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Accountants, bankers and CFOs work with financial information daily, but a number of successful small business owners and managers may not understand financial statement differences or accounting terms that are often used to explain business performance.
Successful sales, marketing, operations and purchasing managers and owners may have an incomplete understanding of financial statements and terms, because they have had little accounting training. Some basic concepts are explained below from a non-accounting business perspective:
Accounting. This refers to the techniques and procedures used to communicate financial information. Accounting is sometimes referred to as the “language of business,” and this language is used by accountants and other financial people to build financial statements.
Financial Statements. These are reports that show the financial performance of a business. The most common reports are the balance sheet, income statement, and statement of cash flows. Most small businesses create a balance sheet and income statement at the end of each month, and larger companies create a statement of cash flows. Think of financial statements as scorecards showing if and where a business is winning or losing.
Cash basis vs. Accrual Basis. These are the two primary ways that revenue and expenses are measured. A company’s financial statements can be built using cash accounting or accrual accounting. Cash accounting records revenue when cash is received and expenses when cash is paid. Accrual accounting records revenue when earned and expenses when incurred, regardless of whether cash has been collected or paid. It is common for small businesses to use cash accounting, but mid-size and larger companies use accrual accounting.
Generally Accepted Accounting Principles (GAAP). These are accounting standards used by public accountants and internal accounting departments. Think of GAAP as a set of guidelines that attempt to create uniformity in financial statement preparation. Bankers often ask for GAAP statements, because they want financial reports prepared according to these common accounting “rules.”
Balance Sheet. This financial report shows a snapshot of a business’ account balances on a specific day. The report has three sections: Assets (what the business owns), Liabilities (what the business owes) and Equity (the difference between what the business owns minus what it owes). The balance sheet always “balances” because the total assets equal total liabilities plus equity.
Some owners think this report shows the net value of the company if all assets were sold or converted to cash and all debts or liabilities paid. This is not entirely correct, because the actual prices earned from selling assets could be higher or lower than the values on the balance sheet. The balance sheet, however, does give an indication of a company’s net asset value and accumulated earnings since the business began.
Income Statement / Profit and Loss Statement. This financial report shows a company’s performance during a particular period such as a month or year, and it has three section: Revenue (money received from the sale of goods and services), Expenses (all company costs incurred to make and sale the goods or services), and Profits or Net Income (revenue minus expenses). Some owners think profits equal cash, but this is incorrect if the company uses accrual accounting: the income statement compares revenue to expenses, calculates a profit and shows what income may eventually be converted to earnings or cash.
The income statement and balance sheet are connected by net income, such that profits (on the income statement) increase equity (on the balance sheet) and losses decrease equity.
Statement of Cash Flows. This financial report shows whether a company has generated or used cash during a period. The balance sheet and income statement are used to build the statement of bash flows, and this report breaks down actual cash that has come into the business or gone out of the business from operating, investing and financing activities. Bankers and investors often focus on a company’s cash flow, but many small businesses unfortunately do not often analyze their cash flow.
Financial statements are scorecards created by businesses to track financial performance. Accounting tools and techniques are used to build financial statements, but even owners and managers who are “accounting challenged” can use financial statements to better understand and improve their company’s financial performance.
Five Remaining Elements of Planning for a Successful Sale to Insiders
The prior article dealt with the first five elements which should be part of a business owner’s plan to successfully transfer his or her company to “insiders” (family members, key employees and co-owners). They were: Time; Defined Owner’s Objectives; Business Cash Flow; Growth in Business Value (using Value Drivers); and Capable Management Desiring Ownership.
This article deals with the remaining five elements of planning for successful sales to insiders that keep owners in control of their business until they are paid the entire sales price.
Element 6: Minimizing Taxes upon Sale.
While no owner wants to pay more taxes than absolutely necessary, those contemplating insider transfers must focus on minimizing taxes. In insider transfers, it is imperative that the owners and advisors structure the sale to minimize taxes on the company’s cash flow (pre-tax income) because, without planning, the cash flow is taxed twice—once when the insider receives it (as the new owner) and then pays taxes before paying the prior owners to purchase the company; and again when the prior owners pay taxes on the proceeds they receive.
