Jan 17, 2019

The Private Company Council Election’s Impact on Valuation

What is the “Private Company Council election?” According to a new report from Pine Hill Group, it is “a proposal that sought to provide businesses with an alternative to the requirement that they separately recognize certain customer-related intangible assets and noncompetition agreements at fair value.” That’s the definition. To go deeper, we met with Curtis Farrow, a manager with Pine Hill Group, and discussed the benefits of the election, the impact on valuation fees, and more.

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By: Bill Hayes, Pennsylvania CPA Journal Managing Editor

Podcast Transcript

What is the Private Company Council election? According to a new report from Pine Hill Group, it's a proposal that sought to provide businesses with an alternative to the requirement that they separately recognize certain customer-related intangible assets and non-competition agreements at fair value. While that can tell you what it is in its simplest form, the report goes into much more detail. Today we have Curtis Farrow, manager with Pine Hill Group, here to break it down for us even further.

Can you tell us a little bit about what the Private Company Council election is, and who it applies to and doesn't apply to?

[Farrow] I'll start with your second question. As the name suggests, private company council is an election for private businesses. I guess, right off the gate, if you're a publicly traded company or you're reporting for the SEC where you need GAAP-based financial statements, this election would not apply to you. To back up and state what it is, it's an election that came out a couple years ago. It's not new, but it's still being figured out in terms of how to use it and when it applies. Really what it states is for companies that can make the election – private businesses – when they have acquired another business in a business combination, there's an exercise that happens called a purchase price allocation. In that process, there's several things that happen in just a linear-step fashion.

First, the purchase consideration is determined. In an all-cash deal, that's pretty straightforward. There's really no valuation work to be had there. Cash is cash. Often we see deals that are a little more complicated and a little more complex where things like rollover equity are coming into play, and maybe there's earnouts or other types of contingent consideration that need to be addressed. Once the final purchase consideration is determined, that is then allocated to the specific assets that were acquired in the business that was purchased. A lot of those assets end up being intangible. You have the tangible things like net working capital, equipment, maybe some real estate that came over as part of the transaction, but you often need a valuation expert like myself to value the intangible assets, things like a trade name, a customer relationship, non-competition agreements, technology, and a whole slew of other things.

What this election does is it allows businesses to not have to separately recognize customer relationships in most situations, and it allows them to also not need to recognize non-competition agreements. Instead, what happens is those get subsumed into goodwill. When you allocate the value to all the different assets that were acquired, any additional consideration that was paid over what was assigned to those identifiable assets ends up on a balance sheet as goodwill. Under this election, the private businesses are going to recognize and put on their balance sheet a little more goodwill than they would under traditional GAAP accounting.

What would you say are some of the main benefits this election is meant to bring to private companies?

[Farrow] It was really put in place to help simplify things and have a little less complexity to this exercise. I guess the second thing that it was meant to do is help reduce the fees that are associated with this work. The idea was you have less assets to value now, so, in theory, that should reduce the fees to get this exercise done and have a little less burden on the compliance aspect for these smaller businesses.

Are there any drawbacks that can be seen from taking the election?

[Farrow] I don't know if drawback would be the right word, but there's definitely things that should be considered in determining whether or not the election is going to be appropriate for your business. To put it in two buckets, I would say one, it really depends on the planning for the business and what an eventual exit of the business might be or where the business is just generally headed in the future. What I mean by that is if the company is growing and increasing in size in hopes of an eventual exit down the road, this is an election that's not going to make sense if ultimately you're on an IPO path, or one of the potential acquirers of your business is a large strategic company that is also public or for whatever reason requires GAAP-based financial statements maybe through their loan covenants. Maybe they have public debt and they have to have SEC filings that way. If your eventual exit is into the public markets, it's not going to make sense.

