Exit Planning Tools for Business Owners

John F. Dini

My Interview with Jerry West on Management

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I once had the thrill of interviewing Jerry West on management. He was “The Logo” for the NBA, although back then they didn’t advertise him as such. Only the Laker followers knew for sure.

In 1989 the “Showtime” Lakers were coming off back-to-back championships.  Pat Riley was a year away from his first of three Coach of the Year awards. Jerry was the GM. Many people don’t know this, but starting when Jerry West was drafted in 1960 until he stepped out of the GM role in 2002, the Lakers only missed the playoffs twice. Those seasons (74-75 and 75-76) were the only two seasons out of 42 that West was not on the Laker payroll.

In 1989 I was enrolled in Pepperdine’s Executive MBA program. Our class assignment was to interview a top executive with whom we had no previous relationship or introduction about his management style.

Mr. West Returns the Call

I was an avid Laker fan, and I thought “He can only say no.” So I called the Forum, asked for West’s office, and left him a voicemail. A few hours later our receptionist called me and said “One of your friends is goofing around on the phone. He says he’s Jerry West.” Obviously, I took the call.

We met in his office underneath the stands in the Forum. It may have been 12 x 12 feet, but the magnetic boards lining the wall made it seem much smaller. Each board had an NBA team’s name on top, and magnetic placards for every player currently on that team.

I asked Jerry about how he approached the management of the Lakers. He gestured to the boards. “My job as General Manager is to put the best team on the floor that I can. I look at these boards every day and think who might be better on the Lakers? Then I look at other teams and think who they might have that will convince the team with the player I want to give him up.”

He went on to say that he was sure that business executives weren’t as singularly focused as he was. He thought about the Lakers from the moment he woke until going to sleep at night. I didn’t try to convince him that he matched the profile of many small business owners.

Jerry West on Management

As a manager, Jerry said that he believed that if you hired someone to do a job, then you needed to step back and let them do it. Pat Riley was a broadcaster with no coaching background. Jerry said that the problem with experienced coaches is that they had already been fired once. West took a flyer on Riley, but to appease the media he agreed to sit on the bench to lend advice.

“It was crazy. Riley had no idea what he was doing. He’d call to put guys in the game that we had cut the week before or to sub in guys who were already on the floor. I lasted about three games on the bench. I had to go to my office and let him learn on his own. The alternative was that I’d kill him.”

One poignant moment was when he discussed his family. I can’t imagine the burden being in the public eye brought with it. He talked about his children being bullied on the playground because the team was on a losing streak. Even worse was having his wife accosted in the supermarket aisle by a fan who was incensed over a trade.

One of his greatest tips was when we discussed keeping things in perspective. He showed me two file folders in his desk drawer. “One of these has the most complimentary of the letters I get when the team is doing well. They tell me I’m a genius. The other folder is the worst letters I get when the team is doing poorly. You can guess what they think of me.”

“Whenever we are on a streak, good or bad, I pull one of the letters from the file when we were doing the opposite. It reminds me that it wasn’t always the way it is today, and it will swing back sooner or later.”

Looking to the future

I wasn’t supposed to discuss the Lakers, but the fan in me couldn’t help it. Jerry had just drafted a guy from Yugoslavia that no one had heard of. This was well before European players dominated the top draft picks. I had to ask him about his choice.

“Wait until you see him,” West said. “Seven feet tall and he can pass the ball like Magic.”

He became the starting Laker center for the next seven years. Then Jerry West traded Vlade Divac to the Charlotte Hornets on draft night of 1996 to get the 13th pick, a teenager named Kobe Bryant.

Always looking at those boards.

We’ll miss you, Jerry.

 

 
John F. Dini develops transition and succession strategies that allow business owners to exit their companies on their own schedule, with the proceeds they seek and complete control over the process. He takes a coaching approach to client engagements, focusing on helping owners of companies with $1M to $250M in revenue achieve both their desired lifestyles and legacies.

Addressing the Value Gap – Truth in Pricing

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Truth in pricing is a common issue when discussing the sale of a business.

The selling price of their company is a point of pride for any owner. When they are willing to share the price they were paid, they usually include everything that was listed in the purchase agreement. While there is nothing inherently dishonest about that, it’s often not exactly the truth either.

