Why sellers should know the value of their company before an M&A event

There is a broad spectrum of concerns first-time sellers have as they approach an M&A event. Sellers wring their hands over the future of their employees and the legacy of the business, but it’s the sale price that can be tough to accept.

“It’s very common that sellers think their business is more valuable than what buyers will pay for it,” says Sean R. Saari, a partner at Skoda Minotti. “Business owners invest so much of their time and money into their business that their estimate of its value is often inflated, and that can create challenges during a sale event.”

Smart Business spoke with Saari about the importance of an accurate valuation in the M&A process.

What common misconceptions do sellers have regarding their company’s value?

It’s not uncommon that sellers, being so focused on running their business, aren’t familiar with the valuation process. It’s more than just applying a multiple to EBITDA. It takes time and careful analysis of the company’s historical and projected financials to determine what multiples are appropriate to apply to that particular business in that specific industry. The end result may look simple, but it takes skill and experience to make sure the valuation assumptions are reliable.

Another common misconception is sellers believing they can retain the accounts receivable of their business without an adjustment to the purchase price. What they don’t realize is that the offered purchase price typically assumes that a level of working capital will be delivered with the business that allows its operation to continue uninterrupted. If the accounts receivable balance is not acquired, the buyer has to make up for the cash flow shortfall during that collection period by investing more of their own money, and is rarely willing to do so without a corresponding reduction in the purchase price.

What are the differences between enterprise value and equity value?

Equity value is the value of the ownership interest in the company or the pre-tax proceeds an owner gets in the event of a sale.

Enterprise value represents the value of the company as a whole, regardless of how it’s financed. Enterprise value equals the equity value plus the interest-bearing debt minus cash. Many times investment bankers talk in terms of enterprise value.

It’s common for manufacturers to fund working capital or fixed asset investments with debt, so there can be times when equity value and enterprise value differ significantly. Therefore, it is very important that sellers understand whether the values being discussed are equity values or enterprise values so that they can appropriately estimate their proceeds from a sale.

What are the differences between financial and strategic buyers?

Broadly, financial buyers aren’t operating in the industry of the business they intend to purchase. They’re buying for a stand-alone investment.

Strategic buyers are often competitors in the same industry as the company they’re seeking to buy. They view the purchase as a growth opportunity. They may be willing to pay more for a business because they could potentially unlock synergies by combining the companies.

Whether pursuing a sale to a financial or strategic buyer, there’s a benefit to having the right advisers to protect and manage the flow of the seller’s confidential information throughout the marketing process. For example, there is more perceived risk with strategic buyers since information regarding customers, vendors, pricing and personnel may be shared. These risks are limited if the marketing process is managed correctly.

What are the factors that drive differences in value between buyers and sellers?

A disconnect is created if there is a difference in:

  • The expected future cash flows.
  • The perceived risk and required rate of return for the investment.

The value of any potential synergies and whether the buyer is willing to pay for some portion of those potential benefits may also drive differences in value.

Sellers know their business better than anyone else, but they’re only one side of the equation. Considering both the buyer’s and seller’s perspectives offers a more accurate picture of the company’s value.

Insights Accounting & Consulting is brought to you by Skoda Minotti

How to read current private equity trends, as a business owner

Investment professionals say: Don’t try to time the market, because you’re reacting to what has already happened. The same holds true for a business owner.

“We often see business owners who aren’t truly prepared to take their business to market, but they want to get it out there quickly to try to capitalize on what they see as a good market trend,” says Scott McRill, a partner in Transaction Advisory Services at BDO USA, LLP.

Private equity is a great alternative for business owners who want to exit their company, so it is important to keep an eye on industry trends, he says, especially if you’ve paid attention and prepared your company for the process along the way.

“The trends are a great indication of what a business owner might expect, but you can have wildly different opinions and results among different private equity firms,” McRill says. “These are good barometers, but don’t assume everything is going to follow this path. The standard deviation among individual deals can be sizable.”

