Leverable assets are ones debt providers will loan against. Generally, these are assets that generate cash flow and can be liquidated (sold) for cash, such as real estate, stocks, bonds, mineral rights, and equipment.

All things being equal, investors will maximize their use of leverage – relative to equity – because debt capital is less expensive.

Why?

1. Contributors of debt (lenders) demand lower returns than equity providers because debt has a senior claim on the assets and cash flow and is therefore less risky
2. The cost of debt (interest expense) is tax deductible

For these reasons, the use of debt (leverage) will boost the return to equity holders – so long as the assets earn a rate of return, i.e. return-on-total-capital (ROC), that exceeds the cost of the debt. Here’s a simple example.

Let’s say the investor has $100,000 to invest. He can purchase a $100,000 asset using all his equity or he can purchase an asset (or assets) of greater value and borrow the difference. Here’s the calculation of pre-tax and after-tax return-on-equity (ROE) at varied capital structures.

In the table below, we assume the assets held are generating a ten percent operating profit (ROC, which is the same as return-on-assets (ROA)) and the interest rate on the debt is 7%. As you can see, both the pre-tax and after-tax ROE rise as leverage increases.

Notice as well the differing values of the assets controlled by the equity holder (the top line). Leverage allows higher-value assets to be owned. As such, one should consider the possibility of changes in the market value of the assets over time. If we assume the assets in the above example rise in value by ten percent, the no-leverage scenario adds $10,000 to equity, for an equity value increase of 10%. In the highest leverage scenario, the rise in equity is $40,000, for an increase of 40%.

Wealth (equity) can be generated rapidly when leverage is utilized. Of course, it works the other way as well. Leverage adds financial risk.

Let’s look at what happens when the spread between the cost of debt and the return on capital shrinks. This can occur by either an increase in the cost of debt, decline in operating profit, or both.

In the table below, we assume the cost of debt rises to 10% and the ROC stays the same (at 10%). The investor gains nothing from the use of leverage (unless he assumes or can achieve a rise in the value of the assets held).

Returns are also impacted by changes in the operating profit (ROC or ROA). To demonstrate, let’s assume the cost of debt remains at 7% but operating profit grows to 15%. That’s a 50% increase on operating profit. Here’s the calculation of ROE at the varied capital structures.

As one can see in the example, when profit rises in a leveraged company, ROE rises at accelerated rates. The higher the leverage, the greater the rate of ROE increase. Again, it also swings the other way when profit declines. Further, if operating cash flow falls below the required debt service, the assets can be lost entirely. In this way, the use of leverage is risky and should be used with great caution. Assets that generate consistent earnings (or more to the point, cash flow) can support higher amounts of debt. Assets that generate unpredictable earnings should not be purchased with debt.

Owners of established and profitable companies will, in most cases, be able to utilize debt to boost equity returns, and do so with a manageable level of financial risk. How much risk is a function of the characteristics of both the business and the owner.

Today, with asset values depressed and debt at historical lows, every business owner should consider ways to take advantage. The first option is to refinance existing personal or business debt. The second is to acquire real estate, whether it’s the space occupied by your business, an investment property, or a new home. So assess your needs and wants, and look around for a good deal. They’re out there. Odds are, the economy will recover; assets will once again appreciate; moderate inflation will return; interest rates will rise to more “normal” levels; and you’ll be sitting pretty.

Identify What You Do Best

What meaningful customer benefit do you provide better than anyone else? Your ability to do so is the only basis by which you will be able to keep customers, earn a profit and stay in business. If you don’t do anything better than the rest, you’re on borrowed time. Not sure what you do best?

You better find out or create something, and quick. To begin, ask your customers why they do business with you and what you do better than anyone else. Write it down. Share it with others. Hone it and revise it until you get it right. Don’t worry if there isn’t conclusive evidence that you do it “better than anyone else,” just get it down. More important than what it says about you today is that it should become the vision for your company and the heart of your mission statement.

It should be achievable and sustainable. It will be how and why you will compete effectively in the future, keep existing customers, gain new clients and succeed.

