Retirement Plan Options for Professional Services Firms

Retirement Plan Options for Professional Services Firms

The pandemic had a significant impact on Minnesota businesses. The combination of forced business closures, new employee safety standards along with supply chain disruptions and sharp increase in materials costs made it very difficult. The uncertainty made many uncomfortable. Concurrently, individuals were also impacted by the changes. The almost overnight changes and abrupt disruptions acted as a catalyst for many to evaluate personal and retirement savings. The result of this reflection has been the increased attention on savings, especially retirement savings.

This change in attitude is a contributing factor behind the Great Resignation. As more people re-enter the job market seeking higher paying positions with more attractive benefits, it has created a real challenge for professional service firms. Although many have already increased salaries, enhanced benefits, and more time off, it seems that more is needed to attract the best of the best. This is where the right employee sponsored retirement plan can make a big difference. Whether it’s a 401k, SIMPLE IRA, or other investment vehicle, there are several options to select from.

Trends in Retirement Plan Benefits

For professional service firms that offer an employer-sponsored plan, there are several ways to elevate current benefits to the next level. Offering a way to save for retirement is a great first step; however, enhancing retirement benefits can go a long way toward employee recruitment and retention.

Willis Towers Watson (WTW) conducted a nationwide survey earlier in 2022 and found that many employers are helping their employees to achieve both short- and long-term financial goals. Flexibility is key.

  • 38 percent of surveyed companies plan to offer alternative contribution strategies, like allowing participants to direct contributions to pay down student loan debt, fund emergency savings, or contribute to a health savings account.
  • 28 percent planned to increase the plan’s automatic deferral amount and use other automatic deferral features to increase employee contributions.
  • 23 percent are looking at allowing employees to contribute to the plan using bonus payments as well as salary and wages.

The findings reflect an interesting pattern. These companies are using flexibility in the retirement plan as a distinguishing benefit in the talent war.

This strategy comes at a good time. Most people improved investing habits during the last two years and want to see the money going further toward personal goals. One surprising finding from Fidelity’s survey was that more workers would rather get a higher employer match to the retirement plan than more paid time off.

Considerations for 401k Plans

Nationwide, employee participation in 401k plans is at an all-time high. It’s the most widely known and available employer-sponsored retirement plan, and for good reasons. 401ks offer some of the most flexible contribution, investment, and benefit options. Some of the most popular features include:

  • Roth option, which could be included as an employer match under SECURE Act 2.0 legislation
  • Automatic enrollment and automatic escalation
  • Financial education for employees
  • Redirect contributions to an emergency savings account or to pay down student loans

It’s important to consider cost. 401ks can have higher administrative costs than other plans. It’s estimated that plan fees will range from 0.5 to 2 percent of plan assets, and smaller plans may be more susceptible to higher fees. Firm owners should look for, among other signals, a high fund expense ratio as a warning that plan fees might be too high.

Owners can reduce 401k plan administration costs in a few ways. Benchmarking plan fees is usually the place to start. An annual or bi-annual fee analysis can help to keep costs down, ensure fees are consistent with participants’ best interests and monitor service providers. More plan sponsors are navigating to lower-cost investment vehicles; for example, some actively managed mutual funds are deducted from employees’ investment holdings.

Then there’s the issue of ERISA compliance. In a professional services firm, most contributions tend to be from the highest earners; this makes sense, considering partner compensation. However, a plan that’s top-heavy – when more than 60 percent of plan assets are in key employee account balances – can fall out of line with ERISA requirements. Firm owners need a strategy to maintain Department of Labor compliance across a range of tests, which must be done annually.

SIMPLE IRAs

401ks aren’t the only option for retirement plans. Firm owners with less than 100 employees and no other retirement plan find that SIMPLE IRAs are an easier solution that often requires less maintenance. Both employers and employees make contributions. The firm wouldn’t need to file Form 5500 and discrimination testing isn’t required.

Eligible employees must earn at least $5,000 in compensation in the two previous years or the current year, though the firm can decide to lower or eliminate these thresholds. There is also a need to provide certain annual notices to employees, maintain timely deposits, and accurately calculate contributions.