In our last article we saw Bob, the owner of Bob’s Widgets, came to the conclusion that he needed to sell his business for $6,000,000 in order to replace his current salary and the Seller’s Discretionary Earnings (SDE) such as the vehicle and health insurance that his business pays for.

He knows that his friend Edgar sold his widget company for $5,000,000. Both Bob and Edgar have about 40 employees. Bob thinks his newer manufacturing equipment allows him to operate more efficiently than Edgar. Edgar freely discloses that his revenues were $4,000,000 in the year prior to the sale. Bob’s sales were $7,000,000 last year.

We will ignore Bob’s EBITDA ($500,000) for this exercise. Whether his expectations are practical as a multiple of profits is a discussion for another time.

Is it unreasonable to presume that if a $4,000,000 revenue company in the same industry can sell for $5,000,000, then a $7,000,000 company should sell for $6,000,000? Bob figures that he is not only being reasonable, but perhaps he is shooting too low.

Truth in Pricing

To begin, let’s see what Edgar’s price consisted of.

Royalty payments on specialty widgets that Edgar patented were value at around $150,000 a year for the next ten years. That was $1,500,000 of his “selling price.” In addition, although Edgar’s equipment was old, it was paid for. His company was debt-free. He generated almost $1,000,000 in EBITDA annually.

truth in pricingEdgar’s buyer also wanted him to stick around for three years. Edgar calculated his salary of $150,000 a year as part of the “purchase price.” He also had an “earn out” of $500,000 a year for reaching certain sales goals in the next two years. In total, royalties, salary and conditional payments made up $2,950,000 of his $5,000,000 price, leaving only a bit more than $2,000,000 as “cash on the barrelhead.”

Did Edgar lie? Not in his own eyes. Given some time, effort and luck., he will eventually realize $5,000,000 in total pre-tax income related to his business. It’s his version fo truth in pricing.

Bob’s Price

First Bob has to consider what his price would include. He has about $350,000 left on the lease/purchase of his two newest widget manufacturing machines, which would have to be paid off by the buyer. He also owes about $300,000 on his revolving credit line.

Bob has always felt that vacation pay is earned, and never bothered to put a limit on its accrual by employees. He would be shocked to learn that his 40 employees, who average about $50,000 in salary, have about 240 weeks of unused vacation time. That’s another $230,000 plus the employer’s payroll taxes. Let’s call it a quarter million dollars. Edgar had a maximum one-week carryover. His liability was about $40,000. If Bob’s buyer is willing to pay a five (5x) multiple of EBITDA, the unrecognized vacation expense could drop the purchase price by nearly $1,000,000.

Bob is also anticipating a stock sale, with a tax burden of about $1,200,000 on his sale price. If it’s an asset sale (90% of small businesses are asset sales), he can expect that number to be much higher. In short, even if Bob could demand $6,000,000, his actual cash price might be more than a million and a half dollars less, and his tax burden almost a million dollars more. Suddenly Bob has the equivalent (in his eyes) of a $3,500,000 sale.

Closing the Value Gap

Welcome to the second part of the Value Gap. Now Bob realizes that not only will he need substantially more money to fund his post-exit lifestyle, but his company can’t currently provide the level of proceeds he was planning on for retirement.

It may seem surprising, but the answer to this problem for many owners is “I’ll just work longer.” The challenge of closing the Value Gap is too daunting to wrap their thinking around.

Some planning could help Bob. He can modify his benefit structures and pay off some debt, but let’s say that his $6,000,000 price is reasonable, and growing the value to $8,000,000 would meet his goals. Breaking that down on an annual basis renders a growth target of less than 6% annually over the next 5 years.

That may be a better solution than “just keep working.” Bob’s time frame may be longer or shorter. He may modify his target income. He may be able to economize in his business operations to increase cash flow. There are a number of options to consider, but they all require that Bob first understands his Value Gap and truth in pricing.

John F. Dini develops transition and succession strategies that allow business owners to exit their companies on their own schedule, with the proceeds they seek and complete control over the process. He takes a coaching approach to client engagements, focusing on helping owners of companies with $1M to $250M in revenue achieve both their desired lifestyles and legacies.

