The problem is that a lot of successful businesses reach a point where their growth starts to slow as the company matures. In fact, the price of doing a great job carving out a unique niche is that the specialty that made you successful can start to hold you back.

If you make the world’s greatest $5,000 wine fridge, you may have a successful, profitable business until you run out of people willing to spend $5,000 to keep their wine cool.

Demonstrating how your business is likely to grow in the future is one of the keys to driving a premium price for your company when it comes time to sell. To brainstorm how to grow beyond the niche that got you started, consider the Ansoff Matrix. It was first published in the Harvard Business Review in 1957 but remains a helpful framework for business owners today.

Sometimes called the Product/Market Expansion Grid, the Ansoff Matrix shows four ways that businesses can grow, and it can help you think through the risks associated with each option.

Imagine a square divided into four quadrants representing your four growth choices, which include selling… 1. existing products to existing customers, 2. new products to existing customers, 3. existing products to new markets, and 4. new products to new markets.

The choices above are presented from least to most risky. In a smaller business, with few dollars to gamble, focusing your attention on the first two options will give you the lowest risk options for growth.

Existing products to existing customers

It’s natural to feel like you’re being greedy when you go back to the same customers for more of their dollars, but the opposite can often be true. Your best customers are usually the ones who know and like you the most and are often pleased to find out that you – someone they trust – are offering something they need.

Greg is a hardware store owner who came to understand the Ansoff Matrix. Greg earns a 150% mark up on cutting keys but his cutter was hidden in a corner of the store where nobody could see it. As a result, he didn’t cut many keys. One day, Greg decided to move the key cutter and position it directly behind the cash register so everyone paying for his or her hardware could see the machine. Customers started seeing the cutter and realized – often to their pleasant surprise – that Greg cut keys.

Not surprisingly, Greg started selling a lot more keys to his loyal customers. The key cutter didn’t woo many new customers, but it did increase his overall revenue per customer.

If you want to sell more of your existing products to your existing customers, draw up a simple chart of your products and services. Don’t be afraid to dust off those old products that you haven’t paid much attention to lately. List your best customers’ names down one side of the paper and your products across the top. Then cross-reference your customer list with your product list to identify opportunities to sell your best customers more of your existing products.

New Products to Existing Customers

Another approach to growth is to sell new products to existing customers. For example, there is a BMW dealership owner in the Midwest whose typical customer is a family patriarch in his forties. When he felt like he had saturated the market for well-heeled forty-something men in his trading area, he thought about what other products he could sell his existing customers. But instead of defining his customer as the forty-something man, he decided to think of his customer as the financially successful family and his market as their driveway.

Instead of trying to sell more BMWs into a market of diminishing returns, he bought a Chrysler dealership so he could sell minivans to the spouses of his BMW buyers. He then realized that a lot of his customers had kids in their teens so he bought a Kia dealership to sell the family a third, inexpensive car.

Once you become successful, it can be tempting to sit back and enjoy your success. But in order to drive up the value of your business, you need to be able to demonstrate how you can grow, and the least risky strategy will be to figure out what else you could sell to your existing customers.

If you are curious to see how your growth stacks up and if you’re building a business you could sell one day, take the 13 minute Sellability Score questionnaire: http://www.sellabilityscore.com/nationwide-valuations/marsha-golgart

Marsha Golgart CMEA, CEPA, ISBA – Nationwide Valuations – (303) 484-3033 (303) 374-6771 (fax)

marsha@nationwidevaluations.com – www.nationwidevaluations.com

Case in point – Roger Elkhart sold his commercial construction company a little over a year ago.  His revenues and earnings had suffered over the last few years.  Roger decided it was time to sell.  He was 56 and had run his family’s business for the last 25 years.  The last few years had been tough and Roger was burned out.  He felt he needed a change.  Now 18 months later, Roger is depressed and lost.  He’s tired of playing golf and isn’t sure that selling his business was the right decision.

A recent survey showed that the number one reason business exits fail is due to a lack of planning on the part of the owner.[1] A separate study showed that most business owners spend more time planning their family vacations then they do planning how and when to exit their business! Rather than being proactive, most business owners are reactive and “forced” to sell because of burnout, health issues, marital problems, or business conditions without the time to prepare correctly.  As a result, most business owners exit their companies at the worst possible time.

Developing an exit plan is the most important thing you can do to protect the value of your business.

What is an exit plan, you ask?  An exit plan is a comprehensive road map that addresses all of the business, personal, financial, legal and tax issues involved in selling a privately owned business.  A good exit plan includes contingencies for illness, burnout, divorce, and even your death.  Its purpose is to ensure the survival of the business; to provide continuity to your employees, customers, vendors; and to preserve wealth for your family.

A well designed and implemented exit plan enables you to:

• Control how and when you exit
• Maximize company value in good times and bad
• Minimize or eliminate capital gains taxes
• Ensure you achieve your business and personal goals,
• Have strategic options from which to choose, and
• Reduce uncertainty for your family and employees.

On the other hand, without a predetermined exit plan, you will probably:

• Undervalue your company and leave hard earned wealth on the table,
• Pay too much in taxes, and
• Lose control over the process by being reactive, rather than proactive.

To be effective, your exit plan must include these six essential components:

1)  A concise statement of your business goals, personal goals, and family/estate goals.  This step is essential to ensure that all of the goals are consistent and set the direction for the rest of the analysis.

2)  A detailed business valuation to establish a baseline value for the business.

3)  Identification of specific ways to enhance the value of the business prior to your exit.

4)  An analysis of the pros and cons of your different exit alternatives such as a third party sale, management buyout, family succession, or liquidation.

5)  Suggestions to minimize any capital gains, ordinary income, and estate taxes related to the exit.

6)  An action plan that details the specific personal and business steps you must take in order to prepare for your exit.

Perhaps the most important thing to remember is that developing a good exit plan is a multi-disciplinary endeavor.  No single professional advisor has all of the expertise needed to design a comprehensive, integrated exit plan.  The best exit plans incorporate input from a team of advisors that includes:

• A business attorney with M&A experience,
• A financial advisor or wealth management professional who does planning work,
• A tax specialist who is versed in the latest tax issues, an
• An insurance professional,
• An investment banking firm that specializes in exit planning, and
• A valuation company to perform a detailed business valuation.

