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Gary Miller: Benchmarking: a tool for small-and medium- sized businesses

The Denver Post | BUSINESS

 BUSINESS

Gary Miller: Benchmarking: A management tool for small – and medium – sized businesses

Gary Miller, staff photo

By GARY MILLER | gmiller@gemstrategymanagement.com | GEM Strategy Management

PUBLISHED: November 25, 2018 at 6:00 am | UPDATED: November 26, 2018 at 3:18 pm

Gary Miller writes a monthly column for The Denver Post.

 

If you don’t know where you’re going you might not get there. – Yogi Berra

 

Now that the mid-term elections are behind us and businesses are closing out the year, it’s time before lunging into 2019 for business owners to take a serious look at how their companies stack up against the competition. One management tool that large businesses have used for years is called “Benchmarking.” However, in the last few years, small- and medium-sized businesses are engaging in this management tool, as well.

Benchmarking is a process for obtaining a measure –- a benchmark. It is a process designed to discover the best performance being achieved –- whether in a particular company, by a competitor or by an entirely different industry. This information can then be used to identify gaps in an organization’s processes, operations and financials in order to achieve a competitive advantage.

Some of the more useful financial benchmarks involve: (1) gross operating and net profit margins; (2) sales and profitability trends; (3) inventory, accounts receivable, and accounts payable turnover; (4) salary and compensation data; (5) revenue and cost per employee; (6) marketing expense as a percent of revenue; and (7) revenue to fixed assets ratio.

Suppose you learned from your benchmarking study that your gross profit margin is 3 percent lower than your competition. For every $1 million in annual revenue, that’s $30,000 a year that they’re making that you’re not. Is it because their prices are higher or their costs are lower? Does their sales mix include higher margin items that you don’t carry, but could? Do they have some sweetheart deal from their suppliers that you should know about? Do they spend that extra gross profit or does it fall to the bottom line? Finding answers to these questions, among others, could change your business strategies going forward.

Another example of benchmarking is considering the metric of “wait time.” It does not matter whether waiting for a car repair at a dealership or making a deposit in a bank lobby, customers do not like waiting in long lines. Similarly, whether waiting on a telephone help line of a cable company or a favorite online retailer, customers do not want to remain on hold. They want their concerns addressed quickly and efficiently.

The bottom line: Important information can be learned by going outside one’s own industry because many customer concerns are the same.

Benchmarking is a difficult, time-consuming process. Most business owners engage a consulting firm that subscribes to various business databases of diverse industries and asks them to evaluate the problems found, recommend solutions, and measure results. However, some small-business owners prefer to take the time and learn for themselves.

For best results:

  1. Use data from similar size companies and, where possible, within your own geographic area.
  2. Use a source that represents a large universe of inputs so that numbers are not skewed.
  3. Choose the industry group that best represents your business North American Industry Classification System.

Below are 10 of the best sources for free or low cost financial data covering a wide range of industries.

  1. Your Industry Association may be the best source for consolidated industry data and financial benchmarks.
  2. The Internal Revenue Service Corporate Sourcebook offers summary balance sheets and income statement numbers for all industries by size of company.
  3. Annual Reports of Public Companies in your industry as well as the 10K and 10Qs provide rich information and often compares their performance with their industry’s overall performance. Also, very important information is often buried in the foot notes, so read them carefully. Though these companies may be larger than yours, their numbers can offer significant insights.
  4. The Bureau of Labor Statistics Labor Productivity and Costs shows output per hour and unit labor costs by industry.
  5. The Bureau of Labor Statistics Labor Pay and Benefits provides information on wages, earning, and benefits by geography, occupation, and industry.
  6. Bureau of Labor Statistics Labor Producer Price Index offers production costs trend data by industry.
  7. Department of Labor reports hours, wages and earnings reports by industry.
  8. Census Bureau Economic Census provides annual and trend data on sales, payroll, and number of employees by industry, product, and geography.
  9. Census Business Expense Survey reports sales, inventories, operating expenses, and gross margin by industry.
  10. Census Annual Survey of Manufacturers covers employment, plant hours, payroll, fringe benefits, capital expenditures, cost of materials, inventories and energy consumption.

In addition, three other inexpensive sources of industry data that are useful for many business owners include:

  • Dun and Bradstreet offers individual company data on sales, employees, net worth, nature of financing, credit worthiness, balance sheet/income statement/ratio data, law suites, public filings, liens, and judgments.
  • The Risk Management Association offers benchmarking data on a business’s performance. This is one source that your bank probably uses to benchmark your business’s performance, so it’s well worth the cost.
  • Morningstar.com offers easy access to financial information about public companies. It also provides the same research information as financial professionals use.

 

No better evidence for the value of benchmarking exists than the Winter Olympic Games. When watching the games we repeatedly hear “the time to beat” as downhill skiers race for the finish line. That information drives skiers to shatter new records set just minutes before.

In business, benchmarking your performance against that of your competitors can propel you to greatness, too. It can help you establish internal goals, pinpoint market opportunities, exploit competitors’ weaknesses, and create the kind of esprit de corps to unify and motivate your team.

Gary Miller is CEO of GEM Strategy Management Inc., which advises business owners on how to sell their businesses or how to buy companies and raise capital. He can be reached at 970-390-4441 or gmiller@gemstrategymanagement.com.

 

Should you consider a “structured earnout” when selling your business?

The Denver Post | BUSINESS

 | gmiller@gemstrategymanagement.com | GEM Strategy Management

PUBLISHED:  | UPDATED: 

A structured earnout is a portion of the purchase price of a business that is paid overtime at a later date contingent upon the acquired business achieving certain agreed to performance targets. Basically, the buyer agrees to pay at closing a certain percentage of the agreed to purchase price with the commitment to pay additional amounts (the earnout) to the seller if the acquired business achieves certain future revenues and profits.

