As a Business Owner – Salary, Draw or Both!

When looking at a balance sheet, there are a few ways an owner can receive compensation at the end of the day.

How to go about this should involve an accountant and an attorney who is on the payroll or ones that are entrusted to give sound advice.

Depending on the structure of the company, the owner might be limited to the ways they are able to bring in a personal income from the business. Uncle Sam has regulations in place for owner compensation which is different as a sole proprietor, to a partnership, or to being incorporated or an LLC.

One way for a business owner to be compensated is with a salary.

This method includes the owner to pay employee taxes and employer payroll taxes. However, if you are an S-Corp or C-Corp, you do not have a choice and must receive a regular salary. If you are an officer of an LLC, which most owners are, then this method also applies. The company’s legal and accounting team will be able to determine the limits which best suit the business so not to overtax the owner.

Regardless of the business type, a salary has other benefits that are not directly related to the money received. It is one way to separate personal and business finances. This keeps the red flags down so Uncle Sam is less likely to audit from irregular cash flow. It can also help to regulate smaller businesses and be a source to offset other expenses. Another benefit to taking a salary is when the time comes for a business transfer or taking out a business loan. Especially if the compensation is comparable to a position the owner is doing in place of hiring an employee, this will allow EBITDA calculations to be easily obtainable in this respect.

Another way for a business owner to be compensated is with an owner’s draw.

For sole proprietors and partnerships, this might be the only way they receive compensation in the beginning. When growing a business, it can be difficult to factor in a salary too. However, when taking an owner’s draw, regular payments are still a good idea for the same reason as with a salary. Unwarranted audits are hardly welcomed, especially if they are easily avoidable. A simple way to calculate a draw is to gather the common personal bills and business receivables that can also be logically documented. These can include shareholder distributions, auto expenses (insurance, gas, loan payment), insurance and medical payments, and cell phone bills to name a few.

What about both?

When taking a salary, additional compensation in the form of a draw is also possible.

The right calculation for each company will vary. There are tax implications for each way of handling how compensation is received. Taxes are owed on profits and revenues which is where the draw is coming from, and taxes are owed on salaries in the form of employee taxes and employer taxes. Bring in the company’s legal and accounting personnel to answer what these implications are as they will be the ones handling the questions once tax time comes around. Knowing the entrepreneur salary options is the first step, having a solid team of business advisers is the safest step.

For further reading that asks all of these questions and more is, The Entrepreneur Salary: How Much (and When) Do You Pay Yourself?


By David M. Wang, Esq.

Collective Insights on business ownership has David Wang posing the question to business owners, “Should I Give Employees Equity in the Business?” with added food for thought from our in-house attorney consultant.

 

Many business owners need to find ways to recruit and retain employees. The cost of training employees is high, and finding a great employee can be difficult and time-consuming. The reoccurring idea to solve this problem is handing out equity. In other words, giving them a participation in the upside as a way of recruiting and incentivizing employees to stay. However, giving employees a piece of the upside is the most complex way to give employees equity. There are many things to consider when making a determination to go this route.

Giving equity is a taxable transaction. You are giving an employee an asset of value.

It may not be cash, but the tax code treats it as income. Outright giving the equity to an employee means that the company will need to do a valuation to determine the value of that equity. That valuation has a cost. The employee will report that equity as income and have tax liability for the value of that equity. The employee will not see getting the equity as a positive experience unless you pay for that tax liability.

Many business owners ask about granting options.

Their friends that work for Texas Instruments and Frito Lay get stock options. Stock options work for a publicly traded company because the employee can sell the stock to convert their stock compensation to cash. This cash can go toward the purchase of a car and pay the taxes associated with getting the stock. The equity of privately held companies does not have a market, and you do not want employees selling your equity to just anyone that will buy it. This means that equity in a privately held company cannot be converted into cash. In fact, the equity in most privately held companies does not produce any cash until there is a sale of the company, which in many cases is a long time or never.