Focus

Once you determine what you do best, stick to it. Don’t create confusion among your customers and employees by offering products or services that are not in your core area of expertise. Fuzzy direction kills more businesses than competition and dying markets. Specialize and be the best at something of value to customers, or die. Domino’s Pizza is a great example. They deliver fast. They don’t sell quality or price but “deliver in 30 minutes or less.” Home Depot is another great example. They could sell about anything in their huge, well-located warehouses. But they sell only home and garden supplies. When you need home and garden supplies, you know exactly where to go, don’t you? On the other hand, Sears tries to be everything to everybody, an approach that simply does not work today when excellence is demanded by consumers. Stake your claim to a niche, stick to it and focus on getting better at it every day.

Know What Your Customers Really Want

Get close to your customers. Really close. If you have closer relationships with your vendors than your customers, you have a problem. Organize periodic gatherings with your customers at which you can get feedback, advice and industry intelligence from them. Find out why they buy, what they really want and what your competitors are offering. Get below the surface and down to the emotional level. Buyers of cell phones want freedom and productivity, not phone service. Fitness centers sell hope, dreams and romance, not exercise. Cigarette and alcohol companies sell self-image and a sense of maturity and independence. McDonald’s sells fun family times, not burgers. What do you sell?

Make What Sells, Don’t Sell What You Make

When you have gotten close to your customers and learn what they really want, give it to them. Your entire organization should serve the wants and needs of your customers, not all customers, but a select group of customers or potential customers who have certain wants or needs that you are more capable of fulfilling (or more determined or focused) than anyone else. If you are making products and then trying hard to find someone who will buy them, you have it backward. Start instead by asking yourself what customer types you are uniquely suited to serve with your products and/or services.

Find the Profit

Identify the products and services that make money and stop doing the rest. Reinforce, improve and solidify the profitable business, and cut all expenses that are not necessary to the delivery of the profitable products and services. Scorn money-losing and break-even products. If a product or service is losing money, try to make it profitable by raising prices. If that does not work, lower prices and see if volume picks up to achieve profitability. If neither works, discontinue the product line altogether. Then resist the temptation to add products or services that are not competitive and thus are not profitable.

Build Your Brand

Once you identify what you do best and commit yourself to total focus, tell the world. Turn your area of focus into your mantra. Be specific. Instead of using generic words like “fast” or “quality,” say “in 30 minutes or it’s free” or “ the only NASA certified parts.” Put your identifying mantra on everything you distribute. Educate your employees, vendors and customers about what you are great at so they, too, can identify customers that might be ideal for you. This is branding – the creation of an identity. Great companies are great marketers. Some of the most successful companies today are led by marketers and do a tremendous job at branding their image, such as McDonald’s, Apple and Nike.

Cut Costs

Above all, the customer wants lower prices, the lower the better. As such, the company that can afford to offer it the cheapest will win. Who can offer it the cheapest? The company with the lowest operating cost. In a competitive environment and during difficult economic times, the most important competitive dimension may be operating cost. The company with the lower cost structure can charge market prices and gain financially on the competition with each unit sold. Or it can use its cost advantage to undercut the prices offered by the competitor and gain market share.

When your costs are lower then everyone else’s, you win every time. So do yourself a favor. Fall in love with being cheap. Don’t buy anything that does not enhance the customer relationship in a meaningful way. Don’t buy anything new unless it is more productive per dollar spent than the used alternative. Moreover, don’t make any product or service in-house that can be purchased elsewhere for less. Beware of any urge to spend money on non-essentials. Take a lesson from The Millionaire Next Door: The bottom line is the only place to flaunt your wealth.

Pay for Performance

Hire proven winners. Downgrade education as criteria for hiring and promotion, and enhance the stature of real results. Within your company, track performance and make the results open to all. Make continued employment contingent on production. Pay commissions based on customer satisfaction survey results as well as sales. Track the results from every marketing and advertising effort, product, employee, vendor and business unit. Incentivize everyone, including your lawyer, accountant and advertising agency. Hold family members to the same standards as non-family members, or watch your company implode.

Remove Politics, Secrets, Lies, Sex, Alcohol, Drugs and Gambling

Demand integrity and make swift examples of those who do not follow your lead. Encourage straight talk, questions, ideas and constructive criticism. Discourage adulation and yes-sayers. Get real people with the guts to express their real opinions — even when they disagree with your own. Treat people fairly. Do what is right and demand the same of others.

