• Capitalization and Its Impact on Management Compensation
  • May 5, 2006 | Authors: Cary S. Levinson; James D. Epstein
  • Law Firm: Pepper Hamilton LLP - Philadelphia Office
  • One of the first -- and most important -- decisions a private equity sponsor must make on deciding to acquire a portfolio company is how to capitalize the acquisition. That's particularly true if the private equity sponsor uses a mix of preferred and common stock, in addition to debt, to capitalize the buyer and anticipates allowing Management to buy into the equity, or it intends to issue restricted stock or options in the common stock. But when structuring an acquisition that way, the sponsor is left with a tough question -- what value can you place on the common stock as of its issuance date (which is typically the closing date of the acquisition), for financial reporting and tax purposes?

    Decisions on valuation of the portfolio company's equity can have profound implications for earnings, company performance and taxation at the portfolio company level, and for management taking part in an equity-based compensation program. In the current environment, valuation takes on ever-increasing importance, as the IRS, FASB and the portfolio company's auditors pay increased attention to valuation and resulting tax and accounting implications, from an income statement and a balance sheet perspective.

    In a typical structure, the sponsor may fund approximately 30 percent of the total cash required for the transaction by buying a strip of preferred and common equity in the acquisition company, and having the acquisition company borrow the remainder. The acquisition company may allow management to buy into the same strip, or it may establish an equity incentive plan consisting of restricted common stock, options to purchase common stock, and other equity-based instruments that are linked to common stock. Historically, the preferred stock ensured that the cash invested would be returned to the sponsor on a preferred basis --so the fair value of the preferred stock equaled the cash invested. Additionally, the sponsors generally sought and received a preference in dividends -- the return on their investment.

    Historically, most sponsors using this capital structure took the position that the preferred stock had a value equal to its liquidation preference. The common stock, by definition, then, had a de minimis value. This permitted the issuance of restricted common stock with little current tax cost to the employees, and no earnings hit to the company. It also permitted options to be issued with de minimis exercise prices. However, Section 409A of the Internal Revenue Code and SFAS 123R have increased the focus on the issue of valuation of restricted common stock from a tax and accounting perspective.

    There is a significant trend in the accounting profession to deny the use of the liquidation valuation of the common stock for financial accounting and tax purposes, even one based on the overall closing date enterprise value of the portfolio company resulting from an arm's-length transaction between two independent parties. As a result, the fair value of the equity after closing may add up to more than the price paid for the company.

    Many accountants now require companies to obtain an independent, third-party valuation of the various classes of equity for financial accounting purposes. The costs of this exercise are not inconsequential: It is not uncommon for the valuation itself to run anywhere from $75,000-$150,000 or more (depending upon the size and complexity of the portfolio company), plus the time of your management, accountants and lawyers.

    Two accepted methodologies for this exercise include customary option valuation methods (price to be paid by willing seller and willing buyer) and the probability weighted average method, which takes into account different scenarios and the probability of each of them occurring, then assigns a value to each class of equity securities based on each of those future events, and discounts that price back to the present to determine the "fair value" of the securities. The scenarios usually considered are:

    1. the portfolio company could continue to operate and generate dividends and cash flow;
    2. the portfolio company could go bankrupt or dissolve;
    3. an IPO;
    4. a trade sale or merger; or
    5. a distressed sale -- selling a business that has flat growth or a decline in growth.

    Others will attempt to apply the Black Scholes formula, but there is considerable debate as to the usefulness of that approach in the non-public company world.

    The timing of this valuation can be critical. Rarely will the sponsor receive the final valuation by the time a deal closes. If, for example, a portfolio company sells 1,000,000 shares of restricted common stock to management for an aggregate of $5.0 million (or $5.00 per share), but the appraisal, received many months later, values that common stock at $6.00 per share, the portfolio company has a charge against the company's earnings of $1,000,000 for compensation expense. While the tax rules are not directly tied to the financial accounting rules, it is difficult to take a position that the employee does not have additional taxable income of $400,000 in this case.

    In this situation, the management could have an unanticipated out-of-pocket tax cost. One approach to cover the cost is for the portfolio company to pay management a cash bonus for the taxes payable. Assuming the portfolio company is a current taxpayer, the company would receive a tax deduction for both the $1,000,000 of compensation expense and an additional amount equal to the cash bonus. That tax benefit could be used to fund the cash bonus, which would either make the cash bonus less costly or, quite possibly, cash neutral to the portfolio company.