hanlogo.gif (5096 bytes)


Appraiser Beware : Potential Liability is There !


Skimpy or loose-end reports, short-cut techniques, false methodology of some highly sophisticated or convoluted approach - all wrong. All problems when it comes to business valuations.

Too often appraisers do not start with common sense as the "rule of thumb" and realize the valuation process, particularly if there is the risk for liquidation to occur post-transaction, must be based on Internal Revenue Service standards - specifically, Revenue Ruling 59-60. Here, the most important language is "reasonable knowledge."

In a number of instances non-qualified experts are hired who , because of inexperience, unfamiliarity or just partly for self-serving reasons - i.e. fee income, place values on business far in excess of reality. They think that they are working in the best interest of their client in "setting up" the value of a business. In reality they are only increasing the probability for an IRS audit and potential penalties to themselves. Thus, before you allow an appraiser to take on a valuation, check out his or her credentials! Cause them at the outset to come to "the conclusion" to make sure their final report and your "objectives" are met. Otherwise, appraisers beware. The IRS might be looking for you under a multitude of penalties including assessments for the following acts:
bullet Negligence [IRC Sec. 6662(b) and 6662(c)]
bullet Substantial Understatement of Income Tax [IRC Sec. 6662(d)]
bullet Substantial Valuation Overstatement [IRC Sec. 6662(b)(3), 6662(f) and 6662(h)]
bullet Overstatement of Pensions Liabilities [IRC Sec. 6662(b)(5), 6662(g) and 6662(h)]
bullet Estate and Gift Tax Valuation Understatement [IRC Sec. 6662(b)(4), 6662(g) and 6662(h)]



An understanding of the methods plus access to relevant data are the keys to unlocking the mystery.The business valuation process doesn't have to be as complex and mysterious as one might think. All one has to do is use common sense and keep in mind the words of the Internal Revenue Service in Revenue Ruling 59-60, where value is defined as the "price at which a property [i.e. a company or a product] would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts ."Companies seeking outside help with the valuation process should understand what techniques are being used [see Ruling - Box for Key Revenue Rulings], since some so-called "experts" have a tendency to place an unrealistically high value on a company, thinking it will be in the best interest of the client when entering into negotiations. In reality, these inflated valuations only hurt the chances for a sound transaction.


There are a number of generally acceptable valuation methods, but caution should be used when selecting a particular method, since circumstance often suggest one method to be more suitable than another. For example, family law in California downplays the use of price/earnings and liquidation as primary methods, considering them only when used in concert with one of the other methods.

The five generally accepted valuation methods are:

Price/earnings multiple


Capitalization of adjusted earnings


Adjusted book value


Discounted cash flow


Liquidation (assuming a quick sale)


In order to arrive at an accurate valuation, the following information about the company must be provided:


A definition of the company's products


An outline of the industry


A description of the market


A discussion of the company's corporate uniqueness. (Especially important if a premium price is being assigned relative to the industry)


Financial data for the last three to five years


A balance sheet for the current year and for the last two years, explaining specific intangibles such as copyrights and patents


Overdue trade obligations and bank indebtedness


A forecast of future profit and loss expectations, for one year and five years


Details regarding management's credentials, shareholder positions, and the general organizational structure


A description of the physical facilities


Information about any employee/union contractual obligations


Investment data, including marketability and investment restrictions on corporate securities





Mistakes that should be avoided are:


Using non-recognized methods and formulas


Applying arbitrary discounts


Careless use of comparatives


Inappropriate capitalization rates


Adjusting for non-current items and non-operating assets/income


  1. The key to successful valuation is what is described as the "Three C's":
  2. Be CONCISE in the facts presented. Keep the format simple and the material all-inclusive. The valuation should be fully supported by its underlying documentation.
  3. Be CONSISTENT in principles used. Do not use a particular method today in order to "get by" if different circumstances in the future will likely require a different method.
  4. Use COMPARABILITYs to test the result. Compare the valuation arrived at to historical data, to the industry, and to other valuation methods. It's a good idea to use two different methods of valuation to arrive at the same conclusion. This way, the opinion rendered will be harder to dispute.
  5. Finally, remember that objectivity and common sense are the primary guideline in business valuation. If you're an owner or a seller, ask yourself, "Would I, if I were a buyer, arrive at the same pricing conclusions?" If so, you are on your way to a successful transaction. Remember the top 10 Revenue Rulings.

(See following rulings)


The Business Valuation Process:

Ten Key Revenue Rulings


59-60: Stocks and Bonds

65-193: 59-60 Modified

66-49: Donated Property

68-609: Excess Earnings

77-287: Restricted Stock

80-233: Charitable Contributions

81-253: Minority Discounts

83-120: Preferred Stock

85-99: Charitable Contributions with Donor

Restriction on Use

93-12: Family Stock Transfers



Description Fiscal Years
(Year ending December 31) (-1) (0) (+1) (+2)
Revenues - Incremental Assumptions $3.7 $4.81 $6.25 $8.13
(1) Revenues % 30 30 30
Actual $ incremented revenue growth over prior year 1.11 1.44 1.88
(2)Profit before tax, after all other costs (excluding 30% management bonus) % 45 45 45
Actual $ incremental profit .50 .65 .85
Prior Year 1.60 2.10 2.75
Base Profit $2.10 $2.75 $3.60
Base Profit for Valuation purposes:
Prior year 1 1.00 1.60 2.10
Prior year 2 1.60 2.10 2.75
Total 4.74 6.45 8.45
3 year average 1.33 1.58 2.15 2.82
Market Valuation Range:
At 6 times profit (65/75% sub renewal rate) 7.98 9.45 12.90 16.92
At 8 times profit (75/85% sub renewal rate) 10.64 12.64 17.20 22.56
At 10 times profit (85% plus sub renewal rate) 13.30 15.80 21.50 28.20
Base Paid Total Consideration Paid
(1) Payment Schedule based on 8 times multiple achievement:
on legal completion of 9/94 10.64 10.64
on settlement of 1994 accounts (3/97) 12.64 2.00
(11) Earn-Out
on settlement of 1995 17.20 4.56
on settlement of 1996 accounts (3/97) 22.56 5.36
Total Consideration in US$ 22.56

(See Case Study # 1)


L & B Pipe & Supply v. Commissioner

Doc. 10329-91, T. C. Memo 1994-187

Case - excess owner compensation: 15% of net sales. Result: IRS lost - 100%! Why, in essence - the experts: right credentials, a sound legal strategy, well prepared and good team interplay, based on realistic valuation methodology.

Who were the experts? EMCO/Hanover, with extensive experience in business turnarounds, capital appreciation and the industry itself; a CPA with specific competitive, geographical industry experience; plus an expert from print media in an industry trade publication.

The defense experts: different ages, complimentary backgrounds versus the single, IRS witness who would not use specific industry data, instead relying on statistical, survey data not tailored to the exact case at hand. The result - a happy client, a winner who was able to pick the right experts!



Estate Planning Vs Merger/Acquisition

Some time ago, EMCO/Hanover was asked to look at a specialty database publishing company whereby the owner believed his business was worth around $10 million based on pre-tax earnings. Since this was being done to support the pricing of the sale of the Company, and not for estate planning, our approach was somewhat different. We treated the income statement as if it were a publicly held company, eliminating owner "extra" benefits, i.e. excessive salaries, non-direct perquisites and unnecessary tax deductible business development costs. We then capitalized appropriate costs under correct GAAP guideline in order to realistically reflect gross margins. The result was not a $10 million value but one that could be upwards of $28 million. Quite a difference! Remember, however, if this valuation had been for estate planning purposes, we probably could have easily justified using a $7-10 million valuation - six times (6x) versus the ten times (10x) selected by causing the Company to focus more on subscription renewals.

A second technique employed here in the body of our report was also to analyze for this potential buyer what it would cost to have someone then enter the company's marketplace. Our seller/client was involved in a merger/acquisition transaction where it was very important to understand that their asking price can be based on the "market entry" values assigned to a business's components. In simple terms, If I (buyer) want to go it alone and not acquire you (seller), how much more would I have to spend versus acquiring your "complete operation", with a defined organization and profitability?



Valuation for a Private Placement

Now let's look at a different scenario! What happens, however, when you have no earnings or an asset base - i.e. a high technology medical product just out of research and development. In these cases you have to be extremely cautious with a finiteness to details - especially in revenue projections, for these can be easily challenged with the results solely based on the appraiser's credentials. It is the latter which builds the convincing documentation necessary. In certain cases, we must recognize, too, that there are industry statistics available. Substitutes could be new public security offerings memoranda, often referred to as an IPO, or selective survey material through a trade periodical/association. Other support data might be customer "usage letters" - whereby they indicate their needs or lend "testimonial" to your product(s') usage! In these instances, a knowledge of the marketplace itself and how others are pricing comparable securities is important, particularly when selling a company in the same industry to a buyer. Here client management participation is key and without them, not even a cost interstructure can be built. In our case we relied heavily on potential customer usage's, laboratory pre-test results and regimented industry data from leading professional periodicals. Difficult, yes but it caused $5 million in new capital formation from a source whose identity plays a key role in the pricing for the company's initial pubic offering! How about thirty times (30x) projected earnings after receipt of capital.


Next Special Issue :

Capital Alternatives, an owner's choice





Capital is probably the least understood and most expensive word in the business dictionary. When you need it most, you can never find it. And when you do find it, the costs are sometimes so high you don't want it after all.

In this two-part series on raising capital, we'll discuss the basic sources of financing and give you tips on how you can negotiate for the capital you need without having to give away the farm.

Equity Financing

With equity financing, you do have to give away at least part of the farm, since sources of equity capital want ownership in the business in order to participate in the profits. After all, if it's such a winning proposition that it deserves a capital commitment in the first place, wouldn't any smart business person want a piece of the action?

Some sources of equity financing:

Individual Investors: Where fledgling companies often turn in order to get off the ground, but usually of limited resource and not to be relied upon for later financing.

Corporation: A good source of capital for companies with compatible products.

Employee Stock Ownership Plan (ESOP): Provides the additional benefits of an attractive tax shelter and a way to lock in key employees.

Venture Capital: A prime source of funds, but requires a demanding growth pattern of at least 30 percent per year. Venture capitalists look for a compound annual rate of return of 35-50 percent or more on their money over a three to five year term. They look for sales volume of $20 million or more after five years.