Smart Business spoke with McRill about what he’s seeing with private equity and his advice for business owners as a result of these trends.

Trend 1: Family offices are fueling investments, competition

Family office investing in private equity has been around for some time and is not going away. A recent BDO study found that of the fund managers surveyed, 64 percent were raising new funds and 42 percent of those receive the majority of their financial commitments from family offices. (See infographic below) This investment pace is driven by skittishness about the stock market’s performance and confidence in private equity.

At the same time, some family offices have grown frustrated by their returns as limited partner investors. These groups have started investing directly in companies, creating more competition in the sector.

The biggest advantage of family offices is they don’t need to follow the typical model of holding on investment for five to seven years. If a family office finds a great company that’s producing cash flow, it may hold on to it for decades. This is appealing to many business owners who don’t like the idea of selling their business to private equity, knowing it will likely be sold again in a relatively short period of time.

Trend 2: Valuations peaking

The deal market has generally been a seller’s market for several years. Valuations have been high for sellers with a quality business. Valuations seem to be softening a little, and the shift from a sellers’ market to a buyers’ market may be coming soon.

Trend 3: Increased sell-side due diligence

The trend over the past 18 to 24 months toward an increasing occurrence of seller-side diligence is expected to continue into the foreseeable future. This kind of diligence — sellers pay for advisory services to ensure their company is ready for sale and that the numbers will stand up to buyer diligence before they take it to market — has been common in Europe, but it now has caught on in the U.S.

A decade ago, advisory services on the sell-side were seldom performed, except for large corporations carving out a division. Today, sell-side work can be 65 to 70 percent of a transaction advisory firm’s practice.

Private equity firms and investment bankers have pushed for this shift. They don’t want to invest time trying to get a deal done to later find out the numbers aren’t what they thought. Sell-side due diligence tightens up the range of value, improves the success rate of completed transactions and increases the deal’s speed.

So, what’s your takeaway for business owners in this environment?

No matter what the economics and deal market is like, you want to plan early and spend time tightening up your policies and procedures to get the business ready for buyer scrutiny. Too many business owners scrape by for years, and then decide they want to sell when there’s infrastructure missing and the records aren’t clean. Value gets lost when that happens.

If you’re thinking about selling in the next couple of years, act now to line up good accountants, an M&A attorney, etc. Although valuations may be about to start coming down, trying to race to market before being prepared will likely result in erosion of value in the long run.

Insights Accounting & Consulting is brought to you by BDO USA, LLP

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Why you shouldn’t wait until someone leaves to begin succession planning

Succession planning should begin before you’re faced with an opening that needs to be filled, says Tyler A. Ridgeway, Director of Human Capital Resources at Kreischer Miller.

“Spend some time thinking about the characteristics that make your company strong,” Ridgeway says. “What is your mission statement? Why do clients like working with you? Your focus should be on creating an environment and a mindset that not only embraces new ideas, but encourages them.”

This will put you in a better position to plan for your future and hire the talent your company needs.

“If you walked in today and learned that four executives were leaving the company, what would you do?” Ridgeway says. “Would you have people ready to step up and assume those critical roles on your team? Succession planning is tremendously important for the health of your business.”

If you haven’t thought about your depth of leadership and your company’s ability to replace departing talent, don’t feel bad. Lack of planning is a common misstep for many organizations.

“It’s not easy, but the best leaders always keep succession planning in the back of their minds and create a culture where there is always mentoring taking place,” Ridgeway says.

Smart Business spoke with Ridgeway about the keys to effective succession planning and how to attract ‘A’ players to your team.

Where should you begin with succession planning?
Start with your company’s strategic plan and be clear about where you want it to go. Do you want to grow organically or through acquisition? If you want to grow organically, do you have the right people to take your company to the next level?

With that information in mind, take a look at your departments and start identifying strengths and weaknesses. Are you strong in operations, sales, finance, marketing, etc.?

If you find a weak spot, perhaps you want to invest in somebody who can jump into that role and fill the gap. You want to proactively create a strategy and a plan for how you’ll meet this goal rather than waiting until the last minute to address change.

