LEVERAGED CAPITAL NEWSLETTER
Vol. 3, Issue 25 August 18, 2003

Leveraged Capital, is a free monthly newsletter that presents growth and strategy issues effecting entrepreneurs and owners of small to medium size enterprises (SME's).

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So where were you when the lights went out? Our daughter spent the evening on our deck, counting stars, discussing metaphysics and the meaning of life with a friend, and watching the sun rise the next morning over a very quiet city; I felt rather jilted to have missed out on all the action even though I was quite comfortable and air conditioned in Atlanta. A wake up call for an inadequate grid system as well as for the low cost electricity that we have taken for granted here in Ontario. A lot of questions yet to be answered - why is Canada tied to the US grid in this manner; just how much more will we pay for electricity; where was the PM through all of this?; seems that the issue is not if this will happen again, but, when. Significant fodder for the conspiracy theorists as the "deregulated" power companies stand to gain tremendously from increased prices passed on to consumers and very large government contributions. Who has "gone long" on the power companies?

I must admit, I was much more concerned and frightened by the fact that, while I was in Atlanta, the television media was hyping the new "Sharon Ozbourne Show" - now that's where a rolling blackout would be useful.

Much (long-term) success to you, DPG.

In This Months Issue: (Click on the Article Title To Go To The Full Story.)

	Value Disciplines: What are they? Do you need them? How do you use them? By: Kendall Consulting Group of Sarasota Florida.
	Fundamentals Of Family Limited Partnerships. By: Alvin J. Geske, Holland Knight, LLP.
	Financial Strategies In Small Firms. A New Study By StatsCan.
	Quick Stuff: Current US Banking Industry Statistics from the FDIC.

Quote Of The Month:
"This isn't a problem for Monday. It remains a problem for Monday, Tuesday, Wednesday, Thursday, and Friday of this week at least. And we don't know beyond that."
Ontario Public Safety Commissioner, James Young on potential for rolling blackouts after the blackout of August 14, 2003

Investment Hindsight:
"Work and acquire, and thou hast chained the wheel of chance."
Ralph Emerson Waldo

Value Disciplines: What are they? Do you need them? How do you use them?
By: Kendall Consulting Group of Sarasota Florida.

What enables some companies to command the respect and loyalty of their customers, while others can't find their niche and must continuously cut costs and retrench in their business? What are the dynamics of the market that let a company be a star for years and then suddenly slip from its leadership position?

In this article, we introduce the concept of Value Disciplines and a short checklist for companies to use in testing their need for the Value Discipline approach. We have also included a brief description of key steps to getting started.

"Value Disciplines" is the term used for three dynamic business leadership strategies - operational excellence, product leadership or customer intimacy - that companies effect to differentiate themselves and provide unmatched value to their customers. A Value Discipline strategy provides the context for a company to set its corporate vision and objectives, target its most profitable customers, and focus and align its functional departments.

According to reengineering guru Dr. Michael Hammer, seventy percent of business change initiatives fail due to a narrowly defined scope of change and inadequate attention to the dynamics of an organization's marketplace (Reengineering The Corporation: A Manifesto For Business Revolution, 1993). Most recent organizational change initiatives have been focused on improving existing internal operations and reducing costs. These are no longer enough for business success. Today, a company must develop and execute a winning strategy aimed at true differentiation and profitable growth.

Value Disciplines force a company to look outward and listen to the voices of its profitability: customers. Traditional marketing segmentation strategies group customers by geography, product mix or demographics. Value Disciplines, however, segment customers according to the product and service benefits which are most valuable to them. Based on research done by Treacy and Wiersema, customers have three distinct value preferences:

• Best total cost
• Best product features
• Best total solution

Customers richly reward suppliers who they believe are uniquely positioned to provide the benefits that are most valuable to them. For example, customers who value the best total cost, no-hassles service, and speed of delivery will be most loyal to an Operationally Excellent supplier. A customer segment demanding state of the art product features will pay a premium price to a supplier who demonstrates Product Leadership. Finally, a customer segment that values a Customer Intimate supplier requires customized products, highly personalized services and will be less price sensitive. Figure 1 shows the landscape for value disciplines.

Figure 1 - The Value Discipline Landscape

The challenge for a supplier is to identify what its customers value in product and service benefits, and to mobilize its organization to provide them. The statement of a value discipline leader's intent is called a value proposition. A value proposition focuses on the benefits to be provided to a specific set of targeted customers. It also describes the products and services used to provide those benefits.

