May 2016 eNewsletter

Is Sweat Equity Real

Larry Grypp, President of the Goering Center

What is “fair value?”  That was the question in play at a recent Goering Center program where family business owners and successors worked through various formulas and considerations when pricing a business that was to be acquired by the next generation.

However, it was the question posed at the end of that session that stirred the most controversy and deeply held sentiments:  “What else does anyone have on their mind about how to value a business?”

Like water pouring over a dam, the next generation family members spilled out some frustration about whether their time working at the company ought to be counted somehow in discounting the purchase price of the business. After all, as family members working in the business, how is it fair that they should expect to pay the same as an outside buyer?  They considered it a form of sweat equity.  Or why should family members not working in the business get the same shareholder deal as someone working in the business? 

Interestingly, the first generation family owners, who were in a different room, were considering the same question, wondering if they owed it to their sons or daughters to discount the purchase price as a way to recognize their contribution.

Oddly, attempts to be fair can actually create some real unfairness across the board.

For example, how do you fairly determine the “value” of a family member working in the business and how can that ever be factored into a purchase price that everyone - including non-employed family owners - can agree is “fair?” It is the management position itself - not the person - that needs to be priced according to its value to the business and its comparable value in the open market. Paying below market salary in return for some future discount on purchase price invites discord, just as would over-paying them simply because they are family. Likewise, if a successor is paid market compensation for a management role, it doesn’t create sweat equity toward the purchase price.

“Fairness” is a foundational value to a successful family. The only way to foster that is to stick with the business facts in compensation and purchase/sale prices.

Five Ways to Drive Value

Nick Sypniewski, ASA, Managing Director, ComStock Advisors

There are a variety of ways to value businesses and plenty of ways to improve any specific business (and, thus, its value). This can result in a lot of potential advice. In setting priorities for action, it is useful to organize advice and ideas around the core of what drives business value, which includes five areas: cash flow, risk, growth, the market and the balance sheet.

Maximize Cash Flow

An investor is interested in the future benefits that ownership will yield – that is, what are the future available cash flows? Historical earnings matter to the extent that they are an indication of future earning power, but in fact, it is the future that matters. Improving profit margins is one approach to improving cash flow, but note that cash flow does not equal net income. A growing company typically needs to reinvest in working capital and fixed assets to support growth. That reinvestment reduces cash flow available to the owner, so managing working capital and capital expenditures is important to enhancing cash flow and value.

Manage Risk

Valuation multiples are often cited for various industries, but underlying these multiples is the risk and growth associated with the industry (or more importantly, with a specific company). The cost of capital for a company is a measure of the market’s assessment of the risk of that company relative to other investments.

In this context, risk is a measure of uncertainty – or volatility – surrounding the generation of cash flows. Sometimes, risk is obvious because a company has experienced volatility in the past. But sometimes risk is hidden; the steady hand of the veteran president or the significant long-term customer can mask the risks associated with the potential future loss of a key person or key customer. Understanding and mitigating risk factors to reduce current and potential future volatility enhances value.

Growth

All other factors being equal, a company whose cash flows are expected to steadily increase over time will be more valuable than a company whose earnings are expected to remain flat. For example, if a low-growth (say 2 percent) company is worth 4 times EBITDA, then a comparable company with 5 percent growth would be worth 5.2 times EBITDA – an increase in value of 30 percent. (Note: there are some assumptions about risk and reinvestment in this example, but the importance of growth still holds true.)

There are three points to keep in mind regarding growth:

1. Pursuing growth would seem to mean taking some risk. However, one could argue that it is far riskier to try to maintain the status quo in an ever-changing world.
2. Growth does entail reinvesting in the company, which can reduce cash flow in the short-term in exchange for long-term growth in cash flow.
3. Remember – it is cash flow growth, NOT just sales growth that drives value. Plenty of companies have grown themselves into bankruptcy by running out of cash as they pursued unprofitable sales.

Understand Market Conditions

Try as one may to enhance cash flow, reduce risk and pursue growth, the fact is that not all things are within a business owner’s control. The value of a business is impacted by external market conditions regardless of how the company is performing. Understanding the market can help a business outperform its peers; however, even a well-performing company in an out-of-favor industry may have difficulty convincing investors (including banks) of the merits of investing in or lending to the company. Therefore, being able to communicate your understanding of the market to others is important. Understand and be able to explain why the business is outperforming its peers, especially if an industry downturn is allowing your company to improve its position relative to the competition, which can generate large benefits in the next upturn. (On the flip side, don’t be complacent if the company is enjoying success in an up market.)

