Dependent Care Assistance Programs for Small Businesses

There is a perception that working for a small to mid-size business (SMBE) provides many advantages in terms of personal and professional growth due to their, well, smaller size.  The trade-off, though, is frequently a reduction in benefits opportunities, either through a lack of funds, HR personnel, or simply awareness of the diversity of low- to no-cost programs out there which can take advantage of significant breaks in the tax code for employees.

Dependent Care Assistance Programs (DeCAPs) and other flexible benefits / Section 125 programs can be set up and administered easily, have almost no direct costs associated with them, and the benefits to employees can be substantial, primarily in the form of income and other tax savings, such as social security.  Employers can also realize some savings on their share of payroll taxes as well. 

The mechanism for the savings is simple:  pre-tax money is withheld from the employee’s paycheck for qualified benefit expenditures like DeCAPs, so neither the employee nor employer are taxed on that portion of the employee’s income.  Depending on an employee’s marginal state and federal tax rates, plus social security, this could result in savings approaching 40-50% on the total amount of the pre-tax set-aside.  DeCAPs are limited to $5,000 per year (with some qualifications), so the tax benefit here could approach $2,500 for the employee, and a $400 savings for the employer (in the form of reduced SSN payments), with very little set up costs.  For other qualified flexible benefits plans, such as Section 125 withholdings for, say, the employee’s share of health plans, the tax benefits can also run into the thousands of dollars.

So what, exactly, is a DeCAP?  In short, DeCAPs help employees pay for the costs of dependent care which they are likely already paying for, up to $5,000 if both parents earn at least that much and file a joint return.  These costs can include day care programs, nanny care, educational institutions up to kindergarten, before and after school programs, and even summer camp in some cases.   Broad enrollment in the plan is important, both in terms of qualifying for the plan and avoiding the characterization that the plan provides excess benefits to owners or key employees.

I have provided links to several helpful resources below:

• ProAssurance Group Employee Benefits Plan from RealDealDocs - this Employee Benefits Plan contains a somewhat detailed section on DeCAPs.  It was filed by ProAssurance, a company in the Insurance sector, with the SEC a couple of years ago.  Many other similar employee benefits plans or other employment agreements are available at www.RealDealDocs.com.
•  DeCAP Program Summary from Beneflex Inc - I found this on the web and thought it provided a helpful overview of the programs (caveat - I’ve never worked with Beneflix, and I have no opinion on their work or benefits plans)
• For those of you with a more legalistic bent, here’s a link to a helpful but much more technical resource at the Cornell University Law School - not for the faint at heart.

From an owner / employer’s perspective, employees very quickly realize the value in the programs, and that is a powerful inducement to set them up, especially given their low overhead.  As with any employee benefits plan, widespread participation in the plan is important, but given the ease with which it can be established and the immediate benefits received, they are well worth the effort.

IRC Section 409A Compliance for the Entrepreneur (part 2)

Following on from a recent post about Internal Revenue Code Section 409(a), which significantly changes the way non-qualified deferred compensation plans are treated for income tax purposes, I thought it would be helpful to provide some additional examples of recent contract documents and language that dealt with the issue.  I had previously posted two examples of employment agreements which incorporated language around section 409(a), and I’ve attached the following example documents as well:

• Smith & Wollensky Restaurant Group Change in Control Protection Plan - the plan appears to be largely built around 409(a) compliance.  This is also available online along with many other change of control agreements.
• Thoratec Separation Benefits Agreement - this document lays out, for a specific individual, how various components of deferred compensation and severance benefits may be altered to ensure Section 409(a) compliance
• Loews Corp Stock Option Plan - this document, recently filed with the SEC, incorporates specific language to make the plan compliant with IRC 409(a).  Thousands of these stock option plans and employee benefits plans are easily searchable online at www.RealDealDocs.com.

The ability to quickly find specific contract language about changing tax or legal requirements can be invaluable in understanding how to deal with these issues, particularly when the documents have been drafted by well-respected law firms.  I hope you find these helpful.

Eight Tips for Negotiating an Office Lease Renewal

So I’m meeting with our landlord tomorrow to discuss a lease extension, and I’m in the process of pulling together my thoughts on the renewal.  Our office building is owned by a small group of investors, so we have a personal relationship with the owners/landlord.  I consulted with several colleagues of mine, and here are our top considerations for effectively negotiating a lease or extension:

1.  Be a good tenant

It’s so basic to sound business practices, but it bears repeating, particularly when you’re dealing with individuals and other small business owners.  Resolve issues along the way as amicably as possible - it all comes back to you in the end.