One goal of tax planning is to subject the company’s cash flow to taxation only once. Accomplishing this feat takes considerable planning, but it’s worth the time and trouble to save a third or more of the cash flow from this type of double taxation. One-time taxation means owners receive more money more quickly and thereby reduces risk of non-payment.
For instance, owners who include in their plan to transfer ownership to insiders a deferred compensation plan payable to the owners directly by the company pursuant to a deferred compensation agreement pay only one tax (though at ordinary income tax rates instead of capital gains tax rates).
Element 7: Regulate an Incremental Transfer of Ownership.
One of the most important advantages of the well-designed insider transfer plan is that it gives owners the ability to regulate how ownership is transferred, when it is transferred and how much ownership is transferred. If company performance falters, employees stumble, or if the owners choose instead to sell to a third party, the well-designed insider exit plan keeps the owners in the driver’s seat.
Element 8: Increased Control = Decreased Risk to Owners.
While business owners take risks every day, they don’t relish risking their own and their families’ future financial security. Therefore, it is advisable to use strategies to retain voting and operating control in the hands of the owners and shift operational business risk from the owners’ shoulders to that of the incoming owners, so that owners stay in control of their companies until they receive the entire sales price.
There are many ways to accomplish this. For instance, one way is to recapitalize the common stock of a company into two classes with one class being Class A Voting Stock consisting of one percent of the total shares (and total value of the company), and the other class being Class B Non-Voting Stock constituting 99 percent of the total shares and value of the company.
Owners can retain voting and operational control by first transferring all Class B Non-Voting shares to the insider and then only transferring the Class A Voting shares once the insider has paid the full purchase price.
Element 9: Written Road Map with Deadlines.
To succeed, it is highly advisable to put a transfer plan in writing and communicate it clearly (and regularly) to the eventual owner(s). If the plan is not in writing, it simply is not credible and neither the business owners, nor the employees, will take it seriously. More importantly, the written plan is the playbook for the business owners’ exit that will be used to coordinate actions with their advisors (thus reducing delay and cost).
The plan should include a timeline and provide accountability—who will do what, when—for all participants, including the owners! Use incremental, staged checkpoints. As they say, you’ll never finish a marathon if you don’t have mile-by-mile goals to meet.
Element 10: Education (yours).
Experience tells us that owners need to understand the ins and outs of insider transfers because, unlike sales to third parties, owners can control the business and the exit process until they are paid the entire sales price for the business. As a business owner, that education began the moment you started reading this article! Thanks for listening!
Planning for a Successful Sale to Insiders
This article deals with Step 4 of our firm’s six step planning process for helping business owners create an optimum succession plan for their business and exit plan which best meets their business and personal objectives.
Last month’s article focused on the keys to reducing the risks of an unsuccessful transfer of a business to “insiders” (family members, key employees and co-owners). This and the next article will present 10 specific elements to consider when planning for a successful sale to insiders, i.e., a sale which best meets the owner’s objectives and that keeps the owner in control until he/she is paid all or most of the sales price (in the event that the chosen successors do not have adequate funds to cash the owner out).
Element 1: Time. The first (and most important) question an owner should ask when considering a sale to insiders is, “Am I willing to take the time (typically 3 to 8 years) to execute and complete an insider transfer (while maintaining control)?” If the answer is no, then it is probably best to consider other alternatives such as a sale to an outside third party.
With the help of advisors trained in Exit Planning, who know how to design successful transfers to insiders (addressing the key factors in our previous discussion), creating the plan can take 60 to 90 days. However, the lion’s share of the time is spent implementing that transfer.
During this 3- to 8-year period, owners work with their management team to build the value of their companies, transition all management responsibilities to their management teams (so that the business not only survives the owner but thrives after the owner retires), and actually sell a substantial portion (or all) of the company to the insiders.