Financial Condition

The balance sheet matters – maybe not so much if the company is being sold, but for an ongoing business, the financial condition of the company impacts value. A company with a strong balance sheet and cash reserves is more likely to weather adverse conditions or be able to move quickly when opportunities arise. An overleveraged company may have little margin for error (although the prudent use of leverage can enhance the return on investment to the shareholder, i.e., value).

Conclusion

A business owner can increase value by understanding and optimizing the factors that enhance the value of the business. Specific factors vary from company to company, but most will fit into one of the five core categories above.

Sales Tax Differences - Ohio & Kentucky

Cheryl A. Ganim, CPA, Barnes Dennig

Companies in border-states like Ohio and Kentucky often have locations and serve customers in both states. Companies may find themselves with identical purchases or sales transactions with the same vendor or customer that are treated differently for sales tax purposes depending on whether the transaction takes place in Ohio or Kentucky. The savviest of finance departments may be taken by surprise to find out their company is on the hook for sales tax payments they collected from their customers but remitted to the wrong state, for inadvertently overpaying sales tax on exempt items, or for purchasing taxable services or goods but not paying use tax. Being assessed under audit for four or more years of sales and use tax, in addition to being charged interest and penalties, is a painful and costly (but avoidable) way to comply with the sales tax rules. Obtaining refunds from the state is challenging, consuming time and resources.

There are steps companies can take to implement best practices for sales and use tax compliance. Accounting systems can be automated to mark vendors as ‘taxable’ or ‘exempt,’ with the caveat that there may be exceptions to this rule. Finance and sales employees can be educated on taxable versus exempt sales, and provided with a simple decision tree specific to the business. Sales tax training is available to update employees on basic rules and law changes. Reverse sales tax audits can help companies discover sales tax positions that are more favorable (refund opportunities) or sales tax positions which should be corrected (exposure). An annual review of internal sales and use tax policies and relevant tax law changes is recommended.

Some of the notable differences in sales and use taxation between Ohio and Kentucky are shown below.

• A nonprofit or tax-exempt entity’s exemption certificate is allowed to “pass-through” to contractors for Ohio jobs. Kentucky does not allow the nonprofit’s exemption status to pass through to the contractor, so the nonprofit should purchase the materials directly for Kentucky jobs or Kentucky purchases. This distinction becomes even more important for contractors to track when a vendor has Ohio and Kentucky locations. Materials the contractor purchases from Ohio locations are tax exempt, while materials purchased from Kentucky store locations are taxable to the contractor.
• Ohio building maintenance, janitorial services and landscaping by vendors who have $5,000 or over in sales of that service during the calendar year are taxable. Kentucky building maintenance, janitorial services and landscaping are not taxable. Sales of services are typically exempt unless specifically designated as taxable in both Ohio and Kentucky.
• The installation of soft surface (carpet) into realty in Ohio is never considered a construction contract – it is a retail sale of carpet for which the customer pays Ohio sales tax (barring another exemption). The installation of soft surface (carpet) in Kentucky is a construction contract, therefore the contractor pays the sales or use tax on the materials.
• In general, sales to repairers of materials, which they use incidentally in rendering their services, is exempt in Ohio, but sales of the same materials to repairers in Kentucky are taxable.
• Certain materials used to carry out contracts with public utilities in the rendition of a public utility service, including natural gas, electric, all forms of telecommunication systems and cable television providers are exempt in Ohio. The public utilities sales tax exemption does not apply in Kentucky.
• Information services that allow data to be generated, acquired, stored, processed, or retrieved and delivered by an electronic transmission are taxable in Ohio but exempt in Kentucky.
• Ohio transactions between affiliated corporations having a parent-subsidiary relationship are ordinarily subject to the sales tax in the same manner as transactions between unrelated parties. However, Kentucky sales tax is not imposed on transfers of property where ownership remains substantially unchanged (IRC Section 351 Property Transfers). Such transfers are exempted as occasional sales.
• The taxability of cloud computing or Software as a Service (SaaS) is an evolving area in all states. In Ohio, certain cloud-based applications and related services are taxable as an automatic data processing service. Kentucky has not issued specific guidance on the taxation of cloud computing or SaaS. Kentucky applies the sales tax to all prewritten software, including software that is sold as a tangible product, and software that is downloaded.

The Streamlined Sales and Use Tax Agreement (SSUTA) is an effort between the states to simplify and modernize sales and use tax administration to reduce the burden of tax compliance. Both Ohio and Kentucky have passed legislation to conform to the SSUTA. Ohio is an associate member, achieving substantial compliance with the terms of the agreement, while Kentucky is a full member in compliance with the SSUTA laws, rules, regulations and policies.

