Taxation of Earn-Outs in Mergers and Acquisitions

Tax  Points – Below is a summary of the tax treatments of earn-outs.  Remember, every situation is different.  These are general guidelines and not specific advice.  Do not enter into any transaction without review of tax issues by competent tax advisors.

Connect with Harvest Business Advisors today – email info@harvestbusinessadvisors.com or call 443.334.8000

  1. Income tax treatment for the seller – earn-outs are recognized by the tax rules as an “installment sale” meaning that each payment received by the seller includes two components:
    a. a portion of the “basis” is recovered (not taxed) and
    b. a portion of the “gain” is received (taxed).
    c. Some assets are excluded from the earn-out treatment, notably inventory and depreciable assets subject to depreciation recapture requirements.  For these asset classes, the gain is recognized in the year of the sale, regardless of payment terms.
  2. Earn-out Contingencies – the final purchase price for a deal that has an earn-out component is not known at time of sale; it is “contingent” on some future event(s) as defined by the earn-out agreement.  Examples of earn-out contingencies are:
    a. meeting specified, agreed upon financial targets (gross revenue, gross profit, EBITDA etc),
    b. customer retention,
    c. contract renewals.
    d. The final purchase agreement will include the formulas used to determine when the terms and conditions of the earn-out are satisfied and the seller gets paid.
  3. Final Purchase Price Determination – the final purchase price agreement will include the language regarding when the final purchase price is going to be determined.  The final price can be:
    a. Stated at a maximum price,
    b. Determined within a defined period,
    c. No maximum price and no defined period
  4. Interest on seller financing – remember that earn-outs are really a form of seller financing during the earn-out period.  Therefore, interest must be separately stated; if not, a portion of the deferred payment could be reclassified by the IRS as interest
  5. “Opt out” provision – this is a non-revocable election made by the seller meaning that if the seller has a change of mind and wishes to revoke the opt-out election, the IRS must approve it first.  The “opt-out” provision can only be elected n the year of sale.  If the election is made, then the the fair market value of the contingent payments are taxed in the year of sale, even though the cash is received in subsequent years.
  6. Depreciation and amortization – this applies to the buyer.  Depreciation and amortization begin when the payment is made, not when the deal is closed, meaning the tax benefits of depreciation and amortization are deferred until such payments are made
  7. 2013, New tax consideration – effective 2013, subject to various tax thresholds, there is a new tax of 3.8% imposed on the “net investment income”.  The definition of “net investment income” includes the disposition of interests in partnerships and s-corporations.  Point is, there is a new tax in town to consider.
Ed Davis, CPA, CVA
Harvest Business Advisors
Business Brokerage, Business Valuation, Transaction Planning
301-325-7687
www.harvestbusiness.com

How to Sell Your Business – Who Is My Buyer? For Middle Market Businesses

What every business broker and business appraiser knows is that in order to get the highest price when you want to sell your business you must identify and attract the best, most motivated and qualified buyer for your business.  This will vary with your size, profitability, industry and so on.  This post is one of two identifying buyer groups.  One of the things a knowledgeable broker and exit planner does is help you identify your business buyer and what they specifically want accurately.  This article contains important general information and buyer groups for lower middle market businesses generally with a value of $3 million or above.

Considering Selling Your Business? Please click here for a downloadable e-book, “ 10 Ways to Increase the Value of Your Business“.

Lets start with a story:

When I was young, I would go fishing with my Dad.  We had fun but Dad knew nothing about fishing.  When I got a little older I went fishing with my brother’s boxing coach, Bud.  Bud was a short, stocky man with a brain tumor – the result of more than four hundred amateur and semi-pro fights.  That probably explained most of the crazy things in his life.  But Bud knew how to fish.

He told us that he would fly shotgun in small airplanes looking for unfished ponds on farms.  (This was long before Google Earth).  Then he would go ask the owner if he could fish their pond.  Inevitably they would tell him that there were no fish in that pond but go ahead.  Bud had his special lures and eighty percent of the time he caught tons of fish.  The first time I went fishing with Bud, we caught so many fish so fast it felt like I was cheating!  Bud caught fish by fishing in ponds that had tons of fish because no one had fished them in years.  Bud knew how to find fish and, with his special lures, he caught them.

What does this have to do with selling a business?  The most important thing you have to do is to figure out who and where your fish (Buyers) are.  These are the people who are likely to be the most interested in your business and therefore the people who will pay you the most.  Who these people are will vary with what you have to sell and what you want to accomplish.  Below, we summarize the major groups and when they are likely to be the best Buyers. We address how to find them later in the book.

