You Don't Know What You Don't Know - Part 1
My conversation with David Hammer
This week, I sat down with David Hammer, a very close friend and investor in one of my businesses, to discuss what he believes all business owners need to know. David is one of the best business and M&A attorneys I know. He sat on my company's board for many years and even served as our general counsel. David is also one of the founders of Business Owners Ed, a nonprofit based here in the DFW area that provides an outstanding education to business owners on growing, scaling, and exiting their business. If you will listen to anyone about what business owners need to know, it's David. Our conversation went on for several hours, so here is Part 1 of 2:
I know you very well, but for those who don't, can you give us a little history of your background and why you settled on business and M&A law?
My undergraduate degree was in accounting, and several months before graduation, I accepted a position with Deloitte. One of my early assignments was to be the junior member of the due diligence team on the acquisition by Chase Manhattan Bank of Doll Finance Company. Three of us went around the country doing short due diligence investigations of several dozen offices of Doll Finance as part of the overall due diligence investigation by Chase. That was my first introduction to M & A. I met attorneys for the first time while at Deloitte, and I was intrigued by what they did. When I began to consider going to Deloitte after I obtained my CPA license, I started thinking about the aspects of law where knowledge of financial statements and accounting and tax law would be valuable, so I settled on business transactions. It was much to my good fortune that the law firm that I joined after graduation from law school had, two weeks before I arrived, picked up a New York stock exchange client, one of the world's largest companies specializing in mainframe software. Because I was the only one they hired that year and not expecting to pick up that big client, I got thrown into everything the company did. The securities were domestic and international software licensing and, most importantly, the mergers and acquisitions for my career. Being one of the largest in the world, later, whenever it redirected the focus of its business, it became a significant divestiture as well.
Wow. That is, that's a lot of amazing experience for a guy just out of law school, right?
Absolutely. When we sold that client in 1987, I was personally responsible for closing over 30 transactions for that New York stock exchange company.
Incredible! Talk about jumping in the deep end. You're not dabbling with small acquisitions here. You're making big acquisitions with a big, publicly-traded company. I love this story, and one of the things that I love about you is that you keep your CPA license current. So when folks are talking with you about M&A transactions, you always have that eye toward the tax consequences, right?
Taxes are one of the things that we all have to pay - none of us like to pay, but they are significant factors in the consummation of a business transaction, yes.
A couple of weeks ago, you spoke at Biz Owners Ed - like you do every year - on important things business owners need to know about selling a business. In that talk, you said, "there are three things that enable a business to sell." What are those three things?
Earnings, earnings, and earnings. When I formulated my Biz Owners Ed presentation years ago, I came up with that line. I meant to be somewhat facetious, and it is, but you don't have to look any further than the PTE column of the Wall Street Journal opposite every listed public company to see how important of a factor is. And if it's the way public companies are valued, it stands to reason that it will also be how private companies are valued.
I completely agree that having recurring revenue improves business value, but why is that, David?
Most businesses start their calendar year on January 1st, meaning they make their first dollar in sales for that year on that day. So every year, they're starting from zero and building up to their cumulative operating result. They have existing contracts that obligate their customer base to pay them throughout the year. On January 1st of each year, they have enforceable contracts to predict the amount of revenue they will generate from those contracts over the next 12 months. According to Jack Welch, predictability is the most critical factor in managing a business effectively. Predictability, avoidance of risk, and profitability, in that order, was Jack Welch's quote, as it related to his management of General Electric, a public company.
Recurring revenue gives a buyer assurance of predictability that the revenue will be there in the future rather than going out and producing it. Is that how you would explain it?
Absolutely. Software as a Service businesses or SAS businesses are the narrow sliver of companies valued on recurring revenue. You don't have to look any further than the regular payments we all make to Apple for iCloud services or Microsoft for OneDrive, to see the shift among even substantial companies toward an annual recurring revenue model. They're valued differently because they don't have to start at a zero balance each year. They have a number of dollars already locked in.
