Is Your Company More Valuable If It’s an S-Corp?
S-corporations are popular firm structures in the AE industry because of their tax advantages. While shareholders of C-corporations are double-taxed—both at the corporate level (corporate income taxes) and then at the individual level (dividends and capital gains taxes)—S-corps (and LLCs) are “pass-through” entities in which individual shareholders are taxed on their share of the profits. Since the effective tax rate for S-corp shareholders is usually lower than for C-corp shareholders, many closely held businesses choose to be S-corps (and LLCs).
How do these tax advantages impact firm valuations?
Buyers, sellers, tax courts, and judges in shareholder and family law cases are increasingly demanding these tax advantages be properly accounted for in valuations. A popular way of doing so is the Van Vleet S-Corp Economic Adjustment Model (“SEAM”). This model adjusts the cash flows that form the basis of most valuations to account for the tax advantage of being an S-Corp. This tax advantage varies widely based on the corporate and personal tax rates in the states where the firm does business, as well as the tax situation of the shareholders.
Is the S-corp tax advantage always appropriate to consider in the development of a valuation? When valuing the S-corp from the perspective of a long-term shareholder who will continue to be subject to the S-corp tax rates, yes. But when valuing the S-corp as a prospective acquisition target for a C-corp, no, as the tax advantages of the S-corp will expire once the transaction is completed.
Preparing Your DBE for an Ownership Transition
Disadvantaged business enterprises (DBEs) in the AE industry face unique challenges when preparing for both internal and external ownership transitions. For both internal and external buyers who would not allow the business to continue to qualify as a DBE, there is a greater risk in acquiring a DBE because it’s difficult to know how much of the target’s revenue might go away when set-asides are lost. DBEs that want to retain their certifications, by contrast, see their pool of buyers severely limited to other DBE firms and employees qualifying for the preference category.
For internal ownership transitions, DBE shareholders should try to determine how much of their revenue is at risk, if possible, by polling clients who may be sensitive to this issue and by testing the waters by competing for more work that is not set aside for DBEs. Owners should also start the process early to identify rising leaders who qualify for the firm’s preference categories as well as seek business from clients—such as those in the private sector—whose procurement processes are less constrained by DBE set-aside requirements.
When it comes to external sales, DBE status lowers valuations because the pool of DBE buyers is smaller and non-DBE buyers may assume that some of the target firm’s revenue will go away. On top of that, that amount of revenue that buyers believe will disappear can’t be easily discerned, increasing uncertainty in valuations. Firms with long-term municipal contracts or master services agreements may be at less of a disadvantage, as these may usually continue to be serviced for the remaining contract term even if the DBE lapses.
For DBEs seeking an external sale, it could be best to find potential acquirers that are DBEs, especially those with the same designation. This is generally only an option for smaller firms, however. DBEs looking to sell to an outside buyer should take a similar step as those making an internal ownership transition and determine how much of their revenue is at risk and seek non-set-aside business.
A guide to help you better understand how AE firms are valued and – perhaps more importantly – what you can do to build value now.Read Newsletter