As the sponsor of a retirement plan, CEOs are helping their employees achieve a secure financial future.
Sponsoring a plan, however, also means that you, or someone you appoint, will be responsible for making important decisions about the plan’s management.
The Employee Retirement Income Security Act (ERISA) requires that those responsible for managing retirement plans, referred to as fiduciaries, carry out their responsibilities prudently and solely in the interest of the plan’s participants and beneficiaries. Among other duties, fiduciaries have a responsibility to ensure that the services provided to their plan are necessary and that the cost of those services is reasonable.
“With more companies offering defined contribution plans rather than the traditional pension plans and given that the future of social security is hazy, there’s both a legal and moral obligation to make certain that the company’s 401(k) plan is managed prudently,” says Roy Rader, manager for audit and business advisory services for Haskell & White LLP.
Smart Business spoke with Rader about what CEOs should know concerning the responsibilities of 401(k) plan sponsorship.
What steps can CEOs take to evaluate plan fees and expenses?
Oversight of the plan’s costs is getting harder to do because many of the plan administration fees are not fully visible to the plan participants. Many CEOs, especially in smaller companies, also serve as trustees or fiduciaries of the 401(k) plans. Therefore, in that capacity, you should first ask for full disclosure of all plan fees and administrative costs. Second, monitor what you are charged via monthly statements and audits to make certain that the plan is compliant. You can certainly shop various firms to see if what you are being charged is in line with market comparables. Before you seek bids or estimates, establish your requirements. You will need to know how much of the work will be done in-house and what duties will be required of an outside administrator. This will help you compare service plans and the proposed fees.
In addition, ask each prospective provider to be specific about which services are covered for the estimated fees and which are not. To help in gathering information and making comparisons, you may want to use the same format to review the pricing for each prospective provider. The U.S. Department of Labor Web site is a very good reference tool that can help you know what fees will be charged and what is reasonable and customary.
What other responsibilities rest with the plan fiduciary?
The fiduciary is held to certain standards of conduct and certain responsibilities including:
- Acting solely in the interest of plan participants and their beneficiaries and with the exclusive purpose of providing benefits to them
- Carrying out all duties prudently
- Following the plan documents (unless inconsistent with ERISA)
- Diversifying plan investments
The bottom line is that, following Enron, plan administrators have greater responsibility to educate their employees about how to manage a defined contribution plan and to make certain that they provide a wide array of investment choices for their employees. Also, if company stock is offered as an investment option in the plan,make sure to stress the importance of diversification through educating the employees about how to choose investments that will fit their risk tolerance and future financial and retirement needs.
What education should fiduciaries provide to plan participants?
Many firms are hiring outside consultants to conduct seminars, and they are providing employees with access to Web sites that provide plan information and help employees figure out how much they’ll need to retire. These same sites provide a long-term forecasting tool that can show expected returns by investment type as well as historical trends. Employees can become more comfortable with their own risk tolerance and how to plan for their financial needs at retirement.
Are 401(k) plan audits required?
All 401(k) plans are required to file a form 5500 annual return/report with the federal government. An audit is required once a plan elects to file as a ‘large plan’ after reaching 100 participants at the beginning of the year. A copy of the auditor’s report must be attached to the form 5500 filing. The information reported under the 5500 is distributed to all of the various governmental agencies that oversee pension plans, including the Department of Labor and the IRS, as well as the public and the plan participants. There are penalties for failing to file required reports and provide required information to participants.
What penalties can be levied against a fiduciary for failing to meet the administrative responsibilities of 401(k) plan management?
Fiduciaries who do not follow these principles of conduct may be personally liable to restore any losses to the plan or to restore any profits made through improper use of plan assets. With so much riding on the success of these plans, it behooves all executives to make certain that their firms are fully compliant with their fiduciary responsibilities.
ROY RADER is manager for audit and business advisory services for Haskell & White LLP. Reach him at (949) 450-6315 or firstname.lastname@example.org.
When Peter Farrell and a team of investors bought the rights to manufacture a medical device designed to solve snoring-related issues, he knew he was going to need a strong entrepreneurial culture in order to succeed.
Farrell helped develop the device while serving as vice president of research and development at Baxter Healthcare, so he understood the product very well. The challenge was that no one else really understood it or the problem it was supposed to solve.
The early estimates projected that 2 percent of adults might suffer from the condition that would be relieved by the device. But when Farrell launched ResMed Inc., sleep-disordered breathing remained largely unidentified as a medical problem by patients, and recognition of the disorder was nonexistent within the tough-to-convince physician community.
In classic marketing terms, Farrell, who serves as the company’s chairman and CEO, had to create the need for the product before he could meet the need through sales of the device.
The only way to do that was by establishing an entrepreneurial culture where everyone understood the product, so that the entire organization could help Farrell solve problems. It also required the establishment of a multifaceted strategic marketing plan that would continually build support and media exposure for the company.
Creating the culture
To help inspire the culture he desired, Farrell and his five founding partners distributed stock options to the staff, from the top of the organization to the bottom, including the employees out on the shop floor. Giving everyone on the team a stake in the outcome established trust and helped the firm attract and retain talent while the company was struggling to develop a market for its product.
“In the early days, trust was the glue that held everything together,” says Farrell. “I was very careful not to overpromise, and I wanted to make certain that people were looked after.
“The culture helped us retain people, and it actually helped us get investors because they knew we would need that type of culture to succeed, and it generated excitement.”
In addition to giving employees ownership in the company, Farrell maintains an open-door policy despite the firm’s growth. He says that hearing messages directly from the staff fosters a non-political environment where everyone feels free to speak up, and in the long run, he’s convinced that, as a CEO, having an open door is a profit-making posture.
“I’d rather get 10 e-mails on the same issue than not to hear about it at all,” says Farrell.
He says that his philosophy has contributed to the firm’s success by serving as the catalyst for directional changes within the organization.
For example, Farrell says that in the early days, the firm was developing a sleep diagnostic system intended for use in sleep labs. One day, a delegation of employees appeared at his office door and announced that after several years of investment, the plan had failed and needed to be scrapped.
