What the Roach Motel and Hotel California Teach Us

About Valuing Pass-Through Entities

“Roaches check in, but they don’t check out”[1] is an apt analogy for many equity investments in financially distressed companies.  These owners typically cannot take distributions due to restrictions in credit agreements.[2]  Cash that was previously ‘checked in’ to the business cannot be ‘checked out.’

“You can check out any time you like, but you can never leave”[3] is also a suitable comparison for several equity investments in financially distressed companies.  These owners can sometimes take distributions.  However, the money has to be returned if the company subsequently files for bankruptcy and a court holds that the distribution was a fraudulent transfer.  The money can (effectively) never leave the company when this happens.

These observations have interesting implications for valuing pass-through entities that are, or may become, financially distressed.  Owners are responsible for a pass-through entity’s income taxes and typically receive distributions to pay them.  However, their ability to receive distributions, or keep distributions after receiving them, is substantially reduced when a pass-through entity becomes financially distressed.  Thus, owners can be responsible for entity-level income tax obligations yet have no ability to get reimbursed by the company that generated the taxable income.

There are two takeaways from these implications.  First, there is a cost to equity holders that should be factored into the valuation of equity interests.  Second, there is often a benefit to the company (and primarily its creditors)[4] that should be factored into the valuation of assets.

Equity as a Call Option

Many valuation practitioners think of equity as a call option.  If assets are greater than liabilities when a decision has to be made, the call option is exercised and equity has value.  Conversely, if assets are less than liabilities when a decision has to be made, the call option is not exercised and equity has no value.  Importantly, equity owners are typically[5] not responsible for bailing out an insolvent entity’s creditors.  Equity, like a call option, has limited liability.

The characterization of equity as a call option is particularly relevant when an entity is financially distressed.  This is the classic example used to make the point and conveniently fits with the theme of this article.

Consider a company that has to sell all of its assets on January 1.  Assume its assets are worth $150 million and that it has $200 million in liabilities.  The sale of all its assets would only generate enough funds to extinguish 75% of its liabilities.  This company is insolvent.  Equity in this situation is worthless.

Now assume that the company does not have to sell its assets on January 1 or file for bankruptcy.  The company is still insolvent because the value of its assets is still less than its liabilities.  However, the call option remains alive and the company’s assets may become worth more than its liabilities at some point in the future.  Equity in this situation has some value, which comes at the expense of the company’s creditors.

The value of equity/call option in this situation primarily depends on three factors:

• First, the degree of insolvency, as equity is worth more when the company has to climb out of a smaller insolvency hole than a larger insolvency hole;
• Second, the duration of the option, as a call option is worth more when it has a longer duration than a shorter duration; and
• Third, the volatility of the asset valuation, as a call option is worth more when volatility is higher, not lower.

Free Lunch

Equity investors can have the proverbial “free lunch” when a business is insolvent.  They can potentially encourage high risk/high reward investments.[6]  If the investments succeed, the insolvent company may become solvent and provide a payout to equity (and debt) investors.  If the investments fail, the costs are borne by the company’s creditors, not the equity investors.  Thus, equity could be characterized as “heads I win (and you win a bit too), tails you lose (and I lose nothing).”

Interestingly, a company’s creditors sometimes actively allow equity investors to have a free lunch.  This occurs when creditors could force the insolvent company into bankruptcy but choose not to in order to protect their own interests.  For example, creditors with claims that are currently worth 90 cents on the dollar may prefer that the company remains outside of bankruptcy if they believe their claims would only be worth 70 cents on the dollar at the end of the bankruptcy process.  Equity investors in this situation get a free lunch because the duration of their call option is extended at no cost to them.

It was common during, and immediately after, the recent Great Recession for creditors to be forbearing as they did not want many insolvent companies to file for bankruptcy.  Creditors would waive covenant defaults and/or extend maturities.  The practice became so prevalent that expressions such as “extend and pretend” and “delay and pray” were used to describe it.

There are other instances when equity investors have a built-in free lunch from the start.  One example is a leveraged buyout financed with covenant-light, payment-in-kind toggle loans.  These loans have limited levers for creditors to pull in order to reduce the duration of equity’s call option when a company becomes financially distressed.

No Free Lunch for Pass-Through Equity Investors

The thought process changes for equity in financially distressed pass-through entities.  These equity investors have more skin in the game than their C corporation (corp) investor counterparts.  This is why equity investors would presumably prefer a C corp over a pass-through structure when the company is financially distressed.

Consider the previous example of a company that has assets worth $150 million and $200 million in liabilities on January 1.  Now assume that the company is expected to generate taxable income over the next three years but the company is not expected to become solvent.  Equity investors will be responsible for making these income tax payments.  However, the potential asset appreciation that is correlated with the taxable income is expected to (primarily) benefit the creditors, not the equity investors.

Equity investors have to make a choice.  They can plan to make the income tax payments (by keeping the company out of bankruptcy) or choose not to invest any more money (by putting the company into bankruptcy before the owners incur an income tax obligation) and exercise their right to limited liability.

Sometimes it will make sense for these investors to plan on making the income tax payments.  For example, the value of the call option may exceed the present value of the income tax payments.

In other instances it will make sense to not make the income tax payments.  The equity investors in this case are effectively exercising a put option as they give their equity to the creditors in exchange for avoiding future obligations that may be incurred.

