Valuations - accounting, taxes, and transaction dynamics

In the course of a carve-out scenario, valuation questions regularly have to be answered on several levels. These questions are partly dependent on the specific reason for the carve-out project, and in all cases, there are local GAAP, international accounting and tax requirements that need to be considered. Early planning of these valuation aspects is therefore essential for a successful carve-out.

Every carve-out must be reflected in accordance with the local GAAP or international accounting standards adopted by companies involved as far as the legal and economic structure of the transaction is concerned. For example:

• Is a split-off, split-up or spin-off (or something else) preferable and how do they differ with respect to accounting rules?
• What does the divesting entity have to record as compensation for the net assets being divested and how does this affect the balance sheet structure. Do considerations need to be made regarding financial covenants?
• At what total value (business value) and at what individual values (asset values) does the acquiring entity record for the transferred entities? Does goodwill arise that can be used by the acquirer for tax purposes?  
• Are there any options to account for the divesture or the acquisition either at fair value (realising hidden reserves) or at current book value (without realising hidden reserves)?
• Does the carve-out have any effect on future impairment tests that should be thought through in advance?

Furthermore, every carve-out has tax consequences that require an understanding of the answers to the following questions:

• Does the disposal of net assets trigger a tax-relevant gain (or loss)? How high is this?
• Are there options to account for fair values or book values from a tax point of view? Can these options be exercised independently of the treatment of the valuations under accounting rules?
• Does my decision today bind (or influence) strategic decision making in the future?

If the carve-out serves to optimise business activities in the current ownership structure, these questions form the heart of a valuation exercise which can form a key part of the tax planning process relating to the transaction. Connected to this, the valuation methods and assumptions being applied as part of the carve-out process must meet the relevant definitions set out in accounting and tax law requirements. For example “Fair Value” or “Market Value” may have different definitions depending on whether the valuation is driven by tax or accounting rules.

A valuation is all well and good but if the primary purpose of the carve-out is to facilitate a sale or another type of exit for the carved-out business, the question of the transaction price often comes to the fore:

• What is the minimum price that should be paid? What is a fair price? What is the maximum price?
• What will change if the carve-out operations are separated from the existing group of companies? Will synergies be lost? What does a stand-alone cost structure look like?
• And how do all these compare to the company’s valuation?

Assessing the value

Company valuations are a key part in addressing the accounting and tax considerations to a satisfactory conclusion. However, a theoretical view of the company's value is only one element in the decision-making process. A negotiation between the buyer and the seller of the company in question may mean that the transaction price is different to the theoretical valuation analysis. As a result, in order to account for the subjectivity which appears in the negotiation process, the parameters for the company valuation become more complex, and more extensive information around the assumptions that should be applied in the valuation analysis is required. Scenario modelling and benchmarking can be very useful tools in helping to assess whether the overall transaction value is reasonable.

Often in these situations, the company’s management team commissions an external opinion regarding the purchase price that should be paid in the transaction in order to ensure a transparent and fair process. This need can be addressed by valuations in the form of fairness opinions. A valuation that takes account of the relevant future economic scenarios and defines appropriate valuation assumptions is therefore a prerequisite for an economically successful transaction.

The detail is in the data

Regardless of the specific valuation requirement – whether it relates to accounting, tax or is transaction-driven, carve-out valuations can be challenging from a practical perspective. The historical and forecast financial data for the carved-out operation is often unavailable or, if it is available, it is not of high quality. As a result of its interconnectedness with other business units, carve-out company financials often have to be recreated for past financial periods.

In this context, significant allocation issues can arise if intercompany transactions exist between the carve-out operations and the rest of the corporate group, but also when resources of the corporate group are shared by different business units. As a result, a reliable valuation can only be performed once this information is available. So early planning of the carve-out process and specifically, how the financial reporting of the business unit is generated to represent a standalone position for the entity in question is of crucial importance. This is not only essential for the company's own valuation considerations but is also regularly the focus of pre-transaction due diligence exercises performed by potential buyers. An opaque set of financial figures can lead to increased uncertainty on the buyers’ side and, as a consequence, can also lead to an erosion of value in the transaction.

Naturally, the Covid-19 pandemic has also had a significant impact on the key factors influencing company valuations. In particular, the preparation and plausibility of forecasts regularly poses major challenges for companies and valuers. In this context, each company valuation should properly reflect macroeconomic consequences such as the recent pandemic.

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This article is part of a series of short articles about managing a successful carve-out. Other articles include:

• Could carve-outs be a strategy for success in the automotive industry?
• IT infrastructure – plan, do, check, act