Business Record - Iowa Biz

8 steps to managing legal costs in a transaction

Steve Sink is the founder and managing partner of Phoenix Affiliates Ltd.

I am often asked by both buyers and sellers for suggestions to control their legal expenses when entering into a transaction. Here are a few suggestions:

1. Most attorneys charge by the hour, so prepare prior to any meeting or call.

2. Familiarize yourself with the documents which will be used.

3. There is no legal document(s) which can cover all contingencies.

4. Scan and email documents vs. mailing and delivery.

5. Consult with others who have experience in transactions (sellers, buyers, CPAs, bankers).

6. Ask for a quote.

7. Determine the experience and expertise level of the attorney who will be representing your interests.

8. Request that the transaction documents be drafted by the other party.

Good Luck!

Steve Sink

CBI M&AMI

ss@phxaffiliates.com

Succession Options

There are plenty of excuses owners use to put off the inevitable process of letting go. The most popular is ‘What would I do if I retired?’ Regardless, at some point in time a responsible decision must be made or it will be made without you.

The typical succession options are:

1. Merge with another business. This will often allow for a continued role in the newly formed business.

2. Sell to the employees or family member(s).

3. Sell the business.

4. Do not do anything with the distinct possibility that the value of the business will be determined by an auction.

Conscientious owners will take the time to consult with their team of professionals (CPA, attorney and CFP) to develop a plan which will allow them to: maximize their alternatives, minimize their tax issues and provide direction for the future success of their business.

Steve Sink, CBI, M&AMI

ss@phxaffiliates.com

Alternatives to EBITDA Multiples

On a regular basis, we seem to be driven to want to know the current Earnings before interest, taxes, depreciation and amortization (EBITDA) “multiples” that apply to businesses in various sectors. We strive to find comparables that we can use to provide a prospective seller with an expectation range of price that he or she can anticipate for the sale of the business that they have worked a lifetime to create. We want them to believe that we will be able to find the right buyer, at the optimum price and that they will not be made to look foolish in the eyes of their peers... who are always parlaying the latest Industry scuttlebutt as to what Joe got for his business and why they think they deserve more. I would like to visit several aspects of price as there is much analysis to insure the optimum value. 

The first aspect to address when speaking to our potential sellers is the tax liability that is being created when the business is sold. If he or she sells assets, they will likely have recaptured depreciation – which is ordinary income. It can be taxed as high as 53% when combining various state and federal taxes. The allocation of purchase price could assist them here. If the purchase price allocation were to set out only the depreciated value for assets that they have taken depreciation, the seller may not have to endure the ordinary tax rate on recapture. This is highly unlikely, as the purchaser wishes to take the tax shelter on those assets acquired in the future. So, the current market value will likely be reflected in the allocation.

If the seller sells the shares of his firm, they can be assured of only paying the capital gains tax. This is a distinct tax benefit and will result in a materially larger after tax proceeds for the seller.

One must consider the advantage of using 1042 Election for the proceeds which will defer all taxes. This is the methodology, wherein you use an ESOP as the acquirer and as a result any and all proceeds that are reinvested in an eligible investment. The proceeds carry the old tax basis and are tax deferred. What an incredible win for the seller in that his net proceeds will likely have grown by 30% or more now that there is not a tax bite. Talk about blowing the EBITDA multiples!

Further consideration should be focused on dividing the sale into real estate and operating assets by using a 1031 Election. Exchanging the real estate for a like property, the seller can defer any recapture of depreciation and capital gains tax as they take this basis to the new property. The purchase price may be funneled into the real estate perhaps through the purchaser paying down or paying off mortgages, etc. on the real estate. A significant portion of the purchase price may now be tax deferred.

Conversely, one must be careful if acting for the seller that any employment agreements that are taken as a portion of the purchase price. Employment income is at the ordinary rate (as opposed to capital gain rate generally half that of ordinary). If we are acting as a buyers’ agent, we would certainly encourage as much of the purchase price in the form of employment agreements as all of this consideration is tax deductible. So, in effect it is almost halved as to net after tax cost. In this instance, we can also pay a very hefty EBITDA multiple (if that is important to the seller) as that portion of the purchase price that is allocated to the employment agreement is tax benefited by at least 30%.

Another significant contributing factor to the EBITDA multiple that can be achieved for a seller is the historical Compounded Annual Growth Rate (CAGR). Revenue, earnings, market share, etc. represent a significant value indicator that allows a purchaser to pay at the top of the range if for example, a 15% CAGR has been achieved over the past three to five years and the marketplace appears to accommodate that continued growth. Compare that against an entity that has demonstrated a 3 to 4% CAGR. Historical growth is a huge factor in determining value. However, it is really the purchaser’s belief that that growth rate can be sustained that truly drives the premium multiple. If the industry is growing, it is merely a matter of stepping on to that moving train and participating in the growth. If the industry is flat or contracting, then all growth has to come from taking business away from the competition...a much more challenging task. So the position of the business in the industry and the growth of the industry has a huge impact on the multiple that can be achieved.

Good Luck,

Steve Sink

Using discounted cash flow for valuations

Discounted Cash Flow Calculator - is a tool to help estimate the present value of a stream of free cash flows discounted to the present. (Photo credit: Wikipedia)

If you used or will be using DCF (Discounted Cash Flow) in the valuation of a company you may want to consider a recent federal bankruptcy court decision court (N.D. Ill.): the “wide” and “striking” disparity between experts “lends credibility to the concept that the DCF method is subject to manipulation and should be validated by other approaches.” In particular, that by taking a discretionary approach to DCF, “a skilled practitioner can come up with just about any value he wants.”

The court cited experts who begin with the same cash projections but end with values nearly $8 million apart for a relatively small, family-owned company. In this case, the experts’ disagreement largely came down to how each calculated the weighted average cost of capital (WACC) thereby impacting: the debt-to-equity ratio, the equity risk premium (ERP), and the size premium—as well as the terminal value. Each expert cited various models and experts to defend their points but “each expert generally selected parameters that pushed his valuation in the direction he wanted to go,” the court says.

The court ruling essentially fell back on “real world” evidence at the time of the company’s acquisition to find that it was solvent, including its lack of debt, its substantial cash in excess of working capital, and its ability to keep current on accounts payable.

Good Luck

Steve Sink, CBI, M&AMI

ss@phxaffiliates.com

Not "To-Do's" when selling

BACKGROUND
An owner decides to retire and sell the business with $20 million of annual revenues. The company owns some locations and leases other locations utilizing the owners' entity. The business is profitable.

IMMEDIATE PROBLEMS
At the initial meeting the following items quickly became issues.

1. Confidentiality: The owner had not planned to bring the CFO into his confidence by implementing a "stay" agreement. With all the ensuing financial updates and analysis, it would be impossible to expect the selling process to be achieved through due diligence without informing the financial offers of the imminent company sale.
   
   The logical potential buyers would be local competitors, which would sign a non-disclosure but there would be no assurance that there would not be a leak. The owner intended to talk to interested acquirers one at a time, thus prolonging the process and increasing the likelihood of a confidentiality leak.
2. LOI (Letter of Intent): The LOI, which the Seller provided, was incomplete and did not require a significant retainer.  
3. Transaction Attorney: The proposed Seller’s attorney had no experience in business transactions.
4. Financial and Business Information: The financials and information regarding the business were incomplete and unprofessional making it difficult to get a true picture of the business, which will result in lower offers or no offer.
5. Lawsuit: The owner wanted to bury a law suit in the fine print.

 

Summary
Many business owners do not appreciate either the complexities of doing a deal or appreciate the benefits of hiring a first-class team (Attorney, CPA and Intermediary) to conduct the sale process. The initial effort is well worth the back-end reward. Watch out for inexperienced dealmakers, they can ruin deals.

Enjoy the Holidays!

Steve Sink, CBI, M&AMI

ss@phxaffiliates.com

 

 

Raising Capital for an Acquisition

When raising capital to acquire a business, or expand an existing business, you’ll need to view the investment from the perspective of the investor. To do so, you will need to know about investment risk vs. return, as every investment has risk. Federally insured certificates of deposits and interest-bearing bank savings accounts have risk.  Not necessarily principal or interest payment risk, but inflationary risk. If you are receiving 3% on your money in a two-year CD at the bank and you are in a combined state and federal marginal tax bracket of 33%, then you are netting out about 2% after tax. If inflation were to rise to 5%, you would actually be losing 3% on your money in the form of purchasing power.

Conversely, one may view lower-priced publicly traded stocks on the Over the Counter Bulletin Board as a high-risk, high-return investment. These investments generally have a higher principal risk but also have higher return potential. In general, risk and potential return go hand-in-hand. The higher the risk one takes on an investment the higher the potential return should be.