Don’t Bet on the Breakthrough Order

Serve your core, existing customers profitably and add more just like them. When you have the luxury to spend some time and money on new products or markets, do so. But don’t bet your business on breakthrough products or customers. Too often, they never come through. Close is not good enough.

Keep It Simple

Track the key results. Manage from a single piece of paper, literally. Track customers won and lost, shipments, back orders, cancellations, returns, payroll expense, advertising responses, number of inbound calls, product development status, cash balance, cash flow and asset balances. Highlight deviations and take swift action when trends are in the wrong direction.

Set Your Priorities

If your bottom line isn’t above the industry average and continually growing, eliminate all nonessential activities that take the time of you or your employees. Duck the speeches, ribbon cuttings and community board duties; you have more important work to do. Consider that you, as the owner of a tax-paying business, are a rare commodity. By being successful and earning a profit, you employ others, provide for families and pay taxes that fund schools, roads, police, politicians and social services. The most important thing that you can do for your community is to keep your business running, employing and pay taxes.

Cash Is King

What you want is cash flow and cash in the bank. Anything else can’t buy groceries. Don’t look at anything but cash and the things that lead to cash. Balance sheet assets are evil. They take up cash, so be relentless in lowering their values. Increasing non-cash assets spells trouble unless your cash flow is growing along with it.

Sell Harder

Sales calls lead to sales. Get your sales force cracking and personally show them the way. As the owner, you should be selling more than anyone else. Track the number of calls, letters, emails, meetings and results.

Focus on Getting Better, Not Bigger

Bigger will come when you get better. Raise quality and two great things will happen:

1. Your costs will fall with lower waste, fewer returns and cancelled orders.
2. Revenues will rise through lower customer attrition and more customer referrals.

The Future Is All That Matters

You are only as good as the satisfaction of the last customer served. Your customers and your bottom line don’t care how long you have been in business or what your grandfather went through to get you where you are today. If your strategy for success includes a historical story or reference, think again. Get over the fact that “we were the first” or “we founded this industry,” and focus on delivering greater and greater levels of real and tangible value to the customer.

Want some suggestions? How about from one of the world’s foremost authorities on entrepreneurship, venture capital and business plan pitches?

John W. Mullins is a London School of Economics professor, consultant, author, speaker and investor. He regularly reviews business plans and sees the common mistakes made. He recently revealed¹ oft-made mistakes and gave suggestions he said should “get you invited back and, if all goes well, raise some capital.” He said good business plans contain three key elements:

1. A logical statement of a problem and its solution
2. A battery of cold hard evidence
3. Candor about the risks, gaps and assumptions that might be proved wrong

The common mistakes business plan authors make?

• Overemphasis on technical or functional aspects of the product
• Overreliance on the size of the market
• Failure to base projection on and/or anchor projection by cold hard facts

Mullins goes on to share the commonly used words and phrases that cause venture capitalists to send plans from their hands to the trash bin:

• “No competition.” Of course your business will have competition! Buckle down and figure out who they are or where it will come from. Further, competition is not a bad thing. Competition suggests that someone besides you thinks there’s a problem worth solving.
• “Huge.” Instead, why don’t you collect and provide reliable data on the market size as well as the narrow niche in which you intend to initially focus.
• “Conservative.” Let the numbers speak for themselves. Just make your best estimates. Capital providers know that the projection rarely pans out.
• “Assumptions.” Investors aren’t interested in investing in a business based on “assumptions.” Instead, find credible evidence that supports each of the figures used in your financial model.
• “We believe.” Similar to “assumptions,” above. Do the research and locate the data necessary to move from “we believe” to “the evidence shows” and “our research reveals.”

Just as anybody can talk about an opportunity or idea, anybody can write a business plan. But if you want to make the effort worth your while, John W. Mullins’ advice seems credible.

¹ In an article titled Why Business Plans Don’t Deliver that appeared in the Wall Street Journal on June 22, 2009.

If your talks take place in a series of emails, as is often the case, be careful. You may unknowingly be entering into a binding contract when you sign a letter or send an email outlining the terms of a proposed deal. To avoid this occurrence, and to maintain your credibility if you have to change the deal, consider ending all negotiating correspondence with a sentence like this:

I will, of course, consult with my attorney before any agreement is finalized, and the matter is subject to my attorney’s and board of directors’ approval.