Why is it important to carefully think about the legal structure of a business long before the business anticipates an exit?
The most important reason is the taxation of the exit. The seller's tax consequences vary depending on the type of organization they have. The buyer's tax consequences will depend on the type of structure and transaction they undertake, given the organization they chose. So it is mainly tax-driven.
Could you give us some examples of the different types of tax structures for a business, and perhaps what that might mean in the context of a transaction?
The easiest way, I think, to understand the tax consequences of any transaction is to think about two different aspects of any business. The first aspect is ownership. Whether it's stock in a C Corp or an S Corp, partnership interest in a partnership, or membership interest in a limited liability company, that's ownership. That's one way that a business can be sold; through the conveyance, by the individual owners, of their ownership.
The second possibility for acquiring a business by any buyer is to simply buy the assets of that business. When a buyer purchases assets rather than deal with the individual owners of ownership interests, the buyer deals with the entity - and the tax consequences can vary depending upon the type of entity. A change in the internal revenue code about 15 years ago made the purchase of assets the preferred method for acquiring a company. The reason is that our economy is, according to the Wall Street Journal, about 70% service-based. Service-based businesses typically don't have massive amounts of buildings, machinery, or land, and they don't have large amounts of fixed assets.
Additionally, because the internal revenue code requires buyers and sellers of assets to allocate purchase price based on categories of assets, they can allocate most of their purchase price to intangibles and Goodwill. Now, those two categories are capital assets taxed at capital gains rates to the entity of buyers. The code provision that made this so prevalent among buyers is that they can write off the purchase price of that business over 15 years. So it doesn't hurt the seller to sell assets, and it's a tremendous benefit to the buyer. Buyer and seller ownership interests are aligned unless you're talking about one particular type of organization where selling assets is penalized. That type of organization is known as a C corporation. The reason corporations take on the title of S Corp or C Corp is because of the particular subchapters of the Internal Revenue Code that deal with the tax consequences of those entities. C Corps are in subchapter C, and S Corps are in subchapter S. Until the tax reform act of 2017, the tax rate on the entity's gain on that transaction was 34%. When the shareholders of the C Corporation receive their after-tax proceeds, the shareholders pay another 20% in tax. So if you're a C corporation and have a buyer who wants to amortize the purchase price over 15 years, you have a complicated negotiation. The buyer won't just give up the tax benefits of amortizing intangibles and Goodwill over 15 years, and you as a seller don't want to get taxed twice. It's a tremendous problem if you're a C Corp attempting to exit. The problem with the organization's selling piece is that it almost always needs to be done at the time of incorporation. Many times that's not the point at which owners began to contemplate the sale of their business. Sometimes owners will start a business, work for several years, and then decide. If they happen to form as a C Corp initially, they're in a certain amount of trouble when it comes to attracting a buyer that will give them a favorable tax result at exit.
C Corps, Subchapter S LLCs, Limited Liability Partnerships are all Pass-Through Corps, right?
Yes, they are, and what Pass-Through means is that those entities pay no tax on their operating results. The operating results of those entities pass through to the owners' individual tax returns. The entity has an obligation to inform the IRS what those pro-rata allocations of operating results are. They do it on a form called form K1, and each individual has the responsibility for including their pro-rata portion of profits and losses on their individual tax return.
We work with clients typically three to five years before they attempt to exit, and one of the first things I have them do is go and visit with their attorney and CPA to look at their tax structure - to make sure that it's the most efficient. Why would you want to do that at least five years before you transition a business?
The primary reason for the five-year figure is that if you are a C corporation, you can change your tax status from C-Corp to S-Corp. Congress didn't much like being deprived of double taxation, so they wanted to make it difficult for people who started as C to change to S. To do so, they devised a concept "called built-in gains." That changed what used to be a 10-year period to a five-year period. So if you sell your business within five years of changing from a C to an S, you still have to pay double tax on your built-in gain. So, you determine how much built-in gain there is as of the date you make your election to change from C to S, and that amount sits out there as a calculation, and if you sell your business within five years, you pay tax twice on the built-in gain.
