by AshleaG@jbval.com | May 3, 2023 | Business Owners, Professional Advisors, Succession Planning
Does the value of your business reflect all the work you put in? Probably not. Shouldn’t it? Absolutely.
Business owners sacrifice for their business – no nights out with friends, skipped weekends with their kids. All to grow their business.
Owners look to the business’ ultimate selling price as the reward for all their work and sacrifice.
Then comes the offer: “That’s all??”
Owners who poured their heart and soul into their company often do not get the return they expect or deserve. Owners who were selling rethink that decision.
The worst in our view is when owners reached a burnout point where they just want to move on. At any cost. Right now. Some are willing to just walk away.
That’s the worst time to realize you could have taken steps to improve today’s profits and increase tomorrow’s selling price.
Can this be avoided? Yes.
Is it easy? Nope. But when is being an owner easy?
These are some key factors buyers will consider in making an offer for a company. By proactively addressing them, owners can refine their business so it has the most value possible. The bonus is their profits will increase near term, too.
Recurring Revenue
Buyers acquire companies with the least amount of risk. Reliable recurring revenue streams greatly reduces risk.
Recurring revenues assure the company will have predictable cash flow. To optimize your revenue stream, identify and focus on recurring revenue opportunities. Not so simple but very valuable.
You have developed relationships with recurring customers. You’ve marketed to them once. Keep them happy and they stay. Marketing to a new customer often eats up 10% of revenues. Marketing to existing customers is much less costly.
Create Processes
Predictability is crucial in running a business. Processes contribute to predictability.
Repeatable processes assure the buyer the company will function effectively without the direct involvement of the former owner.
A business with no documented processes holds a lower value. The value it does have is associated with not the business but with the employees. Only they know how to handle the workflow. This is a risk to a new owner.
With repeatable and documented processes, the value belongs to the business. New people can readily learn how to best perform their jobs. There are fewer opportunities for error or “I forgot” situations.
The goal of creating and documenting processes is to keep it simple. While it sounds harsh, any individual employee should be dispensable. Especially you.
Diverse Customer Base
There’s no bigger red flag for a buyer than a company that relies on a few (or even a single) customers. If those customers move on (and it does happen), how much is your company now worth? Little to nothing.
To be attractive to potential buyers, diversify your customer base. Diversity applies to the industries served as well as the customers themselves.
The more diverse your customer base, the more options a company has when external challenges arise. The COVID pandemic, for example, slammed some industries and led to explosive growth for others. Spreading your risk leads to more stable sales and profits.
How to diversify? Look to expand into new sectors. One way is to simply expand geographically. Then, think outside the box. How could my service or product provide value to a completely new set of customers or industries? What about complimentary services? Is there something close to your core competency that is an obvious add-on?
Let’s say you produce hinges for kitchen cabinet makers. Why not sell to cabinet makers for marine applications? If your products can be easily adapted for use by a new segment, go for it!
Scalability
Think like the potential buyer of your business. Would you want a business that has room to grow or one that has reached its ceiling? The choice is an obvious one though few business owners consider this.
Investopedia defines scalability as “a company’s ability to grow without being hampered by its structure or available resources when faced with increased production.”
Scalable businesses have higher profit margins. Overhead increases at a much slower rate than sales.
Improving Cash Flow
Buyers like companies with a stable cash flow but LOVE those with rising cash flow.
Addressing the suggestions in this article will create higher cash flow. Look for profit leaks (those practices your business has that leak cash but do not improve the bottom line). One example is addressing slow paying customers. If they consistently pay late and require a lot of follow up, are they worth being your customers?
Your CPA can assist finding these leaks.
