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Investment Basics

  • How Securities Are Bought And Sold


The term “securities” encompasses a broad range of investments, including stocks, corporate bonds, government bonds, mutual funds, options, and municipal bonds. Investment contracts, through which investors pool money into a common enterprise managed for profit by a third party, are also securities. Securities may be traded on an organized exchange or traded “over the counter” between investors.





Securities are bought and sold in a number of different markets. The best known are the New York Stock Exchange and the American Stock Exchange, both located in New York City. In addition, six regional exchanges are located in cities throughout the country.


A corporation’s securities may be traded on an exchange only after the issuing company has applied to the exchange and met any listing standards relating, for example, to the company’s assets, number of shares publicly held, and number of stockholders. Organized markets for other instruments, including standardized options, impose similar restrictions. The exchanges facilitate a liquid market for securities where buyers and sellers are brought together. Listing on an exchange, however, does not constitute approval of the securities or provide any assurance as to risk and return.





Many securities are not traded on an exchange but are traded over the counter (OTC) through a large network of securities brokers and dealers. In the National Association of Securities Dealers’ Automated Quotation System (NASDAQ), which is run by the National Association of Securities Dealers (NASD), trading in OTC stocks is done via on-line computer listings of bid, which asks prices and completes transactions.


Like the exchanges, NASDAQ has listing standards that must be met for securities to be traded in that market. Similar to an exchange it provides a “meeting place” for buyers and sellers. The typical investor generally will not know whether their security is bought or sold through and exchange or over the counter. The investor engages a broker who arranges the transaction in the appropriate market at the desired price.





If you buy or sell securities on an exchange or over the counter, you will probably use a broker, and your direct contact will be with a registered representative. The registered representative, often called an account executive or financial consultant, must be registered with the National Association of Security Dealers (NASD), a self-regulatory organization whose operations are overseen by the Securities and Exchange Commission (SEC), and with the states in which the broker is conducting business. The registered representative is the link between the investor and the traders and dealers who actually buy and sell securities on the floor of the exchange or elsewhere.



  • How Prices are Established

How are the stock prices that appear in the financial section of the newspaper arrived at? Market prices for stocks traded over the counter and for those traded on exchanges are established in somewhat different ways.


Exchange Prices

The exchanges centralize trading in each security at one location-the floor of the exchange. There, auction principles of trading set the market price of a security according to current buying and selling interests. If such interests do not balance, designated floor members known as specialists are expected to step in to buy or sell for their own account, to a reasonable degree, as necessary to maintain an orderly market.



Over the Counter

In the OTC market, brokers acting on behalf of their customers (the investors) contact a brokerage firm which holds itself out as a market-maker in the specific security, and negotiate the most favorable purchase or sale price. Commissions received by brokers are then added to the purchase price or deducted from the sale price to arrive at the net price to the customer.


In some cases, a customer’s brokerage firm may itself act as a dealer, either selling a security to a customer from its own inventory or buying it from the customer. In such cases, the broker hopes to make a profit on the purchase and sale of the security, but no commission is charged. Instead, a retail “mark up” is added to the price charged by the firm when a customer buys securities and a “mark down” is deducted from the price paid by the firm when a customer sells securities.



Bid and Ask Prices


In both cases, a stock is quoted in terms of bid and ask. The bid is the price at which the market or market maker is willing to buy the security from you. Similarly the ask is the price at which the market or market maker is willing to sell the security to you. Not surprising, the ask price is higher than the bid price. The difference between the two is called the spread. For example, if a stock is quoted 18-18 ¼ , this means that the investor could sell the stock for $18 a share or purchase the stock for $18.25. The higher the spread the more the market maker profits and the higher the cost to investors. Heavily traded securities typically have narrow spreads while infrequently traded securities can have wide spreads.



  • How Your Securities are Protected


Investors’ money is protected in three ways: by federal laws and regulations, enforced by the SEC; by self-policing in the industry; and by state law.


Under the federal securities laws, those engaged in the business of buying and selling securities have a great deal of responsibility for regulating their own behavior through SROs (self-regulatory organizations) operating under the oversight of the SEC. These SROs include all of the exchanges; the NASD; the Municipal Securities Rulemaking Board (MSRB), which establishes rules that govern the buying and selling of securities offered by state and local governments; and other organizations concerned with somewhat less visible activities such as the processing of transactions.


The SROs are responsible for establishing rules governing trading and other activities, setting qualifications for securities industry professionals, regulating the conduct of their members, and disciplining those who fail to abide by their rules.


In addition, the federal securities laws provide investors with certain protections, including the ability to sue if they have been harmed as a result of certain violations of those laws.


Many brokerage firms may require that their customers sign an agreement containing an arbitration clause when they open a brokerage account. If you sign an agreement with an arbitration clause, you are agreeing to settle any future disputes with the broker through binding arbitration, instead of through the courts.


Arbitration proceedings are administered by the SROs, and the rules that apply in arbitration proceedings are specified by each SRO. Although the SEC oversees the arbitration process, it cannot intervene on behalf of or directly represent individual investors, nor can the SEC modify or vacate an arbitration decision. The grounds for judicial review are very limited.


Further protection for investors is provided by state laws designed to regulate the sale of securities within state boundaries.



