Increase Business Value with Agreements

/in , /by Jim Leonhard
I recently completed an exit planning valuation of a business that enjoyed a very favorable discount on purchases of a key component used in the assembly of its products. The discount, negotiated many years ago, was a handshake deal between the founder of the company and his former employer who manufactured the component.  This large discount enables the business to be significantly more profitable that it would be otherwise.  Any investor or buyer for this business will naturally be concerned about whether the company can continue buying this component at the same below-market price.
We advised the business owner that before putting the business on the market, he try to secure a long-term contract with the vendor at the favorable discount, or attempt to find an alternate supplier of a comparable component at a similar price.  If successful, his business will have substantially higher value and will attract more potential buyers when he goes to market.
Agreements, properly structured, can increase enterprise value by reducing risk for buyers and shareholders.
Agreements to Have in Place Before Selling a Business
  • Facility lease
  • Client contract
  • Construction contract
  • Equipment lease
  • Supplier contracts
  • Distribution agreement
  • Employment agreement
  • Independent contractor agreement
  • Non-competition agreement
  • Collective bargaining agreement
  • Financing of various kinds
  • License or royalty agreement
  • Franchise agreement
  • Advertising agreement
  • Joint venture agreement
  • Others specific to your business
As part of an exit plan, business owners should examine all of their company’s third-party agreements, whether written or verbal, for things such as clarity, economic terms at market or better, contract term, exclusivity, transferability, legal validity and more. Involve competent legal counsel in all but the most routine business arrangements.
 
For advice on selling your company, preparing it to sell, or understanding its value and transfer-ability, call Jim Leonhard at 916-800-2716 or Email jhleonhard@exitstrategiesgroup.com. 

Tip for Maximizing Business Value: Diversify Your Customer Base

/in , /by Al Statz
16__272x300_Our seller and business valuation clients are usually proud of their company’s long-term relationships with major clients, and with good reason. Having a high percentage of business with a few customers can be a very profitable and personally satisfying way to run a business. It allows management to focus its attention and fine tune company operations to deliver exceptional service in a very cost-efficient manner. Customer acquisition expenses (marketing, sales, estimating, etc.) can be greatly curtailed or eliminated. It’s wonderful while it lasts.
 
So, what’s the problem?
When it comes to selling a company, owners need to know that customer concentration is a major problem. Most buyers won’t purchase a business with a highly-concentrated customer base.  Or, given two potential business acquisitions that offer the same expected return on investment, they will buy the less risky one. They will acquire the riskier business only if compensated by higher expected returns; in other words, by paying a lower price.
In general, when a business goes through an ownership or management change, it becomes more susceptible to losing clients. Also, since financial leverage is used in most business acquisitions, the effect of a major client loss on cash flow is more severe for buyers than sellers. Losing a top client can be an inconvenience for shareholders under the seller’s watch, and catastrophic to a buyer.
What can cause a key customer stop buying? 
  1. They get lower pricing from a domestic or foreign competitor.
  2. They bring production of your product or service in house.
  3. Their parent company shuts down the division that you’ve been supplying, or relocates it outside of your service area.
  4. They acquire one of your competitors, who becomes their preferred supplier.
  5. Or, they are acquired, and the parent has another preferred supplier.
  6. Your key contact person retires; new management doesn’t have the same loyalties and may prefer another supplier.
  7. Products run their course; the next generation product will no longer use the component you’ve been supplying all these years.
  8. The company changes strategic direction and no longer needs your products or services.
  9. Any number of other business motives and external circumstances beyond your control!
Strategies to mitigate customer concentration risk
Develop a deep understanding of your key client’s business risks. Take a close look at their financial condition if you can, and closely watch your payment terms to them. Understand their product life cycles and how that affects your company. Also, if you are the primary contact person, introduce one of your sales staff to the client so that future sales are not dependent on your personal relationship.
Another strategy to partially mitigate concentration risk is to negotiate a long-term supply agreement with dominant customers (an suppliers).  A supply agreement commits your customer to buying and you to selling your product or service on specified terms and conditions for a certain period of time. Putting a long-term supply agreement in place can be an interim measure while you develop a longer-term diversification strategy.
The most obvious strategy to reduce customer concentration risk is to expand your customer base. Embark on a sales and marketing program to get more customers. A good rule of thumb is that no one customer should represent more than 10% of your annual sales.
Business owners looking to maximize value in a sale must find a way to diversify their customer base!
Customer concentration is just one of many factors that drive value in a business. Feel free to call us if we can provide additional information or help with your exit strategy. Al Statz can be reached at 707-778-2040 or alstatz@exitstrategiesgroup.com. 

