Shareholder Disputes Complex Valuation Issues and Potential Solutions

Shareholder Disputes Complex Valuation Issues and Potential Solutions Daniel R. Van Vleet, ASA Managing Director Stout Risius Ross, Inc. dvanvleet@srr.com

Overview The Delaware Chancery Court and S Corp Valuation Valuing S Corp Equity with an ESOP in Place 2

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The Delaware Court of Chancery and S Corp Valuation

The Delaware Court of Chancery 6/17/2015 Owen v. Energy Services Group 4/26/2006 Delaware Open MRI v. Howard B. Kessler Bernier v. Bernier, Massachusetts Supreme Court Some have suggested that the Delaware calculations are an S corp valuation model Calculations are not a model and only correct in limited circumstances Calculations are a limited-use mathematical reworking of the Van Vleet Model 5

Relevant C Corp and S Corp Tax Attributes C corps subject to entity-level income taxation S corps not subject to entity-level income taxation C corp dividends subject to shareholder-level taxes S corp distributions not subject to shareholder-level taxes Undistributed income of C corp does not affect tax basis Undistributed income of S corp increases the tax basis 6

Important Fundamental Principles Efficient Market Hypothesis Shareholder level taxes affect equity security pricing and resulting equity investment rates of return Substantial academic research supports this finding Academic studies fail to estimate impact with precision S corp shareholder tax attributes are substantially different than C corp shareholder tax attributes Differences require adjustments to the analysis when C corp data is used to value S corps 7

Decision Calculations 29.4% tax rate when combined with 15% dividend tax rate results in a net shareholder return of $60.00 Equivalent to $60.00 net shareholder return of S Corp after single layer of tax at 40% 8

Deficiencies of Decision Calculations C corp tax rate and ordinary income tax rate are assumed to be identical Differences between dividend and capital gains tax rates are not addressed Dividend payout ratio of C corps is not considered Assumes C corp dividends are 100% of earnings May not be used to tax affect debt-free earnings Only applicable to equity earnings measurements May not be used to capitalize pretax earnings EBIT, EBITDA, etc. 9

When can Decision Calculations Be Used When C corp and ordinary income tax rates are identical When dividend and capital gains tax rates are identical If not, C corps must have 100% dividend payout ratios When capital structure of S corp and C corps are identical When using an Income Approach Cannot be used to adjust market or asset approaches When capitalizing equity net cash flow Cannot be used to capitalize debt-free earnings Cannot be used to capitalize pretax earnings 10

Fundamental Investment Return Equation k 1 = Equity investment rate of return during period 1 S 1 = Stock price at end of period 1 S 0 = Stock price at beginning of period 1 d 1 = Dividends paid during period 1 Ni x D P = Dividends (d 1 ) Ni x (1 D P ) = Capital Appreciation (S 1 S 0 ) 11

Why the Dividend Payout Ratio Matters (A) (B) C Corp C Corp (1) Income Before Taxes $ 100.00 $ 100.00 (2) Corporate Tax Rate 40.0% 40.0% (3) Net Income $ 60.00 $ 60.00 (4) Dividend Payout Ratio 50.0% 50.0% (5) Dividends $ 30.00 $ 30.00 (6) Dividend Tax Rate 15.0% 15.0% (7) Net Dividends $ 25.50 $ 25.50 (8) Capital Appreciation $ 30.00 $ 30.00 (9) Capital Gains Tax Rate 15.0% 30.0% (10) Net Capital Appreciation $ 25.50 $ 21.00 (11) Net Shareholder Return $ 51.00 $ 46.50 12

Decision Calculations Tax Rate Analysis 13

Decision Calculations and Debt-Free Analysis (A) (B) (C) (D) (E) Tax Percent of Rates of Adjusted Capital Weighted C Corporation Principal Return Rates Structure Averages (1) Debt Capital $ 300.00 10.0% 6.0% 50.0% 3.0% (2) Equity Capital $ 300.00 20.0% 20.0% 50.0% 10.0% (3) Weighted Average Cost of Capital (WACC) 13.0% 14