The greatest pitfall companies face today is "trying to be all things to all customers." The strength of Value Disciplines is its focus on the most profitable customer segments, and its focus of company resources on developing and maintaining leadership in one Value Discipline. Companies should not try to be leaders in Customer Intimacy, Operational Excellence and Product Leadership simultaneously.

Commitment to one Value Discipline will use most corporate resources to their capacity, and thus excellence in more than one discipline is extremely rare. For example, technology can be used for operational excellence, for innovation in product development or for customization of products and services. Organizational structures and cultural norms can stress customer service, internal efficiency or creativity. Rarely can all of these objectives be met simultaneously in one organization.

While an organization must choose one Value Discipline to drive all aspects of its business operations, the organization must maintain industry parity with its competitors in the other two Value Disciplines. For example, if Dell Computer pursues Operational Excellence (best total cost) in its market place, it can only achieve market leadership if its products and services are as good as its competitors. If MBNA credit card services are Customer Intimate, its customers will expect highly personalized service, and a credit card with a competitive annual fee and wide acceptance in merchant locations. If Sony is a Product Leader, its customers will maintain their loyalty only if its products are innovative and its maintenance services are as good as its competitors.

Does Your Organization Need Value Disciplines?

Your customers are leaving you. Has your best customer just informed you that they are changing to your competitor? Or are your customers just "trickling away" to your competition each year? Are you losing old customers as quickly as you are adding new ones?

Sales revenues are declining. Are you losing market share, especially in a growing market? Are you fighting through cost reductions to maintain your margin, while your sales are flat or decreasing? Are employees overworked, demotivated and cutting corners? Are sales campaigns failing to deliver sought after results?

You are losing competitive advantage. Is your unique reputation in the market place declining as new solutions are being offered by your competitors? Are customers' expectations being consistently raised by your competition? Are your products and services "me too's," too late and too expensive? Are your manufacturing costs greater than your competitor's price?

Objectives for your change programs are unclear and frequently changing. Does your company chase fad after fad? Do people in your organization disagree on your company's priorities? Is the connection between your market position and your vision and change programs missing? Do departments have trouble defining their "strategic role?"

Your knowledge of your customers is dated and incomplete. Did you survey your customers, but after the data was analyzed, realize that you asked the wrong questions? Can you answer with confidence "Why is this customer doing business with us?" Have you developed too many products that missed the mark with your customers? Do your competitors seem to understand your customers better than you do?

You are sometimes disappointed in the results of your strategic initiatives. Do you find yourself forced to react more to competitor initiatives than framing the competitive field yourself? Are your customers demanding that you equal competitive offerings? You are blind-sided by non-traditional competitors?

Your employees are frustrated in their ability to serve the customer. Do your organizational procedures make it difficult for your employees to do the right thing for the customer and your company?

What Should You Do?

If you have identified with any of these scenarios, you will benefit from Value Disciplines. Here are some steps you should consider:

1. Get an introduction to Value Disciplines. Understand what Value Disciplines are and how to use them. Learn about value discipline leaders. Understand the implications of each discipline in strategy formulation, structure, technology deployment and human resource development. Explore how we at Kendall Consulting Group have applied our Value Discipline methodology in companies similar to yours. Learn how to introduce the Value Discipline concept to your management.

2. Determine your present explicit and implicit value alignment. Assess the value direction and success of your strategic initiatives and management directives. Compare your organization's capabilities to your perceived customers' value preferences. Assess your organization's capabilities and vulnerability to its competitors. Determine whether value disciplines represent an opportunity (or threat) to your business.

3. Develop your strategic plan using the Value Disciplines concept. Use our methodology and coaching to segment your markets by value discipline, identify opportunities (or threats), and choose a differentiated value proposition that you alone are uniquely able to provide your customers. Identify blocks to your implementation and develop tactics to deal with them. Learn from the experience of a firm who has done this before. Use proven techniques which can reduce your time and effort. Develop the skills of your management team so that they can apply the methodology in the future.

4. Use Value Disciplines to set priorities and direct business change efforts. Identify the most important aspects of customer value and prioritize processes for business process redesign. Develop relevant measures of performance and procedures to reinforce customers' perceptions of value.

Summary.

Establishing Value Discipline leadership is hard work. Implementing Value Disciplines requires a company-wide ambition which is championed by the executive team; a compelling and detailed vision that is understood throughout the organization; a management directive that gives this activity priority and redirects the necessary people to do the work; and an openness and willingness to share information, opinions and experience across work management levels, functions and geographic boundaries.

