Companies spend more than $2 trillion on acquisitions every year, according to an article in Harvard Business Review. Yet studies frequently cite failure rates of mergers and acquisitions (M&A) between 70 and 90 percent.
David E. Shaffer, a director in the Audit & Accounting practice at Kreischer Miller, says problems are often the result of poor planning. Companies are enticed by the opportunity to create synergies or boost performance and fail to consider all ramifications of an acquisition.
Smart Business spoke with Shaffer about ways to mitigate the risk and ensure a successful transaction.
Why is the M&A failure rate so high?
Many companies don’t establish a clear business strategy for mergers and acquisitions. Some questions that need to be answered include:
- What are the goals of the merger or acquisition?
- Do you want to leverage existing resources or create a new business unit?
- What is the maximum price you are willing to pay?
- Must the seller agree to some holdback of the price?
- What happens to administrative functions and management of the target company?
- Must key employees sign agreements to stay?
- Will you negotiate between an asset purchase and a stock purchase?
- Is culture important?
You should be proactive in identifying candidates for acquisition. Companies that have done many acquisitions tend to ignore requests for proposals because the sellers in such situations usually go with the highest price. They reason that the law of averages is against them and at least one competitor will overpay.
Instead, companies involved in many acquisitions prefer to target entities and establish a relationship before that stage in order to avoid a bidding war.
How should the due diligence process be conducted?
It’s important that you don’t take shortcuts in your due diligence. Hire professionals who are knowledgeable about the industry; they can negotiate better deals for you because they are not emotionally attached and can push harder for seller concessions.
Due diligence should address internal and external factors that create risk in the acquisition and focus on key factors driving profitability — employees, processes, patents, etc.
The more risk present, the more you should ask for holdback in the selling price. For instance, if much of the profit is derived from a few contracts, require that the contracts be renewed under similar terms if the seller is to receive the full purchase price.
M&A failures often result because buyers concentrate too much on cost synergies and lose focus on retaining and/or creating revenue. Client retention at service organizations is at significant risk following a merger or acquisition, according to a 2008 article from McKinsey & Company. Clients will receive misinformation, so it’s important that the acquiring firm step in quickly to assure clients that service levels will equal or exceed what they have been accustomed to expect.
What needs to be done post-acquisition?
It’s important to have a clear post-acquisition plan, including financial goals, with as much detail as possible. The quicker value is created by the acquisition, the better the result for the buyer.
Key post-acquisition steps to ensure a successful integration include:
- Developing the organizational structure.
- Developing sales expectations.
- Identifying what processes and systems will change, and when.
- Developing performance measures.
Finally, you also need to hold key management responsible for producing results.
David E. Shaffer is a director, Audit & Accounting, at Kreischer Miller. Reach him at (215) 441-4600 or firstname.lastname@example.org.
Social Media: To keep in touch with Kreischer Miller, find us on Twitter: @KreischerMiller.
Insights Accounting & Consulting is brought to you by Kreischer Miller
Most business leaders want to greatly improve customer loyalty, and I am no different.
To drive loyalty to my promotional products business, we have tried all the usual means — low prices, free shipping, membership club benefits, discounts and exclusive product offers.
Once, we even tried sending a vase of fresh flowers after each order. None of these initiatives resulted in the dramatic improvement that we sought. Over the years, we have engaged a series of expert consultants to find even more ideas to try. But in our business, customer loyalty remains a tough nut to crack.
The pharmaceutical giant Eli Lilly & Co. struggled with similar obstacles when it came to problem-solving in their business. Many were scientific, and — even though Eli Lilly’s substantial R&D group is staffed with talented technical experts — some problems resisted a solution for years. However, the company did invent a way to solve some of its problems quickly and cheaply.
Use expert advice — of others
Here is the gist of it: Eli Lilly discovered that it could solve a lot of the most intractable problems by giving them to experts from other fields. Simple? Yes. Counterintuitive? Yes. The surprise is that it seems to work.
The company put together an online network of thousands of scientists from other disciplines and “broadcast” their brain-stumping challenges to these experts from other fields. In many cases, the experts solved the problems by simply drawing on knowledge common in their own areas and applying it to Eli Lilly’s dilemma.
Eli Lilly’s scientists, we may presume, know just about all there is to know in their respective fields of expertise. Likewise, in my company, our experts know just about all there is to know about the industry, our products, our customers, competitors and so on. When the subject-matter experts can’t solve a problem, you need to cast a much wider net. If the specialists are stumped, then a solution, if found at all, will come from people outside the field.
Modify your individual process, if needed
Today, our company is using a version of Eli Lilly’s method in our business, which other organizations might also use to address their toughest problems. I didn’t have the time or means to put together a large team of experts from outside disciplines to work on my company’s challenges. So we use a modified Eli Lilly approach: We deliberately, routinely expose our in-house experts to nontraditional experiences and knowledge.
