When Do Companies Need Valuations?

I’m Eric Sundheim, CEO & Principal at Mercovus Valuations. This is a presentation I've given many times in the San Francisco Bay Area to other B2B service providers. After giving the presentation, many attendees have asked me, "Is this available online somewhere?" Well, now it is.

The inspiration for this topic came from my attendance at networking events where I frequently field the question, “You do valuation – is that like for M&A or something?” If you're an advisor to a company, you definitely need to stick to your own lane, but you also need to know what's going on in other lanes. And if M&A is all you know about valuation, you're missing a lot: Valuation is an integral part of tax, accounting, legal issues, and insurance. This presentation will hopefully inform you about how valuation is involved in those areas.

Credentials

I am credentialed as an Accredited Senior Appraiser by the American Society of Appraisers (ASA). When people think about obtaining a valuation, their first stop is usually their tax preparer. I don't prepare taxes, and the other appraisers I know don't prepare taxes. It's a different discipline. If you're looking for someone to provide a business valuation, you want to find somebody that specializes in this field.

I've been appointed as an expert witness by California judges; I have an IRS (Internal Revenue Service) security clearance; I’ve provided expert testimony before the SEC (Securities and Exchange Commission); I've been published in the Business Valuation Review; I have courses that are provided by Business Valuation Resources and Forbes. These are the kinds of things you'd expect to see from a professional appraiser who's going to put together a good work product and defend that work product before an adverse third party.

Valuations Are Not Fungible

As we talk about these next seven subject areas, the first place to start is with an understanding that there's no such thing as “a valuation.” Valuations are not fungible. They're authored as of a specific point in time (we call that the Valuation Date), for a specific purpose, and they value a specific asset. That asset could be common stock, it could be equity, it could be the business enterprise, a security like convertible debt, or SAFEs (Simple Agreements for Future Equity). So, there's not such a thing as “a valuation.”

The purpose of that valuation could inform the concluded number. Even if we're talking about the same security as of the same date, if I'm doing an appraisal for tax purposes versus investment purposes, I might get a very different value. So, it's important to understand that, just because you have a valuation for tax, that doesn't mean you can use that value for your divorce because, among other things, the appraiser is not going to defend it for that purpose. “We have a valuation” is usually a starting point for a conversation – not an ending point.

Fairness Opinions

So, yes, we do valuations in the context of M&A (Mergers and Acquisitions), but it's not frequently in the way that most people think about it. If a company is going to enter in a transaction, the Board of Directors will make that decision. And you might have a Board member that was the lead investor in your Series B. You think of them as the Series B director, but that Series B director has a duty – not just to themselves and the other holders of Series B – but also to the holders of all interests in the company. And in satisfying that fiduciary duty, the Board members frequently seek a third-party opinion of value to show that they're not behaving in any improper self-dealing.

There might be a transaction that's very good for that Series B class but results in no value to common. If that happens, expect a lawsuit from common shareholders. Something like this happened in this court case, Smith v. Van Gorkom. The court found that the Board did not satisfy its fiduciary duties. It specifically pointed out that, had the Board obtained a fairness opinion, they might not have been liable. So, this was an indication for everybody contemplating a transaction to obtain fairness opinions.

The SEC has made a similar comment regarding continuation funds. Fund managers’ compensation is based on the value of their managed portfolio. When they establish a continuation fund, LPs (limited partners) want to make sure managers are not receiving undue compensation as a result of these stated values. So, managers could seek a fairness opinion with regard to that as well.

Any time there's a transaction where a Board member is going to opine on a value, then it's a good time for them to talk to a firm like Mercovus about getting a fairness opinion.

Equity Grants

We're located in the San Francisco Bay Area, and in the Bay Area, cash for companies is like water in the desert: It’s very hard to come by. But equity is like sand in the desert, and companies are relatively happy to distribute it. Many employees here receive equity as part of their compensation package.

An engineer might receive RSUs (Restricted Stock Units), incentive stock options (ISOs), or cryptocurrency. These are all taxable, just like when you receive cash: You must pay taxes on it. That means the companies are required to report values to know how much tax is owed on them.

You might also need a value in setting the terms of that compensation. For stock options, companies want the strike price of those options to be at or above the fair market value of the security into which they're exercising. It’s for that purpose that they obtain a 409A valuation.

This is not just a tax issue; it's also an issue for accounting. If you’re issuing equity, you will to have a line item on your P&L called Stock-Based Compensation (SBC). When your audit firm audits that line, they're not allowed to opine on what the value of your stock is (because they're conflicted out of that work). But they're also not supposed to just accept whatever you say is. So, they have to test the assumptions behind the valuation.