“I was continuing to stay with the idea, and the physicians virtually ignored it,” says Farrell. “We must have wasted three to four years developing it, but the employees convinced me that we needed to go in a different direction, and it was the right call. As the CEO, you need to have an open-door policy because you want to find out where the next problem is coming from so you can focus on continuous improvement, and you have to be flexible and listen to your employees.
“I think my experience working for a large company like Baxter really shaped my thinking. In the early days, in particular, we really strove to keep things simple because bureaucracy is a cancer. We really needed to be fleet-footed and focus on outcomes.”
In order for the firm to succeed, it would need to continue to develop new medical devices as well as marketing strategies. Farrell says that he has maintained a lean organizational structure to keep new ideas surfacing and moving quickly through the pipeline.
Hiring for entrepreneurial spirit
Since its beginning with a staff of six, ResMed has grown to more than 3,000 employees worldwide. Sourcing and hiring large numbers of employees who demonstrate both a strong entrepreneurial spirit and the ability to thrive in the corporate culture have resulted from a hiring process that Farrell describes as both an art and a science.
“I like to hire opportunity-seekers who will also get things done in a timely fashion,” says Farrell. “We use the interviewing process, references and checklists to assess for traits like intelligence. I also like people who have a strong sense of urgency and will just go ahead and do something and ask for forgiveness rather than permission, because it’s essential to making progress.”
He says that he prefers apolitical employees for the firm’s candid culture, and he frequently asks candidates if they have ever said that they believed in something when, in fact, they really didn’t, as a barometer of their political nature.
“I also think that checking references and getting copies of transcripts are very important because I won’t hire a candidate who has lied on their resume,” says Farrell. “You can’t fix broken ethics.”
While hiring movers and shakers has been critical to the firm’s success, Farrell is the first to admit that hiring isn’t easy, and he doesn’t always succeed. However, he strongly values education and leads by example because he possesses a doctorate degree. Once he has the employees on board, he supports their development by advocating a continuous learning culture.
Through development of an internal university called The Learning Center, Farrell educates ResMed employees on everything from sleep-disordered breathing to leadership skills and how to work effectively in teams. The goal is that people grow along with the business, and employees feel valued and want to stay with the organization.
The other major challenge Farrell faced was to educate the health care market about the problem his product solved.
“The medical community works in silos, and traditional medicine stops when the lights go out, so no one understood the problem,” says Farrell.
ResMed initially funded medical research studies because Farrell says that he needed data to win the battle against ignorance and to convince the medical community of the disorder’s existence. The research studies found that sleep-disordered breathing was much more prevalent than Farrell had originally forecasted, affecting as much as 20 percent of the adult population.
Additional research studies showed links to other diseases, as well, but progress was slow. After several years of trying to convince doctors of the medical need for the product, Farrell finally achieved a breakthrough with cardiologists. Cardiologists were not initially projected to be the early adopters, but Farrell says that he learned from his experiences to be flexible and that start-up ventures are marathons, not sprints. So he took the initial endorsement from the cardiologists; then he focused on gaining the support of other physician groups.
Farrell compiled his first physician success stories and the results of the medical research studies, and he took the message out on the road. Because peer endorsement is important when marketing to professionals, ResMed uses thought leaders, who are recognized medical experts in their fields, who speak at medical conferences and symposiums, and convey the medical findings from the firm’s research studies.
His vision is effective marketing through education, and his goal is to educate everyone who will listen.
“We invite the physicians to seminars to educate them on the results of the research studies, and we even go out and educate our distributors’ sales forces because they have to have credibility and knowledge when they meet with physicians face-to-face,” says Farrell.
He also developed a public relations program built on unique alliances. Farrell approached a competitor with the idea of co-funding PR campaigns designed to build worldwide awareness of sleep-disordered breathing and its associated impact on other illnesses and conditions. The program raised device sales for both firms.
“This is not Coke and Pepsi,” says Farrell. “There’s a giant under-served market out there, and we needed to get the word out. There’s no industry association, so we had to make our own.
“Initially, it was also very difficult to get the attention of the medical community, so we tried something different. We launched an education and awareness campaign aimed at the patients. The idea is that by educating the patients, they will bring up the topic with their doctors. Our goal is to have something in the media every day which announces the results of one of our studies and helps to educate patients.”
His marketing campaign has solved the problem of demand as evidenced by 48 quarters of successive growth for ResMed, and his open-door policy keeps the news coming in, even when it’s not good.
“You can have a lot of success by getting into a monster market early,” says Farrell. “You are going to run into challenges and roadblocks along the way, but I get up in the morning and I’m glad I’m in the business. Of course, I also think that I’ve been successful because I have a high tolerance for bad news.”
But for the most part, the news has been good.
The company posted $607 million in net revenue in 2006, and its innovative culture has fueled approximately 1,300 patents granted or pending and 565 design registrations granted or pending worldwide as of December 2006.
“Now that we are successful, many people ask me why Baxter wasn’t interested in developing the product and the marketplace for themselves,” says Farrell. “If you’ve ever worked for a big company, that’s a really dumb question. Once a company gets big, (the executives) are so busy thinking about next quarter and maintaining their existing business that an idea like this would just die on its own backside there.”
HOW TO REACH: ResMed Inc., www.resmed.com
Succeeding a much revered founder can be a daunting challenge for a CEO. Now consider becoming the head of Directed Electronics Inc., famous among San Diegans for being the company that Darrell Issa (R-Calif.) and his wife, Kathy, built. Creating further potential jeopardy was the task of repositioning the firm to move beyond its run rate of $100 million in annual revenue.
In 2001, all of these challenges awaited Jim Minarik, a veteran of Clarion Corp. as he accepted the role as president and CEO of Directed Electronics when Issa sold the firm to a venture capital company following his election to Congress.
Directed Electronics possessed a dominant 50 percent market share position in a niche electronics business vehicle security systems and was very profitable. As it existed, although tremendously successful, the company was positioned to maintain revenue and profits, but not to increase them.
“My first rule was don’t break what wasn’t broken,” says Minarik. “It was a tough first six to eight months and quite a challenge getting the employees on board with all of the changes.