Element 2: Defined Owner’s Objectives. If owners are willing to devote the time necessary for this exit strategy, they also must define and quantify their objectives. These may include: Making sure they have chosen and properly trained the right successors able to profitably grow the company in the absence of the owner; Planning their (and their spouse’s) financial security and independence during their retirement; Choosing a date to begin retirement; Keeping the family legacy (or company culture) intact; Rewarding key employees; and/or Taking the business to the next level—on someone else’s dime. In a well-designed transfer plan, these objectives are met before control is transferred.
Element 3: Business Cash Flow. Healthy cash flow is critical to any sale. No buyer (insider or outsider) wants to buy a company with anemic cash flow. In a transfer to insiders, cash flow assumes gargantuan importance because initially it will be the major, if not sole, source of the owner’s sale proceeds.
Element 4: Growth in Business Value. Like healthy cash flow, buyers look (and pay top dollar) for companies that have the potential to grow in value. In transfers to insiders, only if cash flow continues to grow does the ownership transfer generally occur. For this reason, it is vitally important that owners contemplating an insider transfer install and evaluate Value Drivers before and during their exit transition. For a quick refresher on Value Drivers, please see our March 2014 article.
Element 5: Capable Management Desiring Ownership. Having a motivated management team in place and capable of replacing the owner seller is hugely valuable to any buyer. In a transfer to insiders, such management is essential. That management group must desire ownership and be willing to sign personally for any acquisition financing or ongoing company debt. Owners often assume that their management teams want to own their companies—and they do—but sometimes only until they realize that they have to pay for ownership (or at least guarantee company loans).
These successors to the owner must be respected by and followed by the other employees as successor leaders who not only are competent owners and managers but also are qualified to control all decisions regarding the future of the company. Once these successors are chosen by the owner, and in place and capable of replacing the owner, the owner should begin to delegate all responsibilities to them.
Next month’s article will address the remaining five elements which should be part of a business owner’s plan to successfully transfer his or her company to insiders.
New business owners have many important decisions to make to get their business off the ground. One of the most important choices is the form of legal entity the business will take. Three of the most popular entity types are limited liability companies, limited partnerships, and Subchapter S corporations. C corporations are still available; however, they have lost popularity in recent years due to a less favorable tax structure compared to ‘pass-through’ entities. Limited liability companies, limited partnerships and S corporations all provide liability protection and are taxed as ‘pass-through’ entities, but there are many important differences between them.
Limited Liability Company
A limited liability company (LLC) is a hybrid entity in that it can be structured to resemble a corporation for owner liability purposes and a partnership for federal tax purposes.
The owners of an LLC (called “members”) are generally not liable for the debts of the business except to the extent of their investment. Thus, the owners can operate the business with the security of knowing that their personal assets are protected from the entity’s creditors. This protection is far greater than that afforded by general partnerships.
LLCs can be treated as partnerships for federal tax purposes. LLC earnings ‘pass-through’ to the members and are reported on the members’ individual tax returns. LLC losses ‘pass-through’ to the members as well and are deductible on their individual tax returns subject to certain limitations.
An LLC that is taxable as a partnership can allocate, among other items, income and losses to its members by special allocation. Also, LLCs are not subject to the restrictions the Internal Revenue Code imposes on S corporations regarding the number of shareholders and the types of ownership interests that may be issued.
A limited partnership (LP) can be the most suitable entity for a new business venture that raises capital from private investors but also provides those investors with limited liability protection.
LPs allow you to raise capital to fund the business without giving up control or being saddled with considerable start-up debt. A general partner assumes the role of managing and operating the business. Investors who contribute capital receive limited partnership interests in exchange for their contributions. Limited partners are able to share in the entity’s financial results without managing the business or risking personal liability.
The general partner is usually personally liable for the entity’s debts. The risk of this liability can be minimized by: (i) creating a corporation to manage the partnership and serve as general partner, and (ii) procuring adequate insurance to cover potential liabilities arising from operation of the business.
