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Month: January 2020

7 Types of Corporate Reorganization

Corporations reorganize and restructure for various reasons and in numerous ways. The bottom line usually is, well, the bottom line. Companies reorganize to increase profits and improve efficiency. The reorganization of a company typically addresses the efficiency component in an attempt to increase profits. It’s not unusual for a corporation to reorganize on the heels of changes at the top. A new CEO often sees reorganization as a cure for a company’s ills, and companies sometimes hire a new leader based specifically on his vision for reorganization.

Possible Reorganization Reasons

Corporate reorganization normally occurs following new acquisitions, buyouts, takeovers, other forms of new ownership or the threat or filing of bankruptcy, according to the Thinking Managers website. The VC Experts website reports that reorganizations involve major changes in a corporation’s equity base, such as converting outstanding shares to common stock or a reverse split – combining a company’s outstanding shares into fewer shares. Reorganizations often occur when companies already have attempted new venture financing but failed to increase company value.

Type A: Mergers and Consolidations

Section 368 of the IRS Revenue Code identifies seven types of corporate reorganizations. As reported by Tax Almanac, the first recognized reorganization type is a statutory merger or acquisition. Mergers and consolidations are both based on the acquisition of a corporation’s assets by another company, according to the firm Greenstein, Rogoff, Olsen & Co., LLP.

Type B: Acquisition – Target Corporation Subsidiary

A Type B reorganization is the acquisition of one company’s stock by another corporation, with the acquired company becoming a subsidiary of the acquiring corporation. The acquisition plan must be carried out in a short time period, such as 12 months, and the acquisition has to be only one in a series of moves comprising a larger plan to acquire control. The transaction also must be made solely for the purpose of acquiring voting stock.

Type C: Acquisition – Target Corporation Liquidation

Unless the IRS waives the requirement, a targeted corporation must liquidate as a condition of a Type C acquisition plan, and target-corporation shareholders become shareholders in the acquiring company. Reorganization provisions dictate tax consequences, not liquidation rules contained in Tax Code Sections 336 and 337.

Type D: Transfers, Spinoffs and Split-Offs

Type D transfers are classified as acquisitive D reorganizations or divisive D restructurings, which include spinoffs and split-offs. For example, if Corporation A contains the assets of former Corporation B and of Corporation A, Corporation B goes out of business, and former Corporation B shareholders control Corporation A.

Type E: Recapitalization and Reconfiguration

A recapitalization transaction involves the exchange of stocks and securities for new stocks, securities or both by a corporation’s shareholders. The move concerns just one company and the reconfiguration of the company’s capital structure. Possible scenarios include a stock-for-stock recapitalization plan, a bonds-for-bonds move and a stocks-for-bonds transaction.

Type F: Identity Change

A Type F reorganization plan is defined in the Internal Revenue Code as “a mere change in identity, form or place of organization of one corporation, however (a)ffected.” F reorganization rules generally apply to a corporation that changes its name, the state where it does business or if it makes changes in the company’s corporate charter, in which case a transfer is deemed to occur from the prior corporation to the new company.

Type G: Transfer of Assets

Type G reorganizations involve bankruptcy by permitting the transfer of all or some of a failing company’s assets to a new corporation. One caveat is that the stock and securities of the controlled corporation are distributed to the previous company’s shareholders under Type D – transfer reorganizations – rules for distribution.

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3 Types of Business Bankruptcy

Most new small businesses don’t survive and are faced with the decision concerning whether they should file for some form of business bankruptcy. About one-fifth of new small businesses from 2005 to 2017 survived only one year.

Bankruptcy is a process a business goes through in federal court. It is designed to help your business eliminate or repay its debt under the guidance and protection of the bankruptcy court. Business bankruptcies are usually described as either liquidations or reorganizations depending on the type of bankruptcy you take.

There are three types of bankruptcy that a business may file for depending on its structure. Sole proprietorships are legal extensions of the owner. The owner is responsible for all assets and liabilities of the firm. It is most common for a sole proprietorship to take bankruptcy by filing for Chapter 13, which is a reorganization bankruptcy.