“Before, everyone reported to Darrell. My initial thought was that in order to make the business scalable, I needed to create a business plan and an infrastructure that would support the growth.”
But all of the plans in the world wouldn’t end up meaning much if the company couldn’t survive the initial change.
As the first firm’s post-entrepreneurial period, Minarik demonstrated that he could successfully follow a politician by using his own political savvy. He set out to win over the existing staff and to take them along on a journey to the next level a professionally managed company.
Succeeding with people
Minarik knew he had to change the tone and set new expectations immediately.
“I wanted to let everyone know that I wasn’t the new ‘daddy,’ this was now our company,” says Minarik. “I clearly communicated the risks to everyone. We could succeed from here and take the company to the next level or we could fail if we couldn’t change. The choice was ours.
“Often what came up was that they hadn’t done things this way in the past. Coming from a Japanese company, I let the staff know that I wanted their feedback and I wanted to build consensus because that’s what I was used to, but that we needed to change to move forward.”
Frequently in entrepreneurial firms, the intellectual capital of the business is housed in the memory banks of the existing staff and the processes are inadequate to effectively continue the business if too many people leave at once. Sensing that might be the case at Directed Electronics, Minarik decided to add onto the house, not tear it down to the foundation.
Minarik says he decided to strategically deliver “carrots” to the existing staff to keep them on board by increasing vacation, sick leave, health benefits and the 401(k) plan.
He also needed to get the employees more involved in decision-making. As is often the case in entrepreneurial firms, decisions and accountability for results resided at the very top of the organization. Minarik says that the limited decision-making structure contributed to a sense of complacency among the staff and a culture where no one took accountability for results.
To help get the change he desired, Minarik promoted many of the existing staff into management roles that increased both their authority and responsibility for results including accountability for profit and loss. Because he wanted to retain the newly promoted employees and have them build the business, Minarik needed the new managers to think more like owners than employees, so he also gave them a stake in the business.
Minarik’s actions were the result of a lesson that he says he learned early in his career.
“The first company that I worked for was run by an iron-fisted entrepreneur,” says Minarik. “I finally left because he had to make all of the decisions. The company made it to $100 million and hit a wall.”
A plan and a team
Minarik says he wanted to achieve balance between effectively paying respect to the history of the company and repositioning the firm to grow through the addition of new product lines. After securing the base, Minarik’s next steps down the path toward building a high-growth company included creating a more scalable infrastructure by adding new leadership who could close gaps in the firm’s expertise, building a cohesive team and teaching the existing management staff to make decisions through data analysis and process improvement.
Minarik hired a new CFO and a vice president of corporate development from outside the company.
Because blending new hires into an existing company can be difficult, he didn’t rely on gut feel. Instead, he used a system called “top grading” to help him select the right external candidates.
“Top grading is a defined program for hiring ‘A’ players using formal candidate assessments,” says Minarik. “It starts with defining the competencies you are looking for and then you develop the questions that probe into those competencies using several interviewers over three-to four-hour interview sessions. The candidates are scored on their responses, which quantifies the selection process.”
The next step was to fully engage the newly merged leadership team into a growth mindset for the company through the creation of a business plan and vision for Directed Electronics. Minarik structured a senior management committee comprised of the new and old leaders and led the team in creating the strategy that would take them forward.
The team’s plan called for doubling the business within three years and hitting $1 billion in revenue within 10 years. Minarik says that he perceived that the most likely succession scenario for Directed Electronics would be that the current venture owners would sell to another venture firm, after realizing some financial gain resulting from
acquisitions and growth. So a near-term public offering was not part of the initial strategy. Had he envisioned the possibility of going public earlier, Minarik says that in hindsight, he would have added even more infrastructure to the company to support all that goes along with being a public company.
“Our plan focused on growth and where we had gaps in our product lines,” says Minarik. “Once you define them, there are three ways to fill the gaps: You can close them with existing product lines via organic growth, you can close them by developing strategic partnerships that will give you access to new products, or you can make acquisitions.”
While Minarik developed a strategic partnership with satellite radio selling aftermarket equipment, which effectively closed one gap, he was also armed with venture money to spend. Consequently, the most obvious route to quick growth was through acquisitions and it was what Directed Electronics’ new owners were expecting. Based upon the business plan strategy, Minarik went on a shopping trip looking for potential acquisitions in the hot home theater speaker manufacturer marketplace, but first he developed a comprehensive checklist of acquisition attributes.
“There were three things that were important considerations as we looked at prospective companies to acquire,” says Minarik. “First, the firm had to be making money and growing at above-average margins. Second, they had to possess a defendable market position or brand by being the industry leader, and third, I was looking for businesses we could expand so I wanted a lower level of customer concentration and a strong distribution network. I didn’t want them to already have 90 percent of the customer base.”
By selectively taking Directed Electronics into targeted markets, Minarik has achieved growth initially as a result of an acquisition and then subsequently he has achieved additional expansion growth within the brand. The plan is designed to optimize the firm’s smallish infrastructure by making the acquisition digestible initially, and then optimizing incremental sales through the firm’s existing distribution network.
This strategy also helps Minarik achieve growth while keeping debt and expansion costs at acceptable ratios when related to revenue growth rates. For the full-year 2006, Directed Electronics reported revenue of $438 million while generating $27.3 million in net income representing top- and bottom-line growth achieved both organically and through new acquisitions.
Minarik says that management decisions should always be supported by data not hunch or whim. Given his roots in the Japanese business culture, he’s a proponent of Six Sigma methodology, which uses the DMAIC problem-solving process to improve quality and productivity. DMAIC stands for: define, measure, analyze, improve and control, and this level of justification for financial expenditure requests represented uncharted waters for many of Directed Electronics’ staff.
He used real situations to teach employees who were raised in an entrepreneurial environment how to analyze the facts and then present their requests along with cost justification.
“As an example, the customer service manager came to me and said that she needed more staff because wait times were getting too long for customers, but there was no data” says Minarik. “So we established metrics, looked at call volumes and sure enough, the metrics supported the fact that we needed to add a couple of [employees].