The partnership is a ‘pass-through’ entity for tax purposes, with each general and limited partner including their share of income, deductions, credits, and losses, on their individual tax return.
Subchapter S Corporation
In an Subchapter S corporation (S Corp), the shareholders are not personally liable for corporate debts. In order to receive this protection, the corporation should be a viable entity separate from its shareholders and incorporated in accordance with applicable state regulations.
S Corp shareholders report their percentage shares of profits and losses on their personal tax returns. S Corp profits are taxed directly to the shareholder whether or not the profits are distributed from the entity. S Corp losses are deductible by shareholders to the extent of their basis which includes what they paid for their stock and any loans made to the entity. Losses that cannot be deducted because they exceed shareholder basis are carried forward and can be deducted when there is sufficient basis. No special allocations to shareholders are permitted.
An S Corp can lose its status if the original shareholders transfer stock to an ineligible shareholder such as another corporation, partnership, or nonresident alien or if shareholder distributions are not distributed according to ownership percentages. If the S election is terminated, the corporation becomes a taxable entity (a C corporation). Shareholders of a C corporation are not able to deduct losses and corporate earnings could be subject to double taxation.
To conclude, the entity choice will depend upon the nature and size of the business entity, the level of activity of the participants, consideration of tax consequences, concerns for succession and management, as well as potential liability protection. The proper choice of business entity is a critical decision, one which shouldn’t be made without solid professional advice. A little planning ahead of time can alleviate unexpected problems in the future.
The Immigration Act of 1990 created the Immigrant Investor Program as the fifth preference category for employment-based immigration—the EB-5—to stimulate the U.S. economy through job creation and capital investment by foreign investors. Approximately 10,000 EB-5 immigrant visas per year are available to immigrant investors who invest in a new commercial enterprise, a troubled business, or a regional center pilot program.
Alien entrepreneurs can obtain an EB-5 immigrant visa if they invest $1 million in a new commercial enterprise which will create at least 10 full-time jobs for U.S. workers. Investors only need to invest $500,000, however, if the investment is made in a high unemployment or rural area. The new commercial enterprise must have been established after November 29, 1990.
If the company was established prior to that date, it can also qualify for investment as a troubled company if it has been 1) restructured/reorganized so as to be tantamount to a new commercial enterprise; or 2) expanded through investment in such a way that the resulting new commercial enterprise yields a 40 percent increase in net worth or number of employees.
In 1992, Congress created another avenue for foreign investment called Regional Centers—economic units designed to promote investment, economic growth, and job creation. A Regional Center can be a private enterprise or a regional government agency that has a targeted investment program, directing and managing investments in the designated business and geographic focus of the Regional Center. Jobs created both directly and indirectly are counted for purposes of meeting the 10-job-creation requirement.
Even if foreign investors want to start their own companies in the U.S., over 90 percent of EB-5 investors choose the Regional Center for their green cards and then come to the U.S. and start a company. They then bypass government examination of where their money is being spent and how the companies are creating the required jobs. There is also no day-to-day management required and less risk with a Regional Center investment.
EB-5 applicants must demonstrate that their investment is both legal and available by filing an I-526 immigrant petition with U.S. Citizenship and Immigration Services (USCIS) along with evidence such as articles of incorporation, bank statements, asset verification, funds transfers, stock certificates, tax returns, I-9 forms, business plans, or other financial transactions as well as documentation of employees hired and a regional center approval if appropriate. If USCIS approves the petition, then applicants can become two-year conditional residents upon completion of the process.
To become a conditional permanent resident (CPR), an investor can visa process or adjust status. CPR status is valid for two years. Three months before CPR status expiration, investors and their family members must petition for removal of the conditions, which, when approved, affords them full lawful permanent resident status.
While the EB-5 program offers significant economic benefits to both investors and job-seekers, the processing time for an EB-5 permanent resident case has been lagging for the past several years. USCIS’s new EB-5 Director Nicholas Colluci, however, is making changes to the EB-5 program with the intent to improve both efficiency and quality.
