Strategic Advisory

---
name: strategic-advisory
description: >
  Contains verified QoE adjustment categories and working capital normalization
  procedures, IRS 9-factor reasonable compensation test with independent investor
  test (Exacto Spring), and coverage gap analysis methodology with key person
  insurance valuation formulas. M&A due diligence, succession planning, buy-sell
  agreements, compensation benchmarking, insurance adequacy, debt covenant
  compliance, capital allocation, advisory pricing. Consult when analyzing an
  acquisition or quality of earnings, planning ownership transitions or ESOP/MBO
  structures, defending officer compensation or building a benchmarking study,
  reviewing business insurance coverage gaps, monitoring debt covenants or
  DSCR/leverage ratios, evaluating capital allocation or dividend vs reinvestment
  decisions, or pricing advisory and outsourced CFO engagements.
---

# Strategic Advisory

Operational procedures for strategic finance advisory services to closely-held
C-corporations. Covers the full advisory spectrum from transaction diligence
through succession planning, with pricing guidance for scoping engagements.

## M&A Due Diligence

### Diligence Phases

Three sequential phases govern every transaction:

1. **Preliminary** — NDA, CIM review, initial financial screening (revenue
   trend, EBITDA margin, customer concentration, capital intensity), IOI with
   valuation range. Engage outside counsel and tax counsel early — structure
   drives economics.
2. **Detailed** — VDR access organized by functional area (financial, tax,
   legal, operational, HR, IT, environmental). Management presentations,
   site visits, detailed financial model, quality of earnings (QoE) report.
3. **Confirmatory** — Third-party confirmations (bank balances, AR, insurance
   coverage letters), working capital peg finalization, bring-down diligence,
   final report to buyer's board or investment committee.

### Quality of Earnings Adjustments

QoE bridges reported earnings to sustainable recurring EBITDA. Three adjustment
categories:

- **Non-recurring** — One-time gains/losses, restructuring charges, transaction
  costs, pandemic-related items (PPP forgiveness, ERTC, business interruption)
- **Owner-related** — Above-market officer compensation (benchmark using the
  compensation methodology below), personal expenses through the business,
  related-party rent vs. FMV, related-party transactions at non-arm's-length
- **Accounting/pro forma** — Revenue recognition differences, inventory method
  conversions, depreciation assumptions, accrual vs. cash conversion,
  full-year run rate of mid-year changes, annualized cost savings

### Working Capital Normalization

Define working capital as current assets (excluding cash) minus current
liabilities (excluding current portion LTD and income tax payable). Compute
the peg using trailing 12-month average of monthly normalized working capital
(24-month for seasonal businesses). Purchase agreement sets the target at
signing; true-up occurs 60-90 days post-close.

### Transaction Structure Decision

- **Asset purchase** — Buyer selects assets/liabilities, gets stepped-up
  basis (higher depreciation), seller recognizes gain per asset (ordinary
  recapture + capital gain on goodwill)
- **Stock purchase** — All assets and liabilities transfer, existing basis
  carries over, contracts/licenses stay in place, buyer inherits tax
  attributes (NOLs subject to Section 382)
- **Section 338(h)(10)** — Joint election on Form 8023 treating stock
  purchase as asset sale for tax only. Buyer gets step-up; seller reports
  deemed asset sale on final return. Advantageous when target has NOLs to
  offset deemed sale gain

### Purchase Price Allocation (ASC 805)

Allocate total consideration to identifiable assets/liabilities at fair value.
Tangible assets at FMV, intangible assets (customer relationships, trade
names, technology, non-competes) each require separate valuation. Residual
to goodwill — not amortizable for book (ASC 350 impairment), amortizable
over 15 years for tax (Section 197). Engage a qualified valuation firm for
transactions exceeding $5M enterprise value.

### Diligence Red Flags

Declining gross margins without explanation, customer concentration >25%
from one customer, heavy related-party transactions, off-balance-sheet
obligations, deferred revenue inconsistencies, sudden revenue acceleration
near transaction date.

> **Deep dive:** Read `references/ma-due-diligence.md` for the complete
> financial diligence checklist (3-5 years of records), tax-specific items
> (ASC 740, NOL schedules, R&D credits), Section 368 reorganization types,
> earnout structures and tax treatment, integration planning (Day-One
> readiness, COA harmonization, cutoff procedures), and recording of
> acquisition entries in the accounting system.

