Posts made in December 2016

The IRS is watching owners who sell their businesses

Gary Miller

The Denver Post | BUSINESS

By GARY MILLER / GEM STRATEGY MANAGEMENT

Posted:  December 18, 2016 at 12:53 am

Home from a long cruise, Bob and Marge stopped by the post office to pick up their mail. One letter stood out — a notice from the IRS stating that it had disallowed a tax deduction of $547,400 from the couple’s 2015 personal tax return. In addition to owing back taxes on the disallowed amount, they also owed penalties and interest. An IRS audit that began eight months earlier examining the sale of their business had led to this devastating news.

How could this happen?

In the fall of 2015, Bob had sold his business for $23 million in a cash and stock sale to a publicly traded company. During the transaction process, Bob received a binding Letter of Intent (LOI) from the purchaser. After negotiating some of the fine points of the terms and conditions, Bob signed the LOI. Followed by the successful due diligence review, the sale closed.

Once Bob had signed the LOI, he and Marge began seriously thinking about what they were going to do with the money from the sale. Bob called his accountant and his family practice attorney, who had advised him for years, to discuss their options. Bob and Marge did not have a financial adviser as Bob had always managed their investment portfolio himself.

Bob’s attorney advised him to establish a Charitable Remainder Trust (CRT). Making a donation to the CRT could help reduce income taxes and estate taxes, avoid capital gains taxes on the donation and receive income from the trust for the next 20 years. They were thrilled and decided to donate 10 percent of the $23 million from the sale to their alma mater. Bob donated 230,000 shares of stock to the trust with a cost basis of $1 per share or $230,000. The publicly traded company’s shares were valued at $10 per share or $2.3 million. Therefore, Bob would reduce his taxable estate by $2.07 million ($2.3 million – $230,000 = $2.07 million). Also, Bob avoided paying the capital gains tax of 23.8 percent on the appreciation of the donated stock. Bob and Marge elected to receive 7 percent of the earnings from the $2.3 million trust generating about $161,000 of taxable income per year for the next 20 years – a win-win for all.

But the IRS disallowed most of the tax savings from the CRT, because Bob had not started his financial planning soon enough. He established the CRT after he had received the LOI from the purchaser instead of establishing his estate plan well in advance of the sale of his company. The IRS held that the CRT had violated the Anticipatory Assignment of Income Doctrine which was adjudicated in 1930 by the Supreme Court to limit tax evasion. By establishing the CRT after he had signed a binding LOI gave the appearance to the IRS that the CRT was nothing more than a scheme to evade taxes.

What should Bob and Marge have done to prevent the IRS problem?

First, Bob should have started his business exit planning including estate planning as early as possible before the sale of his company. Many wealth planning experts recommend that planning should begin from one to five years before the sale of the company

Second, had Bob hired a Registered Investment Adviser (RIA) early in the exit planning process, the adviser would have examined Bob and Marge’s entire financial picture, assessing Bob’s and Marge’s goals. That would have been the time to establish the CRT and a Donor Advised Fund (a charitable giving vehicle sponsored by a public charity that allows the donor to make a contribution to that charity and be eligible for an immediate tax deduction) to reduce income taxes and to achieve Bob’s and Marge’s goal of supporting their alma mater.

“Bob should have started his planning at least six months in advance of receiving the LOI.  Anything less could spell trouble with the IRS,” said Shelley Ford, a financial adviser with Morgan Stanley Wealth Management.

She continued, “Bob should have engaged key advisers including an exit-planning M&A consultant, a trust and estate planning attorney, a transaction attorney to guide the negotiations of the transaction and corporate and personal tax advisers to give expert advice on how and when to establish their estate plans in anticipation of Bob selling his company.”

Scott Fleming, regional president – Rocky Mountain region for BNY Mellon Wealth Management, agreed.“Wealth planning should begin as early as possible, with a team of experts to examine all of the available income and estate tax savings strategies, to avoid what happened to Bob and Marge,” Fleming said. “Had they started their planning early enough, they could have examined a number of income and estate planning strategies in order to meet their personal goals and at the same time avoid/defer income and estate taxes.”

Fleming continued, “Strategies often examined are a Grantor Retained Annuity Trust, a Grantor Retained Interest Trust, a Grantor Retained Unit Trust, an Intentionally Defective Grantor Trust, Irrevocable Life Insurance Trust, Charitable Lead Trust and potentially a Family Limited Partnership.”

Unfortunately, Bob made a number of mistakes that could have been avoided had he sought specific professional advice. And while his attorney and accountant tried to give good advice, they were not experts in estate planning and wealth preservation. Bob and Marge paid the price for not hiring experts.

Gary Miller is founder and CEO, GEM Strategy Management, Inc. an M&A management consulting firm specializing in middle market privately held companies. Gary’s team provides advisor services on M&A planning, exit planning, business transfers, preparting companies to raise capital, or owners to sell their companies, due diligence, valuations, and merger integrations.  You can reach Gary at 970.390.4441 or gmiller@gemstrategymanagement.com

60% of small companies that suffer a cyber attack are out of business within six months

Gary Miller

The Denver Post | BUSINESS

PUBLISHED: October 23, 2016 at 12:01 am | UPDATED: October 24, 2016 at 11:01 am

It seemed like just another ordinary day for a small online retailer in the Midwest. Little did they know that the simple click of an e-mail link was about to threaten the entire business. One of the company’s employees received an e-mail with a link to a seemingly benign catalog. One click and the company’s system was infected with Crytowall malware that affected accounting software, customer account files, including credit card numbers, social security numbers, customer names and addresses among other information.