It's commonly referred to as a look back, right? The IRS does a look back over those years so that you can be potentially taxed on them?
Correct. They keep track of the time that has elapsed between when you changed from C to S and when you sold your business, and if you do that within five years, they will come looking for a built-in gain.
What do you think about financial statements related to running and selling a business?
The best predictor of future success in a business is past success. Unless you have timely and accurate financial statements, your buyer cannot predict the likelihood of your future success. So financial statements are essential to knowing where you've been, how you're currently doing, and where you're going - every buyer looks at it. You can't manage what you can't measure. If you don't have financial statements, you are not measuring your operating performance, and if you're not measuring your operating performance, you can't manage your business information effectively.
I've heard you say, "the financial statements are the scorecard."
Yes, they absolutely are. You don't even have to think hard to understand the score's importance. Would any of us spend what it takes to see a baseball game if the parties announced they wouldn't keep score? Keeping score is essential. When you express that in an athletic context, it's humorous to the point of absurdity, yet there are still people in business who don't produce timely financial statements.
Many small businesses use cash financial statements as opposed to accrual. What do you recommend, cash or accrual financial statements, and why?
Accrual accounting is a generally accepted accounting principle. Every other form of accounting is not. Whether it's cash basis, tax basis, modified cash/tax basis, none of those are generally accepted accounting principles. The law requires public companies to present their financial statements on an accrual basis. The IRS permits cash basis accounting for smaller companies, and I believe the threshold for permitted cash basis accounting is 10 million in annual revenue. Once you surpass that threshold, even the IRS requires you to go to accrual basis accounting, so it's probably better and easier to start with accrual basis accounting than starting with cash basis accounting and attempting to convert at some later date.
You mentioned something else in your talk at Business Owners Ed. You talked about the number one reason that businesses fail. What is that reason, David?
The number one reason privately held businesses fail is that they simply run out of cash. It's a documented statistic that goes back many decades.
The first thing I want to know as a business owner every day is which way the cash is flowing - Is more coming in or is more leaving? It tells me when I've got a potential train wreck coming. It's better to see it three or six months in advance than walking in and finding out you have no more cash.
It all goes back to using financial statements to manage your business. Privately-held businesses often overlook the statement of cash flows on their financial statement. It's the third financial statement required under generally accepted accounting principles - after the balance sheet and the income statement. Many entrepreneurs don't use the statement of cash flows the way they should because its preparation is relatively complicated. But if you master the use of that statement, it's a very effective tool for managing cash on a month-to-month basis.
Let's switch gears here a bit. What types of risk should every business owner be concerned about - both as it relates to general operation and exit strategy?
The one that is of most concern to most of my clients is customer concentration. Having any customer whose revenue comprises more than 15% of your total revenue is a threat to your business. That customer can realize how important they are to you and demand pricing concessions. That customer could run into difficulty leading you to lose that revenue. It is very, very important to manage your customer base so that no customer comes to dominate your business. I'll offer you my version of the old saying about pools and boats. The happiest day in your life is when you get the biggest customer in your market. The second happiest day of your life is when you get rid of them. Customer concentrations are a tremendous threat to your business because you can't control what goes on in that customer's business. Their size relative to your business's size can control you.
What about other risks, like suppliers?
Concentration is a concern when it comes to suppliers, especially if you're in a manufacturing-oriented business. Assume the supplier of an essential component of your product places that part on backorder or increases its price. If you don't have multiple sources of supply, you are shut down. Automobile companies are experiencing that right now as it relates to semiconductors. So, having multiple sources of supply is very important. You can play favorites; nothing wrong with that, but buying enough from multiple sources of supply to keep all of them interested in your business. It protects your business in the long run.
How about a bank? What risks are associated with banking?
