Compensation of Business Owners! The Good And The Bad!

Owners of small private companies normally receive income as a salary, rather than dividends, and capital gain on the sale of their stock. They also receive other compensatory benefits. In many cases, the business owners can receive rental income from property and assets leased to the company and owned personally (either outright or in trust) by the business owner.  

Because of the tax structure of the company, business owners often find it more tax effective to pay the compensation, rent, royalties from their company to the owner, at the high end of the scale, rather than the low side (common in C Corps).  

A Detriment to The Owner When There Is an Exit 

Receiving this higher scaled income and rental, may have some advantages for tax purposes, and the creation of wealth.  

Having the tax advantages for the business owner, may be a detriment to the selling price during exit planning. This is because the rents and compensation paid to the owner on the higher side lowers the net income of the business.  

When rental and salary compensation are paid on the elevated level, they affect the net income/or net operating cash flow, which creates a downward impact on the selling price! 

At the Time of Exit Transition 

The owner must justify the payout of rental income, compensation, royalties, and other compensatory income. They need to justify the overpayment of this compensation. In a way, the owner must back track the justification of paying the enhanced payouts in the stated areas of compensation. This may put the owner in a position of receiving nondeductible “constructive dividends” paid by the company, resulting in a retroactive tax liability.  

Minority shareholders of the company could complain that the enhanced payments to the owner’s transgression of overpayments is a breach of a fiduciary duty owned to them. Since the over self-generous payouts to themself, there is an effect on the stock value. Consequently, minority stockholders are going to be affected by depressed value. This concerns stock bonus to minority stockholders and key persons.  

One of the solutions to this issue is to start to shift part of the enhanced payouts to more of a mid-level range of the fair market value. This will allow you to enhance the net income/net operating income for the company.  

Along with enhancing the net income and net operating income for the company the shifting of revenue to middle-management, will build a stronger management team.  

Your Key Group Has Great Value And Creates A Better ROI For Your Company’s Value!

Over the years I have written of the importance of the key group in your company is, and how they enhance your profitability and company value. Not only do they make you profitable while you are running your business, but this group is the key element to selling the business for the highest potential value in the future.  

 The inside key group creates the actions that help enhance value, such as implementing value drivers and making sure they are being applied correctly. Key management groups make sure the value drivers are implemented, working, and being enhanced constantly. 

The Key group learn about the business, in some cases better than the owner. They make business more valuable. They are so talented the competition is aware of their value, and in many cases would like to recruit them.  

It would be wise for the owners to recognize the value of the person or group (key person) and put in place strategies to keep them.  

  1. Incentive programs:  The purpose of this is to keep the key person around. To continue the growth of the person within the business. He may be the person who buys, or totally runs the company.  
  1. A vested incentive program:  This is to carry out #1, but also to protect the employer from the key person leaving.  
  1. Address the potential of your exit strategy in advance. This can be in the form of a discussion about a “stay bonus.”  The “stay bonus,” is used when an owner wishes to sell the company but would like the key person to stay on with the new owner. This enhances the value of the purchase price.  
  1. Keyman/group:  Potential purchasers of the company. It is also important to recognize that the owner may be thinking of becoming a passive owner, wishing to have the key group run the company while the owner peeks their head in occasionally.  

There are many ways to address the future knowing the key group is key to your exit strategy. This can range from incentive plans, to things like stock options.  

 Existing Key Employee  

Equity Based Incentive program:  

  • Stock Bonus 
  • Stock option 
  • Stock Purchase
  • ESOP

Cash based incentives 

  • Cash bonus 
  • Deferred compensation 
  • Phantom stock bonus 
  • Stock Appreciation Right 
  • Supplemental Employee Retirement Plan (SERP) 
  • Executive Coaching Program 

Awards based on 

  • Individual key employee performance 
  • Key employee group performance 
  • Company net income growth 
  • Company sales growth 
  • Vesting Formula 
  • Forfeiture Events 

      Agreements 

  • Non-compete 
  • Non-disclosure 
  • Non-solicitation 
  • Any other agreements that will protect the owner should the key person (group), leave 

Three Key Value Drivers  and Why Do They Matter? 