The most complex part of giving equity is how you get it back when the employee takes another job, is fired or laid off.

Most businesses do not want employees to be able to keep the equity after they stop working for the company. The concept is that the employee needs to be employed when the equity becomes cash. This means that you will need to have buy-sell terms that deal with the employee quitting, getting fired for cause, getting laid off, getting divorced, dying and becoming disabled. These terms will need to include what triggers the buy-sell terms (i.e. what is “cause” and what is “disabled”), how to determine the purchase price, payment terms of the purchase price, and other important terms. Then, the governing documents (i.e. company agreement for a limited liability company) need to take into account voting rights of the employee, manage participation, tax treatment and other complex issues.

As you can see, giving an employee equity is complex and must be documented with solid agreements. You cannot go with an “understanding.” Employees will remember the “understanding” the way they need to remember it. Getting all of this squared away could mean a few thousand dollars in legal fees and other professional fees, including valuations.

One way to look at equity is that the only people that should be equity holders should be people that are your true business partners.

True business partners, in this sense, means that they are people that can and will borrow from their 401K to make payroll. They are people who will not “go get a job” when the going gets tough. The investment that is required to take on and deal with a partner is significant and that person should be worth that investment.

So when asking, “Should I give employees equity in the business?” the decision should include a conversation with your attorney and CPA for why, how and which ones. You can also consider giving employees participation in the upside through bonuses and profit sharing plans. These alternatives are usually easier to structure, give you more control, and can require less in professional fees. These alternatives can be explored in future articles.

 

David M. Wang is a partner of Grable Martin Fulton, PLLC. He is a business attorney with over 21 years of experience. He can be reached at (214) 334-4755, or dwang@grablemartin.com.

 


Losing Sight of the Big Picture is Easy to Do

Challenge: To Recognize the True Value of an Acquisition, Not Just Focusing on Today

TVG represented a project-based business that had a few million dollars in current backlog. This backlog represented over 100% of the current yearly revenue. When we went to market, our valuation was based on several factors including the historical cash-flow as well as the strength of the future backlog. The buyers agreed to the valuation in the Letter of Intent (LOI), but during the due-diligence period, the buyers got lost in the minutiae and tried to negotiate a lower price. The sellers were ready to retire but did not want a “fire sale” either. The buyers took the sellers’ desire for a quick sale as a weakness and tried several different ways to reduce the price.

Approach: Confidence in the TVG Valuation

TVG was confident in the valuation that we prepared and felt this was a fair yet aggressive price for this business. There were many existing positive attributes of the business that were addressed clearly in the valuation for the buyer to have the full picture of the selling company.

Finally, the seller was tired of the buyer’s indecisiveness and attempts to tear down the agreed upon price. The seller was ready to terminate the LOI and find another buyer. TVG understood the seller’s frustration. We discussed with the seller how we would make the buyer see reason and urged them to give the buyer another chance. TVG then went to the buyers and very bluntly explained to them that they were days away from the seller walking away from this deal. We showed them the solid facts that they would be missing a huge opportunity because they were trying to shave off a few dollars. The price of the deal was more than fair. On top of that, the value that this particular buyer would be able to bring to the company very quickly would more than make up for the feeling of overpaying for the company.

Result: Buyer Agreed to Honor the Original LOI

The deal was able to close in a relatively close proximity to the original closing schedule. Nine (9) months after the close, TVG followed up with the new buyers. The business had grown 25% in less than nine (9) months, and the new owner offered thanks and apologies for breaking down during the due diligence process.


Knowing and Understanding ODCF – Owner’s Discretionary Cash Flow

It cannot be stressed enough the importance of verifiable cash flow on a small business.

Replacing an income from corporate America is the main drive for a high percentage of first-time buyers. They are typically looking for a small business to “cut their teeth on” for their first or only business purchase.

What is ODCF?

