Mike Adhikari
Adhikari International, Inc.
175 Olde Half day Rd., Suite
100
Lincolnshire IL 60069
Phone: 847-438-1657
Fax: 847-438-1835
Email: info@BusinessValueXpress.com
Web: www.BusinessValueXpress.com
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S Corp. vs. C Corp.
Valuation
(Revised 08-01-2010)
Minimal impact even
after not-tax-affecting S Corp. income
Background:
Valuation of S Corp.
vs. C Corp. has received focus as a result of three recent court rulings in Gross,
Adams,
and Heck. According to these court rulings S Corp.
income should not be tax-affected for valuation purposes. This is in contrast
to the common practice by the valuation community of tax-affecting S Corp.
income.
If one were to use
traditional income approach for valuation, not tax-affecting S Corp. income
would cause S Corp. to be valued higher than an otherwise identical C Corp. The
value difference could be significant. As an example, an S Corp. could be
valued 1.66 times more than an identical C Corp. if both had the same operating
income, no debt and the C Corp. tax rate was 40%.
However, such
valuation difference between an S Corp. and an otherwise identical C Corp. is
not found in the market.
Also, the valuation practitioners value both corporate structures essentially
the same. They arrive at equal value for an S Corp. and a C Corp. by
tax-affecting S Corp. income, and using traditional income approaches for
valuation (tax-affecting means reducing S Corp. income by the tax liability
incurred by the S shareholder). If they were to implement the above court
rulings of no tax-affecting, and continue using traditional income approach for
valuation they will wind up valuing S Corp. significantly higher than an
otherwise identical C Corp.
So, the question arises, is the court decision correct? If
the answer is yes, then may be the market is wrong in assigning equal values to
both the corporate structures. However, market being wrong is unlikely. This
leads one to the easy route of challenging the court decision. However, there
is another explanation … the valuation process is flawed.
Below is an analysis
by the author, Mike Adhikari (MBA, MSME, MSEE, CBI, CM&A), on the above
subject. Adhikari has 25 years of experience as an M&A intermediary
involving transaction valuation. The analysis is backed by a new business
valuation method developed by him.
Summary:
The court ruling that
the S Corp. income should not be tax-affected is a correct decision. Also, the
market is correct in valuing the S Corp. and C Corp. equal. However, the
traditional income based valuation approach is inadequate.
A vast majority of
the transactions in the real world are financially leveraged transactions. Market databases reflect these leveraged
transactions. Financial leverage reduces taxable income, and hence reduces the
negative impact of C Corp. double taxation. In addition shareholders are
generally not permitted to take distributions under financial leverage. Thus,
the “cash distributed” to the shareholder under financial leverage is little or
none, which tends to equalize S Corp. and C Corp. valuation.
When S Corp. and C
Corp. are valued based on “cash distributed”, as is done here, there is minimal
value difference between the two if there is financial leverage. This is true
even when S income is not tax-affected. Traditional valuation methods are
inadequate because they are based on “income” earned, or on generated “free
cash flow ”, rather than on “cash distributed”. If there were no financial
leverage (i.e. 100% equity infusion), an S Corp. would be valued significantly
higher than an equivalent C Corp.
Analysis:
Following are some
comments and clarifications on topics related to S Corp. vs. C Corp. valuation.
1) Value of a firm is determined based on cash flow to the
investor and his expected pre-tax ROI
using DCF (Discounted Cash Flow) method.
The cash flow to the investor is the distribution from the after-tax income of
the corporation. Investor’s
pre-tax ROI should be based on “distribution received”; it should not be based
on income or free cash flow of the corporation. The word “pre-tax” means that
the ROI is measured on the gross cash flow received by the investor before the
investor pays shareholder level taxes on the distribution. It also implies that
the investor has no other liability arising from his interest in the entity
other than the shareholder level taxes on the “distribution received”.
2) Some experts have argued, “How can two identical businesses
with same operating income have different values, just because one is an S
Corp. and the other a C Corp.?” This is entirely possible. As discussed
earlier, investor’s value assessment is based on his expected pre-tax ROI.
Higher the cash flow to the investor, higher the value, if pre-tax ROI
expectation is the same. Such would be the case for an S Corp. over a C Corp.,
if the purchase is with 100% equity.
3) In situations where an ownership change does not involve a
third party, a business should be valued based on what an independent buyer
would pay. Value to the independent buyer depends on the expected future cash
flow to him ... not on prior cash flow, or prior earnings, or prior dividend
policy.
The valuation would be high if one assumes financial leverage, and the value
would be low if one assumes no financial leverage i.e. 100% equity infusion.
4) Traditional income based valuation approaches use “income”
earned, or generated “free cash flow” as a proxy for investor’s cash flow. As
discussed earlier, this substitution is wrong … value should be based on
“distribution received”, not on income or free cash flow. Unfortunately, we have used these “wrong”
measures for so long that they are accepted as the “right” approach. The debate
on, to tax-affect or not to tax-affect S Corp. income, arises primarily due to
the use of these “wrong” measures as a proxy to investor’s cash flow.