What if it is the owner or CEO who is stepping down?
When a company embarks on a process to select a new leader at the top, there are two important psychological elements at work. The first is that you, the person who is stepping down, should try to overcome the fear of letting go and work on being able to say, ‘I’m going to turn this over to someone to operate the business and then stay out of the way.’ That’s not easy for an owner to do.

The second is that you should accept that your replacement may make changes you don’t agree with or approach growing the business in a new way. Resist the urge to step in and allow the new leader to chart their own course. This is especially important if your plan is to remain with the company in some capacity.

What are critical elements of conducting a search for a new leader?
It can be very helpful to use an outside firm to conduct the search. An executive recruiter brings an objective, fresh perspective to the process, which can be especially useful as internal candidates come forward who are interested in the opportunity.

In that case, you can say, ‘We’ve hired a professional search firm. They know what we’re looking for and you’re going to be part of the process. But it’s going to start with them.’

Externally, we are seeing more and more that job seekers are looking for opportunities to make a strong impact. Compensation is important, but just as importantly, they want to be part of a dynamic team and make a strong contribution to the company’s growth.

And they expect to be compensated for those efforts. So as you go through your search, think about creative methods of compensation beyond the traditional salary and bonus in order to lure top-level talent. ●

Insights Accounting & Consulting is brought to you by Kreischer Miller

Size isn’t an excuse for not budgeting and forecasting

There are many excuses business owners concoct to avoid budgeting and forecasting. Some feel they’re too small for budgeting and forecasting, thinking they have a handle on their finances so there’s really no need. Busy business owners often avoid it, believing it’s too time consuming. Others say they need a budget but they don’t know how to create one.

“Budgeting is important for business growth, helping companies think strategically — not about the budget, but about their goals,” says Dawn M. Gainer, CPA, managing director of Small Business Services at Skoda Minotti.

Smart Business spoke with Gainer about the uses of budgeting and forecasting, and the reasons not to skip them.

How does forecasting compare to budgeting? How do the two interact?

Budgeting can be thought of as a static, annual process through which company goals are determined for the next year.

A forecast takes a budget as the starting point and incorporates real numbers. Using actual data, forecasts change monthly or quarterly as information is gathered. Results are compared to the budget, but the budget doesn’t change — the strategic plan is adjusted as new information comes to light.

At the end of the year, real data accumulated through the forecasting process is compared to the budget and the variances are analyzed to see what worked, what didn’t and what came up unexpectedly. That information is used to manage the business and make appropriate decisions.

When a business is reactive — taking a day-to-day approach with its finances — what can be the results?

When a business is reactive, it’s only looking at where it has been but not where it’s going. That can lead to missed opportunities or making expenditures that it doesn’t need or can’t afford. In manufacturing for example, equipment purchasing should be built into an asset life cycle plan rather than reacting to a breakdown, which can disrupt the budget, extend downtime and lead to lost sales. It also could mean not having the finances to capture the momentum of a surging trend.

For companies that don’t budget, what advice can you offer to help them get started?

Start small and at a high level, thinking strategically and not financially. Analyze the business and its opportunities by examining trends in the current and past markets. Determine the direction of the business and then put numbers to those plans.

Once a goal is set, calculate the projected revenue and expenses that reaching that goal will incur. Pick the highest drivers of your expense structure and spend the most time forecasting those, don’t spend a lot of time budgeting for static expenses — postage, for instance. This doesn’t require special tools or knowledge. It can be done on the back of an envelope. What’s important is the strategic thinking behind the budget, not the numbers.

How can a budget be used to create a marketing plan?

A budget helps an owner think strategically about where to focus marketing initiatives and how much to spend. The process of budgeting encourages research to learn more about the market, find the target audience, set price points and pinpoint sources of demand while avoiding saturation.

What unique challenges might manufacturers face if their budgeting and forecasting processes aren’t solid and reliable?

