Guest post from Sami Jadallah - Mistakes I Made Starting a High Tech Business

This week, I turn the blog over to Sami Jadallah, a long time friend and client, who started a high tech automotive service business.  Take it away Sami...

Few years’ back I came up with an idea to keep track of service and maintenance of cars/trucks on a smart card. Having worked in Europe for few years, smartcards where a hot thing and with bright future. Ah well.

I proceeded to file for a patent, which took almost 14 months to prosecute and secure, and over $100,000. I won the patent then it was time to raise money and organize a team.

1.      Raising the fund:

Because of my many years of doing business overseas it was not too difficult to raise money, given my performance and my professional integrity. One of my clients agreed to come in as partner together with others. My share of 1/3 was a developer and manager of the project while the overseas investors put up the entire funds.

As it happens one of them ran into financial difficulties and did not pay his share, so I used my own money to pay for his shares including collateralize my stock holding even taking out second mortgage… Big Big dumb and stupid mistake… Never ever do that.. Let the company go down the drain but never ever put what you have a risk for the business.

2.      Selecting a team:

The business required both technical and business. On the technical side there was an Israeli company with advance technology in the field of smart card technology. A business associate of mine introduced me to the company and I negotiated an agreement with them to provide the technology (software) and the hardware. The company sent one of their top software developer to the Washington area where I made several appointments for him with local dealership to understand the automatable dealership software and who they electronically file all the service and maintenance records. Upon his return they filed a proposal of 9 months to develop and test the software. Well, they worked at but it seems it was not their priority since they were gearing to go public and my project was one way for them to present a large business opportunity to go the market and raise money.

As it happened, they did raise the needed capital using my business idea and contract with potential investors.

However when it came to the software they did a very shitty job of it and they were late, quite late… and when their team arrived in the DC area to test the software, none of what they did work and I had to hire a professor from University of Maryland to help fix what they could not fix. Lacking a technical team I was at their mercy and the delay and false start lost me a big opportunity to go public (more on this).

Finally we fixed the software but we lost precious time and confidence with dealership and industry, but never the less we proceeded any way.

To help develop the business and marketing, I hired a former VP of a Premier top of the line German car manufacturer who also happens to be the former president of a smaller European car manufacturer. To be the be the president of the company… he was also a head of a major though smaller European car manufacturer.

I also hired a VP of an extended warranty company to be the VP in charge of marketing.

Meanwhile I continued to work overseas and trying to earn income and enough money to pay there top of the line and expensive executives.

As it happened both were losers and my advice to any one… never ever hires a have been … these top executive can only go down and never go up. Hire a hungry young MBA willing to make something of himself and succeed and never higher guys who can only go down and who are used to big expense account, dinners, wines etc… and charge the small struggling start up company.

Also never ever hire anyone with a salary that is not tied up to performance… Once they have a contract they simply don’t give a shit about happens as long as they get their fat check every month.

3.      Legal Team:

Ah well, lawyers are no better than these car guys, specially when one of them is using your business to score a point for partnership, and keep dragging the business and legal process so that he can keep billing until he secure his partnership.  I lost a big big opportunity to go public with the idea, since it was a hot idea when .com companies were raising millions on names only without a product. And I had a product and had a patent to support it.

4.      Conclusion:

·         Never put your house or saving at risk for a business… no matter what, and if necessary let the company and business go down the drain rather than risk your personal financial security and lose your business too.

·         Never ever higher a technical or business partner who will use your business relations to go to the market or secure a big contract using your business as bait to catch the big fish and you lose every thing.

·         Always make sure that you put a substantial sum as penalty for poor of failing product… let the SOB pay for their failing and make sure that their failure is not all charge to you.

·         Never ever hire a have been, top executives who are used to big bucks and perks to head a start up company because they will milk you along the way as they buy themselves time to get a better job or secure retirement. A had been can only go down never go up… and the bigger they are the bigger they fail because they do not have the time or the smart to learn something new.

·         Always make sure you hire a young energetic smart young graduate who will work hard to succeed and who will also make you succeed.

·         Always tie up compensation to both salary and performance and never salary alone… it gives no one any incentive to succeed since they are guaranteed the money… They will work hard when they know they have to perform and deliver to the bank account.

·         As for lawyers, even the best lawyers are out for themselves… think 100 times before you hire a lawyer who will help you with your business.

I lost over $2.5 millions on this project and I continue to be angry with myself, have not reached peace with my self having put my family and their financial security at risk and I put my self at great financial risk… I did not mind if I lost the business because of the economy or bad product, but to lose it because off these so-called top of the line executive is a crime…

Sami Jamil Jadallah

Fairfax, VA

Buying a Business - Making An Offer Part II

I promise to keep this rant to two paragraphs, not counting this one.  Then I'll get on topic.  If I don't, you can bitch slap me up side my ugly, arrogant head.

I'm tired of caring about crazies.  Notice I didn't write "mentally ill", "clinically depressed", or any of the other PC euphemisms for crazies, nuts, and whack jobs.  Instead, we need to aim our concern towards protecting potential victims.  Psychiatrists worry about stigmatizing nuts.  Their victims are already stigmatized.  Many times they're called corpses.

Ron White says you can't cure stupid.  Well, you can't cure crazy either.  Many of the craziest people in society are psychiatrists, like Sigmund Fruit (Archie Bunker's term).   Show me one brand of crazy that has a cure.  The crazy thing about crazies is that they won't take medication, because they're too crazy to believe they need it.  What's my point?  (I'm running out of space.)  We need to put nuts in nuthouses.  Their rights are less important than the rights of their victims.

In part I of making an offer, I covered the basics of deal structure.  Yes, it was a couple months ago.  Give me a break, I've been driven crazy worrying about crazies.  In this installment, I'll cover determining your offering price.

