We Appraise Both Businesses and Real Estate

April 2008

Lease Issues and Business Value

Many businesses do not own the real estate they occupy.  Instead, the premises are typically leased.  A lease is a written agreement that transfers the right to use and occupy real property for a specified period of time in return for rent.  Leases often include many other provisions, some of which can be quite complicated, that may affect the value of the business occupying the site.    

Business appraisers must carefully consider the implications that the lease has on business value.  There are many.  I have chosen to discuss of few of them in this article.

First, an outrageous, but real example.   A few years ago a retail store located in a regional mall was put up for sale.  It had been in the mall for quite a few years and had been very successful.  Due to large amounts spent for advertising and good business practices, the retail store’s revenue and profits had grown each year and it appeared to be highly desirable as a business purchase.  A buyer was found that made an acceptable offer on the business and both the buyer and seller were happy.  Only one problem existed.  The real estate lease was expiring in less than a year and it turned out that the regional mall had a new jewelry store in mind for the space that was willing to pay a much larger rent.  When the buyer applied to assume the lease and requested a renewal of the lease, the mall told them that the lease would not be renewed.  The pleadings of the seller and references to long-term loyalty including spending lots of dollars to bring customers to the mall were to no avail.  The lease was not renewed, the business relocated outside the mall but it never regained profits anything like what they were while in the mall and it eventually went out of business.  As shown in this example, the failure to be able to renew and transfer the lease eliminated what had appeared to be a significant business value.

Lease issues that must be considered when valuing a business include, but are not limited to, the following:

The remaining term of the lease is usually the easiest potential problem to spot.  Usually, the expiration date of the lease is clearly defined.  Some businesses are easier to move to a new location than others.  The easier it is to relocate a business, the less impact on the value due to the lease.  Conversely, the more difficult to move the business, the greater the impact on the value related to the lease.

Renewal options can be tricky.  Many leases spell out specific formulas or fixed amounts for the rent for each renewal option, however, quite a few leases call for vague and ambiguous rent provisions for the renewal periods.  A clause that calls for an agreement to agree on the future rent is not very worthwhile and cannot typically be relied on to assure renewal of the lease.  A reference to market rent at the time of renewal can also be a problem.  If the business is highly dependent on the location and market rents soar for any number of reasons, the future market rent may be so much higher than current rent as to eliminate all or much of the business profits.  Estimating future market rents five or more years down the road is difficult as well.  Such a renewal option increases the risk of achieving the forecasted business income stream effectively reducing the value of the business.

Transferability issues are relatively obvious.  They can cause huge problems as shown in the example.  Often, the lease calls for landlord approval of transfer of the lease with approval “not to be unreasonably withheld.”  Other times the lease gives the landlord a great deal of discretion regarding transferability of the lease again effectively reducing the value of the business.

Below or above market rent may affect the value of the business substantially.  A long-term lease with below market rent that is clearly transferrable may increase the value of the business, however, should the property be foreclosed upon, the lease may be extinguished eliminating this increased value.  If a business is paying above market rent, the business is often motivated to relocate and thus reduce this expense or may be able to renegotiate the lease if relocation is a strong possibility.  These factors are challenging to deal with in business valuations.

Percentage rent or other participation clauses must be taken into consideration especially when forecasting future revenues.  Some leases, particularly long-term leases for businesses like restaurants, have a clause that requires the tenant to pay a certain percentage of gross revenue if that amount exceeds the basic rent.

Default provisions can create uncertainty especially if a business has difficulty avoiding some provision that could be used by the landlord to get out of the lease.

Ownership of leasehold improvements is generally specified in the lease.  Many businesses include leasehold improvements on their balance sheet, however often at the termination of a real estate lease they become the property of the landlord.  Even if they really do belong to the tenant, are they worth anything if the tenant leaves the location – can they be removed and used elsewhere?  Usually, the leasehold improvements have no value as they cannot be removed and used elsewhere; they are simply on the company’s books and the cost is being recovered by depreciating them.

Requirements to restore premises to original condition can be particularly onerous depending on the nature of the business and the amount invested.  If some environmental issues are involved and total clean-up is required, the cost of the remediation is sometimes larger than the value of the business enterprise.