Corporations and partnerships are legal business entities separate from their owners. They can file for bankruptcy protection under Chapter 7 or Chapter 11, which is a reorganization bankruptcy for businesses. The different types of bankruptcies are called “chapters” due to where they are in the U.S. Bankruptcy Code.

Chapter 13 – Adjustment of debts with individuals with regular income

Chapter 13 bankruptcy is a reorganization bankruptcy typically reserved for individuals. It can be used for sole proprietorships since sole proprietorships are indistinguishable from their owners. Chapter 13 is used for small business when a reorganization is the goal instead of liquidation. You file a repayment plan with the bankruptcy court detailing how you are going to repay your debts. Chapter 13 and Chapter 7 bankruptcies are very different for businesses.

Chapter 13 allows the proprietorship to stay in business and repay its debts and Chapter 7 does not.

The amount you must repay depends on how much you earn, how much you owe, and how much property you own. If your personal assets are involved with your business assets, as they are if you own a sole proprietorship, you can avoid problems such as losing your house if you file Chapter 13 instead of Chapter 7.

Chapter 7 – Liquidation

Chapter 7 business bankruptcy may be the best choice when the business has no viable future. It is usually referred to as a liquidation. Chapter 7 is typically used when the debts of the business are so overwhelming that restructuring them is not feasible. Chapter 7 bankruptcy can be used for sole proprietorships, partnerships, or corporations.

Chapter 7 is also appropriate when the business does not have any substantial assets. If a business is a sole proprietorship and an extension of an owner’s skills, it usually does not pay to reorganize it. and Chapter 7 becomes appropriate. Before a Chapter 7 bankruptcy is approved, the applicant is subject to a “means” test. If their income is over a certain level, their application is not approved. If a Chapter 7 bankruptcy is approved, the business is dissolved.

In Chapter 7 bankruptcy, a trustee is appointed by the bankruptcy court to take possession of the assets of the business and distribute them among the creditors. After the assets are distributed and the trustee is paid, a sole proprietor receives a “discharge” at the end of the case. A discharge means that the owner of the business is released from any obligation for the debts. Partnerships and corporations do not receive a discharge.

Chapter 11 – Business reorganization

Chapter 11 may be a better choice for businesses that may have a realistic chance to turn things around. Chapter 11 business bankruptcy is usually used for partnerships and corporations. it is also used by sole proprietorships whose income levels are too high to qualify for Chapter 13 bankruptcy.

Chapter 11 is a plan where a company reorganizes and continues in business under a court-appointed trustee. The company files a detailed plan of reorganization outlining how it will deal with its creditors. The company can terminate contracts and leases, recover assets, and repay a portion of its debts while discharging others to return to profitability. It presents the plan to its creditors will vote on the plan. If the court finds the plan is fair and equitable, it will approve the plan.

Reorganization plans provide for payments to creditors over some time. Chapter 11 bankruptcies are exceedingly complex and not all succeed. It usually takes over a year to confirm a plan.

Small Business Reorganization Act of 2019

Recently, the Small Business Reorganization Act of 2019 was passed by the U.S. Congress and signed by the President. It enacted a new subchapter V of Chapter 11. The Act will go into effect on February 20, 2020. This subchapter of Chapter 11 seems to favor the side of the applicant for business bankruptcy. It only applies if the applicant wants it to apply.

Subchapter V, for example, does not require that a committee of creditors is appointed or that creditors have to approve a court plan.

Sole proprietorships or incorporated entities should consult with a good business bankruptcy attorney before deciding on which type of bankruptcy you will file or whether you need to file bankruptcy at all. There may be other options that can be explored.

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What the Small Business Reorganization Act of 2019 Means for Creditors

Small Business Reorganization Act of 2019 “Reorganizes” Ch. 11 Bankruptcy Proceedings in Favor of Debtors

On August 23, 2019, the Small Business Reorganization Act of 2019 (SBRA) was signed into law, creating “Subchapter V” in Chapter 11 of the Bankruptcy Code as part of an effort to streamline the structuring process for small businesses (defined as those whose total noncontingent liquidated secured and unsecured debts do not exceed $2,725,625). The new law will go into effect February 19, 2020.