The bottom line: no free lunch for equity investors in pass-through entities.

This issue presumably affects many insolvent pass-through entities that have not filed for bankruptcy.  In order to transition from insolvent to solvent, many businesses will have to generate taxable income during the intervening period.  Thus, equity investors have to decide if they are willing to be responsible for future entity-level income tax bills while the company is insolvent and cannot be the financing source for these payments.

Fraudulent Transfer Lawsuits

A fraudulent transfer lawsuit can claw back an equity distribution that occurred two years before a debtor’s bankruptcy filing under federal law and over a longer period under many states’ laws.  A fraudulent transfer generally[7] occurs when, (a) the debtor did not receive reasonably equivalent value in exchange for the transfer, and (b) the debtor was insolvent[8] when the transfer was made.  Thus, payments made by the debtor to its owners over a multi-year period may have to be returned.

The plaintiff in a fraudulent transfer lawsuit presumably has to argue that the owners have the income tax obligation, not the company.  This argument is required to get around the reasonably equivalent value safe harbor.  The distribution cannot be clawed back if the debtor got a reasonably equivalent benefit in exchange for the payment, which is presumably the case if the company has the income tax obligation.[9]

This has an important valuation-related implication.  An argument could be made that entity-level income taxes should not be considered in the valuation of a pass-through debtor’s assets in the context of a solvency analysis.  More specifically, entity-level income taxes should not cause, or deepen, the debtor’s insolvency.  This is so because the debtor is not, (a) responsible for paying entity-level income taxes, and (b) legally allowed to make a distribution to its owners when it is insolvent.

This concept is not new.  Judge Easterbrook (a well-respected appellate judge that has addressed many business and valuation-related issues) took a similar position when reviewing a fraudulent transfer claim in Paloian.  He stated that entity-level income taxes “concern the market value of [a debtor’s] securities, not the state of [the debtor’s] balance sheet.”[10]

It does not necessarily follow that a pass-through entity is almost always solvent.  As previously discussed, the owners may be unwilling to be responsible for entity-level income tax bills when they cannot take a distribution and decide to put the company into bankruptcy.  This could potentially result in a bankruptcy filing that may not have happened if the business was structured as a C corp.

However, it seems reasonable to conclude that holding everything else constant, a pass-through entity is often more likely to be solvent than a C corp when the company is financially distressed.  Consider a business that is technically solvent (i.e., assets greater than liabilities) but inadequately capitalized and thus insolvent for fraudulent transfer purposes.  The equity owner will typically be motivated to make the entity-level income tax payment for the pass-through entity because the call option is valuable.[11]  The end result is the pass-through entity becoming better capitalized than the C corp that has to pay its own entity-level income taxes.

Conclusion

There are trade-offs when a business is set up as a pass-through entity instead of a C corp.  The potential for lower combined (entity and owner-level) income taxes is a key potential benefit for the pass-through structure.  However, the potential benefits come with potential costs such as those discussed in this article.  Any valuation of a pass-through entity’s assets, or claims on its assets, should take these trade-offs into consideration.

[1] This was the tagline for the Roach Motel commercials.

[2] For example, a credit agreement may prohibit distributions when the EBITDA/Interest ratio is less than 1.0.

[3] This is from the lyrics for the Eagles’ song titled, “Hotel California.”

[4] A balance sheet has to balance.  A dollar not spent by the company on entity-level income taxes is a dollar saved by the company, which results in more assets.  The beneficiary of the marginal increase in assets is often the creditors, not the equity owners, when the company is financially distressed.

[5] A personal guaranty on a debt obligation is an example where an equity owner is responsible for bailing out some of an insolvent entity’s creditors.

[6] A discussion about what is, or is not, a breach of fiduciary duty is beyond the scope of this article.

[7] The qualification stems from the so-called ‘actual intent’ prong.

[8] There are generally three tests of solvency: (a) assets vs. liabilities, (b) adequate capital, and (c) ability to pay debts.  For my perspective on how to execute these three tests, see: Michael Vitti (2014) Grounding Retrospective Solvency Analyses in Contemporaneous Information (3 of 3).  Business Valuation Review: Fall 2014, Vol. 33, No. 3, pp. 50-80.

[9] The income tax obligation would presumably be an antecedent debt if the company was responsible for the income tax obligation.  The repayment of an antecedent debt falls under preference laws, not fraudulent transfer laws.  A key difference is the look-back period as it is only one year for preference payments made to insiders.

[10] Paloian v. LaSalle Bank, N.A, 619 3.d 688, 694 (7th Cir. 2010).

[11] The option is in-the-money (the business is technically solvent) and has considerable upside as well.  The upside is due in large part because of the financial leverage that is implied by the characterization of this company as financially distressed.

Michael Vitti, CFA, joined Duff & Phelps in 2005. Mr. Vitti is a Managing Director in the Morristown office and is part of the Disputes and Investigations practice. He is also a member of the firm’s Complex Valuation and Bankruptcy Litigation group, focusing on issues related to valuation and solvency. Mr. Vitti has more than 19 years of valuation experience.
Mr. Vitti can be reached at: (973) 775-8250 or by e-mail to: Michael.Vitti@duffandphelps.com.

The author is not an attorney and is not offering legal advice. This article is written from a business valuation practitioner’s perspective who works on, among other things, bankruptcy-related matters.