While SIMPLE IRAs are comparatively easy and cost-effective to set up, the employer matching rules can get complicated. Firms must make either a two percent nonelective contribution for each eligible employee or a three percent matching contribution. Contributions are still required if cash flow is tight. And unlike 401k plans, participants cannot take out loans.

To establish a SIMPLE IRA, the firm would need to create and provide a written agreement to all employees with information about the plan. Then, an IRA account for each employee. The firm may choose the financial institution or allow employees to choose – either way is fine by the IRS.

The deadline to establish a SIMPLE IRA for the tax year is October 1.

Simpler Alternatives to an Employer-Sponsored Plan

There are other options available, depending on the firm size, structure, and needs.

  • SIMPLE 401k Plans: As its name implies, this is a simpler version of the typical 401(k) plan. It’s only available to firms with 100 or fewer employees an established employer contribution level must be established. Employees are permitted to make contributions, too. Firms are prohibited from having another retirement plan and must file Form 5500 annually.
  • Simplified Employee Pension (SEP) Plans: Any size company can offer a SEP. They’re easy to establish and annual filing requirements are unnecessary. Employees are 100 percent vested from the beginning, but they can’t contribute themselves. Only the employer contributes to a SEP. Employees can’t take out participant loans and there are contribution limits.
  • Payroll Deduction IRA: This allows employees to set up their own traditional or Roth IRA and set up an automatic payroll deduction to fund it. Only employees contribute, and the employer has little involvement in the plan; there aren’t any filing requirements, and the employer doesn’t contribute. It’s purely to offer employees an incentive to easily save for their own retirement.

Take the Next Step

Offering retirement plans to employees often come with tax benefits. Newly established plans may be eligible for tax credits to offset the cost of plan setup, and employer contributions may be tax deductible. Further, firms with a low cash reserve can use retirement plans to supplement a compensation package; some plans can even be structured so that higher profits equal higher employer contributions.

Overall, the biggest benefit to firm owners – other than their own contributions – is fostering a collective of loyal, talented employees. An employer-sponsored plan with flexible, innovative benefit options can be a defining feature of your firm’s recruitment and retention strategy. If you have questions about the information outlined above or need assistance with a retirement plan issue, Smith Schaefer can help. For additional information, click here to contact us. We look forward to speaking with you soon.

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4 Manufacturing Industry Issues & Trends for 2022

4 Manufacturing Industry Issues & Trends for 2022

The manufacturing industry continues to grow, even with labor and supply chain challenges. According to the May 2022 Manufacturing ISM Report, the US manufacturing sector’s economic activity grew for the 24th consecutive month. The May 2022 Manufacturing PMI index was 56.1 percentage points (scores above 50 meaning growth).

The indexes within the industry seeing growth include new orders, production, raw material inventories, and a backlog of orders. However, a few indexes indicate trouble areas for the industry, including employment, supplier deliveries, and customers’ inventories. Manufacturers should navigate these elevated risks while advancing technology and process priorities to maintain their growth momentum. This article explores four manufacturing industry trends to help companies turn risks into advantages and capture growth.

Top US Manufacturing Trends & issues in 2022

Employment

Workforce shortage continues to be an issue for the manufacturing industry, with most companies looking to hire additional employees and seeing high turnover rates in those they can employ. The ISM’s Employment Index (which measures if employers feel the labor market is stronger, the same, or weaker than the previous month) came in at 49.6% for May 2022, a slight contraction from the 50.9% in April 2022. Although hiring continues to be a challenge, the survey showed some signs of improvement, with 7% of May 2022 respondents saying they noted greater ease in the hiring process, up from only 1% in April 2022. According to survey respondents, employment levels remain the top issue affecting further output growth for the industry.

Due to issues with the small pool of applicants and the significant turnover of employees, many companies in the industry are focusing more on ways to attract and retain talent. Executives must find ways to balance internal goals for retention, culture, and innovation with the flexible work environment many industries are moving into in the post-pandemic world. Engagement with a broader talent pool to reach diverse, skilled individuals may help offset the recent exits. Manufacturers that can navigate workforce shortages and changes are poised to come out ahead.