Why has Airborne Express been able to achieve sales growth of 20% per year since 1985? Airborne Express succeeded in growing its Customer Intimate business because its management targeted a set of customers who valued overnight delivery at special times with special delivery instructions. Because Airborne Express was uniquely able to deliver these benefits, they did not have to depend on low prices and high volume to survive. Airborne refined its organization and systems to be the best at serving its customers' special delivery needs.

Striving for Value Discipline leadership is not trivial. It is the most aggressive strategic initiative that a company can choose to implement. Success with Value Disciplines requires that organizations find a new way of thinking beyond a traditional approach to business strategy.

A Value Discipline leader cannot be a partially customer intimate organization, demonstrate some product leadership, and be operationally capable. Instead, the company must develop and maintain its organizational capabilities in a way which delights its selected customers and continues to raise their expectations to a level which none of its competitors can come close to equaling, now and in the future.

Kendall Consulting Group is an international general management consulting firm specializing in strategy execution, change management, and executive education. We invite you to contact us for how we might help you and your company grow and prosper. Visit http://www.kendall-consulting.com .

Fundamentals Of Family Limited Partnerships.
By: Alvin J. Geske, Holland Knight, LLP.

A family limited partnership (FLP) is a limited partnership composed of a general partner and limited partners. The general partner, who has the power to make virtually all decisions on behalf of the partnership, is generally an entity (an S corporation or limited liability company (LLC)) controlled by family members. The general partner ordinarily has a very small percentage interest in the partnership (usually one percent). The initial limited partners are the members of the older generation, who have a very large percentage interest in the partnership (usually 99 percent). Under the partnership agreement, the limited partners have no rights to participate in the day-to-day management of the partnership. The partners contribute investment assets, and profits and losses are allocated pro-rata to the partners. The limited partners may, and frequently do, make gifts of limited partnership interests to the younger generation during their lifetimes.

Tax Advantages.
The principal tax advantage is a valuation discount, usually of from 30 to 48 percent on the value of the transfer subject to tax. Discounts may exceed 50 percent in appropriate circumstances, but there is penalty exposure if such a discount is completely disallowed. The transfer tax savings is generally a highly important reason for a client to utilize a limited partnership. The discount is generally greater for real estate and less for publicly traded securities. It is also generally greater when the property does not produce cash flow.

Valuation Discount. The valuation discount arises because non-controlling ownership interests in business or investment entities are not valued at the value of a proportionate interest in the underlying assets (net asset value). Recognized valuation methodology provides that such interests are entitled to discounts for lack of marketability and control. These discounts recognize the economic realities that such interests cannot be sold for net asset value because they are not marketable — that is, they cannot be readily sold like shares of stock in a publicly traded corporation — and they do not permit the transferee to exercise control over the activities of the business or investment entity, thus resulting in the owners’ subjection to the discretion and business judgment of another party both for operating results and the timing of distributions (if any).

Trying to quantify the expected tax savings involves determining when property is likely to be sold as well as determining effective transfer tax and income tax rates. In general, the transfer tax savings must be offset against the present value (as of the time the transfer tax would have been paid) of the income tax cost resulting from the reduced basis step-up (which applies only if the estate tax applies because the limited partnership interest is included in the decedent’s estate). If property is expected to be retained in the family for many years, the income tax offset can be ignored. Also, when the property is sold there will be cash proceeds to pay the tax, which is not the case with the transfer tax.

Example 1. Taxpayer owns raw land worth $5 million with a zero basis that will be sold five years after the taxpayer’s death. The discount is assumed to be 50 percent. The estate/gift-tax rate is 49 percent. The combined federal and state income tax rate on the sale is estimated to be 25 percent. The estate tax savings will be roughly $1,225,000 [49 percent of $2,500,000]. The loss of a full basis step-up will mean that the capital gains taxes on sale would be $625,000 [25 percent of $2,500,000] greater, but that figure would have to be reduced to the present value as of the due date of the tax return to reflect that the tax has been deferred by about five years. Stated another way, the savings would be $600,000, plus the time value of having $625,000 for five years. Even at an assumed discount rate of four percent this deferral is worth about $111,000.

Example 2. Taxpayer owns publicly traded stock worth $5 million with a zero basis that will be sold five years after the taxpayer’s death. The discount is assumed to be 40 percent. The estate/gift-tax rate is 49 percent. The combined federal and state income-tax rate on the sale is estimated to be 20 percent. The estate tax savings will be roughly $980,000 [49 percent of $2,000,000]. The loss of a full basis step-up will mean that the capital gains taxes on sale would be $400,000 [20 percent of $2,000,000] greater, but that figure would have to be reduced to the present value as of the due date of the tax return to reflect that the tax has been deferred by about five years. Stated another way, the savings would be $580,000, plus the time value of having $400,000 for five years. Even at an assumed discount rate of four percent, this deferral is worth about $72,000.

