Exit Planning Tools for Business Owners

business strategy

Selling to Employees: Is Your Exit Strategy Right in Front of You?

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When I interview a prospective client for exit planning assistance, we usually explore selling to employees. The first reaction is always “That won’t work. They don’t have any money.”

If you have a company with reasonable cash flow, a talented management team and sufficient time, selling to employees is not only a realistic option; it may be the best way to get value from your business. I’ll define those parameters for you in a minute.

If you haven’t read my eBook Beating the Boomer Bust, follow the link for the free download. My research shows that the hard numbers will inevitably translate into a hard market. There are 3,000,000 Baby Boomers (over 50) who own businesses with employees. Over the next 20 years, that’s an average of 150,000 owner retirements per year. Intermediaries (brokers, private equity and M&A) account for about 9,000 transactions a year.

That leaves a lot of folks looking for a way to cash out. Selling to employees is a process that lets you keep control until retirement. By structuring the sale correctly, you can leave with the proceeds in the bank, not in a promissory note.

How does that work? It requires a bit of mental gymnastics. First, any owner has to accept that the only source of funding for any transaction is the cash flow of his or her company. If a buyer pays cash, he expects that cash flow to pay him back. If a bank finances the acquisition, they expect the cash flow to service the debt. If you finance it, you are the essentially the bank.

Selling to employees is the same. You use the current cash flow to help employees buy stock. In return, they qualify by working to increase the value of the business until your final return is equal to (or more than) what it was when you started.

Think of it as taking a note for 30% of the purchase price while you are still in control, so that you can get a 70% cash down payment when you leave.

Now, let’s discuss the parameters.

Cash Flow: Your company has to be earning more than just your paycheck. My rule of thumb is that around $500,000 a year after owner’s compensation gives enough to work with. More than that doesn’t change much, since then we are usually looking at a higher purchase price. Less than that is doable in a longer time frame, or if the owner is willing to subordinate some debt to the bank.

Management Team: You need at least one decision maker who does more than just go through the operational motions. Any third-party lender wants to be comfortable with company leadership when you’re gone. A large portion of our planning surrounds transfer and documentation of management capability sufficient to satisfy a lender.

Time Frame: Many business owners tell me “I’ll think about exiting in five years.” That’s fine, if your plan is to retire in fifteen years. Generally speaking, the longer you have, the more lucrative an internal sale can be. I’ve done three year plans, but five is much more comfortable, eight years is even better, and we regularly work on transitions of ten years and longer.

all for one one for allSelling to employees requires legal agreements, specialized compensation plans and a willingness to run the company transparently. The return is a team that is committed to the long term, highly motivated, and all on the same page when it comes to growing the business.

Why should you consider selling to employees?  Because your company lives on with the culture you created. Because you can choose the value, not negotiate it. Because your employees aren’t comparing your company with other investments. Because you control the timing of your exit.

Because it is probably the biggest financial transaction of your life.

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What’s in YOUR Nondisclosure Agreement?

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A Nondisclosure Agreement (NDA) has become one of the basic standard documents in every company’s wallet. Between the rising swell of Baby Boomer owners entertaining exit planning, and greater caution surrounding the legal issues of strategic partnering, an NDA is now the standard next step following many initial exploratory conversations.

What should you protect in an NDA? (Note: I am not an attorney, and I don’t create Nondisclosure Agreements for clients.)

Secret informationFirst, there is the question of who is covered by the agreement. Most allow for advisors to each party to see the agreement. That can encompass accountants, attorneys, consultants, bankers and employees. I think employees present the greatest risk, since they are the most likely to personally benefit from information about customers, vendors and pricing.

Some attorneys include language requiring every person who shares the information to sign and return a separate copy. That is cumbersome, and opens the question of enforcement. If you talk to someone on the other side of the transaction, and don’t have a signed copy of the agreement first, have you voided that condition yourself?

Try to keep the responsibility for protecting information with the other side. One mechanism is to have each person who sees information add their signature to the agreement, with language that makes it the other party’s responsibility to only share with signatories. At a minimum, the other party should be required to make certain everyone on their side is informed of the confidential nature of the information. Electronically stamping everything “Confidential” and converting it into pdf is also a basic caution.

Then there are decisions about what information to share. Most potential acquirers are concerned about customer concentration in sales. They will ask for customer purchasing history as one of the first items in preliminary examination of your company.

That is a legitimate concern, but it doesn’t mean they need the names of the customers until much later in the process. We provide redacted reports, identifying customers by letters or numbers.

The same type of common sense applies to vendors, employee compensation and margins by product line. You can provide sufficient information for valuing the business without the details. No matter how honest or well intentioned the other party may be, he or she will remember that you are making 10% more on a specific product, or are selling substantial amounts to a customer they thought was all theirs.

Finally, we recommend that the Nondisclosure Agreement go beyond just keeping information confidential. It should always include a non-employment clause regarding your employees. Non-solicitation is okay, but it’s hard to prove if the company claims the employee approached them. Just make it simple; they can’t hire any employee for two years following your discussions. You may be surprised at how many potential partners balk at this condition.

Always have a qualified attorney draft any Nondisclosure Agreement, but there is no need to go wild. One page is typically insufficient, but more than two pages and you are usually loading it up with conditions that are either irrelevant or unenforceable.

No NDA will stop someone from being dishonest. It is intended to make plain what you consider yours, and how you expect it to be handled. As in any other business transaction, what’s written on the paper doesn’t replace trust.

 

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What the Heck is Exit Planning?

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The wave of Baby Boomer retirements is beginning. I’ve been writing and speaking about exit planning nationally for the last ten years, (you can download my free eBook on the subject here), but the inevitability of the demographics is gaining momentum.