If you can’t agree to a request, explain why and try to offer something in exchange. Good deals are built on a series of concessions and compromises. Finally, be sure to get sound advice when negotiating any major contract. That way, all the business, tax and legal considerations can be thought out well in advance.

Negotiating Checklist

Here is a list of items you should make sure are covered in any contract. Being familiar with them will also help you during your negotiations.

• Identify the parties and the purpose for entering into the contract. This is critical to establishing the overall reason for the purchase and sale.
• Delineate precisely the price, terms, delivery requirements, payment schedule, cancellation provisions and penalties for noncompliance.
• List all warranties and representations (e.g., accuracy of the financial statements), and specify the conditions to be met prior to closing.
• Be sure the contract is self-contained, meaning that it excludes all items not written into the contract, such as prior memoranda. If prior memoranda prepared by the other side are very important, your lawyer should include them as addenda to the contract. This also applies to any information you rely on and the accuracy you want the other side to attest to.
• Provide for instances of default and a specific time period to correct the default.
• Secure the right to assign the contract because it may be very important when negotiating and closing a future transaction. An example might be a real estate lease. You will want the right to assign the lease to another party if you need to relocate prior to expiration of the lease term.
• If you’re a buyer, check all liens, tax claims, employment contracts, legal disputes, warranty liabilities, unfunded pension costs and any other contingent or off-balance-sheet liabilities.

Internet marketing expert Matt Bailey guesses businesses own somewhere between 20 and 30 Web domains (aka URLs) each, on average — a surprisingly high number. I think I own maybe 15 or 20. But a quick check revealed we own 88.

Holy smokes! These things stack up like junk in a storage closet. They’re basically impulse buys, just a click away, $3 to $10 a pop.

Business owners buy the URLs for their business names, and pick up product names, too. Oh, and common misspellings of each one, with dashes between the words? Goodness, better be safe and also control each in .net, .org, .biz, .us, .info, et al.

Need a bigger closet.

But why waste $100 to $1,000 per year and some administrative time on domains with no utility? Will someone please explain which ones we should own or not own?

We talked to Matt Bailey, president of SiteLogic, and Steve Schneiderman, president of Schneiderman Marketing, two people who should know — if anyone should. Here’s what they agreed on:

1. Buy your company name, product name(s) and personal domain name (e.g., JohnDSmith.com) if you can get them.
2. Buy common misspellings of your main URL. Example: AcquisitionAdvisors.com owns www.AcquisitionAdviser.com and www.AcquisitionAdvisor.com and forwards them to the main URL.
3. Buy your company name and main product name(s) with dashes between the words, e.g., www.The-Business-Owner.com. Direct them to the domains they mimic. This keeps them out of the hands of others who might use them to your detriment.
4. Concern yourself only with .com, .net and .org. Don’t worry about .info, .biz, .us et al.
5. Buy your business name + sucks. Example: This publication is The Business Owner. We own www.TheBusinessOwner.com. We should buy www.TheBusinessOwnerSucks.com. Disgruntled employees or customers could have a lot of fun with a URL like this (often do)!

Schneiderman says you have to think about what the devious might try to pull, such as buying derivations of your name, business name or product name, and using them to make a defamatory message pop up when people search for you or your products or services. That’s why we suggest you buy your “sucks” URL as described above.

Bailey and Schneiderman both explain that while it’s wise to own your business names and trade names — to keep them out of the hands of others — it’s even better to put them to productive use. For example, use a URL for a particular product by creating a dedicated landing page. This allows for enhanced traffic tracking as well as a Web “place” that focuses exclusively on a single task, e.g., selling a particular product or service.

A sale not collected in cash is not worth anything, so why are you paying commission on sales?

Why not pay commission on cold hard cash? When the cash comes in the door, your salesperson’s job is complete. Reward him or her right then.

Pay commission on cash received and he or she will do a much better job of:

1. checking out the prospect’s ability to pay, i.e., credit
2. negotiating accelerated payment terms

They won’t put up with it? Think again. They’ll scream and yell and, if you refuse to back down, they’ll capitulate. You might lose one or two, but you must design your company for the long haul. Build it intelligently and you’ll find success.