2.  Start early and understand your options

Particularly in a very tight commercial real estate market, you’ve got to allow at least 9-12 months for the process to play out.  It can take several months to research your alternatives, open up negotiations with prospective landlords (especially concerning tenant improvements), and then come back to your current landlord.  And you’ll want to allow 2-4 months if you have to plan a move (assuming you’re an SMBE like us).

3.  Understand your market, and particularly concessions that new tenants can extract.

 While market rental rates are important to understand, there are a number of other considerations new tenants may enjoy, including tenant improvements, rent holidays, and other benefits.  Understanding these will not only give you a sense for what you might expect if you go elsewhere, but it can also help you negotiate your current renewal.  Why shouldn’t you enjoy at least part of those benefits on the renewal?

4.  Consult with (if not retain) a broker.

I’m a big believer in at least talking to experts in a field, and I generally recommend using them to represent you in a lease negotiation.  Depending on the size of your business, this can represent anywhere from a $350k to a multi-million obligation over a 3-5 year period.  Brokers can give you a sense for the market, current conditions, and offer other valuable input.  Face it - while you may know your business better than anyone, you’re probably not an expert in commercial real estate.  If you are going to use a commercial real estate broker, I suggest using a tenant only representative, as they are less likely to be conflicted than brokers who may represent either side.  That being said, they are a lot like realtors in that they only get paid when a deal gets done.  The good news is they are frequently paid for by the lessor, but that may affect the terms of the deal.

5.  Depending on how much leverage you have, work to “share the savings”.

Just as you may want to avoid the headaches and costs associated with moving, your landlord may have the same interest.  If you’ve been a good tenant and are paying near market rents, the last thing your landlord wants to deal with is several months of vacancy, showing the space, negotiating and paying tenant improvements, and then having to deal with an unknown.  So work to value how much benefit each side is getting out of the renewal and see if you can’t find some common ground.

6.  Think outside the box and understand your landlord’s situation.

Your landlord is interested in three things - the underlying value of the property, current income/cash flow from the property, and avoiding headaches.  Understanding the relative importance of each can be very helpful in your negotiations.  For example, commercial property is essentially valued at a multiple of cash flow (it’s a cap rate if you want to be specific) over a period of time, with an emphasis on future cash flows.  If the landlord is thinking about re-financing or selling the property in 2-3 years, she will want to boost the cash flow in that later period.  This can provide you with a path to reducing your near term rental outlays in return for increasing the rent at a time when it particularly matters to the landlord.

7.  Put together a spreadsheet balancing overall costs for your various rental options

Feel free to let your landlord know you’re doing this, and make sure that you’re  getting all the information you need to make a balanced and informed decision.

8.  Get your hands on a bunch of actual lease agreements and extensions.

This can help give you ideas for different terms that you might want to incorporate into the lease agreement that you may not have thought of.  Of course, if you have representation, you should encourage them to do this - you’d be surprised how often this is overlooked.  There are lots of resources out there for looking at sample and (even more helpful) actual, negotiated lease agreements.

What do you mean, are we 409(a) compliant?

I was recently talking with a friend of mine who also operates and administers an SMBE, and I just happened to mention IRS Section 409 to him while talking about an independent stock option valuation we did last year.   He was familiar with the issues around stock option pricing, but less so about potential implications on things like bonus plans and severance agreements, both of which affect him personally.

This is by no means intended as tax advice, but IRS Section 409(a) regulations were just finalized, and the section significantly changes the way non-qualified deferred compensation plans are treated for income tax purposes.  I’m not aware of any specific carve-outs for small businesses or entrepreneurs (please enlighten me if you know of any), so we all need to pay attention to them.  I found a nice resource discussing 409(a) from Goodwin Proctor.  The rules appear to be complex but relatively manageable. The key is that the IRS has instituted a deadline of December 31, 2007 to make sure that all affected plans are in compliance.

I also wanted to pass along a couple of employment agreements which either generically or specifically refer to IRS Section 409(a). I accessed these documents from the thousands of employment agreements and compensation plans available online at RealDealDocs.com.

The first agreement was evidently drafted by Morgan Lewis & Bockius, LLP and Taylor Colicchio & Silverman, LLP, and it is an employment agreement between Pharmanet and its CFO. It has several specific references to 409(a) provisions with regard to severance payments and the like.

The second is an employment agreement filed with the SEC a couple of months ago by Argo Group International Holdings and its President / CEO. FYI, the company is organized under Bermuda law, but I liked the generic carve-out to allow payments to be accelerated to avoid applicability of 409(a).

It’s tough to stay on top of all these issues, and it highlights the importance of having access to appropriate accounting and other professional resources. The challenge, as always, is to do it cost effectively.

