To walk or not to walk? In negotiations, go with your instinct but check these signs.

Gary Miller

The Denver Post | BUSINESS

POSTED:  August 20, 2017, at 12:01 pm

by Gary Miller | GEM Strategy Management

Prepare long before you start the negotiation process 

It was late. Time was running out and negotiations weren’t going well. It was Larry’s third trip to the headquarters of his acquisition target to hammer out the final terms and conditions of the deal.

After three days of going back and forth, it seemed that Wayne, owner of the target company, was picking away at the purchase price from every possible angle. Both men were tired and becoming increasingly frustrated with the negotiation process. After some consideration, Larry, having run out of patience, stood up and abruptly ended the meeting and led his deal team out the door.

This is an old and familiar story.

In business, buyers and sellers must be able to know when or when not to walk away from a deal. It is key – whether that means deciding against an acquisition that on paper would create significant synergies, or when the price is becoming unreasonably high. Other reasons to walk away include culture misalignment, a toxic workplace or due-diligence that reveals major problems. For the most part, you can go with your gut instincts. But there are other signs to look for that aren’t as obvious.

Below are six recommendations that could prevent you from walking away from a potentially good deal or signal that walking away is your best option.

  1. Prepare long before you start the negotiation process. Knowledge is power. The more knowledge you have the more leverage you have when negotiating. Research your acquisition target and the industry carefully; learn who are the major players and examine the major trends that might affect your current business strategy — with or without an acquisition. If trends are changing significantly, then an acquisition could be less expensive in the long run than attempting to adapt to those changes without an acquisition.
  2. Establish with your deal team what things are deal breakers before you begin negotiations. Identifying the potential deal breakers early can save everyone time, effort and money, not to mention the stress of a high-stakes negotiation that winds up breaking down. For example, not having a walk-away price might lead to giving away too many concessions during the negotiation process. Be sure to cost out each concession before granting it so that the concessions do not exceed your walk-away number. Having a firm number is absolutely crucial.
  3. Establish a rigorous due-diligence process that goes beyond verifying the financials, operations, customer records, sales and marketing forecasts, disaster recovery, cyber security and other items before you enter into negotiations. Too often, due-diligence becomes an exercise in verifying the financial statements and a few other items, rather than conducting a fair analysis of the company’s strategic value and the logic supporting the strategy. For example, does this acquisition fit my growth profile and strategic business plans? Can the acquisition deliver results on schedule to deliver the value I need? Deal-making is glamorous; due diligence is not.
  4. Develop a binding detailed letter of intent (LOI) subject to a satisfactory due-diligence review vs. a term sheet (TS), which often is more like a skeleton to be filled in later. The LOI is more detailed and focuses almost exclusively on the major business issues vs. the legal issues. Legal issues, business terms and conditions, representations and warranties are addressed in the definitive purchase and sale agreement that follows the LOI. The LOI can flush out major issues early that are going to be difficult.
  5. Determine how much time and effort will be necessary to realize the synergies expected from the acquisition. Ask yourself, is this a cultural fit for my company? Are we in alignment with common goals? Does this acquisition fit our criteria? What am I really buying?
  6. When you do enter into negotiations be constantly aware of inconsistencies during the process. Inconsistencies can be the root of future problems and could be a sign of trouble to come.

Deal-making is as much art as science. If you decide to walk, you’ve said “no.” And “no” is a very powerful word.

But it doesn’t necessarily mean it’s over. By walking away from a potential deal, you’ll learn how much the other party wants to work with you. I’ve walked enough times that I’ve learned to appreciate the power of “no.” If the target is seriously interested in working with you, pulling out will force them to try to get you back. Or they’ll be relieved and let you walk. Either way, you’ll get resolution.

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. If you have questions, he can be reached at 970-390-4441 or gmiller@gemstrategymanagement.com.

 

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How to Negotiate Concessions to Close Better Deals

By Gary Miller, GEM strategy Management, Inc. | Axial Forum August 9, 2017

Strong negotiating skills are often the single most important differentiator between closing good deals vs. great deals — or not closing any deal at all. Negotiation is more art than science, as it involves creatively reading your audience, knowing when to dig in, and when not to. Often, I have been called in to help close a deal or save a deal. Many times, I have found that both buyers and sellers, engaged in trying to make a deal, are so locked in their positions that there is little opportunity for give and take. Feelings are strained, attitudes are entrenched, respective positions are hardened, and therefore opportunities for compromise are lost.

For any negotiation to work successfully, both parties need to feel they are getting a good deal. The deal can’t be lopsided for it to have any reasonable chance for success. Structuring deals means working towards a win-win outcome for both parties.

This brings us to the art of compromising with concessions.

Concessions are almost always necessary to complete any successful transaction. You have to be willing to make concessions to get concessions in return. But the process isn’t easy.

First, don’t assume that your actions will speak for themselves. Often, concessions go unappreciated and unreciprocated. Unless you establish that you have made a major concession, your counterparts will be motivated to overlook, ignore, or downplay your concessions. Why? They want to avoid the strong social obligation to reciprocate.

Emphasize the benefits of your concessions to the other side. My own research suggests that negotiators reciprocate concessions based on the benefits they receive, while ignoring how much others are sacrificing. One way for an owner to highlight the benefits he is providing is to contrast his offer with those made by similar firms (assuming they were lower).

Second, don’t give up on your original demands too hastily. Timing is important in any negotiations. Every deal has a life of its own. If the other side sees your first offer as frivolous, your willingness to move away from it too soon will not be seen as concessionary behavior. By contrast, your concessions will be more powerful when your counterpart views your initial demands as serious and reasonable. So when you give a concession, let it be known that what you have given up (or what you have stopped demanding) is costly to you. By doing do, you clarify that a concession was, in fact, made.