Photo provided by Mark T. Osler

Gary Miller writes a monthly column for The Denver Post.

Structured earnouts increase or decrease sharply depending on economic conditions. During the Great Recession, economic volatility made it more difficult to accurately project revenues and profits and tight borrowing conditions made it difficult to finance transactions. As a result, buyers and sellers increasingly relied on earnouts to consummate transactions.

However, today buyers have regained confidence in the economy. Competition for quality investment opportunities has increased, creating a seller’s market for quality companies.

Therefore, sellers of high-quality companies have become less willing to enter into earnout agreements. But, for those companies for sale whose financial performance is inconsistent, who have a concentrated customer base, or are operating in poor market environments, a structured earnout could be the best option for selling your company.

Introduction to earnouts

The purchase price of a business is determined by many factors including future cash flow, earnings, growth rates, among others –- topics that are major subjects of disagreements between sellers and buyers. These disagreements often reach an impasse during negotiations because of a gap in their expectations about the future performance of the business.

The seller expects the price to reflect his/her projections on the potential future revenues and earnings. The buyer is reluctant to agree when the projections do not seem realistic. An earnout can help the parties bridge this gap and therefore complete the transaction.

The parties need to agree on what those performance targets are –- financial and/or commercial.

If they are financial, they can be set at the top of the P&L statements (e.g. gross revenues or net revenues), or at the bottom of the P&L statements (e.g. EBIT or EBITDA). If they are commercial (e.g. diversification of the customer base, or the launch of new products) milestones can be set to measure those commercial achievements during the earnout period. Most earnouts are a combination of both.

Although earnouts are an excellent tool for bridging the gap between the parties’ expectations, they have become controversial due to the potential for future disputes. Many M&A practitioners (including this writer) question whether they are ultimately good for either party. There have been various court cases in connection with earnouts. Vice Chancellor Travis Laster of the Delaware Chancery Court famously observed in the Airborne Health case: “An earnout often converts today’s disagreement over price into tomorrow’s litigation over outcome.”

Advantages of earnouts

For a buyer, the advantages of using earnouts are hard to challenge. By deferring payment(s) of a portion of the purchase price and making it conditional on the achievement of certain performance targets, the buyer is actually transferring the risk of the uncertainty of future revenues to the seller. For a buyer, this is the most valuable benefit of an earnout, as it will only pay for those potential revenues/earnings when they are achieved. The frequency of payments and the earnout period are determined by the purchase agreement — usually paid on a quarterly or semiannual or annual basis over a one to three year time period.

Another advantage for the buyer is to use the earnout as a tool to protect itself against misrepresentations or a breach of covenants by the seller. If at some point during the earnout period, the buyer makes a claim against the seller for misrepresentations, breach of covenants or other terms and conditions, the buyer may decide (depending on the purchase and sale agreement) to deduct the amount of its indemnity claim from any earnout payments due to the seller.

Finally, earnouts can help a buyer retain key employees. For example, when the seller is also the CEO of the business, having an earnout would encourage him/her to remain with the company after the transaction closes. For the seller, remaining with the company would give more control and a strong personal incentive to do his/her best to meet the performance targets.

Disadvantages of earnouts

The biggest disadvantage of earnouts is the risk of post-transaction disputes. Typically, the disputes center the seller’s ability to achieve the earnout performance targets. More often than not, disputes arise when performance targets are not met because the buyer (at the shareholder level) makes certain management decisions that prevent the acquired business from achieving its performance targets.

Structuring the earnout can be a serious challenge too. If the earnout is not tailored to or in alignment with the uniqueness of the business’s operations, complications followed by disputes can arise. Since each business operates differently, even when operating in the same space, special attention to operating details is required for a successful earnout structure.

Although the risk of earnout disputes is difficult to eliminate, earnouts work best when a seller-CEO stays with the acquired company after the transaction closes because (1) a continuity of management practices will be in place; (2) the risk of disputes based on the seller’s lack of control over the company’s operations is reduced and, (3) the seller will be rewarded for his/her own performance rather than for the performance of a new management team brought in by the buyer.

Most importantly then, one should think of an earnout as creating a partnership between seller and buyer. If an earnout is structured properly, the buyer and seller become partners, sharing in the upside and downside risk of a deal.

Gary Miller is CEO of GEM Strategy Management Inc., which advises middle-market private business owners how to prepare to raise capital, sell their businesses or buy companies. He can be reached at 970-390-4441 or gemstrategymanagement.com

Seven expectations if you sell your business to a private equity firm

The Denver Post | BUSINESS

By GARY MILLER | gmiller@gemstrategymanagement.com | GEM Strategy Management | He writes a monthly column for The Denver Post.

POSTED: September 23, 2018, at 6:00 am

 

Recently, Kevin and his board of directors asked me to join them in a discussion of how a private equity (PE) firm will value its business and what to expect in their examination of the company. A few weeks earlier, a PE firm had approached Kevin stating that they were interested in purchasing his company to expand its portfolio of similar companies. They wanted to know if Kevin was interested in selling his company.

Kevin’s firm is 18 years old. Over the past three years, it has averaged $12 million in annual revenues and has averaged $2.1 million in earnings before interest, taxes, depreciation, and amortization. I gave Kevin and his board the following advice.