Sticking to your exit plan is just as important as having one.  You should meet with your advisors on a regular basis to ensure that crucial steps are being completed on schedule.  Nobody likes to pay unnecessary fees, but the cost of developing a good exit plan is usually tiny compared to the additional value received at the time of sale.  After all, exiting your business is probably going to be the most important deal of your life time.  Don’t just shoot from your hip.

Your exit plan should be focused on two main objectives; 1) maximizing your company’s value prior to your exit, and 2) ensuring that you accomplish all of your business and personal objectives as part of the exit.  Venture capital firms and private equity groups never invest in a company without having a clearly defined exit plan in place first, why should you?  It is never too earlier to create your exit plan – so act now!

Marsha Golgart CMEA, CEPA, ISBA – Nationwide Valuations – (303) 484-3033 (303) 374-6771 (fax)

marsha@nationwidevaluations.com – www.nationwidevaluations.com

As many of you may remember, singer Paul Simon said there are 50 ways to leave a lover.  If you are a business owner thinking about how to leave your business you really only have nine options to consider. Here’s a brief summary of these options.

1. Sell or give your company to a family member;
2. Sell your business to one or more key employees;
3. Sell to your employees (ESOP);
4. Sell your business to other shareholders;
5. Sell to an outside third party;
6. Bring in an outside investor and keep a minority interest;
7. Go public;
8. Hire a management team to take over and become a passive owner; or
9. Liquidate your business.

Determining exactly which option is right for you is a challenge that many business owners put off until it is too late.  Opportunities pass with time.  If you wish to “leave your business on your terms and on your time table,” you need to be proactive about understanding your exit options.

We recommend that you follow a four-step process to determine which exit option is best for you. This process will ensure that your exit options are consistent with your personal goals and take into account the realities of your company and the marketplace.

Choosing a Path

Step One: Set Personal Goals.  You need to identify your most important objectives; both in terms of financial goals (“How much money do I need from the exit to ensure my family’s financial security?”) and in terms of non-financial goals (“I want the company to stay in my family,” or “I want to my key employees to be rewarded during the exit”).  Establishing well defined and written objectives is the first step in the exit planning process.  Doing so in advance of your exit gives you and your advisors the time necessary to make your goals a reality.

Step Two: Make Sure Goals are Consistent.

With the help of your advisors you need to determine whether your goals are consistent with each other.  Very often this is not the case.  For example, many business owners want to receive all cash at closing when they exit their business.  At the same time the owner may want to transfer the business to a family member or a key employee.

Unfortunately, these two goals may be mutually exclusive.  Family members and key employees often do not have sufficient capital to structure a transaction this way.  A great deal of stress and heartache can be avoided by addressing these kinds of issues early in the process.

Step Three:  Understand Value and Salability Issues.  Once you have defined a set of consistent objectives, you need to understand the market value and salability of your company.  This analysis is important in that it will provide you with further direction and can eliminate certain exit options.

For example, if the value of your company is below what you feel you need to support a comfortable lifestyle after your exit, you may decide to take some time to enhance the value of your business or to do further financial planning to ensure  you clearly understand your financial needs.

In addition to understanding the value of your company you also need to understand how salable your business is.  Value and salability are not always the same.  Salability determines how quickly a business will sell and how much leverage a business owner will have when negotiating with a buyer.  Salability depends to a large extent on external market conditions.  External conditions are things that are out of your direct control like business, market or financial conditions.  For example, the option of selling your business for cash to an outside buyer may be eliminated because of a downturn in your business or industry.

It is recommend that you work with an investment banking firm to determine the value and salability of your company.  Only an investment bank that is actively talking with buyers can give you an accurate read of the marketplace and a “real world” sense of the value and salability of your company.

Step Four: Understand Tax and Legal Implications.  The final step in determining the best exit path for you is to evaluate the tax and legal consequences of the exit options that are available to you.  This evaluation will include factors such as legal structure of your business entity, how its ownership is structured, exiting legal agreements, as well as any changes that must be made.

For example, if a transaction involves a sale of assets and the company is a “C” corporation, there would be significant adverse tax consequences.  Good advice from your CPA and attorney can help minimize the taxes you would otherwise have to pay.

Using this four-step process, you will be able to narrow the list of exit routes to determine which one is best for you.  The important thing is to start early and create a plan.

Marsha Golgart CMEA, CEPA, ISBA – Nationwide Valuations – (303) 484-3033 (303) 374-6771 (fax)

marsha@nationwidevaluations.com – www.nationwidevaluations.com

On June 1, 2011, both Floyd’s Coffee Shops in Portland, Oregon were busier than usual. The regulars were elbowed out of the way by new customers visiting the store for the first time to redeem their coupon and get $10 worth of coffee for $3.

This tempting offer was made because Floyd’s had been picked as the first-ever Google Offers “deal.” Google Offers is the company’s first baby step into the world of “social buying” style promotions where a special, limited time offer is made by a business hoping that the deal will spread virally and thereby introduce a new legion of customers to their business.

Google, of course, did not invent the deal-of-the-day category; they were goaded into it after their generous $6 billion dollar offer to buy Groupon was turned down.

Now Groupon is starting to feel the pinch after thumbing their nose at one of the world’s most valuable companies. According to compete.com, Groupon’s traffic went from 33.7 million unique visitors in June 2011 to just 18.3 million unique visitors in January 2012. That’s a drop of almost half inside less than a year. Not surprisingly, Groupon’s stock is also down around 25% since its IPO last year.

Over-playing your hand

The moral of the story is to be careful not to over-play your hand when being approached by someone who wants to buy your company. Acquirers usually have deep pockets and, while you may think your business is unique, never underestimate the resolve of a big company with lots of cash.

They do have an alternative to buying you: they can simply compete with you.