Let's set some ground rules about the size of potential business purchases I am addressing.  In this installment, I will cover buying businesses from roughly zero to five million dollars in annual revenue.  For businesses larger than that, the principles are the same, but the details, calculations, and deal structure tend to be different.

First, let's define what you are buying.  When you buy a business, you are really buying a cash flow stream or a stream of profits.  You aren't buying the seller's cash flow; you are buying the cash flow of the business in your hands.  That's an important point.  The cash flow available to you from the business and the cash flow to the seller are usually different.  Sometimes your cash flow is higher, but sometimes it will be lower.

Determining the cash flow available to you is an art as much as a science.  You start out with profit from either financial statements or income tax returns.  Then, you add back non-cash expenses, such as depreciation, and financial costs like interest expense.  You will also add back any discretionary expenses, such as the rent on the owner's girlfriend's apartment.  You also add back any other owner perks, like family on the payroll and extravagant auto expenses or benefits.

You can expect the owner and his broker to volunteer most of the above additions to cash flow.  They won't volunteer anything that should be subtracted.  If the owner worked actively in the business, but you don't plan to, subtract the cost of a manager to replace the owner.  In some admittedly rare cases, family members are paid below market value.  You'll have to pay more to replace them.  Determining the cash flow of the business in your hands is the objective.  I doubt you'll pay for the girlfriend's apartment unless she is really cute and digs you.  That last part you verify with some due diligence in a seedy motel.

After you determine the cash flow available to you, determine the appropriate multiple of that cash flow to get your offering price.  My business broker friends tell me small businesses are selling from two to three times cash flow.  To get multiples for your type of business, you can find databases of small business sales such as Bizcomps and the database from the Institute of Business Appraisers.  These cost money.  Your CPA, if a valuation professional, probably subscribes to these already.  Don't rely in any way shape or form on multiples from franchisors.  Their job is to get the highest prices for their franchisees.  To do so, they'll lie to their mothers.

You will find that multiples of cash flow sometimes vary wildly even within an industry.  Company size has a big effect.  Larger companies typically sell for larger multiples.  Even accounting for size, you may see some pretty wide variations in multiples.  Don't expect a "correct" answer in your search for a multiple.  If you get outside two to three times as a multiple, you are outside the norm, and you need to perform some detailed research into the reasons for higher or lower multiples.

If you find that businesses of similar type and size sell for three times cash flow, don't immediately offer three times.  Multiples are subject to negotiation.  Don't go to your top acceptable multiple immediately.  The seller will likely counter your offer.  You need some wiggle room.

Expect to accept terms somewhere between your original offer and your top acceptable price.  If you can't get a price in that range, walk away.  The number one frustration expressed by buyers about deals is buyer's remorse about paying too much.  Remember that the friendly business broker represents the seller, not you.  He'll tell you his price is fair all day long.  He gets a percentage of that price.

The final price for a business will probably be a multiple times cash flow plus any inventory.  You will likely not get receivables, and you should probably not accept any liabilities.  For businesses with significant equipment, you will probably have to buy the equipment in addition to the price as calculated above.

Once you have determined your offering price, don't immediately rush to the seller and definitely don't fill out the offer form from the broker.  Run to your attorney.  You will be making an offer with a plethora of caveats.  For instance, your offer will be subject to verifying the financial numbers provided by the seller.  If the numbers are garbage, you won't consummate the sale.  The offer will also explicitly detail what assets you are purchasing and what assets and liabilities you do not want.  There will also be state law niceties to consider.  Since, I'm only a shit house lawyer, get some real advice from a real lawyer.

Thanks for reading!  As always, please visit the main S&K web site for real tax and accounting advice, www.skcpas.com.  Also please like the "How to Screw Up Your Small Business" Facebook page.  I post tidbits of incredible value there daily.  Yes, that's sarcasm.  Sometimes, I just spew forth.  You get what you pay for.

Until next time, let's do it to them before they do it to us!

The Value of Faith (an Empirical Approach)

This post builds on the ground breaking research of Greg Kyte, the funniest CPA in the business and a noted agnostic.  Greg publishes a blog at cpaagnostic.blogspot.com.  In one post, he evaluates Pascal's wager, which is the assertion that one should believe in God, because if he doesn't exist, you have suffered no harm.  However, if he exists and you don't believe, you get everlasting accommodations in hell.

Having studied Pascal's wager in depth, I find that it has never been subjected to rigorous academic scrutiny.  I propose a model for valuing faith, for which Pascal's wager represents only two extreme cases.  A real mathematical model of faith in God yields substantially richer results than Pascal's believe or else model.

In creating my faith model, I asked the question I always ask when performing a business valuation.  "What would Shannon Pratt do?"  If you're in the business valuation biz, you're laughing your ass off now.  If you're not, Shannon Pratt is Jesus Christ, Mohammed, and Jennifer Aniston all rolled up into one for business valuators.  You can't discount his advice (another marvelous biz valuation pun).

In creating my faith model, I started with the basic rule that anything, including faith, is worth the net present value of its benefits.  That yields the following equation:

F = NPV((P * H) - S - T)  The variables in his equation are as follows:
F is the value of faith in God.
P is the probability that God exists.
H is the value of heaven's benefits.
S is the value of unforgiven sin.
T represents the transactional costs of religion.

Thus, this formula states that faith is worth the present value of its benefits less related costs, in other words what you give up to get to heaven.   Let's examine each variable in detail starting with the easiest, transaction costs.

Transaction costs are the costs of maintaining faith.  Tithes and offerings are an obvious cost.  Less obvious, unless you're Catholic, is the potential cost of having family members molested by religious authorities.  If you're a member of a cult, don't forget the costs of the Kool Aid.  If your religion requires human sacrifices, count the costs of finding your victims, I mean sacred offerings.