The Function Of The SEC


The SEC, an independent agency of the U.S. Government, was established by Congress in 1934 to administer the federal securities laws. It is headed by five Commissioners, appointed by the President, who direct a staff of lawyers, accountants, financial analysts, and other professionals. The staff operates from its headquarters in Washington, D.C. and from five regional offices and six district offices in major financial centers throughout the country.


The SEC’s principal objectives are to ensure that the securities markets operate in a fair and orderly manner, that securities industry professionals deal fairly with their customers, and that corporations make public all material information about themselves so that investors can make informed investment decisions. The SEC accomplishes these goals by:


Mandating that companies disclose material business and financial information;

Overseeing the operations of the SROs;

Adopting rules with which those involved in the purchase and sale of securities must comply; and

Filing lawsuits or taking other enforcement action in cases where the law has been violated.

Despite the many protections provided by federal and state securities laws and SRO rules, it is important for investors to remember that they have the ultimate responsibility for their own protection. In particular, the SEC cannot guarantee the worth of any security. Investors must make their own judgments about the merits of an investment.



What Companies Must Disclose


Before any company offers its securities for sale to the general public (with certain exceptions), it must file with the SEC a registration statement and provide a “prospectus” to investors. In its registration statement, the company must provide all material information on the nature of its business, the company’s management, the type of security being offered and its relation to other securities the company may have on the market, and the company’s financial statements as audited by independent public accountants. A copy of a prospectus containing information about the company and the securities offered must be provided to investors upon or before their purchase. In addition, most companies must continue to update, in filings made with the SEC, this disclosure information quarterly and annually to ensure an informed trading market.


The SEC reviews registration statements and periodic reports for completeness, but the SEC does not review every detail and verification of each statement of fact would be impossible. However, the securities laws do authorize the SEC to seek injunctive and other relief for registration statements containing materially false and misleading statements.


Persons who willfully violate the securities laws may also be subject to criminal action brought by the Department of Justice leading to imprisonment or criminal fines. The laws also provide that investors may be able to sue to recover losses in the purchase of a registered security if materially false or misleading statements were made in the prospectus or through oral solicitation. Investors must seek such recovery through the appropriate courts, since the SEC has no power to collect or award damages or to represent individuals.



How the SEC Supervises Industry Professionals


Another important part of the SEC’s role is supervision of the securities markets and the conduct of securities professionals. The SEC serves as a watchdog to protect against fraud in the sale of securities, illegal sale practices, market manipulation, and other violations of investors’ trust by broker-dealers, investment advisers, and other securities professionals.


In general, individuals who buy and sell securities professionally must register with the appropriate SRO, meet certain qualification requirements, and comply with rules of conduct adopted by that SRO. The broker-dealer firms for which they work must, in turn, register with the SEC and comply with the agency’s rules relating to such matters as financial condition and supervision of individual account executives. In addition, broker-dealer firms must also comply with the rules of any exchange of which they are a member and, usually, with the rules of the NASD.


The SEC can deny registration to securities firms and, in some cases, may impose sanctions against a firm and/or individuals in a firm for violation of federal securities laws (such as, manipulation of the market price of a stock, misappropriation of customer funds or securities, or other violations). The SEC polices the securities industry by conducting inspections and working in conjunction with the securities exchanges, the NASD, and state securities commissions.



  • Protecting Yourself


You should be as careful about buying securities as you would be about any other costly purchase. The vast majority of securities professionals are honest, but be aware that misrepresentation and fraud do take place. Observe the following basic safeguards when “shopping” for investments:


Never buy securities offered in unsolicited telephone calls or through “cold calls” – ask for information in writing before you decide. Check on the credentials of anyone who tries to sell you securities.

Tip: Beware of salespeople who try to pressure you into acting immediately.

Don’t buy on tips or rumors. Not only is it safer to get the facts first, but also it is illegal to buy or sell securities based on “inside information” which is not generally available to other investors.

Get advice if you don’t understand something in a prospectus or a piece of sales literature.

Tip: Be sure you understand the risks involved in trading securities, especially options and those purchased on margin. Be skeptical of guarantees or promises of quick profits. There is no such thing–without an accompanying increase in risk.

Remember that prior success is no guarantee of future success in an investment arrangement.

With tax-sheltered investments, partnerships, and other “liquid” investments, be sure to ask about the liquidity and understand that there may not be a ready market when you want to sell.

Don’t speculate. Speculation can be a useful investment tool for those who can understand and manage the risks involved and those who can afford to lose money, but it is dangerous for most people.

Tip: For the average investor, more conservative investment strategies are generally appropriate.

Professional guidance can be very helpful in developing a sound investment program.


  • Types of Investments

There are two broad categories of securities available to investors- equity securities (which represent ownership of a part of a company) and debt securities (which represent a loan from the investor to a company or government entity). Within each of these types, there are a wide variety of specific investments. In addition, different types can be combined (e.g., through mutual funds) or even split apart to form derivative securities.

Each type has distinct characteristics plus advantages and disadvantages, depending on an investor’s needs and investment objectives. In this section, we provide an overview of the most common classes of investment securities.