Tip for Maximizing Business Value: Build for the Future

/in , /by Al Statz
Is your business built for the future?
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Consumer behaviors, markets, regulations and technology are changing so fast these days that many business owners are having trouble keeping up.  And if the business doesn’t have a strong future, it simply won’t trade at a high valuation, or many not have any value at all.
Private business owners must constantly monitor changes in their industry and marketplace, and make appropriate investments and take appropriate steps to insure the long-term relevance, growth and value of their company when they are ready to sell.
Read the Forbes article, “Leadership Matters – Comparing Ballmer to Bezos and Lessons You Should Learn”.

Why Should I Bother Valuing My Business?

/in , , /by Al Statz
ForbesA new article at Forbes.com addresses a question in the minds of many small business owners, “Why Should I Bother Valuing My Business?” 
The author explains several of the common reasons small business owners have their businesses appraised by an independent business valuation expert, as they prepare for a sale, buy-out, contingencies, retirement, or passing the business on to children.

Importance of a Proper Valuation before Offering a Business for Sale

/in , , /by Bob Altieri
Lately I’ve been spending a lot of time working on an acquisition search for a client, and in this process I found many business offerings that were priced far too high and several that were under-priced. From a buyer and seller perspective, overpricing is a massive waste of time. At the other extreme, when price is set too low, seller’s leave hard-earned money on the table. Both situations can easily be avoided by obtaining a proper business valuation before going to market.
Business valuation is an integrated process of research, historic financial review, normalization adjustments, trend analysis, financial ratio assessment, economic and industry conditions and outlook, and detailed company-specific SWOT analysis. Studying the internal strengths and weaknesses of a business, how it compares to its industry peers, and having a detailed understanding of external conditions helps the appraiser properly apply the market and income approaches to value. Relying on financial analysis alone is like trying to climb a mountain face without a rope. You might make it to the top, or it could end in catastrophe!
For example, look at the printing industry. Years ago, large expensive printing presses were needed to produce the end product. Capital equipment investment was huge. With the introduction of digital printing and digital media, the opposite is true. If one were valuing a printing company back in the 1990’s and didn’t consider the industry outlook, the value conclusion would have been unrealistic. Another example is when a few customers represent a high percentage of a company’s revenues. The financials may support a higher valuation, but the risk is high and value will be heavily discounted. Banks usually turn down such loans.
Even when an exceptionally high price for a business has been agreed upon, the probability of a successful closing diminishes because of the financing component. Without third-party financing, the number of business sales transactions getting done would be lower, average percentage cash to sellers at the closing table would be less, and average purchase prices would be lower. Financing cannot be ignored.
As I discussed in a previous Blog (Reducing Cost of Capital in a Small Business Acquisition, posted Aug 27, 2013), most SBA loans, the primary source of institutional debt financing for small business acquisitions (up to $5,000,000 transaction size), require a business appraisal by a certified appraiser. In such cases, if the agreed upon price is higher than the appraiser’s conclusion of value, the lender will typically loan on the appraised value only. The price of the business has to be reduced, the buyer must come up with more cash (without borrowing it somewhere else), or the seller must finance the excess, without receiving payment for several years.
Market participants should also be aware that lenders and appraisers have to adhere to certain standards when an SBA loan is involved. For example, lenders will not accept certain income statement adjustments, such as state income tax paid by California S-Corporations (most buyers will likely want to form their own S-Corp), health insurance premiums (most buyers will also want to pay this out of the business cash flow), and excessive personal expense adjustments. Also, any representation of cash flows that are not reported on the books is not allowed, for obvious reasons.
Lastly, please remember the Principle of Substitution, which states that “the value of a thing tends to be set by the cost of an equally desirable substitute,” and the fact that buyers have choices in an active market, pricing a business properly is a critical first step toward a successful sale.
Pricing your life’s work at its intrinsic value to you, relying on rules of thumb, or basing it on a broker or accountant’s back-of-the-envelope calculations is usually either a waste of your time or a big financial mistake. When there’s so much at stake, do it right the first time and having your business properly appraised by an expert. It’s just good business.
Thanks for reading, and please let us know when you’re ready to properly price your business. — Bob

Thinking of Selling Your Business? Don’t Let Built-In Gains Tax Surprise You.