Any new company or venture will generally be viewed as very high risk by most savvy investors; therefore, a very high return potential must accompany that risk, but not too high, otherwise it becomes unbelievable if a "too good to be true" scenario. The trick to attracting capital for start-up and early-stage companies is using different deal structures to reduce the risk components of the securities being offered for the investor while maintaining the high return potential.

One attractive deal structure is to use a security such as a note, which is convertible to a participating preferred stock. This changes the risk return continuum for the benefit of the investor. A "marketable" deal structure allows for maximum upside while minimizing the downside... by utilizing creative financing structures buyers can create an attractive investment which can effectively compete for funding from individuals.

Simply think of yourself as an investor. How would you like to invest $100,000 in a new company or venture in the following manner: You purchase a $100,000 first mortgage note, with a 10% interest rate, and a first lien position on 100% of the assets of the company? Once the notes are ready to mature, you roll over the $100,000 into a participating-preferred stock being offered by the company that returns 10% in stated dividends and participates in 20% of the net profits of the company. By selecting this combination as your company deal structure, you would have reduced risk while maintaining a high potential return.

Good Luck,

Steve Sink

CBI, M&AMI

ss@phxaffiliates.com

Burned out?

Burned out, tired, your business is no longer fun? We sell a lot of businesses because of this. But-don’t feel alone; at some time most business owners will have that “Burned Out” feeling. Many surrender and sell or close the business. And - some take control. If you are getting that feeling, you might want to consider the following to get you back on track:

1. Take some time away from the business (completely away!). You will return with a new perspective and energy.

2. Consult with some professionals about your business and the opportunities. Did you ever hear about the forest and the trees?

3. Learn to say “NO”.

4. Stop being the employee.

5. Get in shape.

6. Remember why you got in business.

7. Protect your time. When you dispense this asset, what is your return?

8. Ask for opinions. It can be easier than asking for help.

Good Luck!

 

Steve Sink

CBI

M&AMI

ss@phxaffiliates.com

Transition teams

English: For Sale by Owner Sign svg (Photo credit: Wikipedia)

When you sold your home, you did not hesitate to use a real estate agent. Exiting your business can be much, much more involved (and financially more significant) than selling your home, and it can require sophisticated, experienced advisors to guide you through the process. Sophisticated business owners will assemble an experienced team to assist them. The team will have responsibilities to:

• Identify and provide guidance to those areas that need to be corrected to meet the owner’s objectives (usually financial).
• Help the owner determine if the objectives are attainable.
• Help to keep the owner focused and on-track.
• Develop a transition strategy for the owner, employees, customers and the business.

While a transition team can be most helpful, the owner has the ultimate responsibility for making it happen. Many an effort has failed because the owner will not change their habits.   

Good Luck.

Steve Sink

CBI, M&AMI

ss@phxaffilaites.com

 

Tax increases with the sale of a business

Many significant provisions of the Bush tax cuts are scheduled to expire at the end of 2012, which will result in significant changes to the tax laws. If Congress should fail to extend the cuts, income taxes, dividend taxes and capital gains taxes will all rise. The Long Term Capital Gains tax is the primary area that will affect most business owners thinking of selling their businesses. These affect the sale of stock.

There will no longer be a 15% tax bracket. It will rise to 20% as a result of the healthcare reform legislation. And it will rise an additional 3.8% via a Medicare tax beginning in 2013. This tax also will be added to dividend income taxes and even ordinary income taxes. In short, selling next year versus this year means the price received will need to be about 16% higher next year to net the seller the same amount as they would receive selling this year. How many owners will be able to increase the value of their business by that amount?

Some examples of possible scenarios:

Assumption: You net $1 million in the sale of your business and make less than $250,000 (AGI).

Option 1: If you sell the business before the end of 2012, the federal income taxes owed from the sale will be $150,000, you net $850,000.

Option 2: You hold out, but still sell for $1 million in 2013. Taxes will be 20% plus 3.8% or $238,000; $88,000 more in federal taxes ($238,000 vs. $150,000).

Option 3: You wait and capital gain taxes go up even more! Based on the government’s need for revenue this is a real possibility.

Plan well!

Steve Sink

CBI, M&AMI

ss@phxaffilaites.com

Financing the business purchase

Loan (Photo credit: Philip Taylor PT)

A buyer’s source of financing depends in part on the size of the business being purchased. The vast majority of businesses (and particularly the smaller businesses) are purchased with a significant portion of the purchase financed by the owner. The buyer, however, still must make a down payment and be sure that adequate working capital sources are available.

If the funds needed for the down payment are not readily available, the buyer must look for financing from an outside source. To grant such financing, an institutional lender is almost certain to require personal collateral for the loan as well as a wealth of financial and operating data of the business to be acquired. The most attractive types of personal collateral from the lender’s point of view are real estate, marketable securities and cash value of life insurance. In addition to personal collateral, it must also be demonstrated to the lender that the buyer is of good character, has a clear source of repayment, and has a good business plan.

Lenders for larger transactions may or may not require personal collateral from the purchaser; however, they will require a personal guarantee. Collateral for larger loans generally will consist of a first lien security interest in the tangible assets of the business, such as accounts receivable, inventory, equipment and real estate. The lender will set loan conditions and restrictions regarding certain activities of the business. In the case of insurance companies and venture capitalists, the lender may insist on an equity position in the business and a role in major management decisions. Insurance companies typically only participate in transactions above $10 million. Commercial finance companies make loans on much the same basis as banks. While the interest rate such companies charge is usually higher than that charged by the bank, they are often willing to take more risk.

It is rare for a privately-held business to be acquired without leveraging the business’s assets in some manner, pledging them as collateral for a loan made either by the owner of the business or an outside lender. The owner has a strong incentive to provide financing if he feels it is necessary to get the price he wants for the business and has confidence in the buyer. An outside lender must be convinced that the loan’s risk of failure is minimal and represents a profitable transaction. Institutional lenders are generally conservative and concentrate rate primarily on repayment. To obtain outside financing it is important to be well prepared and have information that a lender needs to make decision. This data should be submitted in the form of a loan proposal and should contain the following items:

1. Purpose of the loan

2. Amount required

3. Term desired

4. Source of repayment

5. Collateral available

6. History and nature of the business

7. Age, experience and education of management

8. Key advisors

9. Product

10. Market area and method of distribution

11. Major customers

12. Suppliers

13. Competition

14. Facilities

15. Employees and unions

16. Three years of business financial statements

17. Three years of business tax returns

18. Current personal financial statement

19. Pro forma business income statement, balance sheet and cash budget (for at least three years)

 In instances where obtaining bank financing on a stand-alone basis is not possible, an SBA guarantee or underwriting by a state or municipal economic development agency may be available.

 

Good Luck,

Steve Sink

Certified Business Intermediary

Merger and Acquistion Master Intermediary

Bzconnection@gmail.com

6 kinds of business buyers

Sale (Photo credit: Gerard Stolk (vers l'Ascension))

Buyers of businesses can generally be categorized as belonging to one of the following groups, and some buyers belong to more than one:

The Individual Buyer: This typically is an individual with substantial financial resources and with the type of background or experience necessary for operating a company. This buyer will typically seek a company that is profitable and will provide a return on their investment. If they lack in financial resources they will turn to family members or other resources for additional financing and rely on the Seller for some financing. These buyers will typically limit themselves to transactions of less than $1 million. Most of these buyers will come from unhappy or unsuccessful job situations.

The Strategic Buyer: This buyer is almost always a company trying to enter a new market, increase its market share, seek a strategic gain or to eliminate a competitor. These buyers can be in the same business or a competitor and will usually seek businesses with sales in excess of $20 million with a proprietary product and/or a unique market share with management willing to stay.

The Synergistic Buyer: Like the strategic buyer, this buyer is usually a company. They seek companies that, by joining the two together, will be worth more (i.e. 2+2=5). The benefit of this type of acquisition helps both companies be more competitive and profitable.

The Industry Buyer: This is often characterized as the “Buyer of Last resort”. The buyer is often a competitor, knows the industry and will not want to pay for the seller’s expertise.  Their interest is in reducing costs by combining the operations. They will typically pay only for the assets (usually not all of them and at a price below the market value). This buyer does not pay for goodwill or want to employ the Seller.

The Financial Buyer: This buyer is driven by the projected return on their investment.  They will have access to financing and will leverage it as much as possible.  Their sole purpose is to make the maximum amount of money with the least amount of their capital.

The Inside Buyer: These are family members or employees and will usually be the most difficult to deal with, require the largest amount of seller financing and often fail to make the payments to the seller. They often rely on the sympathy of the seller.