Drawing the Line - Seeking Credit Lines for your Venture backed Business

Over the past 3 years, we have raised and deployed some $10 million in venture capital to build out our products and infrastructure and expand our marketing reach at Practice Technologies (www.practicetechnologies.com).  As we approach operating profitability, we have a series of important questions to answer as we continue to pursue great market opportunities:

1. When should we supplement our ability to internally fund growth with additional capital infusions?  Considerations include business focus, valuation issues, and the availability of various capital sources.
2. What are the implications of the various funding alternatives to important constituents (investors, management and our customers)?  For example, debt takes a senior position in the capital structure to equity holders, and you will have various loan covenants and triggers relative to financial plans and balance sheet ratios.  Make sure these are well understood as you are aggressively chasing market growth.
3. How do you balance the competing interests of your stakeholders? 
4. What is the true cost of each potential source of capital?

Given our stage of development (post revenue, several successful products, positive cash flow), we’re able to consider securing a somewhat traditional bank line of credit.  I say “somewhat” because, being a technology and content provider, we don’t have a lot of traditional assets to collateralize, and until recently, we haven’t had the cash flow to justify a bank line from commercial banks.  Fortunately, there are some great lenders for companies like us, including Silicon Valley Bank, Comerica, and a relatively new entrant that we’re quite impressed with, Square One.  These banks are looking to make a premium over traditional lenders through warrants and fees, and in establishing a long term banking relationship with a hopefully growing new company.  In return, they are providing lower cost capital in the $500k-$2mm range to allow you to stretch into better valuation milestones.  They are not a substitute for larger venture financing or in situations where current cash flow can’t meet line repayment obligations.

In the “fixing to get ready” category, the banks will suggest putting together the following materials for your initial discussions:

• 2 years historical and YTD Financial Statements
• 2 Year (Current plus Next Year) Forecast Financials (Income statement, Balance Sheet, and Cash Flow Statement)
• Aged listings of A/R and A/P
• Current Capitalization Table
• Most recent Power Point Deck used in connection with fund-raising or Board communication (to gather a sense for the market opportunity, the competitive landscape, the technological differentiator(s), the Management Team, etc.)

In addition to these, I’d add a few more (some obvious, some not so much):

• In the obvious category, take care of the general housekeeping.  Make sure you’re all caught up with tax and corporate compliance issues.  These deals are all about credibility, and potentially they can be time sensitive. 
• As much as it can seem like it’s all about the numbers, the good ones in the venture-backed technology lending space are looking to the following in evaluating the application (in some order):
  • Your venture partners.  Are they excited about your growth prospects, or are they getting tired?  And why do they feel that a line is more appropriate at this time than another venture round?
  • The management team.  Is it seasoned, well grounded and reasonable?  Do the financial projections make sense, or do they look like an enormous hockey stick?  (See my previous post on financial projections for further comments.)
  • Understanding the business opportunity.  Your venture backers got in, but is it something the bankers can get excited about?  And how much of a banking opportunity is it?
• As an entrepreneur, you need to be able to succinctly talk about your business, and you’re always selling.  This is no exception.  Again, with your feet firmly planted on the ground, be able to present this as an exciting opportunity.
• Start building those relationships early.  The longer they have to get to know you and watch the business, the more comfortable they will be.

One of our challenges is to value the true price of the line relative to other potential sources of credit.  In addition to the hard costs (application fees, interest expense, etc.), the line has a finite life and must be repaid.  Assuming it is not refinanced, against a $500k line that is fully drawn down in the first year, you might have about $150-200k in costs over the 4 year period (the draw down, plus say a 3 year repayment) for temporary access to $500k in Yrs 1-2, $300k in Year 3, and $150k in Year 4.

Surprising?  Look at the breakdown:

• Application fee - $15-25k (including legal)
• Warrants - 3% of line ($45k in exercise price - value is up to you)
• Interest costs - 12-14%/yr, or $60-75k in years 1-2, $40-50k in year 3, and $25k in year 4.

True, you’re ideally providing your venture investors with a 35-40% ROI over that period, which compounds very quickly, and there are plenty of other strings attached.  But at least you’re not repaying that money over what might be a cash-constrained period, and your venture investors are all about value creation, not loan repayments.  Oh, and if you secure a new venture round, new money is generally not fond of paying off prior obligations. 

I’ll keep you posted as the discussions unfold over the next 3 months.