(A) (B) C Corp S Corp (1) EBIT $ 130.00 $ 130.00 (2) Interest 30.00 30.00 (3) EBT $ 100.00 $ 100.00 (4) Corporate Tax Rate 40.0% 29.4% (5) Net Income $ 60.00 $ 70.59 (6) Equity Capitalization Rate 20.0% 20.0% (7) Value of Equity $ 300.00 $ 352.94 (8) EBIT $ 130.00 $ 130.00 (9) Corporate Tax Rate 40.0% 29.4% (10) Debt Free Net Income $ 78.00 $ 91.76 (11) WACC Capitalization Rate 13.0% 13.0% (12) Value of Invested Capital $ 600.00 $ 705.88 (13) Debt Capital 300.00 300.00 (14) Value of Equity $ 300.00 $ 405.88 15

Decision Calculations and Debt-Free Analysis (A) (B) Debt Equity (1) EBIT $ 30.00 $ 100.00 (2) Tax Rate 40.0% 29.4% (3) EBT 18.00 70.59 (4) Capitalization Rate 6.0% 20.0% (5) Values $ 300.00 $ 352.94 16

Decision Calculations & Van Vleet Model Decision Calculations Tax Rate (Ts) = 29.4% Ordinary Income Tax Rate (T i ) = 40% Dividend Payout Ratio (D p ) = 100% Dividend Tax Rate (T d ) = 15% Capital Gains Tax Rate (T cg ) = 15% 17

Decision Calculations & Van Vleet Model C Corp Net Shareholder Return = $51.00 SEAM = 1.1765 S Corp Net Shareholder Return = $60.00 18

READ THE ARTICLE Delaware Open MRI and the Van Vleet Model Business Valuation Review American Society of Appraisers June 2015 19

VALUING S CORP EQUITY WITH AN ESOP IN PLACE 20

$25 million $25 million Note Basic Leveraged ESOP ABC Corp $25 Million $25 Million Note Bank ESOP 1/3 Ownership Interest $25 Million Owner 21

Balance Sheet Pre Transaction ESOP ESOP Transaction Post Transaction ESOP (1) Assets $ 100,000,000 $ 100,000,000 (2) Liabilities 20,000,000 20,000,000 (3) Debt - $ 25,000,000 25,000,000 (4) Equity 80,000,000 $ (25,000,000) 55,000,000 (5) Assets & Liabilities $ 100,000,000 $ 100,000,000 Valuation Pre Transaction ESOP ESOP Transaction Post Transaction ESOP (6) Enterprise Value $ 75,000,000 $ 75,000,000 (7) Outside ESOP Loan - $ 25,000,000 25,000,000 (8) Value of Equity 75,000,000 50,000,000 (9) Non ESOP Interest 100.0% 66.7% (10) Value of Non ESOP Equity $ 75,000,000 $ 33,333,333 (11) Pre ESOP Transaction Shares Outstanding 300,000 (12) Post ESOP Shares Held by Owner 200,000 (13) Post ESOP Shares Held by ESOP 100,000 22

Year 0 Year 1 (1) Enterprise Value $ 75,000,000 $ 75,000,000 (2) Outside ESOP Loan 25,000,000 15,000,000 (3) Value of Equity $ 50,000,000 $ 60,000,000 (4) Non ESOP Shares 200,000 200,000 (5) Allocated ESOP Shares - 40,000 (6) Shares Outstanding 200,000 240,000 (7) Value per Share $ 250.00 $ 250.00 (8) Inside ESOP Loan Balance $ 25,000,000 $ 15,000,000 (9) Value per Share $ 250.00 $ 250.00 (10) Shares to Repay Inside ESOP Loan 100,000 60,000 (11) Shares Held by Control Owner 200,000 200,000 (12) Value per Share $ 250.00 $ 250.00 (13) Value of Subject Interest $ 50,000,000 $ 50,000,000 (14) ESOP Shares Outstanding - 40,000 (15) Value per Share $ 250.00 $ 250.00 (16) Value of ESOP Interest $ - $ 10,000,000 23

Value of Non-ESOP Shares Year 0 Year 1 (1) Enterprise Value $ 75,000,000 $ 75,000,000 (2) Outside ESOP Loan (25,000,000) (15,000,000) (3) Value of Equity 50,000,000 60,000,000 (4) Inside ESOP Loan 25,000,000 15,000,000 (5) Adjusted Value of Equity 75,000,000 75,000,000 (6) Total Shares Outstanding 300,000 300,000 (7) Value Per Share $ 250.00 $ 250.00 (8) Non ESOP Interest 200,000 200,000 (9) Value Per Share $ 250.00 $ 250.00 (10) Value of Non ESOP Equity $ 50,000,000 $ 50,000,000 24

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