What does this mean for creditors?

Harder to contest Chapter 11 bankruptcy cases

The SBRA makes it more difficult for creditors to contest small business Chapter 11 cases. It favors small business debtors by eliminating the Absolute Priority Rule (APR), which previously required full payment to unsecured creditors for debtors to retain ownership of assets.

The APR will continue to apply for secured creditors.

While this new law only applies to businesses whose debts are less than $2,725,625, debtor businesses may qualify by paying down debts at negotiated discounts, since contingent and unliquidated debts are not calculated in the total.

What’s changed?

Before SBRA:

Previously, debtors would be unable to retain ownership of their business without paying creditors unless: 1) the class of creditors voted to accept the plan, or 2) the equity holder paid a “new value” to the debtor business in a substantial and essential amount.

Because debtors were not able to pay a large amount upfront in cash, they would often attempt to negotiate to buy back ownership, offering to provide new value in payments over several years. Thanks to the immediacy of the APR, these attempts would mostly be unsuccessful, with the result that over 90% of Chapter 11 cases would transfer to Chapter 7 liquidation proceedings instead.

After SBRA:

Without the APR in place, debtors can retain ownership of its assets without paying unsecured creditors in full, which means they are more likely to be successful in reorganizing and creditors are less likely to receive substantial payment.

The silver lining: fewer preference lawsuits

It’s not all bad news for creditors. The SBRA also makes changes to Preference Laws that favor creditors by increasing the threshold and due diligence requirements for preference lawsuits.

Under current law, trustees and debtors in possession can file lawsuits to recover preferential transfers made in the 90 days before the bankruptcy was filed, or one year, for insiders. If the amount was less than $13,650, then they would have to file a lawsuit to recover the transfer in the federal district where the defendant resides, rather than the bankruptcy case district.

Under SBRA, the threshold is raised from $13,650 to $25,000 for non-insider defendants, and the trustee or debtor in possession is required to exercise reasonable due diligence, taking into account “a party’s known or reasonably knowable affirmative defenses.”

Prohibitive costs and logistics generally prevent filing of preference suits outside of the bankruptcy case district, so raising the threshold effectively protects most transfers $25,000 and under from recovery. The new due diligence requirement will also help to reduce the number of preference lawsuits.

Actions creditors can take

In light of the new law, creditors and their attorneys, when settling lawsuits with businesses, should:

  • Insist on liens upon assets with equity, including during contract negotiations;
  • Insist upon entry of a judgment – or, at the very least, an admission of liability – exceeding $2,725,625 in order to disqualify the business from Subchapter V;
  • Obtain admissions of wrongdoing in the settlement agreement, since the same debts that are non-dischargeable under other chapters of the Bankruptcy Code remain so under Subchapter V;
  • Lean more towards larger transactions (exceeding $2,725,625) instead of smaller ones;
  • Focus on anything that may create a lien or property interest, such as a writ of attachment, lis pendens, or judgment lien, as these will increase the chance of a substantial payment.

In order to find more successful outcomes under the new Subchapter V, creditors should be more selective about extending credit, insist on obtaining liens wherever possible and monitor the assets that secure the liens on a regular basis.

Make More Informed Decisions with Cedar Financial

Business Credit Reporting

Cedar Financial offers Global Business Credit Reporting, Skip Tracing and Investigative Services to help you make more informed decisions about your business transactions.

In light of SBRA, knowing your customers is more important than ever to reduce potential credit risks. You don’t want to be left in the dust if your trusted business companion decides to file for bankruptcy.

Get the financial knowledge you need to put your best foot forward and maximize your profits. Ask us for a sample credit investigation report today.

The Best Legal Representation, Anywhere

When you place your claims with Cedar Financial, we do everything we can to resolve your accounts amicably, without litigation. But in the event, it comes to that, you’re in good hands – no need to hire a separate commercial debt collection lawyer.

Our clients receive access to full legal support through our in-house counsel and vetted creditor’s rights attorney network for the most trusted legal representation around the globe.