“Under DMAIC you don’t always add to headcount because sometimes you can improve the processes and achieve the productivity results without increasing expense. The company had systems in place but in many cases they were just enough to get by and when you grow, you find that you have really big holes and you have to scramble to get things fixed. I have been doing a great deal of training so we can get better processes in place.”
As the growth of the company accelerated, the option of going public as opposed to selling to another venture firm became more viable because costs of both transactions began to equal out. In early December 2005, going public became a real possibility.
“That’s when the nightmare began because right when we went to file our S-1, we had to replace our accounting firm and re-audit the previous three years,” says Minarik.
“I would tell anyone reading this article, if you are even thinking about going public you should meet with your accounting firm a couple of years ahead of time. It was absolutely a huge headache. What gets you through it is a lot of persistence and determination and in the end it’s worth it because as a CEO I like the way it looks on our balance sheet, but I wish I would have started a whole lot earlier.”
HOW TO REACH: Directed Electronics Inc., www.directed.com
If you are the CEO or a CFO of a private company, beware the wrath of Sarbanes-Oxley (SOX). In the post-Enron era, the heavily criticized American Institute of Certified Public Accountants (AICPA) has issued audit reform standards that will affect private companies. The eight new standards will be effective for audits of financial statements for periods beginning on or after Dec. 15, 2006.
The new standards require auditors to look more carefully at every organization’s financial reporting process and business environment, and they require auditors to obtain more evidence before rendering an opinion on the financial statement.
“We are moving toward having the same types of internal controls in private companies as are required of public companies,” says Sam Salty, audit manager with Haskell & White LLP. “Auditors can no longer merely inquire about the controls; we have to test them.”
Smart Business spoke with Salty about the impact of the suite of new standards on companies and organizations and how CEOs can prepare for the changes.
What audit changes will affect private companies?
There are eight major provisions designed by AICPA SAS 104 through SAS 111 that will affect the audits of private companies. The impetus behind the provision changes is to drive more effective audits and to enhance the auditor’s application of the audit risk model in practice.
The provisions establish standards and provide guidance concerning the auditor’s assessment of the risks of material mis-statement in a financial audit. In addition, the new standards provide guidance on planning and supervision, the nature of audit evidence, and evaluation of whether the audit evidence is strong enough to support the auditor’s opinion on the financial statements under audit.
How will these changes affect the way audits are conducted?
Auditors will no longer be able to rely on one-size-fits-all checklists. They will need to customize each audit and prioritize their time according to the risks of the business. Depending on the auditor’s judgment about a financial statement’s level of risk, more experienced members may be necessary on the audit team.
Simply stated, audits will be more thorough.
As an example, one of the major changes is that SAS 104 expands the definition of ‘reasonable assurance.’ In the past, auditors were required to collect enough evidence to be reasonably assured of the audit findings as a way to limit audit risk. Now the auditor must obtain a higher level of assurance by looking at more evidence.
Essentially, auditors will need to perform more testing and they will need to see evidence that internal controls are documented and implemented. In the past, we gained an understanding of the existence of internal controls and only for audit planning purposes. Now, gaining an understanding is not sufficient and documentation alone is not enough. We now must evaluate the design of internal controls and decide if they have been implemented.
The new standards effectively eliminate the ability of the auditor to assess risk related to controls at a maximum level without having a basis for the assessment. Audits may become a bit more time-consuming, but there are steps that can be taken to help reduce the time and cost of upcoming audits.
How will SAS 104 through SAS 111 require the auditor to examine the business risk from new perspectives?
The auditor is now required to examine how the business compares to other businesses or competitors in the same industry as part of the documentation that supports the auditor’s risk assessment of the business. In addition, the auditor will dive deeper into an analysis of the skill level and the tone set by the management team in order to assess the organization’s internal control environment.
How can CEOs and their auditors prepare for these changes?
Document your existing controls and make certain they are in place. Tasking small steps like designing flow charts of your control processes before the auditor arrives will not only save time and money once the audit begins, but the mapping process itself may expose gaps in your processes so that CEOs have the opportunity to take the necessary steps to close the gaps.
Consider having an audit planning conference with your auditor to know how to collect the documentation necessary for the new audit process. Not only will you save on billable hours once the auditor arrives, you can avoid costly rework resulting from the need to restate the documentation or capture the information once the audit has commenced.
While controls in smaller organizations can be less formal, they must be equally effective. By starting now and talking with your auditor about what will be required, you will be able to save time, money and headaches once audit time rolls around.
SAM SALTY is an audit manager with Haskell & White LLP. Reach him at (949) 450-6359 or email@example.com.
At the time, ISI was a local firm generating about $18 million in annual revenue, mainly from carpeting sales to new homeowners. The founder was looking for a little more time on the golf course; Treaster was just looking for a job.
Since Treaster was hired, the company has been sold twice, both times to venture investment groups, and he was named president and CEO of ISI in September 2000.
“When I exited college, I really didn’t have any specific goals except to move up the corporate ladder,” says Treaster. “Then when I got up there, I really wanted to move back down. I think part of the reason that I’ve stuck it out is the quality of the people involved in carpet manufacturing and the culture.”
The private equity investors sensed an opportunity when they initially purchased the firm. The industry was primarily made up of family-owned businesses, which were providing flooring, window coverings and countertop products to new home buyers.
Homebuilders were expanding their operations throughout the southwestern United States, in search of less saturated countercyclical markets, and an expanded ISI could ride on the coattails of the builders and capitalize further through unrealized revenue potential.
While builders usually have a transactional sales relationship with their customers that ends when the home is purchased, design services offer both repeat and adjunct sales prospects for other products and services needed by homeowners. The key to increased sales would be through owning the customer relationship.
Under Treaster’s watch, the Carlsbad-based firm has grown to more than $450 million in annual revenue, mainly through acquisitions, and has become one of the largest providers of outsourced interior design services in the country.
Maximizing the expansion opportunity required Treaster to acquire design firms with strong customer relationships that needed to be maintained through the assimilation process, as well as working closely with the private equity firms to maintain growth.
