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August 2007
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Reducing Risk Will Pay off at the Closing Table
When considering the idea of selling your company, it is important to understand that the relationship between risk and cash flow will likely be the main consideration in determining its value. Depending on the size of the company, Seller’s Discretionary Cash Flow, EBITDA, or EBIT are all standard levels of adjusted cash flow potential buyers will look at as the basis for determining value.
Ultimately, it is the present value of these future cash flows that a potential buyer is purchasing. The buyer also has to assess the risk associated with your company’s ability to actually generate these future cash flows. Generally, the first step in this process is to normalize the company’s Income Statement to eliminate or adjust for discretionary (personal), non-recurring, and non-business related expenses (“add backs” or “adjustments” are common terms for these items). Traditionally, larger companies have few adjustments during the normalization process, whereas smaller companies generally are the opposite.
You might assume that a higher value is associated with more cash flow, but that is not necessarily true. Consider two companies listed for sale that are identical in every area except risk. Here is a summary of the Income Statements for each:
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Company A
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Company B
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Sales
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$5,000,000
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$5,000,000
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COGS
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$1,000,000
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$1,000,000
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Gross Profit
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$4,000,000
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$4,000,000
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SG&A
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$3,750,000
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$3,950,000
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Taxable Income
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$250,000
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$50,000
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Excess Officer Salary
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$250,000
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$250,000
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Depreciation
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$150,000
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$150,000
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Interest
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$100,000
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$100,000
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Auto
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$50,000
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T&E
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$50,000
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Non-Op Salaries
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$100,000
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EBITDA
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$750,000
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$750,000
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After normalization, both companies have an EBITDA of $750,000. When looking at the Income Statement of Company A, we find that the only adjustments made are for excess Officer’s Salary, Depreciation, and Interest (where Depreciation is a non-cash charge and the buyer is purchasing the company on a debt-free basis) . When looking at the Income Statement of Company B, we find that in addition to excess Officer’s Salary, Depreciation, and Interest, there are other adjustments totaling $200,000, including personal automobile expense, non-business related travel and entertainment, and non-operating salaries (for the owner’s family).
In the scenario above, which company do you think has more value? Company A would be the correct choice because it has cleaner financial records. As a result, Company A’s adjusted cash flow levels are considered less risky; hence, it carries a greater value. Let’s say in this same example that Company B has been in a declining trend for the last two years, where Sales and EBITDA have declined by 25%. Combine that trend with the $200,000 in additional adjustments and you have significant financial risk, which may result in a very conservative valuation.
Now, let’s take the same scenario and change the dynamics. In this example assume that both companies are identical, including the $750,000 in EBITDA, and the only adjustments being made are for excess Officer’s Salary, Depreciation, and Interest. The Income Statements for both companies are shown below:
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Company A
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Company B
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Sales
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$5,000,000
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$5,000,000
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COGS
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$1,000,000
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$1,000,000
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Gross Profit
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$4,000,000
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$4,000,000
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SG&A
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$3,750,000
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$3,750,000
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Taxable Income
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$250,000
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$250,000
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Excess Officer Salary
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$250,000
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$250,000
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Depreciation
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$150,000
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$150,000
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Interest
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$100,000
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$100,000
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EBITDA
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$750,000
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$750,000
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Assume that Company A generates 40% of its annual revenues from a single customer, while Company B’ s top customer represents only 8% of annual sales. Which company is more valuable under this scenario?
Company A carries more risk because of a customer concentration issue . If Company A were to lose that key customer, $ 2,000,000 of annual sales (and corresponding profit ) would be lost – something that the company might have a hard time recovering from in a short period of time.
This increased risk would likely result in a lower valuation. This may seem like an obvious outcome, but people frequently over look this key piece of information. As a business owner, it is important to re member that risk will impact a company’ s value. Risk can come in many f orms, such as financial risk, management risk, technological risk, and industry risk. When risk (above and beyond the general risk associated with investing in privately-held companies) can be identified, the severity of that risk will have an effect on the company’s value in one way or another. Since profitability and resulting cash flo w are the most significant drivers of a company’s value, it is important to eliminate as much risk associated with the company’s cash flow as possible before selling your company. Therefore, if you are considering selling your company, make one last investment before you place it on the market. Take the time to prepare the company for sale. Common activities include organizing the facilities (inside and out), renegotiating vendor contracts, reducing customer concentration, securing key employees, and, most importantly, cleaning up the company’s Income Statement. All of this may take anywhere from one to three years, but it is worth it. A well-organized company, with three years’ worth of clean and profitable financial records, will carry a significantly enhanced value. Do not let increased taxes be an excuse! The increase in value resulting from your time and effort in preparing the business for sale will far outweigh the taxes you will pay.
