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The Independent Contractor Revisited

As the federal government and the state governments look for more ways to bring in money, the independent contractor status is a likely place for them to look. After all, by using independent contractors rather than employees, employers don’t have to withhold taxes, provide workers’ compensation, contribute to unemployment compensation, or provide any benefits such as 401-k programs, health insurance or other benefits. Plus you can use and discontinue independent contractors as needed.

Certainly, in this age of home-based businesses, the use of outside sources makes a lot of sense. Outsourcing a lot of business needs has been done for years and will only increase with growth of small business. Most one-person and small businesses don’t need full-time employees. Many requirements can be outsourced to independent contractors who in turn outsource many of their requirements.
It is the use of workers who are classified as independent contractors, but are really employees that can cause legal issues. FedEx Ground has been in the middle of this type of legal dispute for several years. FedEx claimed that their drivers were franchisees and therefore independent contractors; several drivers (and later the IRS) challenged that status, claiming that the drivers were really employees.

Here are some basic distinctions between independent contractors and employees:

Lack of employers’ direction is one major difference. In other words, the worker is left to his or her devices and does what the particular job requires without direction from the employer.
Is the worker working primarily for one employer or working for several employers on an as needed basis?

The worker is not in the same general business as the employer. A full-time consultant in the same line of business as the employer might be considered an employee. If the employee has his or her own business and also works for other companies, he probably would be considered an independent contractor.

Just because the worker creates an LLC or even an S-corporation doesn’t necessarily protect both sides from being classified as an independent contractor.

The federal government and the states are narrowing the definition of an independent contractor. One must definitely be truly independent to be considered an independent contractor. FedEx franchises (for lack of another term) wear FedEx garb, have FedEx logos on their trucks, and deliver FedEx packages on defined routes. However, we understand that they buy their own trucks and can sell their FedEx routes. But, consider the old saying: If it looks like a duck, acts like a duck and makes duck-like noises, there is a very good chance it is a duck. The battle goes on, but the penalties for violating the status of your people can be very expensive.

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Entrepreneurship Is Alive and Well!

A recent article in the Boston Globe reported that although more attention is on the large, primarily publicly held companies, more and more people are making their living by operating their own businesses. In fact, nationally, over 500,000 new businesses are started every year.  What this means is that over 10 percent of workers are “either starting a business or working at one that is less than 3 1/2 years old.”  And, as indicated by frequent reports, new businesses create new jobs.

Those people who start businesses generally do not have their own funds available for start-up expenses. This is due in part to the fact that bank and SBA funding is not available to them.  In addition, fewer than seven percent of new or prospective business owners will receive actual venture capital funds.  So, where does the money come from?  Second mortgages, credit cards, and family loans are the most common sources of start-up funds.  The Globe added that “over the past few years, more than 80 percent of Inc. Magazine’s Fast 1000 companies have been started with about $50,000 or less.”

The article concluded with a plea for “seed” capital and funding from both public and private sources.  Perhaps this article and similar ones will lead the way towards the recognition that those who own and operate their own businesses deserve a less arduous journey toward making the right start.

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Small Companies Are Innovators

Small companies are the innovators. The need for large companies to acquire small companies is necessary in order for the former to capture new products and services.  According to Fortune magazine, “Big companies almost never innovate. This is unfortunate because innovation is one of the few ways to gain proprietary advantage and stay profitable.  It’s not that innovation itself is rare – it’s occurring everywhere.  Which means, mostly, elsewhere.  And as engineers and inventiveness continue to flourish in China and India, elsewhere moves farther and farther from here.  A healthy business must therefore not only innovate more within its walls but leverage innovation elsewhere too.