The accounting software and customer files did not live on the employee’s computer; it lived on the company’s network drive, so the malware was able to encrypt 15,000 accounting and customer files. A ransom demand soon followed, demanding $50,000 in exchange for a decryption key.  The company’s backup systems had not been working for months, and with the virus proving impossible to remove without the loss of crucial company data, the company had no choice but to pay up.

But the decryption key didn’t work. Business came to a standstill. The owner could not afford to pay to rebuild the network systems. Six months later the company closed its doors, strangled by lack of sales and cash flows.

The U.S’ National Cyber Security Alliance found that 60 percent of small companies are unable to sustain their businesses over six months after a cyber-attack. According to the Ponemon Institute, the average price for small businesses to clean up after their businesses have been hacked stands at $690,000; and, for middle market companies, it’s over $1 million.

Recent events have proven that nobody is safe from the threat of cybercrime – not large corporations, small businesses, startups, government agencies or even presidential candidates.

Small and mid-sized businesses are hit by 62 percent of all cyber-attacks, about 4,000 per day, according to IBM. Cybercriminals target small businesses because they are an easy, soft target to penetrate. They steal information to rob bank accounts via wire transfers; steal customers’ personal identity information; file for fraudulent tax refunds; and, commit health insurance or Medicare fraud.

So what can you do besides pray and hope you’re not next?

Remember, most cyber breaches happen because an employee does something that they aren’t supposed to do. Basic training can stop a majority of low-level threats. But, coaching your employees on data protection is not enough. Business owners must establish data security protocols, policies, practices and procedure that every employee takes seriously.

Create a business continuity and incident response plan. This will be put into effect immediately once you know your systems have been compromised.

Keep security software current.  Having the latest security software, web browser and operating systems are the best defenses against viruses, malware and other online threats.

When in doubt, delete it. Links in e-mails, tweets, posts and online advertising are often how cybercriminals try to steal information. Even if you know the source, if something looks suspicious, delete it.

Protect all devices that connect to the Internet.  Along with computers, smartphones, tablets, and other web-enabled devices need to be protected from viruses and malware.

Plug and scan.  USBs and other external devices can be infected by viruses and malware.  Use your security software to scan them.

Consider cyber insurance.  While premiums continue to rise, the cost of the insurance will look small in comparison to the cost of experts and consultants to restore your systems — or the cost going out of business.

Expand beyond IT. Don’t delegate cyber-crime prevention solely to your IT department and tell them “get on with it.” Embed these practices across all areas of your business.

Encrypt your most sensitive files.  Encrypting data is a process of converting data into a form, where it becomes unintelligible to any person without access to a key/password to decrypt the data.  Encryption may be hardware or software based. Hardware encryption and decryption processes are executed by a dedicated processor on the hardware encrypted device. In software encryption, the resources of the device on which the software is installed are used to encrypt and decrypt the data.

Robert Fleming, founder and president of Blacksquare Technologies, a Denver manufacturer of the Enigma hardware encryption device, said hardware encryption is faster. “The cryptographic key is stored in a separate, inaccessible portion of memory storage or stored off site, thus making it more secure than software encryption. Even if a company is hacked, and the bad guys capture your files, they cannot open any files that are encrypted”.

Websites hacked. Corporate data leaked. Identities stolen. The threats are real and growing.  Small business owners have to assume they will be victims of cybercriminals since 75 percent of all organizations have experienced a data/cyber security breach in the past 12 months and 82 percent of all Social Security numbers have been hacked more than once. Cybercrime is now the world’s largest business running in the trillions of dollars.  So far the “bad guys” are winning.

So business owners need to do more than hope and pray that their businesses won’t be next.

Gary Miller is founder and CEO, GEM Strategy Management, Inc. an M&A management consulting firm specializing in middle market privately-held companies. Gary’s team provides advisor services on M&A planning, exit planning, business transfers, preparing companies to raise capital, or owners to sell their companies, due diligence, valuations, and merger integrations.  You can reach Gary at 970.390.4441 or gmiller@gemstrategymanagement.com

 

The hidden trap of convertible debt

Gary Miller

The Denver Post | BUSINESS

Published:  September 18, 2916 at 12:01 am | UPDATED:  September, 15, 2016 6:26 pm

Last month I received numerous comments and inquiries regarding my column discussing the pros and cons of convertible debt. One problem that I did not address is the hidden trap of the liquidation preferences. Many entrepreneurs seeking capital from angel investors, venture capitalists or other early investors overlook this hidden trap as it relates to their convertible debt.

To understand liquidation preferences, and the hidden trap, it’s important to understand a few terms:

  • Conversion cap: This is the maximum valuation of the company at which the note may be converted into shares by its owner, regardless of the actual valuation of the company. It is the “triggering” financing round that permits the note to convert.
  • Conversion discount: This enables the convertible note holder to pay a lower price per share when converting the note into shares based on the triggering financing round. Investors in the financing round that triggers the conversion of the convertible notes usually purchase preferred stock in the company.  Preferred stock typically permits the holder to convert the preferred stock to common stock at any time on certain terms, and certain contractual liquidation preferences.
  • Liquidation preferences: These are the contractual terms determining who gets paid what — and in what order of priority — in contractually defined “liquidity events”. There are two types of liquidation preferences:  Non-participating and participating.
  • Non-participating liquidation preference: This gives the preferred stock holder a liquidation preference over the common stock holder equal to the per share price the investor paid or some multiple of that per share price. The holder can choose to convert his preferred shares to common shares or not. If the holder does not convert to common shares, the holder is paid the amount of his note plus any interest (paid in kind) before any of the common stock holders can share in the proceeds of the liquidity event. If the holder of the preferred stock chooses to convert to common stock, then he/she is paid the amount they loaned to the company first, plus any interest, followed by sharing on a pro rata basis of ownership any gain realized from the liquidity event.
  • Participating liquidation preferences: These are the same as the non-participation liquidation preferences except, the holder of this preference, assuming the holder converts, is paid the amount loaned to the company first, plus interest, followed by his/her pro rata share of common stock ownership of the remaining profits before any other distributions are paid to the remaining common stock shareholders. Normally, the conversion ratio is one share of preferred stock to one share of common stock – a 1x conversion ratio. Although, depending on what has been negotiated between the parties, the conversion ratio could be higher.

Let’s assume that the founders of High-Tech Industries owned 3 million shares of common stock and Silicon Ventures invests $2 million to buy 2 million shares of preferred stock. The percentage ownership is 60 percent for the founders and 40 percent for Silicon Ventures (3 million common shares plus 2 million preferred shares = 5 million shares). Silicon Ventures has a non-participating liquidation preference at 1x of their investment amount or $2,000,000.

Suppose that High-Tech Industries was acquired for $10 million. The preferred stockholders convert their preferred stock to common stock to participate in the gain. If the preferred stockholders did not convert they would only be entitled to their liquidation preference, or $2 million. By converting to common stock with a 1x conversion ratio, the investors would receive their pro rata share of the $10 million along with all of the other common stock shareholders. Therefore, Silicon Tech Ventures will now hold 40 percent of the common stock and entitle them to 40 percent of the $10 million, or $4 million.

However, if Silicon Ventures had a participating liquidation preference, it would receive its $2 million original investment (the preference) plus the right to participate in the gain on a pro rata basis (40 percent ownership of common stock after conversion) in the remaining $8 million. Therefore, Silicon Ventures would receive their preference ($2 million) plus another $3.2 million (40 percent of $8 million) for a total of $5.2 million. The other common shareholder would receive 60 percent of the remaining $4.8 million ($8 million minus $3.2 million).  This example is a 1x participating liquidation preference and is the most common liquidation preference for preferred stock owners investing in startups.

And now the trap. Imagine that Silicon Ventures owned preferred stock with a 4x participating liquidation preference.

Since High-Tech Industries sold for $10 million, the preferred stock owners would receive four times their original investment (4x the preference) or $8 million plus sharing 40 percent of the remaining $2 million or $800,000, for a total of $8.8 million. The founders and other early round shareholders would split 60 percent of the remaining $1.2 million. As you can see, Silicon Ventures received an outsized bounty.

What should you do about it?

Fortunately, this problem is easy to fix before finalizing the convertible debt documents. Fixing this problem later can be painful; you’ll either have to go back to early seed-round investors and ask them to give up some of their rights (never popular), or you’ll end up with a messy capitalization table.  And for startups, your cap table mantra should be “cleanliness is next to godliness”.

Whether you’re a new entrepreneur or a seasoned one struggling to raise capital, it’s easy to let what seems like a minor detail slide. I see it all the time. So it pays to retain a knowledgeable attorney with expertise in creating convertible notes with liquidation preferences — before you start raising capital.

Gary Miller is founder and CEO, GEM Strategy Management, Inc. an M&A management consulting firm specializing in middle market privately-held companies. Gary’s team provides advisor services on M&A planning, exit planning, business transfers, preparing companies to raise capital, or owners to sell their companies, due diligence, valuations, and merger integrations.  You can reach Gary at 970.390.4441 or gmiller@gemstrategymanagement.com

 

 

Executive’s Desk: Valuing a business for sale is part art, part science

Gary Miller

Albuquerque Journal

Monday, September 12, 2016 at 12:02am

Many sellers of privately owned businesses overvalue their companies. This mistake is a major reason why businesses fail to sell. However, there are solid techniques and procedures that can be used to help both buyers and sellers calculate an appropriate value for any particular business. Above all, buyers and sellers should realize that valuation is art and science, which is one reason a seller’s valuation is often quite different from a buyer’s.

I recommend that my clients seek professional advice from an outside valuation firm or from M&A experts at an investment bank. The pros understand business-value drivers that are unique to sellers and buyers, the value of the business’ intellectual property, and how investment decisions are made by venture capital and private equity firms, and strategic and financial investors.

There are three generally accepted methods that should help sellers and buyers formulate a reasonable valuation. They are asset-based, income-based and market-based. Each can produce different valuations, so they should be used to triangulate a range, while still allowing for other factors that are unique to the business to boost or lower the final valuation.

Here’s how they differ:

Asset-based valuation methods estimate the value of a business as the sum total of the costs required to create another business of equal economic value. They are useful for calculating a business purchase price allocation, an important element of structuring a deal. The two central methods under the asset approach are the asset-accumulation technique and the excess-earnings technique.

The asset-accumulation technique is a framework for tabulating the market value of the business’s assets and liabilities. The difference is the business value. Note that this method differs from the typical cost-basis accounting on a balance sheet. Important off-balance-sheet assets include intellectual property, customer lists, customer contracts and licensing agreements. The liabilities side of the balance sheet accounts for such things as pending legal actions, judgments and the costs associated with regulatory compliance.