The type of equity securities with which most people are familiar is stock. When investors buy stock, they become owners of a “share” of a company’s assets. If a company is successful, the price that investors are willing to pay for its stock will often go up–shareholders who bought stock at a lower price then stand to make a profit. If a company does not do well, however, its stock may decrease in value and shareholders can lose money. The rise in the price of a stock is termed ppreciation or “capital gain.” The stockholder is also entitled to dividends, which may be paid out from the company. Investors, therefore, have two sources of profit from stock investments, dividends and appreciation. Some stocks pay out most of their earnings as dividends and may have little appreciation. These stocks are sometimes referred to as income stocks. Other stocks may pay out little or no dividend, preferring to reinvest earnings within the company. Since all of an investors potential earnings comes from appreciation these stocks are sometimes referred to as growth stocks. Stock prices are also subject to both general economic and industry-specific market factors. There is no guarantee of a return from investing in stocks and hence there is risk incurred in investing in this type of security.


As owners, shareholders generally have the right to vote on electing the board of directors and on certain other matters of particular significance to the company. Under the federal securities laws, most companies must send to shareholders a proxy statement providing information on the business experience and compensation of nominees to the board of directors and on any other matter submitted for shareholder vote. This information is required so that stockholders can make an informed decision on whether to elect the nominees or on how to vote on matters submitted for their consideration.


Stock investments are typically common stock, which is the basic ownership share of a company. Some companies also offer preferred stock, which is another class of stock. Preferred stock typically offers some set rate of return (although it is still not guaranteed), and pays dividends before dividends are paid for common stock. Preferred stock may not, however, participate in a much upside as common stock. If a company does really well, preferred stockholders may receive the same dividend as any other year while common stockholders reap the rewards of a great year.



Corporate Bonds


The most common form of corporate debt security is the bond. A bond is a certificate promising to repay, no later than a specified date, a sum of money which the investor or bondholder has loaned to the company. In return for the use of the money, the company also agrees to pay bondholders a certain amount of “interest” each year, which is usually a percentage of the amount loaned.


Since bondholders are not owners of the company, they do not share in dividend payments or vote on company matters. The return on their investment is not usually dependent upon how successful the company is. Bondholders are entitled to receive the amount of interest originally agreed upon, as well as a return of the principal amount of the bond, if they hold the bond for the time period specified.


Companies offering bonds to the public must file with the SEC a registration statement, including a prospectus containing information about the company and the security.



Government Bonds


The U.S. Government also issues a variety of debt securities, including Treasury bills (commonly called T-bills), Treasury notes, and U.S. Government agency bonds. T-bills are sold to selected securities dealers by the Treasury at auctions.


Government securities can also be purchased from banks, government securities dealers, and other broker-dealers.


Similar to corporate bonds, these bonds pay interest and the amount of principal at maturity. Some (viz., Treasury Bills) may not pay cash interest. Instead the bond is purchased at a discount and the interest is built into the amount the investor receives at maturity. Contrary to popular belief investors must pay income tax on U.S. government bond interest.



Municipal Bonds


Bonds issued by states, cities, or certain agencies of local governments (such as school districts) are called municipal bonds. An important feature of these bonds is that the interest a bondholder receives is not subject to federal income tax. In addition. the interest is also exempt from state and local tax if the bondholder lives in the jurisdiction of the issuing authority. Because of the tax advantages, however, the interest rate paid on municipal bonds is generally lower than that paid on corporate bonds.


Municipal bonds are exempt from registration with the SEC; however, the MSRB establishes rules that govern the buying and selling of these securities.



Stock Options


An option is the right to buy or sell something at some point in the future. An option is a type of derivative security. There are a wide variety of these specialized instruments such as futures, options and swaps. Most are not appropriate for the average investors. The type of options with which we are concerned here are standardized, exchange-traded options to buy or sell corporate stock.


These options fall into two categories-


“Calls,” which give the investor the right to buy 100 shares of a specified stock at a fixed price within a specified time period, and

“Puts,” which give the investor the right to sell 100 shares of a specified stock at a fixed price within a specified time period.

While options are considered by many to be very risky securities, if used properly they can actually reduce the risk of a portfolio. Generally you buy a call option if you are bullish on a stock (i.e. you expect the price to go down). The price you pay is called the premium. You would purchase a put option if you are bearish on a stock (i.e. you expect the price to go down). If the stock moves in the right direction you can profit handsomely. If it doesn’t you lose the premium that you paid. Buying puts and calls is not a risky strategy, but selling puts an calls is. One exception is selling a call option on a stock you already own. This is known as a “covered call.” This actually reduces the overall risk of your portfolio in exchange for you giving up some of your upside.



Mutual Funds


Companies or trusts that principally invest their capital in securities are known as investment companies or mutual funds. Investment companies often diversify their investments in different types of equity and debt securities in hope of obtaining specific investment goals. In a mutual fund you invest in the mutual fund which then invest in individual equity and debt securities. This relieves you of the necessity to make individual purchase and sale decisions. It also provides an easy way to diversify a portfolio. Rather than purchasing 50 stocks yourself, you can purchase one mutual fund.


Related Guide: For more detailed information, please see the Financial Guide INVESTING IN MUTUAL FUNDS: Time-Tested Guidelines.



