Monthly Archives: June 2016

Business Succession Planning – Am I Really Not Immortal?

Tue, JUN 28th, 2016

This article is for all business owners out there. You’ve spent the last several decades deep in the trenches. At first it was a real struggle. “Will I make the next payroll?”, “what if I lose that key customer?”. Then roots began to take hold. Your customer base expanded, your business processes solidified. Employees were added to back you up. The growth continued and your team grew broader and deeper. Each day you arrive at the office motivated to continue the project you began decades earlier: your business.

Yet, somewhere in your mind the thought arises that you need to plan for a future without you pulling the levers of control. You need to plan for your succession. If you are like the vast majority of business owners, you’ve done nothing in this regard – less than 30% of owners have a written succession plan.

We are not just talking about a handful of companies: over 95% of the businesses in the country are privately held – ranging from sole proprietors to multibillion dollar conglomerates. These private companies create 45% of our nations’ GDP; in fact 175 of the 500 largest companies are family owned. Yet, only 28% of family businesses have a succession plan while over 50% of small business owners – defined by the U.S. Census Bureau as firms with fewer than 500 employees – are over 50 years old. Despite this lack of planning 78% of owners intend to sell their businesses to fund their retirement. Surprisingly, 71% of business owners over age 65 intend to continue working indefinitely.

The most common succession plan is a vague notion that you’ll give the company to your kids. How realistic is this? In 1900 families on average had 3.5 children. Back then half of the work force was engaged in agriculture and an additional significant percent was involved in a labor intensive family business. In that environment it was likely that at least one of the children would demonstrate the attitude and aptitude to take the reins – and support their parents in their waning years. In 2006 the average household had 1.8 children and the effort and expense required to successfully launch them in our economic system is much greater. College is often in the picture. Graduate school is also a distinct possibility. Often the child’s career path does not align with the family business. So, if it’s not a slam dunk that the kids will take the business over, why don’t owners get serious about succession planning?

Succession planning requires business owners to face the uncomfortable reality of mortality. It also causes a reassessment of position in personal family structures, within peer groups, and larger communities. In many cases your identity as a founding business owner is closely wrapped up with your firm. You feel needed – essential in the lives of others. “I’ll get to succession planning when I have time” remains your dominant planning technique.

How can you get motivated to plan for your eventual exit? Focus on the same factors that helped you lead your company to success: control, choice, value, risk, and taxes. Let’s break these down. Succession planning allows you to have much greater influence on the future of your company. Devising a plan offers the opportunity for you to have greater control and choice in how the succession will impact various parties including sellers, buyers, employees, customers, and your community. The value you’ll likely receive in a planned succession is far greater than what you’d get in a forced sale or transition. Planning allows you to imprint your values on the transition. What is more important – maximizing the dollars received or ensuring long-time key employees, customers and the community benefit from the continuation of the business? What’s the appropriate balance between such competing objectives? A thoughtfully planned transition allows you to decide. Don’t forget that a solid succession plan greatly reduces risk for both you and the ongoing success of the enterprise. Finally, a thoughtful plan can go a long way toward reducing the tax bite that’s often a big factor in an ownership change.

Succession Planning is easy. Identify your goals, determine how to best meet those goals, and implement your plan. Easy yes – but far from simple. Let’s break this down. In phase one envision what you want and take stock of what you already have. This means a thoughtful assessment of the future you want for yourself, your family, and your company. Critically, envision how the company will continue to succeed with you no longer there.

Phase two involves protecting and growing your assets, institutionalizing the company culture and leadership, and building resilient business processes. It requires a clear assessment of the roles you fill in the organization and a clear analysis of who can take over those roles. Replacement management may be members of your existing team or may require bringing in new talent. The transition almost always requires a multiyear mentorship as the new leadership team learns the culture, core competencies, and customers of your enterprise. To maximize your control, choices, and value, and minimize your risk and tax bite the process needs to start well in advance of the transfer. An internal succession may take as much as a decade to execute successfully.

How should you handle an unsolicited offer for your company? First and foremost reach out to your team of advisors. Initially they will help you determine whether an internal succession is feasible. If not, and if the business is significant enough, they will most likely urge you to retain a quality investment banker whose role it is to help you structure your business for sale and identify strategic buyers who will place the greatest value on what you’ve created. A seasoned investment banker is extremely valuable. In one typical instance an owner received an unsolicited $12 million offer for his company. He realized he was ready to sell and, as his financial advisor, we encouraged him to hire a banker who knew his industry rather than take the first offer. He ended up selling for over $30 million.