The excess-earnings technique is an established way to determine the value of business goodwill and total business value. It has been used by the U.S. Treasury Department since the 1920s. It is used for business purchase price allocation in legal disputes, IRS challenges and to prove that the business is worth more than its tangible asset base.

Income-based valuation methods determine the business value based on its income-producing capacity and risk. The two main techniques that are used are capitalization of earnings and discounted cash flow income streams to calculate business risk. If a business has consistent earnings year over year (an uncommon situation), then both techniques are equivalent. You can use the current year’s business earnings and an earnings growth rate as your business valuation inputs. The capitalization rate is then simply the difference between the discount rate and the business earnings growth rate.

However, if the business earnings vary materially over time (the more common situation), use the capitalization multiple of earnings technique by discounting its cash flow. Because you can model reasonably accurate earnings projections only so far into the future, make your business earnings projections only out three to five years. Assume that, at the end of this period, business earnings will continue growing at a constant rate. Discount your projected business earnings at this point. Capitalize the earnings beyond this point. This gives you the residual or terminal business value (that point in the future when the investors hope to cash out).

Market-based valuation methods help you estimate the business’ value by comparing recent selling prices of businesses similar to yours and comparing the multiples paid based on the earnings of the other similar businesses – usually earnings before interest, taxes, depreciation and amortization. Both types of methods compare the subject business to similar companies that sold recently. Valuation comparables from M&A transaction data for public companies are usually more reliable than comparable data from privately companies. However, in reality, no two businesses are exactly alike. Therefore, each business’s unique characteristics should be factored carefully into these comparable transaction analyses.

A final point to remember: The art of any successful valuation is bringing together the subtle components and important intangible variables – such as the quality of management, the quality of earnings, a highly skilled labor force and other variables – along with the application of various valuation methodologies.

Gary Miller is founder and CEO, GEM Strategy Management, Inc. an M&A management consulting firm specializing in middle market privately-held companies. Gary’s team provides advisor services on M&A planning, exit planning, business transfers, preparing companies to raise capital, or owners to sell their companies, due diligence, valuations, and merger integrations.  You can reach Gary at 970.390.4441 or gmiller@gemstrategymanagement.com

 

The pros and cons of convertible debt

Gary Miller

The Denver Post | BUSINESS

PUBLISHED: August 21, 2016 at 12:00 am | UPDATED: August 19, 2016 at 6:-3 am

In recent years, convertible debt has become a common financing vehicle used by entrepreneurs to fund early-stage companies, particularly tech startups. Convertible debt wasn’t always this popular, and there are more pros and cons (and complexities) to convertible debt than most entrepreneurs know. While this column is insufficient to discuss the many details and nuances of convertible debt, here’s a quick overview of the upsides and downsides of convertible debt, and what other alternatives might exist for your company..

Convertible debt is a hybrid: part debt and part equity.  It functions as debt until some point in the future when it may convert to equity with some predefined terms.

Convertible debt generally has the following principal terms:

  • Interest and payments: A relatively low-interest rate (generally 6 to 9 percent). Typically, interest accrues “in kind” (meaning that the interest grows the principal and is not paid in cash) until the maturity date or conversion into equity.
  • Term: Generally as short as six months or as long as two years maturity, but commonly in the 12-18 month range. For the entrepreneur, longer is better because financing always takes longer than you expect.
  • Conversion into equity: Generally it converts during future equity financing.  The event that “triggers” this conversion typically is called a “Qualified Equity Financing”, and is specified in the convertible note documents.
  • Discount and cap: Since the holders of the convertible debt took an early bet on your company, typically they receive two principal benefits in relation to the investor who negotiates a later equity financing with you — the discount and the cap. The discount is the rate at which convertible debt converts into equity at a lower price per share than the equity investors who are purchasing shares. The cap is a promise that you won’t use the investor’s money to grow the valuation so amazingly high that the discount doesn’t adequately compensate him or her for their high risk, early bet on your company. The cap is negotiated at the highest valuation at which the loan may be converted.

Convertible debt has its upsides. It is widely known to investors and accepted by them. It is easy and quick to negotiate — the only major terms are the interest rate, discount and cap. A convertible debt transaction is quicker and less complicated than stock offerings. It also has lower transaction costs. An experienced transaction/securities lawyer that works with startups or early stage companies on financing transactions has standard convertible debt documents, so there’s a good chance the transaction will cost you less than $5,000 in legal fees. Compare that with attorney’s fees for a typical venture capital preferred stock deal that could run $15,000-40,000 — or more.

And there are some cons. You can easily end up with many early investors since you’re often receiving relatively small checks from angel investors. If this is the case, it can be administratively messy when you bring in an equity investor who sets the conversion terms for all of those early folks.

If it doesn’t convert, the company must pay the money back at maturity, just like any other loan.  And the maturity date may be uncomfortably short.

One early stage tech company (for which I provided consulting services) that has had success with convertible notes is TekDry International. In the competitive Front Range startup market, TekDry founder and CEO Adam Cookson said investors seemed to prefer the convertible note “after they determined we had priced it fairly, and that we were the right team to be successful.” TekDry now is engaged in a major expansion with Staples throughout the country.

What about other possible funding options?

A SAFE. This acronym stands for “Simple Agreement for Future Equity.” The investor buys the right to buy stock in an equity round when it occurs. It can have a valuation cap, or not, just like a convertible note.  But the investor is buying something that’s more like a warrant, so there’s no need to decide on an interest rate or fix a term.