Example 3. The facts are the same as Example 2 except there are two separate blocks of stock – Stock A, with a basis of $2,500,000 and a fair market value of 2,500,000 and Stock B, with a basis of zero and a fair market value of $2,500,000. For simplicity, it is assumed that decedent retained a 90-percent limited partnership interest at death, with respect to which the net asset value in the partnership was $4,500,000. As a result of the 40-percent valuation discount, the interest is included in decedent’s estate at a value of $2,700,000. The donor’s spouse receives a 45-percent interest in the limited partnership and the other 45 percent is left to decedent’s children. Stock B is distributed to the spouse in liquidation of the spouse’s partnership interest within two years of the transfer of the interest to the spouse. The adjustment should increase the basis in Stock B to $1,350,000 – the basis is the spouse’s inherited partnership interest under Section 732(d) of the Internal Revenue Code. Note that this is better than an election under Section 754, which would result in a basis step-up of only $450,000 [$2,700,000 – 2,250,000 (2,500,000 x 90%)].

Example 4. Taxpayer owns a family business corporation worth $5 million with a zero basis that will be not be sold for many years. The discount obtained by placing the corporate stock in a family limited partnership is assumed to be 50 percent. The estate/gift-tax rate is 49 percent. In this situation, the potential income tax offset can be ignored. The estate/gift tax savings will be roughly $1,225,000 [49% x $2,500,000].

Non-Tax Advantages.
The non-tax reasons to form a family limited partnership include:
* Transfer a group of assets into a form of ownership that is simpler to transfer (to facilitate annual and other gift-giving programs).
* Centralize management and obtain the benefit of continuity of management over the partnership’s assets.
* Provide protection to partnership assets from claims of future creditors of the limited partners and to limit the limited partners’ liabilities for partnership debts.
* Provide unified control (through the general partner) over distributions of cash derived from earnings on the partnership’s assets.
* Provide flexibility in business planning not available through trusts, corporations or other business entities.
* Conduct investment and business activities in an entity that is not itself subject to federal or state income taxes.
* Avoid the delay, publicity, inconvenience and expense associated with probate administration of multiple separate investments of the partners upon their respective deaths or liquidation.

Disadvantages.
* Locks assets in the partnership for a period of time, generally not ending until the expiration of the statute of limitations for the last year during which transfers were made.
* Records must be kept, and annual tax returns must be filed, for the partnership and the corporate or LLC general partner. Appraisals must be made to establish the value of the gifted limited partnership interest. The investment in legal, accounting and appraisal fees for formation and administration of a FLP are significant, but the savings achieved often exceed costs by a multiple of 20 or more.
* Use of FLP clearly enhances the chance of gift or estate tax return being examined, and perhaps contested in court. Many "traps for the unwary" if partnership form is not respected.
* Could create or increase liquidity problems of estate by locking up assets that could otherwise be used to pay estate tax.
* Could be problems if highly leveraged real estate is being transferred to the partnership.
* Could be income tax problems if property is distributed to donees within seven years of contribution (see disguised sales rules of Sections 731(c) and 737 of Internal Revenue Code).

For Whom Is this a Good Strategy?
* Estate of at least $2.0 million for single individuals and $3.0 million for married couples.
* Generally requires ability to put at least $1.5 million of securities or "non-personal use" real estate in a partnership and be supported by non-partnership assets. There are situations in which personal use property may be used effectively, but donor must not be put in a situation where he or she must rely on invasion of partnership principal for support.
* Donor must have a toleration for complexity of maintaining assets of partnership separate from personal assets and for filing separate tax returns for partnership and corporate or LLC general partner.
* Usually works best with marketable securities or real estate, although limited partnerships have been used successfully to hold interest in closely held businesses, personal use property, or certain types of tangible personal property (e.g., horses or cattle).
* For greater estate tax savings, donor must not control general partner at the time of death.

Comparison with other Estate Planning Techniques Like Gifts or Family Sales.
There is no requirement of surviving a particular period to obtain benefits (as long as it is not a true "deathbed" transfer). Also, there is an immediate reduction in the value of property, which will apply to lifetime transfers and death time transfers.

The benefits do not require interest rate plays or that property appreciate at a greater rate than an assumed interest rate.