Finding the right match
The acquisition process starts with communication.
“When I speak with the management team from a prospective firm during the acquisition process, I am looking mostly for similarities in philosophy,” says Treaster. “I’m looking for great relationships with the builders, a good customer service level and a book of business that has been developed on value, not price. While I obtain most of my information about their philosophy through one-on-one meetings, I then validate many of the prospect’s assertions through a review of the financial data and by speaking with their vendors.”
Treaster says he has an advantage when he conducts interviews with a prospect in a new market because he can inquire about its bidding price points without being a competitive threat. Knowing the industry, he says that he can tell by the prices it is submitting in response to bid proposals what its true pricing philosophy is. If he hears that the owner often competes by bidding down the price, he expects that a review of the financials will show lower margins, and that may translate to less than desirable customer relationships.
If a prospective firm doesn’t look great on paper, that doesn’t necessarily rule it out as an acquisition prospect. The data analysis may reveal places where ISI could bring expertise or resources that would make the new acquisition financially successful because the solidity of the customer relationships has value.
“In 2002, we purchased a firm in Las Vegas that wasn’t making money, but they had good customer relations,” says Treaster. “We thought that we could improve their buying power, which would increase their margins and improve their back office function, which would improve their return on cash, all of which would make them more profitable.
“Another way that I evaluate an acquisition is looking at their data to see how aggressively they have pursued their turn on cash. I like to get down into the detail and classify which customers are paying slowly. If they are also paying slowly with other competing design firms that we’ve looked at, then they are probably a bad customer. If we’ve seen that the customer is turning invoices more quickly elsewhere, then we know we can move up the DSO [days sales outstanding, a measure of how quickly a company collects receivables] through process improvement.”
Treaster also has to take into account what his investors are looking for.
“One thing I’ve learned from working with private equity firms is to find out where their comfort level is and bring them deals that make sense to them and to remain flexible,” says Treaster. “In this case, the comfort level consists of deals in highly populated markets within the 11 Western states.”
Treaster says he has developed an acquisition sweet spot that seems to work well for the owners of the firm that he’s acquiring, as well as for ISI’s venture capital owners.
“What works best for us is acquiring firms that are $25 to $50 million in revenue, as they tend to have an owner who is over 50 years old and who has a limited exit strategy, because we can help with the succession of the business,” says Treaster. “Our model is to have the owner stay intact with the business for two to four years to make certain we maintain the customer relationships.”
Maintaining customer relationships
A prevailing wisdom among CEOs is to leverage the newly acquired acquisition debt by eliminating redundant functions and reducing costs through back office consolidation, especially when private equity firms want to see a return on their investments sooner rather than later. Treaster says that he originally went down this same path but soon learned that it often caused damage to locally built customer relationships.
“When we did our first assimilations, we centralized everything because we thought it would be easier to manage and it would save on costs,” says Treaster. “We found out that it just doesn’t work that well having someone from California call a customer in Arizona to collect cash.
“Also, the job-costing process isn’t as customer-friendly. So we refocused and put a local payables/receivables person in each of the local branches, and they develop relationships with the local builders. The result of the change is that we have experienced a higher level of acceptance in the local market, a more rapid turn on cash, and the customer relationships are better.”
During the due diligence process, Treaster reviews each customer and defines who in the organization owns the relationship. He also makes certain that the customer is introduced to ISI management during the assimilation period, reducing the possibility of customer loss down the road when the original business owner transitions out of the firm.
Treaster’s decision-making flexibility plays a vital role during the development of his assimilation plan. He says that he treats each situation differently and adapts his consolidation strategies for each acquisition using a centralized/decentralized model. He generally centralizes functions that don’t touch the customers and leaves the rest within the control of the local firm.
While the downside is running at a higher cost, Treaster says changing something that is working well for the customer is a mistake.
“What I’ve learned is that when companies are acquired, the last thing that 80 percent of the customers and employees want is change,” says Treaster. “So I’ve learned to change as little as possible that touches the customer. Centralizing functions can take the heart and soul out of the company you just bought.”
While effective assimilation is important, it can be a great challenge for CEOs to create a corporate infrastructure that can withstand rapid growth and to develop a management team that can handle hundreds of millions of dollars of increased business. Treaster says that the key to managing growth has been building a management team that has experience in rapid-growth environments.
With that primary selection criteria defined, Treaster has added a CFO with significant acquisition experience and a COO who has experience in a rapid-growth environment. They assist him in the due diligence process and make suggestions where to consolidate functions and develop the company’s operational infrastructure.
As an example, ISI has made significant investments in IT infrastructure. This provides newly acquired firms with greater data prowess and increases technical support while facilitating an operational cost reduction without negatively impacting customer relationships because the data can be accessed from anywhere.
“The most important ingredient in successfully managing growth is the quality of the people you have on your team,” says Treaster.
“They don’t have to be from the same industry, because floor covering is not brain surgery, but they have to have been around other environments that were supporting rapid growth, either through acquisitions or organic growth, and they have to thrive on it.”
Because part of ISI’s acquisition plan is to facilitate exit strategies for the owners of the companies it purchases, Treaster says that long-term growth in the acquired firms will be achieved by replacing the original owners with more professional business managers. While he says developing those managers is still a work in progress, he recently instituted a mentoring program with the goal of developing managers in- house for those opportunities, as well as increasing the firm’s bench strength.
Both moves will help take the company to the next level and reduce vulnerability resulting from owner or management departures.
Success with equity firms
Treaster says listening is key, not only with customers but also with investors.
“I think I’ve shown that I’m adaptable because I made the decision to centralize most of the back office functions post-acquisition and then reversed it,” says Treaster. “I think you have to learn to listen first and then formulate your plan.”
Treaster says that he developed his philosophy through experience. He says he learned early on, when he brought an acquisition prospect to the table that was located in Florida, that the private equity executives were not comfortable starting with such a broad geographic expansion right out of the gate. He refocused closer to home and found his suggestions were more on target.
“The private equity industry operates in a pretty high-risk, high-reward type of environment,” says Treaster. “I have learned not to give them any surprises so they feel comfortable that I am making good decisions.”