Financial Modeling: Murder by numbers…

To borrow a line from the Police, it might seem as easy as your a-b-c’s, but there’s a lot that goes into effective financial modeling.  For the past 8 years with Practice Technologies (www.practicetechnologies.com), and going back some 10 years before that, financial modelling has always been central to the analysis I’ve relied upon to evaluate a business’ health or justify an investment in its growth. 

There are several important steps to follow in developing a financial model which will serve your objectives as an entrepreneur, whether you’re trying to manage what you have or raise capital for what you could.  This is particularly true for newer enterprises, as the discipline associated with identifying and thinking through the key business drivers is invaluable to the early planning process.

1.  Figure out what you’re trying to accomplish. 

As an entrepreneur, you have a number of competing objectives.  Depending on how established you are, you may have a business to run on a day-to-day basis, and it’s hard to find the time to plan, build and manage against a set of financial models.  You may be tempted to build a simple income statement-type spreadsheet that lays out revenue assumptions and backs out costs.  But effective financial models can and should be used for so much more.  Using them, you can look six to sixty months down the road to plan for organic growth, evaluate opportunities to enter new markets or take on new sources of capital, or anticipate liquidity problems.  I highly recommend taking the time to build a model which will generate a consolidated set of financial statements that will provide a more comprehensive picture of your business.  And the sooner you identify the range of scenarios, the easier it is to plan and build your model to accommodate them.

2.  Plan, and then plan some more

A rule of thumb in traditional software design and development is that for more complex projects your engineering team may spend half of the overall project timeline in planning and design.  In my view, that’s overdoing it for financial modelling, but not by much.  Key planning considerations include:

• Breaking down the key business drivers and assumptions, and how they are all related (more on this below)
• Determining the level of detail / drill-down capabilities
• Building a simple map of how your supporting sheets will roll up to your consolidated financial statements
• Determining what type of sensitivity analysis you want to model and present

3.  Identify the key business drivers and assumptions 

Particularly if you’re looking to raise capital, breaking down and modelling your key assumptions and drivers is the most important aspect of building your projections, and one of the most important elements in presenting your business.  It will reflect your understanding of your market(s), growth opportunities and drivers, operating requirements, and what it takes to pull it all together.  It is also an opportunity to demonstrate that your aspirations are firmly grounded in the reality of reasonable expectations about time to market, delays, cost overruns, etc.

So if you’re modelling a new product roll-out, it’s not sufficient to say you’ll sell X Widgets each month for $Y per and multiply the two numbers.  Instead, you need to model out what drives unit sales, what are the elements of pricing (including discounting, upsells, bundling, etc.), how each of these elements might change over time, and then pull it all together.  As you gain more information and market experience, or if you simply want to run some scenario analysis, you’ll be able to tweak each of these variables and watch it flow through the analysis.  This holds true for almost every revenue and cost driver - wherever possible, use formulas to do the work on clearly identified sets of assumptions that can be easily updated without needing to reformat the sheets manually.

4.  Do the Sanity Check

Far too often, reasonable assumptions accumulate to generate unreasonable outcomes, particularly when the financial model is extremely sensitive to changes in key variables or if compounding effects occur in the revenue streams.  For example, in modelling an e-commerce business line recently, seemingly minor changes in the conversion rate of site visitors to paid subscription accounts (from, say, 0.75% to 1%) had a dramatic effect on the cumulative revenue stream over the 36 month forecast period.  So it’s essential that the model pass the smell test.  If the compounded growth rates are not credible, it is frequently a reflection on your judgment as an entrepreneur, and it can negatively affect your access to capital.  Putting “dampers” on your model, such as by decreasing growth rates once you achieve a certain market penetration, or simply adjusting your assumptions downward at various stages can help present more reasonable outcomes.

5.  Put together a range of scenarios

You’ll want to generate downside and upside scenarios to complement your base case view of the business.  Again, this requires judgment to put the pieces together and determine which scenarios make sense and which ones are a perfect recipe for disaster by showing a complete business collapse or a path to unlimited growth.

6.  Take a step back and figure out what it all means 

Frequently, someone will present a set of numbers who hasn’t taken the time to figure out what they really say or how they stack up to comparable companies.  Understand and communicate, in plain language, what your margins are, where your forecast business is most sensitive to breakout opportunities or potential setbacks, and what your overall level of comfort is with the forecast.

***

Of course, the sad fact of model building is that no matter how careful you’ve been to lay everything out, you’re going to be, well, dead wrong.  It’s simply not possible, particularly in a newer (or even pre-revenue) business, to predict what’s going to happen with any level of precision.  But the process of building out the model will not only test, and then shore up, your understanding of your business, it will give you a sound foundation to measure your results, analyze them relative to your expectations, refine them, and continually improve your ability to plan for your business’ growth.