The Hempstead Letter
Business Valuation & Corporate Finance News
Vol. XX, No. 1
In This Issue:
Reducing Fiduciary Liabilities
in Down-round Venture Financings
Since the NASDAQ crash of April 2000, the "down round" has become
entrenched as part of the venture capital landscape. A down round
is essentially what it suggests: a financing where investors purchase
stock from a company at a lower valuation than the valuation placed
on the company by earlier investors. As a result, down rounds
cause dilution of ownership for existing investors, which can
often demoralize the company's founders and employees whose stock
or options are worth much less or nothing at all. Down rounds
also force existing investors to negotiate with new investors
on various features of the financing. However, given the alternatives
of going out of business or finding a buyer at the lower valuation,
down rounds are often necessary and welcomed.
Before approving a down round, a company's board of directors
should carefully deliberate because directors have fiduciary duties
to protect the company's shareholders. One step in this process
is to obtain an independent valuation or fairness opinion to support
the transaction, with the opinion to be rendered by an independent
business valuation firm selected by independent and disinterested
directors.
In one recent case, Kalashian v. Advent VI Limited Partnership
(Sup. Ct. Calif., No. CV-739278), that is being watched closely
in the venture capital community, the board of directors of Alentec
Corporation were sued for breach of fiduciary duty and fraud after
approving a down round and several subsequent rounds of financing
that greatly reduced the ownership percentage of the company's
founders in favor of a venture capital fund which owned the company's
preferred stock. The court's finding in this case suggests that
any stockholder that is subjected to additional dilution mandated
by a down- round might have a claim that directors of the company
failed to exercise their fiduciary duties and protect the stockholders'
interests when the directors voted to approve the transaction.
In documenting the fairness of a dilutive financing, directors
should attempt to build steps into their decision making process
to support a record of their deliberation and good judgment on
behalf of shareholders.
In particular, directors approving a down round should be particularly
sensitive to issues involving conflicts of interest. These types
of conflicts occur where one or several directors stand to benefit
from the down round due to either the dilutive effect it will
have on the company' capitalization, or their participation in
the down round (typically referred to as an "inside down round").
Independent Transfer
Pricing Studies Play Critical Role in Supporting Royalties Paid
to Intellectual Property Holding Companies
Faced with the prospects of severe budget crunches, many states
have launched full-scale attacks on intellectual property ("IP")
holding companies. Dozens of cases are in litigation across the
country, and widely varying results have been reported from state
to state.
Many corporate structures today include the establishment of
an IP holding company that typically owns the corporate group's
intellectual property and receives royalty income when the intellectual
property holding company licenses the intellectual property to
the operating companies within the group.
If the IP holding company is established in a jurisdiction, such
as Delaware, that does not impose a corporate income tax on certain
forms of passive income, such as royalties, the operating entities
may be entitled to state tax deductions on their royalty payments
to the IP holding company.
One of the states' key lines of attack is to assert expansive
theories of nexus against IP holding companies whose only presence
in the taxing state is the use of their intangible assets. Increasingly
though, states have also begun to deny or seek adjustments for
royalties paid to IP holding companies under state law authority
similar to federal Section 482 of the Internal Revenue Code. Federal
tax law provides that a transaction between controlled corporations
should be respected if the transaction has a valid business purpose
and has economic substance.
Under IRC Section 482, related parties (also referred to as "controlled")
must trade at arm's length. According to the U.S. regulations,
"arms-length" is intended to refer to the behavior that takes
place when unrelated parties make exchanges under competitive
market conditions. The Section 482 regulations put emphasis on
the results (i.e., profits) that would have been obtained at arm's
length under circumstances comparable to those of the controlled
parties, and established the concept of an "arm's length result".
In short, imposition of the arm's length standard is the method
by which tax authorities endeavor to create market conditions
within a controlled group of companies.
Within the context of IRC Section 482, taxpayers seeking to create
arm's length results within a related party group may choose upon
a set of methodologies detailed in the Section 482 regulations
(the "specified methods") or they may apply some other means ("unspecified
methods") to establish intercompany prices. Selection of an arm's
length approach is guided by a set of steps collectively as the
"best method rule."