Third, demand and define reciprocity. Establishing the fact that you have made a major concession in itself helps trigger an obligation to reciprocate, but sometimes your counterpart is slow to act on the obligation. To increase the likelihood that you get something in return for your concessions, try to explicitly — but diplomatically — demand reciprocity.

Consider the following negotiation between an IT services firm and a client. The client suggests that the IT firm’s cost estimates are unreasonably high; the IT firm believes that the cost estimates are accurate (even conservative) given the complexity of the project and the short deadline. If the IT project manager is willing to make a concession, she might say: “This isn’t easy for us, but we’ve made some adjustments on price to accommodate your concerns. We expect that you are now in a better position to make some changes to the project deadlines. An extra month for each milestone would help us immeasurably.”

Notice that this statement achieves three goals:

  1. It establishes that a concession was made (This isn’t easy for us, but we’ve made some adjustments . . .”).
  2. It tactfully demands reciprocity (“We expect that you are now in a better position to make some changes . . .”).
  3. It begins to define the precise form that reciprocity should take (“An extra month for each milestone . . .”).

Remember that no one understands what you value better than you. If you don’t speak up and define what reciprocity means to you, you’re going to get what your counterpart thinks you value or, worse, what is most convenient for your counterpart to give.

Ideally, negotiating parties establish an environment where they do not nickel and dime one another throughout the process. Rather, each side learns about the interests and concerns of the other and makes good-faith efforts toward achieving joint gains. Unfortunately, this is not always possible because one side or the other is not negotiating in good-faith. When trust is low, or when you are in a one-shot negotiating scenario, I recommend clients make contingent concessions. A concession is contingent when you state that you can make it only if the other party agrees to make a specified concession in return.

Contingent concessions are almost risk-free. They allow you to signal to the other party that while you have room to make more concessions, it may be impossible for you to budge if reciprocity is not guaranteed.

A final negotiating technique I use is giving concessions in installments. Extensive research by the late Stanford University professor Amos Tversky and the Princeton University professor Daniel Kahneman indicated that while most of us prefer to get bad news all at once, we prefer to get good news in installments. This finding suggests that the same concession will be more positively received if it is broken up into parts and offered at different times in the process.

There are other reasons to make concessions in installments. Most negotiators expect that they will trade offers back and forth several times before the deal is finished. Installment concessions may lead you to discover that you don’t have to make as large concessions as you thought. When you give away a little at a time, you might get everything you want in return before using up your entire concession-making capacity. Whatever is left over is yours to keep.

The above strategies are aimed at guaranteeing that the concessions you make are not ignored or exploited. Effective negotiators ensure not only that their own concessions are reciprocated, but also that they acknowledge and reciprocate the concessions of others.

About the Author

Gary Miller is the CEO of GEM Strategy Management, Inc., an M&A business consulting firm, advising middle-market private business owners on how to sell their businesses for the highest valuation, buy companies and source capital for growth and expansion. He is a sought-after consultant/speaker on M&A issues, strategic business planning, business valuations, exit planning, what buyers are looking for in acquisitions & how to prepare for due diligence. He can be reached at 970-390-4441 or gmiller@gemstrategymanagement.com

 

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In negotiations, making concessions and reciprocating can lead to great deals

The Denver Post | BUSINESS

Posted on July 16, 2017, at 12:01 am

Negotiators should reciprocate concessions based on the benefits they receive

By GARY MILLER | GEM Strategy Management

Strong negotiating skills are often the single most important differentiator between closing good deals vs. great deals, or, not closing any deal at all. Negotiation is more art than science, as it involves creatively “reading” your audience, knowing when to dig in, and when not to. Often, I have been called in to help close or save a deal. Many times, I have found that both buyers and sellers are so locked in their positions that there is little opportunity for give and take. Feelings are strained, attitudes are entrenched, respective positions are hardened and therefore opportunities for compromise are lost.

For any negotiation to work successfully, both parties need to feel they are getting a good deal. The deal can’t be lopsided, for it to have any reasonable chance of success. I advise clients that structuring deals mean working towards a win-win outcome. This brings us to the art of compromising with concessions.

Concessions are almost always necessary to complete any successful transaction. While most business owners understand that negotiation is a matter of give-and-take, you have to be willing to make concessions to get concessions in return. But the process isn’t easy. Often, concessions go unappreciated and unreciprocated. Don’t assume that your actions will speak for themselves. Unless you establish that you have made a major concession, your counterparts will be motivated to overlook, ignore or downplay your concessions. Why? Your counterparts want to avoid the strong social obligation to reciprocate.

Emphasize the benefits of your concessions to the other side. My own research suggests that negotiators reciprocate concessions based on the benefits they receive while ignoring how much others are sacrificing. One way for an owner to highlight the benefits he is providing is to contrast his offer with those made by similar firms (assuming they were lower).

Second, timing is important. Every deal has a life of its own. Don’t give up on your original demands too hastily. If the other side sees your first offer as frivolous, your willingness to move away from it too soon will not be seen as concessionary behavior. By contrast, your concessions will be more powerful when your counterpart views your initial demands as serious and reasonable. So when you give a concession, let it be known that what you have given up (or what you have stopped demanding) is costly to you. By doing so, you clarify that a concession was, in fact, made.

Third, demand and define reciprocity. By establishing the fact that you have made a major concession helps trigger an obligation to reciprocate; but sometimes your counterpart is slow to act on the obligation. To increase the likelihood that you get something in return for your concessions, try to explicitly – but diplomatically – demand reciprocity.