If a company is granting stock-based compensation, for both tax and accounting reasons, they're going to want to obtain a third-party valuation.

Spin-Offs

Another thing we've run into a lot are spin-offs. That’s typically when companies have been hatching this egg, and when they crack it open, they realize there are two businesses inside. Maybe they've been developing a service product, and in conjunction with that, they developed some software, and that has applications well beyond just this service business. It could have applications to other industries. And there are a whole set of different investors that are interested in funding that. So, we might see a company spin off or split off those assets into a new entity and create two businesses.

There are many ways to effect that. There are very different tax consequences, depending on how that's structured. But in any event, you're going to need a tax basis in the new entity. So just like when you purchase Amazon stock from Vanguard, the price on that day that you bought it sets the basis for that stock purchased. Similarly, we need to know the basis in your new entity that's been spun off. So, if you hear a company say, “We realize there's two businesses,” know that they're probably going to need a valuation for that.

Purchase Price Allocation

Another time it might get brought in is after an acquisition has taken place. Some might wonder, “Well, after an acquisition, hasn't the price already been set?” Yes, but there's going to be some accounting that needs to happen with regards to that acquisition. And it's not always clear what the total price was in that acquisition. If the purchase consideration included both cash and stock, or there's some sort of earn out, the value of the purchase consideration is debatable.

Companies will obtain third-party valuations, which are called Purchase Price Allocations (PPAs), to determine the purchase value and allocate the purchase price into various categories of assets on the balance sheet. Working capital and property, plant, equipment, are items yes, but there's also different categories of intangible assets. Those could include developed technology, in-process R&D, customer relationships, and goodwill. Companies will seek a third-party purchase price allocation to help account for this purchase even after it's taken place. So, if you hear someone say "We bought another company," that's a good person to refer to Mercovus.

Estate and Gift Transfers

Now we get into estate and gift transfers. Around Series D, we start to see tech executives get rich on paper. And these executives know they're going to be even richer in terms of cash once there's an IPO or acquisition. Series D is therefore a good time to do some estate planning. We'll often see executives make gifts to irrevocable trusts, and those gifts are probably going to be at a lower value than what that stock ends up being worth in the future. But the executives do need to know exactly what that value is now to report on their gift taxes and track their estate exemption.

So anytime there's a transfer like that, that person's going to obtain a valuation. They're even going to get a valuation if it's done for charitable purposes. Any time there's a tax deduction claimed on property that's worth more than $5,000, the IRS requires the taxpayer to obtain a third-party valuation to establish what that valuation is and substantiate it.

So, if you hear somebody say, "Our CEO is making a gift," whether that's a charitable gift, or an estate-planning-type gift, know they're going to need a valuation.

Buy-Sell Agreements

Alright, so the last one, you might have to generate these words yourself. And those words are, “Do you have a Buy-Sell Agreement?” A Buy-Sell Agreement is probably the most important document for small businesses with simple ownership structures. By simple ownership, I mean two owners, 50/50, or three owners, 1/3, 1/3, 1/3.

Oftentimes, these owners have more foresight and hair pulling over fear about their personal relationships than they do their business relationships. We've worked with executives that have prenuptial agreements, but they don't have Buy-Sell Agreements. Well, just like things can go South in personal relationships, they can go wrong in business relationships too. You want to plan ahead for how things will be handled in that scenario. So, that’s one reason to obtain a Buy-Sell Agreement.

Another reason to get the Buy-Sell Agreement would be in the untimely death of one of your partners. Maybe you have a partner that you've worked with for ten years, and you don't want 50% of your business’s equity going to that person's spouse when they pass – because that spouse may not know anything about the business. So, you want to be able to repurchase that interest while fairly compensating that spouse. A Buy-Sell Agreement can account for all that before there's a problem.

It's nice to come to an agreement when everybody's sitting on the same side of the table. Now, the way these are typically structured, it’s almost like a full-employment provision for the appraisal profession because they say “Well, one party should get a valuation, the other party should get another valuation, and if those two numbers are more than 10% off, then we'll get a third valuation.” That's great for us as a profession, but I don't think it's great for the clients. There are better ways to structure that. So, we've been called in to quarterback how to structure and fund these buy-sell provisions. So if you hear anybody saying, “We're getting a Buy-Sell” or you're asking them, “Do you have a Buy-Sell?” and they say, “No,” that's a good time to bring in Mercovus.

So that's my quick overview of the different types of work that we can do. Please reach out to me with any questions you have. I'm Eric Sundheim, Principal and CEO with Mercovus Valuations. Thanks so much for your time.

Eric Sundheim, ASA

Principal

Mercovus Valuations