Typically when they make the decision to walk away from the negotiation table they do not leave empty-handed. They come away with new-found insight on how you run your business, what works, and what flops; so they have an enormous head start to launch a competitive company.

And it doesn’t just happen in Silicon Valley. Take a hypothetical example of a home security company generating $500,000 per year in profit (before tax) installing and monitoring home alarms.  One day a big alarm company comes along and says they want to buy the business and they’re willing to pay four times pre tax profit.  The alarm company owner turns up his nose and demands six times earnings.

Now the suitor has a choice. They can try and negotiate with the owner, but that would undermine the economics of the model they’ve used to buy hundreds of similar alarm companies across the country, or they can simply hire someone to start an office to compete with him.

Let’s say they pick door number two and hire a young, aggressive manager. They guarantee her $200,000 a year in the first 12 months on the job while she is building her business.  You have not only lost the opportunity to sell your business; you’re now competing against a young, motivated rival with a parent company who has an extra $1,800,000 ($2,000,000 withdrawn offer minus the $200,000/ year salary for their manager) that they didn’t use to buy you and they’re putting it towards helping your new competitor build her business.

If you’re lucky enough to get approached by a big company who wants to buy yours, remember that they are usually not choosing between buying you or buying your competitor. They are often choosing between buying you or setting up shop to compete with you.

Wondering if you have a sellable business? The Sellability Score is a quantitative tool designed to analyze how sellable your business is. After completing the questionnaire, you will immediately receive a Sellability Score out of 100 along with instructions for interpreting your results. Take the test here:

http://www.sellabilityscore.com/nationwide-valuations/marsha-golgart

The Facts: 

Ms. Gallagher owned 3,970 units of Paxton Media Group, LLC (“PMG”), at the time of her death on July 5, 2004.  As of July 2004, PMG was a publishing and media company that published 28 daily newspapers, 13 paid weekly publications, and a few specialty publications, and owned and operated a television station.  Ms. Gallagher was the largest single shareholder in PMG at the time, holding 15% of PMG’s 26,439 outstanding units.

The estate filed Form 706 on September 30, 2005.  The return stated the value of Ms. Gallagher’s units as $34,936,000 or $8,800 per unit, based on a July 12, 2004, appraisal of PMG’s units performed by PMG’s president and CEO, Mr. David Michael Paxton.

The IRS selected the return for audit and on June 13, 2007, the estate of Ms. Gallagher received a deficiency notice stating the fair market value of the PMG units owned by Ms. Gallagher was $49,500,000, as of the date of her death.

The estate obtained an independent appraisal of the units from Sheldrick, McGehee & Kohler, LLC (SMK), which appraised the units at $26,606,940.  Prior to the start of the trial, the estate hired a second appraiser, Mr. Richard May, who valued the units at $28,200,000, or approximately $7,100 per unit.  Also before trial, the IRS hired Mr. John Thomson of Klaris, Thomson & Schroeder, Inc. (KTS) to perform an independent appraisal of Ms. Gallagher’s units.  Mr. Thomson determined the fair market value of the units to be $40,863,000, or $10,293 per unit.

The Court accepted both Mr. Thomson (an ASA with the American Society of Appraisers) and Mr. May (an appraiser who had previously performed several appraisals of publishing companies, including those who hold radio and TV broadcast assets) as expert witnesses in the case.  Mr. Thomson valued the units using both a market approach and an income approach, and applied a 17% minority discount to the income approach and a 31% marketability discount to both approaches – concluding that the decedent’s units had a fair market value of $40,863,000.  Mr. May, in contrast, relied primarily on an income approach and used the market approach only to establish a reasonable estimate of fair market value.  Mr. May applied a 30% marketability discount to his income approach method – concluding that the decedent’s units had a fair market value of $28,200,000.

The Arguments and Findings:

The Court was asked to determine the fair market value of Ms. Gallagher’s units as of her date of death, and in doing so, thoroughly examined both expert opinions.  The estate and the IRS disagreed over the following items: (i) the date of financial information relevant to the date-of-death valuation; (ii) the appropriate adjustments to PMG’s historical financial statements; (iii) the propriety of relying on a market based approach, specifically the guideline public company method, and the proper application of this method; (iv) the application of the income approach, specifically the discounted cash flow valuation method; (v) the appropriate adjustments to PMG’s enterprise value; and (vi) the proper type and size or applicable discounts.   Each argument is summarized below:

                              i.        Financials Utilized: Mr. Thomson utilized financial data gathered from PMG’s internally prepared financial statements ending June 27, 2004, and financial information for comparable public companies for the quarter ended June 30, 2004.  Mr. Thomson considered the information more accurate than an earlier date, despite the quarterly numbers were not published until one to two months after the valuation date.  In contrast, Mr. May utilized internally prepared financial statements for PMG through May 30, 2004 – the latest statement published before the valuation date (July 5, 2004), and through March 28, 2004 – the latest quarterly data available before the valuation date for comparable public companies.  Mr. May argued that a willing buyer and seller would be unaware of the later financial information utilized by Mr. Thomson as of the valuation date, and therefore it should not be utilized.  The Court agreed with Mr. Thomson’s use of PMG’s June 27, 2004, financial information and the June 30, 2004, public company financial information, stating that the hypothetical buyers and sellers could have made inquiries as to the financial state as of the later date and would have been able to acquire such information.  In addition, the Court also indicated that as the estate did not allege any intervening events between the valuation date and the publication of the June financial statements that would cause them to be incorrect.   

                            ii.        Adjustments:  Both appraisal experts made adjustments to remove nonrecurring items from PMG’s historical financial statements to better represent the company’s normal operations.  Mr. Thomson made a single adjustment to subtract a $7,895,016 gain on divested newspapers in 2000.  Mr. May made several adjustments to PMG’s financial statements, including three which drew objection from the IRS: (a) reduction of PMG’s EBITDA in 2000 of $7,900,000 for a gain on divested newspapers; (b) subtraction of a $700,000 gain from an inherited life insurance policy in 2003, and (c) subtraction of a $1,100,000 positive claim experience from PMG’s self-insured health insurance in 2003.  The Court accepted the gain recognition in 2000 because the IRS own expert also made the same adjustment but disregarded Mr. May’s life insurance and self-insured health insurance adjustments as he provided no explanation as to why the gains were nonrecurring.  In addition, Mr. May made several other financial statement adjustments which the Court disregarded because Mr. May provided no explanation as to why they were made.