Consider the following negotiation between an IT services firm and a client. The client suggests that the IT firm’s cost estimates are unreasonably high; the IT firm believes that the cost estimates are accurate (even conservative) given the complexity of the project and the short deadline. If the IT project manager is willing to make a concession, she might say: “This isn’t easy for us, but we’ve made some adjustments on price to accommodate your concerns. We expect that you are now in a better position to make some changes to the project deadlines. An extra month for each milestone would help us immeasurably.”

Notice that this statement achieves three goals. It establishes that a concession was made, it tactfully demands reciprocity and it begins to define the precise form that reciprocity should take. While each of these elements is critical, negotiators often overlook the need to define reciprocity. Remember that no one understands what you value better than you. If you don’t speak up, you’re going to get what your counterpart thinks you value or, worse, what is most convenient for your counterpart to give.

One hallmark of a good negotiation is to establish an environment among the negotiating parties of not nickeling and diming one another through the negotiating process. Rather, each side learns about the interests and concerns of the other and makes good-faith efforts toward achieving joint gains. Unfortunately, this is not always possible because one side or the other does not negotiate in good faith. When trust is low, or when you are in a one-shot negotiating scenario, I recommend clients make contingent concessions. A concession is contingent when you state that you can make it only if the other party agrees to make a specified concession in return.

Contingent concessions are almost risk-free. They allow you to signal to the other party that while you have room to make more concessions, it may be impossible for you to budge if reciprocity is not guaranteed.

A final negotiating technique I use is giving concessions in installments. Research by Amos Tversky and Daniel Kahneman indicates that while most of us prefer to get bad news all at once, we prefer to get good news in installments. This finding suggests that the same concession will be more positively received if it is broken into installments.

The above strategies are aimed at guaranteeing that the concessions you make are not ignored or exploited. Effective negotiators ensure not only that their own concessions are reciprocated, but also that they acknowledge and reciprocate the concessions of others.

Gary Miller is the CEO of GEM Strategy Management Inc., an M&A consulting firm advising middle-market private business owners. He can be reached at gmiller@gemstrategymanagement.com.

 

 

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Business owners often cheat themselves by not getting a business valuation

Every business owner should obtain a professional valuation

The Denver Post | BUSINESS

By Gary Miller | GEM Strategy Management

June 18, 2017

Gary Miller

Your local assessor’s office has a record of what your house is worth. The popular automotive Blue Book tells you what your car is worth. Articles in Consumer Reports and personal finance magazines provide the pricing data you need to find the best deals on refrigerators and BBQ grills, how to compare the cost of mutual funds and even where to find the best values in college education. So why is it that most small-business owners don’t know what their businesses are worth? The answer is simple: Most business owners don’t want to spend the time or money to obtain a professional, independent, third-party valuation.

This is a big mistake.

Every business owner should obtain a professional valuation, especially at the time he or she decides to sell the business. Valuing your business accurately is essential if you don’t want to risk leaving money on the table by valuing it too low or scaring away potential buyers by valuing it too high. But there are other important reasons for having an up-to-date business valuation on hand. It should be conducted at least every two years. Here are the main reasons:

  1. A major event could happen to the owner. If the owner dies, faces health issues or becomes incapacitated, major changes in the business operations are affected. Having a current business valuation would help the family deal with the potential sale of the business.
  2. An opportunity to sell or merge could come unexpectedly. Often owners are faced with having to make a decision to sell quickly.  An up-to-date valuation allows you to take advantage of that opportunity and will help you negotiate the transaction with potential buyers.
  3. A partner or family members could join the business.  This situation necessitates knowing the value of your business to determine the buy-in price.
  4. A partner or shareholders could leave the business. You will need to know the value of your business to determine the value of the departing partners/shareholders’ membership interests/shares in order to pay them out.
  5. An exit strategy could be on the horizon. You may be reaching a time when you are considering retirement. Knowing the value of your business will help you construct an exit strategy, examine estate plans and minimize tax obligations. In many cases, the value of a business represents a sizable percentage of your net worth, so working on an estate plan is impossible without an accurate valuation.
  6. A loan could be needed for expansion of the business. Often, banks require an up-to-date business valuation as a part of the loan decision process.
  7. A weather disaster could interrupt the business. After a business disaster — like the storm damage that closed Colorado Mills in Lakewood in May — it is very useful for insurance purposes, particularly if you have business continuation insurance.
  8. A divorce could occur. If you are dealing with divorce settlement issues, you will need an independent valuation of the business to assure both parties that the value has been obtained fairly.

While all of these are compelling reasons to seek a business valuation, it’s still easy to put it off. After all, valuing a business is much more complex than thumbing through a Blue Book to value your car.  I often find that business owners don’t know where to go to find valuation experts. I recommend that they look for those with certifications such as Accredited Business Valuation (ABV) and/or Certified Valuation Analysts (CVA).

Some owners turn to their accountants or their lawyers for valuation advice. In my experience, accounting firms tend to be too conservative and undervalue their clients’ businesses. Law firms, on the other hand, tend to be too optimistic and overvalue their clients’ businesses. They may fail to properly estimate qualitative factors including the general economy, industry conditions, company size, financial performance, management experience and business drivers.

Keep in mind that if you sell to a larger company, you’ll probably be dealing with an acquisition team that uses sophisticated financial analyses and modeling. The company will be much more impressed with your management ability if you have a detailed valuation prepared using earnings-based valuation models. The models include comparing your company to publicly traded companies in your industry; comparing your company to previous mergers and acquisitions transactions (much like “comps” in the real estate industry); a discounted cash-flow analysis analyzing future cash-flow streams; and a leveraged buyout model that computes the value of your business based on how much acquisition debt your business can support.