Many manufacturers have multiple product lines, each of which must be analyzed and budgeted for. Without the latter, a line could seem like it is making money when it actually may not. Making future projections can help manufacturers plan for potential cost increases on materials, for example, which gives the company an opportunity to make moves preemptively — improve processes, or find new materials or a new provider. It’s the same with machinery and equipment — upgrades and new technology are needed to stay competitive.

Manufacturers have people, equipment and materials to consider, which can be more complicated than what other businesses face. If they aren’t looking forward, they risk being caught off-guard.

Don’t let excuses get in the way of budgeting. Set aside some time each year to come up with a high level plan and monitor your progress against that plan. It’s not as time consuming as it might seem.

Insights Accounting & Consulting is brought to you by Skoda Minotti

A look at how to avoid common retirement distribution mistakes

Typically, qualified retirement plans such as 401(k)s and individual retirement plans (IRA’s) make up a large portion of an individual’s assets. As such, it is extremely important to be aware of the complex rules surrounding the distribution of retirement assets.

The penalties for running afoul of these rules are some of the highest imposed by the Internal Revenue Code.

Smart Business spoke with Susan P. Stutzman, CPA, and a director in the Tax Strategies group at Kreischer Miller, about some of the more common mistakes taxpayers make in the distribution of their retirement assets and how to avoid them.

Required minimum distribution (RMD) rules
When an individual reaches the age of 70½, they are required to begin taking distributions from their IRA or 401(k) by April 1 of the year following the attainment of that age.

If still working, the 401(k) may further be delayed unless the individual owns more than 5 percent of the sponsoring employer. Most IRA and 401(k) administrators track your age and notify you when you must start taking distributions, but it is the taxpayer’s responsibility to make sure the RMD is made.

There is a penalty of 50 percent of an RMD not made on a timely basis. In addition, there may be confusion about when the second RMD must be made. Although the first distribution can be delayed until April 1 of the year following attainment of age 70½, the second distribution must be made by Dec. 31 of that same year, resulting in two RMDs in the same year.

If this places you in a higher tax bracket, you may want to take your distribution prior to Dec. 31 of the year you reach 70½.

Changes in RMD upon the death of owner
If the rules for RMDs are not complicated enough, they become even more so when the account owner dies. Different rules apply depending on whether the owner dies before or after he is required to commence the RMD and whether or not he designated a beneficiary.

It is extremely important that you consult with an informed advisor to guide you through these rules as the proper course of action will be highly dependent on your specific circumstances. In addition, the decedent’s executor should make certain that an RMD is not missed in the year of death, thereby avoiding a 50 percent penalty.

Beneficiary designations
The designation of a beneficiary is important as it not only affects who receives the benefits, but also affects how long the funds can remain in the retirement account. Generally, the surviving spouse has the most options regarding the eventual payout of the funds and the most tax advantages.

However, it is important to consider naming contingent beneficiaries. There are numerous post-mortem planning opportunities. For example, the surviving spouse can disclaim their interest during a limited time after the account owner’s death.

New beneficiaries cannot be named after the date of death, but if the spouse disclaims their interest, the account would then pass to the contingent beneficiaries.

If the spouse does not need the funds, the disclaimer technique would allow the contingent beneficiaries (perhaps the decedent’s children) to withdraw the funds over their longer life expectancy. In addition, there may be reasons to name a beneficiary other than a spouse to benefit children from a previous marriage or to provide for someone with special needs.

The rules relating to retirement plan distributions are quite complex. In order to maximize the tax deferral and avoid penalties, it is very important to discuss your particular circumstances with a qualified professional who can successfully guide you through the rules. ●

Insights Accounting & Consulting is brought to you by Kreischer Miller.

If you’re behind on your ACA reporting, here’s what to do next

Some employers dropped the ball with the Affordable Care Act informational reporting — mandatory for applicable large employers (ALEs).