Entrepreneurs should think about the end value of their business throughout their business’ life. Steps such as these not only add to the endgame sales price, but they also increase your profits today.
by Kevin Jennings | Nov 12, 2018 | All Blog Entries, Succession Planning
Most
professionals working with small businesses have stories they hear from clients about bad situations that could have been avoided. Here are two that we’ve heard from our clients:
A substantial New York-based electrical contractor had two 50% partners. They started and grew the business over the years from scratch. Each has a lifestyle they never imagined could happen. At age 55, one partner passed away from previously undetected heart failure, and that’s when the troubles began. The partners had only an oral agreement that if one should pass away, the other would buy him out at book value.
The widow had buried her life partner and realized her main source of income was gone. She contacted her deceased husband’s partner for advice. He told her about the agreement he had with her husband. He let her know the amount of money he would be paying her. The widow told her children of the conversation. They balk at the amount involved. Enter the lawyers. The case still continues into year three.
Had the partners had a formal written and reasonable buy-sell agreement, this situation would never have happened. What constitutes a reasonable agreement depends on the company. Book value for a contractor is typically not a good indicator of company value. Engaging experts to determine a fair and unbiased value may have costs associated, but the surviving partner in this story has told me he regrets not having taken this step years before.
In the second situation, a Massachusetts boutique printing company started by parents employed their two adult children. All were very well paid. The son ran the company full time, the daughter contributed on a part-time basis.
After some time, the son convinced Mom and Dad to transfer 100% ownership to him, leaving Daughter out completely. He then proceeded to remove her position, eliminating a $400,000 salary. Here, too, the lawyers enter and the case continues at high expense. And it gets even uglier: As a result of feeling betrayed, the Daughter has forbidden her parents from seeing their grandchildren.
How did this happen, you might ask? The son told me he is still angry his sister took his teddy bear away when they were children.
A succession plan must be fair, as difficult as that process can be. Request our booklet Business Transition Planning: Maximize Your Legacy to see how this process can work best for you.
by Kevin Jennings | Apr 12, 2017 | All Blog Entries, Corporate, Succession Planning
In a business owned by more than one partner, the need for a buy-sell agreement may seem remote, especially while the business is still young and growing. Understandably, the owners are focused on the urgent and important matters of running and growing the business. Investing time into planning for the future exit of a partner seems like a distraction. Drafting legal documents requires an attorney, and that costs money.
As the business matures, the need for this document that defines the orderly transition of the business becomes more acute, but is often still neglected. The result is a nagging worry about what would happen if a partner became ill or decided to retire.
The sooner a buy-sell agreement is created, the more peace of mind the partners and their families will enjoy. Dealing with an unplanned exit situation will stress and cause conflict among even the friendliest of partners.
A well-planned buy-sell agreement can help avoid those pains. And, while the buy-sell agreement puts a legal framework around the transition process, the heart of the matter – and, the likely bone of contention — is the value of the business.
In some cases, the agreement stipulates a fixed dollar price. The partners adjust the price on a regular basis as the business expands or contracts. However, when the moment arrives, the heir of a deceased partner or the exiting partner hi/herself may claim this price does not accurately represent the true value of the business. The next step often involves lawyers.
A second approach to valuation involves the use of a formula or set of formulas that are based on revenue, EBITDA or some other definable metric. Valuation experts may be consulted to help produce these formulas. However, businesses change, markets change, the economy changes, which can alter the cost of producing those revenues. These changes can influence the selection of formulas, so that a formula which may seem appropriate in Year 1 may be wildly off base in Year 6.
A third common method for defining a fair valuation is to engage the services of a valuation firm. This approach is taken to arrive at an independent, neutral view. But there are ground rules that must be established to achieve a result everyone deems fair. Should the valuation value the entire company with no discounts and assign a pro-rata share to each owner? Should a minority owner’s interest reflect lack of control and lack of marketability discounts? Should these minority interests’ value also ignore above-market compensation paid to owners/officers, above market rent paid to related parties, and the like?
What about the proceeds from life insurance that was purchased to cover this buyout? Does the valuation analyst consider this a business asset and include it in the valuation, or is it to be treated solely as a funding mechanism for the buyout and ignored for the valuation?
