Tax affecting is alive and well in the Delaware Court of Chancery, as new Chancellor Bouchard’s recent decision in a joint fiduciary duty and appraisal action makes clear. As part of the discussion, the court addressed the issue of whether or not a valuation based on the controlling Kessler model should consider the company’s earnings distribution policy.
‘Blitzkrieg-style’ merger: A company’s former president sued his partners—and the company—alleging they orchestrated a “boom, done, Blitzkrieg style” merger in which he was cashed out for a mere $26.3 million. At the same time, he petitioned the court to determine the fair value of his shares. The company was organized as a Subchapter S corporation.
Both of the opposing valuation experts performed DCF analyses but arrived at spectacularly different conclusions. According to the petitioner’s expert, the stock’s value was $52.65 million. In contrast, the company’s expert said it was worth $21.5 million. Tax affecting was one of the major disagreements shaping the results. The petitioner’s expert concluded it was appropriate to tax affect the company’s earnings using a 21.5% tax rate to account for its S corp status. The company’s expert rejected tax affecting and applied a 44.8% tax rate. But he said that, if the court were to tax affect, it should use a 34.1% tax rate. This rate was based on the premise that the petitioner should only receive the value of being an S corp stockholder for the actual distributed earnings (76.7%), not for earnings the company retained and reinvested in the company (23.3%).
The court found this rationale problematic. At the start of its analysis, it noted that the petitioner had a right to that which had been taken from him. “A critical component of what was ‘taken’ … in the Merger was the tax advantage of being a stockholder in a Subchapter S corporation.” It said that adequate compensation for the petitioner’s loss required tax affecting the company’s earnings as part of a DCF valuation.
Operative metric: In terms of how much of the earnings should be subject to tax affecting, “the operative metric under the Kessler-based valuation method is not the actual distribution made by a Subchapter S corporation, but the amount of funds that are available for distribution to stockholders.” To conclude otherwise would deprive the petitioner of “his proportionate interest” in the company as a “going concern,” the court said. Also, here, the company did not actually reinvest significant amounts of its undistributed earnings in the business. Instead, it kept the earnings as cash on its balance sheet. And it did not need to reinvest earnings to grow. Both experts testified that the relevant projections included all of the capital expenditures necessary to enable the company to generate the projected future cash flows.
Using the Kessler model, the court determined the appropriate tax rate was 22.71%. Under its own DCF analysis, it valued the petitioner’s shares at $42.16 million.
Takeaway: Experts using a DCF analysis in a fair value proceeding must treat company earnings in a way that accounts for the tax advantages of being an S corp stockholder, i.e., tax affect. What matters is the amount available for distribution to stockholders, not the company’s decisions of how much to distribute.
Find an extended discussion of Owen v. Cannon, 2015 Del. Ch. LEXIS 165 (June 17, 2015) in the October issue of Business Valuation Update; the court’s opinion will be available soon at BVLaw.
Extra: The recent book, Taxes and Value: The Ongoing Research and Analysis Relating to the S Corporation Valuation Puzzle, is a major advance in thinking about tax affecting with respect to pass-through entities. The book, authored by Nancy J. Fannon (Meyers, Harrison and Pia LLC) and Keith Sellers (University of Denver) is available from BVR. For more details, click here.