  • Investment Contracts and Limited Partnerships


Investors sometimes pool money into a common enterprise managed for profit by a third party. This is called an investment contract. Such enterprises may involve anything from cattle breeding programs to movie productions. This is often done through the establishment of a limited partnership in which investors, as limited partners, own an interest in a venture but do not take an active management role. Some of these securities have been issued in the past primarily for purposes of reducing income tax liability. Such opportunities are limited today. Care should be taken in investing in these securities since they can be illiquid and require a great deal of expertise. You should consult with your financial advisor regarding these types of investments.



Real Estate Investment Trust (REIT)


Real estate investment trusts are set up in a fashion similar to mutual funds. Instead of investing in stocks or bonds, however, REIT investors pool their funds to buy and manage real estate or to finance real estate construction or purchases. Real estate limited partnerships are also common. This is a way to get iversification from real estate investment without the headaches of property ownership and management.



Asset Allocation


Asset allocation is the process of allocating your investments among the broad categories of stocks, corporate bonds, government bonds, etc. It is extremely important in investment success. In fact, portfolio selection should generally be based on asset allocation, whether formal or informal. This process can be complicated, but computer programs are available to assist in performing the allocation.


Related Guide: For a discussion of this very important concept, please see the Financial Guide ASSET ALLOCATION: How To Diversify Your Assets For Maximum Return




  • Risk vs. Return


One of the more basic relationships in investing is that between risk and reward. Investments that offer potentially high returns are accompanied by higher risk factors. It is up to you to decide how much risk you can assume. Always keep in mind your current and future needs.





There are many types of risk. The one most people think of is market risk, which is the risk that market prices can fluctuate. If you have a short investment horizon, generally something less than five years, this risk is important since the market could be down at the time you most need the money. On the other hand, if you have a long time horizon, for example when saving for retirement, you may be unconcerned with market risk. The investment has the opportunity to come back prior to the time you need the funds.


Another risk, which many people don’t think about, is purchasing power risk. This is the risk that your investment will not keep up with inflation and you will not be able to maintain your desired standard of living. A bank CD for example might pay interest of 3% and have no market risk. Your principal does not fluctuate in value and you are insured against loss. However, if inflation exceeds 3% you will lose purchasing power.


Tip: In general, prospective investors should avoid “risky” investments unless they have a steady income, adequate insurance, and an emergency fund of readily accessible cash.

Tip: U.S. Treasury bills, notes, and bonds are the safest possible investments.

You need to assess how much risk you can tolerate. One easy way to measure this is how well do you sleep at night. If you lie awake worrying about your investments, you risk tolerance is probably too low for your current investment strategy. In general the longer your investment horizon the greater the amount of risk you can afford to take. Your financial advisor can also assist you in measuring your risk tolerance.


Risk can also be reduced through diversification. Rather than buying one stock, buy a basket of 20 to 30 stocks. This reduces your overall risk. You can also reduce risk by combining different investment types such as stocks, corporate bonds and government bonds. These securities are not highly correlated (i.e. they tend not to go up or down at the same time).





Why would one want to take on more risk? Because it generally comes with a higher expected return. While stocks may have the greatest market risk, they have also provide that highest market return over the long haul. Stock returns have averaged between 10 and 11% since the early part of this century. Corporate bonds on the other hand have averaged between 6 and 7% and government bonds closer to 5%. As you can see the lower the risk the lower the expected return. You must balance the amount of risk you are willing to tolerate with the amount of return you expect to achieve. There is no such thing as a high return/low risk investment.



  • Planning Techniques


You should assess your current resources and future goals. This will assist you and your advisors in determining what rate of return is necessary to achieve your goals and how much risk you can tolerate. Here is a suggested checklist:


Assess your current financial resources. How much do you have to invest?

Assess your future financial resources. Do you have an excess of income over expenses that can be invested?

Determine your financial goals. How much money do you need and when do you need it?

Determine the rate of return you need to achieve your goals.

Determine how much risk you can tolerate based upon your time horizon and personal preferences.

Choose an appropriate asset allocation to achieve the desired risk/return relationship. How should you allocate your investment among the various classes of investments?

Choose the individual securities within each asset class. Which securities should you buy?



  • Security Selection


Once you have decided what percentage of your assets should go in each asset class, you need to select the appropriate individual securities. You should consider the same techniques as in selecting the asset classes to invest in. For each security you must evaluate its unique risk and its expected return. There are a number of sources of information about specific securities that you can explore.. Generally, the most important of these for mutual funds and new stock issues is the prospectus, which is the security’s selling document, containing information about costs, risks, past performance (if any) and the investment goals. Read it and exercise your judgment carefully, before you invest. You can obtain the prospectus from the company or mutual fund or from your financial advisor.


In the case of a mutual fund, there is also a Statement of Additional Information (SAI, also called Part B of the prospectus). It explains a fund’s operations in greater detail than the prospectus. You can get a clearer picture of a fund’s investment goals and policies by reading its annual and semi-annual reports to shareholders. If you ask, the fund must send you an SAI and/or its periodic reports. This process is time-consuming and requires a great deal of time and expertise.


Keep in mind that proper security analysis is extremely complex. Computer programs (the good ones are usually quite expensive) are invaluable in helping choose an appropriate portfolio; however, these programs require a familiarity with their use and an understanding of their limitations. Generally, if you do not have the time to perform the necessary analyses or the experience or expertise in security selection, you should consult with your financial advisor.




  • Six Investing Pitfalls To Avoid

Here are the top mistakes that cause investors to lose money unnecessarily.


