Most Mid-Size Businesses Owners Needlessly Pay Huge Estate Taxes & Unnecessarily Expose Business & Personal Assets to Creditors.

For Business Owners Preparing for a Sale
The Potential to Materially Reduce or Eliminate
Taxes can be Quite Substantial and Time Sensitive.

The Interview – Asset Protection & Estate Tax
We have interviewed dozens of Business Owners regarding their estate plans. Of those Owners that do have a plan the most frequent set of responses are:

LockeBridge: What kind of trust do you have?
Bus. Owner: I’m not sure.

LockeBridge: There are many different types of trusts. Can you call your lawyer to find out what you have!
Bus. Owner: My lawyer tells me that I have a revocable trust that will protect me.

LockeBridge: Did you know that currently your revocable trust will only shelter $5.45M from federal estate taxes for each of you and your wife and there is a good change that you will have to pay state and federal estate taxes of more than 50% of your net worth.
Bus. Owner: Are you kidding! I expect my Company to grow significantly so the taxes are going to be huge. Why didn’t my lawyer tell me about this?

LockeBridge: Well, did your estate attorney speak with you about the eventual disposition of your Company.
Bus. Owner: No, when I was speaking with him I was not considering the sale of my Company. Now that I have decided to sell it these issues are more tangible to me

LockeBridge: I assume that your also not aware that you can also shelter substantially more of your Company from estate taxes by valuing the Company utilizing an IRS acceptable Lack of Marketability and/or a Minority Interest Discount prior to gifting or selling it to a irrevocable trust. I would be happy to illustrate for you how much you can save by doing this. I would also be happy to refer you to another estate attorney.

If you are contemplating the sale of your business
in the foreseeable future, it is even more important to act now
or you will most likely lose much of the opportunity to reduce estate taxes.

More Than Estate Tax Protection – Protection From Creditors
In addition to estate taxes a proper trust vehicle can keep both the business owner’s personal and business assets safe from creditors such as:

• Divorcees
• Tax Collectors
• Accident victims
• Health-care providers
• Credit card issuers
• Business creditors

Select Client Experience – Estate Planning and Asset Protection

“LockeBridge gained a clear understanding of our objectives which went well beyond the transaction itself. They gave us invaluable guidance on estate planning and wealth management. This was a part of the process we had given very little thought to but turned out to be a very important step in completing the deal and preserving our wealth”

Joe Montesano
President and CEO – Something Sweet, Inc.

“Not only did LockeBridge structure a very favorable deal and manage all the steps to closing, they provided services far beyond the transactional requirements focusing on the personal interests, tax minimization, and wealth creation of the owners. Winning Proposals was actually a subsidiary holding of a pension fund with multiple layers. The objective was to create a transfer that would result in deferring materially all taxes while at the same time meeting the Owners’ post-closing income needs.”

David Claiborne
President -Winning Proposals, Inc.

“LockeBridge gave us invaluable advice on how to both minimize and defer the taxes which resulted from the transaction. Because the buyer was a foreign public company, on the Stockholm exchange, the financial considerations were even more complex. In the end we made a very favorable transaction and protected our assets from creditors which were exposed to certain potentially adverse foreign policies.”

Matthew Nekoroski
President -Surgical Tables, Inc.

* LockeBridge advises its clients on strategies to minimize estate and income taxes. When appropriate LockeBridge refers its clients to attorneys and accountants which are pre-approved via an arduous screening process which seeks both excellence in performance and uncompromising client commitment. LockeBridge does not charge retainers and we do not accept compromising referral fees. Mission Statement / No Conflict of Interest.

Jake Robson
Editor in Chief
AQC Magazine

The LockeBridge Award can be viewed on page 63 in the AQC Global Awards Publication or by clicking here. The Award will also be advertised on CNN and The London Financial Times website.

This article has been specifically written for the small business owner.

Low interest rates have also been one of the principal drivers behind favorable valuation multiples and these low interest rates are soon to rise causing downward pressure on valuations.

# # #

All else being equal, when interest rates go up the value of businesses go down. This includes the value of lower mid-market businesses (generally classified between $5M – $100M in value). How much the value will go down in part depends upon the amount of debt available to the buyer in a potential transaction (i.e. the leverage amount) as well as the the buyer’s required return on equity. Commenting on the increase in the CPI, Todd Hedtke, Vice President for Investment Management at Allianz Investment Management, states, “I think it’s a decent sign for the economy. I don’t think it’s a good sign for capital markets.”