We can evaluate your accounts, review collectible assets and recommend the best course of action for potential legal proceedings. Every case receives the same close monitoring, management and follow-up as our in-house collections accounts, so you don’t have to deal with anyone else.

For more information about our services, contact our representatives at 800-804-3353.

*The information provided on this website does not, and is not intended to, constitute legal advice; instead, all information, content, and materials available on this site are for general informational purposes only. Information on this website may not constitute the most up-to-date legal or other information.

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Thank you, U.S. Tax Code!

Thank you, U.S. Tax Code? Those are words that are rarely said, thought
or believed! But a proper tax strategy can literally help you build and
pay for an ADU, one of the best, and safest decisions you can make for
your personal financial health!

If you thought building an ADU was a good opportunity, you are wrong –
it’s an incredible opportunity! Without the proper tax strategies, an
ADU will still generate as much as a 12% cap rate. That rate is about 3
times higher than the typical San Diego cap rate for investment
properties of 4%. So even if you stop reading now, building an ADU can
be a very good financial decision.

With the proper tax structure, your property can generate a 12% cap rate
and a net cash flow of 36%! How is that possible?!

Step 1: Write off the share of all property operating and maintenance
expenses associated with the ADU. On an ADU that you lease to renters,
this can save over 60% of your net rental income. Lower income means
lower taxes.

Step 2: Depreciate the cost of the structure, the furniture, fixtures
and the improvements on the land. That can offset your rental income by
as much as 80%!

With just those 2 steps, you can offset your rental income by as much as
140%! To the IRS, that means you are losing money. In some cases, you
may Use that loss to offset other income, and now you are paying less
taxes, and keeping the cash from the rental income.

Does the math sound too good to be true?! Don’t believe this article,
talk to us to verify the facts. There’s no tricky strategies or
techniques being employed. We’re following the same IRS code that
everyone else must follow.

There’s only one question that remains: can you afford to wait and
think about it?

By Henish Pulickal, CEO at CalHomeCo and James Harnsberger, Enrolled
Agent at SMIB Management, Inc.

*Disclaimer: numbers and assumptions on this article are used for
illustration purposes. Your actual numbers will vary. Consult with
your tax advisor before making any decisions, or we can refer you to an
expert.

The Right and Wrong Ways to Resolve Tax Issues

Having Uncle Sam breathing down your neck over a tax issue can make anyone seek out a quick fix, but before seeking help from a company, experts advice doing your due diligence.

While there are reputable firms with accredited certified public accountants, enrolled agents and tax attorneys to assist in settling tax issues, there are also unscrupulous companies pledging to resolve tax problems for pennies on the dollar—and that isn’t a reality, claim experts.

Advertisements on TV and radio from companies claiming “we can save you 90 cents on the dollar if you retain us to negotiate the resolution of your tax liabilities” are likely too good to be true, says David Moise, principal-in-charge, Tax Procedure and Controversy Practice at accounting, tax and advisory services firm, WeiserMazars.

“That may be true under certain limited circumstances, but that advertisement seems to indicate that when you go to the IRS, you negotiate a resolution of the tax liability irrespective of your financial ability to pay and that’s not true.”

And it’s not just advertisements, dishonest companies are also reaching out directly to consumers offering their help for a retainer upfront with the promise to settle outstanding obligations.

“If a company says to you, ‘we’re going to charge you some money upfront’ and they go as far as to say ‘we can guarantee that we can cut your obligations by 60, 70, 80%,’ that immediately is a red flag,” says Michael Eisenberg, of Eisenberg Financial Advisors. “There is no way anybody can guarantee that they can cut the tax obligations by any amount until they’ve discussed something with the IRS.”

Rather than entering a potentially risky situation and end up paying more in fees and interest without a resolution, here are three steps the experts recommend taking when faced with tax issues.

Step 1: Contact the IRS

After receiving notice of any outstanding tax obligations or penalties, it’s essential to contact the IRS and address the issue immediately, says Moise.

“If you speak to a revenue officer, he is going to be willing to work with you depending on your circumstances. The revenue officer is going to say you need to submit certain financial information to show me what your ability to pay is and then we can discuss/negotiate a collection alternative.”