Although FLP issues have been litigated frequently and taxpayers win these decisions far more often than not, the availability of benefits is less secure than benefits with specific statutory sanction, such as Grantor Retained Annuity Trusts (GRATs).

When compared with use of undivided fractional interests in real property, the advantages are often as follows: (1) the discounts generally are higher (especially in cases where the property yields current income); and (2) the FLP is much easier to use for periodic transfers because interests are more easily assigned. A disadvantage of the FLP is that the undivided property approach may make it somewhat easier to avoid IRS challenges to the structure of the transaction. The IRS could still argue that there was no transfer in substance if the donor retained all of the income from the property, even though valuation of the interests may create a dispute.

Special Considerations.
Gift on Formation. The IRS may argue that diminution in value on formation of partnership results in an immediate gift. So far this argument has been unsuccessful where documents are properly done. Exposure is greatest where other parties control general partner at formation.

Qualification for Annual Exclusion. Gifts of limited partnership interests qualify for the $11,000 per donee annual exclusion only if they are gifts of present interests. If the recipients have no rights to transfer the interests or to receive distributions, the gifted interests may not qualify.

Retained Control Pulls Back Gifted Interests into Donor’s Estate. Code Section 2036(a) generally requires inclusion in the decedent’s estate of property transferred during lifetime if he retained sufficient control over the gifted property. The IRS has argued, with some degree of success that this provision applies when the decedent controlled the general partner or had the power to remove the general partner and the general partner’s power over distribution and transfers of interests are sufficient to conclude that the interests were not completely transferred.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

Holland & Knight LLP is one of the largest commercial law firms in the world with more than 1,250 lawyers, practising in over 100 areas of law. The firm's multi-office, one firm structure enables it to provide efficient legal advice to local and international clients. Visit www.hklaw.com

Financial Strategies In Small Firms.
A New Study By StatsCan.

A new study has found a strong relationship between knowledge intensity in small and medium-sized enterprises in Canada and their patterns of financing.

Companies that operate in high-knowledge industries - innovative sectors that stress research and development, technology use or skilled workers - are less likely to maintain debt-intensive financial structures, according to the study.

In other words, small and medium-sized firms in high-knowledge industries make less use of debt instruments than those in other sectors. In high-knowledge industries, such firms had, on average, 38% of their capital in the form of short- or long-term debt. For those in low-knowledge industries, the average debt share increased to 56%.

The findings are based on an elite group of successful small firms, the 20% of new businesses that survive their first decade of life. Data came from the 1996 Survey of Operating and Financing Practices, which collected data on the business strategies and financial characteristics of successful small firms.

The study did not show that small firms are debt-constrained or equity-constrained. Small firms in knowledge-intensive industries might use more equity because debt financing is harder to obtain. Alternatively, they might use more equity because they prefer equity over debt to finance their business activities.

The study found that the rate of growth among small and medium-sized enterprises was not a strong predictor of their financial structure. Faster-growing firms were no more likely than those that grew more slowly to exhibit debt-intensive capital structures. There was some evidence, however, that faster-growing firms drew on more sources of capital to finance their operations.

Overall, however, financial structures of small firms were not very diversified. Most of the firms in this study relied heavily on equity instruments with relatively little debt, or debt instruments with relatively little equity.

The study also showed some evidence that expectations about future growth were related to patterns of debt and equity use. Small and medium-sized firms that expected to grow rapidly tended to maintain more debt in their capital structures than those with more modest expectations of their future performance.

The economic analysis research paper Growth history, knowledge intensity and capital structure in small firms is now available on Statistics Canada's website (www.statcan.ca). From the Our products and services page, under Browse our Internet publications, choose Free, then National accounts. Also available on Statistics Canada's website is information on related papers on small-firm financing.

For more information, or to enquire about the concepts, methods or data quality of this release, contact Guy Gellatly (613-951-3758), Micro-economic Analysis Division.

Quick Stuff: Current US Bank Industry Statistics from the FDIC.

US Commercial banks as of 3/31/03

	7,864 total institutions
	$7.2 trillion of assets
	4,114 institutions have less than $100 million in assets
	7,451 institutions have less than $1 billion in assets
	1 failed institutions this quarter
	50 mergers this quarter
	24 new charters this quarter

US Savings institutions as of 3/31/03

	1,450 institutions
	$1.4 trillion of assets
	500 institutions have less than $100 million in assets
	1,298 institutions have less than $1 billion in assets
	No failed thrifts this quarter
	15 mergers this quarter
	2 new charters this quarter

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