                           iii.        Use of Guideline Public Company Methodology:  Both experts performed the guideline public company method.  However, only Mr. Thomson placed any reliance on it in his final valuation conclusion.  Mr. May indicated that reliance on this methodology is improper because no companies sufficiently similar to PMG existed to support the method’s application.  Mr. Thomson compiled a list of similar companies from a number of frequently used databases, and screened out companies that did not perform newspaper publishing as their primary function.  Mr. Thomson then further pared down the list from 13 companies to four companies most similar to PMG in terms of size, and utilized a market value of invested capital (MVIC)-to-EBITDA multiple to estimate the fair market value of PMG.  The Court determined that the four companies Mr. Thomson ultimately chose were not similar enough to PMG to be comparable with major differences in size, products and growth.  The Court determined that Mr. Thomson’s use of only four companies under the method with such large differences from PMG, was an improper use of the method, and disregarded it altogether. 

                           iv.        Use of the Discounted Future Earnings Method (DCF):  The Court stated that given the lack of public company comparables to PMG, the Court agreed that the DCF method was the most appropriate method to utilize to determine the value of Ms. Gallagher’s units.  Both experts utilized the method but disagreed on: (a) PMG’s projections; (b) whether to tax affect PMG’s earnings in calculating value; (c) cash flow adjustments; and (d) the appropriate rate of return.  For (a), the Court decided to construct their own operating income projections in discounting PMG’s net cash flow.  First, the Court determined that Mr. Thomson’s revenue growth projections were more persuasive and relied upon Mr. Thomson’s revenue projections for their cash flow computation.  Second, the Court disallowed an adjustment to account for higher industry newsprint costs as projected by Mr. May because of his inability to support this assertion.  Third, the Court agreed with Mr. Thomson’s operating margin analysis that estimated operating income at 39.5% of revenue as they did not have confidence in Mr. May’s projections as they stated it was “based on improper earnings and newsprint cost adjustments”.  However, the Court modified Mr. Thomson’s forecasted operating margin to include Mr. May’s projected depreciation adjustment of 3.1% – which they found to be reasonable.  Thus, the Court determined that PMG’s projected operating margin was 36.4%.  Finally, the Court also adopted Mr. Thomson’s projection of other income (expense) of 0.1% of revenue – which they considered to be reasonable.  For (b), Mr. May tax affected PMG’s earnings by assuming a 39% income tax rate and also assumed a 40% marginal tax rate in calculating the applicable discount rate to utilize in the DCF.  In contrast, Mr. Thomson disregarded shareholder-level taxes in projecting both the company’s cash flows and computing the appropriate discount rate.  The Court elected to not tax affect PMG’s earnings and discount rate and stated “the principal benefit enjoyed by S corporation shareholders is the reduction in their total tax burden, a benefit that should be considered when valuing an S corporation”.  Furthermore, the Court stated that because Mr. May provided no further evidence for ignoring such a benefit, the Court elected to not impose a fictitious corporate tax burden on PMG’s future earnings.  For (c), the Court accepted the definition provided by Mr. May that net cash flow is defined as net operating income after tax plus depreciation and amortization expenses and minus working capital adjustments and capital expenditures except for the “after tax portion’ as discussed in point (b) above.  The experts disagreed on both the capital expenditures and working capital assumptions.  The Court found Mr. Thomson’s capital expenditure projection to be more reasonable – stating once again that Mr. May failed to support his projected increases in capital expenditures.  Furthermore, the Court also found that Mr. Thomson’s estimate that PMG’s debt free working capital would remain at -2.5% of revenue throughout the projection period was more reasonable than Mr. May’s due to his complete lack of support for the annual fluctuations purported by Mr. May (which is interesting because Mr. May actually provided projected income statements, balance sheets and cash flow statements which provided explicit detail as to why working capital would fluctuate.  I personally think that they just didn’t understand this part of Mr. May’s analysis).  For (d), both experts used PMG’s weighted average cost of capital (WACC) as the appropriate rate of return with which to discount PMG’s expected future cash flow under the DCF method.  The Court indicated that it is their usual preference NOT to use the WACC, but adopted it anyway because both parties utilized it in their analysis.  Mr. Thomson computed a 10% WACC (assuming a 0% marginal tax rate), whereas Mr. May calculated a WACC of 12.3% (assuming a 40% corporate tax rate).  The Court agreed that the tax rate should be 0% to be consistent with the pretax treatment of the cash flows.  Regarding the cost of equity component of the WACC, Mr. May used a capital asset pricing model formula (CAPM) to derive a 13.5% cost of equity capital and Mr. Thomson used a buildup method to compute a 20% cost of equity capital.  The Court agreed that the buildup method was the appropriate method to utilize when valuing closely-held companies, but disagreed with Mr. Thomson’s calculation and performed their own calculation arriving at a cost of equity of 18%.  Regarding the cost of debt capital component of the WACC, Mr. Thomson estimated PMG’s pretax cost of debt at 6.6%, while Mr. May calculated a 5% average cost of debt.  The Court was not convinced as to the accuracy of either expert’s analysis, but decided to accept Mr. Thomson’s calculation as his proposed higher cost of debt results in a lower present value of expected cash flows.  Mr. Thomson assumed a mix of 75% debt and 25% equity, taking into account both PMG’s current capital structure and the guideline companies’ median capital structure.  Mr. May assumed a mix of 15% debt and 85% equity, and provided little support for how he arrived at these percentages.  The Court agreed that the 75% debt and 25% equity capital composition is appropriate.  Accordingly, the Court’s revised WACC computation using an 18% cost of equity also determined the appropriate WACC to utilize in the DCF was 10%.

