Litigation + Valuation Perspectives

Demystifying Valuation, Economic Damages + Forensic Accounting

8 Essential Elements of an Exit Strategy for Business Owners: Part II

Improve Profitability and Cash Flow

A company is more valuable when it is profitable and has good cash flow.  Therefore, an owner should always strive to have the company as profitable as possible.  Several steps can be taken to improve the profitability of a company.

If the owners are paying personal expenses through the business that are deducted on income tax returns filed with the IRS, they should cease this practice. Continuing to do so could raise questions in the minds of a potential buyer as to the credibility of the business owner; i.e., if the owner is misrepresenting the business to the IRS, is he/she also misrepresenting the business to me? Owners should also remove all non-working family members from the company payroll. 

It is much easier to attract quality buyers when owners have managed the enterprise strictly as a business.

Get all Agreements in Writing – No More “Hand Shake” Deals

A significant part of the value of most businesses today is represented by the value of intangible assets, such as trade names, patents, technical know-how, proprietary software and databases, customer lists and relationships, franchise and license agreements and similar property.  The documentation of these assets should be reviewed for organization and completeness. To the extent any agreement is based on a “hand shake,” such as deals with major customers or vendors, it is appropriate to obtain a written understanding between the parties. A potential buyer may see these “hand shake” deals as relationship contracts with limited value.  A business owner should get these unwritten contracts committed to writing if possible. A potential buyer would have a greater assurance as to the value of those agreements and can more easily perform due diligence.  Even purchase orders to a vendor or from a client contain legal obligations that a potential buyer will review.  The longer a contract period, the more secure a potential buyer may feel about the intangible value of the contract/relationship.

 

When multiple business entities are established by families to operate the same or similar businesses, the line of ownership of intangible assets can become blurred.  This can affect the market value of those assets. For example, assume a family restaurant chain is operated by several different family members through separate legal business entities and all companies use the same trade name and menu.  Also assume that no licensing agreement exists. A question arises regarding the true ownership of the intangibles. The fair market value of the trade name might be substantially diluted without a proper licensing agreement. Also, if one family member decides to sell its restaurants to a third party, it could result in the creation of additional competition for the restaurants owned by the remaining family members and a decrease in value of the remaining businesses.

 

It is also important to have loan agreements between the company and owner documented and in place with an established track record of compliance with the agreements.  Properly documented loan agreements will allow a seller to repay the loans with proceeds from the sale on a tax-free basis. It is also a good opportunity to review corporate records such as corporate minutes, stock ledgers and other documentation and update them as appropriate.

 

Settle Legal Actions

Nothing will lower the value of a company or make the company unsalable than unresolved litigation matters.  The buyer of a company wants the assets free and clear, with no potential legal problems after the sale.  This is the reason most business sales are structured as asset sales versus stock sales. Be prepared for a potential buyer to walk away from a transaction when there is outstanding litigation.  Also, protracted litigation costs reduce the value of a business, because the legal bills lower the company’s net income, which in turn can lower the net present value of expected future cash flows.

 

Upgrade Financial Reporting – Understand the Balance Sheet

Good financial reporting always adds value to a business.  Internal reporting that provides quality financial and operational information quickly and accurately adds value to a business by helping the current management team to manage the business better.  In addition, during either a valuation or sale of the business, valuation analysts and potential buyers base their values on computations initially based on the financial information provided by the company. The quality of the financial data is a factor considered by valuation analysts and potential buyers in the evaluation of company risk.

The gold standard for financial reporting is audited financial statements.  Audited financial statements provide the management of a company and a potential buyer with assurances that the financial information being represented is factual and verified by an independent accounting firm.  In addition, audited financial statements add a level of credibility to internally generated financial and operational information that a buyer will request during its due diligence on a company.

 

An owner should remember that buyers generally are buying the assets of a business, so it is imperative that a seller understand their balance sheet and the intangible assets of the business. Intangible assets can include licensing agreements, patents, trademarks and similar assets.  A properly prepared financial statement will provide some assurance to a potential buyer that the tangible and intangible assets that it is buying have been well-managed and that the income statement information and statement of cash flows are also most likely accurate.

 

Intangible assets developed internally by the business are not typically reflected on the balance sheet.  Therefore, it is important to identify these assets and prepare appropriate documentation supporting their values.

 

Next week I will continue with three more of the 8 Essential Elements of an Exit Strategy for Business Owners.

Stephen E. Koons, CPA, ABV, CFF, ASA and Daniel R. Silburg, CPA, CVA