The idea is to see whether we can find our own answers by investing to acquire experiences outside those we normally encounter. In recent months, this new approach has involved my participation in a variety of eye-opening situations, including a meeting with the Cavalia producers, lots of museum visits, a guided tour of London graffiti and a design school workshop at Stanford University. On a personal level, I’m trying much harder to add new concepts and idea possibilities to my thinking.
I don’t know whether we’ll crack the customer loyalty problem in this way, but I can tell you that the ideas we discuss now are fresher than those we used to generate. That’s why my prescription for increasing the likelihood of solving the toughest problems is this: Live outside the box.
Jerry McLaughlin is CEO of Branders.com, the world’s largest and lowest-priced online promotional products company. McLaughlin can be reached at JerryMcLaughlin@branders.com.
Family businesses typically enjoy employee loyalty and deep-seated pride because the family and the business are one and the same. However, with those advantages come certain risks.
“I tell people often, family business is the best and the worst form of business,” says Jonathan Theders, president of Clark-Theders Insurance Agency Inc. “You’ll do anything for family. It’s always amazing to me how family businesses aren’t run like typical businesses.”
Theders says 90 percent of the businesses in the U.S. are family businesses — a massive segment of the economy.
Smart Business spoke with Theders about the unique risks these businesses face and how to mitigate them.
What unique risks do family businesses have to consider?
One is an informal or complete lack of company policies or business plans. You should document your responsibilities and expectations for each family member in a family charter, but it is rarely done. It might be called an employee handbook in a typical business. If someone doesn’t perform in a regular business, you remove him or her, but it’s hard to do that with a family member.
At the end of the day in a typical business, the employees go home. But you can’t always separate the family business from the family. On holidays or birthdays, it is still business. You also know more of what’s going on in their personal lives than you would know with regular employees, which can pose challenges.
The majority of a family’s assets are tied up in the family business. Everything links to it, and it’s the source of all good and frustration. Divorce, illness and financial hardship normally create productivity issues for employees, but in a family business, it’s more complicated. You have to consider who owns shares of the company and the valuation of those shares. Maybe the business was worth $100,000 when the founder got married, but now it is worth $1 million and a soon-to-be ex-spouse is entitled to half of it. Where is that half million coming from? It’s probably coming from the sale of the business because the founder doesn’t have half a million in cash to pay off the divorced spouse.
If you have HR policies and procedures for general staff for sick days, absenteeism, behavior and dress and a family member is not adhering to those same standards, it also creates problems.
How do you handle special treatment concerns?
You have to be extremely cognizant of how you treat and compensate family and non-family employees. Make sure you are consistently selecting the most qualified individuals to fill roles in the company. This is a huge problem, because most of the time companies fill holes with family members that are not performing as well and other employees subsidize that. Take the family aspect out of it, and it could be easier to have the right people on the right seat on the bus.
How can you mitigate the risk of unhappy employees who are also family members?
If a normal business’s goals don’t match up with an employee’s personal goals, that employee can find a new job. It’s not as easy in a family business. It’s difficult to tell a parent you’re leaving or tell a child, ‘You’re not right for the business.’
That added family dynamic makes failure much more intense, and why it’s important to devise a plan that balances the family goals and business goals. For example, one family business had 70 employees; 36 were family members. The matriarch mom believed everybody with the same last name should be compensated equally whether they were pushing a broom or the president of company. That causes major problems when you have such differences in roles and responsibilities and abilities. Everybody wants mom’s wish to be true, but it doesn’t make good business sense.
How can you stop family conflicts from bleeding over into the business?
The adage ‘Leave your personal problems at the door’ doesn’t apply in a family business. It’s too difficult to separate family and business conflicts.
There’s a lot of sibling, and even cousin, rivalry. You grew up fighting for the last piece of chicken or the last point on the basketball court, and it continues on when you come into the business.
It’s unrealistic to believe that all family conflict can be removed from business, but you have to work harder at establishing those boundaries. Understand the potential family conflicts that can come up and try to address them ahead of time.
Family decisions are often extremely emotional and irrational. One recommendation is family council meetings that encourage members to get together and talk about where the business is, estate planning and other long-term issues. A third-party moderator often needs to be involved because it is so emotional. Another way is involve your board of directors or advisers, which brings an objective view to company performance and future strategy.
How are the transition risks different in family businesses?
The failure rate of businesses moving to the second generation is very high. Statistics show that 85 percent of family businesses don’t make it to the third generation. That’s often because the first generation has trouble letting go or hasn’t prepared the second generation to take it to the next level.
Often, family business owners do not have succession plans or an exit strategy. At 70 or 80 years old their entire personality, their every breath is related to the company; they’ve put 40 to 50 years in, through hard times and good times. They don’t know how to get out, but they are not the ones to lead it into the future.