Valuations play a part in all strategic transactions, tax, and many litigation matters. For additional information or advice on a current situation, please do not hesitate to call.  We value both real estate and businesses, including machinery & equipment. 

March 2008

S Corp Valuations & Gross v. Commissioner

In the now famous court case entitled Gross v. Commissioner,[1] a very profitable Pepsi Cola distributorship that paid out large amounts as distributions to its shareholders was valued by the taxpayer’s expert using the then standard valuation technique of tax-affecting the income stream “as if” the entity were a ‘C’ corporation.  This technique was disallowed by the court causing an upheaval in the valuation profession.  Since this time, this valuation concept has been studied, reported on, and analyzed by many valuation experts.  Several valuation models have been developed which are now commonly used to value minority interests in ‘S’ corporations especially when the report is prepared for tax purposes.  Tax-affecting the income stream “as if” the entity were a ‘C’ corporation is generally considered perfectly appropriate when valuing a 100% control interest in the entity, but it certainly is not appropriate when valuing a minority interest in an ‘S’ corporation.  

Whether or not a minority interest in an ‘S’ corporation or a ‘C’ corporation is worth a different amount has been the subject of many arguments and articles in the business valuation profession since the Gross v. Commission case was first published.  Since then, several more cases have strengthened the IRS’s resolve to disallow tax-affecting the income stream when valuing minority interests in ‘S’ corporations.  

The basic concept underlying the valuation of a minority interest in an ‘S’ corporation is fairly simple:  “if you have to pay income taxes on the income you receive from an investment, you end up with less in your pocket than if you didn’t have to pay taxes.  Therefore, all things being equal, if one investment has taxes levied on it, and the other does not, an investor would choose the one that does not.”[2]   

‘S’ corporations were originally authorized by congress so that small business corporations that elected this status could be taxed in the same manner as partnerships effectively doing away with the double taxation problem that ‘C’ corporations have, i.e. income is taxed at the corporate level and then dividends paid out to shareholders from after-tax income is taxed again to the shareholders.  The creation of ‘S’ corporations eliminated the dividend tax that the individual shareholder must pay.  In fact, the shareholders of ‘S’ corporations pay the income tax that a ‘C’ corporation would have paid personally on their share of the income, whether or not cash is actually distributed, at personal income tax rates.  Currently, personal and corporate income tax rates are substantially equal so the real benefit to the investor is that the investor does not have to pay dividend tax on any amount distributed to them from an ‘S’ corporation.  

An additional benefit of an ‘S’ corporation when less than 100% of profits are paid out to shareholders is that the earnings not paid out will increase the shareholders basis in their investment and lessen the eventual capital gains tax that will have to be paid when the investment is actually sold.  Some ‘S’ corporation models attempt to quantify this benefit by making a number of subjective assumptions regarding the likely holding period of the investment and generally use a different risk rate to discount this future benefit as the risk of receiving it is much higher than the benefit of not paying dividend taxes.  Unless a transaction is expected in the near future, the present value of this benefit is generally immaterial.  Investors in closely held companies typically have a long investment horizon, often estimated at approximately fifteen to twenty years.  Under the fair market value standard of value, a typical investment holding period is assumed, therefore, this possible benefit is often not given any weight in many valuations.  

Depending on the amount of cash distributions relative to the amount of income tax that must be paid by the shareholder personally, the value of ownership interests in ‘S’ corporations may be worth less than an otherwise similar ‘C’ corporation, may be worth the same, or may be worth more.  For example, some ‘S’ corporations pay out less cash to shareholders than the shareholder will have to pay personally in income taxes for the investment, some pay out just enough to cover the personal income tax liability, and others pay out more than is necessary to pay the personal income tax liability.  

Since the Gross v. Commission case was decided, a number of valuation models have been developed to value minority interests in ‘S’ corporations.  Among these models, the one that we believe best presents the value in an understandable manner is the model developed by Chris Treharne, ASA, MCBA, BVAL in his article entitled “S Corps:  Follow the Cash” presented at the 2006 Institute of Business Appraisers conference and based on the article entitled “Valuation of Minority Interests in Pass-Through-Tax Entities” published in Business Valu