A word on the Letter of Intent (LOI). Seller misunderstanding of the LOI is the biggest single factor that can cause transactions to fail. The LOI outlines the best possible deal the seller will achieve and signals the opening of a comprehensive due diligence process. The buyer will be seeking out any aspect of the business that is not as was represented and will insist on a reduction in price to compensate for all that are found. It’s critical to be sure all your business process are clear, clean, and concise before signing a Letter Of Intent. To be crystal clear – the time to have a skilled attorney on your team is BEFORE you sign your letter of intent, preferably months or even years before.

Another important insight is that sellers can normally dictate price or terms – but not both. Typical sellers will focus on the highest possible price. However achieving that top line number likely means accepting some ongoing risk. Perhaps the deal includes some seller financing with a recourse option if the terms of the debt aren’t met. Do you really want to foreclose on the business that likely has been poorly managed and may have lost critical staff in an effort to salvage your retirement dreams? Probably not. Be aware of this tradeoff as you structure your transaction.

You’ve made it through the article; congratulations. But what’s going to motivate you to act? Circle back to the benefits of succession planning – increasing your control, choice, and value while decreasing your risk and tax bite. Now pick up your phone, open your e-mail, or pound out a text and reach out to your professional team and set your succession planning process in motion!

John Bird, CFA®, CFP®, MBA
President, Principal and Co-Founder
Albion Financial Group
jbird@albionfinancial.com
(801) 487-3700.

Macro Focus – Thinking Through May’s Surprising U.S. Jobs Report

Fri, JUN 17th, 2016

As is often the case when the jobs number is released, my plan was to sit down and carve out some time to put into context for this blog the latest U.S. monthly employment situation report. After pouring over the data in this latest release, looking at the trends, and digesting the report against history and other current labor market indicators, the narrative became clear. Then, on Monday morning I came across Barry Ritholtz’s piece, which captured so nicely the tone I wished to convey that I dropped my pen (err … took my fingers off the keys) and decided to share his article instead. It is very good.

_______________

Job Market Is Getting Stronger, Not Weaker
JUNE 13, 2016
Barry Ritholtz

The reaction after May’s disappointing jobs report was predictable: The candidates babbled, markets trembled and expectations that the Federal Reserve would raise rates this month or next was suddenly off the table. All of this because the net increase in a group of more than 150 million employed people was 0.02533 percent versus analysts’ estimates of 0.10533 percent. That’s before we account for either 35,000 workers out on strike (0.02333 percent) or the margin of error of 100,000 (0.06667 percent).

I have discussed the problems of trying to model the economy in real time too many times to detail here. But let’s not look at the employment situation. Instead, let’s consider some data involving actual dollars.

I was reminded of this by a recent article that noted that tax data show that the job market is getting better, not worse.

‘The job market didn’t suddenly start sputtering over the past few months, as suggested by the surprisingly weak May employment report. Actually, the labor market has been getting stronger over the past several months after steadily losing steam last fall and then sinking with the stock market early this year. The latest data through Friday June 3 show that, over the previous four weeks, withheld taxes rose 4.7% from a year earlier, the fastest growth rate in seven months, an IBD analysis finds.’

This is a compelling line of thought, based on taxes withheld from payrolls. This data is from the Bureau of the Fiscal Service of the Treasury Department, which releases daily information on collected receipts. What we see here isn’t consistent with the idea that employment growth is slowing, and instead suggests a modestly expanding labor market.

A few caveats: First, this data isn’t seasonally adjusted; that means there are calendar effects, such as seasonality, annual or quarterly bonuses, and other issues that can skew it. Second, data on withheld taxes tells us little about the quality of those jobs being created. Last, tax cuts and increases also affect the numbers.

But it is hard data. The site Daily Jobs Update, run by Matt Trivisonno, tracks Treasury’s daily withheld tax revenue. Have a look at the chart created by the site showing monthly changes. It indicates a steady improvement during the past three months, and strong gains year over year.

taxes held

Note this is cumulative, so it benefits from prior monthly gains in employment.

