Tag: business value

Set the Standard of Value in Shareholder and Partnership Agreements

 

Set the standard of value in business agreementsDefining “value” can help you avoid negative consequences

Do the valuation provisions of your shareholder or partnership agreement specify a standard of value? If they do, is the standard of value “fair value,” “fair market value,” or something else? If the standard of value is not fair value or fair market value, does the agreement define the standard of value to be used in the event a valuation of the business is required?

The Internal Revenue Service defines fair market value as “The price at which property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”

Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.

Depending on the characteristics of the ownership interest being valued, minority and marketability discounts may be applied in valuing the ownership interest under the fair market value standard. The amounts of these discounts are fact sensitive, but discounts between 30% and 40% are not uncommon.

The impact of Brown v. Brown

The fair value standard was created in New Jersey in the case of Brown v. Brown 348 N.J. Super. 466, which is basically fair market value without discounts. The Court’s logic in this divorce case was that since the business was not being sold, the nontitled spouse should not suffer discounts in the distribution of marital property.

I have also been involved in a situation in which the agreement used the term “value” without definition. The parties in that dispute spent a significant amount of money on professional fees that resulted in an arbitrator deciding on a definition.

As you can see, the use of the single word “market” in the standard of value may have a huge impact on the valuation result. What does your agreement say, and is that what you intend?  Although discussing this issue and updating business agreements may be uncomfortable for some, it is far better than ignoring this issue, because doing so may very likely end up in litigation.

A Few Considerations Before Acquiring a Small Business

 

Whether you are buying a retail store, a franchise, or a service business, your due diligence and valuation process is not much different than that employed in purchasing a multi-million-dollar business.

The three main things you want to know when you’re considering purchasing a small business are:

  1. What is the amount and timing of money you expect the business to generate in the future?
  2. When you are ready to sell the business, how much will you be able to sell it for?
  3. What is the risk that items 1 and 2 will not occur as expected?

business valuationAs evident from these questions, the thing to focus on is the future. Although the seller will certainly focus on past performance, what happened twenty, ten, or five years ago is of little significance; you want to know what will happen in the future.

It is not uncommon for small business buyers and sellers to agree on a price based on an industry “rule of thumb” formula such as three times net income or 80% of gross revenue. Unfortunately, rules of thumb are nothing more than old wives’ tales.  Every business is unique and no business should be purchased based on a formula purported to be applicable to an entire industry.

Sometimes a buyer thinks that he or she is buying a business, but they are really buying a job. On the most basic level, the value of a business is based on the amount of money you can earn above and beyond the value of the services you provide to the business.  For example, if you earn $100,000 per year as an employee and you have the opportunity to purchase the business where you are employed, the purchase would make sense only if it gave you the opportunity to increase your earnings. Investing in a business is risky.  If you purchased the business and continued to earn the same $100,000, you would not receive any return for taking the risk, and would be better off investing your money elsewhere.

Get professional advice before buying a small business

Professional advisors understand the issues; know the questions to ask and procedures to employ to help you understand the business you are considering and what it is worth. The earlier in the process that you get professional advice, the better off you are.  Even if you just ask your CPA to look at the last few years’ tax returns of the business and offer comments and questions, you will save a lot of time and money, and get unbiased advice from an experienced professional.

For more about understanding how to value a business you’re considering purchasing, read “Why You Need a Business Valuation.

Structuring a Business Sale to Minimize Income Taxes

Many of the considerations in structuring a business sale are dependent upon the type of entity that operates the business.

For the purposes of this post, we will limit our discussion to sales of businesses operating in the corporate form, either as S or C corporations.

Tax Advice Puzzle Shows Taxation Irs HelpIn a business sale, the seller prefers to sell the stock representing the business ownership, but the buyer prefers to purchase the assets of the corporation. The seller wants a stock sale because it generates a capital gain, taxed at a 20% rate.  The buyer prefers to purchase the assets because the full purchase price is allocated to the assets purchased, creating tax deductions for depreciation and amortization.  In a stock purchase, the buyer steps into the seller’s shoes, receiving no tax benefit from the price paid until the business is sold.  This issue is usually resolved by compromise, sometimes involving a price adjustment.

C corporation vs. S corporation asset sales

There is a significant difference between an asset sale by a C corporation and an asset sale by an S corporation. Sale by a C corporation results in double tax because the selling corporation is taxed on the gain on the asset sale, and the shareholders are taxed on the distribution to them by the corporation.  Sale by an S corporation that has been an S corporation for at least five years preceding the sale is subject to only one level of tax.  Because S corporations are pass-through entities that do not pay federal income tax, the entire gain is passed through to the shareholders for inclusion on their personal income tax returns.