“So why is innovation so hard for big companies?  The main reason is that innovative people tend to prefer working in smaller organizations that have more focus and less bureaucracy.  Even in small companies, adopting a large-company style can frustrate the innovators.
“The problem with large companies isn’t that they fail to do large and seemingly ambitious projects; it’s that they fail to do small, quirky, controversial projects  – that  have the potential to grow.  (If everyone thinks an idea is okay, how can it be innovative?)  A large organization – its missions threatened by new ideas – is often incredibly hostile to its own innovators; the antibodies to change are strong.”

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Small Company Growth Trends

The median sales of a company going public has gone from an average $15 million in 1999 and 2000 to $164 million in 2004.  Smaller companies have decided not to go public as often as in years past, and they reap the quick – and cheap – money as a result of that decision.  The question is “why?”

A company with only $15 million in annual revenues would most likely not want to have an IPO and absorb all of the attendant costs and the on-going fees related to going public.  They also would not want to have to spend the money necessary to comply with the Sarbanes-Oxley regulations.  Smaller companies have to pay a hefty price to go public – and remain public.  In fact, a recent Business Week article reported that “Bankers expect a record number of U.S. companies to go private this year, topping last year’s 86.”

Many CEOs, in order to rapidly grow their businesses, merge or acquire other companies.  However, many of these do not work out and the acquired entities eventually get sold off.  But as long as mergers and acquisitions are in vogue, large companies will acquire smaller ones in an effort to grow as rapidly as possible.  Therefore, many smaller companies that won’t go public because of the costs and subsequent compliance issues will be absorbed by larger companies.

The trend today, at least in manufacturing, is to provide complementary services.  For example, General Electric manufactures aircraft engines and medical equipment, but they also provide financing and maintenance services for the things that they manufacture.  These ancillary, but complementary, services are big profit makers.  Small service companies that provide these services may be excellent acquisition targets for manufacturers.  If smaller companies want to grow, adding complementary services such as GE does may be the best way.

On the flip side, many large companies are divesting themselves of companies that don’t fit into their core strategy.  For example, McDonald’s purchased Boston Market and several other food franchises in an effort to continue their growth. McDonald’s discovered that they were much better off focusing on their core business than they were trying to grow new concepts.  It is believed that these other franchises will be sold or they may already have been.  Smaller companies may want to divest themselves of products or services that aren’t complementary to their core business.

Some companies have almost reinvented themselves by adding new, more profitable, and “sexier” services or products.  This can increase the value of the company.  Smaller companies, because of their size and the fact that they usually have one manager, can shift quickly.  They can get rid of products or services that don’t generate commensurate profits, or add new products or services that can add to profits, much more quickly and efficiently than their larger counterparts.

Small companies, at least for the short term, will not be likely to go public, will be able to shift gears quickly to improve profits, but may also become acquisition targets by larger companies.

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A Board of Advisors

In most jurisdictions, a board of directors is not required for privately held companies.  However, many of these companies have appointed what might be termed advisory boards.  Although they may not have any legal authority, owners of these privately owned companies have discovered that this team of outside advisors can assist them in many ways.

One important way they can help is just by having their name and/or company affiliation attached to the company.  This can open doors to new customers and new relationships.  Appointing advisors from both the accounting and legal fields can help insure that the company maintains strong controls on these important areas.  This board can also assist in developing company strategy and systems.  A business-savvy board can also help in management succession and can help prepare the company for sale.

In order to create a strong and helpful advisory board, “cronies” should not be included. The advisory team can consist of two to four people. They should meet several times a year, or in emergency sessions when necessary, and be available by telephone.  They should also be compensated for their time just as any consultant would be.

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Closing the Price Gap

The deal is getting down to the wire, the price differential is close, but the parties are not yet in agreement. Following are some ideas that might get the ball rolling and help bring the parties together.

  • Let the seller retain the real estate and rent it to the buyer, thus reducing the price. The same could be done for major pieces of equipment. Let the seller lease them to the buyer reducing the price. The lease should, however, like most leases, provide for a buyout at the end.
  • Structure a royalty on sales rather than an earnout on gross margins or EBIT.
  • Have the parties create a subsidiary for the fastest growing part of the business in which the buyer and seller share 50/50.
  • Let the buyers acquire 70 percent of the business with the requirement that they purchase 10 percent more each year on the same multiple of EBIT as in the 70 percent sale.
  • Arrange a consulting agreement with the seller to provide additional compensation to be paid annually.