The second chart is a plot of the annual growth rate of withholding-tax collections (red line) with a 21-day moving average (blue line).

taxes held 2

The chart reveals two things: First, the rate of growth in withheld taxes has been decelerating for the past 18 months; it was 5.5 percent in early 2015, and it’s now about 4 percent. That suggests a labor market that is maturing, and growing less rapidly than before. This is consistent with the idea that the economy is approaching full employment. This also jibes with the unfilled-jobs-opening data in the Job Openings and Labor Turnover Survey issued by the Bureau of Labor Statistics. As Trivisonno observes:

‘While this deceleration is similar to what we saw in 2008, it is much less steep. The Fed was trying to pop a real-estate bubble back then, but is far more dovish today. So, while the trend is clearly down, a 2008-style plunge seems unlikely without the Fed turning hawkish.’

Second, 4 percent growth is still growth that, as Trivisonno notes, counts for a lot in a low-inflation environment.

The key takeaway is that last month’s nonfarm payroll gain of 38,000 was a noisy number, likely affected by one-time events. It may also have simply been one of those months when the model generated a weak reading. This month may be the opposite, with a large number of new jobs. If that happens, it might be equally misleading. The bottom line is that it is premature to declare this economic expansion dead, and a recession imminent. As the data on tax withholding suggest, the economy is still expanding at a good clip.

_______________

Jason here, what Mr. Ritholtz is basically saying is that the labor market is nowhere near the stinker that the report’s headline, the pundits, or the financial markets all suggested it to be. And while my breath was certainly taken away for a moment at 6:30AM (MST) last Friday when the number crossed the tape, after further analysis in the hours and days since I tend to agree with his take. The report contained a lot of noise; there was much to unpack; and it simply did not jive with other firm indicators of the labor market’s strength – notably initial claims JOLTs, wages, and investment plans (which includes human capital). It is also noteworthy to consider the historic string of durable job growth that the American economy has enjoyed in this contemporary recovery. It is not unusual, in fact it is an expansion norm, to see soft months – what I refer to as growth “speed bumps” – along the way. Keeping that perspective in mind is good practice when assessing economic conditions.

Bottom line: the jobs report headline was indeed like a cold splash of water, but I urge caution in taking it at face value drawing broader dour economic inferences from it.

Jason L. Ware, MBA / Chief Investment Officer
Albion Financial Group
jware@albionfinancial.com
(801) 487-3700

Investing for Income

Mon, JUN 6th, 2016

Until the financial crisis, many investors could meet their income needs simply by investing in high quality bonds backed by blue-chip companies.  People found this to be an ideal match – they could meet their income goals without taking much risk.  However, as interest rates dropped, investing for income became much more challenging.  While the Federal Reserve has cautiously begun the process of re-normalizing rates, it could easily be several years until interest rates return to their pre-financial crisis levels.

This has created a real challenge for income investors.  It is not just bonds that have been affected. Other commonly used income investments are experiencing their own systemic concerns.  Oil and gas master limited partnerships have historically been a staple in many income portfolios.  However, the drop in the price of oil over the past 2 years has made these investments as challenging as ever.  Real estate investments face the opposite situation.  In many parts of the country, real estate values are at all-time highs.  As prices have gone up, real estate yields or “cap-rates” have gone down.

So what is an investor to do?  Unfortunately, there is no perfect solution.  As with most aspects of life, investing involves trade-offs.  Short term, high-quality bonds have historically offered investors a great deal of stability.  Stability is enormously valuable but it doesn’t pay much.  The purpose of this article is to briefly explore four broad categories of income investments.  Each has important risks associated with them.  Readers are strongly advised to work with an investment professional to fully understand these risks.

Bonds

The benchmark of a “safe and liquid” investment is a short term U.S. Treasury Bill.  Unfortunately, the yield on three-month treasury bills is 0.27% or just $2,700 a year on a $1 million investment.  As one moves away from bellwethers like this, bonds quickly become increasingly complex.  As the world witnessed during the financial crisis, simply relying on a bond’s rating to understand its risk is insufficient.  There can be financial engineering and gamesmanship behind the scenes that make it possible for bonds with very different risk profiles to hold identical ratings.  Fundamentally, the strength of a bond is directly tied to the health of the issuing entity.  Puerto Rico’s current inability to repay its municipal bonds highlights just how quickly and dramatically the health of the issuing entity can change.  In addition, bonds from the same issuing entity can also have different risk profiles if they have different priority claims on the issuer’s cash flows.