Representing the value of unforgiven sin, S consists of the benefits, net of related costs, of indulging in behavior at odds with at least one of the Ten Commandments.  This is where you record the benefits of banging the babysitter.  Please remember to subtract from the value of the orgasms: incarceration time, alimony, legal costs and possibly child support if you don't wear a condom.

Here's some personal advice based on mathematics.  If the costs of the sin exceed the benefits, you might want to avoid the sin.  In other words, if you can't do the time, don't bag the babysitter.  Woo a TGIF waitress instead.

You might reasonably ask why only unforgiven sin is a subtraction in calculating the value of faith and not forgiven sin.  Forgiven sin does not reduce the benefits of heaven, at least not in this model.  Further research on this point may be necessary. For instance, Hitler and Mussolini are rumored to have asked for forgiveness on their deathbeds.  If they received a heavenly reward, hell may well be empty.  Apparently, the materiality of a sin does not reduce its capacity to be forgiven.  In any case, the obvious strategy is to sin like hell until just before you die.  Then repent and avoid the subtraction in this model of faith.  Disclosure - please consult your own competent religious authority for advice pertinent to your particular situation.

Let's tackle P next, the probability that God exists.  P would seem to have only two values, but Pascal erred when he assumed that either you believe in God or you don't.  He implicitly assumed P was either zero or 100%.  This is not necessarily the case.

For instance, what about Sunday Christians?  Their value for P equals 1 divided by 7 or roughly 14%.  For those, who attend church only at Christmas and Easter, P equals 2 divided by 365.  We can safely ignore leap years as an immaterial variance, except in the year of death, when you really don't want to take chances.

Further, what about worshippers of Satan?  Their values for P may actually be negative.  Clearly their P values must not be zero, since a belief on Satan would seem to imply a belief in God also.  I'll leave this last point for those seeking an interesting thesis for their doctoral degrees.

Finally consider H, the value of heaven's everlasting benefits.  You might think the value of heaven is infinite, but that is only a cursory consideration.  Consider that the definition of fair market value is the value at which a property would change hands between a willing buyer and a willing seller.

First, who in the hell would sell heaven willingly?  I searched both the BIZCOMPS and Mid Market Comps databases looking for comparable sales in vain.  Finding no comparable sales of heaven, we must conclude that heaven is a non-marketable minority interest requiring substantial discounts for both minority interest and marketability. Those discounts could total 100% and wipe out the fair market value of heaven entirely.

In conclusion, Pascal was a poor gambler.  He'd lose his ass in Vegas with his wager.  Much more federally funded research into the empirical model of faith is required.  As a small first step, I filed a Freedom of Information Act with the NSA requesting all of their metadata on God.  We need to know just whom God talks to on his / her cell phone.  What televangelists does he / she have in his / her contact list?  What are his / her favorite porn sites?  Maybe he / she hasn't spoken to the Pope in centuries after that Reformation thing.

Once Congress finishes screwing up the federal debt ceiling, I'll ask them for a $5 billion grant to further my research.  Please take your Congressman hostage until he supports my grant.

Thanks for reading!  For real tax and accounting advice, please visit the main S&K web site at www.skcpas.com.

Until next time, let's do it to them before they do it to us.

Buying a Business - Making an Offer, Part I

If you haven't read my previous post on break even analysis, please read it before reading this one.  It teaches determining whether you are going to make an offer to purchase a particular business.  In this post, you'll learn about putting together your offer.

You have a few decisions to make when putting together an offer to purchase a business.  First is whether to buy the assets of your target business or the business entity itself.  This is a critical decision.

If you are buying the business entity, you are buying all of the assets and all of the liabilities, known and unknown, of your target business.  If your target business is a corporation, you are buying the stock of the business.  If the business is an LLC, you are buying the actual LLC.

At first, you might wonder, "Who in his right mind would take on the possibility of unknown liabilities?"  Sometimes, however, if makes perfect sense to buy the entity, and you can mitigate the possibility of getting stuck with unwelcome surprises.

If you seek a federal government contracting company with existing contracts, buying the entity is pretty much the only choice.  Federal contracts are not assignable.  To get the contracts, you have to buy the entity.  You can't purchase the contract as a separate asset.

You do not, however, have to buy a business entity to get a valuable existing business name.  The name is a separate, valuable asset that can be purchased.

When you purchase the assets of a company, you get to pick and choose exactly what you are buying.  You can, for instance, buy the customers, inventory, and hard assets of a company without buying the accounts receivable.  You can leave those with the existing owner to collect.  If the receivables are bad, that is the previous owner's problem.  You don't have to take any of the liabilities at all.  However, if you take the receivables, the existing owner will probably insist that you take the payables that produced the receivables.  But, all of this is subject to negotiation.

Let's look at the tax differences between purchasing the business entity versus purchasing the business assets.  When you buy the entity, you get no immediate tax deduction.  Your purchase is like buying Ford Motor Company stock.  If and when you sell the stock in either Ford or your new business, you'll get capital gains tax treatment on the sale.  If fact, your seller gets this treatment as well if you buy the entity.  Sellers prefer to sell their entities for this reason.  They get lower tax bills on their sales.

When you purchase the assets of a business, each type of asset has a separate tax treatment.  For the hard assets, such as equipment, vehicles, and furniture, you get a depreciation deduction.  For inventory, you get a deduction when you sell it.  Thus, purchasing assets is typically a better tax deal for a buyer even before you consider that you don't have to risk getting unknown liabilities.

If the seller wants an entity sale, but a buyer wants an asset sale, what factors determine which happens?  To capitalize on the tax advantage of an entity sale, most sellers will accept a slightly lower price for an entity sale.

A buyer can mitigate the potential danger of unknown liabilities by setting aside some of the purchase price in an escrow account.  That amount typically runs between 10% and 25% of the purchase price.  The money is released after a period of time sufficient to determine that no unknown liabilities have arisen, typically three years.