Issues such as these must be addressed in the buy-sell agreement as they will significantly impact the valuation. The time to consider them and put the proper documents in place is now, when the business is running and partner exits are still a long way off, not at a time of crisis or disruption.
by Kevin Jennings | Dec 21, 2016 | All Blog Entries, ESOP, Succession Planning
Section 2704 Proposed Changes: Much Ado About Nothing? A Different Kind and Level of Estate Taxation? A Golden Opportunity? All the Above?
The December 1 IRS hearings on proposed changes to the Section 2704 Regulations demonstrated the significant opposition from taxpayers, advocacy groups and other interested parties. Thousands of comments, almost all against the proposals, were submitted. A record crowd attended the five-hour hearing. No supporter (or just one depending on the reporting source) came forward.
The controversy includes limits to valuation discounts many see in the proposed regulations. Experts disagree on the extent and intent of these limits.
After the hearing, some believed the IRS would rework their proposals. Others thought it may be moot.
As part of his sweeping tax plan, President-elect Trump calls for the elimination of estate taxes. Most presume this would include gift taxes. When/if this broad-reaching tax plan is passed depends on how many Senate Democrats Mr. Trump can persuade to join him to reach the 60 votes required. And where in his list of tax changes do estate taxes fall? Many times, we have seen proposed tax changes negotiated away.
Trump spoke of implementing a capital gains tax at death. Most agree stepped-up asset values would remain. The Tax Foundation thinks otherwise. They read into Trump’s proposal that estates over $10 million would effectively lose their stepped-up basis. They further believe the capital gains tax would be deferred until the inheritor disposed of the asset. (Interestingly, the Tax Foundation projects a repeal of estate taxes would lower federal government revenues by $240 billion between 2016 and 2025 and would have a positive 0.9% effect on GDP over the same period).
A capital-gains-at-death tax could mean an effective tax of 20%. It’s uncertain if the federal exemption would continue. In 2017, that exemption rises to $5.49 million ($10.98 million for a married couple).
Estate planning professionals are understandably unsure how to proceed. Many unknowns are in play.
One strategy is certain: with no change, a new tax or a tax repeal, moving assets out of an estate remains beneficial.
- If no change occurs, the benefits seen today remain.
- If a new tax is enacted, the benefits diminish but will still exist.
- If the tax is repealed, this becomes a golden time to move assets, potentially federal tax free.
The biggest uncertainty: What happens when Democrats regain control?
by Kevin Jennings | Jul 5, 2016 | All Blog Entries, ESOP, Succession Planning
This recent estate tax case is rife with valuation issues. And it is one of the few that the issues are clearly defined and resolved.
The United States Court of Appeals for the Ninth Circuit (the “Ninth Circuit”) remanded the case to the Tax Court to reconsider its decision on the valuation of the Estate’s interest in the Giustina Land and Timber Company Limited Partnership (the “Partnership”).
On January 1, 1990, the Partnership was formed to operate a sustained yield timber harvesting company. (A sustained-yield timber harvesting company looks to harvest timber and replace it with new plantings at a rate that will allow it to continue into the foreseeable future). The partnership agreement stated the Partnership would continue in business until December 31, 2040, 50 years after it was formed.
The partnership agreement placed all control of the partnership into the hands of the two general partners. This control included the ability to sell off the land and harvested products. The agreement stated a general partner could only be approved or replaced by limited partners owning at least two-thirds of the limited partnership (“LP”) interest. (Note the two GP’s were family members operating through corporate structures. The decedent was not a GP. All limited partners were either family members or trusts for the benefit of family members). To dissolve the partnership, the backing of the same two-thirds ownership of LP interests would be required.
Natale Giustina passed away on August 13, 2005 holding a 41.128% LP interest. The Estate’s valuation expert and the IRS’ valuation expert opined widely divergent values, primarily from the IRS expert’s reliance on a net asset method and from very different results from the guideline company method.
The Tax Court primarily agreed with the IRS. The Court ultimately derived a value based on the net asset method and the cash flow method. The Estate appealed.