Another risk is what is known as duration risk.  The longer the duration of the bond, the more susceptible it is to interest rate risks.  Simply put, you feel differently about interest rates rising if your bond matures in 12 months than you do if you must wait 10 years to be repaid.  Theoretically, a 1% increase in interest rates will knock off close to 7% of the market value of a 10-year treasury bond, and close to 15% off the market value of a 30-year bond.  It would take three to five years of bond interest payments just to get back to where you started.

Dividend paying stocks (yield: 2-4% per year)

Quality dividend paying stocks tend to increase their dividend payments at a rate faster than inflation. Over the past 10 years, inflation has averaged just a bit more than 2%, while dividend paying stocks in the S&P 500 have increased their dividends by over 5% per year – more than double the pace of inflation.  A retiree living off of dividends from high quality stocks has seen his or her purchasing power dramatically increase over time.  Yet there is a tradeoff: dividend stocks are subject to stock market volatility. Additionally, there is no guarantee that a company will continue to pay dividends at its current level.

Real Estate Funds (yield: 4% – 7% per year)

Most readers are familiar with the basics of real estate investing.  In positive economic cycles, real estate investments tend to do fairly well. Done wisely, real estate produces reasonable cash flows and the opportunity for capital appreciation.  Real estate funds are attractive to many investors because they eliminate the time consuming aspects of owning real estate directly.  Unfortunately, many fund managers take much of the economic upside as well.  These funds take as much as 50% of the profit on top of annual fees.  A major risk for any real estate investor is buying at the wrong time.  Are we now close to a real estate market high?  Our crystal ball is broken but many smart real estate investors are currently choosing to be sellers rather than buyers.

Master Limited Partnerships, MLPs (yield: 5-8% per year)

MLPs are tax efficient investments that typically involve the transportation, processing or storage of oil and gas – such as pipelines.  Pipelines function as a toll road and most of their revenues are derived from the total volume of material they transport.  They are somewhat indifferent to the price of that material.  That said – supply and demand does have an impact.  If either drops, so will revenues – reducing cash flows available to investors and negatively impacting the firm’s stock price.  They are also subject to the credit risks of their underlying customers (energy companies) which is one of the reasons MLPs have seen their market values decline materially as the price of oil has fallen.  Like dividend stocks and publicly traded real estate funds, MLPs are subject to market volatility.

Private Debt Business Development Companies or BDCs (yield: 6-9% per year)

BDCs are funds that pursue a variety of strategies.  One is providing debt financing to privately held, medium-sized companies.  These firms typically pay higher interest rates on their loans than would larger public companies.  BDC investments may include leverage and pursue a wide range of businesses from risky start-ups to safer, more mature companies.   Because of this, the market price of BDCs can be volatile.  Look for BDCs that have a long track record and that provide floating rate loans to larger companies; floating rates will help protect you from rising interest rates and larger companies tend to have more alternatives if difficult economic times return.  Analyzing the health of any lender’s portfolio of outstanding loans is difficult but critically important.  A long track record gives investors some insight into a fund’s past underwriting success.

We began this article with the advice to keep risks in mind when analyzing any investment.  We close with the sometimes counter-intuitive advice to consider including some risks in your investment strategy.  A portfolio of just short term high quality bonds has its own risk – the risk of underperformance.  If an investor needs a 5% per year return to achieve his or her goals, investing only in short-term treasuries guarantees this investor will fall short (1-year treasuries yield just 0.54%).

That is the challenge with “safe” investments – you sleep soundly each night as you drift further and further away from reaching your investment goals.  Most investors need some exposure to stocks/equities to reach their goals.  The challenge is determining what asset allocation – what mix of stocks and bonds – is right for you.  Asset allocation is one of the most important factors in determining your investment success.  Touch base with your financial advisor and have this discussion.  If you don’t have a financial advisor, give Albion Financial Group a call. We’d be happy to discuss this with you.

Doug Wells, MBA, CFA, CFP
Partner
dwells@albionfinancial.com

Jon Larsen
Portfolio Manager
jlarsen@albionfinancial.com

Albion Financial Group
(801) 487-3700