So don't completely discount the idea of purchasing the business entity, but be aware that the escrow account ensures you'll still be dealing with the previous owner until the escrow money is disbursed.  The seller and the business aren't yet completely divorced during that time period, and like an ex-wife, he'll be hanging around to make certain you give him his money.

Almost all small business sales are done as asset sales, because they are less risky for the buyer from a liability standpoint and provide for a clean split from the previous owner.

If you decide to make an offer for a business in the form of an asset purchase, you next have to determine what assets you are buying.  For small businesses, the seller typically keeps the cash, accounts receivable, and all liabilities.  The buyer gets the business name, customers, hard assets, inventory, and can choose whether to accept an existing lease.  The seller also normally agrees not to compete with you for a period of time within a specified mileage range of the business.

While you decide which assets you want to buy, you absolutely need an attorney to write the formal offer you will present.  Do not allow the seller's business broker to write YOUR offer.  As with real estate, the broker represents the seller's interests, not yours.  Most broker written boilerplate documents also have lots of legal issues.  It's your offer.  Get your representative to write it.  Paying an attorney now is way cheaper than paying one later to unwind a poorly written document.  I know from painful personal experience.

My next post will cover determining how much to offer for your target business.

As always, thanks for reading!  Your comments are appreciated and helpful to others reading the posts.  For real tax and accounting advice, please visit the main S&K web site at www.skcpas.com.  Also, please like the "How to Screw up Your Small Business" Facebook page.  I post business tips there several times daily.

Until next time, let's do it to them before they do it to us.

Buying a Business - Break Even Analysis

The fast food workers' strike was hilarious, proof that they deserve low wages.  If you want better wages, get a better job.  That's the way the U.S. economy has worked since...since forever.  Of course, you might have to get some training.  If you aren't improving yourself, you deserve the job and the wages you have.  I'm the wrong person to gripe to about this.  I paid for my own college, additional night courses, and CPA exam review course.  Your job situation isn't my problem.  Your job situation is your problem.  President Obama's "less fortunate" is really a euphemism for "lazy."  If you don't know what a euphemism is, give me fries with my burger, please.

Once you identify a business to purchase, you determine how and whether you can make money in the business with break even analysis.  Break even analysis reverse engineers the historical financial statements of a business to determine the level of sales necessary to not lose money.  Above that level, you make money.  Below that level, you lose money.

I suggest using an average of the three most recent years of either the business tax returns or profit & loss statements.  Use either the tax returns or the financial statements.  Don't mix and match.  Sometimes the tax returns are on the cash basis and the P&L's are on the accrual basis.  You want apples to apples.

First, divide the expenses of the business into two categories: variable expenses and fixed expenses.  Variable expenses are expenses that increase when sales increase and decrease as sales decrease.  For example, the food costs of a restaurant are variable expenses.  Materials are a variable expense of a home remodeling company.

Then subtract each year's variable expenses from yearly sales. That is gross profit.  Next, divide gross profit by annual sales to get a percentage.  That percentage is your gross profit percentage.  Average the percentages from the three years.

Fixed expenses don't vary with sales.  Rent is normally fixed in amount.  For the most part, so are the salaries of a restaurant.  Another word for fixed expenses is overhead.  Ignore non-cash expenses such as depreciation.  Total the fixed expenses for each year and then compute the average.

With the average gross profit percentage and the average fixed expenses, we have the inputs to determine the break even annual sales.  We simply divide the average fixed expenses by the gross profit percentage.  That gives you the annual break even sales amount.  Simple enough?  The most important task is next.

Determine if the break even annual sales level is realistic.  If the break even number is $600K, but the business has never grossed more than $400K, what are the chances you can increase sales to get to break even, let alone profitability?

If the break even sales level isn't realistic, don't bother going further into the purchase process.  Flush this turd, and move on to the next opportunity.  If the break even sales level is realistic, use the model we have developed to determine how much in sales you need to make your desired annual profit.  This formula is a simple derivation using our break even formula.

This time, instead of dividing fixed expenses by gross profit percentage, add your desired annual profit to fixed expenses before doing the division.  This gives you the sales level necessary to reach your profit goals.

If this sales level is realistic, you are ready to consider making an offer.  The next step is determining the offer.  I'll cover that in my next post.

As always, thanks for reading!  For real tax and accounting advice, please visit the main S&K web site at www.skcpas.com.  Also, please like the "How to Screw Up Your Small Business" Facebook page.  I post snarky business tips several times daily.

Until next time, let's do it to them before they do it to us.

Die Without a Buy-Sell Agreement

I just returned from a week of sightseeing in Boston.  Reading a book on Thomas Jefferson ignited my interest in the pre and post Revolutionary war periods. We did all of the normal touristy stuff.  At the end of our week, we took a Ghosts & Ghouls tour of Boston burial grounds.  As part of the tour I was hanged at Boston Commons.  Please send money to my not so mourning family.  Then the tour guides married me off to a serial killer.  She killed her first four husbands before being slain by her fifth.  It was a tough week.

September 2012 was a tough month for me.  Actually, it wasn't so much tough on me but on my clients.  Four died in one month.  Our staff joked that being my client was a terminal disease.  Three of these clients had their affairs well in order.  But one didn't.  He owned a business with a partner.  He died without a buy-sell agreement or an operating agreement.

Fred and Al owned an IT business that served the federal government.  They provided fail over services for government agencies.  If you had computer operations in say... the World Trade Center, and someone flew a plane into the building destroying your IT facilities, Fred and Al made certain your operations continued as usual.  You can probably understand that Uncle Sam had quite an interest in their services.

Fred and Al were both in their mid-forties and in good health.  Then Fred got run over by a truck, literally.  He died instantly.  Fred and Al had neither a buy-sell agreement nor an operating agreement.  What happens when your business partner dies, and you don't have the legal documents to ensure an orderly transfer of the business?