Value drivers are the elements of a business (systems and procedures), which create business value.   This post will cover  Next Level Management (NLM).  In part 2, I will cover  diversified client base  and  operational systems.  

Although there are nine transferrable value drivers, I am going to concentrate of three of them. Although all the value drivers are important, the three I will discuss are considered key drivers.  

The three value drivers are key in creating appeal to prospective purchasers of the business. They are important drivers, and at the very least, drivers’ businesses must have in order to grow.   

When a new business owner asks me when they should be thinking  about their future exit of their business, my answer always is, “the day theystarted their business is the time to start planning for an exit.”     

As you will see, the value drivers in most cases  need time to develop.  As we go through the three of them, you will see that they are strategies that can be implemented at once, but in many cases, need time to develop.    

Next Level Management (NLM):  Successful businesses with value, require business owners to delegate responsibilities to the management team.  NLM is particularly important because without a good management team, it would be hard to implement the other value drivers which are needed to create the maximum business potential value.i    

Finding and developing a  NLM  team is a challenge for many business owners. However, once the NLM is created, they usually become the team responsible to make the difference between where the business is now, and where the business would like to be.   The NLM is the key to  implementing the value drivers and the operation of them.   

Roadblocks for Business Owners in Developing Their Next Level Management

Many owners believe only they can keep and control the company’s success, since they built the business from infancy.   They  struggle  giving up even small types of control. The thought of not being involved in some of the daily business decisions, scares the daylights out of them, nor do they like the loss of control.    

Lack of installing the value drivers over time.   

 They spend their time working in the business as opposed to working on the business.   I call it their “Business DNA.”    Change is scary and thinking that someone else would be running the business is not consistent with their  fundamental  beliefs.  The possibility of someone else making decisions, which could build or ruin their business is too much for them to imagine.   

Fear of change.    Even if a business owner is not thinking in terms of an exit plan, they do like to think of creating business value. Once they are educated as to how value drivers affect the future value of their company, they become more open to  creating the value drivers, and making the changes.    

Misconception of owners:   Benefits derived to the business owners by installing value drivers is the result of the “full potential value of the business.”   The business grows as the business owner does less work, since the work has been handed off to the NLM.     However, owners have the common concern that installing value drivers will take too much of their time.  With proper planning, implementing the value drivers will create a more stable business, create better performance and scalability.   It is important that the owner understand the concept of developing the NLM team, so that team can create, implement, and manage  the value drivers, as opposed to the owner.     

It is possible for the owner to create the NLM where the owners have some control, and still can play a key role in the company.  Their leading role would be to delegate more responsibilities to the NLM, while focusing on other business responsibilities.    

 Many owners continue to do tasks they despise, just to keep a perceived control.  In many cases, the owner needs to take small steps in giving up control before they can start to feel more comfortable.  This is understandable since these are the things, they did to grow their business from day one of the business.     

The owner will see more growth in their company by implementing the value drivers, which will create more options for them when a future transition is a being considered.   

In my book, “Unlocking Your  Business  DNA,” I  discuss the problems business owners have working on their business as opposed to time spent working in it.  One of the factors missing is the value of creating value drivers for their business growth.   Once they realize value drivers create increasing company value, they get on board for future changes.  

 Through our discussions with business owners, we need to express to them that most future buyers will not want to buy the owner.   They want systems, management, and growth ability.       

Many owners think that they need to be involved with all the problems and issues of their company, thinking they have all the answers and the solutions.   Although this makes the owner feel in control and gives them  self-worth, it does absolutely nothing for the future value of the company, and in some cases may decrease the value.   

Success In Business Is Not Without Challenges!

DEFINITION OF BUSINESS GROWTH AND TRANSITION 

I often refer to my business planning as “Business Growth and Transition,” because I consider the business and the owner, as two separate and distinctive entities.  

For example, when the business is growing, the owner of the business needs to grow with the business and envision needed growth. As a business owner, he/she needs to continue to learn, ask more questions, depend on their instincts, experiment, be willing to fail, along with many other experiences to create the changes neededWithout the business owners’ creativity and involvement, the business will stop growing.  

Likewise, when planning for the business entity, we also plan for the owner personal needs. The business success creates personal challenges for the business owner, such as succession, estate taxes, family distribution, protection of the assets, and a host of financial and personal planning areas.  