Jonathan Theders is president of Clark-Theders Insurance Agency Inc. Reach him at (513) 779-2800 or email@example.com.
Insights Business Insurance is brought to you by Clark-Theders Insurance Agency Inc.
In some grocery stores, your smartphone uses GPS to ping you when you’re near items on your shopping list. Other retailers allow customers to order something online, and when they arrive to pick it up from the store, the item(s) is already bagged and ready to go. Others still provide customers with options of where to buy, where to pick up or have delivered, and have price guarantees in order to create a positive customer experience and resulting sales.
With the retail industry facing challenging times, savvy risk managers are helping their companies understand how to manage costs and allocate capital strategically while finding ways to stay ahead of market trends, says Lynn Serpico, managing director at Aon Risk Solutions.
“These risk managers have the opportunity to help shape the business as they manage operations and costs,” says Serpico. “At most retailers, risk managers are responsible for mitigating — for keeping the operation efficient, making sure that the use of insurance, self-insurance and alternatives are in line with overall company objectives and that the treatment of risk is agreed to by all internal stakeholders. At a retailer, these stakeholders can include treasury, legal, logistics, marketing, merchandising or IT.
Smart Business spoke with Serpico and Todd A. Dillon, senior account executive at Aon Risk Solutions, about the current risks that retailers face and the best ways to mitigate them.
What is new in the retail industry with risk?
Aon compiles a retail industry analytics report annually, collected from proprietary data and client interviews, identifying the top 10 risks. Retailers say the global economic slowdown is the No. 1 risk. With consumer discretionary spending as the biggest driver of retail sales, the industry constantly battles variables that are out of its control, such as gas prices.
Second, retailers worry about damage to their reputation or brand. For any retailer, the worst possible scenario is that customers stop shopping in their stores. The third-biggest risk is a market of increasing competition. This is one of the biggest trends in retail. How are people making their shopping decisions? What does this mean for retailers, and how can they respond? For example, how do they prepare for a situation in which a customer walks into the store, and tries something on before buying it at a lower price on their mobile device?
Other risks include:
- Distribution or supply chain failure
- Regulatory and legislative changes, particularly surrounding workers’ compensation, normally the largest contributor to a retail risk manager’s total cost of risk.
- Technology failure
- Failure to innovate and meet customer needs
- Failure to retain top talent and, therefore, manage crime, theft, fraud and employee dishonesty. With plenty of turnover, there is a need for safety training and internal loss control to ensure not only a good store experience for customers but also employee safety and that employees are behaving in ways beneficial to the company.
What risks are critical priorities to manage?
Most retailers have gotten really good at managing the more traditional risks — property, workers’ compensation and general liability. For example, they know how to get their stores running after a natural disaster and they have programs to get associates back to work after an injury.
Emerging and changing risks are the new focus. These include network security, products liability for vendors, and wage and hour litigation. Network security is key, as this feeds in to a retailer’s reputation. It has customer data, employee data, financial information and, in some cases, medical data, and the risk is ever evolving because bad actors are getting craftier and losses are high profile.
Vendor/supplier contract management also is critical. A store might have products from 50 countries, so how does it control and manage contracts and litigation while understanding its exposure? Additionally, employment practices liability policies exclude wage and hour claims. However, this often drives a retailer’s exposure. Finally, retailers must continuously innovate and drive down costs so savings can be passed on to customers.
What best practices address common mistakes for retail risk managers?
As an industry, margins are thin, so retail risk managers need to carefully analyze their portfolios to determine the best use of capital. For example, should you have higher retentions on certain programs because the loss history is predictable? Or perhaps you might be buying too much insurance on other programs. Maybe there is a way to self-fund a certain amount of loss and buy excess capacity, which could reduce fixed costs. Is there an alternative that has not been considered?
If you have a loss that is not insured, have you vetted the process internally? Do you know how it will be funded? Risk managers are asking these questions as they work to create operational efficiencies for their companies. Asking questions helps avoid buying too much or too little insurance. Risk managers can also identify maximum capacity for loss across multiple lines of business. For instance, a $10 billion retailer may be able to absorb a penny per share of loss in a given year. However, you need to know what would happen if you have losses totaling five cents a share in a worst-case scenario year with a fire in your main distribution center, a customer death in a store and a security breach that compromises customer data. It is important to get feedback internally and ensure that all stakeholders understand decisions being made around insurance and the effect those have on the business from a financial perspective.
Know your overall retentions and whether they are aligned with the corporate strategy. Some companies are extraordinarily risk averse, so retentions are low, while others are very comfortable managing their own risk. It is up to risk managers to know the appetite of their company and make decisions that align with the financial objectives. In addition, whenever there’s a loss, multiple internal stakeholders need to be involved in the process.