You end up with unwanted partners, and they aren't usually the silent type.  Al was contacted by a personal injury attorney representing the two daughters from Fred's first marriage.  Al barely knew the daughters existed.  Since, there were no legal agreements regarding what happened to the business upon Fred's death, the attorney volunteered to draft an operating agreement for the business installing the two daughters as Al's new partners.

Here's the problem with allowing a personal injury attorney to write an operating agreement in these circumstances.....  Personal injury attorneys don't know a damn thing about estate law, at least this moron didn't.  Fred's daughters were not the rightful owners of Fred's share of the business even though they were his heirs.  In Virginia, Fred's estate owned Fred's share of the business.  The attorney was busy writing an invalid agreement.

I referred Al to an estate attorney, who began the process of probate for Fred's estate, working with Fred's second wife to close out the estate.  In Virginia, counties administer the probate process.  Periodically, the estate executor files an asset inventory and reports on the progress in winding up the estate.  Besides the legal fees, the county requires substantial probate fees based on the value of the estate.
Fred's share of the business was his primary asset.  So the estate engaged me to provide a valuation of Fred's share on the date of his death.  Al, and the estate attorney, hoped to use this valuation to settle the estate and buy out any claim on the business from the daughters.  Hoped is the key word here.

If you are caught in Al's situation, you can be certain of one thing.  The heirs of your business partner will smell the pot of gold.  They are thinking millions of dollars for their share even if they peed in his porridge while he was alive.  It's party time, baby.  Fred's daughters were no different.

Fred and Al had a nice business, but it was really just two well paying jobs.  They provided all of the services personally, relying on their combined forty years of engineering expertise creating fail over systems.  That doesn't make for a valuable business.  For Al to continue the business, he needed to hire someone with similar expertise.  These people aren't cheap.  In fact, it was going to cost more to replace Fred than Fred's salary.

Fred and Al were very valuable computer engineers, but the business itself was worth pretty much nothing since the pool of potential buyers was almost nonexistent due to the technical qualifications required of a new owner.  I valued the business at just the cash on hand and the receivables at the date of Fred's death.  Fred's half of that was about $100K, hardly the millions his daughters envisioned.

Are you surprised that they weren't happy with me?  Al was faced with tens of thousands of dollars in legal fees, not to mention the business disruption.  He offered the daughters the opportunity to pick a business valuator of their choice.  But, that would cost them money.  They were content to threaten legal action and delay the closing of the estate.  The county was after the estate to close and continued to impose more fees.  The business was being ignored.

In frustration over the lack of progress getting the business out of the estate, Al hired a litigation attorney.  Al's attorney asked the daughters to submit what they thought the business was worth telling them that Al would either buy it from the estate for that price or sell his share for that price.  They would then be obligated to buy Al's share at his option.  Of course, they refused.  They had no money, but they had plenty of attitude.

Al's attorney then told the daughters that Al was resigning from the business.  Since there was no operating agreement, Al was free to withdraw from the business and form his own new company.  Of course, he couldn't take any existing contracts with him, but those contracts were worthless without him.  The daughters would never be able to manage the existing contracts, and the business would fold.  Then Al could bid to get the contracts back.

The daughters' attorney called for a mediation meeting and the daughters settled for almost the exact value I had calculated.  Al had his company back after spending $20K or so, not exactly a happy ending, but a satisfactory one in the end.

Dying without buy-sell and operating agreements is malpractice for a business owner.  You are ensuring heartache for your family.  Of course, if you hate your partners, spouse, and family, go for it.

Thanks for reading!  For real tax and accounting advice, please visit the main S&K web site at www.skcpas.com.  Also, please like the "How to Screw Up Your Small Business" Facebook page.

Until next time, let's do it to them before they do it to us.

Use a Revenue Multiple to Value Your Business

A month ago, I lamented my inability to buy life insurance on RGIII. I'm really sorry now. Last Sunday, he was crushed trying to avoid a pass rush and run for a first down. He suffered a concussion on a hit from a Falcons linebacker near the Redskins sideline. First a concussion, death to follow. At least the Redskins are determined to kill him.

RGIII is the most exciting Redskins player in forever. At least, I don't remember anyone as exciting. With him, they can score from anywhere on the field. Without him, they're back to where they have been for the last ten years. They'll be lucky to score twenty points per game in a league where it takes thirty to win consistently. To be competitive, the Redskins need RGIII. Of course, with a leaky offensive line, he's going to take hits like last week's almost every game. I'm still looking for a good insurance policy on him, but I think the price just went up.

Tell me why I'm valuing a business, and I'll tell you whether the owner thinks my value is too high or too low. When he's buying out a partner, he'll say I'm too high. If he's selling his business, my value is too low. Being a valuation professional is like being an NFL referee. Someone thinks you're wrong 100% of the time.

Business owners love to cite revenue multiples when bragging about the worth of their businesses. Almost every time I complete a valuation for a potential business sale transaction, the owner tells me about his neighbor, who got some ridiculous sales price for his business. He'll tell me his buddy got 1.5 times annual revenue. He doesn't understand why his dog poop pickup business isn't worth the same. He then follows with the argument that his franchisor says companies like his go for between one and two times revenue. Of course I never get to see the actual sales agreement for his buddy, and the franchisor won't reveal the names behind their figures.

Revenue multiples are a popular way to value businesses, because they are simple and don't require much information. All you need is annual revenue and the multiple, and you instantly have the value of your business. What could possibly be wrong with such a simple method? A lot.

Let's examine the basic logic behind revenue multiple valuations. It goes as follows. Find a revenue multiple for your industry from some credible source. Apply it to your business, and you have a credible valuation. There are three fatal problems with revenue multiple valuations. First, revenue multiples assume that all businesses of similar size in an industry will sell for the same amount. Does this make any sense?