Yes, you’ll be in the minority. Maybe even get some weird looks. But you won’t be alone. Some companies pay commission on cash received. Some very smart companies. Only by daring to be different might you earn an outsized share.

Reviewed by David L. Perkins, Jr.

Michael Gerber’s The E-Myth is the book most frequently recommended to me. That’s probably why I never read it. I have a fad phobia. “In vogue” is a call to all lemmings, as far as I’m concerned.

The E-Myth was first published in 1985. The E-Myth Revisited was published in 1995. It’s perennially on lists of best business books. It’s on the required reading lists of classes taught at institutions of higher learning the world over, such as Stanford. Not sure why I finally decided to pick up a copy, but let’s just say I’m not hopelessly stubborn.

It’s a good thing. Gerber says successful entrepreneurs tend to be open to learning new things. Always searching for knowledge. On a quest to get better every day. Ready to drop less productive methods for better ones.

Gerber addresses what we all know — few businesses owners break through and find the quality of life, freedom and financial success they desire. But of considerable value is his reason why.

Most businesses are started by people with technical expertise, he says. The entrepreneurial (“E”) myth is that technical expertise can provide a strong foundation to build a successful business on. In reality, success comes only by learning and effectively implementing certain proven techniques for growing and managing a business.

I’ve said for years that businesses should exist to serve their owners. Similarly, owners should not be slaves to their businesses. Gerber agrees, but he ALSO tells us HOW we can organize our business so we may be better served. So we can have a business and also a life.

Gerber says the trick is to build the business so:

• Every job is standardized, i.e., all job functions detailed in job descriptions and job manuals
• Every person knows exactly what to say and do in every instance (because it’s detailed in a written job manual)
• All tasks, even managerial, can be performed by the lower-skilled (and lower-cost) workers

The E-Myth says every business should be built as if it’s going to be franchised and the business owner must move from technician (and laborer) to leader.

Gerber says operations should be standardized so each employee knows exactly what to do and when to do it, and so managers spend their time bringing in business. How? The business owner’s job is to determine which marketing and sales methods work best and standardize those, too. Standardize the client acquisition side of the business so that — just as the operating side — the lowest skilled workers can execute and deliver results.

Gerber says the greatest development in business in the past century is the development of the franchise model pioneered by McDonald’s. Gerber says that 75 percent of franchises that open survive past their fifth anniversary. Non-franchise businesses — less than 20 percent.

I wish I had read The E-Myth 15 years ago.

Business owners find their motivation in varied things. Commercialize a pioneering methodology. Be one’s own boss. Prove naysayers wrong. Provide a great place for people to work.

While every entrepreneur has his or her unique set of goals, virtually all share one in common — to one day sell for a boatload. How much? Well, more is better. And so the question every business owner asks is: “What can I do today to maximize the eventual sale price of my business?”

To be sure, the answer depends on where the business is in its development and the time horizon of the business owner. But whatever the answers are to these questions, there are things that can be done. Acquisition Advisors has put them on paper. A single piece of paper.

“When the goal is to get absolute maximum sale price, the task entails both building a business that possesses the characteristics desired by buyers and conducting the sale effort in a certain manner,” says David L. Perkins, Jr., managing director of Acquisition Advisors. “Our ‘Best Practice Map’ titled ‘The Path to Absolute Maximum Sale Price (of a business)’ clearly and simply shows the important elements of both.”

The map format — as opposed to an article — allows a tremendous amount of information to be summarized in an easy-to-read format. The instructional “best practice” data are organized into four distinct sections. Each section is a phase in the journey that leads to the sale of the business at maximum value:

Phase 1: Build a Valuable Company

Phase 2: Plan and Prepare for Sale

Phase 3: Execute Sale Strategy

Phase 4: Post Closing

Under Phase 1, for example, two sections offer valuable guidance to business owners: “Accumulate Value Drivers” and “Eliminate Barriers to Marketability.” Listed are 19 value drivers and 11 barriers to marketability. Perkins explains, “To the extent a business owner can add the value drivers and eliminate the barriers to marketability listed, the value of his or her business will rise. Incidentally, the business will also enjoy enhanced profitability, lower risk and greater stability.”

