Archive for January, 2008

Taxes & Valuation: Can You Have Your Cake And Eat It Too?

Monday, January 28th, 2008

What Every Business Owner Needs To Know About Taxes & Valuation

 

Inevitably, one day the time will come for a business owner to move on. The reason for the exit may be anything from retirement, health problems, burnout, or just taking some chips off the table.

Planning this exit can have a significant impact on how much the business owner takes home from the event. Maximizing the take home requires the business owner to present the business, especially the financial aspect, in the best possible light. Here is where paying attention to accounting details makes a difference.

Businesses typically spend an inordinate amount of time setting up and using accounting practices that reduce the owner’s tax liabilities. CPAs use various business ownership structures and techniques to defer/reduce the revenues or accelerate/inflate the expenses to help business reduce its tax burden. The unforeseen side effect of this exercise is that, to a potential acquirer, the profitability of the business may appear much smaller than what it really is. There may also be other after-sale tax consequences attributable to corporate structure and to depreciation. Business intermediaries “add-back” non-business, non-cash expenses and “recast” the financial statements to get a better picture of the finances, but in most cases this is more of a band-aid than a real solution.

Since most businesses trade in multiples of the business’s cash flow, the practices utilized to save the business a lot of money may result in an artificially low valuation when the business sells. Does this mean that business owners have to give up all of their tax benefits? Not really!

When it comes to taxes and valuation, there may be ways in which business owners can have their cake and eat it too. With advanced planning, a competent M&A advisor can help mitigate potential adverse affects at sale time. Some aspects of accounting that need to be revisited in preparation for an exit include:

–      Business ownership structure

–      Aggressive revenue deferrals or expense accelerations

–      Burdening the business with personal, family and other unrelated expenses

–      Commingling revenues/expenses of related businesses

–      Wasteful spending

–      Inaccurate inventory statements & inventory write downs

–      CapEx budgets

–      Off-the-record transactions

–      Accrued assets and liabilities

–      Nonperforming or underperforming assets on the balance sheet

–      Appreciated, overstated or understated assets on the balance sheet

–      Deciding on Compiled, Reviewed or Audited financial statements

Ideally a business owner planning his/her exit three to five years prior to the actual sale has the best opportunity to do the proper financial planning and make the financial records accurate and presentable.

However, it is never too late to plan for a sale and even a year’s worth of planning is better than no planning at all. Be aware that generally the more time the owner works the problem, the better the results will be.

Posted in Finance, M&A, Miscellaneous, Tax Related, Valuation | No Comments »

2008: Exit Planning For The Year Ahead

Thursday, January 17th, 2008

2007 is over! That is a welcome relief for many business owners.  After several years of solid growth, 2007 has been a harsh year for business executives. Empirical evidence suggests that a vast majority of businesses have seen their revenues stagnate or decline in 2007.

For Business owners who were planning to retire or cash out of their business for other reasons, 2007 was tough. Business was soft, long term interest rates were near 5 year highs, credit was hard to come by, and liquidity levels were low. All of these translated into a very negative environment for deal making especially in the housing, construction and retail industries. Business owners who had their businesses on the market saw less than stellar business valuations and, in several cases, found that their deals did not close as planned. Several other business owners who were planning on exiting held back – unwilling to face a reduced valuation and hoping things would be a bit better in the not so distant future.

As we look into 2008, it appears that we have not seen the bottom in the economy. Does this mean business owners should delay their exit/recapitalization decisions until late 2008 or 2009? Not necessarily!

When evaluating the consequences of environmental trends on the business sale/recapitalization process, it is useful to keep in mind that the business sale/recapitalization process for a mid market business can take about 12 months. Most acquirers/investors look carefully at business performance as they navigate through the deal process and positive trends along the way can be helpful in closing a deal and in getting the terms sought by the shareholders.

Here are some key factors business owners need to take into account while planning exit/recapitalization strategies this year:

Ø  Economy: While we have not seen the bottom in the economy, some segments of the market are starting to pick up. Most construction related businesses continue to be in the doldrums, but the prognosis for several other business categories is getting positive. Based on the commentary we are hearing from industry sources, it seems likely that most businesses will end 2008 with more positive trends than what they are seeing now. These positive trends can be beneficial to companies and shareholders with near term plans to exit or to recapitalize their businesses.