  1. The goal of a PE firm is the same as any other company — to make money. It looks for businesses that show clear growth potential in revenues and profits over the next three to five years.
  2. Typically, PE firms buy a majority interest in a company, leverage its networks and resources to help make the target more successful than it was before the purchase. Then, they ultimately resell the company for a profit — usually after three to five years. This process can be likened to someone buying a classic car, restoring it, and then selling it for a profit.
  3. PE firms determine a company’s true value through rigorous and dispassionate due diligence. A top-to-bottom examination of the company allows them to test their “going-in” assumptions against the facts. This examination provides a clear understanding of the business’ full potential and what it could be worth in the future. Such a tightly focused due diligence process builds an objective fact base by scrutinizing several factors that help answer the fundamental question: “Will this acquisition make money for investors”? Such scrutiny can help PE firms discover a compelling reason to pay more than another bidder — or throw up red flags putting the brakes on a flawed deal.
  4. The PE firm verifies the cost economics of an acquisition. Veteran acquirers know better than to rely on the target’s own financial statements. Often, the only way to determine a business’ stand-alone value is to strip away all accounting idiosyncrasies by sending a due-diligence team into the field. Often they rebuild the balance sheet, profit-and-loss and cash-flow statements. The team collects its own facts by digging deeply into such basics as The cost advantages of competitors over the target company; and, the best cost position the target could reasonably achieve.
  5. PE teams do not rely on what the target tells them about its customers; they approach the customers directly. They begin by drawing a map of the target’s market, sketching out its size, its growth rate, its products and customer segments; then it breaks down that information by geography. These steps allow the PE firm to develop a SWOTs (strengths, weaknesses, opportunities, and threats) analysis, comparing the target’s customer segments to its competitors’ customers segments, answering the following questions.
  • Has the target fully penetrated some customer segments but neglected others?

 

  • What is the target’s track record in retaining customers?

 

  • Where the target’s offerings could be adjusted or improved to grow sales and/or increase prices? And,

 

  • Can the target continue to grow faster than the market’s growth rate?

 

  1. The PE firm’s due diligence teams always examine the competition. They dig out information about business strategies, operating costs, finances, and technological sophistication. They examine pricing, market share, revenues and profits, products and customer segments by geography. Normally, PE firms have a deep understanding of industry data so they can benchmark the target and its competitors. This due-diligence process is a powerful tool for unmasking the target’s fatal flaws.
  2. PE firms take a long view, looking ahead to the time when they’ll be selling the company to another acquirer. With that in mind, the goal is to hit a three-to-five-year growth target, and build sustainable growth into the company’s DNA.

What can business owners do to increase their company’s values?

A business owner can emulate these same PE firm processes to increase his/her company’s value. Many owners know far less about the environments in which they operate than they think they do. As a result, they often don’t challenge their own conventional wisdom until it is brought to their attention by the potential acquirer. By then it’s too late to have maximized the company’s value.

By digging deep into the data, owners can discover their company’s full potential and the underlying weaknesses that could make them less attractive as acquisition targets. By examining the factors that drive demand and measuring products and services against competitors, owners can identify performance gaps that need to be addressed.

Looking at the broader picture owners should ask themselves:

 

  • What key initiatives will have the most impact on my company’s value in three to five years?

 

  • What are the customers’ future purchase behaviors, if we do nothing?

 

  • What technologies could disrupt my business?

 

  • What market changes could affect our market share?

 

These questions are hard to answer. The key is to define the future business environment for the company. Owners need to see what the facts say about the company and what levers can be pulled to create more value for their companies.

Gary Miller is CEO of GEM Strategy Management Inc., which advises business owners on how to sell their businesses or to buy companies and raise capital. He can be reached at 970-390-4441 or gmiller@gemstrategymanagement.com

 

Should I buy my father’s business?

The Denver Post | BUSINESS

POSTED: August 26, 2018, at 6:00 AM

By GARY MILLER | gemstrategymanagement.com | GEM Strategy Management, Inc.

Last month, Bill and Mary, owners of a successful hardware distribution company, came to see me about selling their business to their son.  Bill Jr. had worked for them for the past four years and was doing an excellent job. He left a promising career to return home after Bill Sr. had a heart attack.  Several of Bill and Mary’s children worked in the business as well but had not expressed any interest in purchasing the company.

I asked them if Bill Jr. was really interested in taking over the family business and was he ready to lead the company. They weren’t sure if he wanted to buy the business now.  As I listened to them, I decided that I should discuss the situation with Bill Jr. privately. They agreed.  After spending time with him, it was clear the Bill Jr. was interested in buying his father’s business but had not seriously considered purchasing it now.

This is the advice I gave him.

I told him that there is no single path to taking over a family business.  More importantly, if he is interested in purchasing the business now, he needs to know how to proceed smoothly. It is wise to take a cautious approach that recognizes the family’s unique personalities, values, and interpersonal relationships since it is his family.

First, Bill Jr. will need to consider the ramifications of taking over the family business. I advised him to take some time to review his career goals and personal life. Since Bill Jr. was in his mid-30’s, he may want the chance to define himself and his career outside of the family business.

Second, Bill Jr. will need to review the benefits and risks involved in purchasing the business.  He should secure the advice of a trusted mentor and a business consultant. There is a range of benefits that come with taking over the family business. You are:

  • Maintaining the family legacy.
  • Getting an established business with a modern infrastructure.
  • Getting the existing talent and knowledge of longtime employees.
  • Getting a profitable business with strong cash flow.
  • Getting a business with a solid customer base.

However, Bill Jr. needs to recognize potential risks, as well. I recommended that he take some time to consider the various risks. Questions he should ask himself are:

  • Is there potential for infighting among family members about the buyout?
  • How will he finance and pay for the purchase of the business?
  • Is the cash flow enough to pay the payments to his parents?
  • Is the initial financial investment economically viable?
  • Are there long-term growth opportunities for the business?
  • Does he have the right skill sets and leadership style for the company culture?
  • Will the existing customers and employees stay with the business if Bill Jr. takes over?