                            v.         Adjustments to PMG’s Enterprise Value:  Both experts agreed that, under the DCF method, PMG’s long-term debt must be subtracted from the present value of its future cash flows in order to arrive at the fair market value of PMG’s units.  They, disagreed, however, as to the amount of PMG’s debt as of the valuation date.  Mr. Thomson determined that the Company had $243,602,413 of debt based on a June 27, 2004, balance sheet and Mr. May concluded that PMG had $243,300,000 of net debt as of May 30, 2004.  As the Court previously agreed with Mr. Thomson that the financial information through June 27, 2004, is acceptable, they also adopted Mr. Thomson’s debt conclusion of $243,602,413.  Mr. May also adjusted PMG’s value by $900,000 to reflect its underfunded working capital whereas Mr. Thomson did not make this adjustment.  The Court disregarded Mr. May’s working capital deficit adjustment as they decided it was not persuasive.  Mr. May also made adjustments to:  (1) add $12,847,000 to account for S shareholder tax savings on all future projected distributions in excess of tax distributions; (2) add $44,262,000 to reflect the future value of the company’s deductible goodwill, and (3) adding $6,693,000 to account for the company’s extra marginal debt tax shield.  Mr. Thomson did not make any of these adjustments.  The Court found that the S-corporation tax savings were already correctly accounted for by using a pretax discount rate and pretax cash flows.  The Court disregarded all three of Mr. May’s adjustments has he failed to convince them of their accuracy. 

                           vi.        Applicable Discounts:  Both experts agreed to the use of discounts in valuing Ms. Gallagher’s PMG units.  Mr. Thomson applied a 17% minority discount to his valuation result under the DCF method and then applied a 31% marketability discount to arrive at an aggregate minority interest value of PMG of $267,000,000 as of the valuation date.  Mr. May only applied a 30% discount for lack of marketability stating that a minority interest discount was unnecessary because the DCF methodology is derived based on cash flows that are assumed to accrue pro rata to all equity holders, therefore the resulting firm value is on a minority interest basis and needs no further adjustment to reflect a minority interest value.  The Court determined that a minority discount was appropriate, but disagreed with Mr. Thomson’s computation of the discount and concluded that a higher minority discount of 23% was appropriate.  In addition, the Court determined that a 31% lack of marketability discount was also appropriate.

Ultimately, after consideration of all arguments, the Court determined that the fair market value of Ms. Gallagher’s shares in PMG was $32,601,640, not the $34,936,000 as originally stated on the Form 706, which was a complete victory for the taxpayer.

Parting Thoughts:

This case was probably the most interesting valuation case that I have reviewed in the last several years.  I found it fascinating the way the Court decided to prepare their own DCF analysis by analyzing the underlying DCF assumptions utilized by each appraiser and either selecting the assumption deemed most credible or determining their own assumption.  I, like many appraisers, was disappointed in the fact that the Court still does not understand the need to tax affect S-corporation earnings or cash flows.  However, it took the Court many years to start recognizing the tax associated with unrealized built-in gains associated with certain company assets, so it is likely going to be a similarly long process.

**BREAKING NEWS – Supplemental Memorandum Opinion Issued October 11, 2011

 On October 11, 2011, the Court issued a supplemental memorandum opinion in order to correct a mathematical error in their computation of the value of the 3,970 membership interests in PMG.  In the original decision, the value was calculated by computing the total present value of the expected cash flows for five years and added to that sum the present value of the terminal value component of the DCF.  However, the Court utilized an incorrect present value factor of (1+0.1)^6 instead of the correct present value factor of (1+.01)^5.

 The end result is that the Court re-determined the value of the 3,970 units at $35,761,760, which is an increase of $3,160,120 over the Court’s original determination as of the valuation date.  However, it is interesting to note that this end result is extremely close to the $34,936,000 originally stated on the Form 706.  So much for the Estate’s refund!

John G. Mack, ASA, CBA – Nationwide Valuations -  (303) 496.0643 (direct)  (303) 586.4554 (fax)

john@nationwidevaluations.com - www.nationwidevaluations.com

The baby boomer generation has been one of the most entrepreneurial generations in the history of our country.  During the last 30 years over 5 million businesses with annual revenues ranging from $1 million to $75 million were founded. The owners of most of these businesses are now 50 years old or older and beginning to think about retirement. Studies by PriceWaterhouseCoopers, MassMutual and Marquette University showed that one out of two businesses will change hands between 2006 and 2016. 

The American Family Business Survey sponsored by MassMutual showed that approximately 30% of these owners plan to sell their business to a third-party buyer.  Another 30% plans to sell to a family member, while another 18% plan to sell in some manner to current employees.   The remainder plan to close and liquidate the business.

For those business owners who intend to sell to a third-party, it will become increasingly important that they position their business to sell successfully in an increasingly competitive market.  Over the next 15 years, the U.S. economy will experience an unprecedented increase in the number of businesses for sale as baby boomer entrepreneurs begin to retire. With one out of every two business owners looking to sell, the result will be a glut of available businesses and downward price pressure for most privately owned companies.  Now, more than ever, it will be important that a business owner focus on doing everything he or she can to increase the attractiveness, value, and salability of the businesses.   

Tragically, the PriceWaterhouseCoopers study showed that approximately 75% of private business owners have no strategic exit plans in place.  An additional 25% have done little or no estate planning.  This is a recipe for disaster. 

Given the number of companies coming to market, business owners will need to focus on improving profitability, building a management team, and growing revenue in order to make their companies more attractive and maximize the proceeds they receive at the time of exit.

An exit plan is a comprehensive, integrated plan that asks and answers all of the personal, business, legal, financial, tax and estate issues that are involved in exiting from a privately owned business.  This plan allows business owners to begin positioning themselves and their businesses so that they can accomplish all of their personal, financial and business goals when they exit.

Exit planning delivers tangible results for savvy business owners.  It is not uncommon for companies that have invested the time and effort to prepare themselves for sale to sell for a significant premium over companies that come to market unprepared.  In addition, with good planning business owners are often able to reduce or in some cases eliminate the capital gains taxes due at the time of sale.  This dramatically increases the after-tax net proceeds that owners keep.  But the most often overlooked component of exit planning, and perhaps the most important, is the peace of mind that comes when a business owner knows that he or she is being proactive and taking charge of the future, rather than waiting passively to let the future take care of itself.  After all, deciding how and when to exit a privately owned business is perhaps the single most important financial and personal decision in a business owner’s lifetime.