The required return on equity goes up with interest rates because equity investments compete with debt investments. The higher the interest rate on debt, the higher the required return on equity needs to be in order to attract investors. Stated another way, as interest rates rise investors are more attracted to fixed income investments, which in turn reduces the amount of capital available for equity investments. In order for a company to attract equity investment the company’s perceived future prospects must increase and/or perceived risk must decrease. The combined costs of equity and debt, called the Weighted Average Cost of Capital (WACC), are used to discount the company’s future expected cash flow and establish on measure of a company’s value.

When WACC increases 1%, what happens to the value of a small business? A typical company with $30M of Revenue and $3M of Earnings Before Interest, Taxes, Depreciation & Amortization (EBITDA) growing at a compound annual growth rate of 5% (the “Model Company”) will lose $945,000 (6.7%) of its value, from $14,038,000 to $13,093,000, with the EBITDA multiple decreasing from 4.91 to 4.5 (refer to below chart).

As illustrated in the chart above, the $30M Model Company will lose $945,000 (6.7%) of its value as a result of a 1% increase in interest rates.

The Federal Reserve has made it clear that they will raise interest rates only when it is confident that the economic recovery is robust and companies have regained the ability to raise prices.

Per our analysis, if the Fed were to raise interest rates by 1%, from the current .13% to 1.13%, in order to maintain the current value of the business, the modeled $30M company will need to increase its operating profit by approximately 7.2% to compensate for a 1% rate increase.

Don’t panic quite yet. Interest rates are not going up overnight. U.S. Federal Reserve Vice Chairman Stanley Fischer said the process of returning to a more normal level of interest rates will take a few years. Last week the Federal Funds Rate closed at .13 percent. Fed economists expect the rate will reach from 3.25 percent to 4 percent in three to four years. Will that mean that our Model Company will go down in value proportionally more? Probably not, for two reasons:

1. Although the interest rate at which businesses borrow moves with the Fed Funds Rate, they do not necessarily move proportionately and
2. As previously stated, the Federal Reserve is expected to raise rates with a growing economy. A growing economy generally translates into an increase in the value of small business.

Take note, there can be and most likely will be a lag between an increase in rates and an increase in valuations. This means that Business Owners who do not have a longer term time horizon, at least five years to outlast a cycle, should consider the impact of a rate hike on the value of their business and the timing of an exit. Keep in mind that even after you decide to start the exit process, between getting valuations, choosing an investment banker and executing the selling process, you are easily looking at 1 to 2 years.

Negotiating a Premium for the Sale of Your Business can take substantial preparation well beyond practicing your presentation. Most Buyers are significantly larger then the Seller, have executed numerous deals and have a team that is well coordinated and trained in all relevant areas of merger and acquisitions. Knowing that most Sellers of small businesses have never sold a business before you can be easy prey for the Buyer if you are not well prepared.

The key to achieving a premium for the sale of your business is not necessarily your ability to make a credible presentation of the valuable assets and opportunities in your business, which are rarely presented in an optimal fashion. When selling your business to a strategic buyer the most critical aspect of the negotiation is dependent upon your understanding of the Buyer’s operations and the determination of the value of the synergies which would be created by the merge of the two companies. Most people relate to the term 1+1=3. What is implied by this term is that the sum of the parts, when combined together, exceeds the total of the individual components when they remain separate. The amount by which the former exceeds the latter is referred to as the value of the synergies.

Synergies can come from either or both the cost side or revenue side of the equation. On the cost side, the consolidation of the operations generally presents a significant opportunity to cut costs. Examples of typical cost cutting are: Closing of duplicative locations, elimination of redundant jobs, an increase in buying power and reduction of part numbers. On the revenue side there may be an opportunity to raise prices or sell more product due to cross selling opportunities, reduced competitive pricing pressure and increased brand marketing.

The general rule of thumb is that the greater the amount of synergies the more the value and the more the Buyer can afford to pay. However, extracting the value of those synergies is quite another story. The savvy Buyer will never disclose the source of the synergies, let alone the value of such synergies. So how are you, the Seller, going to estimate the value of such synergies, which is the first step in executing a negotiating strategy which will reflect the value of the synergies in the price of your business.

As seen in the illustration below, the Normalized or Recasted EBITDA (i.e. adjusted for such items as owner’s excesses and one time events) of the Seller’s business is $2,000,000. Applying a 4X EBITDA multiple, a typical multiple for small businesses with little to no growth which are purchased by financial buyers, yields a price of $8 million. On the other hand, Strategic Buyers often pay multiples of 5 to 8 times EBITDA, depending on the magnitude of the synergies. Because of the synergies, the Strategic Buyer can justify paying a much higher price while still achieving their required return on equity (ROE). Let’s be clear, the required ROE for the Strategic Buyer is the exact same as that of the Financial Buyer. The only difference is that the Strategic Buyer, because of the value of the synergies, can afford to pay a higher price while still achieving the required ROE. Of course just because he can afford to pay a higher price does not mean that you, the Seller, will be able to negotiate such a premium price for your company.