Remember to make your business as desirable as possible for your ‘best’ buyer.  This may involve physical changes to the business over time.  It may involve providing financing or training that is a little out of the norm.  It certainly will involve looking at the prospective buyers of your business as you would your regular customers and make your product (the total business) as great as possible.

Below, we are outlining how we classify buyer groups.  As with any grouping of people some people will fit several groups and some will not fit any.

Synergistic Buyers.  These are companies that are in the same or a related business that will have sales or operational advantages allowing them to pay more for the business than what is justified by the current selling business cash flow alone.  The classic example of this is a delivery business that buys a competitor with the same territory.  Now instead of making an average delivery for 10 miles of driving they might make one every 5 miles greatly reducing the average cost per delivery.   The key with synergistic buyers is they CAN pay more if they wish.  They tend to be very picky about what and when they buy.  You must understand what they are looking for and when they are buying be willing to sell then.

Private Equity Groups (PEGS).  These are investment groups that are looking for growth oriented opportunities.  Generally they want $3 million of EBITDA (Earnings Before Interest, Taxation, Depreciation and Amortization – a measurement of cash flow potential).  They want a good management structure in place and they want to be about to multiply the company size and resell the company in 5 to 10 years.  Usually the first company they buy in an industry is called a “platform” and is a larger business.  Often after they acquire a platform they will then buy smaller businesses as ” add-ons” as part of their growth strategy.

Competitors.  Sometimes competitors are owned by PEGS and/or are Synergistic but here I am referring to them in a more generic sense.  Competitors are buyers but unless they are actively acquiring competitors they tend to pay poorly and often (but not always) are a last resort buyer.  Of course, if you are in financial trouble they may be the only potential buyer.

Form an ESOP.   An ESOP is an Employee Stock Option Plan.  It is beyond the scope of this article to describe but in the right circumstances is an excellent way to sell your business.  The sale is to a trust that will own your stock for the benefit of your employees.  It is a retirement plan under the internal revenue code so it is quite complex.  Generally if you have 25 or more employees, stable earnings above $2,000,000, then and ESOP should be reviewed as an option.

Whichever buyer type makes the most sense for you and your firm make sure you understand what they will buy, when they might buy it, and most importantly what they will never buy.  As always you may call us to confidentially review your situation.

 

Gregory R. Caruso, JD, CPA, CVA
Harvest Business Advisors
609-664-7955
gcaruso@harvestbusiness.com
www.harvestbusiness.com

Business Valuation for Business Sale Price Estimates – More Detail on Calculating a Valuation Multiplier

Small business valuation for selling your business, or business merger and acquisition purposes is tricky and depends on many factors.  In this article I summarize how a valuation multiplier for a small business could be calculated.  The calculated value should also be checked against the business sales comps available from one or more databases such as Pratt’s Stats, www.bvmarketdata.com  and BizComps, www.bizcomps.comYou can also look in The Business Reference Guide by Tom West, available at www.bbpinc.com  .  Also, get a check from a reputable experienced business broker or valuation professional in all cases before entering into contracts or even negotiations.

Want to know more?  Please click here for the downloadable e-book. “7 Things You Must Know Before You Order a Business Valuation” 

This methodology is most effective for businesses with a value between $150,000 and $1,500,000.  Below $150,000 in value in my experience it is hard to reasonably calculate value although in many cases it does exist.  If the value is low enough you must also look at what the liquidation value of the assets may bring.  Sometimes this is the highest value.  Once a company grows larger than $1,500,000 there are other methods that may be more accurate which should be used to estimate value. We will post another article or articles on valuing larger businesses in the near future.

This methodology works for estimating the business value or business sales value of most types of companies including subcontractors, electrical companies, HVAC, plumbing, engineering firms, service firms such as CPA’s and consultants, manufacturers, government contractors, retailers, restaurants, etc. 

Generally, the multiplier is calculated by looking at risk and how the business will continue to generate cash flow for the new owner and the perceived desirability and growth prospects of the firm.  This is similar to the concept behind bonds or bank accounts.  Junk bonds pay more interest than government insured savings accounts in order to attract your investment dollar.  Of course, you will never lose principal on the government insured savings account.  Small businesses are very risky and carry a large discount usually in the 20% to 50% range.  The safer the business the higher the multiplier.  The higher the multiplier the higher the value and price when it comes time to sell.