Steve Sink

Certified Business Intermediary

Merger and Acquisition Master Intermediary

ss@phxaffiliates.com

When to seek seller financing

Sellers hate it, but buyers are bound to ask themselves, “What is wrong with this business, when the seller will not bet on the future viability or their business and I am? I mean, other sellers are willing to provide seller financing?"

Here are some good reasons why seller financing is important:

• Seller financing increases the chances for a sale.
• The seller will usually get a much higher price.
• The tax advantages are better than an all-cash purchase.
• Seller financing tells the buyer that the seller believes in the future of the business.
• Most banks will require some seller financing i.e. “If you don’t believe in the future of the business (and you know more about it than we will ever know), why should we believe in it”?

Lastly, Sellers will need to protect themselves in the same manner that a bank does when making a loan.  Some areas you may want to include would be:  Require good financials from all parties, run credit checks, use an attorney, get more than one party to guarantee payment, require quarterly financials, have a balloon payment option, keep title to the equipment, etc.

Feel free to contact me if I can be of assistance.

- Steve Sink

CBI

M&AMI

ss@phxaffiliates.com

 

Thinking of Selling Your Business?

If you are thinking of selling your business here are some guidelines, based on the actual sales for various businesses:
* Restaurants (full service): 30 to 35% of reported sales plus inventory.
* Motorcycle dealerships:  10 to 12% of annual sales plus inventory.
* Car Wash-self-service:  4 times annual reported gross sales.
* Convenience Stores with Gas: 2.5 to 3 times owner’s earnings and benefits.
* Dental Practices:  60 to 65% of annual sales.
* Fitness Centers: 70 to 100% of annual sales plus inventory.
* Manufacturing-Metal Fabrication:  6 times EBITDA.
* Pizza:  Nonfrachise 35% of annual sales plus inventory.
* Pizza:  Franchise: 45 to 55% plus inventory.
* Retail:  30 to 35% of annual sales and market value for the inventory.

These are historical averages based on reported sales.  Individual sales will naturally vary based on location, earnings, seller financing and other issues.   Feel free to contact me if you would like additional information on you business.

Steve Sink
ss@phxaffiliates.com
Certified Business Intermediary
Merger and Acquisition Master Intermediary

Transitioning the business to your employees

If a transitional sale to your employees is your exit strategy, you may want to consider some common issues that often occur:
* Owners will often over compensate employees, thereby selling the business or a portion of it below market value to employees.
* Employees may cash-in their ownership position for a handsome profit when offered fair market value for the company and the owner receives nothing for their generosity.
* Employees will demand a role in the management of the company. Often this will lead to management disputes, office politics, confusion and loss of direction.
* Will the company be forced to buy back a minority position at fair market value when an employee leaves? What will this loss of cash do to the value of the business for the remaining owners?
* Is it better to make employees earn an ownership position or allow them to buy it?
* Is your success as an owner making you feel guilty and triggering these possible events?

In short, there is no one set of answers to these questions. Taking care of your employees by helping them succeed so they can afford an enjoyable lifestyle and retire comfortably, should leave you with nothing to feel guilty about.

Steve Sink
ss@phxaffiliates.com
Certified Business Intermediary
Merger and Acquisition Master Intermediary

Using an appraiser to value the business

So, you have found a buyer for your business but there is a significant difference in the offer and the asking price. One common method to handle this issue is for both parties to agree to use appraisers to determine the value of the business. If appraisers are going to be used to determine price in a valuation process, they need instruction regarding the specifics the parties to a buy-sell agreement are seeking. The agreement should define the issues/guidelines the appraiser(s) will use to provide the valuation.

1. Standard of value

2. Level of value

3. The “as of” date

4. Qualifications of appraisers

5. Funding mechanism

Standard of value

Will the pricing value be based on “fair market value” or “fair value” or some other standard? If the standard of value provision in a buy-sell agreement is not clear, appraisers may have to decide what the written words mean—a decision they may prefer not to make. Or the parties, whose interests have already diverged, will have to agree on a standard of value to provide instructions to the appraiser(s). Neither situation is ideal.

Level of value

The levels of value suggest a range of values, from the strategic controlling interest level of value of the enterprise as a whole, to the non-marketable minority interest level of value applicable to illiquid, minority interests. This lack of direction leads to some of the largest variations in valuation opinions by appraisers. These differences almost inevitably arise from absent or ambiguous specifications regarding the applicable level of value in particular agreements.  For example, is the company valued from the perspective of a non-marketable minority level or as a strategic acquisition?  Situations like this can and do happen and they are never pretty in their resolution, nor are the parties generally satisfied with the ultimate results.

The ‘as of’ date

The effective date of an appraisal is often called the “as of” date. It is the date the appraisers will use to assess the economic environment and the facts known about the company at that exact date on which they base their valuation.

Qualifications of appraisers

Buy-sell agreements are often silent regarding the qualifications of appraisers.  Parties to buy-sell agreements should consider appraiser qualifications when agreeing on an appraisal process. The logical requirements become apparent as parties begin to reflect on individual appraisers and appraisal firms. Therefore, the qualifications of appraisal firms should be specified based on their size, the scope of their business, and perhaps, on their specific industry expertise. 

The Funding Mechanism

The agreement should have a funding mechanism designed to ensure that the agreed-upon value will first, be affordable to the company (cash flow, financeable, viable assets etc.); and second, realizable by the seller. The funding mechanism is an essential business element of buy-sell agreements but only part of the due diligence process.

- Steve Sink

When the economy gets tough, tough get going

Running a business is hard enough without the added market convulsions, the collapse of the housing market and the general uncertainties. A forward looking business owner will most likely view this current climate as one of opportunity.  

- Prime locations are selling at discounted prices.

- Weak competition (market share) can be purchased for pennies on the dollar.

- The cost of money has not been this low in decades. 

- Often you can buy for less than you can rent.

Surviving in times like these is not for the faint of heart. However, by definition entrepreneurs are risk takers. They can see opportunities not in the balance sheets or market studies and are not distracted by the naysayers.  Some owners have survived by abandoning “business as usual”.  Many new boat dealers now focus on selling used boats, many of them repossessed by lenders, and they have discovered a huge offshore market for used boats. 

In short, when the economy goes in the tank, leaders retool and followers - well they just follow.

- Steve Sink

ss@phxaffiliates.com

Early acquisition planning

So you finally made an acquisition.  Now what do you do?

In my experience, buyers and sellers have a “plan of sorts” to integrate the two businesses before closing. Yet they often fail to provide for any explicit connection between the deal-making process and the eventual integration of the two businesses. This disconnect may ultimately undermine an acquisition’s value and its perceived operational advantages. Both Buyer and Seller should require that there is a clear integration plan and designated manager who is responsible for managing the integration effort.

I know of no small business with a standing integration plan or team.  Owners seldom require that discussions on integration start early enough in the process. Those discussions are critical to avoid surprises later. The integration process has important implications for the due diligence, structuring of a deal and employee retention, all of which can look very different depending on whether the acquirer aims for full integration or plans to leave the target more or less untouched.

In conclusion, companies need to have a post deal learning process where employees can communicate key insights from the merger of the two companies, thereby enabling a future acquisition to be more successful. For example, they might hold workshops, analyzing each step in the acquisition process, documenting what has been learned and observed along the way, key lessons, the quality of the process and the business goals reached, employee reactions and document the observations for the future.

Good Luck

Steve Sink

Certified Business Intermediary

Merger and Acquisition Master Intermediary

ss@phxaffilaites.com

The ESOP Option

Image via Wikipedia

Over the last two decades, employee stock ownership plans (ESOPs) - spurred on by various tax incentives - have become widely established among both publicly-traded and closely-held companies. One of the unique features of ESOPs is their effectiveness as tools of corporate finance. However, their use as financing tools also increases their complexity.

Here are some thoughts for consideration.

What is an ESOP? At its core, an ESOP is merely a tax-qualified savings or retirement account plan (such as a profit sharing or 401(k) plan). However, unlike profit sharing or 401(k) plans that invest in mutual funds or other general investments, an ESOP is designed to invest primarily in the stock of the sponsoring employer. And although some special rules apply to ESOPs that do not apply to profit sharing plans, most rules (including eligibility and vesting rules) are the same.

What is a leveraged ESOP?  

One of the unique features of an ESOP is its ability to use borrowed money to purchase employer stock. When an ESOP borrows, it is referred to as a "leveraged ESOP." With the proceeds of a loan, a leveraged ESOP can purchase employer stock on the open market, from any selling shareholder(s) or from the employer itself. Thus, a leveraged ESOP can serve a number of corporate objectives, such as reducing the number of outstanding shares, buying out existing shareholders and financing corporate expansion.

How does a leveraged ESOP work?  