Supply Chain Instability

Supply chain issues remain at the top of the manufacturing industry’s list of challenges. According to the May 2022 ISM Report, the ISM Price Index registered 82.2%, indicating raw material prices increased for the 24th consecutive month. The leading drivers of price increases include oil and fuel, packaging supplies, commodity materials (copper, steel, and aluminum), and petroleum-based products. However, there was an indication the industry may be slowly moving into price softening, with 5.6% of respondents reporting lower prices in May.

Another issue within the supply chain for manufacturing companies is the delay in supplier deliveries. The ISM’s Supplier Deliveries Index registered 65.7%, showing suppliers still have difficulties meeting demand. With the current labor issues mentioned previously, along with new COVID lockdowns hitting some of the major cities in China, deliveries are expected to continue to remain a major headache for the industry. Due to transportation issues in China, many companies in the industry are beginning to move their supply chain back within the US if they can find their inputs at competitive prices compared to what they would typically pay overseas suppliers. Another strategy being used is diversifying supply chains from historic vendors and spreading orders around to multiple, so even if one is unable to meet a deadline hopefully the other will. Companies have also begun to place orders earlier in their process to allow longer lead times before the product is needed.

Industry Demand

Although much of the talk around the manufacturing industry is typically around the issues surrounding the supply chain and employment, the demand for manufacturing is strong and continues to grow. The ISM’s New Orders Index registered 55.1% in May 2022 (meaning demand for new orders is growing), an increase of 1.6% over April 2022. Of the 18 manufacturing industries within the survey, 11 reported growth in new orders in May, and only one reported a decline. The ISM’s Backlog of Orders Index also registered 58.7% in May 2022, a 2.7% increase over April 2022. Respondents noted backlogs continue to expand as they bring in new orders, and output remains constrained. In order to deal with this increase in demand, companies can increase pricing if the number of orders being placed is unfeasible for the company to meet. By increasing prices, a few of the customers may go elsewhere, allowing for the company to see increases in revenue while not overloading their backlog at the same time.

Another sign of high industry demand is the number of customer inventories companies have on hand. The ISM’s Customers’ Inventories Index registered 32.7% in May 2022; 4.4 percentage points lower than April 2022. This decrease indicates company’s inventories are too low to meet demand and is the 68th consecutive month of them being too low. In many cases, businesses are shipping products out as soon as they are manufactured, as they typically wait on supply-side issues to finish orders on time. A positive of this low inventory issue is customers continued demand for the product, allowing room for growth in production as employment and supply chain issues begin to be resolved.

Integrating Software

One thing companies can do to assist their employees and managers in the current environment is to invest in new software or update existing software. Software updates can help improve efficiencies and organization and make managers’ jobs easier. This could include updates to payroll software, project management software, and inventory management systems, just to name a few.

As noted previously, manufacturing companies are currently seeing high turnover in employees. Improving the software employees are using to complete their daily tasks may make their jobs run smoother with less stress placed on them, which could lead to improved retention rates. New software may also include improved capabilities that help with the current supply chain instability strain. For example, new software may have features to help managers better understand the status of their supply chain and help them get ahead of future shortages and/or delays.

Questions?

It is important to closely analyze these aspects of your manufacturing business – from hiring employees to improving technology to meeting customer demand – and likely much more. This article is based on the May 2022 version of the Manufacturing ISM Report, these reports are issued monthly and are available on the ISM website. If you have questions or need assistance with a manufacturing tax, accounting, cash flow, or technology issue, we can help.

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ESOPs & Succession Planning for your Transportation company

ESOPs & Succession Planning for your Transportation company

Succession Planning – the process and strategy for identifying the critical positions within your transportation company and developing an action plan for potential leaders.

This article will provide insight on employee stock ownership plans (ESOP) and how they can be an option for succession planning for transportation companies. An ESOP can provide many benefits, such as tax savings for owners and the business and increasing the culture of ownership by involving employees who have shown service and loyalty. No matter what succession planning strategy is used, it is crucial to establish a plan early and set goals to achieve the objective.

