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.  

Diversified Customer Base, and Operational Procedures, and Systems And Their Importance!

Diversified Customer Base:  Related to the customer base, if customers are too concentrated representing more than 10% of sales. Or, if the company has too few customers which are representing most of their sales.  

This is a particularly important value driver! 

Private Equity firms will often discuss the key value drivers of a company, such as Next Level Management (NLM), operational systems, and diversified customer base 

While there are nine major value drivers, Diversified Customer Base (DCB), is one of the most important for maximizing the potential return and value of a company.  

DCB, typically is where no single client accounts for more than 10% of the total sales. By doing this, it insulates the company from a loss of a major company. It also stabilizes the cash flow and makes it predictable for future planning.  

Any buyer would be concerned if the company they were considering purchasing had 45-55% of their sales in 2 or 3 clients. The purchasers would have a legitimate concern if any of the clients left as it would have a significant impact on the cash flow.  

There would also be a concern if the major clients had a loyalty to the key person or owner, and not the business itself. Since there would not be diversification in the customer sales percentage, a future purchaser would see this as a greater risk factor, and one to avoid.  

To increase the client base, the company may have to consider other markets, services, and products. Going back to having a NLM team, makes implementing a diversity program much easier, with the focus on creating a larger client base, and not one that is very concentrated on a few clients.  

Operating System 

Operating systems that improve and sustain cash flows are a key element in the future value of a company.  

It is extremely important that the business has established and standard business procedures which can keep profitability after the business is sold, and without the current owner.  

Having the ability as an owner, to show potential purchases, that there are procedures, and that they are procedures that work, is of tremendous importance.  

A company would benefit from creating and documenting systems and processes in all the aspects of the business. This ensure consistency of execution or delivery and creates sustainable competitive advantage.  

Documenting systems and processes are such a crucial factor in building company value as it creates the ability for the owner to leave their company on great terms and gives them the potential to receive the highest potential value for their company.  

Critical Step Needed To Create An Exit Strategy! Part 1 

Some business owners think that selling their business is a matter of getting an appraisal and putting the business on the market hoping for a good offer.

Many business owners that I have worked with initially assumed they knew the value of their business and what they could sell it for.

Through our education process they realized there is much more to selling their business, then just the establishing a value and then going to market.     One of those factors or variables is whether the business owner needs the business value for their future retirement, most do!

Helping the owner figure out what they need for retirement is critical in establishing what they need to sell their business for, and what action is needed to increase the future value of the business (Value Drivers).  In this article I will cover two of the seven steps that  are the most critical when planning a future exit from the business.

Whether the sale is one year or ten years from now, these are the steps needed to sell  a business.

  1. Must identify the Exit Objectives (why, when, and in some cases who) 
  2. Identify Personal and business financial resources; (this is part of the future financial security of the business owner and their family).  
  3. Maximize and Protect Business Value
  4. Ownership Transfer to Third Parties
  5. Ownership Transfers to Insiders
  6. Business Continuity
  7. Personal Wealth and Estate planning

In this post I will cover steps 1-3, and cover steps 4-7 in the June issue.  

In comprehensive Exit planning, (when you break the process down it looks like this):

Your Exit Objectives

  • Building and preserving business value
  • Selling your company to a third party
  • Transferring your ownership to insiders

Your Business and Personal Financial Resources

  • Business Continuity
  • Personal wealth and estate planning

Owner’s goals and aspirations are

  • Financial Need
  • Overall Goals
  • Value based goals
  • Defining the owner’s goals and aspirations shows the client’s wants and needs and identifies what is  important to the business owner. By spending time collecting this information from the business owner we establish a strong relationship, while differentiating you, and allowing you to be the quarterback of the plan.

Accurate information from the owner is critical to planning.      Calculating what the GAP of resources the owner needs to have in order to supply their future retirement income is critical.  It is here where the measurement of their resources helps to decide what they need to sell their business for, to help fund the gap.    Continue reading “Critical Step Needed To Create An Exit Strategy! Part 1 “

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

 

Life Insurance Proceeds In Business Valuations

If life insurance proceeds are considered as the funding vehicle, then the proceeds of the policy received following the death of a shareholder would not be considered a corporate asset for valuation purposes.(1)

It would be recognized that it was purchased for a specific purpose of funding the buy-sell agreement (BSA). IF it were considered a corporate asset, it would offset the company’s liability to fund the purchase of shares, added back as a non- recurring expense.

Treatment 1: (used as a funding vehicle, not a company asset)

Example: A company with a $10m value, has two shareholders, owning 50% of the company. The company holds a $6m life insurance policy on each owner (assuming no alternative minimum tax issues).

RESULTS: At Shareholder #1’s death, the company collects $6m of life insurance benefits. The surviving partner will receive $10m company value, and $1m of net tax-free proceeds, a total of $11m value. The deceased stockholder receives the $5m for the business.

Treatment 2: (A corporate asset)

Treating the life insurance as corporate assets for valuation purposes.

The proceeds are treated as a non-operating asset of the company. This asset along with other net assets, would be available to fund the purchase the of shares the of a deceased shareholder. Keep in mind that the expense of the deceased stockholder might be added back into income as a nonrecurring expense.  (2)

The treatment type can have a significant effect on the net position of a company or selling shareholder. There is also an affect in the ability of the company to purchase the shares of the deceased stockholder, and impact of the position of the remaining shareholders.