In a typical leveraged ESOP transaction, the ESOP will use the proceeds of a loan from a bank or other lender to purchase employer stock. The employer will guarantee the loan and agree to make contributions to the ESOP in order that the ESOP will have money with which to repay the loan. Because contributions to the ESOP (a tax-qualified retirement or savings plan) are tax-deductible, the employer achieves something that can only be done through an ESOP -- the ability to repay a loan using tax-deductible principal and interest. The amount that can be borrowed is limited by the amount of tax-deductible contributions needed each year to repay principal on the loan (generally, about 25 percent of the payroll of ESOP participants).

The stock that the ESOP purchases with the proceeds of the loan is held as collateral by the lender. Each year, as the loan is repaid, a prorated portion of the shares held as collateral will be released and allocated to accounts of individual plan participants, where they will be held until distributed and/or forfeited following the participants' termination of employment.

ESOP Loan Example

Assume an ESOP borrows $1 million to purchase 100,000 shares of employer stock, which the lending bank holds as collateral. Assume further that the company will make contributions to the ESOP sufficient for the ESOP to repay 10 percent of loan principal each year.

Each year, as 10 percent of the loan principal is repaid, 10 percent of the shares held as collateral will be released. Thus, after the first year, 10,000 shares will be released. The released shares are allocated to each participant's account prorated based on the compensation of such participant to the total of all participants' compensation.

Note that the value of the stock has no bearing on either the number of shares released from collateral or the number of released shares allocated to participants' accounts. Participants therefore receive the full benefit of any stock appreciation.

What other ESOP tax incentives are there?

In addition to enabling an employer to borrow using tax deductible principal and interest, subject to some restrictions, the following tax incentives further encourage ESOP borrowing:

• Below-Market Rates: A lending bank is permitted to exclude from taxable income 50 percent of the interest it receives on qualifying ESOP debt, thus allowing an ESOP loan to be made at below-market rates.
• Dividend Deduction: Although dividends are not normally deductible, they are when used to repay a qualifying ESOP loan. In effect, this allows dividends to be used to increase the amount of ESOP loan that can be repaid with tax-deductible dollars.
• Tax-Deferral Opportunities for Selling Shareholders: A shareholder of a private company who sells his shares to an ESOP can defer recognition of gain on the sale by reinvesting the proceeds in publicly-traded U.S. companies. The seller's basis in the old shares is carried-over to the new shares. In effect, an ESOP provides not only a market for non-tradable shares, but also allows a private shareholder to convert an illiquid investment to one that is readily tradable. To qualify for the tax-deferral, the ESOP must hold at least 30 percent of the stock immediately following the sale and the selling stockholder must have held his shares for at least three years.

What are the drawbacks of an ESOP?

In exchange for the generous tax incentive afforded ESOPs, there are numerous requirements. Some of the more important requirements are the following:

• Participant Voting Rights: In general, participants must be permitted to vote employer stock that is allocated to their ESOP accounts (regardless of whether or not vested). However, if the employer's stock is not publicly traded and the ESOP has a loan that does not qualify for the 50 percent interest income exclusion discussed above, then participants need only be given the right to vote on significant corporate matters (like a merger or recapitalization).
• Put Option Requirements: In general, an ESOP can make distributions in either cash or stock, but participants have the right to demand stock. In the case of a closely-held company, participants must have the right to require the company to purchase their shares at fair market value. The "put" price may be paid in installments over not more than a five-year period. Stock of a closely-held company may also be subject to a right of first refusal requiring the shares to be sold to the ESOP or the company. It is important that a closely-held company budget for put option liabilities. If ESOP shares increase significantly in value, the put option requirement could become a drain on the company's cash flow.

• Annual Stock Appraisals: If the employer's stock is not publicly-traded, the shares must be valued by an independent appraiser at least annually. The appraisal is critical for purposes of valuing distributions and put option rights. Annual appraisals can significantly increase the cost of maintaining an ESOP. Appraisals are also subject to scrutiny to ensure that they are performed independently and adequately reflect the fair market value of the stock. If the appraisal does not meet these standards, the fiduciaries of the ESOP may face liability.
• Fiduciary Concerns: Fiduciaries of an ESOP are often officers and other key management personnel. As fiduciaries, they owe a special duty of care to the ESOP and its participants. However, they also owe a duty to the company. Because of the potential conflict of these roles, ESOP fiduciaries must be alert to possible conflicts of interest. Just as an independent appraisal of stock is required for ESOPs of closely-held companies, the use of independent fiduciaries and financial advisers to represent the ESOP may be appropriate in connection with transactions involving an ESOP.
• The cost to maintain an ESOP can be significant.  ESOP’s require audited financial statements and most companies will contract with an independent fiduciary.
• The annual capital requirements to support the ESOP can have a negative impact on growth.

Is an ESOP right for your company?

There is no quick and easy answer. Companies that establish ESOPs often do so for the following reasons:

• to buy out shareholders who wish to retire, capitalize on all or some of his or its shares, or otherwise no longer own the Company
• to reward employees who have contributed to the success of the Company
• to improve productivity and reduce turnover by giving employees a stake in the business
• to provide employees with a tax-favored retirement savings plan
• to provide a tax-favored means of corporate finance

Implementation of an ESOP is a significant event requiring careful planning and analysis utilizing qualified financial and legal advisors. While many of the objectives enumerated above may be achieved in a number of ways, an ESOP is a unique vehicle that delivers on all of them.

- Steve Sink

Managing to Keep Managing

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Failure to change is the number one reason that businesses fail.

I work with many entrepreneurs in the early stages of building their businesses. They are going the proverbial 100 miles an hour and experiencing most of the classic growing pains: working capital is tight, they work too many hours, they are going different directions at once trying to devote the time needed to the various facets of their business. 

One of the suggestions I make is for the owner to bring on a consultant to help him take his company to the next level by prioritizing obligations, adding systemization and positioning the business to be able to handle the challenges and changes required to grow.

The first reaction is almost always, “I don’t need to hire a consultant, all they do is ask me for my watch and tell me what time it is. I know how to run my business better than they will. I’m short on cash and already have too much on my plate.”  

I then suggest to the owner that the more successful an owner is, the more likely they will seek outside opinions and consultants do provide a tremendous benefit. A vivid example might be professional athletes hiring coaches to make them better. 

Hiring a professional helps keep you on top of your game and helps take you to the next level of your management capability. It’s so easy to get set in our ways, think that we know it all and be resistant to change. Like it or not, change is going to occur. So you must be ready and willing to prepare yourself for the journey.   

Epilogue:  I've seen a number of entrepreneurs who were too proud to ask for help and now the bank is managing their business.

- Steve Sink

Putting a Value on a New Company

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Occasionally, I come across a new company that has been successful, and the owners would like to sell. They would like to set a selling price. And without a great deal of history, but with a lot of promise, what should the selling price be? 

The truth is that this is usually an “art”. To place a value on a business that has not been tested is virtually impossible. A positive bottom-line on new businesses is rarely found and may even not be a positive sign. Given these parameters, the valuation process becomes a subjective process for the both the Seller and the Buyer. And it will vary greatly depending upon their expertise, their tolerance for risk, their experience, thier perception of management and the opportunity.

Either party may use discounted cash flow to arrive at a value, but growth projections can cause this number to have wide variations. Therefore, this method is rarely used.

A guide that a Seller might use would be to follow the model for valuation which an experienced Buyer might use: 

1.  Assemble a team of professional advisors.

2.  Determining a value for the tangible and intangible assets. 

3.  Review the customer base and their growth projections.

4.  Check for contracts. 

5.  A review the competition, the market and entry barriers. 

6.  Evaluation of the management.

The sum of these factors will assist the Seller in determining a valuation and provide a        credible foundation for negotiations with any potential Buyer.

Good luck.

- Steve Sink

Possible Tax Consequences of Seller Financing

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You have sold your business and elected to do some seller financing to maximize the sale price. But, before you start to spend those payments, be sure to check with your accountant. In general, the gain or profit from the sale of property can be reported under the “installment method” of accounting for tax purposes.

This rule was put in place under the theory of tax law that taxpayers should not be required to pay taxes when they have not received enough cash to cover the tax bill. It started out as a good rule, but Congress has put so many restrictions on the use of this rule that, without careful analysis, you can face a bigger tax bill than any amount of cash you’ve received!

Some of the most common exceptions are:

1) Depreciation Recapture: You’ve been claiming accelerated depreciation on your business assets and you are now disposing of the business before the assets are fully depreciated. Now you have to go back and “recapture” any excess depreciation claimed over the straight-line method of depreciation. This “recapture” amount must be taxed in the year of sale and is not allowed in installment sale calculations. Again, for the sale of a partnership interest, you must “look through” to the assets of the partnership, and this rule could apply.