Let's assume we have two identical doggy poop pickup businesses. They both have $1 million in annual sales. The only difference is that your doggy poop business makes a $100K per year profit after expenses, and mine loses $100K per year. We look up a revenue multiple and find that it is 75% of annual revenue. We take our annual revenue of $1 million and multiply it by our 75% multiple. Both are our businesses are worth $750K. Does it make any sense that a business that loses $100K is worth the same as one that makes $100K? Of course not.

If you have a little sophistication in the valuation area, you might say, “Frank, your business really is worth the same to a buyer as my business. A buyer will understand that your business is poorly run and will improve operations.”

I agree that a buyer will fix my operations after the purchase. But why should he have to go to the effort to fix my business, when he could have bought yours for the same amount? I agree that the valuation of my business will be somewhat more valuable for its potential, but it certainly isn't worth as much as your finely tuned operation.

The second issue with revenue multiples is its application to past revenue. Businesses are sold on future revenue not past revenue. The only time past revenue is relevant is when it assists an accurate projection of future revenue.

Let's again assume we have our two doggy poop pickup businesses with $1 million in annual revenue for this year. Let's even assume that our 75% multiple has been blessed by some dude standing behind a burning bush and handed on down on stone tablets to us. Let's even assume our businesses will have the same profit this year. Surely our businesses are worth the same $750K. Surely not.

What if my business serves neighborhoods in an area about to have significant job layouts, and your business is located in Washington, DC, land of the big handout? What is likely to happen to my revenue next year compared to yours? Of course, my revenue is likely to decrease. Our businesses are not worth the same amount. Yours is worth 75% of next year's revenue as is mine. But your revenue will be higher than mine. Thus, you business is worth more.

I have been working a lot valuing government contractors lately. In researching revenue multiples, I noticed that they were all over the place. The data spread was really wide for any annual revenue range. What did that tell me? It told me that the businesses will the highest multiples had the best sources of future revenue. In government contractor speak, they had the biggest contract backlogs.

The third problem with revenue multiples doesn't just apply to revenue multiples. It applies to any other type of multiple like cash flow, earnings, or EBITA. These multiples come from studies of business sales. The problem is that you can never see what's behind the statistics. Business sale statistics are like sausages. You don't know what goes into them, and you probably don't want to know.

Two businesses could each have been sold for two times revenue and even sold for the exact same dollar amount. However, one deal might have been all cash, while the other might have been for a long term note payable. The reported sales price in the study is the same, but wouldn't you rather have the all cash deal as a seller? So were these sales really for the same amount? Sometimes businesses are sold for stock in the buyer. If the stock in the buyer is over-valued, how reliable is the sales price reported in the studies?

All of these disparate sales are ground up and stuffed into a sausage blend of multiples. These multiples don't really seem that reliable, do they? Multiples, in general, are best used as confirmations for valuations using better methods. Tell your neighbor that you'll believe his valuation when he moves out of your neighborhood and finds a better class of friends – like Mitt Romney. Otherwise he's likely exaggerating.

RGIII, after apparently passing post concussion tests, will start this week's game against the Vikings. I used the word, apparently, because how could he possibly be mentally well if he agrees to play behind that offensive line? I'd love to see a mortality table on playing quarterback in the NFL. You need a concussion to be crazy enough to play quarterback in the NFL.

As always thanks for reading. For real tax and accounting advice, see our main S&K web site at www.skcpas.com. Until next time, let's do it to them before they do it to us.

Are Your Real Estate Flips Flops? Part II

The real referees are back. No more referees rejected from college training programs. This week, Ed “Big Guns” Hochuli will be back torturing the Redskins. Hochuli makes Arnold Schwarzenegger feel inadequate physically. He's built like a Redskin hating Greek god. Of course, there was that officiating gaffe that cost the Chargers a playoff spot a couple years ago as well. Yet, I am a forgiving person, especially given the danger to RGIII from the fake referees.

In my previous post, I explained how you calculate return on investment for real estate investments or for that matter for any investment. The basic calculation was profit divided by investment. I encourage you to read that post first before this one. In this post, I assume you understand the basic ROI concept. I will also use a more complex example. Let's plunge into an example with some realistic numbers in place of the very simple ones from the last post.

Our objective in this exercise is to calculate how much we have to sell an investment property for in order to obtain a desired rate of return over a particular period of time. In simpler terminology, we are fixing up and flipping a house. To accomplish this, I have to give you some numbers. Here they are:

Purchase price of the house $350,000

Settlement costs on the purchase $10,000

Fix up costs $50,000

Loan amount at 80% of the purchase price at an annual interest rate of 8%

We intend to sell the house after six months with a 50% annual rate of return.

Settlement costs on the sale $20,000

Our objective is to determine the selling price of the house to get our 50% annual rate of return in a six month period. Let's start out with how much money we need to invest in the house. We need this information to know the dollar amount of the return we desire. To get the total amount invested in the house, we add the purchase price, the purchase settlement costs, and the fix up costs, which gives us $410,000. We can borrow 80% of the purchase price or $280,000. The bank typically won't finance the settlement and fix up costs. If we then subtract the loan amount from the total amount we have in the house, we get our investment of $120,000. That's our money in the deal.

Next, let's determine the profit we need to achieve our annual rate of return of 50%. Since we are holding the house for 6 months, our actual nominal rate of return is 50% divided by 2 or 25%. So we take the 25% times out investment of $120,000 to get $30,000, which is our desired profit.

Finally, we determine the selling price we must get. Add the original cost of the house including the purchase price, fix up costs,and purchase settlement costs. That gives us $410,000. To that we add 6 months interest on the loan, which is $11,200. The bank isn't loaning you the money for free. Then we add the settlement costs on the sale, which are $20,000. Finally, we add in our desired return on investment of $30,000. That gives us a desired selling price of $461,200.

Put simply, to achieve a 50% annual return on our invested funds, we need to sell the house for $461,200 in six months. If you don't follow the math exactly or would like to run your own scenarios, I have an Excel spreadsheet I will send you if you shoot me a message requesting it at fstitely2@gmail.com. I have no agenda in this. I ain't looking to sell you nothin'.