Interstate commerce is the norm versus the exception, so investing the time to understand the sales tax requirements at the outset will pay off in the end.

Cincinnati IT Service Firms Provide Backbone to Economy

Louie Hollmeyer, Director of Marketing, Advanced Technology Consulting (ATC)

While small-to mid-sized businesses (SMBs) may not generate as much revenue as large enterprises nor get as much attention, clearly they are a critical constituent of the national economy. Taken further, they are the driving force in the strength of “local” economies. Greater Cincinnati is no different. Yet SMBs face unique challenges in a technology-driven business world.

SMBs need the same technologies leveraged by large corporations in order to compete. In fact, one could argue that they need to be more nimble and agile and therefore are much more technology dependent. Therein lies the issue. In order to succeed they must have enterprise-level, workforce-enabling technologies that facilitate collaboration and productivity. Of course, these technologies come with a price and an “upkeep” operational expense. Most SMBs are not prepared to deal with today’s complex and rapidly evolving IT landscape. In addition, SMBs cannot afford to be distracted from their core business and often don’t have the resources to build out a diverse IT department.

This environment has led most SMBs to outsource segments or all of their IT operations, and these efforts usually center on the concept of adding IT capabilities while maximizing the use of IP and cloud-based technologies. The premise is to free up internal resources to take on more strategic, customer-centric roles.

The SMB Behind the SMB

As a result, agile IT service firms are backfilling a core need in Greater Cincinnati for versatile, responsive technical expertise. Firms that can handle both the day-to-day break-fix issues and the big strategic picture (think IT roadmaps) are the cornerstone behind today’s SMB, and thus the economy. Other more niched IT service firms are also delivering value supporting the SMB with core competencies in IT segments such as disaster recovery, business continuity and security.

Fortunately, Greater Cincinnati is home to a diverse and talented set of IT service firms. These companies add tremendous value to the tech ecosystem by supporting SMBs with their infrastructure needs, while helping clients adopt the appropriate technologies to drive business outcomes.

Why Private Companies Should Look Into Valuations

Lawrence Van Kirk, Valuation Research

Why should a private company board consider a valuation of the company?

From my perspective as both a valuation professional and as someone who has served on a number of closely held boards, valuations are needed regularly. The most common driver of a valuation is the sale or purchase of company equity. Internal stock transactions – when stock is being transferred from one executive to others – as well as any incentive compensation plans also usually trigger valuations. I’ve seen valuations become part of a detailed strategic planning process when management is seeking to make a significant strategic move and would like to analyze how that move might affect the company’s valuation. The triggers are numerous, and increasingly we are seeing boards take their fiduciary obligation to scrutinize valuations very seriously.

If the company is considering a sale process, when should a board seek a fairness opinion or an independent valuation?

The answer to this question is nuanced. It requires an examination of the relationships of the parties and whether the sale could become controversial or contentious.

If it is a sale with multiple bidders and a high degree of confidence in the sale process and pricing, then an outside fairness opinion may not be necessary. If there is the potential for controversy, a fairness opinion or at least an independent valuation is prudent. For example, if there is only one interested buyer and no other bidders, the fairness opinion might provide a higher level of confidence that the price is appropriate and offers an outside view without the escalation of risk. The relevant rule that addresses fiduciary issues including procedures, liability, and disclosures is Rule 2290 as published by FINRA and approved by the SEC.

Do internal transactions or incentive compensation for key executives cause a need for a valuation?

Yes, valuations of internal stock transactions or stock incentive compensation programs are required to meet both tax and financial reporting requirements. The relevant rule, ASC 718, addresses the financial reporting of stock compensation. The tax reporting requirements generally surround documentation and support for Section 409a of the Internal Revenue Code, often called the cheap stock rule, which governs reporting related to non-qualified stock compensation. While it is important for board members to understand these value derivations and indications, they are also important for compensation or audit subcommittees.

Does a valuation enable the board to evaluate the impact of management policies?

After performing a standard valuation, we are often asked to speak to the board to discuss the drivers of value and steps that could enhance value. For example, if the board is considering an expenditure for a new piece of equipment, it may want to consider the impact on cash flow and, ultimately, value. So the valuation process and a thorough discussion can help inform the board whether their investments are just a revenue enhancer or a value enhancer.

We sometimes see companies that are divided by an older, more conservative generation and a younger generation seeking to pursue more growth. In other words, the older generation doesn’t necessarily want to invest while the younger generation wants to spend more and take some risks. We are asked to consider the valuation implications of a more growth-oriented/risk-tolerant philosophy and what it might mean for the valuation of the company.