“I’ve had employers tell me, even a few weeks ago, ‘I don’t have to worry about that. I just have 300 part-time employees,’” says Kimberly Flett, senior director of Compensation and Benefits at BDO USA, LLP. “But your part-timers are converted to full-time equivalents, so you can’t presume you’re not an applicable large employer. You need to triple check that.”

You may be late, but you still need to get this done, Flett says. Some IRS penalties have been reduced, but you still run that risk.

Smart Business spoke with Flett about the latest regarding Forms 1094 and 1095.

What’s the first thing you’re advising employers?

Employers need to determine whether they were an ALE — had more than 50 full-time equivalents — during 2014. If yes, then they must issue Form 1095-C to all full-time employees, whether or not they are enrolled in the health plan, and part-time employees who enrolled. In addition, regardless of size, if you offer self-funded health insurance, you must issue Form 1095-C.

These forms demonstrate to the IRS whether your organization offered minimal essential coverage. They provide details about the coverage offered, the lowest-cost premium available and the months when the coverage was available.

The deadline to get this form into the hands of participants was pushed back to March 31, 2016. Taxpayers, however, could file individual returns without it and shouldn’t have to amend their return.

Don’t presume, based on head counts, you did the math correctly for whether you’re an ALE or not. Demonstrate your reasoning in writing and back it up with your advisers, including CPA and legal counsel.

What other informational reporting forms need to be transmitted?

Form 1094-C, the transmittal form ALEs must send to the IRS, had its due date pushed back to May 31 for paper copies and June 30 for electronic fillings. If you have more than 250 forms, you must file electronically and need access to appropriate vendor software.

If you’ve missed the March 31 deadline, what should you do now?

Reduce the risk by getting your Form 1095-Cs out quickly. The penalties reflect the timing. If you issue them within 30 days late, it’s $50 per statement, with a maximum penalty of $500,000 per calendar year. If you get it corrected before Aug. 1, it’s $100 per statement, with a maximum penalty of $1.5 million. Otherwise, the penalty could be $250 per statement, with a maximum penalty of $3 million. The penalties apply to both the IRS and participant copies.

If you fail to file correct information, the IRS may waive penalties for a good faith effort. But the term ‘good faith’ is a nebulous and generally means you’ve hired the right expert help. Therefore, errors could draw the same potential penalties.

Also, if you’ve missed the March deadline, you can still transmit Form 1094-C on time, which likely reduces your penalty risk.

What else should tardy employers know?

Now that payroll companies and accounting firms are past the initial crunch, many are again accepting new business — helping employers complete forms or understand the complicated coding on the forms. Some codes trigger a penalty and it’s not easy to pull verbatim from the IRS instructions. Talk to a tax or legal expert who can decipher exactly what will result if you put that particular code down.

Also, it’s important to gather all data, such as dependent Social Security numbers and who was covered. If you hadn’t done this in 2015, circle back and get that information, and then maintain those records on an ongoing basis for future tax years. This year, you must demonstrate a reasonable effort to obtain Social Security numbers — three written solicitations or informing employees of the $50 IRS penalty for failure to provide a dependent Social Security number. Then, if you don’t obtain the data, you can use birthdates.

The IRS will start processing the forms this summer. The next step is seeing what penalties may be assessed. If you get a bill, don’t just pay it. Get help from your advisers to sort through the IRS assessment.

Insights Accounting & Consulting is brought to you by BDO USA, LLP

Tax risks to watch out for when buying your target company

Whenever you’re going into a business deal, there’s an asymmetry of information. The sellers know certain things; the buyers know other things, and both sides are trying to get up to par.

If you’re on the buy side of the equation, you have to understand how the target company will integrate with your operations and how it’s going to impact you. One of the risks of managing and completing an acquisition relates to potential successor liability — you don’t want to end up with unforeseen taxes from the purchase.

Conducting tax due diligence not only helps you identify and manage potential risks, it’s also very important for structuring and planning purposes going forward. A rigorous diligence process may give you and your advisers the ability to leverage your knowledge and understanding of certain risks to unearth new value in the deal, such as stepping up the basis of the assets.