## Succession and Ownership Transition

### Valuation Approaches

IRS Revenue Ruling 59-60 requires consideration of all relevant factors.
Three primary approaches:

- **Asset-based** — Adjusted net asset value (restate each asset/liability
  to FMV). Best for asset-intensive businesses or holding companies.
- **Income-based** — Capitalization of earnings (normalized earnings / cap
  rate; typical small-company cap rates: 15-30%) or discounted cash flow
  (5-10 year projections discounted at WACC plus terminal value). Best for
  operating companies with earnings history.
- **Market-based** — Comparable transactions (BizBuySell, Pratt's Stats)
  or guideline public company multiples with size/liquidity adjustments.

Most engagements use two or more approaches and reconcile.

### Valuation Discounts

- **DLOM (lack of marketability):** 15-35%, supported by restricted stock
  and pre-IPO studies
- **Minority/lack of control:** 15-25%, derived from control premium studies
- **Key person:** 5-25%, based on revenue/profit at risk from departure
- **Combined discount cap:** Stacked discounts exceeding 40-45% attract
  IRS challenge; each must be independently supportable

### Buy-Sell Agreement Structures

- **Cross-purchase** — Remaining shareholders buy departing shareholder's
  stock; buyers get stepped-up basis. Unwieldy with >3-4 shareholders.
- **Entity redemption** — Corporation redeems stock. Simpler for multiple
  shareholders. Risk: Section 318 attribution may recharacterize as dividend.
- **Hybrid** — Entity has first right of refusal, then remaining shareholders.

Funding mechanisms: life insurance (most common for death trigger), installment
notes (5-10 years, must meet AFR minimum under Section 7872), sinking fund
(no underwriting required but exposed to creditors).

### Ownership Transition Paths

- **Internal sale** — Installment sale, gift/sale combination using lifetime
  exemption, GRAT for appreciation exceeding Section 7520 rate
- **MBO** — Management equity + seller financing + third-party debt; consider
  Section 338(h)(10) election
- **ESOP** — C-corp seller can defer gain under IRC Section 1042 if ESOP
  holds 30%+ post-sale and proceeds reinvested in qualified replacement
  property within 12 months
- **Third-party sale** — Competitive bidding, 3-5 years clean financials,
  representations and warranties insurance
- **Liquidation** — Last resort; double taxation (corporate gain + Section
  331 shareholder gain)

### Estate Tax Considerations

Lifetime exemption: $13.99M per individual (2025). TCJA sunset risk: reverts
to ~$7M if provisions expire. Anti-clawback rule (Treas. Reg. 20.2010-1(c))
protects gifts made under higher exemption. Section 2701 special valuation
rules apply to junior equity transfers when senior interests retained.

Planning horizon: 3-7 years for optimal tax and operational outcomes.

> **Deep dive:** Read `references/succession-planning.md` for full
> treatment of Section 1202 QSBS exclusion, accumulated earnings tax
> implications for transition cash reserves (Section 531), Section 302
> redemption qualification tests, equity tracking for shareholder
> positions in the accounting system, and key person risk quantification
> methodology.

## Compensation Benchmarking

### IRS Reasonable Compensation Framework

The IRS 9-factor test (from the Reasonable Compensation Job Aid):
training/education, duties/responsibilities, time/effort, comparable
compensation, revenue/complexity, nature/scope of work, compensation history,
ratio to non-shareholder employees, and compensation agreements.

**Independent investor test** (*Exacto Spring Corp*, 7th Cir. 1999): Would a
hypothetical outside shareholder be satisfied with the return on equity after
officer compensation? Calculate implied ROE: (net income after compensation) /
shareholder equity and compare to risk-adjusted market returns.