Lynn Serpico is a managing director and the National Retail Practice Leader at Aon Risk Solutions. Reach her at (203) 326-3464 or firstname.lastname@example.org.
Todd A. Dillon is a senior account executive at Aon Risk Solutions. Reach him at (314) 854-0864 or email@example.com.
Insights Risk Management is brought to you by Aon Risk Solutions
Often, business owners frame their own future in stark, binary terms — either I keep the business or I sell it. This binary thinking becomes most pronounced as business owners begin to contemplate retirement or an ownership transition. In reality, there are a variety of options that can span those two outcomes. For many business owners contemplating a retirement or transition event in the next five years, simply keeping or selling are suboptimal outcomes — either tying up critical value that could otherwise be used to diversify or foregoing the potential upside value in their business. In addition, these binary outcomes often overlook other important value drivers for business owners such as legacy, succession, well-being of current employees and the continuity of their current business. When evaluating which options to pursue, it is critical for business owners to first establish clear goals that define what they want to accomplish and when. This includes an honest assessment of their personal and professional desires and other value drivers (including those mentioned above). While these options each present unique opportunities and risks, they offer business owners a more tailored and optimized approach to achieving their future liquidity, retirement or transition objectives. Mezzanine debt recapitalization A mezzanine recapitalization will often allow business owners to seek partial liquidity or growth capital, without significantly diluting their ownership. Business owners can use the proceeds to diversify their holdings, while retaining equity control and the potential upside of the business. However, this option will add incremental, high coupon leverage to the business and could limit operational flexibility in periods of economic or business distress. ESOP — employee stock ownership plan ESOPs allow business owners a tax efficient roadmap toward partial or full liquidity while creating a mechanism for transferring ownership to employees. This allows business owners to maintain short-to-medium-term ownership and helps to preserve business consistency and legacy. It also rewards employees for their hard work and loyalty. However, once the ESOP has been established, it can significantly restrict ownership flexibility. MBO — management buyout MBOs allow business owners to achieve either partial or full liquidity while maintaining operational consistency throughout the organization. The MBO also rewards management’s loyalty and performance with the opportunity to acquire a significant stake in the business. However, MBOs often require management to partner with outside equity or debt providers — which can be time consuming and introduces new partners and influences on the business. Minority investment Minority investments from an outside investor (either institutional or individual) will allow business owners to seek partial liquidity, or growth capital, while maintaining a majority stake in the business going forward. The minority partner can bring valuable outside perspectives and skill sets to supplement your own. However, most minority investors tend to be only passively involved and often require onerous ratcheting provisions that could give them control if the business fails to meet operational objectives. Partnership transaction A partnership transaction will allow business owners to seek significant immediate liquidity while preserving some ownership and elements of control in the business going forward. Business owners can use the proceeds to diversify their assets, while maintaining potential upside in the business. The new partner can bring many valuable strategic and financial resources to bear to strengthen the business and pursue growth and value enhancement initiatives. However, new partners will seek elements of control and often utilize leverage to affect the partnership. Understanding the many options available to business owners will help lead to more tailored and optimal achievement of personal liquidity, retirement and transition objectives. Josh Harmsen is a principal at Solis Capital Partners (www.soliscapital.com), a private equity firm in Newport Beach, Calif. Solis focuses on disciplined investment in lower middle-market companies. Harmsen was previously with Morgan Stanley & Co. and holds an MBA from Harvard Business School.
It’s the big day. You’ve managed to score a meeting with one of the biggest companies in the world to talk about your brilliant, one-in-a-million business concept. You can’t wait to talk with their executives and share your vision for your ideas — ideas that are guaranteed to change the face of business forever, while earning billions of dollars in the process.
One problem. Unless you’ve been diligent in protecting yourself, you might well find yourself taken advantage of, or even have your ideas stolen altogether.
Sad to say, but there have always been people out there just itching to pick your brain and take your original thoughts without paying for them. Sometimes it’s inadvertent — they may not realize that your ideas have monetary value — and at other times it’s purposeful and with ill-intent. Either way, it’s important to recognize this reality and do everything you can to safeguard yourself.
Earlier in my career, I would often find myself in a meeting, and with my inherent enthusiasm (It’s for real, folks!), I’d elaborate on everything from product concepts to marketing and sales strategies. The next thing you know, the people I was meeting with would all be whipped into frenzy and we would verbally agree to continue the dialogue and develop our business plan in the weeks and months ahead. We’d have numerous phone calls and even some follow-up meetings.
And then suddenly … nothing. When I finally managed to get hold of them again, I’d be told they had changed their minds and were not going through with the project. Yet months later, I’d find they had actually gone ahead with the product without me — and using all the ideas I had given them in our meetings. Think I wasn’t royally peeved?