On the other hand, remember that value is in the mind of the beholder. A professional valuation can tell you the price that an average buyer might pay for your business. When it comes to negotiating with an actual buyer, the valuation is just a starting point. A particular buyer might have a strong strategic reason for acquiring your company and might be willing to pay a premium over what the average buyer might offer. Another buyer might simply be looking for certain assets to augment his or her own business and might not be willing to pay for your company’s enterprise value (total value) at all.

The final excuse for not securing a business valuation is that you’re “too busy” running the business to concentrate on the valuation process.

Think about that.

Remember, you have spent years, even decades building your business. It is your life’s blood. If you don’t take care of it, you could lose much of the value you’ve built.

Gary Miller is the CEO of GEM Strategy Management, Inc., an M&A consulting firm, advising middle-market private business owners prepare to raise capital, sell their businesses or buy companies. If you have questions, he can be reached at 970-390-4441 or gmiller@gemstrategymanagement.com.

http://www.denverpost.com/2017/06/18/business-valuation/

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Alternative online lenders can be a good option for small businesses, but mind the details

Gary Miller

The Denver Post | BUSINESS

Pitfalls can include much higher interest rates and hefty fees, but some options are doable

By GARY MILLER | GEM Strategy Management

POSTED:  May 21, 2017, at 5:00 am

It was Friday afternoon when Bob received the call from his bank telling him that he had been turned down for his $250,000 loan request. He had purchased a second location as part of his business expansion plans and needed the bank loan to purchase inventory for his new location.

Bob was devastated.

Why had it taken over two months for the bank to say no? The bank’s reason for turning down the loan request was that they were not comfortable making an inventory loan of that size. He couldn’t understand why the bank wouldn’t work with him. He had good credit. The business was profitable, and it had shown solid growth for over 10 years.

Worse still, time was running out to purchase the inventory at a steep discount from a competitor going out of business. He needed the money in a week to close the deal. Where could he turn to get a $250,000 loan in a week?

Small businesses are core to America’s economic competitiveness. According to the Small Business Administration, small businesses make up 99.7 percent of U.S. employer firms. Yet in recent years, small businesses have been slow to recover from the Great Recession and credit crisis that hit them especially hard.

For decades, small businesses could only look to traditional banks, credit unions, the SBA, credit cards, or in a few cases, factoring firms, (who purchase your receivables in exchange for immediate cash) to meet their capital needs. Recently, however, a massive wave of new national and highly scalable alternative online lenders (non-bank companies) has entered the market. These alternative lenders offer higher acceptance rates and faster capital deployment (one to 14 days) than traditional lenders, and as a result, have seen tremendous growth in the market over the past five years. The alternative lending industry now stands at $1 trillion dollars, according to CrunchBase, which monitors public and private companies globally.

In a recovering economy where big banks are restricted by complex regulations (Dodd-Frank), small businesses are turning to alternative lenders that are upending banks’ conservative lending standards by automating loan approvals. Instead of relying on collateral and credit scores, these cash-flow lenders use software that reviews online sales, banking transactions and comments on social media sites among other criteria, to make loan decisions within minutes instead of weeks or months.

With most alternative lenders, borrowers apply for loans online and usually receive an answer the same day. If approved, funds are available anywhere from a day up to a couple of weeks, depending on the size of the loan.

Alternative lenders generally fall into two categories: (1) peer-to-peer lenders like Lending Club, Funding Circle and Prosperous, which raise funds from groups of investors that lend money to businesses from individual investors or (2) direct lenders like On Deck, Kabbage and Balboa, which lend money to businesses from funds raised by institutional investors.

Alternative lenders make loans from $2,000 to $5 million for all kinds of business needs. Loan types include purchase order financing, export financing, inventory purchasing, equipment purchases or leasing, credit insurance, cash advances, working capital, lines of credit and growth and expansion plans.

While specific statistics are hard to pin down, there are about 1,300 alternative lenders. They compete for about 1 percent of the overall credit market, compared to about 6,500 traditional banks competing for the remaining 99 percent. Banks decry these loans and insist that the alternative lending industry is serving what traditional banks call “unbankable loans” – loan requests that commercial banks will not consider.

Since the alternative lending market is becoming overcrowded, it is hard for these companies to differentiate themselves. In turn, it is easy for a borrower to become overwhelmed when searching for the best provider. Nearly all the alternative lenders inundate potential borrowers with a strikingly similar array of direct mail, email and online advertisements. Most of these lenders make credit decisions and approve loans in the same amount of time, have similar costs of capital and charge roughly the same rates. Moreover, most lenders have nearly identical customer acquisition costs, ranging from around $2,500 to $3,500 per loan. All alternative lenders position themselves for fast approvals, fast funding, flexible terms, little paperwork and loans that can be unsecured.

Most loans come with hefty fees and high-interest rates that can carry effective annual percentage rates (APRs) from 20 percent to 60 percent, according to USA Today. By comparison, bank interest rates for similar loans average 4.5 percent to 6 percent. However, some alternative lenders will lend at rates as low as 11 percent. Many of these loans can be subordinated to other debt the business is carrying and require no personal guarantees. Also, less-than-perfect credit is rarely a deterrent to receiving a loan.

Repayment and other terms and conditions are often quite flexible, ranging from three months to three years. Loans can be repaid on a daily, weekly or monthly basis.

