Small Business Podcast: Hello everybody. Welcome back to Small Business Podcast. Thanks for joining us for another interview this week. All of these interviews are designed to give entrepreneurs and small business owners the ideas to think about running their businesses more efficiently and to take you through each step of the process of starting, running, and eventually selling your business. We are going to concentrate on the selling aspect of it today. Our guest is Matt Donnelly. He is an appraiser of businesses and he is going to talk to us about how we value business and if you're getting ready to retire or sell your business, maybe some options you have. He specializes in ESOP. We are going to talk about that as well, what that is, and maybe an option to sell your business when you're ready to retire using those. So, Matt thanks very much for joining us on the phone today.
Matt Donnelly: You're welcome. It's a pleasure.
Small Business Podcast: Well, you have been appraising businesses for 21 years so you have seen a lot of these. Can you give us just the basics, you know, you get calls and someone says, "I'm ready to
sell my business." What's the first couple of things you do to try to get a handle of what their business is worth?
Matt Donnelly : Well, I first tell them that the first thing we need to do is have the business appraised, and once we get an independent appraisal of the business, then we can decided whether or not that is acceptable to you. If the appraiser said the business is worth $7.95 and you were hoping for a couple of million, then we have to figure out what we can do about it.
Small Business Podcast: Right.
Matt Donnelly : So, first, we need to know what is the fair market value of the business.
Small Business Podcast: You know the common thing probably is you've got your net profits. What they're actually is left over after all the bills are paid and the equipment you have. Are there other things that help contribute to the value?
Matt Donnelly : Yes. It's length of time of being in business and whether or not there are any key people who will be remaining with the business, and what the future looks like. If they make buggy whips, the future is not too bright. If they're in a growing business, then that is taken into consideration and that we try to estimate what the sales will be and the profits will be for the next 10 years and incorporate that into our determination of the company's value.
Small Business Podcast: Now I would imagine a lot of small business have the problem of the owner being such an influential person in the business that replacing them can sometimes, I would imagine, take away from the value or if they are going to stay on, maybe add to the value.
Matt Donnelly : Well, it depends on how long they are going to stay. Most times, sellers are willing to stay for a couple of months to show the fellow where the light switches are and those kind of things and that helps. But being available as an ongoing side consultant for the new owner is very helpful and sometimes we'll fashion the selling price at "X" amount plus a monthly salary for continuing to be close to the business and helping them out. That extra feature, an extra addition to the selling price, is not subject to capital gains but it is subject to income for the seller who gets such an ongoing stipend.
Small Business Podcast: Do you find these days a lot of business owners do overvalue? I would imagine most people feel like, "My business is worth more than it may be appraised to." Is that a common problem?
Matt Donnelly : Well, see I don't think of it as a problem. It's a fact of life and what the business owner has to be willing to do is to pay attention to what the fair market value is. I advise them that whatever is determined as the fair market value by a competent business appraiser; don't try to get more for it. Be happy if you can get in that vicinity of what the value was. But, yes, some people have an idea of what their business is worth. I tell them not to tell me. I don 't want to hear what you think it's worth because we are going to tell you what we think its worth in the market today and that's a critical factor. So, sometimes they think it should be worth more, that's fine. Sometimes, we can help them figure out a way that it is worth more. We do that all the time.
Small Business Podcast: Now there is a million ways to slice it up when you're ready to sell the business and ways to do it. You focused on something called an ESOP. Can you explain what that is?
Matt Donnelly : Well I don't focus on that but ESOP is approved by the government, a method of setting up a trust on behalf of the employees and selling your shares of stock; if it's a C corporation, selling your shares and stock to the trust and they hold it for the employees. It enables you to get full fair market value without paying a sales commission and without paying capital gains tax. So it's a big boon to somebody who has a C corporation, or if they have an S-corp they can easily convert to a C-corp but it has to be a C corp at the time of the sale and stock from the selling shareholder to the
ESOP Trust. Now, the trust gets some money from contributions from the company out of the profits and generally, we can avoid most of that companies income taxes, the years that we begin to make contributions because they are all tax deductible from the company. So in effect, if an owner installs an ESOP, he can get tax-free money for his sale at the full fair market value of his business. It's paid for from tax deductible dollars that are contributed to the ESOP trust. When I first started discussing this with the owners, I stressed this tax-saving feature. I find that most small type business owners where the employees are more like family, he is interested in taking care of them and if he can see that he is leaving them a legacy, that they will be owners of the business and able to share in the future profits, then he is happy and both parties win.
Small Business Podcast: Does this help avoid that double taxation then of the C corporation?
Matt Donnelly : Yes. It avoids all taxation. The taxes that the seller will get from shares is tax free. No capital gain tax, no income tax except if they pay any interest on a note that they might get back to it. The corporation pays no taxes on a monthly contribution. The participants of the plan, the employees, when they go to retire, they sell the shares that have been accumulated in the trust on their behalf. They sell that back to the trust or to the company and then that is intaxable to them. So what we usually do at the time that they're terminated, we take the money, roll it over into some kind of an IRA or 401(k) plan or whatever is appropriate and that eliminates any taxes until that retiree goes to draw from his newfound
401(k) or IRA and then he'll pay taxes when he does takes the money out at whatever his income tax level is at that time.
Small Business Podcast: Is there any particular type of business that lends itself really well to this type, whether it be an industry or something?