STAGES OF A BUSINESS 

The business has two distinct stages it goes through which are critical; I define them as survival period and growth period 

Survival period is just what it means! Staying alive! This is where owner learns how to maneuver through the maze of “business savvy” strategies. “What doesn’t kill you, will make you stronger.” 

The survival period of business consists of: 

  • Excessive amount of time, sweat, and patience, luck, and much more.  
  • Bottom line:   Survive staying in business.  
  • Cash flow, Capital improvements, Inventory, client development create many challenges. 

The Growth Mode: 

 Not to simplify, but this is where the action is. It is up, up, and awayWhat needs to be done during this stage:  

  • Creates the opportunity for the future value of the business.  
  • To expand in all areas of the business. 
  • Inventing yourself and the company if needed, this includes building value drivers and transferable values. 
  • To become creative, reinventing of products, customers, process. 
  • To reinvent your markets and your clients. 
  • To build a customer base with loyalty, creating culture, and next level management. 
  • Much More… 

The expansion in Growth, (NOT ONLY) in markets and products, but also employees and the culture of the business. This is extremely important for the future of the business value, with the focus on growing your business value and to create transferrable value for the future. Owners need to start the process of giving up some of the control to middle management. This also means creating strategies which allow the owners to walk away and allow the business to run effectively and efficiently normally. This is my “Can you Take three months off” question, without an impact on your business profits?   

Disadvantages of Growth/ and letting Go 

You are giving up control to your management team! You are giving up things you controlled from the very infancy of the business. This is good because a future purchaser wants to buy your business as a running entity. They want a business that can run, and without YOU!  

When you start to delegate to others, things can happen. Your key people will learn how to run your business, and start thinking like an employer. They will develop greater relationships with your customers, advisors, and vendors. They will start to create profits for you, ease your time in the business, and allow you to enjoy more free time, however, there could be a price to pay!  

Tough Questions to Ask 

  1. What if your key people got to know your business so well, and they wanted to buy it from you, what would you do 
  1. What if you did not want to sell it to them at the time they want to buy? Will they walkWill they stay? Will the relationship change?  
  1. Will they go to a competitor 
  1. Will they take your customers and employees with them 

If this happened, what are you doing to protect yourself 

Consider this:  I recently had a client who went through this nightmare. The key people (2 key employees), left and started their own business. They also took other employees and customers with them.  

Unfortunately, the protection which we outlined to the owner three years prior was never implemented, and they are paying the price for it now.  

We told them to make sure they had programs in place to protect themselves from the business growth and success. 

Things Such As:   

  • Key person documents:  such as non-compete, non-disclosure and non-solicitation of customer and employee agreements.  
  • Benefits with Vesting:  We also suggested that they put in a vested benefit package for them and stagger the time where they would only have a partial vesting immediately  (we have found this to be a valuable motive to stay).  

Lesson to be learnedIf it happened to them, it could happen to you. Your key people will take over your business, which is good because as it creates transferrable value for the future. However, you must protect yourself from your business success.  

Planning Your Business For An Exit! 

Repeatedly, when the topic of exit planning is discussed in conversation with   my business clients, they tell me they are not ready to sell their business.   In which I reply, “the moment you started your business, your “exit planning” should have started.  I get the raised eyebrows.   

Let me explain why this happens; The generic term “exit planning” has taken on a meaning of, “when I want out of the business and when I am ready to sell.”    Advisors use the term as though it was a noun, such as a piece of property.     

To me “exit planning” means: “Actions taken by an owner to create the highest potential value for their company, so when the need arises in which they wish to sell,   or make a financial transition with the company they are prepared”.   

I liken my reasoning to owning a home, keeping it up to date, and fixing problems as they arise, knowing at some point someone may knock on the door and make a great offer to buy the home.  The great offer is the highest potential value for the home.    

If on the other hand the homeowner let the home deteriorate over time, under the same type of scenario the offer the owner would have received would have been much lower, if any.    

If an owner chose to use my definition of “exit planning,” they would start at once to implement the value drivers needed for a company to create the highest potential value for the future. Creating these transferrable value drivers take time, in many cases years to implement.    