Once upon a time, we didn't think so. "Once upon a time" goes back to 1929, wherein we had the first massive bank failures of the 20th century. Since then, we've had several banking crises, with banks getting into trouble because of the composition of their loan portfolios, defaulting borrowers, and the like. That's why it's important to cultivate multiple bank relationships in the same way as multiple suppliers because you don't even know if or when your bank will get in trouble. If your bank does get in trouble, you don't want to be the customer whose loan is called, you don't want to be the customer whose loan is not renewed, and you don't want to be the customer whose loan rate goes up at renewal. So keeping multiple sources of banking relationships in your business is essential. Every bank wants to be your exclusive bank, but what your bank wants is not always in the best interest of your business.
What about litigation risk as it relates to business value and selling a business?
They say that "litigation is simply a cost of doing business." My question is, "is it really?" You can do certain things, like documenting processes and procedures and behaving consistently related to employee relationships, that significantly reduce your risk of litigation. If you find yourself heading toward litigation despite your best efforts, you need to remember that litigation is not about truth, justice, and fairness. It's about winning and losing, and winning and losing comes with a cost. The lawyers for both litigants do really well. The litigants don't do so well because they usually pay the lawyers. People who litigate over 'the principle of the matter' are asking for extensive attorney bills over an extended period of time, not to mention the time out of their schedules dedicated to the litigation itself. It's generally an unprofitable position. My advice to clients has always been to litigate only over six figures or for the survival of the business.
In 2013, a longtime client was sued in a family dispute over a business. The plaintiff was actually seeking the breakup of the business. That's survival-related, and they spent several hundred thousand dollars in legal fees to survive. That's totally justified, but short of survival, it's challenging to justify that kind of attorney bill for just about any kind of dispute that you might have. Dallas County has a rule requiring business disputes filed with the court also submit to mediation which has helped. I never did think much of mediation as a technique because it's voluntary. If the parties haven't been able to agree to such a level where one is filing a lawsuit, I don't understand how they could persuade them to agree in a mediation setting. Still, I've seen it happen twice in seemingly intractable family business disputes. If it can happen in those circumstances, it can happen anywhere. But the point is you don't have to file a lawsuit to avail yourself of mediation. If you believe that there's a possibility of resolving a dispute, take every opportunity to do so before you get to the courthouse. Don't wait until somebody files and you have attorneys with a vested financial interest in controversy because anytime anyone has a vested financial interest in the controversy, there will be controversy, and lawyers will be the beneficiaries.
Next week’s blog will pick up where we leave off today.
Take action on what you learned today from David. Rate yourself on a scale of 1 - 6 on each of the points we touched on today: Financial Statements, CPA Relationships, Corporate Structure, Cash Flow, Customer Concentration, Supplier Concentration, Banking Relationships, Risk Strategy. If you scored a 1 - 2 in any of these then there are your priorities. We also have a tool that helps you see where you are today and help you get to where you want to be for your business. Schedule a call with me today, we can help you achieve your dream exit.
Here is this conversation live on the Maximize Business Value Podcast - episode 101.
ABOUT TOM BRONSON
Tom is the founder and President of Mastery Partners, a company that helps business owners maximize business value, design exit strategy, and transition their business on their terms. Mastery utilizes proven techniques and strategies that dramatically improve business value that has been developed during Tom’s career 100 business transactions as either a business buyer or seller. As a business owner himself, he has been in your situation a hundred times, and he knows what it takes to craft the right strategy. Bronson is passionate about helping business owners and has the experience to do it. Tom has authored, “Maximize Business Value, Begin With the Exit in Mind,” his book on the importance of exit strategy as good business strategy. Tom’s passion is to equip and educate business owners so they can be in the 17% of business owners who successfully exit their businesses. Check out our resources to help you maximize business value - our website, our blogs, our youtube channel , our podcast and our MasterYclass.
Mastery Partners, where our mission is to equip business owners to Maximize Business Value so they can transition their business on their terms. Our mission was born from the lessons we’ve learned from over 100 business transactions, which fuels our desire to share our experiences and wisdom so you can succeed.