As a result of transferring the adjudication of I-526 petitions to the D.C. office, USCIS processing times on EB-5 applications have improved. Unfortunately, the wait time for processing I-526 petitions is still 12.4 months.
Colluci plans to increase staffing in the D.C. office to continue to reduce processing times and advance quality control by hiring staff with backgrounds in economics, securities and immigration law to identify investment projects that are likely to succeed.
If EB-5 demand continues at the current pace and exceeds the supply, USCIS may establish a cutoff date for those investors born in China who account for more than 80 percent of the 10,000 EB-5 visas available. In the past, the predicted establishment of a cutoff date for China EB-5s never occurred because of the slow pace of I-526 approvals.
If USCIS does establish a cutoff date, it will likely occur in August or September of this year. Chinese investors should not be alarmed by the prospect of a cutoff date, however, because a new supply of visas will be available at the beginning of the new fiscal year starting in October, eliminating the shortage.
Successful businesses set prices and then deliver services or produce goods at costs that are lower than these prices. The difference between the cost and the price creates the profit that the business earns as goods and services are sold. To price correctly, most companies develop some type of Cost/Price Model to estimate their costs, and then they apply a markup to calculate the price.
For a new business owner, estimating accurate costs can be difficult because there may be unexpected expenses not included in the initial Model. As owners and companies mature, cost estimates usually become more accurate. Unfortunately, once the Model is trusted, businesses may not re-evaluate or update the cost estimates in their Models. If actual costs increase above the cost estimates, profits can shrink. The income statement, however, can be used to periodically check a company’s Cost/Price Model.
As an example, let’s assume that a company buys steel shelving units and delivers and installs them in customer warehouses. The company has eight installers, and two installers work together on each team. One leased truck is provided per team (4 trucks) and fuel cards are used to purchase gas. The shelves come in different sizes and shapes, and only a small markup can be added to each shelving unit. Most of the profits are earned from the installation service.
A Cost/Price Model is used to quote jobs which includes material costs based on the shelf sizes and estimated direct labor hours including travel time. The labor estimate is multiplied by $50.00 per hour, another $50.00 is added to each job as a trip charge, and a 25 percent markup is added to the total cost estimate to cover all other costs and provide a profit. Last year, the company completed about 1,200 jobs.
To check the Cost/Price Model, we identify those costs on the income statement that we believe are included in the Model, and we calculate average component costs based on some quantity (quantity produced, hours worked, days, etc.). In this example, we know that the company completed 1,200 jobs last year, so we divide the income statement expenses by 1,200 to calculate average costs per job and compare these to the Model. Each number below matches and explains a red circle on the table:
1. An average Cost/Price Model appears on the right. The material cost is estimated at $1,000, installation will take 5 hours, and a $1,687.50 price is calculated.
2. Based on 1,200 jobs, the average material cost per job in 2013 was $900, so the material estimate seems reasonable.
3. All labor and benefit costs are totaled and divided by 1,200 jobs. The Model could be under-valuing labor costs per hour and job, so more research may be needed.
4. Truck, fuel and insurance costs are added and divided by 1,200 jobs. The $100 trip charge in the Model seems adequate.
5. There are Cost of Sales expenses on the income statement that are not specifically estimated in the Cost/Price Model. These costs must be covered by the markup, or there will be an income loss on the job.
6. In this example, the job will be profitable if a price of $1,687.50 is charged. Unfortunately, the average price per job in 2013 was $1,500, so the company had a year-end loss.
By using the year-end income statement as one large Cost/Price Model, you can identify cost estimates that might be inaccurate. In our example, the company might decide to increase its labor rate charged, or add some additional costs to the Model, or increase its markup to increase 2014 profits.
This article deals with Step 4 of our firm’s Six Step Planning Process: Determine whether to transfer your business to “insiders” (family members, co-owners or key employees) or “outsiders” (outside third parties).
Steve Smith was no different than millions of other baby boomer business owners. He daydreamed about transferring the business to his oldest daughter and perhaps to a member of his management team, yet he couldn’t gauge their passion for owning a business and hadn’t tested their management skills.