/in , /by Al Statz

I was recently asked by “Chester” to help him sell the $10 million service company he founded 24 years ago. Chester, who is 65 years old, has had some health concerns and wants to travel the world with his wife Margie. Two of his competitors have been acquired in the past 3 years by strategic buyers. His business is doing well and he thinks the time is right to sell. In Chester’s industry, almost all acquisitions are asset (versus stock) purchases.

When Chester told me that he converted from a C- to an S-Corporation 6 or 7 years ago, we asked his CPA to estimate his tax burden if he sells now. It turns out Chester faces a large Built-In Gain (BIG) tax bite, which was a surprise to him. In my experience as an M&A advisor, Chester is not alone.  Many S-Corporation owners are unaware that such a monster is lurking in the shadows.

What is a Built-In Gain?

C-Corporation owners face a “double tax”, where gains on a sale of assets are taxed at the corporate level and subsequent dividends are taxed at the shareholder level, whereas in an S-Corp there is no federal corporate level tax. Congress’ enactment of built-in gains tax was intended to prevent C-Corp owners from making an S election just before selling their companies’ assets to avoid corporate-level taxes.

When a C-Corp converts to an S-Corp, a “built-in gain” is determined, based on the Fair Market Value of the corporation’s assets (both tangible and intangible) less the tax basis in the assets on the date of conversion.  Essentially, built-in gain is the gain that would have been taxed had the C-Corp sold its assets on the conversion date. Built-in gain should be determined, in the eyes of the IRS, by a business valuation prepared by a qualified independent business appraiser, as of the conversion date.

How much is the tax and how long after C to S conversion does it apply?

Built in gains was codified in 1986 in Internal Revenue Code Section 1374. Per the code, an S-Corporation is subject to a Built-In Gain tax for 10 years from the first day of the year of conversion from C to S. And yes, Built-In Gain tax is commonly called the “BIG Tax”. Who says the IRS doesn’t have a sense of humor!

For Federal purposes, at the corporate level, built-in gains are taxed at 35%. Additionally, a dividend tax at the shareholder level is assessed, and state taxes are assessed at both the corporate and shareholder level.

IRC Section 1374 was amended to reduce the 10-year recognition period to 7 years for asset sales occurring in companies’ 2009 and 2010 tax years, and to 5 years in 2011. The American Taxpayer Relief Act of 2012 extended the temporary 5-year recognition period to 2012 and 2013. By the way, California continues to require a 10-year holding period. Welcome to California; now open your wallet!

Unless Congress acts, if a Company sells in 2014, the original 10-year recognition period will apply. That means there might be a real incentive to close a sale before the end of this year. Otherwise an S corporation owner might want to hold on long enough to outlast the 10-year BIG recognition period. This is the decision Chester made. At 65 years old with declining health, Chester made a gut-wrenching choice that involves real financial risk and adds emotional stress to his next few years in business.

So what should S-Corp owners with a BIG problem do?

  1. If you own a C-Corp and your expected holding period is 10 years or more, seriously investigate converting to an S-Corp now.
  2. If you previously converted from a C-Corp to an S-Corp, and you plan to go to market within your BIG window, be sure to have an independent, IRS-compliant business valuation prepared as of the date of conversion. Valuations can be prepared retrospectively.
  3. If you’re considering selling now, close your deal before the temporary 5-year BIG window reverts to 10 years in 2014. Time is running out if you want to hit this window.
  4. When an asset sale is reported for tax filing, the selling price is allocated among the various assets sold (AR, inventory, equipment, goodwill, etc.) If you sell next year, one way to reduce (though probably not escape) the BIG tax is to allocate part of the sale price to personal assets, such as personal goodwill. However, personal goodwill is not justifiable in many businesses, and any attempt to allocate price outside the corporation will be closely scrutinized by the IRS, and should be supported by an independent valuation.

Please be sure you understand the tax consequences of a sale of your company, whether you plan to sell this year or several years from now.  Exit right, retire well!