2) Sale of Publicly Traded Property: Congress determined that if you are selling assets that are readily traded in a market (i.e., an established securities market), the asset is liquid enough that you can sell it in order to pay tax on the gain. Therefore, we have this exception to the installment sales rule.

3) Sale of Inventory: The term “installment sale” does not include disposition of personal property that is included as inventory of a taxpayer. This includes the sale of a partnership interest to the extent that the sale is attributable to the partnership’s inventory.

4) Sale of Depreciable Property to Related Persons: Selling your business to a relative? Don’t expect installment sale treatment to apply to the depreciable assets. Note that this only applies to depreciable assets – if your building is included in the sale, you can still get installment sale treatment on the land under the building. “Related persons” includes selling any property to another company in which you, or a related person, owns 50 percent or more of the stock.

In short, if you have lots of inventory or depreciable equipment, you may find that the installment sale rules are not going to help you come tax time. Therefore, be sure to have your CPA review all terms before entering into an agreement to sell.

Good selling.

-Steve Sink

Financing the Deal

 A buyer’s source of financing depends in part on the price of the business being purchased. The vast majority of smaller businesses (less than $2million) are purchased with a significant portion of the purchase financed by the owner. The buyer, however, still must make a down payment and be sure that adequate working capital sources are available.

If the funds needed for the down payment are not readily available, the buyer must look for financing from an outside source. To grant such financing, an institutional lender is almost certain to require personal collateral for the loan as well as a wealth of financial and operating data of the business to be acquired. The most attractive types of personal collateral from the lender’s point of view are real estate, marketable securities and cash value of life insurance. In addition to personal collateral, it must also be demonstrated to the lender that the buyer is of good character, has a clear source of repayment, and has a good business plan.

It is rare for a privately-held business to be acquired without leveraging the business’s assets in some manner, pledging them as collateral for a loan made either by the owner of the business or an outside lender. The owner has a strong incentive to provide financing if he feels it is necessary to get the price he wants for the business and has confidence in the buyer. An outside lender must be convinced that the loan’s risk of failure is minimal and represents a profitable transaction.  To obtain outside financing it is important to be well prepared and have information that a lender needs to make decision. Here is a typical check list of the information you should be prepared to submit to the lender.

1.      Purpose of the loan

2.      Amount required

3.      Term desired

4.      Source of repayment

5.      Collateral available

6.      History and nature of the business

7.      Age, experience and education of management

8.      Key advisors

9.      Product

10.  Market area and method of distribution

11.  Major customers

12.  Suppliers

13.  Competition

14.  Facilities

15.  Employees and unions

16.  Three years of business financial statements

17.  Three years of business tax returns

18.  Current personal financial statement

19.  Pro forma business income statement, balance sheet and cash budget (for at least three years and the first year by month)

Good Luck,

 

Steve Sink

Certified Business Intermediary

Merger and Acquisition Master Intermediary

ss@phxaffiliates.com

Leaving the Partnereship

Many business owners enter into a partnership without a good buy/sell agreement in place.  Often this puts a heavy burden on the buyers, sellers and heirs.   The problems with most agreements are:  1. Failure to define the terms of the exit, 2. What criteria will trigger the agreement?  3. How the company is valued today and in the future, 4. Defining the terms of transferring the business to the new owner(s), 5.  Will the partners honor the agreement and the penalty if they do not?  6. The valuation terms for a partner who leaves voluntarily or is terminated, 7.  What happens when the company has other obligations that do not allow it to meet the terms of the buy/sell agreement?   8. Failure to use a professional in drafting the document.

Personalities make it difficult to define the perfect buy/sell agreement.  However, some elements for a buy/sell agreement should include:
1.  Establish the valuation formula and terms before the deal.
2.  Insure that there is a clear path for the separation.
3.  Define the criteria that will be used in determining valuation, surviving partner, exiting, deal structure, and a non-compete agreement.
4.  When the parties cannot agree, who will arbitrate and what authority will they have?


Good Luck
Steve Sink
Certified Business Intermediary
Merger and Acquisition Master Intermediary
ss@phxaffiliates.com

So You Want to Buy a Business

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With a lot of hard work and a little luck, you can have your own business. 

This country is filled with the entrepreneurial spirit. In fact, more people are striking out on their own than ever before. But how they make the jump from employee to owner is what's news today.

Many of these new business owners are no longer starting from scratch. Instead, a significant number are choosing to purchase one of the more than 1.7 million businesses that, for one reason or another, are up for sale on any given day across the country.

So why are business acquisitions gaining in popularity? The main reason is money. Often, the only feasible way to break into a particular field, such as a hotel or restaurant, is to buy an existing business. Start up costs for many types of businesses prohibits ground-up construction.

Many middle managers who have been the victims of corporate downsizing are forced to open their own businesses because they have difficulties finding a new job. These seasoned veterans are often highly successful in their second careers as business owners.

The advantages of acquiring an existing business are many. Here are a few points to consider:

Customers: Buy a business and you also buy its customers. The more customers (be careful of customer concentration), the more you will pay for the business. Still, you'll have an immediate cash flow and an opportunity to improve on existing business relationships.

Product: When you purchase an existing business, you usually receive the inventory. This will give you an idea of what sells and what doesn't and allows you to spend your capital on other necessary items such as advertising or payroll.

Employees: Once the business is yours, you can keep any or all of the business' employees. Seasoned, knowledgeable employees can help you overcome the early jitters and share with you any quirks or insider information that's vital to the business or industry. There can be apprehension by the existing employees, so this is an area of opportunity as well as concern.

Identity: Good or bad, existing businesses already have an identity and an image. You may have the opportunity to improve on the existing image or you may need to repair and improve a tarnished one (you’ll pay less for a bad image).  Intangible assets such as an image are often one of the most valuable and overlooked attributes of a business.

The most common reason people state for not owning their own business is the lack of a down payment and little start-up capital. However, commercial real estate and business brokers who are knowledgeable about Small Business Administration (SBA) guaranteed loans have the ability to offer their buyers the option of obtaining a long-term, highly leveraged business loan for business acquisitions.

The SBA offers guarantees on loans made through qualified lenders, with terms that are very appealing to small business owners. Highlights can include: high loan-to-value; fully amortized loans with no balloon payments; terms of up to 25 years (real estate), depending upon the use of the funds; no prepayment penalties; and competitive interest rates and fees.

As with any major financial commitment, it is important to consult experts in the field to protect and advise as the transaction progresses. Legal questions ranging from property lines, to labor union concerns, to tax issues are a very real part of business acquisitions and necessitate the consultation of an experienced attorney and certified public accountant.

A few dollars invested early on can save you money and grief down the road. With careful shopping and more than a little prudence, a business acquisition can be the best way to be your own boss.

- Steve Sink

Hiding the Money

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Hiding the Money

I attended a meeting where a business broker spoke about a visit he had with the owner of a company. The owner had contacted him and asked to meet with him to discuss the possibility of selling his business. The owner provided the broker with a review of the financials and a tour of the factory.

While walking through the factory, the broker noticed that the warehouse was reasonably filled with inventory and the machinery was significant and up-to-date.

When they returned to the owner’s office the broker pointed out that there appeared to be a significant difference between the amount of inventory on the books vs. what was in the warehouse. The owner quickly agreed, stating that if he reported it, he would just have to pay taxes. In addition, his sales would be lower because he would not have as much inventory. Therefore, he would not make as much money.

The subject changed to the equipment, which was on the books for much less than it was obviously worth.The owner agreed and indicated that all parts for the equipment are charged to cost of goods. He then would have his employees assemble the parts for the new machinery.

The broker polled the group for their thoughts. The group, to a person, felt the business was not saleable and did not want to be associated with this type of a transaction. The owner had a serious income-tax evasion issue and the potential liability for the buyer could be significant.

The owner needed to go to a tax specialist NOW. He was probably going to need five years or more to clean up his books before he could put it up for sale.

- Steve Sink

When to Sell?

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When to Sell?

Selling a business can be one of the most difficult decisions an owner ever makes.  The owner has built it, survived the ups and downs, experienced many emotional moments and wonders what he or she would do if they ever sold it.

Owners will want to position their business in a positive situation and should never put themselves in a position where they are selling for negative reasons. Buyers have too many other choices than to worry about buying a business with problems.

So what are some of the areas for consideration when selling?

The Fire is Out -The “fire-in-the-belly” is gone. It is no longer fun to go in early and come home late. You may even be bored.

You have reached retirement age - All owners reach this age at some time. Some can afford to retire and some feel they cannot and have to keep working.

Your Health - Buyers like to buy from owners who are in good health. They will need assistance in transitioning the business and will need to have a healthy owner around to assist.

Economy - Good businesses sell in just about every economic condition.

Employees - You’ll need to protect the good employees, they helped you get to the party and they are assets of the business.