5) If one were to value a business based on actual cash flow to
the investor, valuation of an S Corp. based not tax-affecting, will be closer
to that of a C Corp. under financial leverage. Financial leverage is commonly
used in the market place to lower buyer’s cost of capital, which helps the
buyer afford a higher price. However, the effect of the leverage is to lower
the available cash for distribution. Also, with financial leverage,
corporation’s taxable income is reduced, which diffuses the impact of the tax
differences between the C and the S Corp. Financial leverage also consumes cash
for debt service, thus further reducing the cash available for distribution.
And, leverage invites dividend restrictions from lenders. All of these factors
reduce available cash for distribution and are applicable to both the S Corp.
and the C Corp. As a result the cash flow to the investor is basically the same
regardless of the corporate structure.
Impact of financial leverage on S Corp. vs. C Corp. valuation
Following is a
valuation analysis of XYZ Inc. XYZ is valued 4 different ways. The two
variables making up 4 combinations are corporate structure and financial
leverage.
In Scenario-A, XYZ is
being acquired without financial leverage. In Scenario-B, XYZ is being acquired
with financial leverage. In both the scenarios XYZ is valued as if it were an S
Corp. and a C Corp. The analysis is based purchasing 100% of the stock of XYZ.
It is also assumed that the buyer will be able to sell XYZ at exit for the same
purchase price multiple that he paid at purchase.
In the example, XYZ
has sales of 5000 and an EBITDA
of 500. It has no growth, and no debt. 100% of the earnings are distributed as
dividend if they are not required in the operation. In the S Corp. analysis
company distributes cash to cover shareholder taxes, and any excess
distribution is grossed up back to the pre-tax level for calculating
shareholder’s pre-tax ROI. Table – 2 provides more details of XYZ Inc.
Scenario-A has no
financial leverage, does not require profits to be reinvested and has no tax
benefits resulting from such things as depreciation. Fixed assets are
eliminated in Scenario-A to avoid the impact of depreciation on valuation.
These assumptions permit distribution of 100% of the earnings. Scenario-A is
generally not observed in real life, but it is used here to show the set of
assumptions required for an S Corp. to be valued 1.66 times more than an
otherwise identical C Corp.
Scenario-B is a more
realistic scenario. Assets are
leveraged to reduce overall cost of capital, tax benefits of depreciation are
captured, and profits are reinvested for such things as capital expenditures.
Scenario-B also assumes that acquisition financing is available as long as the
cash flow can support it.
The valuation
multiples in Table – 1 are derived by applying DCF method to buyer’s cash flow,
and using 25% pre-tax ROI. An important distinction is that the DCF is applied
to Buyer’s cash flow, not to XYZ’s cash flow. Buyer’s cash flow is calculated
after servicing debt, after funding working capital,
after funding capital expenditures, and after paying taxes. Each value is
derived to simultaneously satisfy the objectives of a willing buyer and a
willing seller. So the
value is the maximum that the seller can get and the one the buyer can afford,
given the parameters of Table – 2. Valuation details (income statement, balance
sheet, cash flow and ROI calculations) are provided in Table – 3, 4, 5, and 6.
Table –1
Valuation Multiples to achieve 25% pre-tax ROI
|
XYZ Inc.
|
Scenario-A
No Financial
Leverage
|
Scenario-B
With Financial
Leverage
|
|
C Corp.
|
2.4
|
4.2
|
|
S Corp.
|
4.0
|
4.5
|
Scenario-A, No
Financial Leverage: As shown in
Table –1, under no financial leverage, buyer can afford to pay no more than a
4x EBITDA multiple for XYZ if it is an S Corp to achieve a 25% pre-tax ROI (S
Corp. income is not-tax affected). In this scenario there is no financial
leverage, and no growth, and hence the full purchase is funded through equity.
He invests 2000 (4 times 500) and gets all of the EBITDA of 500 each year for 5
years as dividend. At exit he gets 2000, the same amount as the purchase price.
However, if XYZ is a C Corp., under no financial leverage,
buyer can afford to pay no more than a 2.4x EBITDA multiple for XYZ to achieve
a 25% pre-tax ROI. He invests 1200 (2.4 times 500) and gets only 300 each year
for 5 years as dividend. (C Corp. pays 200 in taxes, so the amount available
for distribution is not 500, but 300). At exit he gets 1200, the same amount as
the purchase price.
If the buyer were to
pay for a C Corp. XYZ, the same price he can afford to pay for an S Corp. XYZ,
i.e. a multiple of 4, his pre-tax ROI would drop to 15%. (In this case buyer’s
cash flow would be an investment of 2000, distribution of 300 for 5 years and
exit at 2000).
