Summary of Issue:
Long-time partners built a very successful business. One of the older/original owners was ready to retire and enjoy the wealth that was created in “the business.” Arxis Financial was contacted to calculate that value and assist the owners with negotiating a buy-out. While that sounded simple, without advance planning, it rarely is. In this case, multiple businesses were created over the years for licensing and other purposes. “The business” was really several businesses with different ownership structures and cash flow. Therefore, there was no buyout of ownership in “the business,” it would be the buy-out of several businesses.
Entrepreneurs think a lot about the end of the business-building process. That thinking generally extends to developing the plan to create wealth, and then someday far off into the future enjoying the created wealth. Rarely, unfortunately, does that thinking involve establishing legal structures and entity identity that lends itself to a smooth exit strategy. But once the exit process begins, attorneys, CPAs, and valuation experts must deal with the situation as it is, not how it might have been, or how one of the owners meant for it to turn out.
In this case, there were several complexities that are presented below as entirely representative of many situations where there is little thought to the “end game”:
- Intellectual property – Business names, relationships, formulas, goodwill, patents, contracts are all intangible assets that require valuation triggered by an exit event. The first step in that valuation process is understanding the ownership of the asset. In a setting where there are multiple entities, the shareholders are often surprised by a report showing which entity actually owns the intellectual property.
- Cash flow – In closely-related businesses, the source and use of cash flow associated with the equity interest in a business can be difficult to assess. With limited internal controls and accounting policies, accounting and transaction flow can become disconnected from economic reality. In this case Income from business A was deposited in the checking account for Business B and several expenses, such as rent, were paid by Business C, although the expenses were properly allocable to all businesses.
- Ownership structure – None of the complexities described so far would matter very much if all the entities were commonly owned by the same shareholders in the same proportion. If two people each owned 50% of the equity of each of the entities, the entities could be more easily valued. In this case, there was disparate ownership percentages and, additionally, some equity owners did not have an interest in all the businesses the entities. Therefore, everything needed to be valued separately, requiring separate representative annual cash flows established for each of the businesses.
The departing partner was involved in the day-to-day operations of one business and, for years, had paid little attention to other lines of the business. His perspective and understanding of the profitability of the business was distorted and inaccurate leading to unrealistic expectations of the value of what in his mind was “the business.” It also led to underestimating the difficulty and effort needed to value the business.
The buyout of the departing owner was a big disappointment. There was no evidence of dishonesty or malfeasance in the accounting for the companies, just years of neglect and ignorance of the consequence of adding owners and entities. The actual costs associated with the various businesses had been masked; extensive work was done to identify the cash flow and intangible assets associated with each business. In the end, the “original” business had very little value and the subsequently formed businesses (where ownership had been “given away to keep employees”) were more valuable.
Beyond the valuation issue, the key take-away from this case from a business ownership perspective is the ongoing necessity (throughout the life of all related businesses owned and intellectual property developed) of working with attorneys and CPAs to properly structure any new business entities, and overall ownership structure, to meet the business transition goals of ownership. Contact Arxis Financial if you need such assistance.