Ø  Interest Rates and Liquidity: Long term interest rates are inching downwards and credit is expected to get better as the year progresses. Twenty out of twenty top economists in a recent national poll forecasted interest rates to go down in the near term. Lower interest rates not only improve liquidity, but also have an effect of making valuations higher. Acquirers are likely to find a higher valuation more acceptable in a lower interest rate regime when they can finance the deal and still meet the cash flow metrics needed. Lower interest rates, coupled with improved liquidity, make the chances of putting together winning deals a lot more likely.

Ø  Taxes: Unfortunately, selling a business with a gain means that a business owner has to pay capital gains tax or ordinary income tax on the gain. Since capital gains are taxed at a lower rate than ordinary income, a competent business M&A specialist attempts to structure much of the gains from the sale of the business as capital gains. In the last few years, business owners have been beneficiaries of a historically low 15% Federal Capital Gains Tax Rate.  With an impending new administration in the White House in 2009, most tax experts believe that the low 15% Capital Gains Tax rate is unlikely to stay at that level and there is a substantial risk of the rate being changed to something higher. The prospect of increased Capital Gains Tax should be carefully thought through in the context of the business exit/recapitalization process.

Ø  Deal Making Opportunities: Acquirers are a lot more likely to buy a business in a flat to upwards trending market than in a downward trending market. Deal making opportunities should become more abundant as the economic trends reverse through the year. Deal making opportunities are also likely to be aplenty if the business is in a growth oriented segment, or if the business is of a type that can be desirable to foreign companies. With the US Dollar being extremely weak, foreign entities are actively looking to make synergistic acquisitions. It is unclear how long the weak dollar will last but the prognosis is for the dollar to continue to be weak for the near term.

All things considered, early 2008 would be an excellent time for business owners to review their exit or recapitalization strategies and determine how to approach the business sale/capitalization process for optimum financial return.

Posted in Deal Structure, Finance, M&A, Marketing, Miscellaneous, Tax Related, Valuation | No Comments »

Buyers Approach To A Stock Sale

Thursday, January 17th, 2008

Steps that acquirers need to take in a stock sale

 

In most small to mid market situations, it is advantageous for acquirers to structure the business acquisition transaction as an Asset sale. However, in some cases there may be significant advantage to going the Stock sale route. Also, asset sales may not be practical in some cases for contractual or other reasons. In such cases, acquirers need to pay special attention to three key factors:

v  Indemnification Agreement: Acquirer should get a bulletproof indemnification from the seller for any potential liabilities that may have occurred before the transaction closes but only surface after you close the deal. A stock sale without a proper indemnification agreement exposes buyers to potentially damaging legal and financial risk.

v  Seller Carry: Acquirer should get a significant amount of financing from seller as part of the deal. It is best to have this spread out over a period of few years so that you will have leverage in the event a claim materializes. The seller carry can come in handy if there is a lawsuit and the seller balks at keeping his end of the bargain.

v  Corporate Structure: The structure of the corporation being acquired may have significant impact on the tax status of the acquirer. If the acquirer owns one or more corporations prior to the sale, some post acquisition structural alternatives could significantly enhance the acquisition benefits.  These alternatives need to be reviewed carefully before the close for maximum leverage.

It is essential for acquirers to incorporate these key factors in any stock sale.

Posted in Deal Structure, Finance, M&A, Tax Related, Valuation | No Comments »

Stock Sale Vs. Asset Sale

Thursday, January 17th, 2008

An Overview of Tradeoffs

 

There are two primary ways of structuring the sale of sale of mid-market companies: Stock Sale and Asset Sale. This document compared the trade offs involved with each of these approaches. Acquirers should keep in mind that regardless of the tradeoffs shown below, asset sales may not be practical in some cases for contractual or other reasons. In such cases, stock sale is the only way to go.