Typical factors in the calculation:

  • Ease of entry into business
  • Location of business
  • Competition in Market Area
  • Historical profit trend
  • Industry trend
  • Size of business
  • Management systems in place
  • No one customer providing more than 10% or 20% of sales revenues
  • No major suppliers that would be hard to replace
  • Availability of financing
  • Condition of Books and Records

 One way to do the analysis is to rate each factor above from 1 to 4, with four being the most favorable, then divide by the number of applicable factors.   In all likelihood your business multiple will be between 2 and 3.  The average is between 2.3 and 2.7 depending on who is collecting the data.  Businesses that tend to be owner intensive such as auto shops and small independent restaurants tend to sell around 2 or less.  Highly efficient larger service firms with contracts may sell for 3 to 3.5.  Again, only proven rapid growth companies or unusually hot businesses (think BMW auto dealerships) reach above 4. 

 Example of Calculating a Multiplier:

 Sam’s Auto Repair factors     

Ease of entry into business                                                              1 easy to enter

Location of business                                                                          3 Sam’s is in an urban area where auto related land usage is discouraged

Competition in Market Area                                                          3  Same as above – few competitors, hard to get a nearby location

Historical profit trend                                                                      3 Sam is profitable

Industry trend                                                                                     2 Too many new cars

Size of business                                                                                   2  Sam’s is still small

Management systems in place                                                   2  Has great receptionist / scheduler

No one customer exceeding 10% or 20%                             4  Few large commercial acc.

No major suppliers that would be hard to replace          4  Many parts stores and suppliers

Availability of financing                                                              2  Hard to finance Auto related

Condition of books and records                                                3  Easy to follow, accurate books and records and tax returns

 

That totals 11 factors with a sum of 29 creating a multiplier of 2.6 which is high for an auto repair but the assumptions make this look like a pretty good small business.  Give him poor financial books, low profitability, and a neighborhood with car repair on every corner and you quickly have a 2  multiplier.                         

Now you just multiply your discretionary cash flow by your multiplier and you get an estimate of value.  ($150,000 discretionary cash flow times 2.6 equals $390,000 estimated value).  If done accurately (experience helps!) this can produce a very good indication of value.  It is also useful for internal purposes just as a check to see how you are doing as good businesses are valuable businesses.

DISCLAIMER:  Please note that this is a useful formula for preliminary planning or tracking your progress but is not a substitute for a proper valuation when selling your business.  NEVER go to market or enter into important negotiations or legal proceedings based on a rule of thumb formula such as this.  Get proper valuation assistance.  Call us.

Gregory R. Caruso, JD, CPA, CVA
Harvest Business Advisors
609-664-7955

gcaruso@harvestbusiness.com
www.harvestbusiness.com

 

Small Business – Business Valuation Formula and Example

Business valuation for M&A or other purposes such as divorce, partner disputes, IRS and estate planning purposes are complex formal processes.  What is provided here is a basic rule of thumb business valuation approach useful for preliminary planning for companies with revenues between $50,000 and $5,000,000 and/or owner profit plus owner salary of $75,000 to $500,000 range. 

Do not use the provided business valuation formula for formal final uses such as going to market in a sale situation or legal proceedings etc. without review and approval of a valuation professional.  Many businesses such as contractors, engineering firms, sub-contractors, specialty contractors such as electrical contractors, plumbing contractors, HVAC contractors, landscape contractors, suppliers, retailers, business services, manufacturers and the like can use this business valuation formula.

Want to know more?  Please click here for the downloadable e-book. “7 Things You Must Know Before You Order a Business Valuation” 

A small, owner-operated businesses with an active working owner who performs day-to-day tasks such as sales, production, direct management etc., can be valued using the following formula: 

Owner’s salary plus profits plus expenses benefiting the owner (such as underemployed family member on the payroll; exotic travel to conventions; auto; heath insurance; pension to owner etc.)  plus one-time charges (perhaps a large legal bill in one year only) plus interest plus depreciation and amortization equals the Seller’s discretionary earnings or SDE. 

If you are an absentee owner in a business that is usually owner run,  then you can add your manager’s salary back to the cash flow.  If you have cost advantages your Buyer will not have, subtract these.  Those often involve rent where you own the building the business occupies.  Most Sellers adjust the rent to market cost at the time of the sale so that should be factored into the formula.                         

Some people call this “normalizing” the cash flow.  The idea is to show a Buyer what her normal discretionary earnings will be.  They are called discretionary earnings because the owner decides what to reinvest and how to pay herself.  You can pull many of these figures directly from the company income tax return.  The total is then multiplied by a value called a multiplier.  In most cases the multiplier is 1.5 to 6 with between 2.3 to 2.7 being about average for small businesses. 