  1. Using A Cookie-Cutter Approach

Most investors-along with many of the people who advise them-are satisfied with a one-size-fits-all investment plan. The “model portfolio” is useless to most investors. Your individual needs as an investor must govern any plans you make for investment. For instance, how much of your investment can you risk losing? What is your investment timetable (i.e., are you retired, a young professional, or middle-aged)? The allocation of your portfolio’s assets among various types of investments-Treasuries, blue-chip stocks, equity mutual funds, and others– should match your needs perfectly.


  1. Taking Unnecessary Risks

You do not have to risk your capital to make a decent return on your money. There are many investments that offer a return that beats inflation-and more-without unduly jeopardizing your hard-earned money. For instance, Treasuries, the safest possible investment, offer a decent return with virtually no risk. Blue-chip preferred stocks, common stocks, and mutual funds offer high returns with a fairly low level of risk.


  1. Allowing Fees and Commissions to Eat Up Profits

Many investors allow brokers’ commissions and other return-eating costs to cut into their returns. Professionals need to be compensated for their time, however, you should make certain that the fees you are paying are appropriate for the services performed.


  1. Not Starting Early Enough

Many investors are not cognizant of the power of interest compounding. By starting out early enough with your investment plan, you can invest less, and still come out with double or even quadruple the amount you would have had if you started later. Another way to look at it is that by investing as much as possible earlier on, you’ll be able to meet your goals and have more current cash on hand to spend.


  1. Ignoring the Cost of Taxes

Every time you or your mutual fund sells stocks, there is a capital gains tax to pay. Unless you are in a tax-deferred retirement account, the taxes will eat into your profits. What to do: Invest in funds that have low turnover (i.e., in which shares are bought and sold less frequently). Your portfolio, overall, should have a turnover of 10% or less per year.


  1. Letting Emotion-or Magical Thinking–Govern Your Investing

Never give in to pressure from a broker to invest in a “hot” security or to sell a fund and get into another one. The key to a successful portfolio lies in planning, discipline, and reason. Emotion and impulse have no role to play in investing. Similarly, do not be too quick to unload a stock or fund just because it slips a few points. Try to stay in a security or fund for the long haul. (On the other hand, when it’s time to unload a loser, then let go of it.) Finally, do not fall prey to the myth of “market timing.” This is the belief that by getting into or out of a security at exactly the right moment, we can retire rich. Market timing does not work. Instead, use the investment strategies that do work: a balanced allocation of your portfolio’s assets among securities that suit your individual needs, the use of dividend-reinvestment programs and other cost-saving strategies, and a well-disciplined, long-haul approach to saving and investment.


Exiting Your Business

Maximize Your Wealth With a Winning Exit Plan


How To Get What You Want When You Leave Your Business


Few things are certain in business life, but there is one universal truth: Be it a carefully planned decision or the result of fate’s swift hand, someday you will leave your business.


Your exit is going to take place in one of two ways:


  1. You will transfer ownership of the business during your lifetime because you’ve decided you want out. Without planning, this will probably mean that you have to liquidate. With planning you will be able to sell the business to a third party, to key employees or co-workers, or to family members – all at minimal tax rates.
  2. You will die or become totally disabled, and the business will have to be liquidated unless some type of business continuity arrangements have been planned and documented.

Most owners measure their satisfaction with their business in terms of the income, wealth, identity, challenge, stimulation, satisfaction and pride that it provides to them. Consider another definition of success that measures a business – not only by how well it operates under your ownership and by the benefits it provides — but also by the rewards it will bestow when you leave it. Because in the end, what you really want and need from your business is the ability to leave it – under the most favorable conditions. The only way you as an owner can do this successfully is to create an exit plan as early as possible and stick to that plan as long as you maintain your business.



Developing Your Exit Plan


What exactly is an Exit Plan that will allow you to leave your business in style and how do you create it? Despite the almost infinite variety of businesses and business owners almost all exit plans contain common elements or goals. Generally these goals fall into three broad categories:


  1. To create and preserve the value of the company;
  2. To provide a means to exchange that value for money with the least tax consequence possible;
  3. To meet personal and family needs by providing security and continuity to your business and for your family either upon your planned departure or if disaster strikes – upon your death or disability.


Creating and Preserving Value In Your Business


Most entrepreneurs are so dedicated to the worthy purpose of making money that they have little or no time to spend on creating and preserving value for their business. You must find the time because…


First, to exit the business in style, you will need cash. That source of cash is the business. To determine the amount of cash you will receive, we must know the value of the business.


Second, if you intend to give the business to children, the business must be valued and that value must be used for gift tax purposes.


Third, the business typically comprises the great majority of an owner’s total wealth. The IRS knows this just as surely as you do. Determining the value now, allows you the opportunity to design an Exit Plan taking your business into account with the goal of minimizing the IRS’s take.


Fourth, well-designed key employee incentive compensation planning is central to increasing business value. Business value is often used as a measuring rod for such plans.


Fifth, if an owner goes through this exercise well before the business is sold or transferred, he or she will be able to pinpoint the factors that are crucial to measuring and increasing (or decreasing) the worth of the business.



How Much Is Your Business Worth?