ODCF stands for Owner’s Discretionary Cash Flow, which is simply defined as money able to be taken out of the business annually.

Why is it important to know about the seller’s ODCF?

A high percentage of first-time buyers come from retiring corporate America. Knowing what the seller is considering as ODCF will allow the buyer to know whether they will be able to immediately supplement their previous salary with the business income without dipping into operating costs. It is not just the owner’s salary that is considered ODCF, in fact, this number is often reduced so not to be overly double taxed with payroll taxes as an employee and an employer. There are many categories that can fall into this bucket on a balance sheet. 

Main elements that comprise the owner’s discretionary cash flow will include:

Net Income – The amount of revenue after paying all business expenses and before federal taxes have been paid. This can fluctuate to keep taxes down. Though prepaying expenses for a coming year might reduce the net income, it does not mean that the business is not profitable.

Owner Salary – This is not always a large amount as to not overly double tax as an employee and an employer.

Depreciation / Amortization – This is added to ODCF as these things reduce taxes as it decreases taxable income.

Interest Expense – This is not a category that is often taken over by the new owners. All previous owner loans and such type expenses should mostly if not completely be eliminated with the business transfer.

Non-Reoccurring Expense – This is a varying amount as the category suggests. However, it is important to see if the balance sheet can sustain this type of ODCF should the need arise.

Owner’s Perks – This is a common way to offset an owner’s salary. It can include things such as auto expenses, cell phones, travel, insurance and 401(k) contributions.

This overall ODCF amount may end up making a small business more appealing, but make sure it is all well documented.

How does ODCF affect the sale or purchase of a business?

Though it is true that many items can fall into the category of ODCF, a bank may not see it in the same light. This is not as much of an issue if the main financing for the business is seller-financed or the seller kept ODCF to just the basics of owner salary. An SBA or conventional bank will have other regulations to adhere to. Sometimes the only thing a bank will consider when making a determination to fund a business transfer is the EBITDA plus the owner’s salary.

 

Should you need to know more as a buyer or seller, the books by Alex Vantarakis, Entrance and Exit are available at our store.

Selling a Business – Woes to Heroes

Challenge: Reporting Financials / Partner Disputes

Due to partnership conflicts, a client went from being a passive minority investor to an active majority owner in a short amount of time. This was in an industry where they had limited knowledge. To further complicate the selling process, late paying customers and a non-traditional accounting approach made year-end financials appear drastically different from the health of the business, which would cause great pause for lenders. Given that a majority of business transfer deals are financed through some type of third-party financing, and saddled with the financial limitations of the company, it was obvious that the buyer pool could be limited, which in turn could increase the time to close. However, the seller was anxious to sell quickly, so we had to balance the seller, the business hurdles, and marketplace.

Approach: Expanded Deal Structure / Demonstrated Value

Established Expectations – Because of the late-paying customer and non-traditional accounting methods, we understood the lending climate would be limited at best if not non-existent. For this reason, we informed the seller that a significant amount of seller financing would potentially be involved. We provided an estimate of value as well as an expected deal structure before engagement ensuring the seller would be open to all types of offers and to lay the foundation that a full-price all-cash offer would be the exception and not the norm.

Told the Story – While every buyer could see the financials were on a decline, the company still had some great assets. 1) The company still had multiple strong accounts, 2) they were focused in a very niche industry within the IT sector, and 3) they still had multiple channels of revenue. The core of the company was still intact and with a focused growth strategy, a new buyer could easily return the company to producing higher revenues.

Focused Marketing Search – Given the issues of the company, we understood a generic buyer probably would not be the best buyer to target. We knew we either needed a strategic partner who understood the assets of the company and could create synergies or an IT professional who wanted to run his own operation.

Result: 
Received 3 competing offers | Closed in 4 ½ months | Seller received 94% of asking price

  • An IT professional purchased the company using a ROBS (Rollover for Business Startups).
  • The purchase price comprised of equity from the buyer and a seller note.
  • Since no outside banks were used, we were able to have a quick close and save time.