Certainly, any agreement or deal structure should be approved by the party’s professional advisors.

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M&A Trends

A  recent article in M&A Today offered some observations concerning current and future M&A trends.

“The business world is constantly changing.  For the first half of the 20th century, vertical integration was the objective in which, oil companies, for example, owned the entire process from drilling to retailing at the gas station.  From 1950 to 1980, diversification was in vogue.  Recently, the trend is to outsource everything except the core business.  One of the new business models known as the new profit imperative is to go downstream and get closer to the ultimate customer.”

Today’s M&A Climate

Many companies still look to acquisitions as the best way to increase both capability and market share.  Acquisitions generally add complementary products, new technology or increase geographic coverage.  Interestingly, today’s companies are investing in new ventures, while, at the same time; divesting themselves of some of their original businesses.  Since these “original” businesses now have low margins and slow growth, they are being sold off.  Quite a few of the large public companies have spun off some of their original core businesses.  One company – Perkin Elmer – sold off all of its businesses including its name and reinvented itself as PE Biosystems.

“The previous M&A drivers, such as the need to grow externally as well as internally; the pressure for industries to consolidate; and the ongoing globalization, are all prevalent.”

Tomorrow’s M&A Climate

1. “Strategic acquirers will not only be more particular and demanding about the fit of the target company, but they will continue to divest divisions with the least potential or with low returns.”  Edward C. Johnson of Fidelity Investments summed it up best: “My own rule of thumb is that a business has to be good for the customer (quality), good for the company (profitable), and good for the employees (rewarding).  If we only achieve two out of three, we have not succeeded.”

2. Gone are the high prices of the late 1990s.  “The structure of the transactions will have a higher cash component, but there will be an emphasis on more contingency factors or tighter representations and warranties in an attempt to minimize risks inherent in the deal.”

3. Intangibles will be more important than ever.  Areas such as “the brand” will be more important.  Branding represents a company’s “credibility, its true identity, its meaning, its uniqueness.”

4.  “The use of strategic alliances and joint ventures will be used more frequently as a forerunner or in lieu of acquisitions.”  Technology changes so quickly today that one company, especially in hi-tech, can’t do everything.  Alliances and joint ventures provide earnings without the dilution of acquisitions.

5. The requirements of the new Sarbanes-Olxey regulations will impede a lot of acquisitions, according to industry experts.  This increase in regulatory requirements due to this new law may not only slow down the process, but may actually kill a lot of deals. This is especially true when public companies acquire a privately held one.  Sellers of these companies are going to provide a lot more audited financial information.

6. Over the years, many mergers and acquisitions have been within the same industry.  There is a trend towards merging companies that can “piggy-back” ancillary services.  The recent attempt by Comcast to merge with Disney is a good example – distribution merging with content.  Another excellent example is General Electric.  They manufacture jet engines, turbines, medical equipment, finance it through a GE finance unit, and then service it through another GE division.  The trend seems to be that more manufacturing companies “will acquire relevant service companies as a way to capture more profitable businesses.”

More recently there has been a trend to outsource everything but the basic business.  One thing is sure in the world of mergers and acquisitions – change will always be taking place.  It is important that sellers and their advisors stay abreast of these constantly changing trends.

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How Many Businesses Are There?

We suspect that the answer to this question depends on who you ask! The Internal Revenue Service (IRS) reports that they received some 24.8 million business tax returns for the year 1999. We can hear the joyful sounds emanating from new business brokers and those considering the profession. Wow, almost 25 million businesses! We can hear them adding up the commission dollars. This is a very misleading figure. Many of these tax returns are for hobby-type businesses, one-person consultants, writers, artists and the like. In fact, one source reports that there are 18 million non-employee businesses, and they account for only 2 percent of total sales. INC, in their Small Business issue, reports that Sole Owners generate only 3.3 percent of all revenues and have annual sales of about $38,000.