Let's have some more fun with these numbers. Let's start out with the selling price we need to break even. That's an easy number to get. We take our desired selling price of $461,200 and subtract the profit of $30,000. Our breakeven price is $431,200. If the price is above that, we make money. If the price is below, we lose money. In other words, we have to sell the house, that we bought for $350,000 and spent $50,000 fixing up, for $431,200. Or we lose money. If we are selling within six months, the house, that we paid $410,000 for after fix-up costs but before settlement costs, has to go up in price to $431,200 or we lose money. The breakeven number is an incredibly important piece of information to have before you plunge into this investment. If you haven't calculated that number, real estate investing isn't for you.

Now that you know how to set your objective and calculate breakeven, let's discuss the circumstances under which you can accomplish your profit objective by flipping a house. Let's start out with a sanity check. Why would somebody pay you $461,200 for a house you bought and fixed-up for $410,000. Why wouldn't someone just go out and buy another house for $350,000 and spend $50,000? What makes your house worth the $461,200 after six months or even the breakeven of $431,200? Few amateur house flippers ever ask themselves this question.

There are three circumstances under which you might achieve the return you desire. The first is that you are in the construction business. That means you are doing a lot of the work yourself or through your employees. You are paying wholesale for materials and labor. You aren't paying for the improvements what the average Rich Dad Poor Dad reader pays. You are paying $50,000 for improvements worth $90,000, assuming no other increase in the price of the underlying house. Are you in the construction business with access to great pricing? Most of you aren't.

The second circumstance is that you have identified a house that is significantly under-priced. Under-priced to the tune of $40,000. In other words, you paid $350,000 for a house that was really worth $390,000. How did you happen to have this magnificent foresight? You might have this foresight if you have been in the real estate business for a long time. You might be able to identify houses in neighborhoods about to become desirable. I have known a few people, who have done this, but damn few. Look in the mirror and be honest. Do you really have this sort of insight?

The final circumstance under which you might achieve our annual return of 50% is that the real estate market has gone truly crazy and there is a buying frenzy. The early 2000's are a perfect example of a real estate market gone crazy. You could buy a house from a builder that had not been built yet. Then you could sell it two weeks later for a good profit still before the house had been built.

Of course, you had better not get in on the end of the cycle. My business partner Paul and I have a saying. “The party is over when the fools arrive.” Fast forward from 2000 to 2006. When the music stopped, a lot of people had borrowed a lot of money on houses that were worth 60% of what they had paid a year earlier. They weren't underwater. They were completely under the riverbed. I had clients whose real estate investments went as follows: profit, profit, bankruptcy. Some of these people were real estate agents. So much for superior market knowledge.

Your ability to make money in a crazy market depends on your ability to recognize the beginning of the price run-up and then get out before the crash. Do you have that level of expertise? I don't. Pretty much no one does.

My intent isn't to tell you that real estate shouldn't be part of your investment portfolio. It should be. However, flipping houses isn't investment. It's speculation. If you're not real estate savvy, you are just gambling – with borrowed money in most cases. If you aren't doing the ROI calculations above and making realistic judgments, you aren't real estate savvy. Your real estate flips will be flops.

Our house is in mourning over the death of the baby panda at the National Zoo. The Zoo has had incredibly bad luck raising baby pandas. There are two possible explanations for this. The first is that the pandas are just another defective Chinese export product.

The second explanation is the lack of sex appeal of the female pandas at the National Zoo. Despite importing male panda studs, the zoo has resorted to artificial insemination. We can only imagine the conversations between the male pandas. “Dude, she's a double bagger. I'm not doing that.”

Maybe panda love works the same way as human love. They should spike the bamboo shooters the males drink. Get them liquored up. Then announce last call for alcohol. The females will probably look a lot more attractive then.

Thanks for reading. Next time, I plan a post on falling behind the times in marketing. As always, for real tax and accounting advice, please visit the main S&K web site at www.skcpas.com. Until next time, let's do it to them before they do it to us.

Do It Yourself Business Valuation

A week ago, a female Washington Post sports columnist opined that we should discontinue the use of war as an analogy for football games. She believes war analogies are disrespectful to our troops. I can go with that. However, for war as a football analogy, I would like to substitute the menstrual cycle. Instead of saying London Fletcher played like a real warrior, we would say that he unleashed his inner bitch. Mike Shanahan should quit yelling at the replacement referees. He should just take a Midol and have a good cry with Dan Snyder.

Football already has a head start with the new menstrual cycle paradigm. There is a pass protection scheme called max-protect. You can be the first to run up to my three hundred plus pound Redskins neighbor, Trent Williams, and tell him he should block like a super-absorbent tampon. Good luck with that. I'll stick with the war analogies.

Can you value your business by yourself? Let's look at a recent sample of DIY business valuation I experienced recently. I was asked to provide a business valuation for a small government contracting firm. After a couple day's work, I sent the owners my draft valuation. In the meantime, they decided to use an internet valuation service. Of course, we were really close on our numbers – of course not.

Here's how they came up with their valuation number. Their company's after tax cash flow was about $100K per year on annual revenue of $3 million. They were projecting next to no growth over the next few years given the uncertainty in the government contracting world caused by Congress's fantastic handling of the federal budget. Yes, that's sarcasm. So far, I have no problem with what they've done. They have accumulated their historical financial results and projected them reasonably into the future.

Next, they went searching for comparable companies in their industry that had been sold. No problem yet. Their search identified ten company sales in the government contracting industry. On average these companies sold for nine times annual cash flow. They took the multiple of nine times their annual cash flow of $100K and concluded their company was worth $900K. I should add that these guys are rocket scientists, literally. So math is their gig, and their math is correct. However, their business valuation is VERY wrong.