Understanding ESOPs for Transportation Business

ESOP Basics

An Employee Stock Ownership Plan, or ESOP, is a qualified defined contribution employee benefit plan authorized under the Employee Retirement Income Security Act (ERISA). This type of plan is similar to the popular 401k profit-sharing plan that many businesses use. Here are a few basics of an ESOP:

  • It can provide employees with the opportunity to own shares of stock in the company.
  • It can be used in conjunction with other retirement plans, such as a 401k plan. However, often an ESOP is used as a replacement for other traditional retirement plans.
  • An ESOP is a tax-deferred investment of shares of company stock allocated to each eligible employee’s account. Ideally, the stock will appreciate over time as the business grows.
  • An ESOP is structured as a trust, with the employees as beneficiaries of that trust. An individual appointed as a trustee administers the plan and makes the majority of the decisions. After the ESOP is created, significant corporate actions usually are voted on by participants in the plan.
  • An ESOP can be funded by cash, stock, or debt. Regardless of how it is funded, cash must be available to pay out to exiting owners who retire or otherwise terminate employment.
  • An annual business valuation is required by an independent professional to determine the fair market value of the business for purposes of determining participant account balances for the plan.

ESOP Benefits for Employees

  • Ownership and retirement savings are directly affected by the success of the business. Employees can align their goals with the company in order to drive growth.
  • Any growth in the retirement plan is tax deferred until the employee retires.
  • There is a guaranteed market for sale of shares in the plan. When an employee retires, the ESOP agrees to repurchase those shares at the fair market value.

ESOP Benefits for Shareholder/Employer

  • If the ESOP purchases at least 30 percent of a C corporation’s outstanding stock, the previous owners can elect a Section 1042 Rollover to avoid paying capital gains tax on the sale of their stock. To do so, all sales proceeds must be placed in a qualified replacement property. The selling owners will pay capital gains tax only when they sell their replacement investments.
    • Qualified replacement property (QRP) – any security issued by a domestic “operating corporation.” An “operating corporation” is a business that, for the taxable year preceding the taxable year in which such security was purchased, had no passive investment income
    • An ESOP may own a portion or all of the stock in a company.
  • If the transportation business is structured as a C Corporation, dividends paid on ESOP-held stock are tax deductible.
  • If the business is structured as an S Corporation, the portion of earnings related to the ownership of the ESOP will pass through to the ESOP (rather than to individual shareholders) and avoid taxation by the individual shareholders.
  • Selling an ESOP will result in a stock sale versus an asset sale. Given the large amount of depreciation recapture built up from vehicles and other equipment, it may be more advantageous to sell stock than assets and receive favorable tax treatment.

ESOPs for Transportation Companies

Historically, many transportation companies have not utilized ESOPs. Setting up an ESOP requires available cash or the ability to take on more debt. Based on how transportation industry participants typically operate, these factors can make it difficult for companies that are heavily leveraged and require large annual capital expenditures. Even if cash restrictions and/or leverage limitations make it difficult to implement an ESOP, the benefits listed above still apply.

Does an ESOP Make Sense for your Business?

Historically, the ideal structure for implementing an ESOP consists of 20 employees or more and annual revenues of $10 million or more. The company must be large enough to spread out various plan costs and investment risks across the participating employees. Below are the general attributes of companies that may or may not want to consider implementing an ESOP:

Yes

  • The business has low debt levels and can finance all or a portion of an ESOP transaction.
  • The company is intended to be transferred to employees (no family in place to take over).
  • The current employee pool is expansive (50 or more) and has qualified management candidates.
  • The owner(s) is willing to receive a significant portion of the benefits of ownership change over a period of time.
  • The company has predictable cash flow and consistent historical earnings performance (no substantial, out-of-the-ordinary large capital expenditures expected for the future).

No

  • The business is already heavily leveraged with debt and would not be able to finance an ESOP.
  • The business is intended to stay in the family.
  • The current employee pool is not qualified to run the business without current ownership, or the existing employee group is small (20 or less).
  • The owner(s) is looking to receive a large part of the benefits of ownership change immediately or in a relatively short time period.
  • The company has unpredictable cash flow and historical earnings performance (this may include large unusual capital expenditures that may be needed in the future).

Contact Us

Due to their significant tax benefits over other exit strategies, employee stock ownership plans have been a compelling succession planning option for transportation companies. If you answered “yes,” to the above and think an ESOP may make sense for your transportation business, let’s talk.

Smith Schafer experts can help determine why and when an ESOP makes sense, the fair market value for your transportation company, and assist in evaluating the exit strategy structure that meets your goals.

