Business Value Can be Managed if the Business Owner Can Manage Themselves

Business Value Can be Managed if the Business Owner Can Manage Themselves

Business Value Can be Managed if the Business Owner Can Manage Themselves

If you read too many business magazines you might find yourself believing that creating a valuable business is more luck than skill. Business value can be managed and if you manage the value you will become more profitable.

Small business owners often confuse business earnings or profit with the actual value of a business. All profits are not created (or valued) equally. A fundamental method of measuring the value of a business is applying a multiple to earnings. Take two businesses that have the exact same earnings of $100,000. Will they have the exact same value to a business buyer? No.

Why not? There are many, many reasons. Here are some examples of why business buyers value earnings differently, we’ll use the $100,000 earnings for company A and B example.

 

  • What is the quality of the earning? Company A earnings have been growing for 5 consecutive years, company B earnings have been down for 5 consecutive years. Which is more valuable?

 

  • Company B financial statements are cleaner than company A and a buyer will pay more for a company with cleaner books because there is less risk. Uncertainty in the quality of the business financial records drives down value.

 

  •  Company A has 5 lawsuits against it, company B never had any lawsuits.

 

  • Company B has well documented processes and it’s easier to train employees, therefore B’s owner can take lots of time off. Company A, with no processes, couldn’t stay open a week without the owner at the business. Which business has lower risk and therefore higher value?

 

  •  I could give you a hundred more variables as to why one business’ $100,000 profit is worth more, or less, than another business’ $100,000 profit.

 

As you can see business value and corresponding multiples of earnings is based on a number of fundamental factors that a business owner can control and these factors effect how valuable the business is. There are many businesses that are very valuable to the current owner but of little value, or much lower value, to a buyer. There have been several good books written about building value in a small business including Built To Sell.

 

7 Business Evaluations and Appraisals to Determine Business Value

7 Business Evaluations and Appraisals to Determine Business Value

There are many circumstances where a formal Business Valuation is required. Business valuations are geographically influenced. A Business Valuation in Houston Texas might create a different value than a similar business in New York. Business Valuations are also known as Business Appraisals. As you might imagine, Business Appraisals are a complicated business. There are different kinds of appraisals for different circumstances. Here is a summary:

1) Business Appraisal “Calculation of Value”

This valuation is often used in Buying a Business or Selling a business. The premise is that the buyer has no formal ties to the business and the transaction is an arms-length transaction for the sale of 100% of the business.  This valuation is generally viewed as a purely financial opinion of market value and makes no assumptions about how a specific buyer might value the business.

2) Estate Plan Valuation

This is a valuation done for business owners who have the business inside their estate and required the appraisal for tax planning issues.

3) Buy/Sell Partner Appraisal

This is often used when one business partner is buying out another business partner.

4) ESOP Appraisal

This is used when the company is installing an ESOP (Employee Stock Ownership Plan) so that the employee-owner has a way to understand the value of their business ownership interests.

5) Divorce Valuation

Self-explanatory and similar in many ways to the Partner buyout valuation listed above.

6) Personal Goodwill Valuation

Sometimes used in a business transaction where an owner is personally involved and critical to the business. For instance, a world renown heart transplant surgeon likely has a lot of personal goodwill built up because people seek out that surgeon INDIVIDUALLY. If that surgeon left the business it’s likely many patients would not contact the business.

7) Minority Interest  Valuation

This is a valuation used to assess the value of an interest in a business where the minority ownership is not liquid. For instance, if I own shares of IBM I call my broker and have the shares sold at a published price in 5 minutes. However, if I own 10% of XYZ, INC that is not a publicly traded company with 90% owned by my boss Mary, then I would need to try to find someone to buy my 10%. In this case, since Mary owns 90% of the company and is my boss, my 10% is probably not worth 1/10 of 100% value of the company. This valuation helps determine what your 10% is really worth

Business Valuation as it relates to Business Sale Price Calculation and Working Capital

Business Valuation as it relates to Business Sale Price Calculation and Working Capital

Deciphering a Business Valuation may take an experienced analyst.

 

General Definition:

{Current assets – Current Liabilities = Net Working Capital}

 

In most cases, the valuation of a business does not include the net working capital of the business at the time of the valuation. Working capital is often excluded from valuations so that business values can be compared to other similar businesses without the need to adjust for working capital. If 2 businesses are identical except one has $1,000,000 in excess cash it won’t affect the valuation comparison because the excess cash is not in the valuation price for the businesses.

However, the working capital can affect the actual selling price of a particular business if the working capital is included in the sale.

 

Example:

Let’s say Business A is valued at $5,000,000 and business B is valued at $5,000,000, both without working capital. If business A has $700,000 in net working capital and business B has $1,500,000 in net working capital, and the buyer wants to buy the working capital with the business, then business A will sell for $5,700,000 and business B will sell for $6,500,000 even though both were valued at $5,000,000.