The net asset method, in my view, is associated with liquidation, not with a going concern. Under a net asset method, the value derives from the analyst’s belief of what the assets sell would for and liabilities be settled for in an orderly sale. At the date of death, this Partnership had been in successful operation for almost 15 years. Predecessor companies existed, dating back to the early 20th century. The GPs had never expressed any intent to cease operations or sell off major assets. This Partnership definitely qualifies as a going concern. The Ninth Circuit apparently agrees.
In its initial decision, the Tax Court weighted the net asset method 25%. It presumed there was a one-in-four chance a limited partner could either replace the two general partners or force a partnership dissolution. As the Ninth Circuit pointed out, not only would this require the backing of limited partners holding two-thirds of the total LP interests, it would mean a new limited partner would turn against the GPs who just admitted him or her to the partnership. (Alternatively, a transfer could occur to an existing limited partner without GP approval). In such a cohesive family partnership, turning other family members against the GPs appears more hopeful than possible. And, as I stated above, the GPs never expressed any intent to sell assets. The fact the entity and its predecessors had been in operation for decades was significant evidence the Partnership was a going concern.
On remand, the Tax Court weighted the cash flow method 100%.
The Tax Court took issue with a component of the company-specific premium the Estate’s expert included. All income-generating assets were timberland in Oregon, significant revenue and geographic dependencies. The Estate expert added a 3.5% risk factor. The Tax Court halved it under the presumption a buyer could force diversification. The Ninth Circuit stated the Tax Court did not provide support for cutting this premium in half. The Tax Court rescinded it.
The Estate expert applied a 35% lack of marketability discount. The IRS expert applied a 25% discount. The Tax Court, in its initial decision, applied a 25% discount, but only to the cash flow result. The Ninth Circuit did not question the Tax Court’s use of a 25% discount. It pointed to the Estate expert’s statement that these discounts can range from 25% to 35%. This supports the standard that all factors used needs to be thoroughly supported. Support for discounting is among the most difficult parts of a valuation. It’s one of the many reasons why a valuation is an opinion.
by Kevin Jennings | Jun 27, 2016 | All Blog Entries, Corporate, Employee Compensation, ESOP, Succession Planning
Valuations frequently assume a third party will purchase a business and primarily run it unchanged. This does not mean a buyer will continue to pay expenses or a level of expense not considered typical. Non-operating assets are typically excluded from a valuation, too. Normalizing adjustments take the atypical expenses or portion of expense (or income) out of the mix.
Non-operating and one-time items include but are not limited to gains and losses from the sale of assets, income and expenses related to investments and legal settlements. Expenses related to layoffs are an example of operating but non-recurring expenses generally removed. If an income source or expense is not related to ongoing operations, it is subject to adjustment.
Discretionary adjustments look to income sources or expenses over which an owner has a choice. Compensation paid to owners and officers as well as rent paid to related parties are frequent candidates for a discretionary adjustment. Rent paid to a related party is often based on the cash flow requirements of that related party. For a property with no mortgage, for instance, below market rent may be paid. This is an example of how adjustments can work as a reduction of expense or an addition to expense.
Various authoritative sources report officer/owner compensation based on industry type, size and location. These sources can form the basis for this adjustment. Real estate appraisals are frequently used as the source for an adjustment to market rent.
Controversy exists over whether to include “discretionary” adjustments when valuing a minority interest. Opponents say no, correctly stating a minority owner has no control over these discretionary expenses. Proponents argue these adjustments should always be considered. Shareholders of publicly-traded companies will invest elsewhere if they deem company management is overpaying executives, for example, resulting in a lower return on their investment. A growing lack of investor interest leads to a decline in share price.
Proponents point to the derivation of yields used when calculating value based on cash flow. These yields are often based on data from public equity markets. As investors price shares and the related returns based on how well management is running the company, a perceived overpaying of expenses will lead to lower share prices and returns.