Stock Sale Vs. Asset Sale Table

 

 Asset Sale Stock Sale
Legal Risk No legal liability for the corporation prior to the purchase Legal liability for the corporation prior to the purchase can be mitigated if seller is willing to sign an indemnification agreement
Cash Flow Most of the assets purchased will be depreciable over 3-30 years with the average being approximately 10 years. This means that you may write off approximately a tenth of the purchase price every year. When you sell, you typically pay back the government for all the deductions you took.Advantage: Time value of money Low depreciable asset base means you do not get benefits of the excess depreciation you can take. On the upside, there is no depreciation recapture tax at the time of sale.
Governmental Administrative work to the extent you need to files Corporation, tax & employment application before the close of escrow. Corporation, tax & employment numbers & documentation in place – any changes can be done at a convenient time at your own pace.
Other Taxes Sales Tax on FF&E No Sales Tax
Employees Rehire employees – administrative hassle with hiring, benefits, payroll processing, etc. before the close of escrow Employee contracts continue. Any changes can me made at a convenient time and pace.
Workers Comp Workers comp rate could potentially be higher – sometimes significantly – you need to determine the impact and the net cost. Workers comp rates lower than yours? If so, you benefit from the lower cost and you may even be able to move some of your staff under this umbrella if it makes sense.
Customers May need to renew or renegotiate contracts Customer contracts likely to continue with minimum hassle
Vendors / Suppliers Re-establish contracts – negotiate transfer of leases and contracts – at the minimum you have administrative hassles and in some cases you may need to come up additional money for deposits. Vendor contracts continue. If any of the vendors offer superior services at better rates, you may move some of your existing business under the same umbrella.
Bulk Sale Need to conduct bulk sale in most cases – costs approximately $600 at current rates and takes about 20-25 days – this process delays the transaction. No need to do bulk sale – which means you close the transaction faster, cheaper and thus enjoying the benefits of the cash flow sooner. None of the creditors are aware of the transaction unless you choose to tell them.
Other Could consolidate book keeping, tax, and other regulatory filings with current entity to simplify operations. Need to continue the book keeping, tax, and other regulatory filings necessary to keep the entity in compliance.

 

Sellers and acquirers need to be aware that while several of these elements can be structured to the mutual benefit of both parties, some of the elements have less favorable impact to one of the parties and negations are necessary to structure a win-win deal.

Where it applies:

The intent behind establishing a type of sale (stock vs. asset) is to pick the most beneficial way to structure the transaction.

Posted in Deal Structure, Finance, M&A, Miscellaneous, Tax Related, Valuation | No Comments »

Structuring An Exit

Thursday, January 17th, 2008

An Overview of Tax Beneficial Strategies

 

There are several possible ways to structure a deal to suit the needs of a seller. This document summarizes some commonly used strategies and the associated trade offs:

Installment Sale

Installment sale is a simple strategy where a part of the sale price is deferred. The deferred amount is paid to the seller in several installments over a period of time.

Some variants:

v  Standard Installment Sale: Payments are spread evenly over a period of time.

v  Performance Based: Payment stream is tied to metrics agreed on by the buyers & sellers

v  Self Canceling Note: Payments are spread until the seller dies.

Benefits:

v  Smart way to structure a sale in special situations (ex: concentrated customer base)

v  Capital gains are deferred as payments are received

v  Self Canceling Notes pull the future interest of the asset outside of the estate

Downsides:

v  Risk of future payments

v  Capital gains rates may rise in future

Where it applies:

v  Seller has confidence in buyer to deliver on future payments

v  Buyer requires the structure due to economic uncertainties

v  Seller has captured most of the value in the upfront payments and does not mind risking the incremental money stream

Structured Sale

Structured sale is similar to an installment sale except that the payment stream is guaranteed by a third party

Benefits:

v  Capital gains are deferred as payments are received

v  Secured payment stream

v  Payment stream can be structured in a very flexible way

Downsides:

v  Capital gains rates may rise in future

v  Time consuming and expensive for buyer to setup

Where it applies:

v  Seller may need to substantially increase take-home dollars to make the sale happen. This tax advantageous method requires a motivated buyer to setup this plan.