Third, I advised him to secure a professional opinion of value from an independent, certified valuation firm. Often, family members will either under or overestimate the value of their business. Without an independent valuation, family feuds can erupt. A certified valuation will help determine whether it is a good business decision to purchase the business and, if so, how much should Bill Jr. pay for it.

Fourth, Bill Jr. should make a holistic decision. Taking the benefits, risks, current financials, family dynamics and his own career into account, make the decision that is right for him.  His advisors should make sure that Bill Jr’s considerations are relevant, thoughtful and logical.

Fifth, assuming Bill Jr. decides to purchase the business, he should be cautious in how he proceeds with the purchase. Nerves can become raw and tense during the transaction process.  To keep things under control, it’s best to take a slow approach and not be too aggressive because either could spark negative reactions among family members.

Sixth, Bill Jr. should develop his own business relationships instead of relying on his parents’ or other family members’ relationships — lawyers, accountants, and consultants. It is advised that each participant in a family business transaction should have their own legal counsel. Bill Jr. will want to follow an arm’s length transaction process as if he were buying a company other than the family business. By using an arm’s length transaction process, he can minimize “family drama”. For example, avoid deciding on a purchase price around the dinner table or with a handshake on a family vacation. Hire a law firm with transaction experience to draw up the definitive purchase agreement and an M&A consultant to help negotiate price, terms and conditions, representations and warranties of the purchase. In addition, Bill Jr. should develop a clear communication and transition plan that addresses the transition of leadership from his father to himself.

Seventh, he should use his unique talents and leadership style instead of trying to run the business like his father. However, he should respect family rules and precedents.

Finally, I told him to be sensitive. When taking over the family business, remember that the last generation may be very attached to what they’ve built.  Whether the business was a start-up or they took it over from a previous owner, they have spent a great portion of their lives building a successful company. Just as starting a business takes a great deal of energy, taking over a family-owned business can be just as taxing — and surprisingly emotional, too.

Gary Miller is CEO of GEM Strategy Management Inc., which advises middle-market private business owners how to prepare to raise capital, sell their businesses or buy companies. He can be reached at 970-390-4441 or gemstrategymanagement.com

 

An unsolicited offer for your business. Wow! What do I do now?

The Denver Post | BUSINESS

POSTED: July 22, 2018 at 6:00 am

By GARY MILLER | gmiller@gemstrategymanagement.com | GEM Strategy Management, Inc.

 

 Most business owners know that merger and acquisition (M&A) activity is very robust.

 

According to Deloitte LLP, in The state of the deal, M&A trends 2018 report,
“Corporations and private equity firms foresee an acceleration of M&A in 2018 – both in
the number of deals and the size of those transactions”. For business owners, this is
good news. However, this flurry of deal activity results in unsolicited offers for many
small business owners. That is what happened to Joe, the owner of a small
manufacturing firm.

Joe called me wondering what to do since he had received an unsolicited offer to buy
his business. The buyer was willing to pay him three times annual revenues, plus his
net assets on an earn-out basis over the next three years. In addition, there were no
non-compete clauses in the offer. However, the purchase price had to be supported by
an independent, certified valuation.

Photo provided by Mark T. Osler

Gary Miller, GEM Strategy Management Inc. He writes a monthly column for The Denver Post.

On its surface, this deal seems workable. However, Joe was caught off guard since he had not seriously considered selling his business.  He didn’t know what to do. Following is the advice I gave him.

First, be careful about how much information you divulge to the person representing the
buyer. Request a signed confidentiality agreement from the potential buyer. A genuine
buyer will not balk at this request. Consider if the offer is coming from a legitimate
potential buyer or from a buyer with ulterior motives, such as acquiring intelligence
about your business and its customers. It is critical to conduct proper due diligence
up front to understand the suitor’s motivations and whether to engage.

Second, take time to consider whether or not you want to sell your business now. Many
owners wait to begin thinking about selling their businesses until their businesses are
declining or they have been hit with unexpected major events, such as divorces, severe
illnesses or deaths in the family, or losses of key employees, large customers or key
suppliers. As a result, owners react, by making emotional decisions rather than strategic
ones. Owners, who plan ahead, are more likely to extract higher values for their
businesses when they are highly profitable and positioned for strong growth.

Third, if you are interested in selling your business, seek help immediately from
professional M&A advisors. They bring professional experience and expertise and
provide significant value by helping you understand all of your options and help you avoid making emotional or irrational decisions. Know that you are at a disadvantage, to begin with, since most buyers, who tender unsolicited offers, have made other acquisitions. They are sophisticated and come with M&A advisors who are strong
negotiators. Generally, most business owners who receive unsolicited offers haven’t
taken the time to prepare their companies for sale. As a result, they often leave money
on the table which is just what potential buyers are counting on.

Fourth, consider whether you have enough capital to continue to grow your business
and stay competitive. Seeking external capital or recapitalizing by selling a minority or
majority interest in your business could be a better option than an outright sale of all of
your business.

Fifth, look at the market you serve. Consider both the short-term and the long-term
prospects for a promising future. You may find, while business is good now, the long-
term prospects are going to be challenging due to emerging trends or new displacement
technologies that could threaten your current business model.

on a few customers or suppliers? Generally, if over half of your business revenues come from 10 to 15 percent of your customer base, you have a concentration of risk. Buyers will not pay top dollar for businesses if they feel threatened by this concentration of risk.