 

Many buyers want to buy a business with adequate or normal working capital. By doing this the buyer has a set amount of capital to raise that allows them to purchase the business. This capital to buy the businesses is likely long-term capital. By including working capital in the purchase, after the sale, the business can operate on the purchased working capital.

The larger the transaction the more likely that working capital will be included in the business sale. The working capital target number (i.e., the amount specified in the LOI to be included in the purchase price) is an important negotiated element of a deal. In the LOI it might be a dollar amount or often an agreed to formula (since the working capital moves virtually every day the business is open) to use to get to a working capital number at closing. Make sure all elements of the working capital calculation is defined and understood.

 

Common Working Capital Elements

(with notes on the tricky ones)

Assets

  • Cash and cash equivalents
  • Accounts receivables
  • Inventory
  • Deposits (Deposits business has at vendors or other i.e., tax deposits, lease deposits, etc)
  • Work-in-Progress (Does your accounting system account for this properly? WIP can also be a liability depending on billing practices.)

Liabilities

  • Accounts payable
  • Accrued payroll
  • Vacation owed employees
  • Gift certificates (Does your accounting system track?)
  • Warranties (Outstanding for products or services)
  • Prepaid service or maintenance agreements
  • Deposits from customers
Selling a Business: The C Corp to S Corp Dilemma?

Selling a Business: The C Corp to S Corp Dilemma?

Selling a business set up as a C corporation can have some very painful tax consequences.

The following is not legal or tax advice. Consult with your CPA and/or attorney before taking any action

Is your business a C Corporation?

If yes, PLEASE READ THIS!

Do you want to pay 50% or more in taxes when you sell your business?

I didn’t think so. If you want to avoid that potential calamity? Read on.

But first, let’s talk a minute about the characteristics of a C corp. A C corp is a legal entity in which a business is operated. An S Corp and LLC are also entities used frequently to operate a business.

The primary difference from a tax perspective is the C Corp profits are subject to “Double Taxation”. Meaning the corporate entity is taxed and then the shareholders are taxed when what’s left is taken out of the C corp by the shareholders.

S Corps and LLCs are often set-up as “pass through” entities meaning there is only taxation at the shareholder or member level (we’ll use shareholder and member interchangeably but there are some differences). There are circumstances where LLCs are taxed as C Corps. Check with your CPA when you establish your LLC to make certain it’s set-up correctly.

Double taxation can be painful

Many business owners have been advised by their accountants over the years to switch from a C corp to an S corp but the business owners have ignored this advise too often. Timing the conversion can have an effect on the impact felt by the C to S conversion. If it comes time to sell your C Corp almost all buyers prefer an asset sale as opposed to buying the stock of your C corp. Therein lies the value trap caused by the double taxation at the C corp level.

Why is important to advisors like us (Mergers & Acquisition advisors and business brokers) who sell businesses for business owners? Because the same “double taxation” on your profits could be a problem upon sale of the business. How would you feel if you spent decades building a business and then when you sell it you get the privilege of paying 50% or more in taxes on the selling price?

How Long does it take to get the S Corp tax treatment after you convert?

There is a look back period in the tax law that is designed so that you can’t just convert your C corp to an S corp at the time of sale and reap the lower tax windfall. The IRS is way too smart for that trick.

The tax code “look back” period has varied in recent years from 10 years to 5 years to 7 years to the current 5 years. Who knows what it might be in the future?

Here are the pitfalls and options:
1) If you don’t plan to sell your business for at least 5 years consider converting from C to S now

2) If you do plan to sell your business in the next 5 years, seriously consider converting from a C to S now

Yes, the advice is the same. Why? Because the look back window starts when you make the conversion and the sooner the clock starts, the sooner you are out from under the C Corp tax burden if/when you sell your business.

Selling a business is more about how much you end up with, not how much you sold it for

What are the steps to convert?

An important first step recommended by most CPAs is to get a Business Valuation done for the C Corp. This valuation captures and locks in the potential C Corp tax burden. Then the value gained above that valuation will not be subject to C Corp taxes in the future. That 10 year or 5 year or 7 year window or whatever other look back period the IRS decides to impose on you.

At the very least talk to your CPA now about converting from your C Corp to an S Corp, I promise, you’ll be glad you did. This tax burden has negatively impacted many business owners because they didn’t act before the issue arose.

In order to convert a C corporation to an S corporation, the business entity must meet the five conditions below.

  1. The business must have been created in the United States — both legally and effectively. A business entity that was not legally incorporated in the US is not eligible for electing S corporation status.

  2. A C corp seeking to elect S status cannot have more than 100 shareholders. If shares are spread – in part or in whole – across a network of immediate family members, they are considered to be one shareholder.

  3. Each and every shareholder absolutely must be one of the following: an estate, a business entity classified as an S corp, a resident alien, or a full-on United States citizen. Further, a handful of types of trusts can also be considered eligible.

  4. If a business can obtain consent in writing from each and every shareholder to flip-flop the status of a C corp to an S corp, the C corporation business entity can be considered eligible to elect the status of an S corporation.

