DOL perceives that many ESOP appraisal reports are internally inconsistent. For example, the DOL has noted instances where the narrative description of the financial analysis is inconsistent with the report exhibits, or where the appraisal conclusions are inconsistent with the economic, industry or company analysis.
While many appraisers believe a newly proposed fiduciary rule is not the answer to these perceived wrongs in the ESOP appraisal practice, it does set the stage for healthy dialog among business appraisers on how appraisal practices can be improved. This shift from stopping a proposed rule to taking action and improving ESOP valuation practices is a positive development in the ESOP community.
By Cindy Andresen, ASA
(*) BV Success E-Letter 18-22, June 4, 2014: “Proposed ‘Fiduciary’ Rule Already Having an Effect on ESOP Appraisers” by Jeffrey S. Tarbell, Houlihan Lokey, and Lars C. Golumbic, Groom Law Group, a publication of the Business Valuation Committee of the American Society of Appraisers.Posted on June 3 2014 by admin
Believe it or not, approximately four years have passed since the end of the Great Recession according to economists who spoke last month at the 2014 Annual Economic Outlook Luncheon hosted by the W. P. Carey School of Business at Arizona State University. Dennis Hoffman, an economics professor, observed that at a state and national level this recovery differs from the ones following the 1980s and 1990s recessions. “The real challenge has been a dearth of consumption,” he explained. “Debt is the new four-letter word. Consumers are ridding themselves of debt and that is a drag on the economy.”
An alarming statistic published by the U.S. Bureau of Statistics in March reports that the U.S. has regained 99% of lost jobs since 2008 while Arizona has only regained 56% of its lost work force. The chart below includes some disconcerting facts regarding most sectors of the Arizona economy that continue to suffer. However, there is encouraging news for the finance and food industries.
“Government spending is actually below what it was prior to the recession.”
“In terms of the quality of jobs being regained, however, Arizona is doing comparatively well. Nationwide, 4 percent of new jobs created in 2013 were in finance. Phoenix was the number one metropolitan area for finance jobs both in terms of rate of growth and absolute number of jobs created. Thirteen percent of new jobs added in Arizona were in health care and another 13 percent were in construction — good jobs at good wages.
“..there’s a 30 percent chance that economic growth could be faster this year, with GDP growth at 3 percent. That’s a level of growth that we haven’t seen for the better part of the last decade, though it’s a level that is considered normal in the long run. Factors that could lead to the faster-growth scenario include less chatter in Washington about fiscal crises, continued stimulus from the Fed, resurgence in consumer confidence and spending, a resurgence in trade, rising housing prices and no more severe weather.”
“So what’s the problem? There are simply not enough jobs. Arizona is an economy that should be producing at least 100,000 new jobs a year — that’s what we did in 2005. In 2014, the state will probably add 60,000 new jobs. In other words, we’re running at half speed.”
“Arizona ranks eighth in the nation in population growth, but at 1.2 percent in 2013 and 1.4 percent forecasted for 2014, growth is not very strong. A year ago, Arizona was ranked third among destinations for people relocating; now Arizona is sixth. And that is slowing down economic growth.”
In summary, our research indicates the recession hit earlier and harder in Arizona and the recovery has been slower than in other parts of the country. Unfortunately, Phoenix and Arizona will not experience a full recovery for at least the next couple of years and it is quite possible that our economy will never again experience the level of expansion seen in prior decades.
The sources for the quotes in this blog are Dennis Hoffman and Lee McPheters, Director of the JPMorgan Chase Economic Outlook Center at the W. P. Carey School, which were included in a May 14, 2014 article in sonorannews.com.
By Gary RingelPosted on May 27 2014 by admin
When I have to testify regarding my opinion of value regarding the ownership interest in a business, I have found a particular strategy that speeds up my time on the witness stand. The strategy often helps settle not only business valuation differences between appraisers, but those relating to economic damages cases as well – before they get to the courtroom.
For example, if the litigated matter involves a business valuation, I prepare a schedule showing, in summary fashion, the components that make up the pieces of my valuation. I also show on the schedule how the opposing expert treated the same parts. Many times we will have several of the components in agreement. Those parts where we are in disagreement are highlighted. If the case goes to trial, the judge or jury can then focus on the parts of the two experts’ reports where they show disagreement.
This type of schedule saves time in the courtroom because attorneys do not have a need to ask questions regarding every figure used by each expert in arriving at their final conclusions of value of a business interest or the amount of economic damages calculated. I have used this schedule to collaborate with opposing experts on both business valuation and economic damages cases. The schedule simplifies the areas where our calculations are different and promotes compromise between experts towards efforts to narrow the gap of disagreement to a range acceptable by the opposing parties.
By Don Bays, CPA/ABV, CVA, CFFPosted on May 20 2014 by admin
- The state’s unemployment rate remained unchanged at 7.3% in March. The U.S. rate was also flat in March at 6.7%. A year ago, the Arizona rate was 8.0% and the national rate was 7.5%.
- In March, the state gained 47,400 jobs compared to a year ago. This is a 1.9% growth rate. Greater Phoenix gained 39,900 jobs over the year ending March for a 2.2% growth rate. Greater Tucson grew by 3,100 jobs or a 0.9% gain. (*)
- While the U.S. has regained virtually all the jobs lost in the last recession, the state has regained just 57% and Greater Phoenix has regained 63%. This is because the decline in Arizona was greater and the recovery started later than in the U.S. as a whole.
- For the first 3 months of the year, Arizona is 12th out of 50 states in terms of percentage growth in jobs (see chart below). Greater Phoenix is 11th out of 27 major employment markets in the U. S. for the same period. While this is satisfactory, it is well below the ranking the state and Greater Phoenix usually hold at this point in the business cycle.
Sluggish Population Growth Responsible For Disappointing Employment Increase
Many prominent economists believe Arizona’s relatively poor employment numbers and slow recovery from the Great Recession is due in large part to the continued slow rebound in population growth. If more people were moving in, it is believed, more jobs would be needed to support those new residents.
The primary sources for information in this blog were The Monday Morning Quarterback published on April 21, 2014 by Elliott D. Pollack & Company and an article printed by ASU W.P. Carey School of Business on December 4, 2013.
By Gary Ringel
(*) The largest numerical gains were in Education and Health services, Trade, Transportation and Utilities, Financial Activities, Professional and Business Services, and Leisure & Hospitality.-- Older Entries »
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