While, it is not yet clear whether the states will prevail with
these arguments, a recent case in New York provides a good road
map on how to implement an IP holding company structure that has
both valid business purpose and economic substance. In Matter
of the Petition of Sherwin-Williams Co., NYS Division of Tax Appeals,
ALJ, DTA, No. 816712, 6-7-2001, a New York administrative law
judge ruled that the New York Division of Taxation could not require
a corporation to file a combined franchise report with its two
IP holding company subsidiaries.
One of the arguments New York State had raised in the case was
that the taxpayer had failed to rebut the presumption of distortion
of income that arose from its substantial intercompany transactions
(i.e., royalty payments). In reaching his decision, the administrative
law judge noted that the taxpayer could rebut this presumption
by showing that the transactions (i.e., royalty payments) were
at arm's length, as that term is defined in the IRC Section 482
regulations. Luckily for the taxpayer, the company had commissioned
an independent transfer pricing report at the time the IP holding
company structure was implemented.
This report utilized the IRC Section 482 methodologies to establish
that the royalties paid to the IP holding companies were at "arm's
length." Upon review of the transfer pricing report, the administrative
law judge found that the royalty rates charged by the IP holding
companies fell within an arm's length range based on the following:
(1) a third-party analysis selected uncontrolled taxpayers that
were comparable within the meaning of IRC Section 482, (2) the
expert made appropriate adjustments to the comparables, (3) the
profit level indicators (rate of return of operating capital and
various financial ratios, including the ratio of operating profit
to sales) were appropriately applied, and (4) the IP holding company's
profit level indicators fell within the required range.
This decision certainly underscores the need to document intercompany
royalty rates using an independent expert. Furthermore, by endorsing
the use of the IRC 482 methodologies in a state tax matter, this
decision has significantly raised the bar as to the documentation
that is required to establish an arm's length royalty rate. At
Hempstead, our professionals have been involved in a number of
projects involving the development of arm's length royalty rates
for intellectual property utilizing the IRC Section 482 methodologies.
If you are considering establishing an IP holding company structure
or are simply concerned as to whether the methodology used to
establish a royalty rate paid to an existing IP holding company
meets the stringent requirements of IRC Section 482, please give
us a call.
New
Jersey Superior Court Denies Valuation Discounts In Marital
Dissolution Proceeding
In a recent appellate decision, the New Jersey Superior court
affirmed a lower court's decision not to apply a minority interest
discount or a lack of marketability discount in arriving at the
value of a 47.5% interest in closely held florist supply business
that was subject to equitable distribution. One of the key issues
in the matter of Brown v. Brown, 2002 N.J. Super. LEXIS 105 (N.J.
Super. Feb. 28, 2002) was whether or not the trial court erred
in adopting the wife's expert's valuation of the husband's interest
which did not discount the value of the stock for minority interest
status or lack of marketability.
In reaching its decision, the appellate court discussed the trial
court's refusal to discount the shares' value for minority interest
status or lack of marketability. The appellate court included
a thorough discussion of its reasoning on the issue, citing to
the prior New Jersey shareholder cases of Balsamides v. Protameen
Chemicals, Inc., 160 N.J. 352, 368, 734 A.2d 721 (N.J. 1999) and
Lawson Mardon Wheaton, Inc. v. Smith, 160 N.J. 383, 397, 734 A.2d
738 (N.J. 1999) along with the "fair value" standard. In reaching
its decision, the appellate court adopted, for marital dissolution
purposes, 2 ALI Principles of Corporate Governance §7.22, which
states that minority and marketability discounts should not be
applied absent extraordinary circumstances to warrant their application.
This is the same principle that was previously adopted in Balsamides
and Lawson. Finding that there were no such extraordinary circumstances
in this case, the appellate court held that the trial court did
not err in refusing to apply discounts to the value of the husband's
interest in the business.
This ruling is part of a continuing trend to recognize that in
equitable dissolution matters, the key measurement of the value
of a closely held business is the businesses' economic worth to
the marital community and its present owner(s) as opposed to the
hypothetical willing buyer standard used in most federal tax matters.
In choosing a valuation expert in a marital dissolution matter,
attorneys should choose an appraiser who is sensitive to the legal
basis behind the differing standards of value that are applicable
in various jurisdictions and the valuation implications of these
differing standards.
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