And, of course, they had no money.
Steve’s company was his economic and financial lifeline. Without its income, without his ability to use the business to accumulate wealth, without the ability to sell his interest to a buyer who had cash, and without a plan, Steve’s wishes would remain wishes.
To Steve, it was obvious that if he ever wanted to exit his business in style, he needed to wait for a white knight buyer to appear on his doorstep bearing saddlebags full of cash. So, Steve did what many, many other owners in his position do: nothing.
If you think that transferring your business to your children or to your management team (insiders) is inherently risky, you are right. Insider transfers are risky because:
1. Insiders typically have no money.
2. Successors’ management / ownership skills and commitment to ownership may be untested.
3. You lose control of the business if you make the transfer before you are completely cashed out.
On the other hand, the possible benefits to this type of transfer include:
1. Keeping the business in your family or extending your legacy through your hand-picked management group.
2. Motivating, retaining and rewarding key employees.
3. Reaping more after-tax money than a third party transfer.
4. Retaining control until all of the purchase price is received.
5. Remaining active in the business while gradually reducing your day-to-day responsibilities.
6. Providing time for you to build up personal assets (via distributions of cash) before your exit.
The trick is to design a plan that minimizes each risk so you can reap all of the potential benefits. Let’s first look at how that might be done.
Insiders have no money; therefore it is too risky to sell to them. That’s true only if you don’t design a transfer strategy that puts money in their pockets as they increase the value of your company. Years in advance of the transfer, you will have to work steadily and effectively to build cash flow (the source for all cash out) through the installation of Value Drivers and through careful planning to minimize taxation.
Unless you carefully plan to avoid it, cash flow can be taxed twice. This double tax (sometimes totaling more than 50 percent) can spell disaster for many internal transfers. Through effective tax planning, however, much of this tax burden can be legally avoided.
Finally, you and your advisors should use a modest, but defensible valuation for the company. Because a lower value is used for the purchase price, the size of the tax bite is correspondingly reduced. The difference between what you will receive from the sale of your business, at a lower price, and what you want to be paid to you after you leave the business is “made good” through a number of different techniques to extract cash from the company after you leave it.
Successor’s management/ownership skills are untested. If that’s the case, create a written plan to systematically transition management and ownership responsibilities to your successor—beginning today. The transition period, during which you test both your assumptions and your successors’ skills, usually takes several years to complete.
You lose control before being cashed out. This is only true if you (and your advisors) fail to implement a transfer strategy designed to accomplish the opposite: you should be cashed out before you lose control. In such a plan, you keep control, in part through a well-designed and incremental sale of the company, over time, based upon improving company cash flow over time. You can also retain control with much less than a 51 percent ownership by recapitalizing the company into voting and non-voting stock and selling the voting shares last.
The keys to reducing the risks of an insider transfer necessary to achieve success are:
1. Plan the transfer well in advance of your desired exit date. Executing an insider transfer takes longer than executing a sale to a third party.
2. Value building activities are just as—if not more—important to an insider transfer as they are to a sale to a third party.
3. Plan design must be tax sensitive.
4. The plan must be in writing and make owners (and advisors) accountable.
This article deals with the final aspect of Step 3 of our firm’s six step planning process for helping business owners create an optimum succession plan for their business and exit plan which best meets their business and personal objectives. To recap:
Step 1: Help the business owner identify his/her life objectives including retirement income, manner of disposition of the business, and non-economic life objectives which add significance to the owner’s life;
Step 2: Determine where the owner (and business) is now and what the gap is in terms of meeting the owner’s economic retirement objectives; and
Step 3: Determine what steps the owner should consider to fill the gap by increasing the value (and selling price) of the business.
Last month we discussed key “value drivers” that qualified buyers look for in a business which increases the business’ value by increasing Return (profitability) or lowering Risk.