The “no surprises rule” has created a relationship built on trust, and so far, Treaster and his team have made decisions that have played out well, a situation that also keeps Treaster in the driver’s seat and the private equity firm in a supporting role.
“As for why my style is a good fit in working with equity firms, I think it’s because I don’t have an ego that has ever gotten in the way of making a good sound business decision,” says Treaster.
HOW TO REACH: Interior Specialists Inc., www.isidc.com
In January 2007, the San Diego Regional Water Quality Control Board adopted a revised National Pollutant Discharge Elimination System (NPDES) permit that requires local governments to further control urban sources of water pollution. As the effects of the amendment trickle down, many business and all new construction projects will be directly impacted.
The permit requires the proper management of runoff from rain and even housekeeping and gardening activities. In some cases, the runoff will need to be treated on-site before it can be released into the municipal storm drain system. Such treatment will require the local installation and maintenance of a water treatment system. The permit requirements will add to the construction costs of new homes or typical business development projects such as new parking lots.
“The new permit requirements not only are more extensive, but they require measures of effectiveness,” says John Lormon, chair of the Environmental and Land Use Practice Group at Procopio, Cory, Hargreaves & Savitch LLP. “All of this will have an impact on costs for homeowners, businesses and taxpayers.”
Smart Business spoke with Lormon about the business effects imposed by the permitting requirements and how CEOs can prepare for the changes.
How will the new urban runoff management program affect the construction industry?
The construction industry will be affected in several ways. For example, that industry is going to see changes in terms of how much land can be graded at any one time.
Because grading can alter the amount of runoff water and the pollutants contained in that water, the permit may only allow for a limited disturbance of land at one time. This could affect construction time lines and potentially project costs.
There are also implications for low-impact development projects such as the construction of restaurants, parking lots or office buildings. When you convert ground that previously absorbed runoff to hardscape, you are changing the volume, velocity and makeup of the runoff. This change is a major concern for water quality regulators; thus, new restrictions are being imposed on development.
Creating additional hardscape can also cause runoff to alter streams, banks and beds, changing habitats. Where site development exceeds 50 acres, the project proponent will be subject to additional requirements, including development and compliance with a hydromodification plan. In time, most projects will be subject to these requirements.
The permit requires the local government to reduce the discharge of pollutants in urban runoff to the maximum extent practicable through various management practices [such as treatment and development of management plans], and these requirements will be passed down from local governments to development projects through ordinances and the land use permitting processes.
These same water quality issues will affect environmental review and could create new mitigation requirements, further adding to project costs.
Are there wider-reaching implications?
Certainly, CEOs should expect to see some of these costs passed through to them under triple net leases, and the permitting process may slow down new construction projects or build-outs. The cost impact may not be as immediate for CEOs who lease building space, but as those buildings undergo renovation, or if the CEO relocates or expands the business, there is the potential for impact.
Also, the agencies have developed stormwater civil and criminal enforcement initiatives. Wal-Mart recently paid a storm-water violation penalty of $3 million.
How will this impact the cost of doing business and the cost of construction?
The building industry says that this may add as much as $30,000 to the price of a new home. Other estimates project a $100,000 cost of construction increase for office buildings, while the cost to government and taxpayers is projected to be $250 million over the five-year life of the current permit.
What should CEOs do in anticipation of this urban runoff management program?
First, they should pay careful attention to site selection and keep both the stormwater quality impacts and the potential cost escalation in mind.
Second, they should anticipate that new construction might be slowed or impacted by the permitting process.
Third, as CEOs look at all new real estate transactions, they should do their due diligence and strongly evaluate projects that might result in hydromodification or treatment requirements.
Fourth, the SEC requires public companies to disclose environmental liabilities.
Last, keep budgets in mind. All of these changes are a consultant’s dream, and any time there are uncharted waters to navigate, consultants are usually hired to help pave the way.
JOHN LORMON is chair of the Environmental and Land Use Practice Group at Procopio, Cory, Hargreaves & Savitch LLP. Reach him at firstname.lastname@example.org or (619) 515-3217.
Approximately 70 percent of clients are underinsured, according to Michelle Baxter, personal lines broker with West-land Insurance Brokers. “It is more expensive to rebuild a home than to build it because of demolition and debris removal costs,” says Baxter. “Many homeowners fail to take those expenses into account when they calculate their home’s replacement cost, if they aren’t advised by a professional broker.”
Smart Business spoke with Baxter about how to close coverage gaps and reduce liability exposure with personal insurance.
How often should I meet with my broker?
Your broker should review your portfolio annually, including an evaluation of all of your assets and your lifestyle. The broker should ‘shop’ your coverage needs among several markets to determine the best value and insurance carrier for you. I say value as opposed to price because coverage should be placed with an A-rated carrier and certain markets cater to high-wealth individuals, so their policies contain clauses that provide protection for the kinds of exposures that executives frequently have. Saving on premiums in the short run often can cost you more in the long run.
What is my broker’s role in reducing my exposure to loss and managing my needs?
You should have one broker, who should place all of your coverage with one insurance company.
Primarily, this allows your broker to view your entire lifestyle and portfolio of assets for gaps in coverage and potential exposure. For example, if you purchase a vacation home and secure the insurance coverage through escrow at closing, that policy might have liability limits of $300,000. Meanwhile, your personal umbrella policy is with another carrier and it provides coverage for losses that exceed $500,000, resulting in a coverage gap of $200,000, which could be avoided by having one broker who oversees all of your needs. Hiring occasional or full-time workers, such as a nanny or housekeeper, can also increase your exposure, as does renting out a vacation home, so all of this must be taken into consideration.
Also, placing all of your coverage with one carrier is generally more cost-effective because it allows for premium credits and elimination of costly redundant coverage.
Finally, your broker should be the first person you call in the event of a loss. When you report a potential claim to a carrier, all insurance companies are notified regardless if the claim gets paid. In some cases, especially where the claim may be below your deductible, it might be best not to report it at all. Your broker will know what the right answer will be for each situation.