If back taxes are owed, Eisenberg recommends doing everything possible to bring the current year up to date before reaching out.

“The IRS is much more likely to work with you if there’s only one year and you’re current on the subsequent years because they realize things do happen, financial issues come about…but if you’ve been good before and you’re good after, there’s a much better likelihood of the IRS trying to help you try to reach an arrangement,” he says. “By doing that, there is nobody you need to pay any additional fees to because you’re able to do it yourself.”

Step 2: Know Your Payment Program Options

Consumers unable to pay off taxes, penalties and fees in full should inquire about their eligibility to participate in the IRS’ offer in compromise program-but be prepared to back up claims of financial hardships with documents and bank statements, says Matthew McGeever, CPA at R&G Brenner Income Tax.

“If I have a $10,000 bill and I can demonstrate to them that I don’t have the wherewithal to pay that but I would be willing to compromise on that for a lesser amount, the IRS is flexible and they will consider it,” he says. “They may require more documentation to prove that you don’t have the wherewithal and they may even say that you do have the wherewithal because we looked at your bank account.”

Depending on their circumstances, taxpayers may also be eligible for the installment payment program.

“Let’s say you owe $6,000 and based on your financial information, you can pay $300 a month until the obligation is paid off,” says Eisenberg. “[But] understand on the installment payment program that interest continues to run on the outstanding balance and you will still owe additional interest until your debt gets paid off.”

Step 3: When in Doubt, Hire an Accredited Professional

Some tax matters get so complicated that it’s best to work with an accredited professional, says BillSmith, managing director of accounting and professional services company, CBIZ MHM.

“Unless it’s a very small amount and you know that you can pay it off over a relatively short period of time…the best thing to do is get to a reputable accountant, tax attorney, specialist, enrolled agent with experience who will explain to you the process and not promise the moon, then you have the facts you can deal with,” he says.

It’s in taxpayers’ best interest to be honest and upfront about their situation and provide the professional handling their case with as many documents as possible to increase their chances of reaching an agreement with the IRS, recommends Eisenberg.

“You could say ‘I took some deductions that I thought were legitimate and honest,’ and the IRS can have a debate with you about that or the amounts of the deductions and you back them up with your paperwork or a third party’s mortgage interest, property taxes, charitable donations–if those things are there, then the IRS is going to allow them,” he says. “Make sure your paperwork is in order, you bring all of the documents to the professional and have a dialogue upfront.”

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Getting Started With Angel Investing

What it is: Angel investors might be professionals such as doctors or lawyers, former business associates — or better yet, seasoned entrepreneurs interested in helping out the next generation. What matters is that they are wealthy and willing to invest hundreds of thousands of dollars in your business in return for a piece of the action.How it works: Generally, the angels need to meet the Securities Exchange Commission’s (SEC) definition of accredited investors.

They each need to have a net worth of at least $1 million and make $200,000 a year (or $300,000 a year jointly with a spouse). Angel investors give you money. You sell them equity in the company, filing the investment raise with the SEC. Angel investments commonly run around $600,000. Most investments rounds also involve multiple investors, thanks to the proliferations of angel groups.Related: What Angel Investors Want Now Upside: Angel investments can be perfect for businesses that are established enough that they are beyond the startup phase, but are still early enough in the game that they need capital to develop a product or fund a marketing strategy.Many businesses receiving angel investments already have some revenue, but they need some cash to kick the enterprise to the next level.

Not only can an angel investor provide this, but he or she might become an important mentor. Because their money is on the line, they will be highly motivated to see your business succeed.Downside: You could be giving away anywhere from 10 to more than 50 percent of your business. On top of that, there’s always the risk that your investors will decide that you are the business’ greatest obstacle to success, and you could get fired from the company you created.Angel investors, like venture capitalists, also like to see an end game down the road that will allow them to pocket their winnings, whether it is a public offering or your business getting acquired by another company. You might have to give up running your enterprise before you’re done having fun with it.