1031 Exchange

Allows for a seller to roll equity and debt into a new property and defer the capital gains tax until some future sale

Benefits:

v  Capital gains deferral

v  Can move tax deferred dollars from active management to passive management

Downsides:

v  Limited time: 45 day to identify replacement property and 180 days to close

v  May not be able to find a desirable property

v  Capital gains rates may rise in future

Where it applies:

Excellent technique to defer capital gains assuming availability of good investment options

1042 Exchange

Complex exit strategy where privately owned stock can be exchanged for publicly traded stock. If a highly appreciated asset is owned by a corporate entity, shares of that entity can be sold and exchanged for shares of a listed stock.

Benefits:

v  Defer Capital gains tax. Exchange can be made with dividend producing Blue-Chip stocks

Downsides:  

v  Capital gains rates may increase in the future

Where it applies:     

v  Might be applicable for business-owned assets that have appreciated in value

Charitable Trusts

v  This method is only applicable if the sellers have determined what they will leave to charity at death. It is possible to make a future gift to a charity in exchange for an income stream. This method allows for an income stream comparable to what is possible with direct sale of business. It is also possible to gift the income payments to charity and have the asset revert to the estate at death.

Benefits:

v  Charitable Organizations do not pay capital gains tax

v  Tax deduction that is some proportion of the value of the gifted property or asset

v  Asset is removed from the estate for purposes of estate tax

v  Asset and income stream are protected from judgments, liens and bankruptcy claims

Downsides:

v  The asset reverts to charity at death of the grantor(s)

Where it applies:     

v  When the seller has already decided on the amount of the estate that goes to a charity

Private Annuity Trust / Deferred Sales Trust

The capital gains benefits available with a Private Annuity Trust may be discontinued. In this method: Grantor(s) establish a trust, sells the asset to the trust and the trust sells the asset to the buyer. Trust makes installment-like payments to the grantor(s) over their lifetimes. Capital gains taxes are due as installment payments are made to grantor(s). At death of grantor(s), asset passes to beneficiaries.

Benefits:

v  Capital gains taxes are deferred and interest is earned on taxes not paid to government

v  Trust assets can be invested in almost anything. Grantor(s) have the ability to borrow money form the trust. Trust assets can be fully withdrawn as long as capital gains taxes are paid at time of withdrawal

v  Trust is held outside of the estate for purposes of estate tax and assets in trust are protected from judgments, liens and bankruptcy claims

Downsides:  

v  The trust needs to have a third party trustee

v  Capital gains may rise in future, but the trust can be liquated as needed

Where it applies:

The intent behind establishing a PAT should be to exchange an asset for a lifetime income, to defer capital gains taxes or to avoid estate taxes or any combination

Posted in Deal Structure, Finance, M&A, Tax Related, Valuation | 1 Comment »

Valuing Companies With Erratic Earnings

Thursday, January 17th, 2008

What is the right metric?

 

A significant number of businesses that come to market do not have consistent stream of earnings. Inconsistent earnings history makes it difficult for acquirers to predict future earnings and create a valuation challenge. Using an “industry earnings multiple”, the most common metric used to value mid-market companies can be meaningless in these situations.

Which earnings number does one pick? The highest? The lowest? Most recent? The average? Weighted average?

On the surface, using weighted average may seem like an appealing answer. However, using weighted average typically leads to overvaluing or undervaluing the company by a substantial margin to the detriment of either the acquirer or the seller.

Assuming a reasonable earnings number can be picked using weighted averages, is “industry earnings multiple” a valid multiplier to arrive at a valuation? In not, how does one value these companies?  

A keen appreciation of financial methods and industry knowledge are essential to answer these questions. The first step in the process is to gain a clear understanding of the reasons for the earnings variability. Some common reasons for earnings variability are:

v  Economic changes in the target market

v  Development phase of the company

v  Large non-recurring income/expenses

v  Loss/gain of large customers

v  Entry/exit of major competitors

v  Changes in management or key employees

v  Changes in physical environment and target market

v  Substantial changes in level or amount of operating equipment or people

v  Changes in COGs that are out of line with changes in final product/service prices

Acquirers may see some of these reasons as problems that reduce the future earnings. They may also see some other reasons as opportunities that increase the future earnings. It is imperative that both the reasons and the impact be well understood early in the valuation process. Once the reasons are identified and their impact assessed, appropriate adjustments can be made to recast the financials to get a more meaningful picture of the company’s revenue and earnings stream. Quite often, these recasted numbers indicate a stable or predictable earnings or revenue stream.