Let’s look at an example. In our example, the synergies which can come from various areas such as cost savings, increase in sales from cross selling, technology benefits, etc., are estimated to be $1.0 million, which results in an adjusted “Synergistic EBITDA” of $3.0 million. Applying the same 4X multiple now results in a value to the Strategic Buyer of $12 million, the “Synergistic Value”, a 50% premium over the “Financial Value” of $8 million. Your ability to get the entire value of the synergies depends upon your negotiating skills. Chances are that the Negotiated Price will end up somewhere between the Financial Value and Synergistic Value. Your ability to negotiate a premium for the sale of you business will depend on several factors including your confidence in the estimated synergistic value.

When selling your business to a strategic buyer, a principal objective should be to identify the incremental value of the synergies created by the merge of the two entities and capture as much of that value as possible. The first step in extracting the value of the synergies is to estimate the dollar amount of value created from the synergies. As stated in the last article, synergies can come from various places such as Cost & Risk Reductions, Process Improvements, Revenue Augmentation and Economies of Scale. According to The Boston Consulting Group, 94 percent of merger announcements which disclose the value of synergies mention only cost synergies or don’t mention the specific nature of the synergies at all. 1 The principal reason for the foregoing is that cost based synergies are the easiest to quantify. For example, estimating savings from eliminating administrative redundancy, consolidating operations and increased purchasing power are relatively straight forward.

With the above stated, bolt-on acquisitions completed by larger companies often result in substantial revenue synergies. Many larger companies acquire smaller “bolt-on” companies in order to add complimentary products to their offerings, which their sales people sell to the existing customer base. Furthermore, cross selling opportunities, the potential to sell both company’s products to the other company, can materially increase the Buyer’s revenue.

According to a 2012 study performed by Thompson Reuters, transaction synergies from a sample of 365 deals with values of more than $300 million that took place from 2000 – 2011 range from 2 to 10 percent (depending on the industry) of the target company’s latest annual sales, with a median of 4.8 percent (refer to chart below). If we assume that a similar level of synergies exist with lower mid-market transactions (i.e. transaction values less than $100M) we can infer that the synergies contribute an additional 50% or so to a typical small company’s EBITDA.2 But what if the Buyer generates billions of dollars of revenues in your market. Simply dropping your products into the hands of their salespeople can result in increasing your Company’s sales by a magnitude!

Accordingly, it is our observation that most Sellers of smaller transactions (< $20M) see little to no increase in value due to synergies resulting from a sale to a strategic buyer. From our perspective, this is unacceptable.

There are a magnitude more potential financial buyers then strategic buyers, so why search for a strategic buyer if the Seller is not going to benefit from the synergies! In fact, the 31% of the total synergies which are captured by the Seller is also unacceptable to us. By effectively preparing the company for a transaction, studying the Buyer’s operations to enable a reasonable estimate of the value of the potential synergies and by applying seasoned negotiating skills one should be able to grab much more than the reported 31% of the synergistic value.

Don’t settle for little to no share of the synergies, let alone the average 31%. Sign up to receive the LockeBridge Newsletter to get the next articles in which we will discuss, how you (the Seller) can grab more than your fair share of the synergies created.

In the prior article titled Investment Banking Retainer Fees – Beware of Conflicts I mentioned that the average closing rate among US intermediaries representing transactions valued in the range of $5 million to $30 million range is approximately 30%. I also stated that the average engagement fee for such transactions is around $50 thousand. Needless to say, I never met a business owner who wanted to pay an engagement fee or retainer, especially with a success rate of only 30%. So what are you going to do about this issue when it is time to sell your business? My suggestion when choosing an investment banker is as follows:

Several common answers to this question are:

My thought on these answers are as follows:

OK, down to brass tacks. The above is all well and good but the fact of the matter is that most advisors in the lower middle market just cannot afford to do enough diligence to provide them with the confidence they need to waive the retainer. Let’s, for a moment, put aside the potential conflicts of interest that a large engagement fee can cause. If the advisor does not have confidence that they will succeed, at least a 70% confidence level as previously stated, then I don’t believe that the business owner should hire such advisor. The worst thing that can possibly happen is that you execute the selling process more than once. This is one process that you want to do the right way the first time. The implications of going to market a second time can be disastrous, but this is a topic for another article.

With the above stated, if you find that you cannot avoid paying the retainer and still want to engage the Advisor, at least you should have gotten a warm and cozy from the answers the Advisor provided to the above questions. I think you will be surprised by the type of answers you get. The worst that happens, as a result of these questions, is that you will learn allot about the thinking of the advisors which may represent one of the most important transactions of your life.