Home-Based Businesses

According to INC magazine, 61 percent of the firms in their 500 fastest-growing companies list started out as home-based businesses. And, on average, 15 months after they started, they moved to outside space.

We dont want to take anything away from these non-employee businesses, many of which are home-based, as obviously some of them will grow to be large businesses. Quite a few of these businesses, rather than have actual employees, use independent contractors or outsource work needed. Many others are making an excellent living for the owner, and still other owners are quite content with the results of their business. However, they are not the kind of businesses that business brokers and intermediaries normally sell. Certainly, there are a few exceptions — some one-person businesses generate sufficient revenues that would be quite salable. And, it’s not really that business brokers couldn’t sell them or that people wouldn’t buy them.  Quite frankly, they are just not commissionable.

Most business brokers, out of necessity, have a minimum fee;  adding $10,000 to a selling price of $10,000 would price many small businesses out of the marketplace. There may be a way of handling them, but these small businesses can’t afford full-service brokerage services. This is coupled with the fact that obviously many, many of these non-employee businesses dont generate enough profit, if any, to make them salable. A total annual sales of $38,000 isn’t going to create a lot of excitement among prospective business buyers.

What Is A Real Business?

As we have discussed earlier, we are really only interested in those businesses that have at least one employee. When we are asked how many businesses there are, we assume the person is asking how many possible businesses are available for sale. The above figures give a false impression of the overall marketplace of businesses that might be for sale at some point. Certainly, many of the businesses that have no employees might be available for sale, but most will not.  Secondly, business brokers and intermediaries will most likely not be involved in a sale if one does occur. Since most people who call are interested in the business brokerage profession, very few of the businesses that file business income tax returns are really businesses that would sell, especially by business brokers.

Our feeling is that to qualify as a real business, it must have at least one employee. As we mentioned above, we suspect that some no-employee businesses use outsourcing rather than go through all of the red tape required by governmental agencies to have even one employee.

An article in the Boston Globe March 4, 2001 stated that there were 7.7 million small businesses with less than 100 employees. Last year’s Business Reference Guide reported that there were 5.5 million businesses with one employee or more. INC in their Small Business issue said that there were 5.8 million with at least one employee. One other source reported 7.2 million.

BizStats reported that there were 5.547 million businesses with at least one employee. We’re going with that figure.

Here Is A Further Breakdown:

4,467,900 represent 80.5% of the total and have sales under $1 million

790,600 represent 14.3% of the total and have sales of $1-5 million

265,600 represent 4.8% of the total and have sales of $5-100 million

23,311 represent 0.4% of the total and have sales of $100 million +

Total Businesses =5,547,400

*Courtesy: BizStats
Here’s A Breakdown By Type of Business:

Services – 40% (87.8% Of Those Have Revenues Under A Million)

Retail – 19.8% (80.3% Of Those Have Revenues Under A Million)

Wholesale – 7.5% (50.7% Of Those Have Revenues Under A Million)

Manufacturing – 6.0% (61% Of Those Have Revenues Under A Million)

Construction – 12% (81% Of Those Have Revenues Under A Million)

Finance, Insurance & Real Estate – 8.3% (83% Of Those Have Revenues Under A Million)

Transportation/Utilities – 3.9% (81.3% Of Those Have Revenues Under A Million)

Agriculture & Mining – 2.4% (89.8% Of Those Have Revenues Under A Million)

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Size Breakdown of Businesses

Here is a common and much-used breakdown by the federal government:

Small Business Administration (SBA):

Very Small Business = 19 or fewer employees

Small Business = 20 to 99 employees

Medium-Size Business = 100 to 499 employees

Large Business = 500+ employees