GOOD REASONS TO BEGIN EXIT PLANNING NOW:

• The number of business owners wanting to sell their businesses each year will continue to increase, creating more competition.
• Selling your business sooner rather than later could provide the best chance of maximizing its value because the younger baby boomers who are retiring from corporate jobs will be active buyers. In the later part of the baby boomer bubble these new entrepreneurs will also be looking to exit.
• It takes approximately 2 years of focused activity to get your business ready to sell at a reasonable price.

To get started on the exit planning process as well as the exit process, get informed. Seek information from the best independent and objective sources possible. One good place to start is to talk with trusted advisors like your attorney, accountant, financial advisor, or insurance professional or an investment banker who focuses on privately held businesses.  Another great place to begin is with a Certified Exit Planner, because they are trained to help you consider all of the many parts to this process, and they can work with you and your advisors to put together a complete multi-dimensional plan to exit your business in the way that best meets your needs.

Marsha Golgart CMEA, CEPA, ISBA  -  Nationwide Valuations  -  (303) 484-3033    (303) 374-6771 (fax)

marsha@nationwidevaluations.com - www.nationwidevaluations.com

Baron Rothschild, when asked how he became rich replied, “I always sell too soon.” By that he meant he never waited to get out of a business at the very top price. He sold while the price was still rising and by doing so minimized the chances of losing money on any of his investments and businesses.   

Every business owner has an inevitable day when they will no longer own their business. Ben Franklin wrote “Nothing is certain but death and taxes,” and he was right. By planning your exit from your business, though, you can leave at the best time for you, your family and your investors.  Just as you don’t want to wait for a fire to plan your exit route from a building, you shouldn’t wait to put a plan in place for exiting your business.

What’s your business worth? What do you want it to be worth? How do you recognize when it’s time to leave? Your business plan is the blueprint to get you to that level and your exit strategy guides you on when to cash out.

It takes a lot of time and dedication to build a business that will be profitable, even more if you want it to grow very quickly. Although it is possible for people to sustain 80 – 90 hour weeks for a couple of years, most people function at their very best with no more than 55 – 60 hours a week at work. Beyond that, they start spinning their wheels and are not as productive as they should be. Once you’ve built your business to a certain point – and that will vary from business owner to business owner, consider making changes that will allow you to sustain growth without dedicating every hour, waking or sleeping, to your company.

One of those changes will be to start delegating a lot of your operations to someone else. This is good for you, because it will give you the opportunity to focus on your business strategy, your management team, your customers and the “big picture.” It is also will help you to position the company so that you can take advantage of any exit opportunities that may occur, and prepare to stimulate opportunities as well.

What are typical exits for business owners? If everything goes well, for the typical small business, it provides a nice income for the owner and is then sold for a good price. The key to a successful exit here is to make sure that your business will bring a top price for its category and location. Small business owners with an eye to exit can manage the business’ income for a couple of years before seeking a sale. Boosting income can be accomplished in a number of ways. One way, of course, is to boost revenues. Top line growth is best, if you can maintain or improve your profit margins. You can also reduce expenditures, by deferring capital expenditures, reducing training and business travel and entertainment. Use a reputable accounting firm, even if you have never before done so, because financial statements that have been audited by a CPA firm have credibility. The offers given to small businesses often discount valuation if there is a chance that the financials are inaccurate. With a clean audit by a good CPA firm, you prove your business’ past performance and can justify full valuation in your asking price.

A great way for someone who has built a business over the years to cash out is by selling it to someone who intimately understands all of the operations and realizes the company value. In a small business, you may have an assistant who would be interested in buying your business. It is often good to offer them part-ownership to start, and then sell them more of the business until they have full ownership. There are a number of ways to finance this. If you know that they are good and that the business is solid, you may consider carrying the financing for the purchase. It’s worth spending some money on a good lawyer when drawing up the sale contract. An enforceable contract can protect you from unexpected business problems.

Larger companies often require more cash and a good source of buyers is the company managers. Often they will not have the money to buy you out, and you may not want receive steady payments. These buyers, with a proven industry track record and your company’s solid assets, may be able to get the money from investment bankers or private equity companies. This process is known as an LBO or leveraged buyout.

Another good exit is to develop close relationships with other businesses that may be interested in acquiring you in the future. Although they can be competitors, it’s usually best if they are not exactly in your market niche. Your most promising opportunities will come from businesses with which you have a strategic fit, where your business makes theirs stronger and vice versa. Those are also companies you may decide to acquire if you have the resources and they appear to be available. The closer the relationship that you have with them, the better you can value each other.

Sometimes, it makes more sense to exit by closing the business at the end. This often happens when the underlying real estate has become valuable – good for you if you own it, bad if you are leasing and the landlord declines to renew the lease or proposes such a change in rent that your business cannot continue to be profitable. A planned store closing can be very profitable. The moderator of the Rules For Revolutionaries list posted recently about a company that left the bricks-and-mortar world two years ago to reposition as a virtual company. They had a “Going Out Of Business: 0% Off Sale” and sold out. Companies that specialize in liquidation sales are very profitable and usually buy high-margin, cheap stock specifically for the “going out of business” sales. If you are running your own sale, that may not be how you wish to be remembered in the business, but you should consider stocking up on items you know will sell based on past experience.

Bankruptcy can, in some cases, be a good exit from your business. A bankruptcy can be used to reorganize the business and allow you to continue operating it. It also works to salvage it and allow someone else such as a creditor to operate and sell it. Finally, it can be a clean break from your old debts and obligations.