Sixth,  many times unsolicited offers come from so-called “private investment search
firms”. These are firms, formed by a group of investors, who promise to fund a potential
acquisition if the right deal comes across their platform. The investors hire a fund
manager to seek out potentially good deals. Once the fund manager has found a
potential target and gone through the transaction process with the seller except for
drafting the definitive purchase agreement, he goes back to the investors and tries to
“sell” the deal. All too often, one or more of the so-called investors balk at the deal and
the potential transaction falls apart. In the meantime, weeks or even months have
passed leaving the owner empty-handed after spending countless hours, energy and
money trying to get the deal closed. The message is obvious –owners should vet the
potential suitor to ensure the search fund has been fully funded and has the financial
capacity to acquire your business.

Finally, identify what methodologies the potential buyers are relying upon to value your
business. This is critical for business owners looking to maximize value. Price is
generally based on a multiple of some form of normalized earnings/revenues.

Therefore, higher adjusted earnings equate to higher purchases prices.

Most business owners need help to sort through the intricacies of selling their
businesses. It is wise to consult qualified advisors such as M&A consultants, transaction
attorneys, accountants, and wealth managers.

Joe did just and wound up closing the deal of a lifetime.

Gary Miller is Founder & CEO of GEM Strategy Management Inc., and M&A consulting firm, advising middle-market private business owners how to prepare to raise capital, sell their businesses or buy companies. He can be reached at 970-390-4441 or
gemstrategymanagement.com

 

Ignoring tax issues before the deal is struck is a big mistake

The Denver Post | BUSINESS

POSTED;  June 24, 2018, at 6:00 am

 

Many business owners put tax issues on the “back burner” when selling their companies. Ignoring tax considerations, until after the deal is struck, is a big mistake and can put you in an adverse negotiating position, even if the letter of intent (LOI) or term sheet (TS) is “nonbinding.”

Sellers should not agree on any aspects of a deal until they meet with a competent tax adviser who can explain how much they will wind up with on an “after-tax” basis. Seven major tax questions should be considered before finalizing a deal.

  1. What type of entity do you use to conduct your business?
    Is your business is a sole proprietorship, partnership, limited liability company (“LLC”) or S corporation? These corporate structures are considered “pass-through” entities and will provide you with the most flexibility in negotiating the sale of your business. Your flexibility may be limited, however, if you conduct your business through a C corporation. The possibility of “double taxation” may arise at the corporate and shareholder levels.
  2. Is a tax-free/deferred deal possible?
    Most sales of businesses are completed in the form of taxable transactions. However, it may be possible to complete a transaction on a “tax-free/deferred” basis, if you exchange S corporation or C corporation stock for the corporate stock of the buyer. This assumes that the complicated tax-free reorganization provisions of the Internal Revenue Code are met.
  3. Are you selling assets or stock?
    It is important to know whether your deal is or can be structured as an asset or stock sale prior to agreeing to the price, terms and conditions of the transaction. In general, buyers prefer purchasing assets because (i) they can obtain a “step-up” in the basis of the assets resulting in enhanced future tax deductions, and (ii) there is little or no risk that they will assume any unknown seller liabilities. Sellers, on the other hand, wish to sell stock to obtain long-term capital gain tax treatment on the sale.

A seller holding stock in a C corporation (or an S corporation subject to the 10-year, built-in gains tax rules) may be forced to sell stock because an asset sale would be subjected to a double tax at the corporate and shareholder levels. In addition, the seller is often required to give extensive representations and warranties to the buyer and to indemnify the buyer for liabilities that are not expressly assumed.

  1. How will you allocate the purchase price?
    When selling business assets, it is critical that sellers and buyers reach agreement on the allocation of the total purchase price to the specific assets acquired. Both buyer and seller file an IRS Form 8594 to memorialize their agreed allocation.

When considering the purchase price allocation, you need to determine if you operate your business on a cash or accrual basis; then separate the assets into their various asset classes, such as: cash, accounts receivable, inventory, equipment, real property, intellectual property and other intangibles.

  1. Can earn-outs/contingency payments work for you?
    When a buyer and seller cannot agree on a specific purchase price, the seller and buyer may agree to an “earn-out” sale structure, and/or contingent payments. The buyer pays the seller an amount upfront and additional earn-outs or contingent payments if certain milestones are met in later years.
  2. What state and local tax issues are you facing?
    In addition to federal income tax, a significant state and local income tax burden may be imposed on the seller as a result of the transaction. When an asset sale is involved, taxes may be owed in those states where the company has sales, assets, or payroll, and where it has apportioned income in the past. Many states do not provide for any long-term capital gain tax rates, so a sale that qualifies for long-term capital gain taxation for federal purposes may be subject to ordinary income state rates.

Stock sales are generally taxed in the seller’s state of residency even if the company conducts business in other states.

Also, state sales and use taxes must be considered in any transaction. Stock transactions are usually not subject to sales, use or transfer taxes, but some states impose a stamp tax on the transfer of stock. Asset sales, on the other hand, need to be carefully analyzed to determine whether sales or use tax might apply.

  1. Should presale estate planning be considered?
    If one of your goals is to move a portion of the value of the business to future generations or charities, estate planning should be done at an early stage, when your company values are low (at least six months in advance of verbal negotiations and/or receipt of a TS or LOI). It may be much more difficult and expensive to simply sell the company and then attempt to move after-
    tax proceeds from the sale to the children, grandchildren or charities at a later date.

Conclusion: Before deciding to sell your business, work with a qualified tax adviser who can help you understand the tax complexities of various sales structures. Above all, do not enter into any substantive negotiations with a buyer until you have identified the transaction structure that best minimizes your tax burden.