If the earnings stream is predictable, the acquirer can use industry price/earnings multiples to arrive at a reasonable valuation.

If the earnings stream is somewhat erratic but the revenue stream is predictable, the valuation may have to rely more heavily on industry price/sales multiples.

If neither the earnings nor the revenues are predictable after recasting, the valuation process becomes highly subjective. In such a situation, the transaction price should either show a substantial discount to a market multiple or be tied to future performance of the business.

Posted in Deal Structure, Finance, M&A, Miscellaneous, Valuation | No Comments »

Valuing Growth Companies

Thursday, January 17th, 2008

The folly of industry multiples

 

I routinely see individual buyers coming up with low valuations for growth businesses based on simple multiple of the most recent year’s profitability and, worse yet, based on a multiple using a weighed average of the profits from the preceding 3 years. I usually offer them this simple way of looking at the problem.

Let’s take the example of 3 different businesses with identical last 12 month revenues and earnings:

v  Business1 has a history of cash flow growth of 10% over many years and the target market is continuing to grow.v  Business2 has a history of a steady cash flow for a long time with relatively minor variation from year to year and the target market is a stable.v  Business3 has a history of steadily declining cash flow for the last several years and the market outlook appears to be unfavorable.

Using industry standard multiple of most recent year’s earnings, all these business are valued the same. Would you value these businesses at the same level? Of course, not!

How about using multiple based on weighed average of last 3 years profits? A quick check would show that this would lead to the conclusion that Business3 has the highest valuation and Business1 the lowest valuation! In most scenarios, this answer would be preposterous!!

So, why did industry multiples and weighed averages give wrong results for these companies? How can you value these companies? I will cover the answer to the former question in a different blog entry. For now, let’s focus on how you can better value these companies.

Setting aside the strategic or synergistic value of these companies, there are a couple of good answers to this question:

v  Use Gordon Growth model to arrive at a growth adjusted value of the earning stream. 

V= E / (R-G)

Where: V= Value of a company

E = Annual earning stream

R = Required rate of return

G = Projected long term growth rate of the Earning Stream

v  Develop a forecast of long term earnings stream and conduct scenario analysis based on discounted cash flow. This method is more sophisticated and requires spreadsheet skills but can be useful in establishing a range of values under different scenarios.

The valuation arrived by these methods gives acquirers a reasonable starting point in many small to mid-market business acquisitions. The acquirer should aware that the real value of these companies has more to do with the strategic or synergistic value of these companies and can be much higher than what these simple methods suggest. We will cover this topic in a different article.

Posted in Deal Structure, Finance, M&A, Valuation | No Comments »

Business Broker, M&A Advisor Or Investment Banker?

Thursday, January 17th, 2008

Picking The Right Intermediary For The Sale Of Your Business

 

You are ready to sell your business. You ask around and find that some businesses are sold by Business Brokers, some by Mid-market M&A Advisors, and some others by investment bankers. The difference in intermediaries can make difference of 20% to 40% or more in what you can take away in many situations. So, picking the right intermediary can have a major impact on your nest egg. Which one of these is right intermediary for selling your business? Who should you use?

The following table shows the applicability of these intermediaries based on various metrics.

  Business Broker Mid-market M&A Advisor Investment Banker
Size Of Business

Less than $2M

$1M – $100M

$50M and higher
Type of Business

Mostly Retail

Distributors, Manufacturers, Healthcare, Technology, Large retail, B2B companies

Public or large private companies
Typical Representation

Seller & Buyer (DUAL AGENT)

Either Buyer Or Seller

Either Buyer Or Seller
Typical # Of Employees

Less than 10

Tens or Hundreds

Any size
Typical Acquirers

Individuals

Corporations, PEGs

Public Companies or Large PEGs
Typical Sale Type

Asset

Asset or Stock

Stock or Mixed
Business Valuation

Street Multiple / Rules of Thumb

Strategic Value, DCF

Strategic Value, DCF
Transaction  Complexity

Simple

Complex

Very Complex
Size of contracts

A few pages

Tens of pages

Hundreds of pages
Typical Fee Structure

10-12%

Double Lehman / Negotiated

Negotiated
Upfront Fees

No

Maybe

Yes
Typical Multiples

2-3x DCF

3-7x EBITDA

P/E>10

The deciding factor in selecting the right intermediary is type of business you have. For small companies with revenues under $1 million and for large companies with revenues over $100 million, the choices are obvious.