Because I knew that what I had to say was worth something, after this happened to me one time too many, I decided that I needed to start protecting myself. So here’s what I’ve learned to do now: If I’m coming to someone with an idea for a product I’ve developed, before I take the first meeting, I make sure I protect my ownership. I file for a patent, trademark or copyright — everything and anything that is appropriate for what I’m offering. I also ask the people that I’m meeting with to sign a nondisclosure agreement and make it very clear from the beginning that I’m prepared to protect myself.
This doesn’t necessarily mean that others won’t still try to take my idea without my permission — patents are worked around all the time — but it does mean that I have some leverage. Without it, I’d be dead in the water.
At the moment, I have a product line that I’ve been developing for several years, for which I have four or five patents, eight to 10 trademarks and 10 to 15 copyrights. These protections give my product value for a possible third party sale in the future. When you come right down to it, if I can’t protect the ownership of my product, it has absolutely zero value.
Besides my ideas for an invention or product are the thoughts I have for developing business strategies, which I present in a meeting or conference call. This is a more difficult situation because I can’t patent, trademark or copyright these ideas. Yet, the success or failure of the product or business idea will hinge to a large degree on how it is presented to potential customers.
These days I proceed with much greater caution that I ever did before. If I’m approached by a company that wants to meet with me because of my expertise in an area, I often charge an engagement fee upfront. I won’t share my best ideas until I know we have an agreement that protects me. Half of the money is paid up front with the balance paid out of royalties or perhaps as a straight licensing fee if we decide to go ahead with a product.
You’ll never be able to stop people from trying to take advantage of you. But whether you’re talking about your idea for a new product or the strategy for how to make it a success, keep in mind that what you have to offer carries genuine value, so never let your excitement override good judgment.
Tony Little is the president, CEO and founder of Health International Corp. Known as “America’s personal trainer,” he has been a television icon for more than 20 years. After overcoming a near-fatal car accident that nearly took his life, Tony learned how to turn adversity into victory. Known for his wild enthusiasm, Tony is responsible for revolutionizing direct response marketing and television home shopping. Today his company has sold more than $3 billion dollars in products. Reach him at firstname.lastname@example.org.
The laws, technology and science regarding your business’s exposure to cyber liability are evolving rapidly. Privacy breach laws passed in other states may apply to your company if you’re a downstream service provider, or your business could fall under federal requirements for protecting personal identifiable information. And with stricter rules in place for consumer privacy, a breach could cost you and your company far more than damage to your reputation, says James Misselwitz, CPCU, vice president for ECBM.
“The average cost to notify a record holder of a breach is now $350,” says Misselwitz. “Part of the restoration costs can require continued monitoring and biennial privacy audits for as long as 20 years, in some cases.”
In the health care and financial services industries, the average breach costs more than $2.4 million, according to Net Diligence.
Smart Business spoke with Misselwitz about what steps employers can take to decrease exposure to cyber liability.
What is cyber liability?
Cyber liability exists because companies collect, store and share information about consumers. The Federal Trade Commission has been charged with safeguarding privacy for consumers. As a result, there is an emerging group of federal regulations in the form of laws such as the Gramm-Leach-Bliley Act, HITECH Act and Health Insurance Portability and Accountability Act, along with guidance from the Securities and Exchange Commission for publicly traded companies that force disclosure on their 10Q reports.
In addition, most states now have passed their own version of privacy breach laws; only Alabama, Kentucky, New Mexico and South Dakota do not have laws on the books. Of these, the biggest game changer came from Massachusetts, which requires all downstream service providers to comply with its law and have a signed contract addendum certifying that they meet the requirements for all customers.
What cyber liability exposure do employers often fail to consider?
It’s obvious the financial, health care and retail segments face exposure. But when you take a closer look at cyber liability regulations, they easily encompass law offices, accountants, nonprofits and any Internet storage provider. Think about the following when trying to determine your cyber liability exposure.
- Do you collect in your files the name, address, date of birth and Social Security number of your customers?
- Do you have more than 500 customers with this information on file?
If so, you need to urgently consider cyber protection.
What are the particular dangers for mid-sized businesses?
Mid-sized business owners need to take steps now to create self awareness of their data. What data do you store? How many files do you have and what information is contained in those? Where and how is it stored? Do those files have back ups and who has access to the data? What controls are in place? Is the data kept on portable devices? As employers go through these questions, they start to get an understanding of what data they have and whether they could be subject to a significant breach.
Employers may believe that if they don’t do business over the Internet, there’s nothing to worry about. However, cyber liability laws cover data, not the way that data is obtained.
How can employers safeguard their businesses and prioritize the protection they put in place?
You need an assessment process to recognize potential breaches. You also can seek expert help in establishing formal polices and procedures while ensuring that portable devices are not loaded with information that would trigger a breach if lost or stolen.
However, the first basic step should be encrypting the data. Encryption is cheap, readily available and usually easy to install. It also provides a great defense.