Gary Miller is CEO of GEM Strategy Management Inc., which advises middle-market private business owners how to prepare to raise capital, sell their businesses or buy companies. He can be reached at 970-390-4441 or gemstrategymanagement.com

 

Half of all business sales fall apart during due diligence.

The Denver Post | BUSINESS

Here’s how to avoid it.

By Gary Miller | Gem Strategy Management

POSTED:  June 3, 2018 at 6:00 am

When a seller tries to hide facts, or doesn’t disclose them to buyers and they are uncovered during due diligence, say goodbye to the deal. According to Forbes, “approximately half of all deals fall apart during the formal due diligence stage, and one of the most common reasons this happens is due to the buyers uncovering  issues which the sellers didn’t disclose earlier.” These situations are never pretty. Accusations are made, lawsuits follow, buyers lose their investments, sellers forfeit any earn-outs and face “financial claw backs” and businesses deteriorates rapidly. Nobody wins. These situations are all too common and in most cases should never happen.

Think about it. You spend years building a successful business. You decide to sell, spend time trying to find a qualified buyer to sign an LOI (letter of intent to purchase your company) and begin negotiations, only to have your potential deal fall apart because of undisclosed items arising during the due diligence process. So what can you do about it? Below are four “musts” for successful deal making.

First, don’t rush to go to market. Rushing to market can be caused by age, illness, burnout, divorce, legal problems, partner squabbles and myriad other reasons. But, in spite of these reasons, rushing to market could significantly impact your ability to get an optimal deal for your company. Going to market unprepared is a recipe for disaster. Since most business owners will only sell a company once in their lives, it’s a good idea to engage a professional M&A adviser to help prepare for the transaction process in general and the due diligence process in particular.

Second, prepare for the buyers’ due diligence process. Prepare for intense buyer scrutiny.  Far too often business owners simply do not do their homework prior to the process and pay the price in the end when their deal falls apart. If a seller is not prepared in advance, due diligence can drag on for weeks; and, often, if it does, buyers get cold feet and move on to other, more attractive opportunities. Have an adviser create a typical due diligence check list and put you through the rigor of answering questions that could arise.

Third, disclose, disclose, disclose. Throughout the discussions, negotiations and the due diligence review between a buyer and seller, credibility is being tested. In your discussions with the buyer, explain your challenges before they find them; understanding them will allow the buyer to get comfortable with your business. Disclosing the challenges actually builds trust and credibility. As long as the parties deal honestly with each other, trust builds. But, if either side tries to hide material information that surfaces during due diligence, trust will be shattered. The cardinal rule of deal making, during the due diligence process, is disclose all material information.

For example, in a transaction involving a moving and storage company, a large percentage of the company’s revenue came from a single government contract. The buyer wanted to read the master contract between the company and the government agency to be sure it was transferrable as the seller had represented. However, the seller knew it was not really transferable and would have to be reviewed by the government agency because of change of ownership. He figured he could convince the buyer to buy the company’s stock instead of the company’s assets after the buyer was emotionally invested in getting the deal done. Wrong strategy. The buyer agreed to complete all other components of due diligence and would review the contract afterwards. Sure enough, the buyer discovered that the contract was not transferable and could only continue with an entirely different deal structure complicated by tax issues and potential liabilities. The buyer felt mislead and the deal disintegrated.

Remember, the goal is to sell the business. Disclosing the good and the bad about the business, warts and all, is just prudent deal making.

Fourth, think like a buyer. Look at your business as if you were a buyer. Ask yourself, what would I need to know about this company if I were buying it?  What are its strengths and weaknesses?

A great exercise for sellers is to put together a list of everything that worries them about their own business – those that keep them up at night. Then, detail potential solutions to each problem that can mitigate a buyer’s concern. For example, if the business has some old equipment, the seller can be proactive and have a spreadsheet ready that details replacement costs and financing options along with the potential improved efficiencies that will contribute to the bottom line.

Despite the dismal statistics of failed deals, transparency between the parties is the key to success. When a buyer wants to buy and a seller wants to sell, and the parties like and trust each other, they will find a way to get the deal done.

Gary Miller is CEO of GEM Strategy Management Inc., based in Greenwood Village, which advises middle-market private business owners how to prepare to raise capital, sell their businesses or buy companies. gemstrategymanagement.com | 970.390.4441

 

Could your employees be stealing from you? Fraud is more common than you may think

The Denver Post | BUSINESS

Employees attempt to steal from their employers in many ways. The most prevalent schemes center on asset misappropriation

by Gary Miller | GEM Strategy Management| gmiller@gemstrategymanagement.com

A business owner I know was seeing a slight decline in his gross revenues and gross margins last year at three of his five retail locations. He couldn’t understand what was going on. So he installed an enterprise resource planning system including a point-of-sale inventory management system. He hoped that these new systems would isolate the problem and improve his company’s profitability.

But things didn’t change. Product margins were less than expected; product sales were flat; cost of goods sold were inconsistent; and, the inventory analysis never reconciled with the company financial books and records. Something was radically wrong. The business owner contacted a management consulting firm for help. After an extensive review, the firm found that the company was a victim of fraud. Someone or several employees were embezzling money through misappropriation of assets.

That business owner isn’t alone. According to the Association of Certified Fraud Examiners, nearly 40 percent of fraud occurs at privately held companies and 30 percent occurs at companies with fewer than 100 employees. The association estimates that fraud causes average revenue losses of 5 percent annually.

