In this article, we delve into the intricacies of valuing individual legal entities as part of a legal entity rationalization, exploring some of the key considerations that must be considered to prepare a robust and cohesive valuation analysis that will be in line with the expectations of tax authorities. By understanding these critical aspects and adopting a structured approach to the analysis, the complexities of valuations for legal entity rationalization can be effectively navigated.
Introduction
Legal entity rationalization is a strategic initiative undertaken by organizations to optimize their corporate structure, streamline operations, and enhance overall tax and operating efficiency. This strategic undertaking often requires - or can be the result of - significant events such as mergers and acquisitions, divestitures, and internal transfer of assets and operations.
Central to the success of legal entity rationalization is a thorough valuation methodology that accurately assesses the value of individual entities within the corporate structure. This valuation process must utilize a bottom-up, discounted cash flow (DCF) methodology (a form of the income approach), where each entity's financial performance (with specific focus on any transfer pricing agreements), risk profile, market position, intellectual property (IP) and other relevant intangible asset rights, and strategic relevance are meticulously analyzed to estimate its fair market value.
A Guide to the Bottom-Up, Income Approach
The bottom-up DCF focuses on evaluating individual entities based on their income-generating potential and risk profiles from historical, current, and a set of entity and consolidated financial projections. This methodology entails the following steps:
- Entity Identification: Begin by identifying all legal entities and analyzing each legal entity’s position within the corporate structure. A crucial step in the analysis is identifying and fully understanding any intercompany transfer pricing agreements. Each entity's unique operations, assets, liabilities, and revenue and expense streams must be thoroughly understood.
- Transfer Pricing: Many large multinational organizations have transfer pricing agreements in place to specify the arm’s length rates at which related parties transfer goods, services, assets, etc. In the presence of a transfer pricing agreement, the underlying assumptions utilized in the valuation analysis must be consistent with those in the transfer pricing agreement. As part of the entity identification process, each legal entity is typically classified into one of the following categories: 1) limited risk distributor; 2) manufacturer; 3) intangible asset holding company; 4) holding company without operations; or 5) an operating company that owns and operates all or many of its assets. It is common that one or more legal entities will own IP that is utilized by other legal entities within the company. To determine the fair market value of each entity, the projected financials utilized for each legal entity must be on a standalone basis, where the owner of any IP receives an arm’s length payment for the use of the IP, and other entities are charged for their IP use or compensated based on their designated returns. The sum of the individual entity projections must in turn reconcile to the consolidated projections for the overall company.
- Financial Analysis: Conduct a detailed financial analysis of each entity, including income statements, balance sheets, cash flow statements, and any other relevant financial metrics. Consideration must be given to aspects such as long-term market growth rates, currency exchange risk, capital requirements, and tax and regulatory environments for each entity. As mentioned above, the financial metrics of any transfer pricing agreement must be incorporated into the valuation assumptions.
- Tax Rate Disparities: Consider differences in tax rates across various tax jurisdictions in which the entities operate, as well as rules on tax depreciation of future capital expenditures, and tax amortization of acquired intangible assets. Analyze the tax implications of entity rationalization, which may create limitations on any net operating losses (or accelerate usage through built-in gains), etc.
- Entity-Specific Net Present Value: Prepare a risk assessment that evaluates the risk profiles of each legal entity, considering factors such as country and operational risks:
- Country risk reflects the economic, political, and financial stability of the countries where entities operate. Entities operating in jurisdictions with high country risk levels, such as geopolitical instability, currency volatility, or legal uncertainties, may experience higher financing costs due to increased risk premiums. Country risk considerations are integrated into the Weighted Average Cost of Capital (WACC) calculation to reflect the specific risk exposures of each entity's operating environment.
- Operational risk reflects the potential for financial losses or disruptions arising from internal processes, systems, people, or external events that affect business operations. Legal entities fall into categories including entrepreneurs, limited risk entities, holding companies, etc. Entrepreneurs face significant operational risks associated with market volatility, product/service innovation, resource constraints, scalability challenges, business model viability, etc. The cost of equity for entrepreneurs is often higher due to the perceived higher risk and uncertainty, resulting in a higher WACC. Conversely, a limited risk entity performs a more stable role in the operational chain, utilizing the IP of an entrepreneur to generate comparably lower returns, while operating with a comparably lower level of risk.
This assessment must be quantified in the calculation of a WACC for each entity. The selected entity-specific discount rates must take into consideration the overall projection risk, as well as industry benchmarks, and cost of capital considerations.
- Sum-of-the-Parts Analysis: Aggregate the individual entity valuations to derive the overall fair market value of the company, alongside the preparation of a single, consolidated DCF, or if applicable, Internal Rate of Return (IRR). This process involves reconciling the estimated fair market values of each legal entity to the overall value of the company. This ensures consistency across the valuation analysis while providing a cross-check to the relative allocation of fair market values within the overall company. In the event that not all of the company’s legal entities are included in the rationalization, at a minimum a high-level valuation of the other legal entities should be conducted for the sum-of-the-parts analysis.
- Valuation Multiples: Calculate the implied valuation multiples from the estimated fair market values and the projected financial metrics of each legal entity to ensure the conclusions are consistent with selected guideline public companies, comparable transactions, etc., as well as falling in line with expectations concerning key value entities. Given the uniqueness of some entities, i.e., one that solely provides manufacturing services on a designated cost-plus basis, observed multiples for comparable companies may not be available or relevant. However, in appropriate scenarios, comparing the implied valuation multiples indicated under the DCF approach for the legal entities wherever possible, as well as those of the overall company provides an added layer of support to the valuation analysis.
- Different Values by Jurisdiction and Multiple Approaches: It is worth noting that the valuation for a legal entity rationalization can trigger a taxable event across multiple tax jurisdictions. The overall analysis could be subject to review by the Internal Revenue Service in the U.S. whereas individual legal entity valuations are subject to review by their local tax authority. It is important at the outset of the project to understand the specific tax jurisdictions for which the valuation report will be utilized. Some tax authorities have very specific approaches and assumptions that are required for local tax purposes, hence it is important to understand what will be deemed acceptable to each local tax authority. It is possible to have two different values for the same legal entity based solely on the local tax authority’s accepted methodology, approach, etc.
By following these steps and adopting a structured approach to entity valuation the conclusions of value will provide the company with a robust and defensible analysis.