Determining The Value


Valuation of your business is likely to be performed by your CPA or a business appraiser using a methodology consistent with the approaches sanctioned by the IRS. This valuation will determine a range of fair market values for your business for purposes of gifting, estate taxation, and general planning. Note that this fair market value is not the same as the sales price for your business. To determine the sales price, the fair market value is used as a hypothetical starting point and adjusted to accommodate factors like timing of the sale and industry cycles, current condition of the merger and acquisition market, interest rates, and geographic location among others.


The technical details of business valuation are beyond the scope of this report. But one aspect worth noting is that estimating the value of your business will be critically dependent on who the business will be transferred to. If you are selling the business to an outside third party, you will seek the highest possible value for your ownership interest. If you are transferring ownership to your children, you must make every effort to develop the lowest defensible value for your ownership interest. This counter intuitive strategy is due to the huge role the IRS plays in the transfer of your business.


If you decide to sell to an outside third party, it will be for cash and you’ll want all you can get via a high value. But your children, your employees, your co-owner don’t have much of that green stuff. Their source of money, or cash flow, is the same as yours – the business. They will need to earn money on the business and pay income tax on it (tax #1) then pay the balance to you to buy the business – at which time you will pay a second tax on the gain (tax #2). The higher the business value, the greater the purchase price. The greater the purchase price, the greater the double tax bite.


For example, if company earnings are distributed to the purchaser (let’s say a key employee), it will be taxed to her as compensation – salary or bonus money. She will then pay the after tax money to you (say 65 cents of the original dollar of earnings). You in turn pay a capital gains tax on the 65 cents received (assume little or no basis on your ownership interest, therefore a tax of about 25 percent). The net is less than 50 cents on each dollar earned and paid out by the company.


In other words, all purchasers, other than outside third parties, need to look to the earnings of the company for money to pay to you because they have no money of their own. This results in a double tax paid on the money received by you (taxed once as the employee/purchaser earns it and once when you receive it for your stock). The higher the business value, the higher the tax, the more difficult it is to accomplish a successful transfer� the less likely you will leave your business in style. Methods for avoiding this double taxation are rather complex for our discussion here, but keep in mind that determining the value of your business will require you to decide early on how you wish to transfer it.



How To Motivate And Retain Key Employees Through Ownership


The one indispensable component of a valuable business is its top employees. Think about it: your top employees are even more valuable than you are for the purpose of creating value for your ownership interest. The more valuable you are to the business, the less valuable the business will be when you leave it. What you need to do is leave behind key employees who add significant value to the business for several important reasons:


  1. Properly motivated by a profit-based incentive plan, key employees do increase the value of your business.
  2. Key employees often become potential owners when you decide to retire or move on to another venture.
  3. If you decide to sell to a third party, the continued existence of a stable, motivated management team will increase the purchase price.

Key employees are not necessarily employees in key positions. Key employees think and act a lot like you, they are eager to be given responsibilities and challenges. Like you, they want to see the business grow and prosper, and they want to grow and prosper along with it. They take pride in being identified with, and contributing to, a successful business. In short, they act like owners. Their continued presence in the business is necessary if the business is to thrive.


There are several incentive packages you can implement to retain and motivate key employees. These incentive packages help your key employees reach their financial and psychological goals – if they stay with you. As your key employees attain their goals, the design of these incentive packages should also help you to achieve your ownership goal of building business value (and eventually converting that value into money). Take a hard look at your current employee benefit programs, especially those aimed at your key employees. Elements of your incentive program should include:


  1. Financially attractive awards that create a potential bonus of at least 10 percent of the key employee’s annual compensation. Anything less than this will not be sufficiently attractive to motivate the key employee to modify his or her performance to make the company more valuable.
  2. Specifics; that is, determinable performance standards, such as the company reaching a certain net income or revenue level.
  3. Structure to increase the company’s value such that, as the key employee reaches measurable objective standards, the net income of the company increases.
  4. Incentive reward vesting or “golden handcuffs” that link payment to tenure thus encouraging the employee to remain on the job in order to receive the reward.
  5. Face-to-face meetings with your key employees to discuss the plan and make sure the incentive arrangements are thoroughly understood and all questions answered.


Four Ways To Leave Your Business – Which One Is Right For You?


Selecting your successor is a fundamental objective that is decided early in the Exit Planning process. Almost all owners want to transfer the business to other family members, an employee or a co-owner; only about 5 percent want to sell to an outside third party. Interestingly, however, most persons first identified as successors do not usually end up as the ultimate owners.


Choosing your successor involves a careful assessment of what you want from the sale of your business and who can best give it to you. There are only four ways to leave your business. If you know these methods and decide in advance which one you prefer, then you have a better chance of leaving your business under terms and conditions you choose. Without planning you are more likely to settle for terms and conditions beyond your control.


  1. Transfer of Ownership to Your Children


50 percent of typical business owners want to transfer their business to their children. Fewer than one in three of these owners end up doing so. Because this is the riskiest way to leave your business, you must prepare for failure by developing a contingency plan to convey your business to another type of buyer.


Transferring a business within the family fulfills many people’s personal goals of keeping their business and family together. It can provide financial well-being for younger family members unable to earn comparable income from outside employment, as well as allow you to stay actively involved in the business with your children until you choose your departure date. Transferring your business to your children will also afford you the luxury of selling the business for what you need to live on, even if the value of the business does not justify that sum of money. You will determine how much you need or want, rather than be told how much you will get.