What are examples of personal lines protection that executives should consider?
Your broker should suggest a personal articles floater if you own jewelry, rare wines, collectables, musical instruments or fine art, and all items should be appraised. This will cover the items at full value against loss or mysterious disappearance without a deductible. If you own a condo as a primary residence or as a rental property, you have personal liability exposure that extends beyond the master policy written on the condominium association. For example, if a fire starts in your unit and damages other units, you might have financial responsibility to others.
Extended replacement cost coverage for homeowners is another recommendation. It provides additional protection in the event you discover that you are underinsured after a loss. For example, if you have purchased $500,000 in replacement cost coverage for your home, and after a fire you find that it will actually take $550,000 to replace it, the endoresement clause will provide for $550,000 in replacement coverage automatically; you need only pay the additional premium. Also, you don’t have to settle for coverage limits provided by the California Earthquake Authority. A professional broker has access to other markets that provide broader coverage for reasonable rates.
What are the other benefits of working with a professional broker?
Brokers can assist executives with busy lifestyles by recommending appraisal firms, companies that will scan valuable documents or videotape your belongings, so you have a catalog of your assets. They can also assist in calculating accurate replacement cost values for your properties. As your wealth builds, so does your exposure to loss and your need for professional guidance. It takes years to build the American dream; it only takes a few minutes to lose it.
MICHELLE BAXTER is a personal lines broker with Westland Insurance Brokers with 20 years insurance experience. Reach her at email@example.com or (619) 641-3255.
While recent changes in the real estate market have slowed the rate of increase in the average home price, several years of double-digit increases have left many Orange County residents with homes that have more than doubled in value.
At the time it was instituted, the Taxpayer Relief Act of 1997 brought what was thought to be welcome relief for taxpayers. It allows homeowners to exclude up to $250,000 of personal property gains for single individuals or up to $500,000 for married couples filing jointly from capital gains taxes. Subject to a two-year waiting period, the exclusion can be used over and over again.
A seller looking to downsize or sell before the two-year waiting period has expired, as in the case of a transfer or promotion, may be in for a surprise.
“I think some people may be startled if they have been carrying forward prior unreported gains resulting from the sale of one or more homes,” says Ryan Woodhouse, tax manager with Haskell & White LLP. “In that case, the $500,000 exclusion may not be adequate, so reducing taxes will call for some planning and creativity.”
Smart Business spoke with Woodhouse about the changes in the way home appreciation is handled for capital gains tax purposes and a creative solution to the problem.
What changes are there in the rollover residence replacement rule?
The main difference has to do with the deferral provision of the old pre-May 1997 rollover residence rule versus the exclusion provision currently in place.
The best way to illustrate this is through an example. Let’s say that a married couple here in Orange County has purchased and sold homes prior to May 1997, which created deferred capital gains of $20,000, $45,000 and $70,000, for a total of $135,000.
Because they always bought a more expensive home, the gain is deferred and they avoided any tax consequence from
the sale under the pre-May 1997 rule. Now, they want to sell their present home, which they purchased in 2000 for $500,000. It has a current market value of $950,000. Calculating the tax under the post-May 1997 new rule requires subtracting the previous deferred capital gain of $135,000 from $500,000 to arrive at an adjusted cost basis of $365,000.
After adjusting for improvements and deducting the cost basis from the sales price of the present home, the gain will most likely exceed the $500,000 deduction, and the balance will be taxed as capital gains.
What is the property exchange solution to capital gains taxes, and how does it work?
If the sellers are to realize gain in excess of the exclusion amount and do not immediately need all of the equity in their homes, such as in the case of trading down residences, converting the property from a primary residence to investment property status may offer an alternative to large capital gains taxes.
IRS 1031 (Like-Kind Exchange Rules) allows for exchanges of investment property without recognizing gain or incurring capital gains tax. The idea is to convert the property from its primary residence status
to a property held for investment. Then the owner can either continue to hold it for the production of income, or exchange it tax-free for another income-producing property.
What steps do you need to take to qualify for a property exchange?
The first step is to make your intentions to change the status of the dwelling from primary residence to investment property clear by leasing the property for a period of time, ideally for a minimum of two years but no longer than three. Once it is clear that the home is now an investment property, it can be exchanged for another income-producing property.
Under the rules of IRS 1031, when a former principal residence is exchanged for a like-kind property, any cash received in the transaction first qualifies under the $500,000 exclusion, and the balance is excluded from capital gains assessment.
What constitutes a like-kind property exchange?
Generally, this means that income-producing property has to be traded for another income-producing property, such as another residential rental house. One option would be to trade for a similarly priced property that can generate more revenue.
For example, if your home is worth $1.1 million, it is likely that the net income that could be derived from rental of the high-priced residence is substantially less than the net income that could be derived from a small apartment building that could be acquired in a swap with the $1.1 million equity value of the residence. If the owner wished to avoid involvement with management of real estate, a trade of the property for high-quality net leased property could be arranged.
All tax laws are complex, and 1031 is no exception. Be certain to consult with a tax professional and evaluate all of your options for dealing with capital gains taxes.
RYAN WOODHOUSE is a tax manager with Haskell & White LLP. Reach him at firstname.lastname@example.org or (949) 450-6341.
Under Sarbanes-Oxley (SOX), CEOs and CFOs of public companies are accountable for assessing the integrity of the company’s financial and information technology controls as well as certifying to the fair presentation of the financial statements. While an increasing percentage of data used in compiling financial statements is captured, processed and stored in the company’s information technology
system, most IT audits are conducted independently from the financial audit, leaving potential gaps in the control systems. Coordination of audits may ensure that compensating controls are in place. Coordinated audits can detect situations where “super users” have universal access to the system or administrators independently set up and manage the security and permission levels for the operating systems, applications and network, thus creating an opportunity for collusion, fraud or confidentiality breaches, says Robert Greene, IT Audit Practice leader with Haskell & White LLP. “The CEO needs to understand that IT controls can complement financial controls. When these combined controls are understood and implemented, there is a greater assurance of the integrity of the financial statements and source data,” says Greene.