### Benchmarking Methodology

1. **Define positions** — Map officer duties to SOC codes. For multi-hat
   officers, identify each role separately with time allocation (e.g., 40%
   CEO, 30% CFO, 30% VP Sales)
2. **Select comparables** — Match by NAICS code (4-6 digit), revenue band,
   geographic market, company maturity
3. **Apply adjustments** — Geographic (BLS area differentials), revenue/size,
   industry, experience, multi-role premium (aggregate weighted market values)
4. **Establish range** — Present 25th-75th percentile; position within range
   based on qualitative factors
5. **Document** — Written study that a third party can follow; retain source data

### Data Sources

- **Tier 1 (free, authoritative):** BLS OES (bls.gov/oes) — median/percentile
  by SOC code and MSA
- **Tier 2 (commercial):** ERI Economic Research Institute, Salary.com
  CompAnalyst, RCReports (IRS-ready reports)
- **Tier 3 (supplemental):** Robert Half Salary Guide, SEC DEF 14A proxy
  statements, trade association surveys

### Documentation Package

Board resolution referencing benchmarking analysis, written employment
agreement (signed before tax year begins), compensation study, job
description, time records, and dividend history (for C-corps, demonstrates
compensation is not disguised dividends).

**C-corp optimization crossover:** Higher compensation reduces corporate
income (21% flat rate) but increases payroll tax (15.3% to SS wage base,
2.9% above). Model both sides.

> **Deep dive:** Read `references/compensation-benchmarking.md` for
> Form 1120 Schedule E reporting requirements and IRS automated screening
> triggers, Section 162(m) $1M deduction cap applicability to private
> C-corps, zero-compensation year handling, and officer compensation
> account setup in the accounting system.

## Insurance Adequacy Review

### Core Coverage for C-Corps

- **GL:** $1M occurrence / $2M aggregate (foundation of any program)
- **Commercial Property:** Confirm replacement cost vs. ACV valuation;
  watch for flood/earthquake/equipment breakdown sublimits
- **BOP:** Bundles GL + property; cost-effective for smaller C-corps but
  compare against standalone quotes when revenue >$5M or property >$1M
- **Workers' Comp:** State-mandated; premiums based on payroll, job
  classification, EMR
- **Commercial Auto:** Required if business owns/leases vehicles; add
  hired/non-owned auto endorsement for employee personal vehicles
- **Umbrella:** $1M-$10M increments above GL, auto, employers' liability

### Specialized Coverage

D&O (critical with outside directors/investors), E&O/professional liability
(service businesses; some contracts mandate minimums), cyber liability
(confirm ransomware, social engineering, regulatory fines, BI coverage),
EPLI (risk scales with headcount), key person life insurance, business
interruption.

### Coverage Gap Analysis

1. Inventory assets and risks (physical, intangible, human capital, contractual)
2. Map each risk to existing policy coverage (limits, deductibles, exclusions)
3. Identify gaps — no coverage, inadequate limits, exclusions negating protection
4. Quantify exposure (replacement cost, lost revenue, legal defense, regulatory)
5. Recommend adjustments prioritized by severity and likelihood

### Business Interruption Calculation

Monthly revenue baseline (trailing 12-month average) plus continuing fixed
expenses plus extra expense coverage. Watch for coinsurance penalty (coverage
below 80% of actual business income reduces payout proportionally). Match
indemnity period to realistic recovery time — 12 months standard but may
be insufficient for manufacturing or specialized operations.

### Key Person Insurance Valuation

- **Compensation multiple:** 5-10x annual salary + benefits
- **Revenue contribution:** % of revenue attributable, projected over 1-3
  year replacement timeline
- **Replacement cost:** Recruiting, training, ramp-up, interim revenue loss
- **Lender-driven:** Loan agreements may specify minimum amounts (overrides)

### Tax Treatment

All standard commercial premiums deductible under IRC 162. Key person life
insurance premiums NOT deductible (IRC 264) when company is owner/beneficiary,
but death proceeds generally tax-free (IRC 101). Prepaid premiums: accrual-
basis C-corps must allocate over the policy period.

> **Deep dive:** Read `references/insurance-adequacy.md` for debt covenant
> insurance requirements (cross-reference with debt covenant monitoring),
> annual review trigger events, common underinsurance patterns, insurance
> expense sub-account structure, and prepaid insurance amortization
> entries.