  • Venture capital financing. Unless you’re Elon Musk, it’s virtually impossible to interest VCs in a Series A round before you can demonstrate significant commercial traction.  Even with such traction, be aware that VCs fund only a small percentage of startups or early stage companies.
  • Revenue-based financing. This can be an easy and cost-effective way to grow your business that enables the founders to retain their control and equity position. The key is that you must have revenue to qualify for such financing since revenue-based lenders get repaid from a percentage your revenue stream — like a royalty.
  • Bank loan. Sadly, banks don’t like to lend to newer businesses that lack significant hard assets and profits.

Be aware of what you’re getting into when you plan out the funding path for your company. My advice to entrepreneurs is to always engage an experienced transaction/securities attorney and pay close attention to the terms and details.

Gary Miller is founder and CEO, GEM Strategy Management, Inc. an M&A management consulting firm specializing in middle market privately-held companies. Gary’s team provides advisory services on M&A planning, exit planning, business transfers, preparing companies to raise capital, or owners to sell their companies, due diligence, valuations, and merger integrations.  You can reach Gary at 970.390.4441 or gmiller@gemstrategymanagement.com

 

When to make the first offer in negotiations

Gary Miller

The Denver Post |

BUSINESS

Published:  July 17,2016 at 12:13 am | UPDATED: July 17, 2016 at 12:11 am

I often receive inquiries from owners who are negotiating to buy or sell a business who wonder if they should make the first offer or wait to receive an offer. Conventional negotiating wisdom says that it’s better to wait.

But you may be better off making the first offer yourself.

By sitting back and receiving the opening offer, the argument goes, you’ll gain valuable information about your opponent’s bargaining position and clues about acceptable terms. This advice makes intuitive sense, but it fails to account for the powerful effect that first offers often have on the way people think about the negotiation process. Substantial psychological research suggests that, more often than not, negotiators who make first offers come out ahead.

 The dramatic effect of anchors

Research into human judgment has shown that how we perceive the value of an offer is influenced by each relevant number that enters the negotiation process. Because they pull judgments toward themselves, these numerical values are known as anchors. In situations of ambiguity and uncertainty, first offers can have a strong “anchoring effect” and can exert a strong pull throughout the rest of the negotiations. Even when people know logically that a particular anchor should not influence their judgments, often they are incapable of avoiding its influence.  But why?

The answer lies in the fact that every material item under negotiation in a business transaction has both positive and negative qualities — qualities that suggest a higher price and qualities that suggest a lower price. High anchors selectively direct our attention toward an item’s positive attributes while low anchors direct our attention to its flaws. Hence, a high market price directs a buyer’s attention to the company’s positive attributes (such as its strong earnings and profit) while pushing negative attributes (such as a high employee turnover) to the recesses of their minds.

Anchoring research suggests that making the first offer often results in a bargaining advantage. Specifically, when a seller makes the first offer, the final transaction price tends to be higher than when the buyer makes the first offer.

When not to make the first offer

There is one situation in which making the first offer may not be to your advantage: when the other side has much more information than you do about the transaction to be negotiated. For example, recruiters and employers typically have more compensation-related information than job candidates do.  Likewise, buyers and sellers represented by investment bankers often are privy to more information than are unrepresented buyers and sellers.

This doesn’t mean that in all cases you should sit back and let the other side make the first offer. Rather, this is an opportunity to level the playing field by gathering more information about the business, the industry and your opponent’s alternatives. The well-prepared negotiator will feel confident about making the first offer, anchoring the negotiations in her favor.

 Don’t be afraid to be aggressive

How extreme should your first offer be? Many negotiators fear that an aggressive first offer will scare or annoy the other side. However, research shows that this fear typically is exaggerated. An aggressive first offer allows you to offer concessions and still reach an agreement may be better than your alternatives.

In contrast, an unaggressive first offer leaves you with two unappealing options: make small concessions or stand by your demands.  By making an aggressive first offer and giving your opponent the opportunity to negotiate some concessions, you may get a better overall outcome and increase the other side’s satisfaction.

Of course, it is important that your opening offer is not absurdly aggressive. An absurd offer can lead the person on the other side of the table  to believe that there is no reasonable possibility , and as such, the appropriate response is to walk away.

Focus on your target price

When constructing a first offer, generally there are two considerations on which you should focus: your alternatives to agreement and a specific target price, above or below which you will walk away rather than reach a deal, and your ideal outcome, including your target price and the agreements, terms and conditions that would fulfill your principal hopes and desires.

I have found that negotiators who focus properly on their target prices make more aggressive first offers and ultimately reach more profitable agreements than those who do not.

A caveat

Negotiators who focus too rigidly on their target prices or ideal outcomes sometimes curse if doing so results in rejecting profitable agreements. Remember that you want to reach an agreement that meets your objectives and that also satisfies the other side. A satisfied counterparty will be more likely to live up to the terms of the agreement and less likely to seek future concessions or revenge.

Gary Miller is founder and CEO, GEM Strategy Management, Inc. an M&A management consulting firm specializing in middle market privately-held companies. Gary’s team provides advisor services on M&A planning, exit planning, business transfers, preparing companies to raise capital, or owners to sell their companies, due diligence, valuations, and merger integrations.  You can reach Gary at 970.390.4441 or gmiller@gemstrategymanagement.com

 

 

 

Executive’s Desk: Acquisition can fuel growth, but be prepared

Gary Miller

Albuquerque Journal

By Gary Miller, Founder & CEO, GEM Strategy Management, Inc.

