Market value for small business retirement concession Div. 152 ITAA

The need for a small business retirement concession

Peloton is frequently invited to assist tax advisers and lawyers when a small business owner contemplates a sale of the business – prompting consideration of the small business retirement concessions in the Income Tax Assessment Act (particularly Division 152).

Division 152 provides that sale proceeds can be directed to superannuation if the business assets held by the taxpayer have a market value less than $6m.

The net tax benefit of Division 152 can be as much as $1.4m.

Peloton is regularly engaged to undertake an assessment of the market value of the equity interest of the taxpayer prior to sale.

Valuation issues and considerations

The assessment of market value must be compliant with the ATO market valuation guidelines which, in turn, reference the International Valuation Standards Council guidelines.

As the assessment of the taxpayer’s (client’s) equity interest in the business is required to be undertaken prior to sale, it is effectively an assessment of value in an ‘as is’ state.

Typical sale and purchase agreements impose a range of conditions precedent which alter the likely dividends that the taxpayer would otherwise receive on an ongoing basis as a result of requirements such as:

1. All shareholders selling into the purchase agreement at the same time and price
2. Contingent consideration relating to the future performance of the business
3. Retention of key personnel for a specified period
4. Employment agreements with key people specifying ongoing remuneration and employment conditions
5. Warranties relating to a range of issues from tax to ownership of intellectual property
6. Other conditions precedent which effectively de-risk the transaction from the purchaser’s perspective.

Typical small businesses exhibit contrasting characteristics, including:

• Lack of shareholder agreement governing sale of equity interests – particularly ‘drag-along’ provisions which require all shareholders to sell if a majority agree to sell
• Key person risk which has not been mitigated through succession planning
• Absence of employment agreements with key personnel
• Identification and protection of intellectual property
• Lack of binding agreements with key suppliers and customers
• Documented strategic and business plans
• Lack of multi-year forecasting including business cases for growth initiatives

As a consequence, the market value of an equity interest in the ‘as is’ state can often be materially different to the price and consideration which a purchaser might be expected to pay under the terms of a typical sale and purchase agreement.

The valuation of an equity interest in an entity operating a small business usually, therefore, proceeds on the basis of:

1. An assessment of likely future profits or cash flows taking into account historical levels of profitability, the need for investment in growth initiatives, key person risk, competitive landscape, existence of systems and processes to ensure maintainability of profits and other factors
2. An assessment of enterprise value based on capitalisation of expected maintainable profits or cashflows and a benchmark capitalisation multiple or discount rate
3. Assessment of non-business assets and corporate liabilities which are part of the entity’s balance sheet
4. Consideration of any shareholder agreement and, in the absence of such an agreement, the risks presented to the equity holder in regard to appointment of directors, pre-emptive rights and share sale provisions in the company’s constitution
5. Consideration of marketability and control premium/minority discounts (including governance risks to a minority holder)

The valuation inputs can be represented diagrammatically:

Peloton solution

Peloton’s valuation assessment relies on four key pillars:

1. Strategic analysis – competitive landscape, existence of an economic ‘moat’, existence of strategic initiatives to preserve and grow the economic moat, potential for disruption of the business via (for example) digital transformation by competitors
2. Capital market analysis of returns including identification of transaction evidence relating to sales of similar businesses
3. Financial analysis of both historical and future profits including identification of normalisation adjustments relating to (for example) non-recurring income and expenses, adjustment to market rates of related party transactions such as wages and premises rent and normalisation of working capital requirements (e.g. in relation to revenue received in advance of production)
4. Legal rights of the equity holder – including consideration of the company constitution and any shareholder agreementA build-up approach to equity value requires assessment of non-trading assets such as cash, Division 7A-related shareholder loans, non-trading investments and strategic asset holdings which do not contribute to the generation of profits. This will sometimes involve assessing the recoverability of related-party loans and marking to market as necessary.

If an operating entity holds property from which the business operates it is often necessary to obtain a property valuation and normalise rent expense in assessing the maintainable profits.

Corporate liabilities including income tax, bank debt and related party loans also require marking to market, as necessary.

Peloton examines these adjustments through a process known as columnar dissection of the balance sheet. This process enables assessment of the impact of revaluation of the enterprise along with adjustments to any non-trading assets and corporate liabilities in order to arrive at an assessed market value of 100% of the equity interests.

After assessment of the pro forma market value of the entity, the ownership and transfer issues such as discount for lack of marketability and control premium/minority discount are considered.

This process results in an assessment of the market value of the taxpayer (client) equity interest consistent with the ATO market valuation guidelines.

Outcomes

Peloton’s team has undertaken many tax-related engagements and many Division 152-specific valuations.

As a consequence, Peloton has developed a robust and reliable process for these valuations – one which is repeatedly relied on by many of Peloton’s referrers.