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document Organization for Your 401k Plan Audit

document Organization for Your 401k Plan Audit

As discussed in part two of our 401k blog series, one of the purposes of a retirement plan audit is to ensure the plan operates in compliance with both plan documents and IRS and DOL regulations. To do this, your auditor will request access to several documents. Some will be plan-specific documents, while others will be HR and related documents.

Organizing Documents for a Smooth 401k Audit Process

Examples of plan-specific documents requested for a first-time 401k audit will include:

  • Plan document
  • Adoption agreement
  • IRS determination or opinion letter
  • Current summary plan description
  • Prior 5500s
  • Agreements with third-party administrators and other plan providers

Other 401k plan-related documents will be requested annually or as updated:

  • Any amendments to the plan document
  • Minutes for meetings related to the plan (trustees, investment committee, etc.)
  • Copy of fidelity bond insurance
  • Compliance testing results received from plan’s third-party administrator

In addition to these documents that the plan sponsor should maintain, your auditor will also need certain documents from your third-party administrator or plan custodian. Most providers will prepare an audit package that includes all necessary documents and can easily be shared with a plan auditor.

Once your auditor understands your plan, they will test a sample of transactions within the plan to determine if it is operating correctly. Examples of the areas tested include:

  • Participant eligibility – likely to include testing an employee’s age and length of service to determine if they are eligible to be in the plan
  • Participant contributions – includes both the participant’s deferral and any employer contributions. This could also include testing the employee’s wages for accuracy.
  • Investment earnings and other participant allocations
  • Plan distributions
  • Loans to participants (if allowed by the plan)

To test these areas, your auditor may ask for some of the following documents:

  • Form I-9 or other documentation showing the employee’s date of birth and date of hire
  • W-2s
  • Company payroll registers
  • Employees’ deferral election forms, including changes made during the year
  • Employee’s election to not participate
  • Support for pay rates
  • Support for hours worked (timecards, work logs, etc.)
  • Payout request forms
  • Support for termination date, if applicable
  • Form 1099-R for participant payouts
  • Loan request forms

Several of these documents might be kept in an employee’s personnel file. Therefore, plan management should ensure these files are complete, clean, organized, and consistent. This will make it easier for management to gather the requested information, improving the audit’s efficiency.

Many plans are set up so that most of the features are available electronically, meaning participants can go online to change their deferral amount, request a payout of their account balance, change investment options/allocations, or request a loan. It is, therefore, possible that the plan sponsor does not have documentation for these transactions. However, since many of these items affect employees’ payroll, plan management will still be responsible for ensuring that the changes are applied appropriately, and that documentation is maintained to support the changes.

Questions about 401k document organization?

Choosing an auditor well-versed in benefit plan audits can be extremely helpful. Smith Schafer frequently works with 401k plans undergoing their first required audit and find many of the plan sponsors are not aware of all the requirements to get the audit completed and timely filed with the Plan’s Form 5500.

If you currently have a small plan but anticipate growing, we recommend you start addressing requirements leading up to the first audit. The more prepared your company is when the audit starts, the more time and resource-efficient both your company personnel and the auditor will be. If you have any questions or have an employee benefit plan that requires an audit, feel free to contact us at [email protected], and we will assist you.

Benchmarking Your Professional Service Firm

Benchmarking Your Professional Service Firm

How Does Your Professional Service Firm Stack Up?

Understanding and knowing current benchmarks is a great way to measure your firm’s success against industry standards. They give you a way to identify areas in which you excel and where attention and resources may be needed. Benchmarks can be used to create a comparative analytics report detailing KPIs relevant to your firm. This article highlights benchmarks for three specific subgroups within the professional service industry: architecture firms, law firms, and marketing consulting agencies.

Professional Service Firms – Industry Benchmarks

Architecture FIRMS

  • The architecture industry is anticipated to experience continuous revenue growth in 2022 after experiencing a sharp decline in 2020. The economic decline brought on by the pandemic led to a steep drop in nonresidential construction in 2020 and 2021, which is a disproportionate influencing factor for industry demand. Declining construction was the result of social distancing restrictions, but also a highly uncertain economic environment in which unemployment spiked, and consumer confidence and spending dropped.
  • Profits are expected to account for 10.4% of revenue in 2022. This is after a five-year decline, which can primarily be traced to the 2020 drop in profit from the pandemic.
  • Wages represent the largest cost component in the industry due to the skilled labor requirements. Total industry labor costs are expected to account for 36% of industry revenue. Industry wages as a share of revenue decreased in the past five years, falling from 37.7% in 2017, mainly due to increased investments in technologies such as computer-aided design and increases in other costs, which helped temper growth wage costs over the past five years.