Posted:  Monday August 3, 2015 at 12:02am

Many companies are facing slow growth due to a tepid economic recovery, more federal and state regulations, the Affordable Care Act and a lack of confidence in the economy.

Faced with these conditions, small- and middle-market companies are developing acquisition programs as a part of their strategy to accelerate financial growth.

Banks want to lend and have money to invest; interest rates are low; and there is a tsunami of companies for sale. It’s a buyer’s market, and companies are charting a path to the next era of opportunity and wealth.

However, growing significantly in a flat environment requires a bold combination of careful planning, savvy thinking and well-executed tactics.

There are six basic steps to develop a robust but risk-averse acquisition program:

  1. Plan an acquisition program: Careful planning includes determining acquisition goals, selecting the acquisition strategy and rationale, determining acquisition criteria and matching them against available financial resources. A company must compare its acquisition program to natural/organic growth alternatives to determine if buying other companies is the most effective path to growth objectives. Select an outside management consulting firm with transaction experience to help guide this process.
  2. Search, find and approach acquisition candidate: Searching for a target comes from leads generated inside and outside the company. Internally, leads often come from boards of directors, employees, sales staffs, suppliers, databases and customers. Externally, they come from accountants, attorneys, investment bankers, management consultants and business intermediaries. Approaching the acquisition candidate might well set the atmosphere throughout the acquisition process. Developing detailed information about the candidate before the approach is made is crucial in developing a narrative that details how the target company fits into the buyer’s plans.

Rarely will you get a second chance to make a first good impression.

  1. Conduct robust due diligence: Due diligence is critical. It centers on helping the buyer recognize what the buyer is buying, understanding how it fits in an overall growth strategy and developing the post-acquisition plan.

Due diligence requires strategic analysis of the company’s market position, competitive position, customer satisfaction, unanticipated strategic issues, valuation, synergies, cultural fit, technology and scenario analysis.

Acquiring companies must analyze the target’s financial statements, accounting methods, quality of earnings, revenue recognition policies and taxes.

Also, it’s important to assess the target’s contracts, leases, real estate, patents and intellectual property, current or pending litigation, employee agreements, compensation and retention, and other legacy risks.

 

  1. Structure the proposal: The first step is to value the company. A third-party valuation company, investment banks and public accounting firms are the best sources. The valuation serves as the basis for the amount the buyer is prepared to pay.

Information gleaned from the process can be used to further refine a proposal. The proposal is intended only to provide a basis for negotiations and will probably undergo numerous changes.

When the offer is presented to the principals of the target company, expect one of three possible outcomes: acceptance without changes, which rarely happens; acceptance with changes; or outright rejection. Regardless, further negotiations will be needed to get to an agreement in principle.

  1. Prepare transaction documents and close: A number of formalities must be accomplished in order to close the purchase. Acquisition agreements are relatively standard and the emphasis should be on thoroughness, not complexity. About half of the agreement is expressed by “representations and warranties.” The “exhibits” to an acquisition agreement are almost as important to the contract as the representations and warranties.

At this point, attorneys for the buyer and the seller are negotiating and refining the final documents for closing.

  1. Integrate the acquired company: Integration plans are extremely important and are often the reason an acquisition fails to add value for the buyer.

Blending both companies’ cultures is the most important function of the Integration process. While integrating accounting systems, manufacturing, infrastructure, computer systems, strategic plans, sales territories, distribution systems, contacts and human resources systems are all important, nothing is as important as building a unified culture. Consultants are often used to help in this process.

Following these six steps can add significant value to the enterprise and more rapidly create shareholder wealth than staying with organic growth plans only. Research indicates that companies that complete more deals than companies that do not generate higher returns on investment and deliver stronger financial performance.

Gary Miller is founder and CEO, GEM Strategy Management, Inc. an M&A management consulting firm specializing in middle market privately-held companies. Gary’s team provides advisor services on M&A planning, exit planning, business transfers, preparing companies to raise capital, or owners to sell their companies, due diligence, valuations, and merger integrations.  You can reach Gary at 970.390.4441 or gmiller@gemstrategymanagement.com

 

How Does an ESOP Work?

Gary Miller

Axial 

FORUM

June 28, 2016

Many owners are now considering selling their businesses as they approach retirement age. When considering their exit strategies, they face difficult decisions for monetizing the enterprise value of their businesses. While a business owner wants to receive a desirable price for the business, he or she may not want to sell to a third party (e.g., a strategic buyer or a private equity firm). The owner may instead want to reward loyal employees who have made significant contributions to the business’s success. If the owner is willing to receive fair market value vs. strategic market value, an Employee Stock Ownership Plan (ESOP) may be a practical exit strategy. Fair market value, which is based on the historical performance of a company, is typically less than strategic market value, which also takes into account future synergies.

Recently, SDR Ventures advised a client in a sale transaction in which the owner chose to execute an ESOP transaction versus other exit options available to him. Of utmost concern to this owner was rewarding his employees and keeping his legacy in-house.

How does an ESOP work? Below is a brief synopsis of this type of exit plan.

What Is an ESOP?

It is a type of qualified retirement plan similar to a profit-sharing plan, but with one main difference. An ESOP is required by statute to invest primarily in shares of stock of the ESOP sponsor (i.e., the corporation selling the stock). Unlike other qualified retirement plans, ESOPs are specifically permitted to finance the purchase of employer stock by borrowing from the corporation, other lending sources, or from the shareholders selling their stock.