The reason for that is at the time of that sale, you're going to have to unwind all of these things that are now far in hindsight. You're going to have to go back and do it the way you would've otherwise normally had to do it if you hadn't made the election. It's going to add a lot more cost on the backend. It's going to add a lot more stress to your employees. If they're gearing up for a sale, there's a whole lot of other things that they're having to deal with. You don't want to pile into that.

The other bucket I would put in in terms of the consideration of whether or not to make the election is while it was put out there in hopes of reducing the fees and complexity, in reality that's not always the case. It's important if you've acquired a business to have an open conversation with your auditor and specifically their valuation group that's going to ultimately be reviewing this exercise and signing off on it as part of the audit because different audit firms interpret this a little differently. While it's true that these assets will ultimately be subsumed into goodwill on the balance sheet as part of that exercise in allocating the value to those assets, some audit firms are still requiring the full valuation, I'll say for lack of a better term, where we would still be required to value the customers and the non-competition agreements. The reason for that is one of the sanity checks on whether the allocation to the assets makes sense is by comparing various rates of return or discount rates.

To get technical here for a moment, the different assets that were acquired have different risk profiles and different rates of return required for them. On the low end, you have things like net working capital. On the risky side, you have the intangible assets that we've been talking about. Goodwill is thought to be the most risky. If you have a larger percentage in goodwill, that increases that weighted average return. It could throw the answer you're getting out of whack. Sometimes the audit firms want to see what that valuation would be so that they can properly determine what that weighted average return on the assets would be and compare that against the IRR of the deal and the weighted average cost of capital determined for the business. Really there's no cost savings there if we're still having to value the assets. Other firms take a different approach. It's one where if the goal is to save a little bit of money, talk to your auditor ahead of time to see if that's in fact going to be the case because, if not, then it might be just another reason why that election may or may not make sense for you specifically.

I have no larger point connected to this, but I just like the term sanity checks. I think that's something that you should have when you're talking about the business world: a sanity check.

[Farrow] Yeah, always good to step back and look at the forest when you're deep in the weeds.

Is there an impact that the election could have on valuation fees that need to be considered?

[Farrow] Yes, and it's what we were just diving into a little bit. Really the conversation should start with the audit firm. That's always the approach we would take whether or not this election is being considered. We've found it's always helpful to take a collaborative approach. At the onset of our engagements, we like to have a kickoff call with the audit team to make sure that everyone's on the same page in terms of what the scope of the work is. That's really where the fees are going to come into. If they're taking the election, are you going to require us to do an analysis to say, "Here's what the customer relationships would have been worth or are worth, even though they're going to be subsumed into goodwill?"

It's also just a good best practice, I think, to get on the same page if there's other areas where the scope may be enlargened or not. A lot of that revolves around the purchase consideration we were talking about earlier. If there's a seller note or there's debt being assumed, we need to assess the fair value of that. Rollover equity, earnouts, and contingent consideration get pretty complex pretty quickly oftentimes. It's just best to make sure everyone's on the same page with how to look at that so that it's taking the management teams away from the normal ongoing operations of their business a little more, and it just makes the process a lot smoother from start to finish.

You may have touched on some of this to an extent, but I guess just as a takeaway as we're wrapping up here, what are some of the other smaller details, if there are any, that a company needs to consider when deciding whether to take this election and determine whether it's a successful choice? Is there anything else that we didn't hit on so much?

[Farrow] Yeah, there is. I guess to just recap some of the things we did address, one is talk to your auditors. Get on the same page with them in terms of what they're going to require from a scope standpoint. Consider the future of the business, what you're trying to accomplish. If you're going to stay private for the next 20 years, that's a situation where it may make sense. Also, talk to your creditors and review any loan covenants you have out there. Sometimes those require a GAAP-based financial statement. If you're going to do that, then you don't want to keep two sets of books. It's going to eat away all the cost savings you have from making the election. Look into those kind of details to make sure that you're not doing anything that requires a true GAAP-based financial statement either now or in an eventual sale. The person that's going to be ultimately purchasing the business down the road, are they required to do those things? If the answer is yes to any of that, then the election may not make sense.

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