Most of the map — indeed three of the four main sections — is dedicated to how a business owner should go about the process of preparing, packaging and selling his or her business.

“There’s definitely a right way and a wrong way to go about the sale of a business,” says Perkins. “Unfortunately, common sense does not lead the business owner down the right path. But the lessons of experience have, over time, revealed the path that will take the business owner to absolute maximum sale price. The essential elements of this ‘best practice’ are displayed in our map.”

Visit AcquisitionAdvisors.com/Best-Practice-Map to view it.

Acquisition Advisors consults on the purchase and sale of midsize U.S. companies and is owned by DL Perkins LLC, publisher of The Business Owner.

A business sale price is a negotiated item. No list prices to go by. Sure, there are some rules of thumb. Some generally accepted earnings multiple ranges. But the ranges are large. We’re talking doubling and tripling of the prices paid. Millions of dollars hang in the balance for the prospective seller of a midsize company. Pair this with the fact that every business seller wants to sell for maximum value and the question becomes: How does the business owner go about securing maximum value?

While it is true …

a. The price and terms at which ownership of a business may change hands is a negotiated item, and

b. The price at which businesses actually change hands varies widely

… the prices at which businesses sell will naturally align themselves along a bell curve.

So we asked the dealmakers at Acquisition Advisors how business sale prices are maximized. They said through skilled packaging, process and dealmaker skill.

Packaging

Presentation matters. Autos on the car lot sell for more than they do in the driveway. Antiques sell for more in the antique store than in the garage. Businesses sell for more when packaged colorfully and professionally. The generic foods fad flopped. People want colorful, pretty packaging and they’re willing to pay for it.

But to maximize the sale price of a business, the packaging must also address a fundamental need of the business buyer: the need for information.

The purchase of a business is an information-intensive and time-intensive endeavor. Skilled M&A advisors do more than build a pretty prospectus. They also fill it with information that business buyers want and need to make a decision. Further, skilled sell-side M&A advisors gather, organize and make available all relevant backup, supporting and “acquisition due diligence” information business buyers want and put it together in a manner that will:

• Provide buyers with information they need
• Allow buyers to move swiftly and efficiently through the data
• Put buyers at ease about the risks and weaknesses of the business
• Position seller as low risk, i.e., honest, cooperative, trustworthy and fair
• Give buyers confidence in the stability and growth prospects of the business

Process

In concept, the process that maximizes sale price is simple. Identify the best buyers in the world for the particular business and then work them simultaneously against each other. Basically, run an auction. A real quiet one, to be sure, but an auction nonetheless. It takes a lot of work, time, energy,communication, experience and skill, but the results, when done right, can literally be golden.

Dealmaker Skill

Shocking as it may be, buyers don’t like to be “worked.” They like to call the shots. Get things their way. If someone is getting worked, they like to be the one doing it.

Most experienced buyers of midsize companies are smart and confident. Strong personalities as well. They don’t like to simply be run through an auction process where the highest bidder wins. So this is where the M&A dealmaker skill comes in. Either they can run this process and keep the buyers engaged or not. Your job is to find one who can.

Enterprise Value

Businesses can’t be sold on packaging, process and dealmaker skill alone, of course. The key is the core value of the business itself. So, there’s no free lunch. Building a valuable business is the tough part, to be sure, but the prices businesses sell for are negotiated items. They vary widely and position themselves naturally along a bell curve. The question is: How does one go about securing a price that’s way out to the right on the x-axis? The answer is, of course, packaging, process, and dealmaker skill.

What does this mean for you, the prospective business seller who desires absolute maximum? Secure skilled representation. Hire the most talented M&A advisors you can get. If you own a business with annual profit in excess of $1 million, you’ll earn your investment back in multiples.

There are no mandates whatsoever on businesses that employ 50 or fewer. Moreover, employers of 25 or fewer that choose to provide health care insurance benefits to their employees may be eligible to receive assistance in the form of tax credits. This aid to small businesses begins immediately (2010 tax year). The accompanying table provides some of the details.