The value of your business to a potential buyer is directly related to the predictability that historical profitability will continue or increase in the future. Therefore, lowering the Risk that your cash flow will be interrupted (or decreased) in the future increases value.
This month’s article focuses on additional steps a business owner should take to reduce Risk as soon as he/she decides to sell his Company—conducting “due diligence” on his/her own business.
A qualified buyer will not normally buy a company without first learning everything there is to know about that company. That learning process is known as due diligence. During due diligence a buyer, his accountant, his lawyer and any other professional advisor he employs will examine every aspect of every contract, procedure, relationship, plan, legal structure, system, lease, employment policy and manual, tax returns, financial statements, etc.
This process requires an extraordinary amount of time and attention on both the buyer’s and the seller’s parts. That’s why we recommend that owners initiate the due diligence process as soon as they decide to sell their companies and have an indication from a transaction intermediary that the business is salable for sufficient money to meet their financial security wishes and needs.
Starting the due diligence process well before the buyer requests documents gives sellers the opportunity to remove any obstacle (i.e., clean up any messes) that might prevent a buyer from traveling a straight path to closing. Keeping the road to closing free from unnecessary impediments compresses the time between the buyer’s offer and the closing. In a sales transaction, time rarely favors the seller, so owners want to condense the process.
Buyers are looking for the skeletons in your closet and are very skilled at finding them. They are looking for malfeasance or undisclosed material risks. They will look for fraud (on the part of an owner or manager) or any misrepresentations you have made such as improperly recognized revenues or expenses, and any information you have omitted, such as: unpaid taxes, pending or threatened litigation or obsolescent business equipment, processes, products or services.
The buyer is also looking for information that would affect the value of the company and the advisability of purchasing it. Up to the moment due diligence begins, you have controlled the information flowing to the buyer. You give up much of that control during the buyer’s due diligence.
Finally, if the buyer’s search for malfeasance, misrepresentations or information that would affect the company’s value yields no results, the hunt is on for anything that the buyer could use to lower the price or improve its terms. And that ulterior motive—lowering price and improving the buyer’s terms—permeates the entire due diligence process. Is it any wonder that sellers hate (and that is not too strong a word) this process?
And, is it any wonder that we strongly suggest (as we do) that you and your advisors clean up every contract, agreement, stock book, record of corporate actions, manual, lease, or threatened law suit before you take your company to market?
If you have any questions about the extent or value of the due diligence process, please contact an experienced transaction attorney.
Next month we will discuss Step 4 of the six step planning process, who you want the business going to at retirement—a sale to an outside third party or a transfer to insiders?
Company owners, managers, bankers, and investors often talk about profits or income when discussing the financial performance of a business, but each may focus on very different numbers. As a continuation of last month’s article, we will now look at two other earnings ratios: net profits and margins and EBITDA.
We will define each term by using two sample companies in the coffee roasting business (see chart). Either company can be viewed as the better performing firm based on the earnings ratio that is selected.
Net Income is operating income less interest expense and taxes. Some company owners focus on this figure because they feel it reflects the final amount of money that the business earned. Unfortunately, income and cash flow does not always match, so owners can have positive net profits, but a negative cash flow. Positive net income should later generate a positive cash flow, but the company must successfully convert its working capital (accounts receivable plus inventory minus accounts payable) to cash at the levels reflected on the financial statements.
Net Margin is calculated by dividing net income by revenue. Company A’s net income and net margin are higher than Company B’s. Since both paid the same taxes, Company B’s higher interest expense is a significant difference.
EBITDA is Earnings Before Interest, Taxes, Depreciation and Amortization, and while it may not appear in a company’s financial statement, this figure is often used by bankers and investors. EBITDA removes the effects of financing costs (interest expense) and location costs (taxes) from earnings and adds back “non-cash” deductions to income (depreciation and amortization).
EBITDA gives an indication of a company’s future cash flows from operations while removing the effects of financing costs and taxes that may vary by location or company structure. Looking at the components that make up EBITDA is also helpful. For example, Company B had higher interest expense. Is this because Company B is more risky from a credit standpoint, or has it financed additional or newer equipment that might later make it more efficient?