## Debt Covenant Compliance

### Common Financial Covenants

- **DSCR** = NOI / Total Debt Service (min 1.20x-1.50x; below 1.0x means
  income cannot cover payments)
- **Leverage** = Total Funded Debt / TTM EBITDA (max 3.0x-5.0x; net
  variation subtracts unrestricted cash)
- **Current Ratio** = Current Assets / Current Liabilities (min 1.0x-1.5x)
- **Tangible Net Worth** = Total Equity - Intangibles (fixed floor or
  ratchet that never decreases)
- **FCCR** = (EBITDA - Unfinanced CapEx - Cash Taxes - Distributions) /
  (Interest + Principal + Leases) (min 1.10x-1.25x)
- **Interest Coverage** = EBIT / Interest Expense (min 2.0x-3.0x)

Always use the credit agreement's definitions — not textbook formulas. EBITDA
add-backs, debt inclusions, and measurement periods are agreement-specific.

### Compliance Monitoring

Quarterly cycle: extract financials as of measurement date, map accounts to
agreement definitions, calculate ratios, compare to thresholds with cushion
analysis, prepare compliance certificate, officer sign-off, submit within
reporting window (typically 30-45 days after quarter-end).

**Early warning thresholds:**
- **Green:** >20% above covenant threshold
- **Yellow:** 10-20% above — proactive client discussion
- **Red:** <10% above or breached — immediate notification, explore remediation

### Breach Consequences and Remedies

Technical default may trigger loan acceleration, cross-default on other
facilities, default interest (+2-5%), restricted line access, enhanced
reporting. Cure options: equity cure (typically limited to 2-3 times over
loan term), 15-30 day cure period for financial covenants, waiver (one-time
forgiveness), amendment (permanent change, 0.10-0.50% fee), forbearance
(temporary standstill).

> **Deep dive:** Invoke `financial-planning:financial-modeling` for the
> full debt covenant analysis reference, including financial report extraction
> workflow, EBITDA build-up from the P&L, ASC 842 lease impact on ratios,
> frozen GAAP provisions, and multi-facility tracking procedures.

## Advisory Engagement Pricing

### Pricing Models

- **Hourly** — Best for first-year or unpredictable-scope work. Rates by
  level: staff $100-175, senior $150-250, manager $200-350, partner
  $250-500. Rates vary by market and firm size.
- **Fixed-fee** — Defined deliverable at agreed price. Include scope-change
  clause reverting to hourly for out-of-scope work. Best for recurring
  engagements with historical data.
- **Value-based** — Priced on outcome value to client (e.g., tax planning
  saving $50K priced at $10-15K = 20-30% of savings). Highest margin;
  requires strong discovery conversation.
- **Subscription/retainer** — Fixed monthly fee for ongoing advisory access.
  Smooths seasonality, deepens relationships. Best for outsourced CFO,
  FP&A retainers.

### FP&A Service Benchmarks

- Outsourced CFO: $2,000-$10,000/month
- FP&A/budgeting projects: $5,000-$25,000 per engagement
- Tax planning: $1,500-$5,000+ or value-priced
- Cash flow forecasting: $3,000-$8,000 model build; $500-$1,500/month ongoing
- Board/investor reporting: $2,000-$5,000 initial; $1,000-$2,500/month ongoing
- Entity restructuring advisory: $5,000-$15,000+

### Profitability Metrics

- **Realization rate** = billings collected / (standard rate x hours). Target:
  85%+ compliance, 100%+ advisory. Below 75% = systemic underpricing.
- **Effective hourly rate** = fee collected / actual hours. A $5K engagement
  in 12 hours = $417/hr; same engagement in 40 hours = $125/hr.
- **Write-down rate** = (standard - actual billing) / standard. Target <10%.

Track time even on fixed-fee work — not for billing, but for profitability
measurement. Rank clients quarterly; bottom 10-20% typically destroy firm
profitability.

### Pricing Communication

Present in order: what the client gets, what it costs, how payment works.
Never lead with price. Never discount without removing scope.

> **Deep dive:** Read `references/advisory-pricing.md` for engagement letter
> pricing terms (payment schedule, expenses, annual adjustment, termination),
> client profitability analysis framework (profitable/high-utilization vs.
> unprofitable/unfixable matrix), bundling discount strategy, fee raise
> timing, disengagement criteria, and time tracking / invoicing setup.