Employees attempt to steal from their employers in many ways. The most prevalent schemes center on asset misappropriation. It accounts for almost 80 percent of employee fraud schemes. Below are the top asset misappropriation employee schemes:

  • Authorized check maker. An employee authorized to sign checks for the company makes a company check payable to himself/ herself. The employee then changes the payee’s name in the company’s accounting records so it seems as if the check was written to an authorized vendor.
  • Altered check or forgery. An employee intercepts a signed company check and alters the original payee name or the check amount using items such as correction fluid, “check washing” solution or a pen eraser. The scheme is perpetrated by an employee who receives bank statements and performs bank reconciliations.
  • Billing manipulation. An employee submits fictitious invoices from a “shell company”, set up by the employee, and then issues payment to the shell company.
  • Non-cash misappropriations. Rather than stealing cash, an employee steals inventory or other physical assets. A physical inventory count would reveal lower inventory levels than those reflected in the company’s perpetual inventory records, a concept often referred to as “shrinkage.”
  • Payroll and expense reimbursements. Employees submit false documents or manipulate the payroll system to create unauthorized payroll disbursements or expense reimbursements, alter data used to calculate performance-based incentives, generate paychecks to non-existent employees, or steal checks payable to terminated employees.
  • Cash register disbursements. Fraud often occurs at the point of sale when an employee processes a false product return or voids a sale that was previously recorded and steals cash paid in the transaction. Alternatively, a salesperson may purposely skip entering a sale into the company’s point-of-sale system when a cash payment is made and pocket the proceeds.
  • Lapping schemes. An employee applies a payment amount on a customer’s invoice that is different than the invoice listed on a customer’s remittance advice. This occurs when the employee is using a lapping scheme to conceal the skimming scheme. For example, if the customer intended to pay invoice #003 per the remittance advice, but the employee instead applied the customer payment to invoice #002, it is likely that the employee previously skimmed the payment for invoice #002 and must now conceal the misappropriation.
  • Unusual number of customer charge-offs or credit memos. An employee identifies an amount as uncollectible when the customer’s payment was actually received and misappropriated by the employee; or, conceals a company’s refund of a customer’s deposit that were initially misappropriated.

Business owners should recognize the signs that might identify fraud:

  • Understand how various asset misappropriation schemes work, and which schemes pose the greatest threat to your company’s operations;
  • Maintain stringent oversight of all accounting operations, and hire a third party to audit your financial operations periodically;
  • Restrict employees from accessing information they do not need to perform their duties, and segregate cash receipt duties among several different employees;
  • Regularly review manual journal entries focusing on entries posted to cash, accounts receivable and sales, and,
  • Install active and passive customer/employee complaint mechanisms such as customer password protected website screens.

Employers want to trust those they have hired, but remember an ounce of prevention is worth a pound of cure. Losses from fraud can have a significant impact on your company’s profitability, as the business owner above found out. He was being skimmed by one employee who had been with him for over 15 years and two accomplices who reported to her.

Gary Miller is CEO of GEM Strategy Management Inc., which advises middle-market private business owners how to prepare to raise capital, sell their businesses or buy companies. 970.390.4441 gemstrategymanagement

You just received an IRS audit notice. Now what do you do?

First, deal with the problem immediately. Don’t let the
problem fester
By GARY MILLER | gmiller@gemstrategymanagement.com | GEM Strategy Management

Last year I wrote an article on eight tips for avoiding an IRS audit. This year, I
want to give you some advice on what to do if you receive an IRS audit notice.

First, deal with the problem immediately. Don’t let the problem fester. Too often
business owners do not open IRS letters or fail to pick up IRS certified letters.
Worse yet, some owners ignore automated IRS phone calls or calls from a revenue
officer. Ignoring the IRS greatly increasing the chances that the government will
resort to collection actions (liens, wage garnishments, levies, seizures) in order to
force taxpayer compliance.

Second, understand what the IRS wants. You have been selected to be audited for a
specific reason. Being audited doesn’t mean you have done anything wrong. Your
circumstances may be atypical. Your business may be cash intensive or you may
have an unusual deduction that the IRS wants to review in more detail.

The most important explanation of what the IRS is looking for is contained in the
Information Document Request (IDR). You will receive the IDR when you are
initially contacted by the IRS. By understanding what the IRS is looking for, you
can prepare and organize your documents, providing the most complete
substantiation possible. The more complete your substantiation is, the less likely
the IRS is going to challenge the information stated on your return.

Third, decide on professional representation or self-representation. If you are wellorganized
and have nothing to hide, there is nothing wrong with representing
yourself in an audit. However, if you have a complex return, failed to report
income, overstated expenses, failed to keep accurate records or reached an impasse
with the auditor, then you should seek professional help.

Since your ultimate goal is to secure the smallest final bill or to obtain a “nochange,”
on your tax return, hiring a tax attorney or a CPA firm to represent you
has significant advantages.

Often tax attorneys and CPA firms have good working relationships with the IRS.
They are knowledgeable about the IRS audit procedures, know the right time to
elevate an issue to appeals and can often move through the audit process quicker
than a taxpayer can alone.

An advantage to engaging a tax attorney is the attorney-client privilege, which
offers a greater level of protection than a CPA. In cases where wrongdoing has
occurred, a tax attorney is essential.

Fourth, limit the scope of the audit. Typically, the IRS has three years to request
examination of a return. They will normally start auditing within one year. The
exceptions are cases of late/no filings, significant errors or omissions in reporting
income or expenses, and fraud. Do not offer up previous tax returns as it might
trigger the opening of up other tax years, or an examination change. The IRS has
the right to make adjustments on additional tax years even though it wasn’t
covered with the initial IDR.