“As a buyer, when you’re done with the diligence process, you might understand certain aspects of that company, especially from a tax perspective, better than the company that is selling,” says Dave Godenswager, senior manager of Transaction Advisory Services at BDO.

Smart Business spoke with Godenswager about the risks of a merger or acquisition, from a tax perspective.

What risks do buyers need to watch out for?

Some areas that create problems are sales and use taxes, payroll taxes and worker classification.

Before you sign the deal, you want to understand what you’re buying, including the deal structure. If you do an equity deal, you’re buying historic liabilities. Often prospective buyers think if they do an asset deal, there’s no successor liability. While that’s generally true for most federal income taxes, it’s not true for other types of taxes like payroll and sales and use taxes.

Make sure you know where the product or service is being delivered, where it is being manufactured and where the service is being performed. With indirect taxes you have to understand where exactly the target is operating and who is performing the service, because rules vary greatly by state and state legislatures keep expanding the sales tax base.

Do they have employees, or independent contractors? Do they have a ‘share economy’ that includes contractors, temporary workers, self-employed, part-timers, freelancers and free agents? A share economy can create state and local tax income problems, because an enterprise might be in more jurisdictions than was originally envisioned, which means a higher compliance hurdle for the buyer.

It’s more challenging to navigate state regulatory filings now. State and local governments are starved for revenue; the tax rules have become incredibly complex and favorable to the states, since state legislatures are the ones who draft the rules. For example, in New York if you don’t do certain bulk sale notifications in an asset deal, you may still be potentially liable for those sales and use taxes.

The business world also is increasingly international, which brings up issues that might not be readily apparent at first. For example, if you’re buying something that’s owned by a foreign company, you may have withholding obligations and must consider the potential impact of the Foreign Investment in Real Property Tax Act of 1980, Foreign Account Tax Compliance Act and other provisions.

How should buyers best mitigate these risks?

Engage your advisers early in the process — even though that comes with a certain cost. That means getting expert help sometimes before the letter of intent (LOI).

After the LOI is signed, your advisers can help digest the information gathered through due diligence and integrate it with the reps and warranties and indemnification provisions of the purchase agreement. Also, the advisers should consider whether to include certain carve-outs, like taxes because you’ve identified a tax issue, from a basket in the purchase agreement. Similar to a deductible in an insurance policy, a basket defines the dollar amount of post closing claims a buyer must exceed before pursuing a refund for the claim from the seller.

It’s all about communicating, talking early in the process and not relegating it to after the LOI.

Insights Accounting & Consulting is brought to you by BDO USA, LLP

What to consider before doing business outside the U.S.

Before conducting business outside of the U.S. for the first time, a company must establish the business case for doing so. That means looking beyond just the profit potential on the product or service to the other costs that can be involved, of which there are many.

“The culture of a country or a particular region affects how business is conducted,” says Jason Rauhe, CPA, principal of International Tax Services at Skoda Minotti. “You need to understand the culture and have conversations with key people. That involves more than networking at a trade show. It can include getting feedback from local focus groups so you can understand the people and their needs — an important early step because U.S. products don’t always translate well.”

There are also logistical issues to consider, the most basic among them are how to ship your product to the country and who will be your distribution partner. It’s far more complicated than shipping domestically.

Smart Business spoke with Rauhe about doing business outside the U.S. for the first time — the early steps and what to consider before making a move — and how to handle transfer pricing.

How long might it take to begin doing business outside the U.S.?

The timeline for launching a product or service in another country varies widely. One contingency is whether you’re just shipping and distributing or you intend to set up your own legal entity. A thorough study should be conducted early in the process to determine its viability.

Generally, it’s important for companies that are considering doing business in a foreign country to slow down and think about all the aspects of it. Too often the sales department gets excited about the revenue potential. When you do your research and get into the details, however, it may not be as good of an idea as it first seemed.