## Capital Allocation Framework

Capital allocation decisions draw from multiple advisory domains. Use this
decision sequence:

1. **Assess debt capacity** — Calculate covenant headroom across all
   facilities. Available capacity = distance from covenant floors to current
   ratios, converted to dollar terms.
2. **Evaluate reinvestment returns** — Model projected ROI on internal
   projects (expansion, equipment, R&D) against WACC. Invoke
   `financial-planning:financial-modeling` for scenario analysis.
3. **Consider acquisition opportunities** — Run QoE-level diligence on
   targets. Compare acquisition ROI to organic reinvestment alternatives.
4. **Review distribution capacity** — For C-corps, model double taxation
   cost of dividends vs. retention. Check accumulated earnings tax exposure
   if retained E&P approaches $250K threshold.
5. **Optimize compensation** — Model the corporate tax deduction (21%) vs.
   payroll tax cost (15.3%/2.9%) crossover point.
6. **Fund succession** — If succession is on the 3-7 year horizon, earmark
   reserves for buyout funding (sinking fund, insurance premiums, installment
   capacity). Document as reasonable business need for AET defense.

## Supporting References

Read these for detailed procedures, formulas, and compliance checklists:

- `references/ma-due-diligence.md` — Complete financial diligence checklist (core financial records, working capital, tax-specific items, legal/operational). Section 368 reorganization types (A/B/C/D) with continuity requirements. Earnout structures (tax treatment under Section 453, open vs. closed transaction doctrine, ASC 805 accounting). Integration planning (Day-One bank/payroll/insurance readiness, COA harmonization, cutoff procedures, opening balance sheet). Acquisition entry recording.
- `references/succession-planning.md` — IRS Revenue Ruling 59-60 valuation framework. Asset/income/market valuation approaches with selection criteria. Discount analysis (DLOM, minority, key person) with empirical support sources. Buy-sell agreement types, funding mechanisms, trigger events. Ownership transition paths (internal sale, MBO, ESOP with Section 1042, third-party, liquidation). Estate/gift tax implications (Sections 2701-2704, annual exclusion amounts, TCJA sunset). Section 1202 QSBS, Section 531 AET, Section 302 redemption. Shareholder equity tracking.
- `references/compensation-benchmarking.md` — IRS 9-factor reasonable compensation test with case law citations. Independent investor test (Exacto Spring). BLS/ERI/RCReports data source hierarchy. Five-step benchmarking methodology with multi-role premium calculation. Documentation package requirements (board resolution, employment agreement, time records). Form 1120 Schedule E reporting and IRS screening triggers. Section 162(m) applicability. C-corp payroll tax optimization crossover.
- `references/insurance-adequacy.md` — Core and specialized coverage types with typical limits. Coverage gap analysis methodology (5-step). Business interruption calculation (revenue projection, continuing expenses, coinsurance penalty, indemnity period). Key person insurance valuation methods (compensation multiple, revenue contribution, replacement cost, lender-driven). Debt covenant insurance requirements. Annual review triggers and common underinsurance patterns. Tax treatment of premiums (IRC 162 vs. 264). Insurance expense sub-accounts and prepaid amortization.
- `references/advisory-pricing.md` — Four pricing models (hourly, fixed-fee, value-based, subscription) with advantages/disadvantages and best-suited scenarios. Service-specific benchmarks (tax compliance, bookkeeping, FP&A, project-based). Engagement letter pricing terms. Client profitability analysis (realization rate, effective hourly rate, write-down rate). Profitability action matrix. Value-first pricing communication. Fee adjustment and disengagement decision points.

## Cross-Plugin References

Invoke these skills for capabilities outside this skill's scope:

- Invoke `financial-planning:financial-modeling` for three-statement models, scenario/sensitivity analysis, and the full debt covenant analysis reference (ratio calculations, report extraction workflow, compliance monitoring, breach remediation)
- Invoke `financial-planning:variance-analysis` for budget-vs-actual context, KPI tracking, and historical trend data that informs strategic recommendations
- Invoke `tax-prep:tax-planning` for tax implications of strategic decisions — entity selection, officer compensation optimization, accumulated earnings tax planning, Section 338(h)(10) election analysis
- Invoke `qbo-integration:qbo-reporting` for QBO financial report extraction supporting covenant calculations, valuation data, and management reporting
- Invoke `accounting-foundation:entity-profile` for entity type, ownership structure, officer details, controlled group status, and foreign ownership that affect M&A, succession, and compensation planning