The law does not appear to have any broad impact on employers of 51 or more until tax year 2014. Then, they may be subject to financial penalties if they do not provide a reasonable health care benefit to their employees. How big a penalty? Well, the quick answer is up to $2,000 per employee, but this is an absolute maximum case that would almost certainly never occur.

First, most large employers already provide health care benefits — many because they must to be competitive in the job market. Second, if a large employer does not provide health care benefits to its employees — or provides only a minimal benefit — any penalty likely would be assessed only on employees who:

• decline the company plan (if there is one), and
• obtain coverage through one of the newly formed state health insurance “exchanges,” and
• qualify for federal health coverage tax credit based on their (low) income level

Big One-Time Charges

Soon after the new health care legislation was signed into law, some large public corporations announced they would take a one-time hit to earnings to recognize future costs they expect to incur as a result — Caterpillar, Deere & Company and AT&T, to name a few.

The charges do not stem from any employer mandate to provide health care coverage. It’s related to elimination of a tax break provided to them in 2006. In short, the government has been reimbursing these large employers for offering prescription drug benefits to their retired workers (under what is known as Medicare Part D) and, beginning with the 2006 legislation, allowing them to “hide” the federal subsidies from income. The new law removes the loophole. That is, these employers must now count the cash they receive from the federal government as revenue (as is normal under the federal tax code).

As a case in point, Caterpillar recently announced a $100 million one-time charge for expenses related to the legislation, but according to the Wall Street Journal, Caterpillar’s annual cash flow will decline by only about $7 million per year — less than 1 percent of its 2009 cash flow — and it will continue to receive $10 million in subsidies from the federal government.

Basically, these companies complain because the net benefit of subsidies they receive has declined.

Mandated Coverage for Dependents up to 26 years of age

The new legislation mandates that insurance companies allow insured parties to include dependents up to 26 years of age. Will this cost employers money? Well, to the extent …

covered employees have dependents aged 21 to 26 that are uninsured (or underinsured) and choose to add them, and

employers are paying all or a part of the insurance benefits of employee dependents

…costs will rise.

Not all covered employees will add their dependents ages 21 to 26 to their policies, and moreover, many employers don’t pay the premiums for dependents. The salient point, though, is some employees will, and some employers do, so costs could rise for some. Of course, employers could choose to lower the amount they pay for dependents. Also, so long as all of a firm’s competitors also bear the added burden the competitive landscape should remain level. The new law should not be too disruptive. But, to be sure, employers will have to raise prices lest they suffer operating profit erosion.

Tax Increases

Included in the new federal law are two surtaxes on individuals with taxable incomes over $200,000 ($250,000 for couples filing jointly), 0.9 percent additional tax on Medicare payroll and 3.8 percent on income from investments (capital gains, dividends and interest). Both begin in 2013. It’s a bitter pill. But unless and until we elect politicians that will reduce spending we’ll face either higher taxes or the continued buildup of federal debt (which will have to be dealt with, at some time, in one way or another).

—

Again, it’s true that the new health care legislation is voluminous, complex and far-reaching, but the employer-related provisions are but a subset and it will be months before all the detailed provisions are even written, much less communicated clearly to the populace. But we do know now that there is absolutely no mandate on employers of fewer than 51 employees. Even more, employers of fewer than 25 may receive financial assistance if they offer a health care benefit to their employees. We also know that for employers with more than 50 employees there are provisions that ensure that the 51st employee is not a “trip wire.”

So, in spite of the alarming rhetoric coming from politicians and talk show hosts, there appears to be, at least at this time, “nothing more to fear than fear itself” for employers of 50 or fewer. For employers of more than 50 there are added burdens stated to go into affect in 2014 but we don’t think they’ll be too disruptive. At least that’s our stance based on the information we have today.

² This is for tax years 2010 through 2013. In 2014 and 2015, all provisions remain the same except the tax credit maximum rises to 50% and applies only to employers that purchase their coverage through an “Exchange.”

³The rules are complex and not even fully developed yet. In short, since this provision of the law does not go into effect until 2014, there is plenty of time to wait for the details to be developed and communicated.

“It is just not responsible to suggest that the new health care law is bad business. Study after study indicates that this new law will create certainty, stability and reduced costs for American business.”

Gary Locke, U.S. Secretary of Commerce