You don’t need a thesis-level study on the new market potential, but thinking ahead and soliciting the aid of an adviser who knows what questions to ask, especially if this is your first attempt at conducting business in another country, is always recommended.

What should companies expect in terms of compliance requirements for doing business overseas?

If you will be doing enough business in a foreign country that you have a taxable presence, you will have local taxes to pay. If you will have a subsidiary in the country that’s tied to a U.S. headquarters, then you will also have a U.S. filing requirement.

The U.S. levies penalties for not filing forms when you have foreign operations that can be as much as $10,000 per form per year, which quickly adds up. Also, the country in which you conduct business will have its own penalties it will claim.

The tax situation, whether foreign or domestic, shouldn’t drive business decisions. But if it’s brought in to the discussion early, decisions can be made to enhance the business opportunity and avoid pitfalls.

What should companies consider if they already have foreign subsidiaries and are worried about transfer pricing?

Transfer pricing is the allocation of profit among legal entities in different countries. In the pursuit of revenue, countries want to maximize their profit in a taxing jurisdiction. Transfer pricing sets arms-length standards for how money is allocated. Have documentation and price accordingly or the country in which business is being conducted will make rules that favor it.

There are two main components of documentation. First, there are legal contracts between legal entities that determine responsibilities, pricing and other standard legal tenets such as interest rate, tangible goods price, hourly rate for service, etc. The second document, which is more economical and functional, outlines who bears what risk and assigns the expected profit for the risk each party is taking. That’s determined through a search of public databases that generate the acceptable price range.

The Organisation for Economic Co-operation and Development has guidelines for transfer pricing. Some countries have additional requirements in their tax legislation. A global policy is established first, then local documents from the country in which business will be conducted are required.

Insights Accounting & Consulting is brought to you by Skoda Minotti

Customer concentrations can be a challenge, but also an opportunity

Customer concentration can be a very serious issue for small businesses. A business that relies on a few big customers for a majority of its revenue can easily be brought to its knees when one or two of these customers suddenly pull out.

Every business is hurt when it loses a customer, but if a significant portion of the total sales of a business are concentrated in that one customer, the consequences can be disastrous.

Customer concentrations create a risk, but more importantly, they present an opportunity, says Robert S. Olszewski, a director in the Audit & Accounting group at Kreischer Miller.

“To prevent your business from falling into the trap of customer concentration, you need to understand your customer base thoroughly and rank each of your customers by its margin contribution,” says Olszewski. “Simply ask yourself how each of your customers is contributing to your business’s profitability and growth potential, and how important you are to your clients.”

Smart Business spoke with Olszewski about customer concentrations and ways to mitigate the risk.

Why should you be concerned about customer concentrations?
If you ask a business owner or other invested party how they feel about customer concentrations, they would probably tell you it’s something that keeps them up at night.

From an academic standpoint, customer concentration is calculated as a customer’s relative size as a percentage of gross revenue.

If you are considering selling your company, it’s important to know that customer concentrations are major concerns for prospective buyers and typically result in a discount of at least 30 percent in corporate valuation.

In addition, lenders and financial institutions are quick to identify customer concentrations, which often results in an increased cost and reduced availability of capital.

How should companies manage customer concentration risk?
Focus on profitability rather than revenue. Revenue targets can be all consuming within a company, with good reason.

But measuring the profitability of a relationship, the real value created for your business, is essential. The risk you take by catering to a significant customer should be rewarded by greater profitability in that relationship.

Companies must always ensure that customer credit policies are being adhered to and that there is specific attention paid to payment trends of a major customer.

What can companies do to mitigate customer concentration risks?
The obvious answer is to generate sales with other existing or new customers, but that is easier said than done. Successful companies effectively delineate between customer service and the sales force.

The natural tendency is for the sales force to revert back and forth between the two roles, making sure the customer gets what they want. However, the amount of time exhausted in identifying and resolving issues distracts from their main role of generating new relationships.

It’s also important to be diversified. There are two main areas of diversification. First is within the customer relationship; don’t tie yourself to any single point of contact. Second is the product or service.