Small Business Investment Company (SBIC): Often funded through the Small Business Administration, this offers a combination of equity and/or long-term loans, sometimes with convertible features and favorable interest rates.

Public Offering: Costly and demanding in terms of reporting requirements by the SEC. However, smaller offerings of under $7.5 million (S-18 Filing) or Reg. "A" exempt filings (short form) for up to $1.5 million provide some latitude and are less stringent.

Personal and Business Associates: Often the most overlooked but easiest source of capital, since the investor knows the people involved in the business.

Debt Financing

With debt financing, you need not give away the farm, just some of the revenues from it. Sources of debt capital do not ask for ownership, but they do demand varying amounts of "rent" for letting you use their money.

Sources of Debt Financing are:

Commercial banks - The most common source of financing and the one which best serves the following ongoing business needs:

Short-term credit - For working capital in the form of lines of credit for cyclical needs.

Medium term credit - For plant expansion or modernization requiring interest and capital debt servicing over three to five years.

Long-term credit - For major expansion, plant and equipment, real estate or acquisitions on terms up to 20 years.

Savings & loan associations: Traditionally these are a source for real estate financing of a commercial nature. Some of these institutions have also formed asset-based lending departments.

Commercial credit companies: Usually engage in "asset" lending. There is often less concern as to the financial performance of the business than with banks, but this could be reflected in higher interest charges.

Factors: Predominantly involved in accounts receivable financing, whereby a company gets a fixed percent advance against sales invoiced and the factoring company collects and administers the accounts receivable as its own asset.

Other Sources of Financing

Sometimes all it takes for successful business financing is a little creativity and the willingness to explore some unusual sources.

Here are some ideas:

Research and development grants: These can arise from a variety of sources, including government, research establishments, foundations or corporate entities. The source usually looks for a common interest in the project, something that will fit into their future plans if proven successful.

Private foundations: Included in this category are private trust accounts set up by individuals. A typical example is the Ford Foundation.

Corporate annuities: Usually covered under various insurance programs, such as guarantees or completion bonds.

Joint ventures: Capital maybe provided by a corporate partner with the entrepreneur doing the project work. The investor sometimes wants the tax write-offs, if any, and thereafter each party participates in revenue under an agreed upon formula.

Licensing agreements: Usually where the company has hidden (off-balance sheet) assets in the form of patents, copyrights and trademarks, all of which may be sold for lump sums.

Vendor financing: Typically applies where a company finances a customer from its own resources in order to effect a sale.

Pension funds: Many corporate and governmental pension funds have entered the specialized capital market and may have funds to invest.


EMCO/HANOVER Case Study - A Capital Alternative

Accountants we'd worked closely with in the past, called EMCO/Hanover and asked us to review a situation with one of their clients. The client was quite successful in the high-tech manufacturing business, with the government as a major customer. Two serious buyout proposals had been made to their client, and the founder/ entrepreneur was considering these proposals, as well as thinking about going public.

Capital Option # 1: Sell

Both buyout offers were in the same ballpark: $2.5 million down and $2.5 million earn-out over the mid-term. But based on the company's financial statements, and even considering the notorious unreliability of governmental contracts in the industry, we felt the company was worth more.

With such a profitable company and no plan to retire anytime soon, we wondered why the owner was considering selling in the first place. Then the truth came out. The company had an earnings retention problem and the owner was worried about having to face the tax liability. Something would have to be done about that.

Capital Option #2: Go Public

Next we turned our attention to the possibility of going public. We enlightened the owner in two areas - that there was no such thing as an underwriter's commitment (except within 24 hours of the closing itself), and that he would be at risk for at least $300,000 in underwriting costs plus six months time, with no certainty of going public at all, much less at the right moment for high-tech stocks. We pointed out that only a handful of companies with its profile went public in 1988, and the swirls and eddies still apparent after the '87 crash could make his launch uncertain. Perhaps 1997 could produce a similar market.

Capital Option #3: ESOP

So having established the undesirability of the proposed buyout, and the unfeasibility of a public offering, why not have the owner keep the company, establish an ESOP to build up some equity, avoid his retention problem, and pick his own fruit? All he would have to sell in order to qualify would be 30%, and the set-up costs for attorney's fees and the appraisal would range from $30,000 to $50,000 - a far cry from the $300,000 it would cost him to go public.

What would he gain from setting up an ESOP?

First, he would retain control of his company.

Second, the transaction price would ultimately yield a higher result, as long as profitability and growth could be sustained.

Third, the contributions made to the ESOP would be tax deductible (even though his own compensation would not be deductible, at least initially).

Fourth, careful structuring of the transaction mechanics would probably eliminate the concern for earnings retention.

Fifth, the sale to ESOP under Section 1042 would

result in deferring recognition on the gain if proceeds are invested in certain qualified replacement property.

In essence, the ESOP option would allow the owner to gain some liquidity, to build his own management, in all likelihood to attain a higher value for his company, and to retain control of his own destiny.

As it turned-out, the result of this engagement was not to confirm a decision at all, but to introduce alternatives and considerations so that the owner could make a better decision.