What's wrong with their analysis? They identified a multiple and applied it to the correct measure, cash flow. That's a hundred times better than most people do. However, when I asked for the listing of companies they used to determine the multiple of nine times cash flow, I saw that the annual sales for these companies ran from a minimum of $15 million to a maximum of $100 million. Just, how similar are these companies to their company? Not very. The smallest company they considered was five times their size.

Women are correct that size matters (it hurts me to write that), especially in the business valuation world. The valuation world consists of several distinct market segments divided by annual revenue. Those segments are divided into the following revenue categories: less than $5 million, $5 to $10 million, $10 to $25 million, $25 to $50 million, $50 to $100 million, and above $100 million. Valuation professionals will say I'm being overly simplistic. There are actually sub-segments within the segments. Each segment has its own valuation characteristics and cash flow multiples. Their analysis used a multiple from revenue segments way above theirs. That was the first mistake.

Their second mistake was not understanding what was really in the comparable sales statistics. Even if they had found sales in their segment, they used a multiple without understanding the numbers behind the multiple.

They took at face value the nine times cash flow statistic. Let's take a look at that cash flow multiple from an investor's viewpoint. Someone paying nine times after tax cash flow for a business is investing nine dollars for every dollar of annual profits. That is an after tax return of 1/9 = 11%. No one invests in a small business looking for an 11% return. Typically, investors look for something in the range of 20% or more after taxes.

That seems like a lot until you consider the risk investing in small businesses. You are as likely to walk away with nothing for your investment as you are to have any return at all. Some of you have tax loss carry forwards in the hundreds of thousands of dollars from bad investments. I feel your pain. Given your investment experience, are you going to invest $900K to get the possibility of a 10% return? Probably not. 20% probably isn't tempting you either. So you can see the nine times cash flow return of 11% just doesn't pass the laugh test.

Were the buyers of these businesses in the study stupid? No. Investors don't buy historical earnings. They buy future earnings. These businesses weren't paying nine times future earnings. They likely paid about five times future earnings. That's an after tax return of 20%. In evaluating their buy-out targets, the purchasers looked for growing companies or companies where the cash flow could be easily improved. The statistic of nine times historical earnings is a classic apples to oranges comparison. A purchase price based on future cash flow is used to compute a multiple based on past cash flow. That doesn't work very well. Even rocket scientists can screw up the math.

What was my valuation? About $300K. That looks like three times earnings and the end result is exactly that. But again the multiple is misleading until you look at the logic that resulted in the final valuation. If you value the company at a reasonable multiple of five times cash flow, you get $500K as the valuation. However, there is an inherent assumption in that price of a ready market for the company. There is no ready market for government contractors with $3 million in annual sales. In fact, there isn't much of a market at all.

First, large companies won't usually bother with really small acquisitions unless there is some really valuable proprietary technology. The expenses of acquisition are basically the same for buying a $30 million company as for a $3 million company. Also, small government contractors typically have contracts set aside for small businesses that large companies aren't allowed to acquire.

Second, the revenue stream of a small company is usually highly dependent on the personal relationships of the owners. If the owners leave, the revenue either stops or decreases significantly. In short, for small government contractors, there is a very small pool of potential buyers.

Based on the two factors above, I discounted the $500K value to $300K. Yes, that is 40%. In the business valuation world, this is called a discount for lack of marketability. A 40% number is not at all unusual.

You could conclude that I used a multiple of three times cash flow, and that is what the statistics would show. However, you can see that multiple would be misleading if you blindly applied it to other companies. Statistics don't lie. They just sometimes hide the underlying truth. Herein lies the problem with DIY valuations and the internet services. You have to know what is behind the statistics to intelligently apply them. Yes, valuation professionals, like me, laugh at the DIY'ers. Sorry.

Those wacky British royals are in the news this week for getting naked in public again. Yes, I know the photographer shot Kate from seven hundred yards away. The royals are apparently unaware of some technical advances that have occurred since Henry VIII started relieving his wives of their heads. There are these things called planes, helicopters, and telephoto lenses. If you are bare ass naked outside, someone can take a picture of you from somewhere – maybe even from earth orbit. Of course, I'm as interested in seeing Kate's Jim Dandies as much as the next horny guy. So if you have these pics, I'd love to take a look. Prince Harry – not so much. Although I would like an invitation to the next nude billiards game in Las Vegas. I promise not to bring my cell phone.

Thanks for reading! For real tax and accounting advice, please visit the main S&K web site www.skcpas.com. Until next time, let's do it to them before they do it to us.

Selling Your Business

At this point, it's an old wives tale that small businesses sell for one times revenues.  I met this morning with a client to review a business valuation I had prepared.  He told me a few of his friends told him about the one times revenue rule of thumb.  That means if your business has $1 million in sales, the business will sell for $1 million.

Part of my process in preparing a business valuation is reviewing sales of comparable companies from a database of business sales compiled from business brokers.  I showed the client four recent sales of relatively comparable companies.  The top revenue multiple was 50% of revenue.

Looking more deeply at this sale with the highest revenue multiple revealed that this company also had the highest cash flow relative to its selling price.  This multiple is called selling price to seller's discretionary earnings (P / SDE).  This is a multiple based on the cash flow of a business.  Given two businesses with equal sales, the one with the higer cash flow will command a higher price.  That certainly isn't rocket science!  If you want a somewhat useful rule of thumb (as much as any rule of thumb can be useful), small businesses typically sell for 3 to 3.5 times discretionary earnings.  This particular client's industry was selling for more like 4 times SDE.

I had a conversation with a business broker last Thursday.  He told me cash flow rules in terms of selling valuations.  He further went on to tell me that banks will no longer finance valuations built on revenue multiples or pro forma (projected) cash flows.

Multiple of revenue valuation can now be archived in history with "per click" internet site valuations, and other dot com valuation fantasies.  Reality is back.