Your Niche - Is the forecast for your niche one of growth or decline?

Sales - A dip in sales, no matter how little, can be a huge RED FLAG for a buyer.

- Steve Sink

Due Diligence Checklist

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You negotiated the deal and your financing is lined-up. Now, all that is left is the due diligence.

Let’s get started. 

Due diligence can be divided into two areas: financial and management. As the buyer, you will ultimately make the final decision, and to do so, you will need to set some firm guidelines. Identifying the reasons a deal will not work before starting due diligence is critical as is eliminating the hangover of emotional or irrational logic.

First, make sure you have a professional to perform the financial due diligence. Your CPA can usually handle this for you. You will need to head up the management area of due diligence and don’t be afraid to get some professional help to assist you.

Second, clearly identify the critical issues for this deal to work along with the deal breakers. Some of the key management areas you will want to examine are:

 1. What additional value will be created by this acquisition?

    Look for acquisitions where 2 plus 2 will equal 5.

 2. Identify cost reductions.

    Look beyond the personnel and at the areas of operation and economies of scale.

 3.  What are the growth opportunities?

     Typically, you will need to make it grow to pay for the acquisition.

4.  What is not on the financial statements?

     Some areas may be under-reported or missing.

 5.  Will the people accept change?

     How well will the employees adapt to the merger of the companies?

 6.  What are the revenue drivers?

     Is the revenue coming from products at the end of their life cycle?

 7.  What is the management style?

     Command and control managers are a red flag.

 8.  What issues are inhibiting sales?

     Are they personnel, money, always done it that way, et cetera.

 9.  What are the financial requirements?

     Identify the numbers you will require to make this work for you.

Your CPA will have an extensive list of areas to check on the financial side.  But you will need to get directly involved in the management issues.

- Steve Sink

 

How to Successfully Lose Value in Your Company

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"Why should I plan to sell my business when I can’t sell my business now or anytime soon?"

If this thought has occurred to you, don’t feel alone. You have joined the majority of business owners thinking the same thing. Sales and profits have been, at best, flat for the last two to three years, you have reduced your overhead, you are working more hours and the future is mixed.

But...one day you get a call and someone wants to buy your business! You have a meeting and you discover that you have been so busy draining the swamp that you forgot about the alligators. So here are some of the alligators:

1. You are the business and you have no management team.

2. The profits and sales have been steadily declining.

3. You have no discipline to your systems (if you have them) or a decision making process.      Everything must go through you.

4.  There is no plan to grow the business.

5.  You want all cash. 

What happens? The buyer runs away….

In today’s financial and economic climate, if a buyer is willing to acquire a company that isn’t a turnkey operation, it will not do so without the owner’s continued involvement.  Buyers do not have the time or the in-house talent to correct deficiencies. Most owners of outwardly successful companies will share this fate: failure / inability to do anything about it.

How long will it take you to avoid this situation and prepare for the sale of your company for top dollar? No one knows. But what is known is that it’s a lot easier to bury your head and go about working in the business than it is to devote the time, energy and resources to prepare for your exit. (The path of least resistance.)

You may get lucky and a buyer will come along. But if you do not want to depend upon luck you will need to take control and use your time to make your company attractive. Increasing the value of your company takes time - time is something that buyers are not willing to take. So guess who has to make it happen?

If you started today it could take five or more years to make a business saleable. And the process could be exacerbated by additional downturns in the economy, your health or employee turnover (they know when the ship is sinking), how the company and its employees can adapt and embrace change, the fact that you are more motivated than your employees and the always present alligators.

Take charge of your future…don’t feed yourself to the alligators.

- Steve Sink

Securing Equity Investors

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Before you contact potential equity investors, if debt will be part of the company's capitalization plan, you should consider getting in touch with your bank or leasing company. You should have a plan outlining the company's basic business plan, which should include the pro forma financial projections that will be used in your presentation to possible investors.

The objective will be to gain indications of interest from the debt side of the capital equation.  Obtaining a conditional letter of commitment from a bank or leasing company and adding that letter to the company's offering documents will carry significant weight in the investment proposal.

For instance, if the bank requires more equity as a percentage of total capital, you will need to rework the numbers to accommodate the bank's request and resubmit that proposal.  If you are looking for $1.5 million of total capital with a proposal such as: "If I raise $500,000 in equity capital, will you loan me the balance?" The banker may say, "Your proposal would be considered generally unbankable, but if you raise $1,000,000 in equity we will loan you the $500,000 in debt." Your next step would be to immediately get the conditional signed letter of commitment from the lender and then rework the pro forma financial projections to reflect the revised debt to equity deal structure.

It is critical to emphasize the importance of obtaining the written and signed letter of commitment. If debt will be a large part of your plan, you should not proceed without one. In an investor's mind, a letter of commitment from a lender is like the Good Housekeeping Seal of Approval. In the eyes of the investor, the transaction has been validated and is further assurance of a successful project or venture. This will greatly increase the response rate from your investor pool and ultimately increase the probability of obtaining the full capitalization amount. 

- Steve Sink

Selling the Family Owned Business

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Having a family owned business is the dream of most parents and one that most of us can only wish for.  Family businesses have served as the backbone of our economy for many years.  Consider the following statistics reported by Maine's Institute for Family-Owned Business:

Some 35 percent of Fortune 500 companies are family controlled. Family businesses account for 50 percent of U.S. gross domestic product.  They generate 60 percent of the country's employment and 78 percent of all new job creation.

Due to the large number of family-owned businesses and the important role they play in the economy, there is a tremendous amount of interest in this special segment. Numerous surveys have been conducted to better understand them to improve their chances for success. One of the best surveys is the Mass Mutual Family Business Survey. This survey does an excellent analysis of the planning, growth and succession issues.  Some of the significant findings were:

1. Nine out of 10 heads of the businesses believe their business will be family controlled in five years.

2. Fourty percent of the heads expect a change of leadership in five years.

3. Ten percent of the businesses are controlled by two or more family CEO’s.

4. Five percenet are headed by females and 25 percent of the current CEOs felt that the next CEO would be a female.

5. Twenty-five percent of the CEOs have no estate plan.

6. Only 30 percent have a business plan.

7. Twenty percent of the heads indicate that 80 percent of their worth is based on the value of the business.

Like any business, members of a family-owned business face the challenge of perpetuating its success. The business, if successful, has provided a comfortable life style for its members creating a form of dependency for the members. As long as the business continues to provide the expected life style for its dependents, the business will continue to function as an orderly business. 

Problems usually arise when the lifestyle is threatened. 

The threat may come from internal and external forces or a combination of the two. Given that only one in three family businesses succeeds in making it from the first to the second generation, it's clear they have their own inherent risks.

Each succeeding generation has its own ideas about taking the company forward Or if, indeed, it wants to join the family business at all.

Successful transition has always been crucial to the continued success of family businesses. Many of the concepts that have bound the family businesses have eroded and new sources of potential conflicts have arisen. The sense of duty and obligation to join the family business has weakened, while the sense of entitlement has grown.

"There's always a decent greed factor out there, whether it's between father and son or between established business executives," said Tom Holly, a tax partner with PricewaterhouseCoopers' Private Company Services practice, which works with a number of family-owned businesses. "But I think there's a substantial entitlement discrepancy between the first and second generations," he said.

At the same time, Holly said, "I'm not seeing the second generation as actively involved in the business as they were 15 to 20 years ago."

One of the biggest mistakes that the controlling owners of a family business can make is not having a definitive transition strategy. It has been widely assumed that the failure of family businesses to survive was due to a lack of planning. In actuality, more recent research suggests four factors that correlate with success or failure:

1. Failed leadership

2. The inability to agree on personal, family succession and the goals for the business

3. Unresolved conflicts

4. Failure, by all parties, to communicate

In short, the owners fail to put the same time and effort into planning and structuring for an internal transition as they would into a sale of the business to an outsider. This failure typically provides the seeds for serious family conflicts.

The same issues that would apply to the sale to an outsider must be addressed and clearly defined:

Financial Issues

How will the owners be able to take cash out of the business?  Often, the business does not generate enough cash to support the new head and pay the retiring owners.

Valuation

Sale prices are often diluted for tax reasons for family members. Outside buyers will pay the fair-market value. 

Capability of Future Generations

Successful transitions to future generations typically require strict guidelines in writing (i.e. MBA, working for a Fortune 500, et cetera) and an authoritative independent screening and evaluation process.

Strategic Issues

A long-range clear vision that can be passed to succeeding generations keeps the future owners focused.

Flexibility

The business must have a Plan B that allows for the sale if and when required.

Personal Issues

The head of the business must recognize when it is time to retire. This can often be the most difficult to address for the controlling owner and other family members. It is usually best handled by an independent authority.

