Further debate on whether pass-through entities create additional value

BVWireIssue #96-4
October 29, 2010

In last week’s BVWire™ piece “Three Fallacies when Tax Affecting”, Mark Harrison (Meyers Harrison & Pia) asked readers to consider some statistics that undermine the “29.4% benefit” that seems to often appear post-Bernier and Delaware MRI.

In a letter to the editor, David Bishop (Bishop & Company) responded: 

1.  I understand the point that the actual tax rate of a small company might be lower than the rate used for tax affecting but I am wondering: Why even use an after-tax valuation method with such a small company? If the company is so small that you have to consider the actual tax rate, isn’t it too small to be comparing to public companies (where you get the after-tax information).   Seems like information from public companies would not be very helpful because of the disparity in size. Why not use a pre-tax valuation methodology such as a multiple of EBITDA—the way it is done in real world transactions for small companies.

2.  If the likely buyer is a larger company, it seems like the relevant marginal rates are those applicable to a buyer rather than the seller.  In those cases, why should the buyer care what the seller would pay?  In creating the hypothetical tax rate, isn’t it more important to consider the likely tax rate of the buyer?

3.  I understand the judge in the case also assumed that all earnings would be paid out while you make the point that most of the earnings are not paid out.  Isn’t it flawed to even consider distribution rates when calculating tax rates (cash flow available to a shareholder is a different concept from net income)?  But if you do consider distributions, shouldn’t you assume a 100% distribution to make sure your method is consistent.  In other words, tax affecting uses hypothetical rates not real rates.  Why is the real distribution rate relevant in this methodology?  Seems like using actual distribution rates would distort your results because some business like to keep more cash in the business just because they don’t want it to be in the family bank account (a form of mental accounting), not because the business needs it.

4.  Looks like to me that business appraisers and courts get tied up in all these contortions because they are trying to use after-tax net income from public companies as the guideline information. Apparently, they think it is more scientific when in fact almost all of these transactions in the real world are priced on a pre-tax basis.  No need to jump through all these extra hoops unless you goal is to be precisely inaccurate.

Any thoughts?  Send your response to editor@bvwire.com.

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