When Congress authorized ESOPs in 1957 and defined their rules in 1974, it had two primary goals:

1) Provide tax incentives for owners of privately held companies to sell their companies; and

2) Provide ownership opportunities and retirement assets for working-class Americans.

How Does an ESOP Work?

In a typical leveraged ESOP transaction, a corporation’s board of directors adopts an ESOP plan and trust and appoints an independent ESOP trustee. After obtaining an independent appraisal of the value of the corporation’s equity, the ESOP trustee negotiates the purchase of all or a portion of the corporation’s issued and outstanding stock from one or more selling shareholders. Often, the corporation sponsoring the ESOP will borrow a portion of the purchase price from an outside lender (the “outside loan”) and immediately loan the proceeds of the outside loan to the ESOP (the “inside Loan”) so that the ESOP can purchase the shares.

The two-phase loan process is used because lenders generally are unwilling to comply with restrictive ERISA loan requirements. If only a portion of the purchase price is funded with senior financing, the remaining portion of the purchase price generally will be funded through the issuance of subordinated promissory notes to the selling shareholders, whereby the sellers receive a rate of interest appropriate for subordinated debt.

To provide the ESOP the funds necessary to repay the “inside loan,” the corporation is required to make tax-deductible contributions to the ESOP each year, similar to contributions to a profit-sharing plan. Upon receipt of these annual contributions, the ESOP trustee uses the funds to make payments to the corporation on the “inside loan.” In addition to these contributions made to the ESOP by the corporation, the corporation can declare and issue tax-deductible dividends (C-corporation) or earnings distributions (S-corporation) on shares of the corporation’s stock held by the ESOP which, in addition to employer contribution, can be used by the ESOP trustee to pay down the “inside loan”. Shares purchased by the ESOP from selling shareholders (or the corporation) are held in a “suspense account” within the ESOP trust. As the ESOP trustee makes its annual principal and interest payment on the “inside loan,” shares of the corporation’s stock acquired by the ESOP from the selling shareholders (or corporation) are released from the suspense account and allocated to the separate ESOP accounts of employees participating in the ESOP.

Gary Miller is founder and CEO, GEM Strategy Management, Inc. an M&A management consulting firm specializing in middle market privately-held companies. Gary’s team provides advisor services on M&A planning, exit planning, business transfers, preparing companies to raise capital, or owners to sell their companies, due diligence, valuations, and merger integrations.  You can reach Gary at 970.390.4441 or gmiller@gemstrategymanagement.com

 

 

Three accepted methods for taking the guesswork out of business valuations

Gary Miller

The Denver Post | BUSINESS

Posted: June 19, 2016 | 2 days ago

Many sellers of privately owned businesses overvalue their companies. This mistake is a major reason why businesses fail to sell. However, there are solid techniques and procedures that can be used to help both buyers and sellers calculate an appropriate value for any particular business. Above all, buyers and sellers should realize that valuation is art and science, which is one reason a seller’s valuation is often quite different from a buyer’s.

I recommend that my clients seek professional advice from an outside valuation firm or from M&A experts at an investment bank. The pros understand business-value drivers that are unique to sellers and buyers, the value of the business’ intellectual property and how investment decisions are made by venture capital and private equity firms, and strategic and financial investors.

There are three generally accepted methods that should help sellers and buyers formulate a reasonable valuation. They are asset-based, income-based and market-based. Each can produce different valuations, so they should be used to triangulate a range while still allowing for other factors that are unique to the business to boost or lower the final valuation.

Here’s how they differ:

Asset-based valuation methods estimate the value of a business as the sum total of the costs required to create another business of equal economic value. They are useful for calculating a business purchase price allocation, an important element of structuring a deal. The two central methods under the asset approach are asset-accumulation technique and excess-earnings technique.

The asset-accumulation technique is a framework for tabulating the market value of the business’s assets and liabilities. The difference is the business value. Note that this method differs from the typical cost-basis accounting on a balance sheet. Important off-balance-sheet assets include intellectual property, customer lists, customer contracts and licensing agreements. The liabilities side of the balance sheet accounts for such things as pending legal actions, judgments and the costs associated with regulatory compliance.

The excess-earnings technique is an established way to determine the value of business goodwill and total business value. It has been used by the U.S. Treasury Department since the 1920s. It is used for business purchase price allocation in legal disputes, IRS challenges and to prove that the business is worth more than its tangible asset base.

Income-based valuation methods determine the business value based on its income producing capacity and risk. The two main techniques that are used are capitalization of earnings and discounted cash flow income streams to calculate business risk. If a business has consistent earnings year over year (an uncommon situation), then both techniques are equivalent. You can use the current year’s business earnings and an earnings growth rate as your business valuation inputs. The capitalization rate is then simply the difference between the discount rate and the business earnings growth rate.

However, if the business earnings vary materially over time (the more common situation), use the capitalization multiple of earnings technique by discounting its cash flow. Because you can model reasonably accurate earnings projections only so far into the future, make your business earnings projections only out three to five years. Assume that at the end of this period, business earnings will continue growing at a constant rate. Discount your projected business earnings at this point. Capitalize the earnings beyond this point. This gives you the residual or terminal business value (that point in the future when the investors hope to cash out).