Ten Highlights of an ESOP

Creates capital for company and shareholder(s)

Enable employees to share in the growth and prosperity of the company through ownership of the company stock

Provide tax deferment benefits to employees - no tax liability to participants while stock is held in trust

. Allows owner to gain liquidity while maintaining control of the company

. Motivates employees, enhances morale

. Allows timely transfer of control

. Provides a means for less costly financing

. Create a market for the stock

. Provides business continuity

. Increase corporate cash flow


Familiarity with the basic rules of capital formation is a necessity for an owner to survive in today's highly competitive capital markets. We still today have the pleasure of the "go-go" markets of the 1980's. Initial public offerings (IPOs) remain strong but for how long and for whom - usually only for the exotically profiled companies. If you are not one of these, perhaps, you should learn what is often referred to as the Five Rules of Capital.

Knowing these five rules of capital is critical to understanding capital markets and knowing which sources best fit a particular situation. How is such value determined? Value is typically based on one's Standard Industrial Classification (SIC) Code and the industry standards used to calculate value. For most industries this is determined by multiplying one's earnings after taxes by the capitalized rates found for comparable companies whose securities are sold in the public marketplace, i.e. on the New York, American or Over - the - Counter Stock Exchanges. Once a company's value is determined, in today's "open" capital markets, just about all capital sources ask for third-party opinions regarding a borrower's financial records and performance. In particular they want to look at the quality of review and certified opinion. The more capital being sought, the greater the need for a CPA certified opinion. Financial sources are also demanding to see copies of the auditor's management letter. Lenders really zero-in

on this as the letter critiques the quality of the financial control side of the borrower's business operations. While the five rules of capital always hold true, the exact requirements of lenders and investors vary with changing economic conditions. Also, none of the requirements are absolute. Financial sources will accept lower ratios or some demand higher ones depending on the individual circumstances of the particular industry and company involved.

By knowing the rules of capital, one can then determine which type of capital you are qualified to get, its costs and availability. Too often, business owners seek capital for which they cannot qualify. If you do your homework and understand the rules, hopefully, you may avoid a disappointing experience - bad or no capital

(see below)

Capital's Five Rules

1. Often the primary capital available is debt. Because of this you should know about your Interest Burden Coverage. Lenders will look closely at your ability to cover interest expenses. A company is required to demonstrate that it can generate at least two to three dollars of income before taxes for every dollar of interest expense to be incurred, including any existing or new debt.

2. You have to Demonstrate Sufficient Cash Flow after taxes because lenders will take a close look at your ability to pay that which you are borrowing. Generally lenders require 1.5 dollars of cash flow for every dollar of amortized debt on a per annum basis.

3. You should know what your Mortgage Debt Coverage is, as lenders apply a special set of capital requirements when funding commercial real estate. In today's market, a good rule of thumb is to demonstrate at least 1.2 dollars of annual earnings after base carrying costs, (i.e. property maintenance, real estate taxes, to name just a few) but before interest and corporate taxes for every one dollar required to carry mortgage debt.

4. Equally important is to know the Collateral Advance Ratios, for asset-based lenders have their own guidelines regarding accounts receivable (typically 75-80%); inventory (from 0-50%); and machinery/equipment (70-80% of "true value"). For example, "eligible" accounts receivable (those under 90 days) usually have a borrowing capability of 80 percent versus inventory of 20-50 percent (excluding actual work in progress). Fixed asset borrowing is typically based on 75 - 85 percent of their liquidation value while real estate borrowing in today's market is worth 65 cents on the dollar. This latter advance varies geographically, too!

5. Lastly, take the Equity Capital Appreciation Test. Today's venture capitalists and other equity investors are looking for a 30-50 percent per annum compound return. Say, for example, in return for a $1 million investment, over a five-year period, the investor must accumulate $7.6 million in equity appreciation (i.e. growth in value). The business would have to grow to more than $15.2 million in capitalized value for the owner to retain controlling interest, defined as 50.1 percent of the equity account, based on the aforementioned $1 million of new equity dollars.


Middle-Market Companies Can Expect More Competition, More stringent Rules for the Availability for Capital Over the Balance of the Next Decade

The balance of 1990s could be a difficult time for raising capital. At one time the public securities market could be relied upon for new capital or restructuring existing debts. But in 1989 only 203 new companies sold stock to the public, down from almost 700 in 1986. Will 1997 repeat this? Mergers and acquisitions could be on the decline as well, if the public market goes out of favor.

Complicating the issue is the decline in the federal deficit but not the nation's debt, and consumer credit, which is near an all time high. Commercial banks and finance companies, traditionally a primary source of capital for smaller businesses, could be tightening their own requirements, if the economy slows.

So where is new capital coming from? Primarily foreign investment. Japan, the United Kingdom, the Netherlands, Canada, and West Germany currently represent 90 percent of the total foreign capital in the United States. Since these same five countries are also heavily invested in Europe, any world or U. S. recessionary pressures could have a rippling effect on the amount of capital available to middle-market business.

The bottom line is that tomorrow's capital is going to be more competitive, more costly, and difficult to obtain. The following is a 13-step program which we have used successfully to help companies compete effectively for capital.

1. Develop a business strategy.

This is a mandatory step in the capital procurement process. In essence, what is the end result you want to accomplish?

2. Define separately your capital needs.

Remember that for each dollar of sales required, a dollar of capital in some proportion is also required.