When prioritizing protection, use a knowledgeable broker and a detailed analysis of risk to review which insurance coverage is available and at what price as an integral part of your cyber liability business strategy. At that point, you’ll need to put in place testing, an audit and a timetable to re-evaluate your exposure. The laws, the technology and the science are changing too rapidly to just buy an insurance policy and leave it alone.
What risk drivers cause business owners to obtain cyber liability coverage?
Usually it takes an event, such as a missing laptop or a disgruntled employee, to get the owner to focus on what just happened and what could have just happened. At that point, they start to think about risks and how to transfer them to an underwriter. More important, they start to consider the steps they need to take to ensure that if this event happens again, they have eliminated or significantly reduced risk.
Cyber liability insurance is at approximately 15 percent of the market and growing. Larger health care providers, credit card companies, social network providers and banks have been the first big purchasers of the coverage.
What do employers need to know about their cyber liability coverage?
You need to understand the amount of limits; how much coverage is in first-party and third-party benefits; whether the legal expense is inside or outside the limits, and does that portion of the policy have limits; and whether your lawyers, accountants and crisis management teams are acceptable to the underwriter. If you are dealing with a knowledgeable broker, these will be part of the due diligence and product design.
Although some 16 million confidential records were exposed through more than 662 security breaches in 2010, according to the Identity Theft Resource Center, if you consider your liabilities carefully you could minimize your risk of joining that number.
James Misselwitz, CPCU, is a vice president for ECBM. Reach him at (888) 313-3226, ext. 1278, or email@example.com.
Insights Risk Management is brought to you by ECBM Insurance Brokers and Consultants
When a company assumes the role of payroll administrator, there are considerations to protect the assets of the company from risk related to various employment taxes.
“There are several circumstances that may cause a company to run the risk of becoming noncompliant or considered evasive of employment withholding tax obligations, requiring employers by law to withhold taxes from their employees, including federal income taxes and other taxes required by the Federal Insurance Contributions Act such as Social Security and Medicare taxes,” says Walter McGrail, senior manager, Cendrowski Corporate Advisors LLC.
Although not discussed here, these same requirements apply to other employer taxes such as FUTA and taxes required by any states.
Smart Business spoke with McGrail about employment tax risks and what companies can do to mitigate them.
What are employment tax risks, and are they a realistic issue?
Companies are required to withhold taxes and remit them to the Internal Revenue Service via an authorized financial institution, as established by the Federal Tax Deposit Requirements. When the taxes withheld are not remitted, or not remitted in a timely manner, the company may be liable for penalties, interest, or, in the case of proven evasion, prosecution. Noncompliance may result in penalties and interest, whereas evasion may subject the responsible parties to criminal and civil sanctions
According to the IRS, for fiscal years 2009 to 2011, it initiated approximately 500 investigations into employment tax evasion. Of these cases, more than 40 percent were investigated, recommended for prosecution, indicted and ultimately sentenced. Additionally, of those sentenced, 80 percent were incarcerated by means of either federal prison, halfway house, home detention, or some combination, lasting an average of nearly 24 months.
These penalties are most commonly levied against the responsible parties, including, but not limited to, corporate officers, shareholders, members and partners.
What are the most common methods, or schemes, related to employment tax evasion?
There are several common scenarios that could result in evasion or simply result in noncompliance when it comes to employment taxes. The most common, according to the IRS, involve pyramiding, utilizing unreliable intermediaries to remit the tax and misclassifying wages or salaries based on worker status or officers’ compensation treated as distributions. Due to the lengths someone may go to in order to evade employment taxes, there is even a listed transaction related to employment and the use of offshore employee leasing to evade these taxes.
If employment taxes are automatically withheld, how can companies be put at risk?
Companies are at risk when withheld taxes have not been paid in a timely manner, as prescribed by the IRS. Fraud can be an integral part of employment tax evasion.
Pyramiding is one of the more common practices. This involves the employer not remitting the taxes and using the monies to cover other liabilities or operating shortfalls. If the employer continuously uses this practice to continue the operation of the company, the amount can accrue over time (pyramid) to the point where business operations cannot recoup the funds utilized and the company is left with a tax liability and no cash. The frequent result is the business going under.
Unreliable payers can also be an issue. A payer can be either a third party or related (someone employed by the company). Both types of payers can be instrumental in causing the company to be at risk of noncompliance.
Third-party payers generally fall into one of two categories: Payroll Service Providers (PSP) and Professional Employer Organizations (PEO). PSPs typically assume the role of payroll administrator and the responsibility for making employment tax payments and filing the appropriate employment tax returns. PEOs effectively lease employees and assume the role of human resources, managing the administrative, personnel and payroll functions for the company. Tax issues can arise when either type of third-party payer is in control of employment taxes or the company dissolves. This can leave employment taxes unpaid.