Consider selling multiple products or services rather than always selling into the same silo. It is essential to become a “must-have” versus a “nice-to-have” in the supply chain.

What can you do if you find yourself dealing with customer concentrations?
A strategic plan is the most powerful tool to address customer concentration risk and drive growth and profit. Studies have shown that only 40 percent of businesses prepare budgets.

A vast majority of these budgets are derived solely from historical results. To greater surprise, less than 10 percent of businesses integrate their strategic plan into the budget.

The greatest opportunities surrounding customer concentrations lie in proactively identifying these customers and the potential impact to your business, and creating a plan to address it. As my father told me, if you fail to plan, plan to fail. ●

Insights Accounting and Consulting is brought to you by Kreischer Miller

Tax programs that offset the cost of innovation for manufacturers in Ohio

The outlook for Ohio manufacturers is steady with some growth potential, which is expected to vary by sector. Capital expansion has been minimal, though companies have stronger balance sheets and go-to-market strategies. Still, regardless of sector, challenges seem to overshadow opportunities.

“The main challenge is finding talent,” says Jonathan J. Shoop, CPA, a principal at Skoda Minotti.

He says the trend of re-shoring — bringing overseas jobs back to the U.S. — comes with a paradox: “Manufacturers need qualified candidates, but few are available,” Shoop says. “The market is attempting to address the shortfall by forging job pathways through community colleges.”

Talent shortfalls contribute to innovation impediments — a lack of qualified people or funds make it difficult to run an effective R&D department. Fortunately there are ways to mitigate the costs of the solutions.

Smart Business spoke with Shoop about ways manufacturers can offset expenditures as they pursue innovation.

What can tax incentives do for companies that lack the resources to innovate?

For those companies that lack the people or cash flow needed to innovate, the R&D tax credit can help.

For example, trial fees from partnering with Ohio’s Manufacturing Advocacy & Growth Network (MAGNET) for new product development qualify for R&D credit. Fees related to product innovation, or the exploration or implementation of a new manufacturing philosophy in partnership with an outsource engineer can be applied to an R&D tax credit.

Manufacturers can also shift some of the burden of the talent problem to InvestOhio, which has programs tailored to address that issue while offsetting the cost of hiring.

There’s also the Work Opportunity tax credit that provides incentives for hiring from certain target groups, like veterans and felons. It helps defray the costs for training and development.

How can organizations such as MAGNET and WIRE-Net serve as resources for manufacturers?

MAGNET and WIRE-Net can connect manufacturers with outsource engineers that can help tackle large projects. The tax credit would be applicable to both public and private companies and can apply even if both internal and external teams are handling the project.

What can the InvestOhio credit do for Ohio manufacturers?

It’s essentially a 10 percent tax credit — dollar for dollar — that was established to facilitate job creation and investment in the state. It can help offset capital improvements, the purchase of real estate and hiring that is done in Ohio. Manufacturers will inevitably invest in their business; InvestOhio allows a company to take advantage of a 10 percent discount while doing it.

How can manufacturer’s improve their administration and office processes?

There are new ways of handling tasks that are performed off the shop floor. While ‘management by walking around’ had been a common method of oversight, multi-location production makes that not as effective, so it’s necessary to manage by reports. Process improvements are increasingly streamlining reporting, with throughput and indirect cost reports helping manufacturers make decisions quicker.

There is also constructive disruption. This method entails looking across office and administrative processes and finding novel improvements. A multi-disciplined team that’s unfamiliar with those processes is assembled to ask questions and suggest improvements.

It’s been said that each manufacturing job creates six jobs up or down stream. The industry is projected to grow 22 percent in the region in the next 10 years, so contrary to what might be considered the common narrative, manufacturing isn’t going away.

For those working in the industry, there are resources available for investment, innovation, talent and even compliance to encourage growth. There are tax incentives, talent and engineering solutions for innovation, and plenty of people here to help strengthen an industry that’s vital to the market. Manufacturers just need to know where to look.

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