3. Research what capital is available.

Capital is like any other commodity - it must be diligently sourced so that once obtained its cost will not cause a negative "backlash" to the recipient.

4. Know the rules.

Understand the type of capital you need and how much it costs. Know about standard coverage ratios, for example, and don't waste time applying for financing for which you can't qualify.

5. Select the type of capital that best suits your needs.

There are basically five types of capital available to a company: venture capital; short-term capital from commercial lenders; long-term capital from institutional sources; mortgage capital; and equity capital. Make sure you choose the right kind of capital for your needs.

6. Use a qualified professional.

The agility to comprehend potential sources of capital and their realistic cost is key to the capital search process. Hire a professional who can interpret, qualify, identify, structure, and negotiate the sourcing of the dollars desired.

7. Intelligently start the search process.

Knowing where and how to find capital is a unique art. If you give the effect of "shopping" a transaction, for example, a capital source is unlikely to address your need on an "ASAP" basis.

8. Ask questions of the capital source.

Ask such questions as, "Have you ever done a transaction of this type?" or "What are the costs, approval process and timing involved?" or "What is involved in your due diligence procedures?" No one expects you to be an expert in capital formation.

9. Don't become entrapped by your capital needs.

When was the last time you heard a company went out of business while in search of capital? This is particularly true in public securities offerings which can cost in the $250,000 to $500,000 range before you even go public. The best time to seek capital is well in advance of the actual need.

10. Create a favorable competitive environment between several capital sources.

Treat capital source relationships just as you treat vendor relationships. Look for the best terms under the best conditions. At the same time, try to create a "two-sided transaction" - one that is satisfactory both to you and the capital source.

11. Negotiate terms.

Of all the costs associated with obtaining capital, probably the least important is the actual interest rate. More important covenants include ownership rights, operational control, limits on executive compensation plus owner's personal guarantee, and restrictions on the procurement of new capital. All these factors are subject to negotiation.

12. Close the deal.

Using an "intelligent sense of compromise, " close the deal without trying to squeeze out the last dollar of costs. Use the same techniques that you use in establishing customer or vendor relationships. Know when to stop negotiating!

13. Employ your new capital prudently.

This is important since you want your funding source to support you when your next need arises. Your ability to raise new capital will depend on how well you spend the moneys from the last capital raised.


If your company is on the verge of a major growth spurt, selling stock through an initial public offering may give you the capital you need to expand to new heights. But just because you have a commitment letter from an underwriter doesn't mean it's a done deal. A commitment letter is not a formal agreement to fund. It's a statement of interest that says both parties will proceed in good faith to work out an agreement with respect to the public offering. The commitment letter spells out conditions and costs, all of which you should be aware of before proceeding. Don't be so anxious to close the deal that you fail to read the details or assume that your advisors are handling everything.

Read the Underwriter's Commitment Letter

To help you avoid some common IPO pitfalls, here are some of the ingredients of the underwriter's commitment letter.

Boilerplate: Some commitment letters can be 15-20 pages in length, most of which is standard copy that comes straight off the computer. Often included in the boilerplate copy is a disclaimer that the letter does not constitute a firm commitment by the underwriter and that there are certain contingencies the company must conform to in order to ensure the underwriter's best efforts.

Amount of Capitalization: This section tells how many shares are to be sold and at what price. Important here is the actual number of shares to be outstanding at the conclusion of the offering and what percentage dilution new shares will be in relation to the total shares outstanding.

Costs: In a typical arrangement, the underwriter will purchase the securities from the company at a ten percent discount and require a non-accountable expense allowance of another three percent. This expense allowance may be stated as a fixed dollar amount, such as $50,000, and be required up front so the underwriter has a "Kitty" from which to work. This is just one of the outlays you must be able to afford ahead of time. In essence, for every dollar of stock a company sells, a company nets only 87 cents. And this does not include other related costs such as legal fees and printing costs. In addition, there are blue sky expenses associated with filing documents with the various state governments where the securities will be sold. This is a cost to the company, not the underwriter.

Underwriter's Restrictions: The underwriter may restrict further public offerings under a right-of-first-refusal clause for a period of up to five years. There may also be certain anti-dilution provisions preventing the company from subdividing its outstanding stock or selling its shares for less than the market price as nationally quoted. Many underwriters also include consulting contracts in their compensation agreements. For example, the underwriter may charge a consulting fee of $5,000 to $7,500 per month for a three year period, payable in its entirety at the close of the offering. This amounts to an aggregate fee of $180,000 to $270,000, which will come out of the offering proceeds.

IPOs Can Be Expensive

Going pubic is not cheap. Expenses mount up, not only in the form of cash outlays after the offering is completed, but also up front, before any money has been received. Such costs could easily approach $75,000 to $500,000, and this is without the guarantee of a public offering ever occurring. Also, you will be required to hold the underwriter harmless against any liability, claims and lawsuits to which it may be subject under various security acts, particularly the SEC Act of 1934. In essence, make sure the information you give the underwriter about yourself and the company is correct. And make sure the underwriter conveys such information clearly and accurately.