If your business operates as a C corporation and you are contemplating sale, you should consider making an S corporation election.  This will allow you to avoid a double tax, but only if the corporation has been an S corporation for at least five years prior to the sale.  If the five-year requirement is not met, the S election will be disregarded for purpose of the sale and the sale will generally be treated as having been made by a C corporation.

In certain circumstances, a sale transaction can be structured in which the seller is taxed at favorable capital gains rates and the buyer receives ordinary deductions for a large part of the purchase price. This would occur if seller had personal goodwill, such as customer or supplier relationships not owned by the corporation.  In this structure, the seller would recognize capital gain and the purchaser would deduct the price paid for the goodwill over fifteen years.

Learn more about selling a business

For more information on this, see my article which may be accessed using the following link: http://krscpas.com/wp-content/uploads/2016/02/Business-Sales-and-Personal-Goodwill-G-Shanker.pdf

This article is intended to present general concepts in structuring the sale of a business. If you are considering the sale of a business, you should contact a qualified CPA for specific advice.

Valuation Considerations in Selling a Business

 

The most important tool in helping evaluate cash flow and risk is good accounting records. If the business has five or more years of good accounting records, the buyer’s perception of risk is reduced, because the records will tell the story of the company’s cash flow, and make it easier to project future cash flow.

Price and Value balance conceptIt is unlikely that any single action will result in a significant increase in cash flow, but the here are some areas where improvement may be achieved:

Expense Reductions – Review your financial statements line by line. Can the company operate with less payroll?  Fewer vehicles?  Can you reduce your space and related rent expense?

Have employee contributions to health insurance costs kept up with rising premiums?  I once assisted with a business sale in which the owner’s mantra was “find an expense reduction or become one.”  Every dollar that is added to the bottom line may increase the value of the business.

Revenue Increases – Can the customer base be expanded?   How will the company’s market share be affected by a price increase?  What about a price decrease?  Can the company take on new product lines?

Accounts Receivable – Can customer payments be accelerated? Money that is not in accounts receivable will be in your bank account, available for the business to use.  For example, a business that has $10 million of annual sales will gain approximately $385,000 of cash by reducing its average collection period by 14 days.

Inventory – Are you carrying obsolete or slow moving inventory? If so, it should be sold at a discount to reduce inventory and raise cash.  This step is also necessary so that prospective buyers of the business will have an accurate picture of normal inventory levels.

Common risk factors

Although different businesses may have different risks factors, some risks are common to all businesses. In evaluation of risk, we identify factors that may cause cash flow to not be received in the amounts expected and when expected. Following are some risks common to many businesses:

Customer Concentration – Is the business dependent on sales to one or a few customers? What would happen if one or more of those customers were lost?

Supplier Concentration – Are business operations dependent upon one supplier? If that supplier ceased to exist, could it be replaced?

Key Employees – Do the key employees have employment agreements and/or non-compete agreements? If not, and they went to work for a competitor, would the business suffer?

Obsolescence – Are your products or the processes used to produce your products approaching obsolescence, or are you updating your products and processes to stay competitive?

To understand the value of the business and how to increase it, a business owner considering selling should have the business valued. This will help him understand the factors that drive the value of the business.  If this is done long before the contemplated sale, this will give the owner and management team more time to make the changes necessary to increase the value of the business.

For more about business valuation, read the posts, “Why You Need a Business Valuation,” and “Goodwill and Your Business.” Also visit the KRS Business Valuation and Litigation Support page.

Considerations in Buying a Business

 

I have helped many clients purchase businesses, and probably advised just as many to walk away from deals.  What makes a deal good and what are the important factors in evaluating the purchase of a business?  If you are considering purchasing a business, your goal should be to minimize the risk that you will overpay for the business.

businessman looking to successBuying a business is an investment decision, no different than buying stock in a publicly traded company. When investing in public company, you consider two factors; how much can you expect to receive in dividends and what do you expect the stock price to be when you sell.  Not all stocks pay dividends, but absolutely no sane person would purchase stock in a company if they expected the share price to go down during their period of ownership.