 Example of Calculating Value:

Consider this example of Bob Smith who owns Smith Electric.  Bob has a steady base of service work with some new construction mixed in.  Bob has four service crews and still often performs remodeling jobs himself.  Bob makes about $100,000 in salary.  His wife makes $35,000 working one day a week as the bookkeeper.  Bob drives a company truck all the time.  He has health insurance through the company.  He spent $12,000 last year on interest and had $35,000 in depreciation.  Bob runs the business from an office warehouse which he owns.  The business does not pay rent to Bob for Smith Electric’s 2500 square feet of space.   

The valuation math would work like this:

 Salary $100,000 plus excess salary to wife estimated at $20,000.  Plus personal use of truck estimated at $5,000 plus health insurance at $11,000 plus interest at $12,000 plus depreciation at $35,000 minus $24,000 estimated rent.  This totals $159,000.  Assuming Bob has a high percentage of service work which tends to be predictable then his multiplier might be around three.  That would put the value of his business at about $477,000.  If Bob mainly performed new construction work obtained from competitive bids, his multiplier would be around two because of the risk involved in obtaining future work. 

Please note that this is a useful formula for preliminary planning or tracking your progress but is not a substitute for a proper valuation when selling your business.  NEVER go to market or enter into important negotiations or legal proceedings based on a rule of thumb formula such as this.  Get proper valuation assistance.  (Call us).

Gregory R. Caruso, JD, CPA, CVA
Harvest Business Advisors
609-664-7955

gcaruso@harvestbusiness.com
www.harvestbusiness.com

 


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How Your Balance Sheet Affects Your Business Sales Price and Business Value in Merger and Acquisition Transactions

Or, In Business Planning such as: Business Mergers and Acquisitions, Business Valuations,  M&A Business Valuations, Exit Planning, Succession Strategies, Business Strategic Planning, Business Brokerage, for Companies Such As, Construction Contractors, General Contractors, Engineering Companies, Sub-contracting Companies, Distributors and Supply Houses, Service Firms, how your balance sheet will affect your ultimate business sales price.

Connect with Harvest Business Advisors today – email info@harvestbusinessadvisors.com or call 443.334.8000

 We mainly focus on the income statement in order to determine earnings and company value.  But your balance sheet is an essential component of any transaction.  This article will briefly address how your balance sheet impacts your business market value in the sales process.

 A strong balance sheet can keep you in business in tough times.  That can be true in business sales also.  After all, if you are running out of cash or have had a loan called – how strong is your negotiating position?

 When selling any business the theory is that the buyer should get the assets necessary to produce the income that they are buying.  These assets may be trucks but they may also be cash and receivables (working capital).  Just like when you sell your house and pay off your mortgage (whether it is more or less than the sales price) debt will be paid off by the seller out of the sales proceeds or at least count as part of the sales price. 

 General balance sheet tips – Have cash.  Manage accounts receivable.  Try to collect as rapidly as possible.  Put systems in place to collect.  This includes making sure your requisition package is complete, all insurance certificates are current and whatever else is required.  Keep inventory as low as possible.  Do you really have savings after handling, storage, loss, etc. from buying in bulk?  The squeaky wheel does get the grease.  Manage accounts payable.  You must pay but do your best to obtain extended terms when possible.  Keep bank debt to a minimum if possible.  I was once told and the saying has never failed me, “A banker is someone who gives you an umbrella and when it starts to rain asks for it back.”

 Have lines of credit but do everything you can to not NEED to be in them.  Keep physical assets in good repair but do not overinvest in the 3-2 years before a sale.

 If you have real estate owned by your company (review with your advisors then in 99% of the cases) get it into a stand-alone entity now.

 In this time of low profits and high receivables many businesses – particularly many contractors are worth more dead than alive.  Namely many contractors have more due to them in accounts receivable than the value of their company.  A market buyer will not give them a price as high as the accounts receivable.   An uncomfortable place for any owner to be.

In summary, maintain a strong balance sheet with plenty of current assets and working capital in order to strengthen your negotiating position in a business sale and tide your company through any short term rough waters. 

 

 Clients choose Harvest Business Advisors for our accurate business valuations and our consistent ability to deliver the highest price in the smoothest sale transaction possible. Harvest provides business brokerage, business valuation, and business succession planning services. We have extensive experience in the information technology and professional services, manufacturing, distribution, and contracting fields. We maintain offices in Maryland, New Jersey and Virginia. Connect with us at info@harvestbusiness.com or 443.334.8000 to discuss selling your business, ordering a business valuation or buying a business.

 

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