Other costs include the transfer agent's fees and the costs of holding annual meetings and issuing certified quarterly and annual reports to shareholders. You may also have to pay a fee to the finder/intermediary who introduced you to the underwriter. In the event the underwriter wants to proceed and you want to cancel, there will be a cancellation fee which typically runs one percent of the face value of the offering.


Establish banking relationship before the loan is needed

Eight rules for dealing with a bank

The most important thing to understand when dealing with a bank is its need for assurance that it will be repaid. This means that your business usually must have both a primary and secondary source of repayment in order to get a loan.

Here's some advice on how to deal with bankers

1. On a regular basis, when your monthly, quarterly or annual results are compiled, give a copy of the statement to your bank. Use this opportunity to explain where you are going financially and how you are performing according to your objectives,

2. Familiarize your bank with your industry and product lines, for every industry has its uniqueness as well as particular cycles and seasonalities. Since you can't expect your bank to know every industry, it takes time for your bank (even as it took you time) to become familiar with the habits of your company and industry.

3. Use facts (real numbers) in dealing with your bank, not cosmetics. The bank wants to know the real earning power of your company, its ability to service and repay a loan, and, of course, the collateral value underlying your assets. Remember that banks are "mathematically oriented" and that they like to use historical results to make projections. Before they lend money to solve a temporary problem, they'll want some insight into your company's future in order to know what the longer-term effect of the money will be.

4. Before you make a request, put yourself in your banker's shoes by asking: "Is my request reasonable? Does it make sense? Do I have the standards the bank requires?" A corollary: Don't waste time going to a bank which is not a lender to your particular industry.

5. Get to know more than one loan offer at your bank. Since bankers do move to other institutions, you may not have the time to educate your banker's replacement when you badly need money.

6. Don't be misled into falsely thinking you have a "deal" just because a banker says he's interested in your company's financing need. Instead, get the banker to express his interest concretely with a detailed proposal - covering the amount, terms, covenants and rates - so you won't be surprised by the bank's response or conditions at zero hour.

7. Be aware "everything is negotiable" - from interest rates to deposit requirements down to the last financial covenant. Like a car salesman trying to sell you extra options, a bank is looking out primarily for its own interest.

8. Be aware, too, that other banks and commercial lenders may offer a loan if you become disenchanted with your bank. That disenchantment could arise from your negotiations or if your bank turns you down flat. Just because you got your loan at one time does not mean you will get it a second time. It is always tougher to get a loan in bad times. For that reason, you must treat your bank just like you do your most important customer. Communicate with your bank in good times too.

Check out our credentials: Since Group inception, more than $3 Billion in Capital Transactions worldwide, as financial advisors More than 200 business turnarounds Plus hundreds of corporate valuations

(EMCO/Hanover's credentials have been accepted multi-state and by U. S. Tax courts)

The MANAGEMENT GAZETTE is a newsletter published seasonally during the year by The EMCO/Hanover Group It is distributed as a public service to clients and other persons interested in the business of management. Information contained herein is intended for general use and should not be used as a substitute for professional advice. The EMCO/Hanover Group cannot be held responsible for the accuracy of information contained in articles submitted by guest contributors. Readers' comments and suggestions are invited.

Please address correspondence to Bruce W. Barren, Executive Editor, The EMCO/Hanover Group

11740-11 Sunset Boulevard, Los Angeles, CA 90049, fax (310) 478-3988

Send e-mail to: brucebarren@emcohanover.com


The Management Gazette

Vol. X, Number 1 Special Edition 1


Lessons from a cash-strapped entrepreneur

Question: How can a company that seems to do everything right somehow fail to attract the "right capital"?

Answer: By paying too much attention to its products and its customers and not enough attention to its capital needs.

Case in point is a retail dress manufacturing business started with $25,000 in borrowed funds. With excellent products and superb marketing techniques, the company managed to gross $250,000 in its first year. By the third year, sales could easily have reached $3 million. But in order to do the $3 million, the owner had to rely on a fabric supplier for $300,000. Because of a cash crunch, the account became in arrears, and the supplier asked for a 50 percent ownership to convert his receivable to equity in the business. The owner refused.

The owner had no choice, then, but to scale down her cash needs by scaling down her sales. So instead of doing $3 million in sales with $600,000 pre-tax profit in her third year, she had to settle for $2 million in sales and only minimal earnings.

Had the owner done some things differently when she first started out, it's unlikely she would have hit the wall as she did in her third year.

The Sizzle Factor

For one thing, had she tried to get equity capital in the beginning, she would have been able to do so under much more favorable terms. Even though it may have cost more and been harder to find, the truth is that equity capital can be sold on "sizzle" in the beginning. And since the fabric supplier already knew her when she started the business, chances are he would have offered more favorable terms then, as opposed to three years later when she was clearly in a pinch.

No Financial Statements

Another mistake our owner made was to disregard the importance of having an operating plan and monthly financial statements. Not only would any potential investor have been in the dark as far as the company's financial situation was concerned, the lack of sound cash management techniques would have raised serious questions about the owner's ability to succeed.

Here are a few thoughts you might consider before beginning the capital formation process which our owner did not do until it was too late.

bulletDetermine the amount of capital needed, taking expected growth into account, and justify its usage.
bulletWrite up the details of your operating record.
bulletBe realistic about what your company is worth.
bulletFind an investor that understands you and your industry.
bulletBecome a student in the rules and "tools" of capital, namely financial forecasting, historical analysis, control systems and after-tax "cash" earnings.