There are 8 Value Drivers:  

  1. Financial Performance:  Your history of producing revenue and profit 
  2. Growth Potential: Your likelihood to grow your company in the future and at what rate.  
  3. Structure:  How dependent is your company on any one employee, customer, or supplier?  
  4. Valuation:  Can your company control cash flow?  
  5. Recurring Revenue:  The quality of automatic revenue you collect  
  6. Exclusive control: How are you differentiated from competitors in your industry?  
  7. Customer Satisfaction: The likelihood customers will re-purchase and refer your company.  
  8. Are you needed:  How would your company perform if you were not able to work for three months?   

As you can see there is a difference in the term “Exit Planning.”  Therefore, I suggest, to everyone who opens a new business that they should start their exit planning at once, so all the value drivers needed to increase their company to its highest potential value will have time to create the value.   

 

Single Appraiser vs. Multiple Appraiser Choices

This month I wrote about multiple and single Appraiser choice.  My friend Ed Pratesi was nice enough to give me some of his thoughts, which I definitely respect due to his experience and training.   Ed, thank you for this contribution.

Ed Pratesi wrote:

I read with interest your comments on Single Appraiser vs. Multiple Appraiser choices that owners have for a BSA. I agree in part with your assessment that the single appraiser choice is preferred but I do have a number of caveats and suggest that before the number of appraisers needed is secondary to choices made before this decision. Let me explain my thoughts:

Firstly, the choice of number of appraisers almost always works, whether one, two or the three step approach – except when it doesn’t!

Prior to the determination of the number of appraisers needed is preceded by what I refer to as the education process that a business appraiser must take the owners through in order to develop an agreement and a process that will likely be triggered when an unanticipated or unfortunate event has occurred.

In never ceases to amaze me that owners will spend money on creating a business plan, invest in physical assets and talent and not spend enough time on one of the most important events that will occur in their lives – either their exit or a partners exit. My complaint is not pointed at the owners but at the appraiser called in to initially called in to assist in the valuation.

My point simply is the an appraiser needs to explain the valuation process, the valuation methods used to value a business, the applicability or not of the methods to the company, a discussion of the definition of value – (for example fair market value or fair value, more on this in a later discussion), a complete discussion of adjustments that appraiser consider in the valuation process, and what discounts could apply and the reasons for application of discounts.

This part of the valuation process is more consultative and sets the framework for the conduct of an initial appraisal and of the work product. Finally, once the appraisal is complete a meeting to discuss the results and the process is essential and should be prefeaced with scenario planning should a provision of the BSA be triggered.

The goal is to get buy-in on the process not just the number!

I hope I have addressed part of the discussion of the number of appraisers – more to follow if desired…

Ed Pratesi

Edward E. Pratesi, ASA, CM&AA, ABV, CVA

Managing Director | UHY Advisors N.E., LLC
6 Executive Drive, Farmington, CT  06032
D: 860 519 5648 | C: 860 558 0453 | F: 860 519 1982

epratesi@uhy-us.com |  www.uhyvaluation.com

www.linkedin.com/in/ed-pratesi-140b762

 

Single appraiser Buy and Sell Agreement!

An alternative to the multiple appraiser agreement, is the single appraiser agreement (SAA).  There are two single appraisers’ processes. I

  1. Single appraiser, select now and value now
  2. Single appraiser, Select and Value at Trigger Event
  3. Single appraiser, Select Now and Value at trigger event

The preference is #1:

However, #2,3 are stopgap processes which can be used.  As mentioned in both of these types, the value is delayed to sometime in the future. 

Postponement of the appraiser selection and initial valuation create substantial uncertainties and potential for disagreements   or disputes.

The SINGLE APPRAISER, SELECT NOW AND VALUE NOW OPTION

In the BSA, the appraiser is named and is engaged to provide an initial appraisal for purposes of the agreement.

SELECT NOW: At the creation of the BSA, the appraiser is named. All parties have a voice and can exercise their choice as difficult as it may be.

VALUE NOW:  The chosen appraiser provides a baseline appraisal for the purpose of the agreement.  In this method, it is recommended that the value be presented in draft and give each party a time period for consideration before entering it in the final BSA. 