Lending alternative companies are emerging as a dynamic and disruptive force using sophisticated technology to address the needs of the small-business lending market. Though small compared to the traditional bank market, these new competitors are providing fast turnaround and online accessibility for customers, and are often using data to create more accurate credit scoring algorithms than traditional banks.

There are pros and cons in seeking a loan from an alternative lender, so I advise clients who are having problems with traditional lenders to examine alternative lenders carefully. Examine the details of the loan terms, conditions, and covenants. Make sure your company can service the debt. If cash flow is a problem, seek professional advice from your accountant or other advisors before signing the dotted line.

That’s what Bob did. I advised him to find an alternative lender for the $250,000 he needed to purchase the inventory for his new location. All ended well for Bob. The alternative lending market is one answer to filling the credit gap for small businesses like Bob’s.

If you need a loan, alternative lending sources are worth a serious look.

Denverpost.com http://dpo.st/2qrM3iE

Gary Miller is the CEO of GEM Strategy Management, Inc., an M&A consulting firm, advising middle-market private business owners prepare to raise capital, sell their businesses or buy companies. He is a sought-after business consultant and speaker on M&A issues, strategic business planning, business valuations, exit planning, family transfers, what buyers are looking for in acquisitions and how to prepare for due diligence. He can be reached at 970-390-4441 or gmiller@gemstrategymanagement.com.

denverpost.com http://dpo.st/2qrM3iE

 

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Planning is key when passing the family business onto a new generation

The Denver Post | BUSINESS

POSTED:  April 16, 2017, at 5:00 am

Advisers can help these businesses thrive in the future 

by GARY MILLER | GEM Strategy Management

Gary Miller

Over the past year, I have been working with a number of business owners who would like to transfer their businesses to their next generation. Yet, fewer than a third of family-owned businesses survive into the second generation, 12 percent to the third, and only 3 percent to the fourth generation. In many cases, the poor survival rate is simply a reflection of economics. Not all businesses are destined to survive.  In some cases, however, otherwise successful family-owned businesses fail simply because they had no plan for business continuation. By employing advisers to help them develop a plan, these businesses have an opportunity to thrive throughout the generations.

There is a myriad of challenges in transferring a family-owned business.  This is why no one professional discipline (law, accounting, tax, wealth planning, and exit planning consultants) has become the profession of choice for business owners seeking exit planning advice. Because of the disparate issues that must be grappled with in business continuation planning, an owner needs the help from all of the professional disciplines named above.

For a successful business transfer, three major strategies must be in place.

  1. Both the business owner and the business itself must survive financially; 2
  2. The owner must have a transfer plan in place before exiting the business; and, 3.
  3. The exit plan must be adequately funded.

To successfully transfer the company, the transfer plan cannot carry financial provisions that strap both the children and the business to the extent that the business cannot survive. Similarly, if the transfer plan financially devastates the owner and family, the transfer plan is a failure.

Several steps need to be taking well in advance of executing the transfer of the business. First, when the business owner decides to create a transfer plan, it is important that the books and records (typically five years of income statements, balance sheets and cash flow statements) are “clean” and follow reporting standards similar to publicly traded companies.

Next, an outside, third-party valuation firm should be engaged to provide an independent valuation of the business. The valuation of a family-owned business is not simply a task of updating the company’s financials. There are several adjustments that are commonly necessary. For example, a valuation adjustment is needed to reflect excess compensation if the owner is receiving compensation above market standards.

Another adjustment is warranted if the owner is not paying market leasing rates for a building that person owns but has put that real estate in a separate LLC, to house the business. Similar adjustments may apply to benefits, travel, company cars, boats, airplanes, country club dues and other discretionary expenses.

Typical analytic methodologies used in a professionally produced valuation include the market approach, the income approach, and the asset approach.

Even though the goal is to transfer the business internally, a truly independent valuation is a key step in the transfer planning process. Some reasons include:

  1. If any kind of financing will be involved in the transfer plan, the financing entity will likely demand an accurate valuation. The valuation may not only be an issue for underwriting the loan, it may also determine the source of the loan and interest rate charged. Whether the loan comes from a commercial bank or nontraditional financing sources such as mezzanine lenders or private equity firms, most will require an independent valuation.
  2. Federal income, gift, and estate taxes may require a defensible independent valuation. For example, estate tax challenges from the IRS under IRS code 2704, Discount for Lack of Marketability (DLOM), can be overcome with a valid independent valuation.

An accurate valuation of a going concern is typically dependent on both a look back and look forward of earnings. The intent of the business analysis is to acquire an accurate valuation of assets and a reasonable assessment of future earnings and goodwill.

Another major consideration for business owners thinking about transferring their businesses to their children is what I call the “Family Dynamics Analysis.”  Throughout my career, I have consistently heard from business owners about “how close their families are.” But often, this “closeness” falls apart when transfer issues are discussed among family members.

For most family-owned businesses, these are the major family dynamics that should be considered

  1. Who’s in charge, in both the family and the business?
  2. How will family members be treated equitably when they have different positions in the business?
  3. Jealousy and loyalty.What are the family and business politics?
  4. Conflicts and disruptions.What situation could cause confrontations, and how can they be avoided or resolved?

Finally, funding the transfer plan is critical to the success of the ongoing business for the children. The plan may be based on maximizing value or minimizing taxes but has to include maximizing flexibility to address economic downturns, unanticipated events and capital needs for future growth.