Market-based valuation methods help you estimate the business’ value by comparing recent selling prices of similar businesses to yours and comparing the multiples paid based on the earnings of the other similar businesses — usually earnings before interest, taxes, depreciation and amortization. Both types of methods compare the subject business to similar companies that sold recently. Valuation comparables from M&A transaction data for public companies are usually more reliable than comparable data from privately companies. However, in reality no two businesses are exactly alike. Therefore, each business’s unique characteristics should be factored carefully into these comparable transaction analyses.

A final point to remember: The art of any successful valuation is bringing together the subtle components and important intangible variables — such as the quality of management, the quality of earnings, a highly skilled labor force and other variables — along with the application of various valuation methodologies.

Gary Miller is founder and CEO, GEM Strategy Management, Inc. an M&A management consulting firm specializing in middle market privately-held companies. Gary’s team provides advisor services on M&A planning, exit planning, business transfers, preparing companies to raise capital, or owners to sell their companies, due diligence, valuations, and merger integrations.  You can reach Gary at 970.390.4441 or gmiller@gemstrategymanagement.com

“alternative” investments require extra diligence, caution

Gary Miller

Albuquerque Journal

Monday, June 6, 2016 at 12:02am

It is no secret the U.S. economy is performing poorly. First-quarter 2016 gross domestic product, the broadest measure of economic output, advanced at a dismal 0.5 percent seasonally adjusted annual rate, according to the Commerce Department. It is the worst performance in two years. Both top and bottom lines for major U.S. corporations are being pressured, according to the Wall Street Journal. Apple Inc., Norfolk Southern Corp, 3M Co., Pepsi Co., and Procter & Gamble Co. all took hits.

With interest rates currently near zero, CDs, bonds and banks aren’t providing attractive yields. This is problematic for individual investors. Therefore, many investors are increasingly looking at “alternative” investments in search of higher returns or yields.

I believe that diligent homework and extreme caution are required. Truly, “the devil is in the details.” Anyone considering “alternative” investments should obtain the advice of trusted accountant, investment, legal and other professional advisers before making any investment decision.

What are “alternative” investments? Opinions vary to an exact definition but, to me, they are potential uses of funds other than for “traditional” investments, such as publicly traded stocks, bonds, ETFs and mutual funds.

“Alternative” investments include, among others, private real estate funds, non traded REITs, oil and gas programs, startup companies, private equity and venture capital funds. They are extremely complex. Some of these “alternative” investments are legally available only to “accredited investors” defined by the U.S. securities laws.

A “private placement” is one type of an “alternative” investment. Under federal and state securities laws, “private placements” can fall within an exemption from SEC and/or state securities registration as a sale of securities “by an issuer not involving any public offering.”

“Alternative” investments require detailed scrutiny. Three overarching considerations are: 1) Each “alternative” investment must be evaluated individually; 2) The documents, disclosures and agreements for each must be received, read carefully and completely, and understood fully before moving forward (this will be time consuming; don’t rely only on presentations and representations provided by management); and 3) If you are asked to invest or commit any money without being provided with proper and complete legal documentation, walk away. Investing your hard-earned money is not a “handshake” deal!

The documents and agreements for a typical private placement generally include: 1) A “private placement memorandum” or “offering document” that contains important details and disclosures about the company, its business, its prospects, the applicable risks (internal and external to the company), use of funds, and the costs and expenses of the transaction; 2) A “subscription agreement” that contains the terms and conditions of the securities sale and purchase; and 3) information regarding the accredited or non accredited status of the investor.

The “securities” being sold can bear many names, including stock, shares, membership interests, limited partnership interests, convertible debt, warrants and options.

Below are eight considerations you should incorporate when doing your “homework” – your own due diligence. Remember, as a passive investor, you will have little or no say in the management of the entity in which you invest.

First, examine the management team’s professional qualifications, experience and past track record of investment performance. Determine if management is putting its own funds in the transaction. Be wary if management has no skin in the game. Check to make sure that management has no criminal or other disciplinary history.

Second, examine the risk factors of the product/service. Is the product/service new to the marketplace or is it a modification of an existing product/service? Would the product/service involve new or significant change in sales practices?

Third, does the entity have enough funds to execute its strategy? If not, the venture could fail quickly. In some transactions, you may be contractually required to invest additional capital in the future if capital calls are made by management.

Fourth, examine the anticipated internal rate of return in the context of the entity’s investment strategy. Is it realistic or is it pie in the sky?

Fifth, understand the duration of the investment. Many investments do not have redemption or “put” rights and are illiquid. Your money could be tied up for years.

Sixth, examine all management fees, costs and other expenses paid to management and others. Review the “use of funds.” A company must describe how it will use the net proceeds raised from the offering and the approximate amount intended for each purpose. Beware of vague statements like “the proceeds will be used for general working capital purposes.”

Seventh, closely examine the securities being sold. Understand the rights, restrictions and class of securities being offered, and management’s ability to change the capitalization structure. Sometimes, the founder or existing shareholders retain(s) full voting control of an entity.

Finally, if you can afford to invest, determine if you can afford to lose all of your investment should the investment crater.

A quote attributed to Will Rogers applies: “Be not so much concerned with the return on capital as with the return of capital.”

Gary Miller is founder and CEO, GEM Strategy Management, Inc. an M&A management consulting firm specializing in middle market privately-held companies. Gary’s team provides advisor services on M&A planning, exit planning, business transfers, preparing companies to raise capital, or owners to sell their companies, due diligence, valuations, and merger integrations.  You can reach Gary at 970.390.4441 or gmiller@gemstrategymanagement.com