If your company is growing well and needs ready access to large amounts of money to continue that growth, you may want to consider positioning it for an IPO (initial prospectus offering.) This is a very expensive and involved process that allows your company to sell stock to the public. For the past few years, some Internet firms were brought to market well before really being established businesses with real revenues and profits. When the cash window is open at the stock market, you may make a great deal more money selling stock in the company than you can in selling the company itself. An IPO is also a very valid strategy to use if you need to raise a lot of money and have access to the capital markets on a continuing basis. One thing to consider, if your company does IPO, is that you will have to follow very stringent accounting rules and meet Securities and Exchange Commission requirements. A lot of information about your company will be filed with the government and will be accessible to the public, including to your competitors.

The end for many business owners can actually be their own “final exit.” If it is unanticipated, a number of unpleasant things can happen to your business and your heirs. At the very least, no matter how young you are, you should know who is going to end up with the responsibility for running the business and who will get the benefit of owning it. Often these will be family members but they can be trusted associates or organizations that provide needed services. You can even set up your own family foundation and leave the business or its proceeds to support purposes that you have specifically chosen. The key to success here is to pick trustees who will follow your wishes as well as your will.

If you do intend to leave a profitable business to your heirs, rather than to a charity or foundation, it is a good idea to transfer ownership to them in an orderly way that will minimize your tax liabilities. A good estate attorney will be able to help you structure the transfer so that taxes and other liabilities will be reduced and you can feel safe that the government will get what it is owed and not a penny more.

Regardless of what your particular plan entails, the important thing is to have a plan in place, and Certified Exit Planners can help you with that.

Marsha Golgart CMEA, CEPA, ISBA  -  Nationwide Valuations  -  (303) 484-3033    (303) 374-6771 (fax)

marsha@nationwidevaluations.com - www.nationwidevaluations.com

Tips on choosing a “qualified” Business Valuation Company:

1.   Ask for the qualifications of their appraisers
The SBA requires accreditation from one of the following recognized organizations:
• Certified Business appraiser (CBA) accredited through the Institute of Business Appraisers
• Accredited Valuation Analyst (AVA) accredited through the National Association of Certified Valuation Analysts
• Accredited Senior Appraiser (ASA) accredited through the American Society of Appraisers, business valuation specialty.
• Accredited in Business Valuation (ABV) accredited through the American Institute of Certified Public Accountants
• Certified Valuation Analyst (CVA) accredited through the National Association of Certified Valuation Analysts

2.   Ask if their reports are both USPAP compliant (Uniform Standards of Professional Appraisal Practice) and compliant with the professional standards of the appraisal organization they are accredited by.  (IBA, NACVA, ASA, AICPA)

USPAP STANDARD 9:  BUSINESS APPRAISAL, DEVELOPMENT
In developing an appraisal of an interest in a business enterprise or intangible asset, an appraiser must identify the problem to be solved, determine the scope of work necessary to solve the problem and correctly complete the research and analysis necessary to produce a credible appraisal.  (note:  there are 6 specific rules under Standard 9)

USPAP STANDARD 10:  BUSINESS APPRAISAL, REPORTING
In reporting the results of an appraisal of an interest in a business enterprise or intangible asset, an appraiser must communicate each analysis, opinion, and conclusion in a manner that is not misleading.  (note:  there are 4 specific rules under Standard 10)

If you would like to see the details of both STANDARD 9 and STANDARD 10, send a request to info@nationwidevaluations.com.  We would be happy to share these very important details.

3.   Ask about their process.  Is it simple, but thorough? 

4.   Ask about their track record with satisfied clients. 

5.   Ask if the approval of the SBA  has confirmed that their process works.

6.   Ask for references.  These should present a compelling story directly from your peers in the banking industry.

7.   Ask how the company is staffed.  Are they a one person shop with limited bandwidth?  To use a sports analogy, do they have the bench strength to get the valuation done on time with experts that can handle questions and special situations.

8.   Ask about turnaround time.   You should not have to wait three or more weeks for a valuation report.

9.   Ask about the availability of rush services.  

A professional, accurate, independent business valuation will help you, the lender, get the information you need to get the loan approved and you’ll have a satisfied client.

For more information contact Nationwide Valuations:  call 888.750.5259, send an email to info@nationwidevaluations.com, or go to www.nationwidevaluations.com and click on “Live Chat”.

The Facts: 

Boltar, L.L.C. (Boltar) claimed a federal income tax deduction for a conservation easement as a qualified conservation contribution of $3,245,000 on their timely filed partnership return.   The IRS disallowed all but $42,400 of the charitable contribution deduction.  The case was brought before the Court to determine the admissibility of Boltar’s experts appraisal of the conservation easement donation at trial.

The Arguments:

The IRS claimed the appraisal produced by Boltar’s experts was “neither reliable nor relevant under the Federal Rules of Evidence and Daubert v. Merrell Dow Pharm., Inc. U.S. 579 (1993).”

According to Section 1.170A-14(h)(3)(i) of the Income Tax Regs, “if comparable sales are not available for an appraisal, as a general rule (but not necessarily in all cases)” the before and after method of valuation should be used.  During the trial the Court determined Boltar and their experts did not provide any persuasive reason as to why they did not apply the method in their appraisal.  In addition, the Court agreed that Boltar’s appraisal assumed, at least in part, potential development of the property which was not feasible.  The IRS claimed Boltar’s appraisal was “based on whatever use generates the largest profit, apparently without regard to whether such use is needed or likely to be needed in the reasonably foreseeable future.”

In addition, the Court also agreed with the IRS that the standard of admissibility of Boltar’s appraisal as evidence in a Tax Court case should not be lower than the admissibility standard at a jury trial- the “Daubert” standard. 

Neither the IRS nor the Court disputed Boltar’s appraisers’ qualifications, but rather “their willingness to use their resumes and their skills to advocate the position of the party who employs them without regard to objective and relevant facts, contrary to their professional obligations.”  The Court was not inclined to admit Boltar’s appraisal and then weigh its judgments because “Neither petitioner nor the petitioners’ appraisers suggested any quantitative adjustment in response to their admitted errors or the problems addressed in respondent’s motion in limine.  The appraisers simply persisted in asserting an unreasonable position.  We are not inclined to guess at how their valuation should be reduced by reason of their erroneous factual assumptions.  Their report as a whole is too speculative and unreliable to be useful.”