Company $10m, before $6m of life insurance. When you add the $6m into the value, the company value is $16m. The deceased shareholder entitled to $8m, the company pays $6m in life insurance proceeds and takes out $2m in promissory note.

RESULTS: The surviving owner, owns a company with 8 million and a note of $2 million.

Which treatment is fair? One owner ends us with $11m while the deceased owner, ends up with $5m. In treatment 2, the surviving owner has to carry a $2m debt to purchase the business. Two dramatic differences. A good reason, why the discussion should take place with your advisors.

More importantly, all parties should understand the ramifications of adding the life insurance proceeds in the valuation or using the life insurance as a specific vehicle to fund the BSA.

——————————

1. Mercer: buy and sell agreements for boomers

2. Non-reoccurring expenses: Non-reoccurring expenses can be somewhat more complex. These are expenses which is  specifically  designated on the company’s financial statements as an extra ordinary or one time expense.  The company does not expect to continue the expense overtime, at least not on a regular basis. Non-reoccurring expenses can be somewhat more complex. 

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!”

Designing a buy and sell agreement can be a challenge to not only the advisor but also the owners of companies! 

Factors to consider when selecting the type of Buy and Sell Agreement for your business.(I) 

Before you can design a buy and sell (BS) you need to consider the following:  

  1. Number of owners: the greater the number, the more likely the BS will be a stock-redemption. 
  2. Nature and size of the entity: As a rule, a larger company will call for a redemption BS, or hybrid do to the fact that ownership interests will probably be worth more.   
  3. Value of the entity: The higher the value, greater chance of a redemption BS. 
  4. Relative ownership interests: Because of larger interest in ownership, greater likely hood a redemption or hybrid because of the cost to purchase. 
  5. Ages of owners: If there is a wide disparity in age between owners, greater chance of using a stock redemption or hybrid BS agreement?  
  6. Financial conditions of the owners: The more questionable an owner’s finances are the more likely a redemption/hybrid. 
  7. Enforcement of buy-sell agreement:  If there is a question as to the likelihood of partners reneging on the BS, or unable to fulfill the purchase obligation, the more likely a redemption/hybrid. 
  8. Desires for new cost basis for the purchasing owner: Chances are a cross purchase arrangement would be used if surviving purchasing partner wanted a higher cost basis.  
  9. Health and insurability of the owners: When there are younger or unhealthy partners, the disparity in premiums will tend to adversely affect the other owners, consequently, redemption will be used.  
  10. Commitment of owners to business: Cross purchase or hybrid can be used so the more committed partner can purchase the non-interested partner directly.  
  11. Availability of assets inside of the entity for redeeming the interest: Since some businesses have minimum-asset performance-bonding, a cross purchase BS would be used. General Contractors would be an example.  
  12. State law with respect to entity redemptions: If lightly capitalized, use cross purchase.  
  13. Existence of restrictions under loan agreements on the use of the entity’s assets to redeem equity interests: Loan agreements may have restrictions on the use of assets as they are the collateral for the loans, usually would use cross purchase. 
  14. Family relationships within the business:  Maintaining equal ownership between family members can be a challenge, normally, a cross purchase agreement works the best, unless the business is capitalized to have different classes of stock. 
  15. Professional licensing or other qualification requirements: Licensing and professional designations with, (professional corporations) will have an impact on the type of redemption agreement.   
  16. Type of entity: If a family C corps, there would be concerns that a redemption would be treated like a dividend, if so, they would opt for a cross purchase, if that was an issue (attribution).  

 As you can see, depending on the situation and circumstances of the company, the type of Buy and Sell agreement is not a random decision. Planning and insight must be used.  This comes down to asking the right in-depth questions when discussing the designing of the buy and sell agreement.

(1) Paul Hoods great book:  Buy-Sell Agreements

If you would like to receive a free report on the 19 questions you need to ask yourself to have an efficient Buy and Sell Agreement, email me at:  tperrone@necgginc.com, request: 19 questions.  I will send this to you immediately,

A Great Benefit Every Business Owner Should Be Aware Of! 

Over the years in the small business arena, when retirement is mentioned, the discussion usually focuses on programs like 401k, Profit sharing, SEP’S, and Simple Plans.   

 They are all very good plans and every business should offer one of them to their employees for the purpose of having a benefit plan where employees can save for their retirements.   

 However, not every employer wants to take on the burden of funding retirement for their employees for many reasons.  The reasons range from a lack of cash flow, employee groups who would rather take the money home.   

 In situations where the employer feels they would like to use their company to create a benefit for themselves, and not the employees, they should look into an executive compensation plan called the CEEP (Corporate Executive Equity Plan).  The CEEP is a hybrid of a few types of benefit plans used for the higher paid group in companies and for the owners.   

 The term “non-qualified “, refers to a plan that normally is not used for the masses, but used for a selected group of people.  As an example:  Employer A can decide that they want to put a plan in for employee B, C but not employees D-Z.  In most cases the plan itself would not be tax-deductible as a “plan”, however, it can be tax deductible under certain conditions. 

How the CEEP works!  

Mr. Jones owner of the Big Dip Donut shop decides that he wants to allocate $25,000 a year into a retirement plan for himself and no other employees of the company.  For the most part, he can’t have a qualified retirement plan without offering it to the employees.  Even a “Simple Plan”, which is the easiest to implement would have drawbacks.    Continue reading “A Great Benefit Every Business Owner Should Be Aware Of! “