Smart Business spoke with Greene about how CEOs can create tighter controls by combining the IT and financial audit processes.
Why is there a tendency to separate the IT and financial audits?
Historically, CPAs did all of the auditing and the IT systems were not audited. Now, more and more data used by finance and accounting comes from IT applications, and the audit planning hasn’t necessarily kept up. The CPA usually has no IT audit experience and the audits are planned separately. IT audits primarily are focused on strategies to protect the firm’s data capabilities not necessarily the financial statements. The CFO and CIO need to understand how IT and finance controls are interdependent; to create controls that will be effective for both.
What is the value of combining the two audits?
First, by understanding who creates and has access to the data, controls can be established that ensure both the integrity of the data and the manual processes that occur independently from the IT system.
For example, the company may have a manual control process that calls for the controller to approve any check exceeding $10,000. The CIO may not be aware of the process, and the software could be programmed to flag any entry that exceeds $10,000 when it is created. In this case, the new primary control would be the exception report generated by the system, the compensating control would be a review of an exceptions report by the controller, and the fail safe is a manual review of all checks over $10,000. This additional capability will allow the CFO to know how many checks should be coming through the manual review process and the CEO could also receive a copy of the report. Having the CIO and the CFO collaborate in creating controls will reduce gaps in both systems.
Second, when the entire team works together, it creates synergistic opportunities to advance the company’s mission and business plan, which fosters growth.
Third, by knowing that the controls in IT and finance work cohesively, the CEO and the board can have greater confidence in the effectiveness of the control system and the accuracy of financial statements.
How should the IT and finance audit teams work together, and what information should they share?
The finance audit team usually makes up the audit schedule. IT should be involved in planning to ensure it knows the time frame and how much time to allocate. The two audit teams should share any concerns in advance, to help stimulate both ideas and solutions. Generally, IT doesn’t understand the financial processes and finance doesn’t understand the IT controls. Therefore, the opportunity to design or recommend complementing controls may be missed.
Jointly, both parties should look at the entire flow of data from creating users in the system, to entering information, processing information and who has access to the information. This process mapping will reveal gaps, as well as opportunities to jointly author process controls and safeguards.
What are the best practices to achieve the optimum results from a combined audit?
First, IT and finance should author the audit plan together. They should talk about what is important to both sides and collaborate on the scope of the audit and the audit program.
Second, the CEO should insure that the budget is sufficient to conduct a thorough, combined audit.
Third, by integrating the process and control training to include both the IT and finance auditors, as well as the respective leadership teams, each group will be able to understand each other’s needs and see the value in combining the audits.
ROBERT GREENE is the IT Audit Practice leader with Haskell & White LLP. Reach him at email@example.com or (949) 450-6340.
The commercial real estate industry has a dirty little secret, and it’s called conflict of interest.
We see the familiar “for lease” signs on buildings, and understand that those agents are working for the property owner. But when you are a CEO looking for a new building, things get murky. The conflicts are obvious when your agent also represents the building owner. But what about when the conflict is more subtle, or when you don’t find out?
Enter the tenant representative, who forsakes all landlord allegiances to represent only the tenant in commercial real estate transactions. Tenant representation has taken root in corporate America, where space users seek out tenant-only brokers and tenant-only brokerage firms have grown in response to this demand.
“We have divided the industry in half,” says John Jarvis, principal and senior vice president with Irving Hughes. “Brokers have to choose between representing landlords or tenants. The days of one agent doing both are gone.”
Smart Business spoke with Jarvis about what CEOs should know about engaging a tenant representative and how to benefit by having one.
What is tenant representation?
Tenant representatives are commercial real estate brokers who work exclusively for the tenant, or ‘space user,’ and never the building owner. ‘Tenant reps’ developed in response to the conflicts of interest that are rife in the industry. They are now a universally embraced, specialized sector of commercial brokerage, with a broader range of services focused on the tenants’ unique needs such as space programming, construction management, lease renewal consulting, site search, financial analysis and strategic negotiations.
Why should a CEO care if his broker is a tenant rep?
There is a very real risk of working with a partner who has blatant conflicts of interest. CEOs are sensitive to the issue of conflicts, and investment banking is a perfect example. As the CEO, you know when you are talking with a promoter, and you aren’t going to rely on him for business advice. Commercial real estate is exactly the same, and the landlord agents are the promoters.
I started in this industry as a traditional landlord’s broker 20 years ago, before the growth of tenant representation. I was given listings and told to go find tenants to fill the space. The objective was to get the buildings filled up at the highest rents, so that we could sell the properties as leased investments for the maximum possible price. But in the process of getting to know the tenants that would fill these buildings, I became aware of these insidious conflicts, and I’ve been a tenant representative since 1993.
How has tenant representation changed the industry?
In the old model, the landlords and their brokers held all the cards. The tenants were merely a means to an end. With the advent of tenant representation, the industry is waking up to the reality that the tenants actually hold all the cards, because the tenants pay the rent. In truth, landlords are utterly dependent on the rent tenants pay as their sole source of income.
The problem is that many tenants don’t realize they hold all the cards, and those that do understand aren’t always sure of the best way to play that winning hand.
What kind of savings can CEOs expect by using a tenant representative?
It is significant. For most companies, real estate is the second-largest expense after payroll, and every dollar we save goes right to the bottom line. But it isn’t just about the hard dollar savings. We are also mitigating risk and negotiating flexibility into our transactions, which can be extremely valuable.
Landlords will always look for the highest possible rent for the longest possible guaranteed duration. Tenants typically want the lowest possible rent and the greatest lease flexibility. So we get creative, develop our leverage, and negotiate solutions that work for our clients.
Is there resistance to tenant representation from the old-guard?
Absolutely there is. From the landlord’s perspective, we are educating customers and helping those customers to develop and use their leverage, resulting in lower rents, greater lease flexibility and more tenant-oriented protections and concessions. You can bet the landlord will try and keep us out of the mix. Also from the traditional brokers’ perspective, we are calling attention to their Achilles’ heel, the dual-agency conflict of interest when they try and represent tenants, and it’s an argument they can’t win.