If the company utilizes an internal department or employee to pay employment taxes, there are different ways the company can be exposed to risk. One way could be rooted in fraud. If the payer were to pay taxes but not properly credit them to the company’s tax account, the company would still have an employment tax liability and no funds to pay the taxes owed.
Much like other frauds that involve payables, funds can be paid or transferred to a taxing authority while being applied to a different account. The company believes its tax liabilities are being properly paid and may not become aware of an issue for months or years.
How can companies safeguard against employment tax evasion and noncompliance?
There are no guarantees, but one way to reduce possible exposure is to exercise due diligence when engaging a third-party or related payer.
Monitoring is essential to the process. The company can insist on paying all federal taxes electronically, utilizing the Electronic Federal Tax Payment System (EFTPS), which allows users to access tax payment history to ensure payments were made and applied to the appropriate tax account. Additionally, verifying and matching the amounts paid against the information reported on the Employer’s Quarterly Federal Tax Return (Form 941) can aid in reducing noncompliance and the possibility of employment tax evasion.
Additionally, ask your CPA to look at wages and related withholdings as part of the tax return preparation for your company.
Walter McGrail, CPA, is senior manager of Cendrowski Corporate Advisors LLC. Reach him at (866) 717-1607 or firstname.lastname@example.org.
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Coping with government enforcement actions is disruptive, expensive and potentially crippling to your corporate image and brand. There is growing evidence that robust corporate compliance programs lead to lesser punishment. Nevertheless, many businesses lack proper internal controls and mishandle crisis situations, says Bruce Reinhart, member, McDonald Hopkins.
Smart Business spoke with Reinhart about the benefits of strong compliance programs and the consequences of breaking the law.
How has the enforcement environment for businesses changed in recent years?
First, the consequences of improper conduct have become more severe. Actions that traditionally were considered a civil or regulatory violation are now being prosecuted as a crime. More companies are being punished with debarment from government contracting and funding programs.
Second, the targets of these investigations have changed. We are seeing increasing prosecutions of corporate executives, officers and directors. Laws such as Sarbanes-Oxley created expanded individual responsibilities for corporate management. Failure to comply with these responsibilities can lead to civil or criminal enforcement action.
Third, the number of agencies with enforcement power is growing. As one example, there has been an explosion in the number of federal, state and local inspectors general whose mission is to ferret out waste, fraud and abuse in government programs. These offices have the power to conduct criminal investigations and financial audits. They can, and do, make referrals for criminal prosecution while also attempting to recoup money that they claim was misspent or misused.
Are there particular industries that are seeing more enforcement activity?
Hot enforcement targets are companies with international operations. The U.S. Foreign Corrupt Practices Act prohibits bribe payments to foreign government officials by U.S.-based companies or companies that have securities registered through the SEC. In 2010 and 2011, companies and individuals paid more than $2 billion in fines and disgorgements in FCPA settlement actions with the government. Like the FCPA in the U.S., the U.K. Bribery Act now creates criminal liability in the U.K. for bribe payments to government officials anywhere in the world. The U.K. Bribery Act is broader than the FCPA because it also provides criminal liability for commercial bribery. As businesses initiate or expand operations overseas, they increase their potential FCPA and U.K. Bribery Act exposure.
There is also increasing activity in the financial services sector. The U.S. Treasury Department continues to expand its requirements that lenders adopt anti-money laundering programs and other customer due diligence. Most recently, new requirements for residential mortgage lenders and residential mortgage loan initiators were enacted with an effective date of August 13. Failing to comply can be very expensive. For example, in August 2011, Ocean Bank in Miami, was assessed $10.9 million in civil penalties for failing to implement an effective compliance program and failing to properly train its compliance staff.
We also expect to see increased enforcement activity in the health care and government contracting sectors. The FBI and the Department of Health and Human Services Inspector General have made health care fraud a top priority. Fraud in minority and small business contracting processes is getting more attention. Other agencies are much more aggressive about tracking government funds and recovering waste, fraud and abuse. An additional wrinkle is the growth of whistleblower private enforcement suits alleging false claims to the government.
Are there tangible benefits from investing in compliance programs and aggressive crisis management?
Yes. For many years it was believed that robust compliance programs and cooperating in government investigations would mitigate punishment if some illegal conduct slipped through the cracks. In a recent case involving Morgan Stanley, the U.S. Department of Justice publicly acknowledged this for the first time. A managing director in a division based in China was criminally prosecuted for arranging a multi-million dollar bribe to a government official. Morgan Stanley was not charged. The Department of Justice said, ‘After considering all the available facts and circumstances, including that Morgan Stanley constructed and maintained a system of internal controls, which provided reasonable assurances that its employees were not bribing government officials, the Department of Justice declined to bring any enforcement action against Morgan Stanley related to [the managing director’s] conduct. The company voluntarily disclosed this matter and has cooperated throughout the department’s investigation.’