Addressing the Value Gap – Living Expenses

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The Value Gap is one of the most used phrases in exit planning. Simply stated, it’s the difference between what a business owner would realize if he or she sold the company today, and what they need to embark on a financially secure “next act” after business ownership.

Both amounts can be determined with some accuracy by professionals. A qualified appraiser will analyze a company, its prospects, differentiation, markets, and comparative businesses and develop a value for the business. A good financial planner will look at savings, expected income, anticipated lifestyle expenses, life expectancy, and inflation and develop a scenario for the amount needed to fund those expectations.

Simple, right? Financial plan requirements minus net proceeds from the business transfer equals the value gap.

Testing the Value Gap

If it is so simple, why do so few business owners do it? Instead, they value their businesses by hearsay, misestimate their lifestyle needs by a substantial margin, and think “I’ll probably be fine.” In fact, fewer than one owner in five has even documented any plan for their transition.

Let’s take my favorite business owner, Bob of Bob’s Widgets Inc. Bob pays himself $120,000 a year and lives nicely on that amount. So he estimates that $10,000 a month should cover his lifestyle in retirement. To generate that, he needs $3,000,000 in savings with a 4% return. That means he has to sell his business for about $4,000,000, assuming 24% capital gains tax.  His company sold $7,000,000 in widgets last year, with a $500,000 pre-tax bottom line, so he is sure it’s worth at least $4,000,000. (We’ll discuss this valuation in my next column.)

But wait a minute. Is Bob really making $120,000 a year? He drives a Ford Super-Duty company truck that cost $85,000. The payment is about $1,500 a month. Insurance, maintenance and fuel are paid for by the company. Bob’s Widgets Inc. also pays for Bob’s $750 a month health insurance, his $1,200 monthly life insurance, and his $7,200 annual personal tax preparation bill.

“Sellers Discretionary Expenses”

Bob’s company expenses are not only common, but he doesn’t really take all that much in comparison to some owners. Any advisor can tell stories of company-paid second homes, family trips and other expenses far less business-related than Bob’s.

Without going beyond what would be considered “normal” owner perks, we can add about $58,000 a year in post-tax spending to Bob’s lifestyle. At his 4% return assumption, that adds another $1,450,000 in post-tax proceeds from the business to his need for a liquid asset base.

Even if Bob’s assumption of a lower capital gains rate is correct (which is not the case in 90% of small business sales) he actually needs a sale price of at least $6,000,000 just to maintain his current lifestyle.

Even Bob knows that his company can’t sell for $6,000,000. Without getting an appraisal or a formal financial plan, Bob has just had his first lesson in planning for the Value Gap.

John F. Dini develops transition and succession strategies that allow business owners to exit their companies on their own schedule, with the proceeds they seek and complete control over the process. He takes a coaching approach to client engagements, focusing on helping owners of companies with $1M to $250M in revenue achieve both their desired lifestyles and legacies.

Owners are a Minority

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When it comes to careers, business owners are a minority of the population. In conversations this week, I mentioned the statistics several times, and each owner I was discussing it with was surprised that they had so few peers.

According to the Small Business Administration (SBA), there are over 33,000,000 businesses in the US. Let’s discount those with zero employees. Many are shell companies or real estate holding entities. Also, those with fewer than 5 employees, true “Mom and Pop” businesses, are hard to distinguish from a job.

The North American Industry Classification System (NAICS) Association, lists businesses with 5 to 99 employees at about 3,300,000, and 123,000 have 100 to 500 employees (the SBA’s largest “small business” classification.)

Overall, that means about 1% of the country are private employers. Owners are a small minority, a very small minority, of the population. Even if we only count working adults (161,000,000) business owners represent only a little more than 2% of that population.

So What?

Where am I going with this, and how does it relate to our recent discussions of purpose in business exit planning? It’s an important issue to consider when discussing an owner’s identity after transition.

Whether or not individual owners know the statistics of their “rare species” status in society, they instinctively understand that they are different. They are identified with their owner status in every aspect of their business and personal life.

At a social event, when asked “What do you do?” they will often respond “I own a business.” It’s an immediate differentiator from describing a job. “I am a carpenter.” or “I work in systems engineering,” describes a function. “I am a business owner” describes a life role.