 

 


Unlock Your Business’s Potential

The value of a small business is primarily driven by its profitability. In most small businesses, there are numerous opportunities to enhance revenues, increase gross margins, and reduce costs. Improvements in each of these areas can result in significant increases in the value of your business. For many small businesses, every dollar in increased profitability will produce approximately three dollars in increased business valuation.

Many small business owners do not have the capability to re-evaluate their whole business on their own. However, a quick way to start, if an advisor is not in the budget is to look at a business’s waste. This can be in the form of raw materials or time. A reduction in waste almost always directly correlates to a reduction in costs and an increase in revenue. Looking at a business from this perspective often leads to other insights for process improvements resulting in higher revenue.

Although many changes can be made quickly, to maximize the benefits of the business sale process, the improved profitability has to be reflected in the financial statements for at least two (2) years before the sale. In other words, if you begin to implement changes only three (3) months before selling, the business valuation will not reflect the positive changes of your last three (3) months. It is never too early to implement profitability improvement efforts, but it is best to try to do so at least four (4) to five (5) years in advance of a business sale.

To gain a better understanding of how small businesses can improve their margins thus improving their business valuations, please consider reading this article: 5 Simple Ways to Improve Your Profit Margins

 

 


The first step in the right direction is deciding to use a business broker because you don’t know what you don’t know!

Ask questions, expect questions and review standard documentation.

Be Bold and Ask Questions

This is your business and selling it should be handled professionally and with transparency.

Credentials such as being affiliated with the national IBBA and local state associations such as TABB in Texas are marks of a knowledgeable broker. However, this information is not always right out in the open. Ask if they have any affiliations. If they are not of these, look up the ones they provide.

Prior business ownership, regardless of the exact type of business, is a foundation of understanding from both sides of the process. Though not necessary, our firm believes in having that connection to better facilitate the transfer.

Expect and be Ready to Answer Questions

The right broker will have a solid understanding of financial analysis and more specifically, an explanation of their own financial analysis process. If they cannot do this…walk away. The first meeting should include them asking you about your business’s financial health and how they plan to market to the right buyers. They should be able to explain these two topics logically and ethically. If they cannot do this…run away. This is not an area of “feeling” the numbers but rather there should be a clear and coherent way they can explain to the seller how they plan to market a business for the price that is dictated by financial and transparent market analysis. From this, options for the deal structure should be presented. The seller should not be railroaded into one plan of attack. Ask about past closed deals and how they were closed, especially for ones that mimic the current company for sale.

First Impressions Really Do Matter

When meeting a prospective buyer, will your business broker be presentable? Will the location or office? Set up a meeting early on to see what the prospective buyer will see. During your meeting, do not be afraid to ask for copies of blank documents such as LOIs, Listing Agreements, Confidentiality Agreements (CA) and Sample Marketing Packages/Plans. These can make or break a deal before negotiations begin. Are they visually presentable? Do they contain viable and valuable content for the buyer?

A major topic of your first meeting or even prior to your first meeting should be that of confidentiality. The broker should initiate this conversation early on. The timing of when it is brought up is indicative of how it is handled in general throughout a deal and even after a deal is closed.

Lastly, References…References…References

To choose the right business broker to sell your business, be prepared with your questions and with the deliverables the broker should bring up to you. If you cannot check off those boxes in your first meeting, continue your business broker search.

 

To learn more about choosing the right broker for you, get EXIT – A Business Owner’s Guide To Selling a Company, by Alex Vantarakis.

 


Murphy’s Law – “If something can go wrong, it will.”

In this case, a deal killer or Murphy’s Law surrounds the concepts of communication and being mindful of a proven process.

The Vant Group was engaged to assist the buyer in a business transfer purchase. They hired us to find a business, and quickly, the buyer ended up finding a business on his own through another source as it was not yet on the market for sale. We met with the buyer and seller and had a great meeting. We indicated at the meeting that we would offer him full price, and the seller was pleased with this arrangement.