Business valuations play an important part in many tax matters, and exit planning for business owners increases their chances of a successful exit. For additional information or for advice on a current need, please do not hesitate to call Al Statz at 707-778-2040 or Email alstatz@exitstrategiesgroup.com.

Role of Business Appraisers and M&A Advisors in Estates and Trusts

/in , /by Al Statz

I was recently asked about Exit Strategies’ role as business appraisers and M&A advisors in estates, estate planning and trust administration.  Here was my answer …

Business Valuation (a.k.a. Appraisal)

As business valuation experts, we provide fair market value appraisals of closely-held corporations, FLPs and LLCs for estate planning, gifting, estate tax, charitable donations, buy-sell transactions and succession planning. We value fractional interests in operating companies and asset holding companies using appropriate discounts. Our appraisers adhere to recognized professional standards, perform appropriate due diligence and meet or exceed accepted reporting requirements. And of course we are prepared to defend our work in the unlikely event of an IRS challenge.

For estates containing closely held business interests, we determine value of the decedent’s interest. We can provide input to the attorney on the effect of using the alternative valuation date.

With regard to trust administration, when a privately held business interest is placed in trust, our business valuation can help the fiduciary establish a baseline value and enhance their understanding of the asset. An independent business valuation can also avoid any potential for conflict of interest, since fees charged by trustees are often based upon the value of the assets managed. Subsequent valuations may be ordered by the fiduciary to assess the investment’s performance over time.

In estate planning where a family business is one of the owner’s major assets, a business valuation is often the starting point for estate planning professionals as they consider various estate planning techniques. Valuations provide a basis for the owner to evaluate potential ownership transfers and gifts; and can safeguard against future IRS challenges.

Landscape photo by Lance Kuehne

Landscape photo by Lance Kuehne

When drafting entity agreement and buy-sell agreement terms, attorneys have to balance flexibility and efficiency of operations with restricting control and marketability. During this stage, we can identify problem valuation situations or problem assets and identify the effects of gift and estate planning alternatives on valuation. We can also provide feedback and input on operating agreement terms that impact value.

When business owners gift ownership in their businesses, we determine value as of the date of gift. When closely held business interests are donated to a Charitable Remainder Trust (CRT), our business valuation can support the charitable deduction by the donor taxpayer.

Sometimes estate planning involves business succession planning. Like estate planning, real business succession planning is emotionally charged and often meets with resistance from clients.  A business valuation provides an objective look at many aspects of a business, including its management, marketability, inherent risks, and future prospects. The very act of going through the valuation process with an experienced and independent appraiser sometimes provides the catalyst that owners and their families need to fully engage in succession and wealth transfer planning.

M&A Advisors (a.k.a. business brokers, investment bankers, intermediaries, etc.)

There are many instances in which a generational transfer of a family-owned business is not the best option for a family. Often the children aren’t qualified to run the company or simply aren’t interested. Or the industry may be consolidating and an opportunity exists to sell the business for far more than fair market value and create substantial wealth and liquidity for the family.

Here, our firm regularly advises owners in the positioning, document preparation, strategic marketing and confidential selling process. We lead the M&A sale process for the client and work alongside their tax and legal advisors to maximize proceeds and preserve wealth.

Business valuations and M&A brokerage play a part in many estate and trust matters and succession planning for family owned businesses. For additional information or for advice on a current need, you can call Exit Strategies’ founder and president Al Statz at 707-781-8580. 

Do Strategic Buyers Share Synergies with Sellers?

/in , , /by Al Statz

In successful M&A deals involving substantial synergies, the deal price usually falls in the range between the standalone fair market value of the target business and that value plus the full value of potential synergies.

Value of potential synergies?
Increased value (over and above fair market value) to a strategic buyer, involves synergies between the acquired and acquiring firm and the additional financial returns and therefore value created by those synergies . There is a “1+1=3” effect in the acquisition process. Synergies come in various forms, including an ability to increase revenues of the target firm, cost savings by eliminating redundancies or achieving economies of scale through combining of business units; and the reduction of risk through, for example, increased size and stability, greater management depth or vertical integration.

How much of this synergistic value component is paid in practice?strategic value_2

Buyers pay, on average, 31% of the average capitalized value of expected synergies to sellers, according to recent research by the Boston Consulting Group. The March 2013 BCG article, titled “How Successful M&A Deals Split the Synergies”, can be viewed here.

From an acquirer perspective, why pay for synergies at all?