Fifth, control the flow of information. If you are representing yourself, you have
the distinct disadvantage of having to answer the auditor’s questions immediately
when asked. Never lie or make material misstatements to the auditor. Doing so is a
federal crime that carries possible jail time. However, during an audit, make every
effort to control the flow of information. Carefully listen to each question the
auditor asks and answer only that question. Be brief. Keep your answers short.
Answer as follows: “Yes”, “No”, “I don’t know”. “I will have to research
that.” Too much “off’-the-cuff” information gives the auditor more ammunition to
make examination changes and potential additional assessments.

Sixth, remain personable and cooperative. Often, it is difficult for many taxpayers
to keep their emotions in check during an audit. Many feel afraid, angry and
inconvenienced and resent the costs of the audit. It is true that some auditors can be
very difficult. However, the best audit outcomes are gained by working with the
auditor rather than butting heads with him or her. Auditors are human, too. They
will often favor those taxpayers who are personable and genuinely trying to work
with them. Being well prepared and organized demonstrates sincerity to resolving
tax issues. Cooperate. Do everything you can to move the audit process along
quickly.

Seventh, pick your battles. Tax attorneys and CPAs tell me that they try to handle
audits from a big-picture perspective. It doesn’t make sense to fight tooth and nail
for every little deduction when it may lead the auditor to open up returns from
other years. You may lengthen the audit and you will surely jeopardize your
working relationship with the auditor. Conceding deductions in some areas or only
taking a percentage of the claimed deduction when you do not have adequate
receipts or records may ultimately be the best strategy. Auditors tend to respond
positively when taxpayers are reasonable with them. Small concessions may lead
the auditor to be more lenient in other areas. Keep focused on the big picture goal –
minimizing your tax obligation.

Gary Miller is CEO of GEM Strategy Management Inc., which advises middlemarket
private business owners how to prepare to raise capital, sell their
businesses or buy companies. 970.390.4441 gemstrategymanagement.com

Paying too much, and nine other mistakes to avoid when buying a company

The Denver Post |  BUSINESS

 POSTED:  February 25, 2018, at 12:01 am

Gary Miller, staff photo

By GARY MILLER | gmiller@gemstrategymanagement.com | GEM Strategy Management


With the economy growing substantially as well as the low cost of capital, many business owners are considering making an acquisition as part of their growth strategies. In the past few months, I have been asked by many business owners about the risks inherent in making an acquisition.

I tell them that most accomplished acquirers admit that they have learned more from their mistakes than from their successes. Current market conditions suggest it is a seller’s market with frothy multiples. Therefore, a comprehensive assessment of the acquisition “target” is a must. In my experience, there are 10 major mistakes to avoid.

  1. Not doing a thorough operational due diligence.

Although standard checklists can be used for due diligence, they are not sufficient. Buyers should examine everything they need to know about the target’s business. A thorough examination requires that a unique due-diligence plan be developed for each deal and each target. Shortcuts at this stage can be extremely expensive down the road.

  1. Not doing a SWOT (strengths, weaknesses, opportunities, threats) analysis.

There are many concerns when making an acquisition (management bench strength, operating structure and systems, industry conditions, competitive barriers, and organizational capacity). Customer concentration is the biggest concern and threat to success. The SWOT analysis will help you match your company’s SWOT to the target’s SWOT – helping you in determine where there are alignments.

  1. Not benchmarking the target acquisition against industry peer performance.

Numerous databases – like Sageworks, First Research and Business Valuation Resources (BVR) – are available to help you to determine how well the business is being managed. Comparing sales growth, profit margins and various components of the balance sheet can determine if the target is in the top or bottom 20 percentile of its peer group.

  1. Not accurately examining synergies.

One of the most appealing parts of an acquisition is the inorganic growth and synergies it can offer. But be careful – cross selling is not a given. Sales synergies are much more difficult to achieve than duplicated cost savings. Remember, cost savings are not free. There is usually some kind of investment required for all cost savings. Know what the net contribution is after calculating the required investments.

  1. Not identifying the organizations’ cultural issues. 

The “we don’t do it that way” attitude will kill the implementation of a promising acquisition. I recommend that a “culture integration outline” be developed between the buyer and seller before signing the definitive agreement. Understanding the differences between the companies’ policies, processes, practices and procedures will help smooth the integration processes.

  1. Not asking the target’s top customers the right questions.

Acquisitions become much less valuable if the target company loses its largest customers. Asking the customers the right questions indicates whether the customers are loyal to the target and if they will commit to the new organization after the deal closes. Interviewing the top 10 to 15 percent of the customers is not unreasonable.

  1. Not having integration and communication plans ready.

According to Global PMI Partners, 70 percent of all strategic acquisitions fail due to poor implementation of integration and communication plans with employees and customers. Without these plans, the acquisition is left dangling and can easily start the integration process off on the wrong foot.

  1. Not having all the key employees tied down to employment contracts.

There is always a hidden trap door for someone critical to the business. Find it and nail it shut. It is critical for the seller to deliver the senior team and key people to the buyer upon closing. If key management and employees are unwilling to sign non-compete/non- solicitation agreements, you may be headed for trouble.

  1. Paying too much for the target.

Offers need to be benchmarked against the market. If the combined businesses – in the worst case scenario – don’t generate an ROI on the purchase price (without earn-outs) greater than the buyer’s cost of capital, you’re paying too much. If you can’t work out a fair price with the seller, don’t walk away, run.

  1. Not getting professional help.

All too often, owners think that they can save money by “going it alone” without professional advisers. The latest research clearly indicates that business owners who use professional M&A advisers have a far greater chance of success when buying or selling a business than those who don’t.

Avoid these 10 common mistakes and you will be well on your way to growing both your top and bottom lines.

Gary Miller is CEO of GEM Strategy Management Inc., which advises middle-market business owners how to prepare to sell their businesses, buy businesses or raise capital. gmiller@gemstrategymanagement.com.