Business Associations Set 3 (Accounting, Winding Up & Valuation)

Front 1

General Rules of Financial Accounting

Back 1

1) The business is an entity separate from itsindividual owners.

2) All entries are to be in dollars.

3) A balance sheet must balance.

4) Every transaction must be entered in two ways if#3 is to be met.

Front 2

Basic Financial Statements

Back 2

1) Balance Sheet

a. Overview of general health of the company

b. Superficial test that tries to capture a broadview of what’s happening

c. Used by lenders and investors but is not theexclusive tool

2) Income Statement

a. More fluid than the balance sheet

b. Traces money as it flows through the company

i. Lessmalleable than the balance sheet

c. Shows cash flowd. Important to lenders, investors, executives

3) Capital Accounts

a. Usually only interesting to the partnersinvolved

b. Captures draws, equity of partners

c. Interesting to lenders and investors to see howmuch money the partners are pulling out of the venture.

d. Profits are not necessarily automatically paidout to partners. It can be rolled back into the company or earmarked forsomething else.

Hint 2

The accounting system uses historical cost for assets asopposed to current value. So a truckpurchased 5 years ago appears on the balance sheet at its historical cost(minus depreciation), though the current value may be significantlydifferent.

It’s easy to substantiate as opposed to fair marketvaluation or some other system which would be subject to a lot of manipulationand abuse.

Front 3

Winding up and distributions

Back 3

Under both UPA and RUPA the debts to external creditors mustbe paid before partners-as-creditors.

UPA 40. Rulesfor Distribution.

In settling accounts between the partners after dissolution, the followingrules shall be observed, subject to any agreement to the contrary:

(b) The liabilities of thepartnership shall rank in order of payment, as follows:

1) Those owing to creditors other thanpartners,

2) Those owing to partners other thanfor capital and profits,

3) Those owing to partners in respectof capital,

4)Those owing to partners in respect of profits.

Hint 3

RUPA§ 807. Settlement of Accounts and Contributions AmongPartners.

(a) In winding up a partnership's business, the assets ofthe partnership, including the contributions of the partners required by thissection, must be applied to discharge its obligations to creditors, including,to the extent permitted by law, partners who are creditors. Any surplus must beapplied to pay in cash the net amount distributable to partners in accordancewith their right to distributions under subsection (b).

BUT Comment 2 to section 807 provides: Ultimately, however, a partner whose “debt” has been repaidby the partnership is personally liable, as a partner, for any outside debt remainingunsatisfied, unlike a limited partner or corporate shareholder. Accordingly, the obligation to contributesufficient funds to satisfy the claims of outside creditors may result in theequitable subordination of inside debt when partnership assets are insufficientto satisfy all obligations to non-partners.

Front 4

Winding up and deceased partners

Back 4

UPA §40(g): The individual property of a deceased partner shall beliable for the contributions…

Hint 4

RUPA §807(e): The estate of a deceased partner is liable for thepartner’s obligation to contribute to the partnership.

Front 5

Winding up when one partner is insolvent

Back 5

UPA §40(d): If one partner is insolvent, other partners contribute the additional amount necessary to pay the liabilities.

Hint 5

RUPA §807(c): If one partner doesn’t contribute, all other partners contribute (in proportions in which they share losses) to satisfy the partnership obligations.

Front 6

Winding up and paying debts

Back 6

UPA §40(d): Partners must contribute the amount necessary to satisfy the liabilities.

Hint 6

RUPA §807(b): Losses resulting from liquidation must be charged to the partners’ accounts. Partners contribute equal to excess of charges over credits in the account.

Front 7

Valuation Approaches

Back 7

1. Asset-based valuations

2. Earnings-based valuations

3. Discounted Cash-flow valuations

4. Market value

Hint 7

Many analysts rely on the weighted average of all threemethodsEach valuation is conducted and then given a greater orlesser weight depending on the perceived reliability of each methodology incomparison to the others.

Front 8

Earnings-based Valuations

Back 8

Based on the historical performance of the company and other comparable companies

Price = yearly earnings divided by the desired rate of return that other investment opportunities offer

Hint 8

Benefits…

· This approach focuses more on the company’searnings and appreciates that the company is a going concern.

· It is also relatively easy to compute.

· Far more meaningful than Asset-Based Valuations

Detriments…

· Historic performance doesn’t guarantee futureperformance· Highly susceptible to manipulation

· More complicated

Front 9

Asset-Based Valuations

Back 9

a. Equity Book Value

b. Liquidation Value

c. Replacement Value

Hint 9

Benefits…

· Easy to compute (subtract one number from another)

. Can be comforting and understandable for business owners

Detriments…

· Fraud and manipulation may be built into the numbers when a business owner is unable to understand how the numbers were arrived at

· Doesn't understand or consider that a business is a going concern

· Fails to capture market value. Just focused on assets, not intellectual capital, brand value, etc.

Front 10

Discounted Cash-Flow Valuations

Back 10

1. Estimate Future Cash Flow

2. Estimate Terminal Value

3. Discount to Present Value

Hint 10

Benefits…

· Forward looking

· Especially useful when future financial resultsare expected to be different from current results

· Recognizes time value of future cash flows

· Accounts for the buyer’s cost of capital

· Does not depend on comparison with similarcompanies

· Based on real cash flows instead of accountingvalues

Detriments…

· Assumes future cash flows and terminal value canbe estimated with reasonable accuracy

· Complicated and convoluted calculation

Front 11

Earnout Agreements

Back 11

· Parties to an acquisition may agree on aconservative, baseline sale price

· Built into the contract are performancebenchmarks

· If company meets those benchmarks, additionalpayments are made to the seller

Hint 11

This is what happens in sports contracts quite often.Riskybecause the buyer may be able to manipulate the benchmarks so they don’t needto make the payments.

Front 12

Capital Losses split among partners

Back 12

UPA §18. Rules Determining Rights and Duties of Partners.

The rights and duties of the partners in relation to the partnership shall be determined, subject to any agreement between them, by the following rules:

(a) Each partner shall be repaid his contributions, whether by way of capital or advances to the partnership property and share equally in the profits and surplus remaining after all liabilities, including those to partners, are satisfied; and must contribute towards the losses, whether of capital or otherwise, sustained by the partnership according to his share in the profits.

Hint 12

RUPA §401. Partner's Rights and Duties.

(a) Each partner is entitled to an equal share of the partnership profits and is chargeable with a share of the partnership losses in proportion to the partner's share of the profits.

(b) A partnership shall reimburse a partner for payments made and indemnify a partner for liabilities incurred by the partner in the ordinary course of the business of the partnership or for the preservation of its business or property.

RUPA Section 401 follows the default approach of UPA Section 18. But the comments acknowledge that the default rule may lead to unfairness in a scenario where one partner solely contributes capital and the other solely contributes labor. Nevertheless, RUPA requires parties to contract around this result. RUPA drafters may want to incentivize people to address it in partnership agreements.