Need Capital? Don't Let Ego Blow the Deal

Here are three common pitfalls you can guard against

Going after expansion capital can be a stretch for everyone involved. Even old hands at raising money can make mistakes.

Here are three pitfalls companies should avoid:

  1. Putting all the eggs in one basket: Firms need to create a "competitive arena" in which different capital sources compete to provide financing. A $30 million aerospace company tried going public in an initial public offering (IPO), but had no contingency plan in place. When the IPO fell through, they were forced to sell the company to a competitor.
    2. Wanting too much too soon: Defer hard negotiating until due diligence is complete and you've got a real offer to look at.
    When a food company tried a $1 million private placement, the owner nixed the first source after opening negotiations, without a formal offer on the table. After shopping the deal he learned the first source had been the best after all but by that time he needed $5 million.
    3. Over-negotiating: When the source meets most of your cost expectation, don't pussyfoot around. Make the deal, provided you can live with the cost!
    Example: When a manufacturer wanted better terms on a bank credit agreement, he let the current credit arrangement expire. But that allowed the bank to switch interest rates from commercial paper to LIBOR rates. The manufacturer lost two points trying to get a better deal. Cost $300,000 in annual interest alone.


Capital is probably the least understood and the most expensive word in the business dictionary. When you need it, you can never find it in time, if at all, and when you do locate the funds you need, you are surprised by the costs.

Before explaining what is or is not negotiable in capital procurement, you must first understand three things about yourself as a potential borrower:

1. If your situation involves asset- based lending, "lendable" collateral is most important. In essence, lenders base their advances against accounts receivable, inventories, machinery/equipment, and real estate.

2. In the case of asset commercial banking or private placement, your interest burden coverage ratio plus cash flow are critical to determine your organization's ability to carry service interest and principal.

3. Your company's current and post-closing debt to equity ratio are important, particularly in evaluating a capital source's risk and return factors.

4. The capital source's experience in your industry and type of lending you desire.


Lenders or investors usually analyze a transaction separately. Just because a particular source has financed a similar transaction for your company or your industry, it does not mean it will do it again especially under the same terms and conditions. In fact, a capital source may decline to finance your situation so as to maintain a diversified portfolio or to prevent a conflict of interest with a competitor it has already financed. Only after you have evaluated your profile in relation to these noted standards can you approach a capital source to seek financing for your needs.

Here are the main essentials of a financial transaction:

Definition of objectives. What is the end result you want to accomplish?

Use of qualified professionals. You may want to hire a consultant if one is not already on staff. That person should be a professional who can interpret, qualify, negotiate, structure, and identify the sourcing of the dollars desired.

Capable and qualified negotiation as to capital sought. The need to be able to comprehend the potential sources of capital and its realistic cost in a negotiation is critical. The box below lists the negotiating points for five types of capital transactions.

The ability to close the deal. You must always close with an intelligent sense of compromise. Remember, everything in capital procurement is negotiable.



Looking for capital? Be prepared for your meeting with your banker by knowing your company's key financial ratios.


Financial ratios are a valuable tool for revealing your chances of obtaining capital, what type of capital you are most likely to get and how to approach lenders, creditors, and investors. In addition to improving a business's ability to raise capital, financial ratio analysis helps management maintain sufficient working capital, make accurate projections, analyze management performance, and measure the profitability of company units, products, and departments.

Ratios place financial data in a meaningful context and highlight areas in need of further investigation. Here are some hints to get the most from financial ratios: Compare your ratios to your competitors' ratios and to industry standards. Use the Standard Industrial Classification (SIC) Codes as the basis for your research and get financial information from trade publications, government figures, and corporate annual reports. Track and compare your own financial ratios from month to month and year to year. Generally, three to five years worth of records are necessary to see meaningful trends. For seasonal businesses, comparing monthly ratios from one year to the next is particularly revealing. Compare your monthly ratios with your short- and long-term plans and budgets to get early indications of whether things are progressing as planned. Presented here are nine key financial ratios (and their methods of calculation) used by lending institutions to evaluate capital needs, performance, and condition of a company.


1. The Working Capital to Sales Ratio shows how effectively a company's working capital is being used to generate sales

Net Sales Working Capital: Working capital is defined as current assets (cash, accounts receivable and inventory, less current liabilities). Generally, the higher the ratio, the better. However, a cash-rich company may have a lower ratio than a financially troubled firm with little working capital.

2. The Current Ratio reveals a company's ability to meet its short-term obligations.

Current Asset Current Liabilities: Current assets include cash, marketable securities, receivables and inventories, excluding prepaid expenses. This ratio should always be greater than 1:1 and at least 2:1 for manufacturers with large inventories. In most cases, any decrease in the ratio means a reduced ability to generate cash. Conversely, too high a ratio may indicate poor management of working capital.

3. The Quick Ratio also measures a company's liquidity and ability to meet immediate obligations. The difference here is that the quick ratio eliminates inventory from current assets which gives a more accurate picture of the company's ability to meet its short term liabilities.