VALUE EACH YEAR (OR TWO) THEREAFTER:  This provides great advantages:[i]

  • Structure and process
  • Known to all parities
  • Selected appraiser is viewed as independent
  • Values are seen before triggering event
  • Since a draft will be provided to the participants, they can review for corrections to the mutual satisfaction
  • The appraiser’s conclusion in known up front and is the price until the next appraisal, or until a trigger event
  • Because the process is exercised at least once, it should go smoothly when employed at trigger events, less time consuming and less expensive than other alternatives

The single valuation process also helps the estate planning process with the annual reappraisals which will facilitate the estate planning objectives of the shareholders. For example, if the planning calls for minority discounts, the supplemental valuations at the not marketable minority level for gift and estate purposes.

[i] This type of valuation process will accommodate most small companies as for many reasons listed above. 

 

Multiple Appraiser Valuation Agreements 

There are two types of appraiser valuation agreement (AVA). Multiple appraisers and single appraises, while the multiple appraisers (MAVA), are the most common.

How they worked

Usually the BSA calls for a 30-60-day window for the seller and buyer to attempt to agree upon a price.  Once the appraisal process is initiated, each party will select an appraiser.

The two will provide opinions of value conforming to the BSA.  If their value is within 10% of each other, then the final value will be the average of the two. 

If the two appraisals are more than 10%, they will agree on a third appraiser.  That appraiser will:

  1. Provide an appraisal is anaverage in the same way the other appraisers (reconciler)
  2. Provide an opinion regardless of theother two conclusions.

When BSA are triggered, the corporation and seller separate and go separate ways as there is different motivations. The seller wants the highest price, the purchaser, the lowest price.   A good reason why each party should reach an agreement on terms before there is a triggering event, where neither party will be as open minded as they were before a triggering event.

Even with appraisers it is possible that each side will be overseen by multiple sets of attorneys looking out for the interest of the various sides to the transaction.

  Thought Processes behind multiple appraisers’ agreements:   

Multiple appraisers are intended to bring reason and resolution to the valuation process. This does not always happen, because the parties have 30-60 window to get the appraisers and the evaluations completed.  This is more than enough time to irritate each other and taint the process, causing in some cases, the appraisals to be compromised.

Since most multiple appraiser agreements (MAA) base the third appraisal to be an average of the former two if within 10%.

Continue reading “Multiple Appraiser Valuation Agreements “

The Interplay Between the Funding Mechanism And the Valuation? 

What happens when life insurance proceeds are part of the funding vehicle of a buy and sell agreement (BSA).    

 Example 

 When a stockholder owner dies and life insurance payments are made, is the valuation of the stock being redeemed as part of the value of the company?   

The way life insurance benefits are treated in the buy and sell agreement (BSA), could lead to different estate treatment and income tax.    In both areas, the results can be dramatic.     

 Does the agreement tell the appraisers how to treat the life insurance benefits in their valuationDoes the agreement provide for the company to issue a promissory note to a deceased shareholder, and what are the terms? 

 Keep in mind, the agreement is no better than the ability of the parties and/or the company to fund any required purchases at the agreed upon price.    An agreement that is silent on this issue is like not having an agreement.  

 Life insurance  

 Generally, life insurance premiums are not deductible, and the pass through of non-deductibility can create pass-through income for the shareholders of S corporations, and the owners of partnerships and limited liability companies.  Knowing how to treat the life insurance premium for tax purposes would be important information for you.  We suggest you discuss this with your CPA.  

 Although the life insurance premium is not deductible, the death benefits generally are tax- free, notwithstanding the alternate minimum tax treatment for C corps.  

Keep in mind the funding mechanism is not actually necessary to define the engagement for valuation purposes and has nothing to do with appraisal standards or qualifications. It provides the funding for the company to afford the value, and to make sure the selling stockholder receives the value.  In essence, it’s the mechanism to fund the liability of the contract, or at least part of it.   

Wants and Needs of the Buyer and the Seller- The normal push and pull!  

The seller wants the highest price and the buyer wants the lowest price.   Without a doubt the best time to set the price would be prior to a triggering event, when both parties are in parity and neither is the subject of the trigger.  It is the best time when both parties will be the most reasonable in setting the rules of the agreements as they are both fair minded in the negotiations.   