The sale of a family-owned business can be initiated by competition, internal forces, the economy, lack of a successor and a hundred or more other reasons. 

Buyers for the business can usually be put into categories: 

1. Strategic Buyers: Will buy for strategic reasons and will usually pay the most.  Typically, these are firms seeking market share or find it cheaper to buy a business rather than compete with it.  

2. Financial Buyers: Will buy only if the numbers make sense to them. (i.e. a private equity company). They can take a majority or minority position in the company, serve on the board of directors and help the company grow the business.  The downside is that the family will have to give up some control and perhaps the company if it gets out of the covenants.  

3. Industry Buyers: They know the business because they are in the business.

4. Hire an outside professional manager and allow them to run the company.

5. Inside Buyers: Employees or family members and are often the most difficult to deal with and will pay the least amount.

The buying process for buyers 1 through 3 typically follows a very predictable pattern (i.e. Sign a CA (Confidentially Agreement), meet the owner(s), ask questions, request information, make an offer, conduct due diligence, secure financing, complete purchase agreement and close on the sale.) No. 4 does not require a sale but it does require surrendering control. The buying/selling process for the family owned business can differ remarkably because of the following reason or combination of reasons: 

1. There can be multiple family members competing with each other for the purchase.

2. The controlling owner can be placed under severe emotional stress to choose sides.

3. The selling price can be seriously reduced because a family member may not have sufficient funds. 

Even though lack of planning may not be the major cause of a family business' mortality, exploring all the options can surely go a long way to sustaining the legacy and providing an opportunity for subsequent generations to preserve the wealth.

- Steve Sink

Free Data for Maximizing the Value of Your Business

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Maximizing the value of your business often requires expensive research for about your marketplace and your competition. Much of the information you will need to have is available from one of the many government agencies. Here are some websites:

Market Size

The Census Bureau assigns you a Standard Industrial Code, or the new North
American Industry Classification System number that describes your service or
product. By knowing this number, which may be found at www.census.gov/epcd/www/naics.html, you can tap into:
   1. Zip code, metropolitan, statewide and national economic trends for your industry
   2.The economic analysis for the country as a whole
   3.Detailed content information, such as sectors, programs, or data products, from subject
      specialists at local or federal census bureau offices

Patent Information

Patent and competitive product information can be found at www.uspto.gov. Using a very powerful and extensive keyword search engine, you can search 31 different fields, including competitor's names (under "Assignee Name" in PTO parlance) or product type (under "Abstract"or "Description/Specification") to find:
  1. All the issued patents for those competitors
  2. All the issued patents of your unknown competitors (In other locations and markets)
  3. How a competitive product works
  4. Competitor's "Published Applications" that are undergoing patent review (You
      can comment on their validity)
  5. Patents of products that the competition decided to abandon (and are now
      usable by anyone)
  6. All the locations of both known and unknown competitors
  7. All the key innovators working for your competitors

Competitive Pricing

More than 9,000 contractors offer their products for purchase to various governmental agencies through the General Service Administration's website at www.gsaadvantage.gov. GSA Advantage is fully searchable database by keyword, part number, manufacturer, contractor or contract number, or product classification. The GSA Advantage website will help you find:
   1 .If your product is priced right against your competitors
   2. If your quantity discounts are competitive
   3. If your delivery times are typical
   4. If the additional cost you offer for setup and delivery are competitive
   5. If there are other distribution methods for the competitive products

Other Information Sources

Many other free government data sources exist. Here are just a few:
  1. The Bureau of Economic Analysis (www.bea.gov): GDP by state and industry,
      corporate profits, state and local personal income, et cetera.
  2 .The National Technical Information Service (www.ntis.gov): Information on
      government funded research in your industry
  3.  The U.S. Department of Labor's "America's Career InfoNet" (www.acinet.org): Wage
       data available by occupation for all states and over 300 metro areas.

Enjoy your search.

- Steve Sink

Finding Value in an Established Business

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If you are just beginning your investigation into finding a business, there is a lot more to consider than return on investment (ROI).

Not to mention ROOPM, or return on other people's money.

Advisers, relatives, friends, lenders and sellers each have their own formula that they use to arrive at an asking and selling price. And every buyer and buyer's relatives, advisers, friends, lenders, et cetera have their formulas too. Rarely, will everyone's formula agree.

Cash flow is cash flow. Are you willing to pay one time or five times? Do you want 100 percent return or is 20 percent reasonable? In addition to cash flow, what else are you purchasing? Unless you have started a business from zero, you won't understand the intrinsic values associated with an ongoing or failing business. Yes, even a failing business might be worth more than the face value of its assets. But, only to an educated buyer.

* Customer list. If there is an up to date customer list, what is the value? The seller may think that they only have hard assets to sell.  The buyer could be interested in growth and those customers who have purchased over the last two years. 
* Website and Yellow Page listing. If you can get a business (open or closed) and can take over its website, the phone number and yellow page contract is worth a small fortune. If you can't, you’ll need to figure out how you will get customers until you can get into the next directory or drive customers to your website.
* Accounts payable. If you are buying a business that buys merchandise at wholesale, then sells at retail, or assembles and resells, are they on a net 30, 60 or 90? Do you understand the value of someone fronting you merchandise and letting you sell it and earn a profit before you have even paid for it? (ROOPM) If you do not have those accounts, your shipments come in COD (bank check), or prepaid on a credit card, or you give money in advance to your supplier and they send you merchandise until your deposit is used up. This can go on for 6-24 months until they 'try' you at net 10-30.
* Procedure manuals. A business plan, operations manual, employee manual and independent contractor’s agreements all add value to a business. They all have a cost associated with them. And each good business has one.
* Supplier list. Arriving at a good supplier list is trial and error. Think profit and loss. Spend a few days price shopping with the telephone for whatever item you want to sell or service and see if you can see a value to having someone hand you years of research.
* Grandfather clauses. Call the building department of the city and county where you are thinking of opening and buying your business. Ask for a list of all the permits, inspections, zoning ordinances, allowed use, licenses, engineering requirements, architectural requirements, ADA requirements, sign ordinances...you get the idea. A savvy business buyer will buy a business with grandfathered use codes in order to not have to comply with today's more stringent codes. For example, a new business may only be allowed to have four square feet of signage per 1,000 square feet of occupied building space. A business that was established 10 years ago may be unlimited and using that billboard for the last 10years. Which one is more valuable?
* Equipment. Most any equipment older than 5 to 8 years is worth little if anything. Or is it? Equipment built today, is built to 'throw away' when you are done. Equipment built 20 years ago was built to last 100 years. They were built with bearings instead of bushings. (If you don't know, you won't understand or believe it!) When South Florida changed the building codes after Hurricane Andrew, it was more expensive to re-tool the newer equipment than the older equipment! Who on earth would spend eight hundred thousand dollars to re-tool equipment that was valued at $300,000 tops? The same person that saw sales jump from $3 million to $8 million while his competitors scrambled or closed their doors.

- Steve Sink

Securing an SBA Loan

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Securing an Small Business Administration loan is often painted as an incredible frustrating task. 

This can be true when the borrower is using a lending institution which is not familiar with the process and has not informed the borrower of their lack of experience. Borrowers desiring an efficient process should always seek preferred SBA lenders or a loan broker specializing in securing SBA loans.

The nice thing about a loan broker is that they only get paid when they place your loan and will shop your application nationally.

While the SBA itself does not make loans, they guarantee up to 75 percent of a loan that a traditional lender will make under the SBA's 7(a) program. The maximum loan amounts change periodically and your lender can provide you with the current amounts. 

As I'm sure you can appreciate, there are numerous conditions attached to SBA loans and some points to note about them which are as follows. 

1.  The business must demonstrate that it can support the debt based upon prior year's tax returns (usually 3 to 4 years of returns).

2.  The buyer's required down payment can vary, but generally is around 20% to 40% depending upon the business.

3.  Almost all SBA loans will require the seller to participate in the financing and be in second position to the bank.

4.  The SBA wants to have as much security as possible for the loan through a combination of the business' and your personal assets including your house.

5.  Loan fees are quite steep; however, the SBA will finance them over the term of the loan (how nice!). Nevertheless, the fees are generally meaningless relative to getting the financing and completing the acquisition.

For more information, click here to visit the SBA's website.

 In summary, given our current economic conditions, almost all lenders, to protect themselves, are placing their business loans with the SBA.  In addition, while the SBA sets minimum loan standards, it does not mean that a lender can have a higher set of standards for a loan.

Good luck!

- Steve Sink

TheTaxman is on the Way

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Selling your Business in 2010 vs. 2011

If you are a business owner contemplating the sale of your business, you should consider the proposed tax rate hikes beginning in 2011.  Owners should immediately consult a tax advisers about the significant adverse impact that the proposed tax rates will have on after tax sale proceeds.