Since most owners can work through maximizing value or minimizing taxes through their professional advisers, I want to address the need for “flexibility” in the exit plan for both the owner and the children. For example, a wait-and-see buy-sell is a common technique in which the agreement among owners provides that the corporation has the first option to redeem the exiting shareholder’s stock; the other shareholders have the second option to purchase remaining shares; and, to the extent any shares remain unsold, the company must redeem those shares. This gives the family the flexibility to determine which course of the sale will minimize taxes.

Regardless of the general information that I have provided in this article, all business owners considering transferring their businesses to their children should seek the professional advice of counsel on all matters pertaining to legal, tax, accounting or exit planning to avoid the pitfalls inherent in family transfers.

Gary Miller is the CEO of GEM Strategy Management, Inc., an M&A consulting firm, advising middle-market private business owners prepare to raise capital, sell their businesses or buy companies. He is a sought-after business consultant and speaker on M&A issues, strategic business planning, business valuations, exit planning,  family transfers, what buyers are looking for in acquisitions and how to prepare for due diligence. He can be reached at 970-390-4441 or gmiller@gemstrategymanagement.com.

 

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8 tips for avoiding an IRS audit

The Denver Post | BUSINESS

By Gary Miller/GEM Strategy Management

POSTED: March 19, 2017, AT 5:29 AM

Gary Miller

Do not round out your numbers, the IRS views this as “sloppy” reporting

It’s tax season. Most business owners have either filed a 1040 tax return or an extension. Still, the question looms: Is this the year I get audited?

Every year the IRS sends notices to thousands of taxpayers informing them they have been selected for an audit. An audit can be a scary situation, one most small business owners try to avoid. Audits involve the government prying into your personal financial affairs, requesting sensitive financial information, and at times making you feel as if you’ve done something wrong. Audits are time-consuming and can be expensive — you may have to pay penalties and interest assessed on a tax liability and the cost of professional tax counsel to help you through the process.

How can you minimize your chance of being audited? It helps to understand how returns are selected. Since the IRS doesn’t have the budget to audit everyone, the agency assigns a numeric score from two scoring systems to every tax return. It is looking for under-reported income and overstated deductions. The higher your score, the higher your chances for an audit. Here’s how it works.

All tax returns are entered into a computer. The IRS uses one computer program called the Discriminate Inventory Function system and another program called the Unreported Income Discriminate Index Formula to determine the probability of inaccurate information and under-reported income. Each score is evaluated in conjunction with the other.

Different formulas are used for different types of tax returns. The IRS does not reveal the exact criteria and formulas used to score tax returns, but some information is known. It is important to note that complex tax returns have a higher chance of being audited – because complex tax returns usually are filed by high-income earners.

There are eight common audit triggers that you should keep in mind as you work on your tax return.

  1. Higher than average income.Taxpayers with incomes exceeding $200,000 have a greater chance of being audited that taxpayers of average income. If this applies to you, keep meticulous financial records in case you are audited.
  2. Disproportionate deductions.The IRS uses schedules to determine how much is too much for various income brackets. For example, if you claim charitable deductions that are out of line with your income bracket, watch out. The IRS will want proof.
  3. Rounded or averaged numbers.If your total deductions are $15,998, don’t report the deduction as $16,000. The IRS agent reviewing your return tends to believe that rounded or averaged numbers are “sloppy” and that the rest of your return may contain inaccuracies.
  4. Home office deductions.These are often abused by business owners. Even though the IRS has simplified the home office deduction method, requirements necessary to take the deduction have not been relaxed. You can still only claim a portion of your home office if it is exclusively dedicated to your business.
  5. Claiming business losses year after year.The agency knows some people claim hobby expenses as business losses, and under the tax code, that’s illegal. If your business claims a net loss for too many years or fails to meet other requirements, the IRS may classify it as a hobby, which would prevent you from claiming a business loss. If the IRS classifies your business as a hobby, you’ll have to prove that you had a valid profit motive if you want to claim those deductions.
  6. Filing a Schedule C.The IRS looks closely at this form. A Schedule C (Form 1040) is used to report income or losses from a business you operate or a profession you practice as a sole proprietor. An activity qualifies as a business if your primary purpose is for income or profit.  You have to be involved in the activity with continuity and regularity. Make sure that you have careful documentation to justify all of your deductions.
  7. Excessive deduction for business entertainment.We all know stories about someone who takes friends out to dinner and then writes it off as a business expense. So does the IRS. Don’t take your family on a business trip and try to write off their expenses. If your return has higher-than-average entertainment expenses compared to your income, you could find yourself sitting across the table from an IRS agent. You will need receipts for all expenses greater than $75 when traveling for business.
  8. Claiming your vehicle as 100 percent business use.Deducting both the IRS standard mileage rate and actual vehicle expenses will cause the IRS to come knocking. In addition, if you claim 100 percent business use on the depreciation form for your vehicle, you’ll need precise records that include mileage logs, dates and the purpose of every trip.

Your best defense against these eight triggers is keeping complete and detailed records. If you have questions about filing your return, seek tax counsel or ask a professional tax preparer. If you have already filed your return and think there could be problems with it, consider amending your return.

Gary Miller / GEM Strategy Management

Gary Miller is the CEO of GEM Strategy Management, Inc., an M&A consulting firm, advising middle-market private business owners prepare to raise capital, sell their businesses or buy companies. He is a sought-after business consultant and speaker on M&A issues, strategic business planning, business valuations, exit planning, what buyers are looking for in acquisitions and how to prepare for due diligence. He can be reached at 970-390-4441 or gmiller@gemstrategymanagement.com.

 

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Headed for a crash? 50 Leading indicators

By Bob Vanourek, Senior Consultant, GEM Strategy Management, Inc.