It is the same when you buy a business. The important factors are how much income will be available for distribution to you (the dividend) and how much will the business be worth when you are ready to sell (the share price).  The problem is, there is usually more uncertainty (risk) in a private business than in a public company.  As a purchaser, what can you do to understand and minimize the risk?

Consider the risk

Accounting records tell the story of a business, and speak for themselves. If the business does not have good accounting records that go back at least five years, that is risk.  The more explanations and stories that are needed to support the accounting records, the greater the risk.  I always tell clients that they should only pay for what the seller can prove.  As far as we are concerned, if income isn’t reflected on the books and reported on the tax returns, it does not exist.

Concentration risk is another important consideration. If the business is economically dependent upon a single customer or a few customers, a single product supplier, or a few key employees, the future of the business is risky.  What would the business look like if the important customer was no longer a customer, the single supplier could no longer supply product, or some key employees went to work for a competitor?  Could the business continue profitable operations if one or more of these events occurred?

More than a salary

If you buy a business and the only thing you get is a salary for working there, you are not buying a business, you are buying a job. Take the emotion out of your decision. You would be better off getting a job somewhere else and not putting your investment at risk. However, if you expect the business to grow, allowing you to receive more money in the future, and eventually sell the business for more than you paid, that is a different story and should be your goal.

I have touched on a few of the many things that must be considered in the purchase of a business. Before you buy any business, you should conduct thorough due diligence, which is usually performed by CPAs and attorneys experienced in business purchase and sale transactions.  This will help you understand the business, its risks, and provide the information that will allow you to estimate the value of the business.

If you’re buying a business and have questions about the risks involved, contact me at 201.655.7411 or [email protected]

How to Increase the Value of Your Business

 

increase the value of your business
Reducing costs can help you increase cash flow and, as a result, the value of your business.

The value of a business is based on two factors: the expected future cash flow of the business and the risk that future cash flow will occur when and in the amounts expected.

Cash flow and risk are the meat and potatoes of business valuation. The valuation report that is produced is just a detailed analysis of these factors. Continue reading “How to Increase the Value of Your Business”

Goodwill and Your Business

 

What is goodwill?  How is it measured?  Why is it important?  Goodwill is often misunderstood by owners of closely-held businesses.

An Intangible Asset

According to the American Institute of Certified Public Accountants’ Statement on Standards for Valuation Services, goodwill is “that intangible asset arising as a result of name, reputation, customer loyalty, location, products, and similar factors not separately identified.”

business goodwill
Goodwill includes intangible assets such as customer relationships, trade secrets, reputation and brand.

The Internal Revenue Service defines it as “The value of a trade or business attributable to the expectancy of continued customer patronage.  This expectancy may be due to the name or reputation of a trade or business or any other factor, and in the final analysis, goodwill is based upon earning capacity.  The presence of goodwill and its value, therefore, rests upon the excess of net earnings over and above a fair return on the net tangible assets.”

What does this mean in English?  Goodwill is the value of a business, over and above the value of its identifiable tangible assets.  It is the expectancy of future earnings.  As a simple example, assume a distribution business’s only asset is inventory with a value of $100, but someone is willing to purchase that business for $500. The $400 paid over and above the value of the inventory is payment for goodwill.

The Value of Goodwill

Why would someone pay more for a business than the value of the tangible assets?  Because they expect to use those assets to earn a profit.  In the distribution business or any business, goodwill may include customer relationships, supplier relationships, reputation, location, trade secrets, or any other factor that causes the business to earn income above and beyond a fair return on tangible assets.

How can you create or increase the value of goodwill in your business?

  1. By earning consistent (and hopefully increasing) net income, which is supported by good accounting records.
  2. By establishing consistent and well-documented procedures, which will hopefully support continued future profitability. After all, someone who buys a business is not doing so because of what happened last year, he or she is buying it with the expectation of what will happen next year.

Who Owns Goodwill?

If goodwill is based on customer relationships, is the goodwill owned by the business or the employees who maintain the relationships?  This is an area of controversy because it has significant tax ramifications in the sale of some businesses, but the courts have generally held that goodwill is owned by the employee unless he or she has executed a restrictive covenant or employment agreement with the company.  If no such agreement exists, and the employee is free to work for a competitor and bring the relationship there, then the company does not own the goodwill.  However, if you are considering selling your business and do not have restricted covenants or employment agreements, consider very carefully whether or not they are necessary.

For more information on this subject, please see my article, Business Sales and Personal Goodwill.

For help in valuing your business, give us a call at 201-655-7411, or email [email protected]