The above analysis
clearly shows that, under the scenario of no financial leverage, the S Corp is
valued higher than the C Corp. where the criterion for valuation is that the
investor gets the same pre-tax ROI. The S Corp. is valued at a 4 multiple and
the C Corp. is valued at a 2.4 multiple of EBITDA. The S Corp. value is 1.66
times more than an otherwise identical C Corp.
The exact
relationship of an S Corp. vs. a C Corp. valuation, in case of no financial
leverage, no growth, no reinvestment and if all earnings are distributed to the
shareholder, is
Vs
= Vc / (1-tc)
Vs is the value of an S
Corp.
Vc is the value of a C Corp.
tc
is C Corp. tax rate
It is also worth
noting that the S Corp. multiple is equal to 1/r, where r is buyer’s expected
pre-tax ROI. And the value of a C Corp. is (1-tc)/r. One should not
apply a multiple of 1/r to the C Corp.
EBITDA Multiple for an S Corp. = 1 / r
r
is buyer’s expected pre-tax ROI
EBITDA Multiple for an S Corp. = (1- tc) / r
Scenario-B, With Financial Leverage: As shown in
Table –1, with financial leverage, buyer can afford to pay no more than 4.5x
EBITDA multiple if XYZ is an S Corp. to achieve a pre-tax ROI of 25% (S Corp.
income is not tax-affected). However, if XYZ is a C Corp. he can afford to pay
no more than 4.2x EBITDA multiple to achieve a pre-tax ROI of 25%. Buyer’s cash flow is calculated after
considering the interest cost of the debt, the debt service, and the capital
expenditure. (Details of the actual financials are shown in Table – 3,4,5,6.
This valuation is derived using the valuation software developed by the author).
Under financial leverage, and without tax-affecting S
Corp. income, the price differential between an S Corp. and a C Corp. is a
multiple of 4.5 vs. 4.2 i.e. S Corp. valuation is 1.07 times more than an
otherwise identical C Corp. The S vs. C valuation spread is only 7% under
financial leverage and 66% without financial leverage. This spread would further
narrow if lender restriction of no dividend distribution were implemented.
(Note: In the analysis here S Corp. income is not tax-affected. In addition,
the analysis makes adjustment at exit for S retained earnings, which are tax
free to the shareholder.)
The following observations are worth noting:
1)
Valuation with financial leverage is higher than w/o financial
leverage. This is true for both the S and the C Corp. This is a result of
reduction of overall cost of capital with financial leverage. For S Corp.
financial leverage raises the valuation from 4.0 to 4.5. For C Corp. financial
leverage raises the valuation from 2.4 to 4.2.
2)
Financial leverage impacts C Corp. valuation more than S Corp.
valuation. This is a result of tax savings from interest cost deduction. These
tax savings are more in a C Corp. than in an S Corp.
3)
Financial leverage significantly reduces equity infusion while
increasing the valuation. In the example here, the equity infusion w/o leverage
is 2000 (for S Corp.) and 1200 (for C Corp.). The equity infusion under
financial leverage drops to 642 (for S Corp.) and 513 (for C Corp.).
Final comments: Court decision of not tax-affecting
S Corp. income is a correct one. Market that values both the S Corp. and the C
Corp. more or less equal is also correct. The reason for differential valuation
of an S Corp. and an otherwise identical C Corp. is current valuation methods.
The formulas and methods used today to transform income and/or cash flow to
value are not applicable under financial leverage, which happens to exist in
most all transactions. When one calculates the actual cash flow to the buyer
under financial leverage, there is no material difference between an S Corp.
and a C Corp. valuation, even when S Corp. income is not tax-affected.
Table – 2
XYZ Corp
Scenario
A
Scenario
B
Sales
5000
same
EBITDA
500
same
A/R
500
same
Inventory
400
same
A/P
300
same
Existing
Debt
0
same
Growth
0
same
Growth
Working Capital 0
same
Dividend
Distribution
100% of available
cash same
Buyer Synergy None
same
C Corp Tax Fed+State 40%
same
S Corp. Tax State 0%
same
S Shareholder Tax 40%
same
Deal Structure
Stock
same
Payment
All cash
same
Buyer’s Pre-tax ROI 25%
same
Exit Multiple
= Purchase Multiple same
S Distribution Grossed up in excess same
of
taxes
Fixed
Assets Book Value 0
250
Fixed Assets FMV 0
500
Depreciation
N/A
5
years
Capital Expenditure 0
10%
of EBITDA
Financing
None
Yes
(see below)
Financing
A/R revolver
80% of A/R at 10% interest
Inventory revolver 40% of inventory at 10% interest
Term Loan 80% of FMV of fixed assets, 5 years at 10% interest
Capital Exp. Loan 75% of cost, 5 year at 10% interest
Cash Flow Loan Available as needed, 5 years at 10%
interest
(In small
deals seller steps in if cash flow lending is not available)