Darren Mize is an Accredited Senior Appraiser (ASA) and is the Managing Partner of Gulf Coast Financial, a full service business valuation firm based in Tampa , Florida, serving Business Intermediaries, Banks, CPAs and Attorneys nationwide. |
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Tax Law Changes: Small Business and Work Opportunity Tax Act 2007
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Congress passed the Small Business and Work Opportunity Tax Act of 2007 in late May. This act is designed to provide relief to small business owners by of setting a portion of the scheduled minimum wage increases. More information is available at the Senate Finance Committee’s website, finance.senate.gov. A summary of the act’s features are listed below:
| Favorable Provisions |
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Unfavorable Provisions |
• Section 179 – One-year extension through 2010. Increase in expensing limit and phase-out level.
• Fa mily Partnerships – Married couples can file as a sole proprietorship. Both spouses receive credit for paying Social Security and Medicare taxes.
• S Corporations – Several modications to maintain tax benefits of being an S Corporation.
• Work Opportunity Tax Credit – Extended until August 31, 2011. Credits to employ ers who hire disabled veterans and individuals in counties with significant population loss.
• Employer Tip Credit – Employers will receive full tip credit despite minimum wage increases.
• Alternative Minimum Tax – WOTC and Employer Tip Credit can be used to reduce AMT liabilities. |
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• Kiddie Tax – Raises the age to under-19 (under-24 if a full-time student) at which income in excess of $1,700 is taxed at parent’s rate.
• Erroneous Refund Claim Penalty – A new penalty for refunds filed without any reasonable basis.
• Suspension o f Interest and Penalties – IRS is able to charge interest and penalties for 36 months after a delinquent tax return is filed.
• Employment Tax Levy Hearings – IRS is no longer required to hold a collection due process hearing before issuing a levy on delinquent employment taxes.
• IRS User Fees – IRS has legal authority to charge user fees.
• Minimum Bad Check Penalty – The minimum penalty for issuing bad checks or money orders to the government is $25.
• Preparer Penalties – Expands preparer penalties to all types of tax returns . |
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Entrepreneurial Activity in the U.S.
A recent study by the Ewing Marion Kauman Foundation found that approximately 465,000 new businesses were started each month in 2006 – a ratio that has remained consistent over the past decade. According to the Kaum an Index of Entrepreneurial Activity, Montana, Mississippi, Georgia, Oklahoma, and Maine had the highest rates of entrepreneurial activity. In contrast, Michigan, Pennsylvania, South Carolina, Illinois, and Delaware recorded the lowest rates of activity. Regionally, the Midwest experienced an overall decline in entrepreneurial activity and recorded the lowest level of activity of all regions. Over the past decade, entrepreneurial activity has increased the most in Mississippi, Hawaii, Rhode Island, and Arkansas. Alaska, North Daota, New Mexico , Tennessee, and Kansas have experienced the largest declines in activity during the past ten years. Throughout the U. S., the construction industry experienced the highest level of entrepreneurial activity. Conversely, the manufacturing industry experienced the lowest levels of activity. More information about this study and the Ewing Marion Kauffman Foundation is available at their website, www.kauffman.org. |
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Making Business Connections
The Internet continues to influence the business world, including how small business owners and professionals network. A variety of websites have been specifically developed to target the networking needs and other interests of today’s working men and women:
• Conenza - An alumni community platform offering news, networking, events, job and resume postings, and other career resources.
• Ecademy - This website connects business owners through networking, clubs, meetings, and blogs.
• Konnects - Develop an online community for your organization and share documents, and employment, and much more.
• LinkedIn - Search for colleagues, a new job, and expert industry advice.
• Ryze - Create a networking-oriented homepage to make new business contacts and reconnect with friends and colleagues.
• Xing - This site allows you to market yourself professionally, as well as manage and expand your network. |
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Mergers