Posted March 6, 2017

Why is it that a corporate financial crash seems obvious in hindsight? The “Monday morning quarterbacks” cite the warning signs that were brewing. But why weren’t those signals heeded beforehand? Is your organization headed for a financial implosion?

Sometimes major external shifts cause a company to go under – shifts such as a major industry crisis or technology transformation. More frequently, a company implodes because of internal deficiencies that leaders ignore. But internally driven crashes don’t occur without emitting warning signs. These warning signs are not financial signals, such as revenue declines, shrinking margins, slowing inventory turns, deteriorating working capital ratios, and falling profits. Those metrics are lagging indicators.

Leading indicators are more important to watch because leaders can address them before the financials go south. What are some early warning signals of a potential crash? Based on my experience as a leader in eight industries and as the CEO of five very different companies, here’s my list of 50 red-flag indicators covering a wide variety of signals. I list 50 leading indicators because, even though some are louder warnings than others, all are important to understand the future of your business

You and some trusted colleagues can score your organization on these warning signals.

 50 Early Warning Signals of an Organizational Crash

Scoring system:

5 points = this happens often

3 points = this happens occasionally

1 point = we don’t have this problem

 

  1. Not holding people accountable for results.
  2. Not paying attention to how results are achieved (sometimes they are achieved unethically, leading to a future blowback).
  3. Tolerating abusive, egotistical superstars.
  4. Seeing complacency in people’s work.
  5. Sacrificing the long-term good for the short-term expedient.
  6. Neglecting integrity, cultural fit, and emotional intelligence in hiring and promotions.
  7. Failing to invest in developing people.
  8. Not listening to people.
  9. Lack of clarity in why the organization exists (is your organization’s purpose inspirational, or is it all about making money for you?).
  10.  Lack of commitment to mutually developed shared values to guide the behavior of people.
  11.  Leaders not flexing between the hard (steel) and soft (velvet) edges of leadership depending on the circumstances.
  12.  Excessively tight controls that stifle creativity.
  13.  Leaders being too easy-going because they want to be liked.
  14.  Excessive deference to the top leader(s).
  15.  Leaders making virtually all the decisions (not empowering others).
  16.  Failing to tap into the capabilities of people.
  17.  Weak, inadequate board of directors or advisors.
  18.  Constantly changing priorities
  19.  Poor communications and secrecy.
  20.  People operating in independent silos.
  21.  Insufficient understanding of how departments are interrelated.
  22.  Lack of discipline to execute well.
  23.  Lack of trust between people.
  24.  Treating people disrespectfully.
  25.  Leaders having favorites among people.
  26.  Excessive employee turnover.
  27.  Incidents of internal sabotage or theft.
  28.  Lack of rigorous, honest feedback from customers.
  29. Lack of rigorous, honest feedback from vendors.
  30. Lack of rigorous, honest feedback from employees.
  31.  Failure to cut unprofitable products or services.
  32.  Failure to understand new market trends.
  33.  Failure to invest in new products and services.
  34.  Excessive debt and interest expense.
  35.  Insufficient capital.
  36.  Lack of reasonable financial controls.
  37.  Excessive dependence on a single, or very few, customers.
  38.  Excessively high or low compensation and benefit levels.
  39.  Excessive travel and entertainment spending.
  40.  Owners taking excessive funds out of the business.
  41.  Leaders not knowledgeable of financial details.
  42.  Lack of rigorous financial planning and budgeting.
  43.  Exploiting vendors with excess pressure to lower costs.
  44.  Giving insufficient attention to local community needs and issues.
  45.  Insufficient policies, systems, and procedures to guide people’s work.
  46.  Poor quality products or services.
  47.  Unaddressed safety issues.
  48.  Excessive stress levels among people.
  49.  Constant surprises.
  50.  Leaders in denial about what’s really going on in their business.

To ensure you have an objective assessment, have one or two trusted colleagues also score your organization, even if they have to make some guesses at some answers. Assure them they will not be penalized for an honest assessment – you are trying to avoid a disastrous crash.

If your organization scored:

·         50-125 points: Congratulations, you are unlikely to crash and burn.

·         126-200 points: There could be trouble ahead. Some changes are needed.

·         201-250 points: Disaster looms.

Practical Applications:

Review and discuss any metrics with a 1 or 3 rating. Then you and your team can brainstorm solutions and prioritize action plans. You’ll unleash their creativity and heighten their engagement.

There is no reason for you to be blindsided by an organizational crash. Pay attention to the warning signs of leading indicators.

Bob Vanourek is a senior consultant with GEM Strategy Management and is the former CEO of five companies and a frequent speaker, consultant, and coach on organizational leadership. He is the co-author of the award-winning book, Triple Crown Leadership: Building Excellent, Ethical, and Enduring Organizations. Bob’s latest book is Leadership Wisdom: Lessons from Poetry, Prose, and Curious Verse http://tinyurl.com/zr2peng You can see Bob’s entire profile on http:gemstrategymanagement.com or reach him at 970.390.4441.

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Key reasons to grow your company and build scale

Gary Miller

The Denver Post  BUSINESS

A new strategic plan can set even an old company on a high-growth trajectory.

By Gary Miller / GEM STRATEGY MANAGEMENT | February 19, 2017 at 12:01 am

I recently visited the owner of a family business whose revenue growth had stalled over the past three years and his earnings had declined as well. Facing significant financial pressure from increased operating expenses and cost of goods, the decline of his net income was projected to accelerate over the next two years. He was discouraged. He asked us to help him stabilize the company so he and his family could maintain their lifestyle.