The seller, who was not our client, called us back the same day and told us that he was very impressed with the meeting and wanted to know if he could use our services moving forward in the future or at least utilize us for advice. Every aspect of this business transfer deal was going quite smooth.

Here is where Murphy’s Law comes into play, and here is how one simple step can kill a deal.

We, our team at The Vant Group, assumed (and assuming will always make an ass out of you and me) that the seller understood that we wanted the business and would provide the LOI to the seller after we had done some very preliminary work up front. The meeting and follow-up had been effortless and with the business not even being on the market, we felt we were already ahead of the game. Well, the assumption was incorrect. Because he did not hear from us, and he did not want to be pushy to call us for our letter of intent, he did not know that we had an LOI already written up. We were under the impression that we were all on the same page.

Since we did not keep up our usual constant communication with him for where we were in the process, another buyer came along and offered him full price, and he signed the deal. So, though from our end, we did everything within a reasonable amount of time, what we did not do is make a simple phone call or send an email saying, “We are on it, let us know if you have any questions. We will get you an LOI.”

Murphy’s Law (as we state here, it is communication or lack thereof that kills deals) came into effect; because if we had done things in our usual manner, even though we were under the impression that it was a done deal, it would not have slipped through our fingers.


– Like Anything In Life, There Are Pros And Cons

Franchise Advantages

Buying a franchise provides resources that can bridge the gap between learning a new business and industry by having a franchise system in place which ensures the likelihood of success through the initial transition years.

The largest benefit of buying a franchise is having that proven system and training for the new owner and their employees. As a franchisee, you don’t have to be the idea man; just follow the system that has the proven success record.

One of the other great advantages is customer exposure by the way of location. One of the resources of almost any franchise is site selection assistance with a professional real estate marketing partner. Having access to a tried and proven demographic model will greatly improve the probability of success.

Franchise Disadvantages

Other than the initial purchase period, and depending on the particular franchise, the franchisor may not provide much assistance or value for the franchisee. The monthly franchise fee, which is between 3-7 percent of gross sales, is mostly allocated to the approved advertising budget. This usually focuses on a national audience and can sometimes be ineffective for the franchisees business and/or area if it doesn’t take into account for current local market trends.

Another disadvantage is the restrictive nature of expanding the business. As the franchisee develops their business, the franchise opportunity often begins to feel confining to an entrepreneurial spirit. Traditionally, it is not possible to implement unique branding or issue process changes into the franchise system.

It is important to ask questions up-front of other owners, vendors, or see an existing franchise location to help answer any of the questions associated with what the owner is willing to accept when moving forward with a franchise purchase.

Exit Strategies Available

Many franchisors have buyout options for franchisees that have outgrown the program. The guidelines of a franchise, the Uniform Franchise Offering Circular (UFOC), will have the procedures for buying out or selling the franchise.
Some franchise programs will even have a transition team that helps sell the franchise, which is often the best opportunity to obtain the highest price when selling the business.

To learn more about franchise business pros and cons get “ENTRANCE“– A Business Owner’s Guide To Buying a Business”, by Alex Vantarakis,


When surveying buyers on why they decided to buy a business, the most common answer is, “I’m tired of working for someone else”.

While being your own boss can be a very rewarding experience, the desire to become a business owner does not automatically mean you should. As an employee with a steady and mostly consistent paycheck, a person can typically just focus on their role in the company and not have to worry about the other facets of running a company.

When becoming a business owner, every decision and responsibility now falls to this person. Being a business owner takes a certain mindset and skillset, and sometimes buyers think they can buy their way to success. Like anything else, buying a business is a process and asking the right questions and creating the right timing for action is critical, even when buying an existing successful business.

Here’s a great article for buyers looking to purchase a business. It details the top questions a person should ask before buying a business.

 

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