Matt Donnelly : Yes, that's a good question and I asked myself. I have been doing this since 18...not 18 but 19.
Small Business Podcast: [LAUGHS] I don't think you're that old. [LAUGHS]
Matt Donnelly : No, almost, though. In 1981, I think I did my first, the first time I did ESOP. Everybody is eligible, but I find the easiest one as the one that most is susceptible to having an ESOP is a contractor, somebody who has been in the contracting business for some time. If you have a contracting business and you do a couple of million dollars a year, who is going to buy it if you're trying to sell it in the open market? Who wants to buy a business like that? Well, employees if they have the money and most of them, they don't have that kind of money. A competitor would, but he won't buy your business forward. He won't. So, we find out that the typical contractors of any kind: construction, electrical contractors or whatever. Especially, the bigger they get, the more they can come out ahead by getting full fair market value for their business and not paying the usual 10 percent sales commission, whatever the selling broker would charge and not paying any capital gain tax, not paying any taxes at all and all of it comes out of the corporation's earnings and it's tax deductible. From the corporation's standpoint, we can avoid earnings and as a consequence, everybody wins out except the IRS and most people don't cry about that.
Small Business Podcast: Right. I think that's probably an OK with most people. The cost, of course, involved in selling business, whether it be attorneys or the 10 percent commission you talked about, what cost are we talking about and how do you determine what those are for this type of exit?
Matt Donnelly : Well in ESOP, we have to get a competent ESOP attorney and that also requires independent and experienced appraisal. So it's not something a small business can do. The attorney's cost will run $40,000 to $60,000 and appraisal will cost may be $10,000. So you got that cost up front, but when you realize the savings you get and not paying any taxes on any receipts and so forth, it's worth it.
Small Business Podcast: Is there a way to do an ESOP if you only want, say the family members that are employed by the company, to take ownership. Could you still do it this way?
Matt Donnelly : No. What we do is we sell it to all the other people and if there's family member in there working, then we make them trustees of the trust so they run the company since they will own the trusts. They will vote the trust shares and the stock and they can say they run the company and set their own incomes and make sure the company succeeds, but as far them getting any stock, no.
Small Business Podcast: Now, how do you determine how much stock each employee gets? Does it have to even?
Matt Donnelly : No. It's done annually and it's based upon their gross income, including commissions or bonuses or whatever. So, if you make $200,000 a year and I only make $40,000 a year, you're going to get five times as much stock as I get. They're allocated to you. You don't get it until you leave but in the accounting for the stock, it's based upon the proportionate income for that year.
Small Business Podcast: Let me get back and switch gears back to the
business valuation part of the topic. I think I left a couple of questions on the table there. In an economy environment like we have now, which is we're in a recession, how much bearing does that have if I'm to retire now? Should I wait until we have a better economic environment?
Matt Donnelly : Well, the valuation is going to be based on how the company has done. So a business that has been suffering and is suffering now as a result of this would probably get less than what they would like to hear or what the fair market value would be in a year or two, depending on what happens during that year. So, whether or not one should continue with the business they have now and wait until the depression or whatever this is were in ends, that's a matter of judgment. It depends on how much more they want to work and if they think they can grow some more afterwards, that's their own management decision on how to do it. If it were me, I would keep on. If I'm doing nicely and even if things are down, I would bet that I'll be back and I would keep on working and building the equity in the business.
Small Business Podcast: If I know that I'm retiring three or four years from now, even five years from now, are there some things I can do as an owner to prepare my company to be sold to try and maximize that value when I'm ready?
Matt Donnelly : Yes. One thing, and it seems obvious, is to improve the net profit. Easy to say, but you make the changes necessary to improve the profit margins. Also, if you were to plan out to do four or five years from now and you have some bank debt now, if you still have that bank debt at the time you did the appraisal for sale, that would be subtracted from the values because that has to be paid. So, if you can work on reducing any bank debt, any interest bearing debt, then you will, at the same value now, will be more as you reduce that into sparing debt if that's possible but that of course is how well things are doing for that particular business. The other thing you would want to do is make sure your books and records are in good shape, clean, easy to read, and easy to understand for the buyer. If you have an independent appraisal done and you can show that to the buyer, and had this done independently and the experienced appraiser would say, "It's worth two and half million dollars and that's what I want for the business whether it be now or three, or four, or five years from now. That's the basis to stay and most of the time, that's where the businesses are sold.
Small Business Podcast: What's more important do you think if I have, let's say a round figure here, 10 million in gross revenues but my net profits at the end of the day are a couple hundred thousand dollars. Is that a more valuable business than if I'm making 5 million but I'm netting a million dollars every year?
Matt Donnelly : The higher net is what determines the value. Now when you say net, we have to take all things into consideration including how much are you drawing as the salary. Maybe it's a 10 million dollar business you took a million dollar of salary for yourself so we would add that back because that's way above normal and so, we need to examine those things before we can give you any kind of an idea which one of the two would be worth more, that's for sure.
Small Business Podcast: Matt, I appreciate you taking the time to talk to us. We should tell our listeners if they want to, you know, start this process or if they want more information, how should they get in touch with you?
Matt Donnelly : Let me give you my toll free number 800-795-8838. I'm in San Francisco or you could use my email address, which is Matt@mattdonnelly.com.
Small Business Podcast: All right. We'll put that in the show notes so listeners, you can click on that and email Matt as well. Matt, thanks for your time.
Matt Donnelly : You're welcome. I'm happy to talk