On the other hand this option also holds great potential to increase family friction, discord, and feelings of unequal treatment among siblings. The normal objective of treating all children equally is difficult to achieve because one child will probably run or own the business at the perceived expense of the others. At the same time financial security is normally diminished rather than enhanced and the very existence of the business is at risk if it’s transferred to a family member who can’t or won’t run it properly. In addition the vagaries of family dynamics may also significantly diminish your control over the business and its operations.


  1. Sale to Other Owners or Employees


One of the great advantages of having other owners in your business is that they can be your means to retirement. Especially with smaller businesses, a common retirement planning technique is to have a younger individual buy into your business while you are still active. Upon your retirement, the younger owner will purchase your remaining stock.


This plan can be advantageous because the younger person learns the business – its structure, employees, customers, operation, and management – under your tutelage. More important for you, the younger person’s capabilities (as well as his weaknesses) are known to you, so you have a pretty good idea of how your business will be run after you leave. And most important of all, the business can be sold to a market you create and control. You structure the deal ahead of time to suit your particular needs and objectives.


Disadvantages in this plan are that there is no cash up front, unless you as the owner have pre-funded the sale, but even then, you have probably pre-funded with money that was yours anyway. A great risk also exists in the fact that the buyout money comes from the future earnings of the business after you leave it. Employees are often employees because they don’t have an owner “mindset.” They’re not entrepreneurs and they don’t respond well to the challenges and pressures of ownership. These disadvantages apply especially to businesses worth more than $2 million. The owner simply has too much money and financial independence at risk, and the price will be too high for an employee to afford.


  1. Sell It To A Third Party


In a retirement situation, a sale to a third party too often becomes a bargain sale – the only alternative to liquidation. But if the business is well prepared for sale this option just might be your best way to cash out. In fact you may find that this so called “last resort” strategy just happens to land you at the resort of your choice.


Although many owners don’t realize it, you should get most or all of your money from the business at closing. Therefore, the fundamental advantage of a third party sale is immediate cash or at least a substantial up front portion of the selling price. This ensures that you obtain your fundamental objectives of financial security and, perhaps, avoid risk as well. A second unanticipated advantage in selling to a third party is the ability to frequently receive substantially more cash than your CPA or other business appraiser anticipated because the market place is “hot.” Finally, this may be the best option for a business that is to valuable to be purchased by anyone other than someone who has access to a considerable source of money.


If you do not receive the bulk of the purchase price in cash, at closing, however, your risk will suddenly become immense. You will place a substantial amount of the money you counted on receiving in the unpredictable hands of fate. The best way to avoid this risk is to get all of the money you are going to need at closing. This way any outstanding balance payable to you is “icing on the cake.”


  1. Liquidate It


If there is no one to buy your business, you shut it down. In a liquidation the owners sell off their assets, collect outstanding accounts receivable, pay off their bills, and keep what’s left, if anything, for themselves.


The primary reason liquidation is considered is that a business lacks sufficient income-producing capacity apart from the owner’s direct efforts and apart from the value of the assets themselves. For example if the business can produce only $75,000 per year and the assets themselves are worth $1 million, no one would pay more for the business than the value of the assets.


Service businesses in particular are thought to have little value when the owner leaves the business. Since most service businesses have little “hard value” other than accounts receivable, liquidation produces the smallest return for the owner’s lifelong commitment to the business. Smart owners guard against this. They plan ahead to ensure that they do not have to rely on this last ditch method to fund their retirement.

Securing Business Loans

Show Me The Money! Strategies For Securing a Loan



Most small businesses will, at some point in their life, go to a bank or other lending institution to borrow money for expansion of their operation. Many small business owners, however, initially fall victim to several of the common and potentially destructive myths that concern applying for loans. For example, first-time borrowers commonly believe…


  • Lenders are lined up and eager to provide money to small businesses.
  • Banks are willing sources of financing for start-up businesses.
  • Loans are obtained by talking the lender out of funds.
  • When it comes to seeking money, the company speaks for itself.
  • A bank, is a bank, is a bank, and all banks are cold, impersonal institutions.
  • Banks, especially large ones, do not need and really do not want the business of a small firm.


Research shows that 67 percent of all small businesses that borrow money get that money from commercial banks. This places banks among the largest sources of credit; and makes them one of the most vital components to small business survival. Understanding what your bank wants, and how to properly approach them, can mean the difference between getting your money for expansion and having to scrape through finding cash from other sources.



A Mile In The Banker’s Shoes


There is a name for people who simply walk into a bank and ask for money… Bank Robbers. To present yourself as a trustworthy businessperson, dependable enough to repay borrowed money, you need to first understand the basic principles of banking. Your chances for receiving a loan will greatly improve if you can see your proposal through a banker’s eyes and appreciate the position that they are coming from.


Banks have a responsibility to government regulators, depositors, and the community in which they reside. While a bank’s cautious perspective may be irritating to a small business owner, it is necessary in order to keep the depositors money safe, the banking regulators happy, and the economic health of the community growing.



Picking A Local Favorite


Banks differ in the types of financing they make available, interest rates charged, willingness to accept risk, staff expertise, services offered, and in their attitude toward small business loans.