Law Firms

  • Certain services are countercyclical, therefore benefiting from the economic turmoil in 2020. For example, bankruptcy and unemployment legal services increased due to heightened business failures and unemployment. Most significantly, an increase in demand for M&A and private equity deals in 2020 drove revenue growth for the industry’s top firms.
  • Revenue for law firms industry was negatively affected by the pandemic in 2020 as businesses were forced to temporarily close and business and consumer spending fell. In 2022, however, revenue is expected to increase an estimated 1.9%. Demand from businesses is expected to increase in 2022, particularly for smaller businesses that were negatively financially affected by the coronavirus pandemic in 2020. Additionally, demand from large corporate clients has remained strong throughout the crisis.
  • This year’s profits are expected to be 21.4% of revenue. Industry profit remained stable overall during the five-year period as declines in revenue have been offset by reduced costs as a result of remote work by law firms. In 2022, the industry as a whole is expected to benefit from broad-based economic growth and resumption in spending by downstream businesses and households.
  • Wage expenses are estimated to make up 37.6% of industry revenue in 2020. Similar to most industries in the professional services sector, wage costs represent the largest cost to industry operators. Attorneys are highly educated and knowledgeable, and lawyers often specialize in a specific legal practice, such as securities law, which requires further experience and expertise. Work in this field also requires personal service and face-to-face contact with clients, and operators compete to attract top talent to their firms. Wages have remained stable as a share of industry revenue over the past five years.
  • Rent accounts for 7.8% of revenue. Many law firms lease office space and larger firms often incur higher rental costs because they are located in high-traffic areas.

Marketing Consulting Agencies

  • Marketing consultants have benefited from overall growth in corporate profits over the previous five years. An increasing segment of revenue comes from internet advertising due to an overall increase in internet availability and usage. This is due to the more specifically targeted nature of the advertising.
  • Profits had risen slightly in the past five years, from 8.7% in 2014 to 8.9% in 2019. Profitability is expected to improve drastically as the overall economy recovers from the pandemic
  • Wages make up a large percentage of revenue due to the need for highly educated employees adept at client engagement and service skills. The continuing advancement of the skill sets of these employees will enable them to command higher wages.
  • Purchases made up a small part of revenue at 2.9% in 2021. These costs are typically for purchasing software and office-related products. Additionally, subcontracting professional services can also be a significant item in this category.

Questions about Benchmarking Your Professional Service Firm?

Every professional service firm is unique, and the above statistics will not apply to all. The metrics should be used as a guideline. Smith Schafer is an ongoing source to help you grow your business with strategies to increase profits, maintain cash flow, identify opportunities, and much more! Click to contact a Smith Schafer professional.

Statistics and information were provided from IBISWorld Reports.

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2022 Business Valuation Considerations

2022 Business Valuation Considerations

Business Valuation Insights Post COVID-19

More than two years after COVID-19 changed the world, business valuations are still challenging. At the midpoint of 2022, the idea that things have returned to ‘normal’ is certainly debatable. In many instances, historic valuation inputs, specifically past performance, cannot be taken as an indication of future performance. In addition, market volatility driven by supply chain disruptions, rising interest rates, and inflation, have only served to complicate matters.

In normal times, getting an accurate valuation of a business or other asset can be challenging. There are multiple inputs that must be considered, and a value derived based on various assumptions. In disputes, two experts can arrive at quite different values depending on the calculation method. Now, there are several other considerations for valuation experts and business owners to weigh. To help clients, prospects, and others, Smith Schafer has provided a summary of 2022 issues impacting business valuations below.

Risks and Market Conditions

COVID-19 created significant market risk for companies during and after the height of the pandemic. Ongoing risks that need to be considered range from the larger economic environment in which a company operates to credit, liquidity, and forecasting risks.