If your business is a small retail or service business and there is no strategic value in the business, any competent business broker may be able to get the job done. However, since there is a substantial  negotiating component in deals this size, your interests are likely to better served if you choose an intermediary to represent you exclusively (i.e. not a dual agent).

An M&A Advisor is the right choice if your business is larger, complex or has a high component of product or service specialization. A competent M&A Advisor can unlock the value in your business, represent you exclusively, and get your business the higher value it deserves. This is extremely important if your business has untapped strategic value or has intellectual property subject to a broad interpretation of value in the marketplace.

Posted in Deal Structure, Finance, M&A, Marketing, Miscellaneous, Valuation | 2 Comments »

The Experience Factor

Thursday, January 17th, 2008

The folly of going with a single buyer

 

“When a man with experience meets a man with money, the man with experience walks away with some money and man with the money walks away with some experience” – Anonymous 

Recently an insurance company executive approached us about selling her company. She had an offer from a national insurance company, let’s call it “XYZ Company”, and wanted to see if we could bring in a buyer to pay more for her company. We have seen many instances where a buyer, typically someone in the same industry, makes an offer on a local company and ends up paying a substantially lower value for the company than what a proper business sale would enable. The best advice we could give her was to retain our company to represent her and conduct a confidential M&A Process to maximize her take home.

This buyer, a sharp lady, is a great insurance executive but, as is the case with most business owners, has no experience selling companies. The national insurance company on the other hand, has done many acquisitions in the past and has a seasoned team working on this transaction. Without representation from a competent M&A specialist, here is what this business owner will likely go through:

v  XYZ starts the process off with a basic, generic, non-binding LOI with an offer well below or at the low end of the business’s value

v  Seller may ask for more money and the XYZ Company may accede depending on their acquisition strategy and how tough its negotiators are.

v  Once the seller thinks she has got fair value for her company, XYZ embarks on an exhaustive due diligence process. XYZ company’s attorneys, accountants, acquisition experts start their inquisition into the seller’s company affairs.

v  The owner gets busy with collecting tons of paperwork, preparing many diligence reports, answering questions and starts losing focus on the business

v  XYZ starts finding several small and big things that are wrong with the company’s financials, sales pipeline, future projections, leases, etc.

v  XYZ puts out an updated LOI which is lower than the initial offer because of all the things that they uncovered in the due diligence process.

v  The terms in the updated LOI are complex, payments delayed, tied to future performance, and generally structured in a way that is not advantageous to the seller

v  By this point in time, the seller has spent countless hours of precious personal time and has also spent several tens of thousands of dollars in attorney fees reviewing the contracts and other legal documents.

v  The process also takes its toll on the business. With the seller’s eye off the ball, the business starts to suffer. Employees get nervous and productivity drops. In some cases, key employees or key customers may leave. XYZ Company’s continued due diligence finds signs of deteriorating business and asks for further accommodations from the seller.

v  If the seller realizes she has been had or if she becomes emotional about the process, she will pull the plug, cut her losses, and go back to rebuilding the company for a sale later. But more often than not, the seller is tired, anxious, stressed out, under time pressure to make the transaction, and eager to move on. Faced with the compelling arguments from XYZ Company’s experts, the seller decides to take the lowball deal and moves on.

The seller could avoid this with one simple step – Start M&A process with a competent set of advisors and let them work with multiple buyers. The M&A process will enable all potential buyers, including the one that started off the process, to compete for the business. The buyer who sees the most value in the business will likely win and provide the seller with the best value as well as favorable terms. A win-win deal for all parties involved.

At our firm, we have routinely done deals where the final take away was 20% to 40% higher than what the seller would have netted had he/she gone with the first offer.

Posted in M&A, Miscellaneous, Valuation | No Comments »