How does a business protect itself?
The first step is fostering a culture of integrity and compliance, which is not as easy as it sounds. In Ernst & Young’s 2012 Global Fraud Survey of senior executives at leading companies around the world, 15 percent of the 1,700 participants admitted they would use bribery to win or retain business, a six percent increase over the 2010 survey results.
Second, invest in compliance up front. Compliance is an integral part of an overall risk management strategy and there are many cost-effective ways to minimize compliance risk. Nevertheless, the 2012 Ernst & Young survey showed that ‘companies pursuing opportunities in rapid-growth markets face specific risks that are not always being managed effectively. For example, due diligence on third parties is expected by regulators but almost half the respondents (44 percent) reported that background checks were not being performed.’
Third, when a crisis happens manage it properly. Conduct a thorough investigation. Especially in crisis settings, better information leads to better management decision making.
Bruce Reinhart is a member at McDonald Hopkins. Reach him at (561) 472-2970 or email@example.com.
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The ubiquitous nature of technology allows businesses to acquire and share information nearly instantly across multiple platforms. And while this can be a great thing for networking, marketing and gathering information, it can be potentially devastating for a business if the technology is used inappropriately by an employee, says Todd Roberts, a partner at Ropers Majeski Kohn & Bentley PC.
Smart Business spoke with Roberts about the risks of electronic media and steps you can take to mitigate them.
Can an employer use social media to screen candidates during the interview process?
As time has gone on and as the labor market has become tighter, employers have been more aggressive in their efforts to screen prospective employees. One way they are doing that is to ask for not only the username of the applicant’s Facebook page but also for the password so that they can see what’s been posted and get to know that applicant in an unfiltered way.
Before employees were more sophisticated about the security settings of Facebook, it was not uncommon for the information that they had posted to be able to be viewed publicly, and for those who were hiring to access those web pages. Apart from the legal issues that are implicated, many prospective employees are completely put-off by what is perceived to be coercive and intrusive conduct.
There’s a clash between the privacy rights of prospective applicants who are looking for a job and business owners who are looking to hire them. There is legislation that is now pending both in California and at the federal level that would restrict, if not prohibit, employers from asking for Facebook account information that includes passwords.
Until the legislation is enacted, however, employers are free to ask for an applicant’s Facebook password, and if the prospective employee doesn’t want to give it, he or she can’t be forced to do so. However, declining may disqualify them for employment under the circumstances. There is definitely a move afoot to prevent that type of perceived invasion of privacy.
Is a business owner able to censor social media use by employees?
There is example after example of employees who have been terminated for acts of disparagement against the employer or other misconduct posted on their Facebook page. There is some movement at the federal level through the National Labor Relations Board, which has stepped in on behalf of workers who are members of a union. Those workers have contended that disciplining an employee for complaints about the employer on a Facebook or other social media page is unlawful conduct in violation of the National Labor Relations Act, because it’s protected concerted activity. These are laws enacted in the 1930s that the NLRB is trying to apply in the digital age.
How can business owners protect their company from improper use of social media by employees?
Some employers prohibit the use of Facebook at work and restrict access to other websites that are not reasonably related to the business. More recently, employers have been forced to adopt social media policies that restrict employees from making statements about the company, that appear to be on behalf of the company, or engaging in any use of social media that would cast the employer in a potentially negative light. There is no ‘First Amendment’ issue because private employers have the power to restrict the speech of their employees in the workplace.
The first step is to draft an electronic privacy and social policy, but the key really is in the implementation and the followup. You can have a 100-page manual consisting of all these regulations, but if an employer isn’t doing anything to enforce the policy, it becomes less likely that a court is going to enforce it, either.
The next step after the adoption and implementation of these policies is to widely disseminate it to employees by way of training sessions. Each person should also be asked to sign off that they have read the policy, understand it and agree to comply with it. Where most employer’s trip up is in the enforcement phase. If an employer becomes aware of misuse or violations that are occurring but turns a blind eye, it becomes more difficult to justify discipline over time.
How can employers address email, cell phone usage and other forms of electronic media?
There’s some overlap, not only with social media, but also with the use of new technologies — email and text messaging are most prevalent — where employers and small business owners can get into trouble or be exposed to liability.
There are also multiple cases in which someone is using their cell phone for work-related activities even if it’s on their day off or otherwise on their personal time. In this instance, the employer could be sued for an accident in which the employee is involved, because the actions involved circumstances arguably benefitting the company at the time of the accident.
Having an electronic and social media policy in place outlining the responsibility of the employee in regard to use of these programs and devices, and then policing and enforcing the policy, is vital to protect the company from unwanted lawsuits or damages.
Todd Roberts is a partner with Ropers Majeski Kohn & Bentley PC. Reach him at (650) 780-1601 or TRoberts@rmkb.com.
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