The Bush-era tax cuts are scheduled to expire at the end of this year will cause long-term capital gain rates on higher income taxpayers to rise from 15 percent to 20 percent for years after 2010. In addition, the U.S. House of Representatives has proposed a surtax of 5.4 percent on the income of high income taxpayers. Assuming the 15 p[ercent rate is not extended and the 5.4 percent surtax is enacted, the combined Federal tax rate on capital gains will rise from 15 percent to 25.4 percent - an increase of 69.33 percent.

Business sellers need to know about the proposed changes in tax legislation. Most will be stunned to see the calculation the tax increase will have on their sale price. Planning for this proposed tax change is likely to cause more businesses owners to strongly consider selling their business so the sale can be closed in 2010.

The higher tax rate is not the only factor you should consider when to sell your business, but it is an important one. Owners who make the decision to sell in 2010 need to start the process sooner rather than later in order to increase the possibility of closing in 2010.

As always, with a sound exit strategy in place, the business owner can minimize their tax burden at closing. Unfortunately, most business owners have not taken the steps to form their exit strategy team and therefore are unprepared for selling their business.

I have never had a buyer offer a lower price due to the owner's tax burden at closing. The structure of the deal yes, but not the price.

-Steve Sink

Scams in the sale of your business

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Scams in the sale of a business is not unusual. 

We have all heard stories about missing inventory, unreported cash and assets that do not work.  But using a stock sale to drain the assets is not your typical scam. 

Here's how that scam works:  An individual contacts a business owner offering to buy the business.  They get some initial information and agree to a price.  The next step is to eliminate communication with third parties by convincing the seller that they will be a hurdle to getting the deal done.  These crooks then offer a to pay the sale price over a short six to 10 month buy-out period with possibly 10 percent down and as a stock sale.  

All sellers and their CPAs love this part for tax reasons. 

With 100 percent of the stock held by the seller as collateral, and of course the sale includes accounts receivable, cash, accounts payable, et cetera - the entire balance sheet. After that, they give the seller his initial down payment (sometimes from the A/R or existing credit line) and take control of the company while the seller is around.  They factor the A/R's, clean out the cash, run the credit cards up to the max and do not remit any payables or liabilities. Then they disappear within a month.  And guess has to pay?

Think no one would fall for this scam? Well, owners have and it has been working the United States for years and this is how they earn their living. Recently, a Peoria, Ill.-based printing company fell for this scam. 

Should your hear of a similar situation, please contact the FBI.

-Steve Sink

Using OPM or Sweat Capital to buy a business

I receive a number of calls and e-mails from individuals who would like to buy a business. Typically, they are very talented individuals who have made a great deal of money for other people and would like to start making money for themselves. 

Their problem, generally speaking, is a lack of capital. As most of us know, buying something without the “cash” requires credit in some form. I usually take the individual through a process to help them explore their options:

First, you must have a proven history of success in business and with people.  If so, you now have a saleable benefit.

Two easy options to explore are:
OPM (Other People’s Money): Do you have or know of people who would be willing to invest in you?  If you have a proven record of success along with a great business opportunity, you will be amazed at how many people will be willing to invest. Just remember, you still have to report to the investors. And you can’t make all the rules, until you own it.

Sweat Capital: There are many businesses that are in need of proven management, specifically businesses that have fallen on hard times; not because it is a bad business, but just poorly managed by the owner. For whatever reason, the owner has lost interest, the business out grew them, the employees are no long motivated, et cetera. These are ideal situations for someone with a proven track record.  Generally the owner and the potential buyer (you) agree to let the potential buyer come to work as a (a possibly unpaid) consultant based on agreed to criteria. And if you prove yourself  - let’s see what you got kid - then you will be awarded a position with the company. Naturally, to go along with your new position, would be an agreement spelling out the terms and conditions which would allow you to buy into the company by using your “Sweat Capital”.

Sweat Capital may be a unique way to buy a business if you lack investors; it may be the only way to accomplish your goal.

Feel free to contact me if you have questions or would like to have a discussion.

- Steve Sink

Eight hard-won lessons on buying a business

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1.  Be proactive in your search for a business. Reactive responses usually create negative results.

2.  Know what you want. Have a clear definition of your requirements before starting the process.

3.  Set limits. Implement strict financial disciplines.

4.  Due Diligence. Look beyond the numbers to the culture fit, the human resources and the strength of the management team.

5.  Be prepared to walk. Do not let emotions dominate the decision making process.

6.  Terms. It is not the sale price, but the terms that make most deals affordable.

7.  Taking over. Have a detailed plan on how the transition will be executed.   Timing is a key issue.

8.  Know what it will be worth if your plans are successful.

Good hunting!

- Steve Sink

Seller Issues

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These are some common issues that sellers will have or face when selling their business:

• The value of your business is not what the seller or advisers say it is. The market determines the value.
• There are two reasons a business will not sell: The business is overpriced or the seller is not motivated. If the business is priced too high, it will not pass a sanity test for the buyer. What that means is if you look at an acquisition from the buyers’ perspective, it has to be priced in such a way that it cash flows. The buyer has to get a living wage, be able to service the debt and cover any contingency spread required by the bank.
• Would you pay this much for your business? If the asking price is unreasonable, all the buyers who look at your business will have the perception that you, the seller, are an unreasonable person. This not only makes it difficult to get them to even make an initial offer, but they will have doubts about working with you during the transition.
• People do business with people who they like and trust. Both buyers and sellers are afraid of unknowns; once they get to know and trust one another they are more inclined to do the deal.
• Most banks and the Small Business Administration require some seller financing. Seller financing shows the buyer that you believe in he future success of  the business and gives them an added comfort level which usually means the difference between getting a sale or not and  a higher price. 
• There are benefits to seller financing, including 15 to 20 percent more in sale price and a probable savings in taxes from deferred payments. Buyers will have more confidence in the company if you finance it.

- Steve Sink

 

Buying a Franchise or Existing Business

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There are many options to consider once you have made the decision to own your own business. As many business brokers advise, one strong option to consider is buying an already existing business or franchise.

Business brokers often suggest that, for beginning entrepreneurs, one of the biggest advantages to buying an existing business is that there is already a known history. Contrary to starting a new business, the owner does not have to develop a product and go through the process of determining how much, if anything, people are willing to pay. As such, business brokers point out that there is no need to come up with tedious business plans.

Business brokers also recommend that buying an existing business or franchise has the benefit of an "established" infrastructure. Existing businesses tend to already have a foundation on which the new owner can build and expand. In addition, business brokers point out that such important aspects as customers, suppliers, employees, the building, and equipment are often all part of the package.

Also important: existing businesses and franchises come with the comfort of knowing that the concept has already been successful. Plus, business brokers suggest that this option can actually be less expensive than starting a new business. Since the learning curve is eliminated, the risk of failure is much lower. The hope, as suggested by many business brokers, is that the existing business will continue to be profitable under your new ownership.

Purchasing a business can be a complicated endeavor, but with the help of a skilled business broker, your transactions are guaranteed to go more smoothly, ensuring your success as you buy a business or franchise of your own.

- Steve Sink

First Time Business Buyers and Due Diligence

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Buyers of a small business face the need for due diligence. And for that they may need expert help. The question: What should they do and what should they expect to pay for this service? 

For the financial due diligence of a business you will need to engage an accountant to complete the review. Before discussing approximate costs, there are several important factors to consider which will have a direct impact on the final costs for their services:

1. Make your offer subject to a "satisfactory" due diligence.

2. Hire an accountant who has experience in completing the due diligence reviews of similar businesses. (How would you find someone?)

3. Use an accountant that makes sense - you do not need a Big Three CPA to review a small business.

4. Lay out very clearly, what it is that you want the accountant to do along with what they recommend.

5. Have the accountant provide you with an estimated cost to complete the work.

6. Get a list to the sellers, defining all items you will require, as soon as possible after you have a signed purchase(?) agreement in place.

7. Do not start the review until you have all (or the vast majority of) documents and files required for them to complete their work.

8. Consider the timing of the due diligence schedule. If it's near the end of a calendar quarter or tax season your CPA may not be able to meet your schedule.

Be sure to review all of the documents that the seller has provided you with everything you have requested.  Make sure the documents are in the format your CPA requested (missing materials can be very expensive to you).  Plan on paying about $2,500 to $5,000 for a transaction less than $500,000. Most accountants will provide you with a very accurate quote of what they feel the final bill will be.

Buyers need to remember they are paying for a financial due diligence which will not reflect future opportunities and the potential of the business.  This area is a management decision.

See www.IBBA.org for additional information.

- Steve Sink