Selection of a bank is essentially limited to your choices from the local community. Banks outside of your area are not anxious to make loans to your firm because of the higher costs of checking credit and of collecting the loan in the event of default.


Furthermore, a bank will typically not make business loans to any size business unless a checking account or money market account is maintained. Out-of-town banks know that non-local firms are not likely to keep meaningful deposits at their institution because it is to costly in both time and expense to do so.


Ultimately your task is to find a business-oriented bank that will provide the financial assistance, expertise, and services your business requires now and is likely to require in the future. Your accountant will be able to assist you in deciding which bank will best suit your needs and provide the greatest value.



Realize The Value Of Schmooze


Devote time and effort to building a background of information and goodwill with the bank you choose, and get to know the loan officer you will be dealing with early on.


Building a favorable climate for a loan request should begin long before the funds are actually needed. The worst possible time to approach a new bank is when your business is in the throes of a financial crisis. That’s like walking into a funeral parlor carrying a body!


Remember that bankers are essentially conservative lenders with an overriding concern for minimizing risk. Logic dictates that this is best accomplished by limiting loans to businesses they know and trust.


Experienced bankers know full well that every firm encounters occasional difficulties; a banker you have taken the time and effort to build a rapport with will have faith that you can handle these difficulties.


A responsible reputation for debt repayment may also be established with your bank by taking small loans, repaying them on schedule, and meeting all facets of the agreement in both letter and spirit. By doing so, you gain the bankers trust and loyalty. He or she will consider your business a valued customer, favor it with privileges, and make it easier for you to obtain future financing.



Enter With A Silver Platter


Lending is the essence of the banking business and making mutually beneficial loans is as important to the success of the bank as it is to the small business. This means that understanding what information a loan officer seeks, and providing the evidence required to ease normal banking concerns, is the most effective approach to getting what is needed. A sound loan proposal should contain information that expands on the following points:


  • What is the specific purpose of the loan?
  • Exactly how much money is required?
  • What is the exact source of repayment for the loan?
  • What evidence is available to substantiate the assumptions that the expected source of repayment is reliable?
  • What alternative source of repayment is available if management’s plans fail?
  • What business or personal assets, or both, are available to collateralize the loan?
  • What evidence is available to substantiate the competence and ability of the management team?


Even a brief examination of these points suggests the need for you to do your homework before making a loan request. It is a virtual certainty that an experienced loan officer will ask probing questions about each of them. Failure to anticipate these questions, or to provide unacceptable answers, is damaging evidence that you may not completely understand the business and/or are incapable of planning for your firm’s needs.


Here are a few additional steps to take before applying for your loan…



Write A Business Plan


To present you and your business in the best possible light, the loan request should be based on and accompanied by a complete business plan. This document is the single most important planning activity that you can perform. A business plan is more than a device for getting financing; it is the vehicle that makes you examine, evaluate, and plan for all aspects of your business. A business plan’s existence proves to your banker that you are doing all the right activities. Once you’ve put the plan together, write a two-page executive summary. You’ll need it if you are asked to send “a quick write-up.”



Have an accountant prepare historical financial statements.


You can’t talk about the future without accounting for your past. Internally generated statements are OK, but your bank wants the comfort of knowing an independent expert has verified the information. In addition, you must understand your statement and be able to explain how your operation works and how your finances stand up to industry norms and standards.



Line up references.


Your banker may want to talk to your suppliers, customers, potential partners or your team of professionals, among others. When a loan officer asks for permission to contact references, promptly answer with names and numbers; don’t leave him or her waiting for a week.


Walking into a bank and talking to a loan officer will always be something of a stressful situation. You’re exposing yourself to the possibility of rejection, scrutiny, and perhaps even criticism of your business. Preparation for, and thorough understanding of this evaluation process, is essential to minimize the stressful variables and optimize your potential to qualify for the funding you seek.


Keep in mind that many times a company fails to qualify for a loan not because of a real flaw, but because of a perceived flaw that was improperly addressed or misrepresented. Finally, don’t be shy about calling your accountant with questions; their experience and invaluable advice will be able to best prepare you for working with your bank.

Starting A Business

3 Things You Must Know


Starting a new business is a very exciting and busy time. There is so much to be done and so little time to do everything and to make all the necessary decisions, let alone stay current with the paperwork. That’s where we can help. There are a variety of federal and state forms and applications that will need to be completed to get your business started.


1) Federal ID Number

Securing a federal ID number needs to be accomplished first since many other forms require it. After form SS-4 is complete the IRS can be called to get your Federal ID#. After the completed form is mailed to the IRS, you will receive federal tax coupons which are needed for payroll tax deposits.


2) State Withholding, Unemployment, and Sales Tax

You will then need to fill out forms to establish your account with the State for payroll tax withholding, Unemployment Insurance Registration, and sales tax collections (if applicable).


3) Payroll Record Keeping

Payroll reporting and record keeping can be very time consuming and costly, especially if not handled correctly. Let our expertise handle that part of your business so you can concentrate on running your business. Also keep in mind, almost all employers will be required to transmit their federal payroll tax deposits electronically. You should keep personnel files for each employee. Included should be the employee’s employment application as well as the following:


W-4 Form – completed by the employee and used to calculate their federal income tax withholding. Also includes necessary information such as address and social security number.


I-9 Form – required to be completed by you, the employer, to verify employees have permission to work in the U.S.