EBITDA / Revenue: EBITDA is dividing by revenue to compare different sized firms. While Company A’s net income and net margin was greater, Company B performs better from an EBITDA perspective.
While no single earnings ratio can explain a business’s overall financial performance, gross profit and operating income (discussed last month) and net income do show total dollars earned at various levels of a company’s operation. Gross, operating and net margins, however, are needed to make comparisons between companies with different revenue levels.
In our example, as we moved through each earnings ratio, the most financially profitable company switched from Company A (higher gross margin) to Company B (higher operating margin) to Company A (higher net margin) and finally to Company B (higher EBITDA and EBITDA / sales).
Today, EBITDA is probably most often used when small business earnings are discussed by bankers and investors, because EBITDA gives an indication of the cash flow being generated from a company’s operations.
It also serves as a good ratio for owners and managers to compare themselves against past periods and others in their industry, because non-cash expenses (depreciation and amortization) are added back to earnings and financing costs (interest) and governmental costs (taxes) are subtracted to show net earnings generated by the company.
Company owners, managers, bankers, and investors often talk about profits or income when discussing the financial performance of a business, but each may focus on very different numbers. While gross profits, operating income, net income and EBITDA all relate to earnings, each emphasizes a different aspect of financial performance.
We will define each term by using two sample companies in the coffee roasting business (see chart). Either company can be viewed as the better performing firm based on the earnings ratio that is selected.
Gross Profit is revenue minus the cost of making a product or selling a service. This is profit earned after direct expenses such as manufacturing labor, materials, supplies and some direct overhead costs are subtracted from revenue. These direct costs are usually referred to as Cost of Goods or Cost of Sales. Wages paid to workers who harvest, roast and package coffee beans, bag and box costs, maintenance costs, and other expenses incurred during the harvesting and packaging process might all be included in cost of goods. In our example, Company A is best, because its gross profit is $165,000 higher.
Gross Margin is calculated by dividing gross profit by revenue, and gross margin allows companies with different revenue levels to be compared. Since Company A has higher revenue, you would expect its gross profits to be higher; its 34.2% gross margin confirms that Company A earns $0.342 gross profit per revenue dollar while Company B earns only a $0.326 gross profit per revenue dollar.
An investor might consider Company A more attractive if he thinks he can significantly increase either company’s revenues, because additional revenue at Company A will generate more gross profit than at Company B. It is important, however, to know the specific costs that are included in costs of goods when making this comparison. In our example, Company B could be including expenses in its costs of goods that Company A includes in Selling, General and Administrative expenses (SG&A). For an accurate comparison, the gross margins must be calculated using similar costs.
Operating Income is gross profit less all selling, general and administrative expenses. These expenses include costs not directly related to making a product or delivering a service. Coffee manufacturers might include rent, management and sales wages, bank fees, advertising and travel expenses, accounting and legal fees, utilities, etc. as part of SG&A. Company B’s operating profit is $15,000 higher than Company A.
Operating Margin is calculated by dividing operating income by revenue. Again, operating margin provides a way to compare companies with different revenue levels to determine who performed best after most expenses are subtracted. Company B has both a higher operating profit and a better operating margin. While Company A was able to produce more profitable products during the manufacturing process (higher gross margin), they are now less profitable from an operating perspective, because their SG&A costs are higher than Company B. A bank or investor might now be more impressed with Company B, because its operating margin is 0.5% higher than Company A’s.
While no single earnings ratio can explain a business’s overall financial performance, gross profit and operating income do show total dollars earned at two different levels of a company’s operation. Gross margins and operating margins, however, are needed to make comparisons between companies with different total revenue.
In our example, when we switched from one earnings ratio to another, the most financially profitable company switched from Company A (higher gross margin) to Company B (higher operating margin). It is important, however, to know the specific costs that are included in cost of goods and SG&A to make an accurate comparison between companies.
Next month, we will use this same example to look at net income, net margin and EBITDA.