Related: 5 Worst Mistakes Entrepreneurs Make When Pitching Angel InvestorsHow to get it: It used to be that angel investors were wealthy people the business owner knew. Or they might be veteran entrepreneurs who were discovered through old-fashioned networking at the local Chamber of Commerce, the area Small Business Development Center, or a trusted banker, lawyer or accountant.These days, though, angel groups are proliferating, offering plenty of mentoring and coaching on top of the money provided.The Overland, Kan.-based Angel Capital Association (ACA) has an online listing of angel groups that are members in good standing, as well as organizations affiliated with the ACA. Other websites to check out include AngelList and MicroVentures.Related: 3 Things You Must Know Before Pitching Investors

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Business Valuation Definition

What Is a Business Valuation?

A business valuation is a general process of determining the economic value of a whole business or company unit. Business valuation can be used to determine the fair value of a business for a variety of reasons, including sale value, establishing partner ownership, taxation, and even divorce proceedings. Owners will often turn to professional business evaluators for an objective estimate of the value of the business.

Estimating the fair value of a business is an art and a science; there are several formal models that can be used, but choosing the right one and then the appropriate inputs can be somewhat subjective.

Key Takeaways

  • Business valuation is the general process of determining the economic value of a whole business or company unit.
  • Business valuation can be used to determine the fair value of a business for a variety of reasons, including sale value, establishing partner ownership, taxation, and even divorce proceedings.
  • Several methods of valuing a business exist, such as looking at its market cap, earnings multipliers, or book value, among others.

The Basics of Business Valuation

The topic of business valuation is frequently discussed in corporate finance. Business valuation is typically conducted when a company is looking to sell all or a portion of its operations or looking to merge with or acquire another company. The valuation of a business is the process of determining the current worth of a business, using objective measures, and evaluating all aspects of the business.

A business valuation might include an analysis of the company’s management, its capital structure, its future earnings prospects or the market value of its assets. The tools used for valuation can vary among evaluators, businesses, and industries. Common approaches to business valuation include a review of financial statements, discounting cash flow models and similar company comparisons.

Valuation is also important for tax reporting. The Internal Revenue Service (IRS) requires that a business is valued based on its fair market value. Some tax-related events such as sale, purchase or gifting of shares of a company will be taxed depending on valuation.

Special Considerations: Methods of Valuation

There are numerous ways a company can be valued. You’ll learn about several of these methods below.

1. Market Capitalization

Market capitalization is the simplest method of business valuation. It is calculated by multiplying the company’s share price by its total number of shares outstanding. For example, as of January 3, 2018, Microsoft Inc. traded at $86.35. With a total number of shares outstanding of 7.715 billion, the company could then be valued at $86.35 x 7.715 billion = $666.19 billion.

2. Times Revenue Method

Under the times revenue business valuation method, a stream of revenues generated over a certain period of time is applied to a multiplier which depends on the industry and economic environment. For example, a tech company may be valued at 3x revenue, while a service firm may be valued at 0.5x revenue.

3. Earnings Multiplier

Instead of the times revenue method, the earnings multiplier may be used to get a more accurate picture of the real value of a company, since a company’s profits are a more reliable indicator of its financial success than sales revenue is. The earnings multiplier adjusts future profits against cash flow that could be invested at the current interest rate over the same period of time. In other words, it adjusts the current P/E ratio to account for current interest rates.

4. Discounted Cash Flow (DCF) Method

This method of business valuation is similar to the earnings multiplier. This method is based on projections of future cash flows, which are adjusted to get the current market value of the company. The main difference between the discounted cash flow method and the profit multiplier method is that it takes inflation into consideration to calculate the present value.

5. Book Value

This is the value of shareholders’ equity of a business as shown on the balance sheet statement. The book value is derived by subtracting the total liabilities of a company from its total assets.

6. Liquidation Value

This is the net cash that a business will receive if its assets were liquidated and liabilities were paid off today.

This is by no means an exhaustive list of the business valuation methods in use today. Other methods include replacement value, breakup value, asset-based valuation and still many more.

