Valuing Global Legal Entities
The valuation process should utilize a bottom-up, discounted cash flow (DCF) methodology, where each entity’s financial performance, 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.
In this article, we delve into the intricacies of valuing individual global legal entities as part of a legal entity reorganization, exploring some of the key considerations that must be thought through to prepare a robust and cohesive valuation analysis that will be in line with the expectations of tax authorities.
Introduction
Legal entities are typically valued as part of a strategic initiative undertaken by organizations to optimize their corporate structure, streamline operations, and enhance overall tax and operating efficiency, typically the result of mergers and acquisitions and internal transfer of assets and operations.
The valuation process should utilize a bottom-up, discounted cash flow (DCF) methodology, where each entity’s financial performance, 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. This methodology entails the following steps:
1. Entity Identification: Begin by identifying all legal entities, analyzing each legal entity’s position within the corporate structure, and fully understanding any intercompany transfer pricing agreements. Each entity’s unique operations, assets, liabilities, and revenue and expense streams must be thoroughly understood.
2. 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. Legal entities are typically classified as either a principal entity, limited risk distributor, intangible asset holding company, contract manufacturer, or holding company. The projected financials utilized to value each legal entity must be on a standalone basis with incorporation of all transfer pricing arrangements. The sum of the individual entity projections must in turn reconcile to the consolidated projections for the overall company.
3. 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 legal entity.
4. Tax Rate Disparities: Consider differences in tax rates across the organization’s various tax jurisdictions as well as local rules on tax depreciation and amortization. Analyze the tax implications of the reorganization, which may create changes in tax attributes and liabilities.
5. Entity-Specific Net Present Value: Prepare a risk assessment that evaluates the risk profile of each legal entity, considering factors such as country and operational risks:
- Country risk reflects the economic, political, and financial stability of the country where the entity operates. Country risk considerations are integrated into the Weighted Average Cost of Capital (WACC) calculation to reflect the specific risk exposures of each legal 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. Entities operating as principals face significant operational risks associated with market volatility, product/service innovation, resource constraints, scalability challenges, business model viability, etc. The cost of equity for principals – which act as entrepreneurs – is often higher due to the perceived higher risk and uncertainty, resulting in a higher WACC. Conversely, a limited risk entity is typically remunerated with a designated return thus operates at a comparably lower level of risk.
This assessment must be quantified in the calculation of a WACC for each legal 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.
1. Sum-of-the-Parts Analysis: Aggregate the individual legal 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 the legal entities 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 reorganization, at a minimum a high-level valuation of the other legal entities should be conducted for the sum-of-the-parts analysis.
2. 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 those of the 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, for example 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.
3. Different Values by Jurisdiction and Multiple Approaches: It is worth noting that the valuation of legal entities can trigger a taxable event across multiple jurisdictions. The overall analysis could be subject to review by the Internal Revenue Service in the U.S. and similarly individual legal entity valuations in other jurisdictions could be subject to review by the 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.
Following these steps and adopting a structured approach to valuing legal entities can provide a robust and defensible analysis.
Disclaimer – The views expressed in this article are the personal views of the author and are purely informative in nature.