In this article we will look at some practical issues worth considering with regard to extracting value from your business. My intention is not to consider any technical valuation models but rather to present some important considerations and food for thought for business owners.
Who owns your business?
It may seem obvious to some, but it is important to remember that, if you run a business through a company, the company theoretically owns the business. You may own the shares and be a director, but it is a separate legal entity through which the business produces income from trading.
The most common ways to extract value from a business that is trading in a company are through salaries, dividends or sale of the business.
Salaries vs dividends
Keeping in mind that salaries need to represent remuneration for services rendered, which allows the expenditure to qualify as valid business expenses, the salaries paid to all employees, including directors, need to be justifiable to SARS as paid in the production of income. As a result they cannot be paid for no, or an unjustifiably small amount of, services rendered.
Within the confines of the above principle, there is then a trade-off between salaries paid to directors (who are also shareholders) and dividends declared and paid to shareholders. These two types of payments attract different effective/marginal tax rates as follows:
The effective tax rate for a company declaring a dividend is currently 42.4% (for tax years ending February 2018), this being the 28% companies’ tax and the 20% dividends tax (being a shareholder tax, but withheld by the company on payment of the dividend). The highest marginal tax rate for an individual is currently 45%. This rate starts at income earned by individuals above R1,500,000.
Less tax is therefore payable on a salary up to an amount of R1,500,000 (assuming no other income in the hands of the individual) - the marginal rate being 41% up to that amount - than on a dividend at the effective rate of 42.4%.
For shareholders who are directors, it is worth considering this “mix” between salaries and dividends (also taking into account monthly personal cash flow requirements).
Availability of cash and shareholder personal finances
A further consideration that follows from the above is whether the shareholder has personal expenses or liabilities to furnish that are attracting high finance costs that would be better off settled in the short term.
To the extent that excess cash is available from the business it may be worth settling such personal liabilities. On the other hand, a profitable business may be generating high rates of return (return on assets/return on equity) and therefore cash re-invested into the business may generate higher rates of return than the finance costs incurred in the shareholder’s personal capacity.
There is a trade-off between removing cash from a business and keeping cash available for expansion in the business. It is important to be deliberate about this. Excess cash not invested in the business (for example remaining idle in a current account) should be considered for investment to earn higher returns, either in the shareholder’s personal capacity (once received through a dividend), or in the company. On the other hand, it is important to ensure that the business has sufficient liquidity on an ongoing basis, and should therefore have a certain amount of cash reserves available at all times.
Your life’s work, in a number
Being approached by someone to buy your business can be a wonderful “once in a lifetime” opportunity. You may be presented with an offer you cannot refuse. A good example would be where someone offers you an amount for your business that, based on your current or foreseeable forecasts of net profits, amounts to a return on investment over a period of time that extends beyond a date you had in mind in the future for retirement (i.e. all things equal, and taking into account inflation, you will have reached your preferred retirement age before generating that amount of value from annual net profits from your business).
The above may however be a rarity. A far more challenging exercise is attempting to sell your business at a time when you wish to retire. If you had never before had your business available for sale, or never before considered the saleability or potential selling price of your or a similar business, the answer you arrive at may not be what you had expected.
Some businesses, arguably, do not have any real value for third-party sales. A good example of this is a business offering a service that, primarily, you perform yourself. A sale of this type of business is potentially going to involve many years of your continued involvement to make it viable to any purchaser, if at all. It may therefore be worth considering alternatives to extracting value from the business over time, and ensuring good investments are made to cater for the future.
Can you afford to sell your business?
The advantage of running a business over an extended period of time, other than increasing the value of the business (through expansion for example), is that you are able to extract value along the way, through dividends and salaries, which can be used to re-invest for the long term (retirement funding, property, investment portfolios etc. as alluded to above) or to settle personal liabilities such as a bond over a family home or vehicle finance.
Due to lifestyle decisions however it is quite possible that, should you be considering a sale of your business at a point in time, you may come to the unfortunate conclusion that most or all of the proceeds from the sale would only serve to settle all your liabilities, leaving very little for investment into the future either for retirement or to start a new business to continue for the foreseeable future.
It is therefore important to match your lifestyle with your business value (ongoing extraction and potential future sale) to ensure you don’t fall into this type of situation, particularly toward the end of your active working years.
Complexities in connection with a sale of business
Here below are a few things to keep in mind, on an ongoing basis, in relation to an imminent or potential future sale of business.
Management retention: As part of a sale of most businesses, key management personnel will need to be retained in order to ensure the business continues operating unhindered and profitably. Part of the strategy for extracting value from a business (monthly/annually) should be a consideration of whether key management are being incentivised to remain with the business long term.
Staff loyalty: Often a two way street: you hope to retain staff on an ongoing basis who have the best interests of the business in mind, and similarly, people employed at your business would hope that the business owners keep their best interests in mind with regard to the sustainability and continuity of the business and their employment.
Client/customer retention: It goes without saying that a business needs clients/customers to continue in existence. These clients/customers are not bound to your business (unless specific contracts exist) and are therefore free to move to other service or product providers as they see fit. Part of the value in a business is therefore the client/customer base and whether the relationship is easily sustainable with a measure of certainty. It is important therefore to consider whether your clients/customers are loyal to you personally, or to your business as a whole.
Value in someone else’s hands: It is always worth keeping in mind what your business looks like to a third party. Keeping an objective view of your business allows you to identify areas of improvement that would increase the current and potential future value. Bear in mind that someone else may be able to do what you do better. This would indicate that the inherent value of your business may be worth more than you have in mind, and this may be a good indication of where you could improve your business currently.
As can be seen from all of the above there are various considerations, both ongoing and for the future, that extend far beyond a simple valuation of your business based on profits and a required rate of return. For most people running a business, significant (if not all) time and resources are invested, hopefully generating wealth for current and future generations to enjoy.
It is worth taking the time to reflect on issues such as those detailed herein to plan ahead to ensure your business serves you, and those around you, well.