Accreditation in Business Valuation

In the U.S., Accredited in Business Valuation (ABV) is a professional designation awarded to accountants such as CPAs who specialize in calculating the value of businesses. The ABV certification is overseen by the American Institute of Certified Public Accountants (AICPA) and requires candidates to complete an application process, pass an exam, meet minimum Business Experience and Education requirements, and pay a credential fee (as of 2018, the annual fee for the ABV Credential was $380).

Maintaining the ABV credential also requires those who hold the certification to meet minimum standards for work experience and lifelong learning. Successful applicants earn the right to use the ABV designation with their names, which can improve job opportunities, professional reputation and pay. In Canada, Chartered Business Valuator (CBV) is a professional designation for business valuation specialists. It is offered by the Canadian Institute of Chartered Business Valuators (CICBV).

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How a Small Business Investment Can Make Money

Investing in stocks of a small business is merely an extension of buying a small portion of a business run by someone else and enjoying your cut of the earnings. Small businesses sometimes are seen as wonderful gifts that, when well-nurtured, can produce a lifetime of financial independence and a standard of living much higher than average. Small business and start-up business investment opportunities often come in the form of penny stocks which can expose the investor to higher risks.

Who Invests in Small Business Stocks For the right type of person, with the right type of skill, temperament, and risk profile, small business investment can be a lucrative investment. Typically, there are only three mechanisms through which you can experience a profit in net worth from a privately held firm. Knowing these three sources of wealth generation is important because new investors are sometimes too quick to jump head-first into potential opportunities without clear ideas of how they will drive the economic engine to gain the financial benefits they desire. The Salary You Pay Yourself For many small business investors, the company never generates more than enough for them and their family to live upon from salaries taken out of the company in exchange for working on the payroll. Though this can be considered a success, the small business isn’t really an investment at this stage. Instead, the founders have essentially created a job for themselves, which includes the benefits and drawbacks of self-employment.

These payroll distributions can limit the total capital the company has to expand, which can explain why many small businesses are never able to move beyond a single location or increase sales significantly. It is isn’t unusual for more successful small businesses to begin as part-time ventures, allowing the founders to continue their day jobs until the company grows large enough to support their small business salary needs. Distributions From Profits When a small business investment has become successful, there is profit remaining for the owners above and beyond the amount taken out of the business in salaries and wages. The owners then can decide to reinvest the profits for future expansion or they can declare a dividend. In the case of a corporation, the dividend is a distribution to shareholders. This payment takes the form of a draw for a limited liability company or limited partnership.

A sole proprietorship small business may use the money in their personal lives, often to build savings, acquire other investments—such as stocks, bonds, or real estate—and paying down debt. Whether or not a small business investor reinvests his or her dividends can have an enormous effect on their ultimate net worth. There is no right or wrong answer. If you desire to live better now and give up more wealth in the future, taking dividends can be a rational course of action. If you would rather be richer in the future and are willing to risk additional capital in that pursuit, reinvesting dividends can be the more intelligent strategy. In any event, when you move beyond having a job, dividends from profits are the second most common source of wealth for small business investors. Capitalized Earnings From Selling the Firm Once a company has grown beyond the small business realm, it could become attractive enough that outside investors want to own it.

When this happens, these investors may offer to buy the company. With few exceptions, the primary source of value for an operating business that generates good returns on capital is the earnings power, not the assets on the balance sheet. For example, manufacturing plant machinery isn’t worth much when bought on the liquidation market, but when acquired as part of an on-going company that produces large profits, it is valuable. Investors will look at the earnings of the business and factor in growth, debt levels, and the economics of the industry as a whole. If things are attractive, they often apply a valuation multiple to the profit stream.

This is the equivalent of the price-to-earnings ratio you hear so much about in the stock market. Thus, a business that earns $1 million per year in profit might reasonably sell for $10 million or $15 million. That figure is the “capitalized” earnings value of the firm. Some small business owners form new ventures for the sole purpose of growing them to the point the earnings can be capitalized and the company sold. This is known in financial terms as a “liquidity event.” There are even special types of investors that focus on this niche investment strategy, such as so-called “venture capitalists” who back nascent enterprises in the hopes of someday taking them public in an IPO or selling them to an established player in a market.

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