 Funding Methods 

  1. Life InsuranceIn most cases life insurance will be the most inexpensive method for funding the death benefit part of the agreement, when comparing, self funding, and loans (including corporate promissory notes) to fund the liability, notwithstanding the ability to get a funding loan from a loaning institution.    In most of the comparisons I have done over the years, life insurance is the least expensive, most guaranteed, and the easiest method of funding for death benefit purposes. 
  1. Corporate Assets: They would have to be accumulated for this purpose, and would likely be included in the valuation, and also would be subjected to taxes during the accumulation stageWhat if the death of the stockholder occurred early after the agreement?  Would there be funds available to fund the liability of the agreement, as there would be a lack of time to accumulate the necessary net profits for the funding?   
  1. External borrowing: Depending on the company’s financial position, it may be possible to fund the purchase price by borrowing.  However, this should be negotiated in advance and before its needed.  Remember, the time to requests funds from an institution is when you don’t need them.  Also, on the other side of this funding element, is the possibility the loan covenant requesting the outstanding note balanced to be called in when there is a dramatic change in ownership and management.    The lending institution may be questioning the ability of the company’s future financial position and the ability to stay profitable.   
  1. Promissory Notes:  If this is going to be used, the terms of the notes should be in the agreement.  Although cash payments are preferable to the seller.   
  1. Combination of cash and promissory notes: Important to note:  Anytime capital is being used by the corporation, it is important not to unreasonably impair the capital of the business. Many state laws prohibit transactions that could impair capital and raise the question of insolvency.  

Without the mention of what funding mechanism is being used in the agreement to repurchase shares, lessens the value of the agreement.  Also, with stated funding, the economic or present value of the redemption price set by the agreement can significantly be reduced, because of inadequate interest or excessive risk leveled on the selling shareholder.   

  

Weak terms in the agreement of the funding mechanism diminishes the value of the agreement from the sellers prospective. However, terms that are too strong can taint the future transactions. What is clear is that it is essential for the parties to discuss the funding mechanism for the triggers of a BSA, keeping in mind both the sellers value position and the purchaser’s ability to fund the costs. 

Succession Planning: 6 Key Questions You Must Answer!

THANKS TO CZEPIAGA DALY POPE & PERRI, LLC, author of this article. (written, March 22, 2019) 

*I came across this article last year and I thought I would pass it forward.  I thought it was written very well and had a great message to it.  Should you have any questions, give me a call.  Thank you Czepiga, Daly, Pope and Perri.  

Building and growing an independent family business is an accomplishment to be proud of. It takes an enormous amount of passion, ingenuity, and downright grit. Preserving and protecting your business also requires some effort, but it’s a task many business owners overlook or put off. 

Business succession planning, like any kind of estate planning, is something that should be addressed with the help of a professional well in advance of the actual event. Unfortunately, the majority of family business owners are missing that window of opportunity. According to a 2016 survey from Price Waterhouse Coopers, while 69% of family businesses surveyed expected the next generation to take over the business, only 23% had invested in creating a robust and well-documented business succession plan. 

It’s not difficult to understand how business owners find themselves without a succession plan. It’s a complex and time-consuming process that involves addressing hard realities and tough questions. But, it’s also a task that’s well worth the investment of time and money in the long run. 

If you own a family business and have not yet developed a thorough business succession plan, you may want to consider the following list of questions. These cover just some of the issues a good plan would address. It’s really never too early to start thinking about what’s next for your business, and these questions will put you on the right path. 

Who will take over when you’re gone? 

  • Whether you’re taking the precaution of planning in case of unexpected tragedy or simply doing due diligence in advance of a planned retirement, one of the biggest questions you need to answer is who will take the reins when you’re no longer in charge. 
  • If you were to become incapacitated or die unexpectedly, is there someone ready to step in to run the business? 
  • In such a situation, would your family or other business stakeholders have fast access to funds that would allow them to hire any necessary resources to keep the business going? 
  • Is your family protected against financial risk if you should pass unexpectedly? 
  • Do you have a detailed management succession plan that clearly defines who will take over which roles? 
  • If you face a temporary disability, do you have a business Power of Attorney in place to manage financial affairs related to the business? 

How much control would you like to retain?  Continue reading “Succession Planning: 6 Key Questions You Must Answer!”