  5. Lastly, the business entity in question can only have one type of stock up for grabs – this means an entity can’t have both preferred and common shares, for example.

Here’s how to elect S corp status:

First, the owner of a business must file Internal Revenue Code Form 2553 — titled the Election by Small Business Corporation. All shareholders and the chief executive officer or president — whoever signs the tax returns once they’re completed — must sign the aforementioned form.

Finally, simply deliver the completed form to an IRS office.

Remember, the preceding advice is no substitute for talking to your CPA or attorney about your particular situation and whether changing your type of business corporation is right for you. But in certain situations, converting your company’s tax status from a C corp to an S corp can save you a lot of money!

Selling a Business in the NEXT Energy Boom

Selling a Business in the NEXT Energy Boom

Those of us who work regularly in and around the oil & gas energy industry recognize the difficulties presented by the current depressed energy prices and its effect on energy services, production and exploration companies. We view the world through the process of Mergers & Acquisitions as we work with business owners to sell their companies. Many Texas businesses are heavily impacted by the swings in energy prices. We see machine shops, water disposal, inspections, welding, tank, vessels, trucking, temporary housing and many other energy related businesses that suffer the financial pain when energy prices and production declines. We also see these same companies reap the benefits of rising energy prices and production cycles. Unfortunately, too many business owners have short memories.

“When the energy business is good many business owners think it will last forever. It won’t.” ~ Dan Elliott

Like you, we have seen this play out before in different cycles and many energy companies (and related businesses) always seem to recover. Selling a business for the highest value is often driven by timing. Will you be ready when the market is?

If your goal is to sell your business in the next energy boom here are 3 things you can focus on now to make sure your business achieves its highest value in the next energy recovery cycle.

1. Get your financial reporting up to standards that will one day survive a buyer’s due diligence.

Excellent financial records increase the value of your business because it reduces the buyer’s perceived risk that poorly maintained financials mean more financial room for error. Make sure your accounting is done consistently from year to year and make sure your current tax structure (C, S, LLC, etc) is what will create the highest value transaction. Look at your financials as a buyer would or better yet give us a call and we can review your information and give you a report that identifies the areas for improvement.

Tip: To most buyers Reviewed financial statements are almost as good as audited financials and a lot less expensive. If you have audited great, but if you just have compiled statements find a good business accountant to do reviewed statements.

2. Work hard on Customer Concentration Issues

A buyer often perceives risks if 1 or 2 customers dominate the revenue of your business. Ideally your largest customer should be less than 20% of your annual revenue (unless you have long term contracts which assure buyer purchases). Shifting customer concentration is often a long process, start now.

Tip: Look at your commission plans for your sales people. Are you rewarding salespeople who diversify their customer base?

3. Review your insurance to be sure you are adequately covered for your business risks

An underinsured claim is a nightmare for a business owner and can interfere with the sale of the business for many, many years. Do you have enough coverage? Do you have the right coverage? The “right coverage” question is even more important than how much coverage. We had a client get hit with a $2 million claim that he thought he had insurance coverage for. He didn’t. The deal to sell his business that we had on the table for millions of dollars was delayed until he found out he wasn’t covered, then that deal disappeared altogether. Talk to more than one agent and certainly more than just your regular insurance agent who may think they know your business but really don’t. Many commercial insurance agents will be more than happy to give you a review.

Tip: Talk to an insurance agent who specializes in your industry. Your trade association knows who they are.

Far too many business owners don’t plan ahead for an opportunity that could arise without much notice. Selling a business for the highest value and best terms is never an accident. The value goes to the prepared.

Common Characteristics of Profitable Businesses

Common Characteristics of Profitable Businesses

As a Business Broker I’ve had the opportunity to meet with and analyze more than 2,000 businesses. I have come to discover that there are 6 basic characteristics that are almost always found in profitable businesses.

6 Characteristics of Profitable Businesses:

  1. The business owner has an firm grip on reality. They understand the good and the bad of their industry and their business.
  2. The business owner spends the money to get good advice. They have an accountant, attorney and financial adviser that is competent in the specific industry and size business.
  3. The business owner makes a good faith effort to have systems and procedures in place so that their product or service experience is repeatable. The vast majority of activity is done the same way each time.
  4. The business owner is always trying to find ways to do #3 better.
  5. The business owner doesn’t blame his employees and his customers for his results. It is shocking to me how often this is the case in bad businesses.
  6. The business owner owns the business for a reason other than it’s just a way to make a living. The owner might want to sell the business to fund their retirement or next venture or pass the business on to their kids or create enough profit to fund a charitable cause important to them or operate a business to allow them enough free time and money to pursue an important cause.
Businesses and business owners with the above characteristics are much more likely to be profitable, more valuable and easier to operate than businesses without these characteristics.
Are there other characteristics that are important to you as a customer? Can you identify businesses with these 6 characteristics?