Because sellers usually anticipate buyers’ synergies and demand to be paid something for them, particularly when multiple strategic buyers are present. In addition, when the buyer is a public company , markets usually react favorably and boost the value of the acquirer when a strategic acquisition is announced. Of course, this increase in value may vanish if the synergies don’t actually materialize! When paying more than fair market value, strategic acquirers must be certain that there will be synergies in the combination. They do not randomly shell out big bucks. The owners of firms that appeal to strategic buyers have a greater opportunity to maximize value in an M&A sale process.

However, not every firm is a strong candidate for a strategic sale.

Most willing buyers for small companies are financial buyers who will operate the business similarly to the way it is operating now, and are normally willing to acquire a company for fair market value. Individual owner-operators, management employees and private equity buyers are examples of financial buyers.

We are always happy to discuss how buyers would typically value of your company. 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.

– See more at: https://exitstrategiesgroup.com/blog.html?bpid=3676#sthash.rrhDOJwx.dpuf

“If you don’t know where you are going, any road will get you there.”

/in , /by Bob Altieri

I’m amazed at how many business owners think about exiting all the time but never do any real exit planning. The most successful business owners I know have an exit plan on the day they open their doors. Their business decisions are synonymous with the plan. To navigate without a destination is like “trying to hold the wind up with the sail,” as Willie Nelson once sang.

As you go through the years in your business, are you focused on building equity? Business equity grows when you pay down debt, increase cash flow and add tangible and intangible assets (intellectual property rights, brand, etc.). On exit, it is this equity that is your 401K retirement, reinvestment cash for another business investment or possibly very early retirement.

Having an exit plan for your business is like setting any type of major goal — it keeps you focused on the things that really matter. Here are some things to consider:

1. Set a financial goal. How much money do you want to receive from a sale to ensure financial security? This is the most important question as it will drive proactive business and investment decisions. Examples include: a) diversifying into new markets, b) adding new product or service offerings, c) acquiring or merging with other businesses, and d) automating internal business processes.

2. Understand value and salability issues. With the help of your advisors, you need to know how to drive value in your business so that it is consistent with the financial goal you have set. Salability deals with internal business conditions and external market conditions that affect marketability (the size of your buyer pool), transferrability, and how much leverage you will have when negotiating with buyers. External conditions are usually not in your direct control, such as market changes, industry or financial conditions. For example, your goal to receive all cash from a buyer may not be possible because of a downturn in your business or industry.

3. Tax and legal consequences need to be evaluated.  For example, if your company is a C-corporation and you sell only the assets (name, goodwill & trade, fixtures, furniture, equipment, vehicles, inventory, work in process, etc.) there would be significant adverse tax consequence as compared with selling the assets of an S-corporation, partnership, LLC or sole proprietorship.

It’s never too late to begin exit planning. By doing so, you will be able to narrow the list of exit routes to determine which one is best and consistent with your long term goals.

Congress Passes American Taxpayer Relief Act of 2012

/in /by Al Statz

During the early morning hours of Tuesday January 1, 2013, the Senate passed a bill that had been heralded and, in some quarters, groused about throughout the preceding day. By a vote of 89 to 8, the chamber approved the American Taxpayer Relief Act, H.R. 8, which embodied an agreement that had been hammered out on Sunday and Monday between Vice President Joe Biden and Senate Minority Leader Sen. Mitch McConnell, R-Ky. The House of Representatives approved the bill by a vote of 257-167 late on Tuesday evening, after plans to amend the bill to include spending cuts were abandoned. The bill now goes to President Barack Obama for his signature.

With some modifications targeting the wealthiest Americans with higher taxes, the act permanently extends provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001, P.L. 107-16 (EGTRRA), and Jobs and Growth Tax Relief Reconciliation Act of 2003, P.L. 108-27 (JGTRRA). It also permanently takes care of Congress’s perennial job of “patching” the alternative minimum tax (AMT). It temporarily extends many other tax provisions that had lapsed at midnight on Dec. 31 and others that had expired a year earlier. Among the tax items not addressed by the act was the temporary lower 4.2% rate for employees’ portion of the Social Security payroll tax, which was not extended and has reverted to 6.2%.

For more information on how the act impacts businesses and individuals: https://en.wikipedia.org/wiki/American_Taxpayer_Relief_Act_of_2012