For example, businesses in some industries may never see the same level of economic demand or production. The same can be said for companies whose demand surged as for those who saw revenue drop substantially. The resulting impact to future cash flows can be unstable and is a significant risk that needs to be considered in a valuation.

And even now, short-term financial and economic forecasts are still uncertain. Some regions continue to experience COVID spikes. Rising energy and material prices are affecting the bottom line and further straining company budgets. How much of this can still be accredited to COVID? It’s important for businesses, especially those exposed to a global supply chain, to account for forecasting risk in a valuation.  

Inflation and the Rising Interest Rates

Since January 2022, markets have become increasingly volatile, reversing a trend that appeared to mark overall economic growth and recovery. Rising interest rates and the threat of inflation are causing the cost of capital to go even higher. Long-term inflation estimates in the U.S. increased from two percent at the height of COVID to 2.6 percent as of May 2022. For valuations, inflation expectations play heavily into the discounted cash flow method (DCF). It also means that businesses may find it harder to create and preserve value.

And with a predicted recession in 2023, business owners with an eye on an upcoming transition will need to do their best to stay ahead of inflation. McKinsey data suggests that to do this, earnings need to grow faster than the rate of inflation, which can be hard for most companies to achieve.

Business Transitions

It’s estimated that three-quarters of current business owners will plan their exit in the next 10 years. As the process unfolds, some of the traditional paths are already going by the wayside.

In business sales, finding strategic buyers isn’t the main priority for most sellers anymore. A Deloitte study found that only 37 percent of potential sellers identified strategic buyers, compared to 52 percent pre-COVID. Additionally, new business combinations and alternative transactions are beginning to replace traditional buy-sell agreements. More businesses are restructuring, which includes reorganizations, changes to working capital, cost reduction, and legal entity changes.

For buyers, access to labor and technology are two driving factors. It’s becoming more common to see buyers snap up companies not for assets or market share but for talent. Strategic partnerships that result in new capabilities are also happening more.

In all these transitions, an accurate, reliable, and current valuation is necessary.

The message here is that what was once a typical valuation transaction is far from guaranteed. Business owners will need to consider their goals for the transaction more than ever. Depending on the outcome, there may be multiple ways for a valuation to support that goal. Talking with a business valuation advisor first can help to ensure the valuation process and methodology aligns with the result.

Valuation Multiples

Public market valuations, which are often seen as a precursor to private and smaller markets, are changing. Multiples for smaller companies are often higher than for larger entities. This is especially true for tech companies that trade based on multiples of revenue and not EBITDA. As revenue expectations are still hard to develop, it can be difficult to forecast the next six months if it’s unclear whether COVID performance was an anomaly or an indicator of future performance.

Using forward-looking multiples to evaluate business value can in some cases better reflect COVID-related pricing and earning impact.

Overall, the focus now seems to be more on forecasts and budgets and less on past results. Consideration needs to be paid to more than just the entity. It’s important now to evaluate all inputs and variables affecting output. The more inputs that the company can control, the more exact and reliable the valuation. A cost or asset valuation approach may be a better indicator of performance in the current environment, though each situation is unique.

Pending Guidance

It’s also worth noting that more guidance for valuation considerations is likely to be released before the end of 2022. One piece of guidance that’s currently in development concerns estimating the discount rate for the fair value measurement of intangible assets.

Next, the discounted cash flow method (DCF) is being questioned for its use in business valuations. Analysis suggests that DCF can be used to value bonds, but not businesses because it cannot accurately represent “the causal mechanisms behind market values.” This is an interesting development, because many valuation experts used DCF during COVID due to its very nature of capturing the net present value of cash flow.

Finally, regulatory requirements to include Environmental, Social, and Governance (ESG) factors need not be included in the cost of capital this year – but that could change in the future. Nevertheless, more buyers and sellers are considering ESG effects on valuations now. 

Contact Us

Valuation approaches post-COVID are as varied and unique as the entities and assets they look to value. A single approach does not work for all transactions, and especially now there is an even greater need for careful, objective analysis. If you have questions about the information outlined above or need assistance with an asset of business valuation, Smith Schafer can help. For additional information, click here to contact us. We look forward to speaking with you soon.

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