When asked for further information, the owner frequently replies in the Imperial first person plural. “We build multi-family housing,” is never mistaken for a personal role in the company. No one takes that answer to mean that the speaker swings a hammer all day.

Owners are a Minority

We process much of our information subconsciously. If a man enters a business gathering, for example, and the others in the room are 75% female, he will know instinctively, without consciously counting, that this business meeting or organization is different from others he attends.

Similarly, business owners accept their minority status without thinking about it. They expect that the vast majority of the people they meet socially, who attend their church, or who have kids that play sports with theirs, work for someone else.

There are places where owners congregate, but otherwise, they don’t expect to meet many other owners in the normal course of daily activity. This can be an issue after they exit the business.

You see, telling people “I’m retired” has no distinction. Roughly 98% of the other people who say that never built an organization. They didn’t take the same risks. Others didn’t deal with the same broad variety of issues and challenges. Most didn’t have to personally live with the impact of every daily decision they made, or watch others suffer the consequences of their bad calls.

That is why so many former owners suffer from a lack of identity after they leave. Subconsciously, they expect to stand out from the other 98%. “I’m retired” carries no such distinction.

John F. Dini develops transition and succession strategies that allow business owners to exit their companies on their own schedule, with the proceeds they seek and complete control over the process. He takes a coaching approach to client engagements, focusing on helping owners of companies with $1M to $250M in revenue achieve both their desired lifestyles and legacies.

Purpose After the Sale

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Purpose after the sale is one of the biggest challenges for an exiting owner.

Purpose – “Having as one’s intention or objective.”

Many exit planning advisors discuss the three legs of the exit planning stool – business readiness, financial readiness and personal readiness. In our previous two articles, we focused on two of the “big three” components of a successful life after the sale, activity and identity. The third is purpose.

So many advisors point to the 75% of former owners who “profoundly regret” their transition, and say it’s because they didn’t make enough money. To quote Mr. Bernstein in the great film Citizen Kane, “Well, it’s no trick to make a lot of money…if all you want is to make a lot of money.”

I’ve interviewed hundreds of business founders. When asked why they started their companies, by far the most common answers are about providing for their families and having control of their future. Only a very small percentage say “I wanted to make a lot of money.”

Decades of Purpose

So what kept them working long hours and pushing the envelope after they had reached primary, secondary and even tertiary financial goals? Non-owners often chalk it up to greed, but Maslov’s hierarchy of needs drifts away from material rewards after the first two levels. Belonging, Self-Esteem and Self-Actualization may all have a financial component, but money isn’t the driver.

For most owners, the driving motivation is this thing they’ve built. The company has a life of its own, but it’s a life they bestowed. They talk about the business’s growing pains and maturity. Owners are acutely aware of the multiplier effect the success of the company has on employees and their families. In a few cases, that multiplier extends to entire towns.

That’s the purpose. To nurture and expand. In so many cases every process in the business was the founder’s creation. He or she picked out the furniture and designed the first logo. This aggregation of people breathes and succeeds on what the owner built.

That’s why so many owners still put in 50 or more hours a week, long after there is any real need for their constant presence. This thing they created is their purpose.

Purpose After the Sale

It’s no surprise that so many owners find that 36 holes of golf each week, or 54, or 72, still isn’t enough to feel fulfilled. You can get incrementally better, but it doesn’t really affect anyone but you. Building a beautiful table or catching a trophy fish brings pride and some sense of accomplishment. Still, it never matches the feeling of creating something that impacts dozens, scores or hundreds of other human beings.

That’s why we focus on purpose as the third leg of the personal vision. In the vast majority of cases, it involves impacting other people. Any owner spent a career learning how to teach and lead. Keeping those skills fresh and growing is a substantial part of the road to satisfaction.

Purpose may involve church or a community service organization. It could be serving on a Board of Directors or consulting for other business owners. It might be writing or speaking. Purpose after the sale doesn’t require a 50-hour week, but it does require some level of commitment, and the ability to affect the lives of others.

John F. Dini develops transition and succession strategies that allow business owners to exit their companies on their own schedule, with the proceeds they seek and complete control over the process. He takes a coaching approach to client engagements, focusing on helping owners of companies with $1M to $250M in revenue achieve both their desired lifestyles and legacies.