In analyzing his company’s operations, we focused on five areas:

  1. Reducing expenses,
  2.  Improving cash flow,
  3. Analyzing the company’s strengths, weaknesses, opportunities and threats (SWOTs),
  4.  Assessing the company’s competitive position, and
  5. Developing strategies for growing the company.

After completing the company review, we sat down with him to discuss our findings. He was pleased with our in-depth analysis but reluctant to embrace new strategies. He feared that investing in new growth strategies, if not handled correctly, would further erode both cash and earnings. He wanted to play it safe and just stabilize the company so he and his family could live off the current earnings, even though they were shrinking annually.

We pointed out that a so-called safe strategy was neither safe nor a long-term solution. While his company was stalling, his competitors were stealing his customers. After several discussions, he asked us to show him that taking a chance on growing his company was safer than maintaining his current status.

The most important reason to grow a company is to create significant enterprise value (Enterprise Value, or EV, is a measure of a company’s total value, often used as a more comprehensive alternative to equity market capitalization.) to broaden the range of exit strategies for shareholders. The higher the EV, the more alternatives shareholders have for monetizing their investments.

Here are 10 additional reasons to grow a company.

  1. Market power: This gives large companies opportunities to establish larger geographic footprints to increase penetration. Expanding a geographic footprint builds scale and provides significant benefits to large companies. It drives credibility among all stakeholders, creates preferential treatment among suppliers and momentum to accelerate growth, stability to weather economic downturns, cost savings for company operations, competitive advantage, and financial strength to compete against larger competitors.
  2.  Inventory power: This provides opportunities to purchase through       master contracting with bulk purchasing and forward contracting that locks in costs of materials, labor and suppliers. A large company can employ just-in-time inventory strategies to increase efficiency and decrease waste by receiving goods only as they are needed in the production process. These strategies reduce inventory costs, improve cash flow and increase margins.
  3. Recruiting power: This gives large organizations greater access to higher-quality talent. Typically, higher-quality talent translates into more larger and higher-caliber clients. A company’s size creates the perceptions of success and, as a result, professional growth and opportunities for career advancement to its employees.
  4. Marketing power: This allows companies to command lower advertising rates due to media volume discounts in major traditional media. More media coverage provides more reach to the company’s target audiences, clients, and the investor community. It improves corporate image, reputation, brand name recognition and increases the brand power. Marketing power gives flexibility in developing new products and services to meet customers’ changing demands. It also offers opportunities for first mover advantage, which allows a company to be first in the market to capture share before other competitors can enter the market.
  5. Negotiating power: This helps organizations attract, recruit and retain higher-caliber clients. Large corporations, generally, have less client turnover and more new client acquisitions. Generally, the cost of attracting new clients is lower for large companies.
  6. Cost reduction power: This provides larger organizations to scale to optimum efficiencies. Operating expenses can be reduced. Policies, practice,s and procedures can be standardized to reduce management inefficiencies. Cost reduction power allows large corporations to substitute technology for labor intensive tasks.
  7. Technology power: This provides the ability to leverage hardware and software technologies to maximize growth, operations, earnings and competitive advantage. Technology power gives opportunities to create intellectual property as a result of developing new proprietary processes and software.
  8. Synergy power: This creates opportunities to meet customer needs through other related enterprises. It offers a holistic approach with a comprehensive portfolio of products and services that can touch clients multiple times throughout customer life cycles. Therefore, building repeat business is easier. It also creates strong brand loyalty and elongates customer life cycles.
  9. Competitive advantage power: This allows a company to scale operations, which leads to critical mass. Critical mass is the point at which the company no longer requires outside investment — of money, resources, or human capital — to continue being viable, to continue growing by itself. This leverage can accelerate growth, earnings, cost reductions, operations excellence and a solid, safe and secure work environment. Competitive advantage raises the barriers to market entry from potential newcomers and pressures smaller competitors who are not performing well.
  10. Earning power: This allows large-scale organizations to earn more for all stakeholders because scale and critical mass can produce increased growth, synergies, and resources at lower costs. Therefore, margins are increased and earnings are improved while operating expense rates are lower. More earnings produce financial stability, flexibility and the ability to take advantage of investment and acquisition opportunities.

Finally, a major benefit for larger corporations is that its bottom lines are larger, providing increased shareholder value. While the firm maximizes its profits, investors can maximize their returns.

After building a compelling case for growing his company, we persuaded the owner to re-examine his company’s strategic plan. He has set a new course for growth to increase his company’s enterprise value and expand his exit plan alternatives.

Gary Miller / GEM Strategy Management

Gary Miller is the CEO of GEM Strategy Management, Inc., an M&A consulting firm, advising middle-market private business owners prepare to raise capital, sell their businesses or buy companies. He is a sought-after business consultant and speaker on M&A issues, strategic business planning, business valuations, exit planning, what buyers are looking for in acquisitions and how to prepare for due diligence. He can be reached at 970-390-4441 or gmiller@gemstrategymanagement.com.

 

 

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Watch out –The IRS is looking at tax returns when owners sell their companies

M & A Source the BRIDGE

POSTED: February 9, 2017

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

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

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

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

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

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

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

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

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

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

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

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

Gary Miller is the CEO of GEM Strategy Management, Inc., an M&A business consulting firm, advising middle-market private business owners on how to sell their businesses for the highest valuation, buy companies and sourcing capital for growth and expansion. He is a sought-after business consultant and speaker on M&A issues, strategic business planning, business valuations, exit planning, what buyers are looking for in acquisitions and how to prepare for due diligence. He can be reached at 970-390-4441 or gmiller@gemstrategymanagement.com.

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