Liquid Current Assets Current Liabilities: Liquid current assets are defined as cash and its equivalents (i.e., marketable securities), and accounts receivable. Generally, the quick ratio should be at least 0.6:1 and preferable 1:1. Too high a ratio may indicate that excess cash is sitting idle.

4. The Total Debt to Equity Ratio indicates a company's degree of financial leverage.

Total Liabilities Stockholders' Equity: Total liability is defined as the company debt, including trade payable, but exclusive of debt owed to shareholders or that which might be converted into company equity.

As a rule, this ratio should not exceed 2:1 if you are looking for quality financing terms. Anything higher indicates a company should avoid further debt increases to finance inventory or fixed assets. Conversely, a ratio that is too low, say 0.3:1, may indicate the company is not taking advantage of the availability of debt capital and therefor not realizing its full potential.

5. The Return on Stockholder's Equity Ratio measures a company's return on equity (invested or permanent capital).

Net Income after Taxes Stockholders' Equity = %: The returns should be at least equal to the current fiscal period's inflationary rate and well exceed what could be earned on a relatively safe investment such as Treasury Bills. Management's capital efficiency can be tracked by following this ratio over time.

6. The Profit Margin Ratio, Net Income to Net Sales is also traditionally expressed as a percentage and measures the actual return a company has on its sales.

Net Income After Taxes Net Sales = %: Be cognizant of unusual nonrecurring events such as inflation or a change in accounting methods, that could skew your numbers. When tracked over the years and compared to other companies, this ratio gives a good indication of how well your company is being managed. A decline in this ratio may signal the need for cost controls or for a hike in prices to offset rising costs. It is also useful to apply this ratio on a product-by-product and gross margin basis.

7. The Interest Burden Coverage Ratio measures how many times interest expenses are covered by a company's pre-tax income.

Net Income Before Taxes Interest Expense: It is used primarily for "new" borrowing to measure a company's ability to carry the cost of a proposed financing. The higher the ratio, the greater the ability to meet interest obligations. To qualify for new borrowings, a company should have an interest burden coverage ratio of at least 2:1 to 3:1.

8. Lenders widely use the Debt Amortization Ratio to determine a company's ability to repay debt financing.

Net Cash Flow Annual Debt Principal Required: Generally, the accepted standard here is a minimum of 2:1. However, in periods of restrained credit policy, it is often lowered to 1.5:1.

9. The Sales to Fixed Assets Ratio shows the productivity of the net fixed assets and reveals the fixed asset investment level required per sales dollar.

New Sales Fixed Assets: This ratio tells how effectively a business is using fixed assets to generate sales. There is no defined standard of this ratio, although there are guidelines by industry. For example, high technology might be 8:1 to 10:1, heavy manufacturing might be as low as 1:1.

Case Study

This company was originally formed as an R&D limited partnership some four years prior. It had just completed its development stage, had one product currently being marketed in the medical heart instrument industry and expected sales to rise to the $10 million level by year two (with commensurate profits of $2.8 million). Pre-financing book equity was $350,000 based on a "technology" invested capital base of $1.8 million. In actuality, the "defined" capital request was for $2 million, which was a 1.5 times fund factor (the equivalent of a 50 percent back-up reserve for contingencies) to the estimated net cash flow required during the company's commercialization phase of growth. A venture capital firm was approached by the company, and given certain information that was contained in a written investment proposal. Management had agreed to form a new business to which would be transferred all of the rights of the technology in exchange for a combination of preferred and common stock.

Amount of capital desired : $2 million in the form of direct equity capital.

What went wrong: One of the most overlooked and misunderstood element of capital procurement is that relating to either equity and/or operating control of a business. In this case, management was not willing to give up certain rights in each category for the $2 million to be invested. They tried to "hard Negotiate," yet had no alternative capital source available.

The rule: If you have only one source of capital, watch your negotiating style. Obviously, alternative sources are the best solution if you have the "leisure!"


Next Special Issue :

Mergers & Acquisitions



Stumped with a valuation or a litigation problem ?

Need fresh insight?

Fax or call us. The Gazette has seen a lot. We'd be pleased to field your initial question-gratis-as a service to our readers.

Telephone: 310/207-4300 FAX: 310/478-3988

Bruce W. Barren, Executive Editor

Julia P. Cominos, Special Edition Editor

Patrick N. Elliott, Senior Copy and Layout Editor


Check out our credentials:

Maxon Industries, Inc. (LA 90-05670)

Westward Ho Markets (LA 93-42048-SB)

Creative Presentations, Inc. (SV 96-18973AG)

Lumber City v. Commissioner (Doc. 94-10934,

T.C. Memo 1996-171)


(EMCO/Hanover's credentials have been

accepted multi-state and U.S. Tax courts)


The MANAGEMENT GAZETTE is a newsletter published seasonally during the year by the EMCO/Hanover Group It is distributed as a public service to clients and other persons interested in the business of management. Information contained herein is intended for general use and should not be used as a substitute for professional advice. The EMCO/Hanover Group cannot be held responsible for the accuracy of information contained in articles submitted by guest contributors. Readers' comments and suggestions are invited. Please address correspondence to Bruce W. Barren Executive Editor, The EMCO/Hanover Group 11740-11 Sunset Boulevard, Los Angeles, CA 90049, fax (310)478-3988 or call (310) 207-4300.