The Findings:

The Court agreed with the IRS’s motion to entirely exclude Boltar’s appraisal from the trial record as “unreasonable, unreliable, and irrelevant expert testimony”.  The Court agreed with the IRS that the taxpayer’s appraisal failed to determine value using the before and after method of valuation and failed to consider the potential residential use of the property.  It also found that the appraisers’ projected condominium development could not physically fit on the property and that the appraisers ignored the effect of a pre-existing pipeline gas easement.  

Parting Thoughts:

This case stresses the importance that appraisers stay objective and be an advocate of their value, not an advocate of the position of the party that employs them.  The appraisers ended up doing a true disservice to their clients in this case.  While this case was for a charitable easement, it establishes precedent for applying Daubert to valuation evidence in Tax Court.

John G. Mack, ASA, CBA – Nationwide Valuations -  (303) 496.0643 (direct)  (303) 586.4554 (fax)

john@nationwidevaluations.com - www.nationwidevaluations.com

The Facts:                                           

Ms. Jensen was a resident of New York when she passed away on July 31, 2005.  Prior to her death, in February 2003, Ms. Jensen had created the Marie J. Jenson Revocable Trust and had appointed herself trustee.  Upon Ms. Jensen’s death, the trust held 164 shares of common stock in Wa-Klo, which equated to a controlling 82% equity interest in Wa-Klo.  Wa-Klo’s principal asset as of Ms. Jensen’s death was a 94-acre waterfront parcel of real estate which included athletic facilities, horse stables and a girl’s summer camp.  Wa-Klo was a C Corporation created in 1956 in the state of New Hampshire.

Upon the death of Ms. Jensen, the estate hired an appraiser to value Wa-Klo.  The appraiser indicated that the asset approach was most appropriate and that the income approach did not apply because (1) the company’s camp operations did not generate significant cash flows; (2) the asset value was the highest and best use; and (3) the estate’s controlling interest could dictate a sale.  Furthermore, the appraiser disregarded the market approach because the underlying real estate appraisal already incorporated sales comparables.  The appraiser computed a net asset value of approximately $4.2 million.  The appraiser then reduced the net asset value by $965,000 to account for the built-in long term capital gains tax liability (calculated on a dollar-for-dollar basis).  The appraiser then computed the value of an 82% equity interest and applied a 5% marketability discount, ultimately valuing the 82% equity interest in Wa-Klo at $2.55 million.

The IRS agreed with the 5% marketability discount and the use of the net asset value approach, but calculated a $250,000 discount for the built-in long term capital gains tax liability.  Thus, the IRS computed and assessed a $333,245 deficiency in the Estate Tax Return.

The Arguments:

The IRS claimed that 2^nd Circuit precedent was controlling (the 1998 decision of Eisenberg v. Comm) – which first allowed a discount for embedded capital gains tax as a question of valuation dependent on the facts and circumstances of the case and taking into account the fair market value standard of willing buyer/willing seller. The IRS argued that only a portion of the built-in gain should be considered in the valuation of the company.  The IRS’ expert examined data from general closed-end funds, finding built-in capital gains exposure ranging from 10.7% to 41.5%.  From these findings, the IRS appraiser was unable to find a direct correlation, at least up to 41.5% of net asset value, between higher exposure to built-in capital gains tax and discounts from net asset value (NAV).  Thus, the IRS appraiser divided the company’s improved real estate assets by its net asset value and concluded that 66% of NAV was subject to tax liability at the corporate and shareholder levels.  However, since the data did not support any discount for the first 41.5% of long term capital gains tax exposure, he deemed that only the portion of gain in excess of 41.5% (66% less 41.5% = 24.5%) should be given a full dollar-for-dollar discount.  This total was then utilized to calculate a 40% Federal and state tax amount, which resulted in an IRS discount of $415,000 (or approximately 10% of NAV).  The IRS also argued that there are additional common ways of avoiding a built-in gain tax, such as a 1031 like-kind exchange or conversion from a C-Corp to an S-Corp.

The estate referred to Court of Appeals for the Fifth Circuit (Estate of Dunn) and Eleventh Circuit (Estate of Jelke) decisions which allowed dollar for dollar reductions in value for built-in gains tax.

The Findings:

The Tax Court reviewed the arguments of the IRS and the Estate.  The Court agreed with the IRS that the broader factual inquiry of Eisenberg applied to this case, but declined to speculate how the 2^nd Circuit “may hold in the future.”  However, the Court rejected the IRS closed-end comparison and analysis because they were not comparable to the assets owned by Wa-Klo.  Wa-Klo owned real estate on which operated a summer camp that was not generating profits.  Therefore the value of the assets was the value of the underlying real estate.  The Court pointed out that closed-end funds have value based on multiple investments in many types of real estate.  Furthermore, when valuing the funds, the market typically considers the skill of the management, supply and demand, investor confidence and the funds’ prior history.

Consequently, the Court reviewed all the evidence and conducted its own present value calculations based on the fair market value of the improved property, multiplied by appreciation (using both 5% and 7.725%) and compounded interest rates (over a 17-year holding period – which was determined to be the remaining depreciable life of Wa-Klo’s assets), plus a 40% effective tax rate to reach a long term capital gains tax liability of approximately $1,200,000.  As this long term capital gains tax liability amount was higher than the estate’s appraised dollar-for-dollar discount, the court concluded that the Estate qualified for the full dollar-for-dollar discount on the calculated built-in capital gain.

Parting Thoughts:

This decision is a good victory for the taxpayer in the arena of the built-in long term capital gains tax liability.  It is important to note that this reduction in value was still allowed even though at date of death neither a sale nor liquidation of Wa-Klo or its assets was imminent or planned.  However, the Court specifically declined to adopt a per se rule of 100% discount for long term capital gains tax liability.  Thus, it is an area that is still ripe for appeal to the 2^nd Circuit.

John G. Mack, ASA, CBA – Nationwide Valuations -  (303) 496.0643 (direct)  (303) 586.4554 (fax)

john@nationwidevaluations.com - www.nationwidevaluations.com