Today, Boomers in their late 60s are starting to sell the businesses they’ve built over the last 30 years or so. They are just the tip of the iceberg. Millions more are steadily approaching their career finish lines at a rate of hundreds every day.

Exit Planning is a new discipline, developed to meet a massive market need. Unfortunately, like any new service offering, there are a lot of people who use the term without fully understanding it, or in hopes that it will associate them with a growing field of professional practice.

Accountants say they do exit planning when they help clients structure their business and personal holdings to minimize the bite of the IRS.

Estate attorneys say they do exit planning when they protect assets and document transfers of inheritances.

Wealth managers say they do exit planning when they provide retirement projections and validate lifestyle assumptions.

Consultants say they do exit planning when they recommend ways to increase the value of the business, presumably maximizing the proceeds from a sale.

Business brokers say they do exit planning when they value and list a company for acquisition.

Insurance brokers say they do exit planning when they write policies to protect owners, their families  and their companies against premature departures, or the absence of key employees.

Which of these professionals really do exit planning? There are two answers:

  1. All of them
  2. None of them

Exit Planning Map MazeExit planning is the process of developing a business owner’s strategy for what may be the biggest financial transaction of his or her life…the transfer of the business. That strategy may be a succession to the next generation of family. It could be a sale to employees. It may be a sale to another entrepreneur, or acquisition by a larger company. In some cases, it could require an orderly dissolution.

In every case, it involves tax, legal, financial, operational and risk management expertise. No one practitioner (including me) has all the knowledge required for every aspect of the plan. Exit planning, in the true sense of the word, is coordinating all those skills so that they work together for a single objective.

Let’s say, for example, you run a warehouse with delivery services. You decide to make it as efficient as possible.

  • You tell the purchasing manager to only order product when pricing and inbound freight are the least expensive.
  • You tell the warehouse manager to develop a system for picking orders with methods that require the least amount of labor.
  • You tell the shipping department to pack up orders using the least possible amount of material.
  • You tell the dispatcher to plan routes for times with the least traffic and the lowest fuel use.
  • You tell the sales department to promise the customer anything that will close the sale.

Now, without letting any of these people talk to each other, you announce that tomorrow you are implementing all their results simultaneously. You go home dreaming about how amazingly profitable your business is about to become.

You don’t have to be a distribution expert to know what is going to happen. The uncoordinated plans are going to explode when combined. You’ve just come up with a great way to go out of business.

Now, what if you told one manager that your overall goal is to sell more product and give excellent service, so customers would become loyal buyers and the company will increase revenues and profits?  Then you had the other managers report to him, so that all of their plans would compliment the overall objective.

That’s what an exit planner does.

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Too Busy to Do Business

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Another tax filing season has passed, and the entire US accounting profession comes up for air. Of course, thousands of businesses and individuals have filed for extensions, thereby postponing the pain of calculating their final numbers for anywhere from a few days to six months.

As the CPAs emerge from their winter burrows and blink in the sun, the rest of the business community reenergizes, suddenly able to move forward with planning and analysis that has been languishing while their numbers-crunchers were busy losing sleep and feasting on ramen noodles.

I met with one firm about doing some valuation work in late February. They appeared to be excited about getting the business. When I called in mid-March with my first project they responded with “It’s tax season. Can you wait until mid-May?”

Perhaps it isn’t totally illogical to expect that an exiting business owner, having spent 30 years developing his largest single asset, should be willing to wait a few more months to begin his transition. The question isn’t so much whether it is unreasonable; it is why it should be necessary.

I have multiple clients with various needs, but all require some interface with their accountant. Some CPAs respond with quick but unsettling responses. “I think you can do this, but you’ll have to wait until after tax season for a definite answer.” Great. Business people always like making million dollar decisions based on “Maybe or maybe not.”

Others simply beg off. “I can’t even take the time to think about that until after April 15th.” Still others don’t respond at all, obviously expecting that their clients will automatically forgive what would be an unforgivable breach of professional service expectations at any other time.

Even the definition of “any other time” is narrowing. The tax rush used to be the few weeks leading to April 15th. Then the weeks leading to March 15th (the business filing deadline) moved back the start of the out-of-service CPA season. With the increasing complexity of tax laws, and the concomitant rise in extension filings, the time between September 1st and October 15th has also become a no fly zone. The week or two leading up to May 15th and June 15th are slightly better, but not by much.

shutterstock_93857353Tax complexity makes handling almost any transaction without professional advice foolhardy, but are we really supposed to just draw a line through 16 weeks, or 1/3 of the annual business cycle?

There are lots of suggestions about how to simplify the code or spread out the reporting deadlines. A flat tax is interesting, but would largely remove the ability of legislators to show favoritism to big supporters and home-state causes, so I’m skeptical of its chances.

Another proposal is to let individuals file by their birthdays, or let calendar-year businesses pick another year-end. The government’s excuse is that it would delay revenues for the year of implementation. Really? Like they were planning on a balanced budget that year? Heaven forbid they would have to borrow any more than the $1,000,000 a minute they do already.

Until we find some more sensible way to fund the public sector, business owners are subject to double indemnity. Not only do we have to pay the bill, but doing so correctly requires that we also at least partially delay our attempts to earn the income that will be taxed.

What is the Right Price?

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Of all the misconceptions by business owners, the ones surrounding their company’s value are both the most common and often wildly inaccurate.

I’ve been working for the last couple of months on the training videos for advisors in our new product, The ExitMap®. (You can take the assessment for free at www.myexitmap.com). In one session, we role-play a vignette about a financial planner discussing the value of a business with a client planning retirement. Part of it goes something like this.

Q: “So Bob, how much do you expect to realize from your business when you sell it?”

A: “I’ve heard from my accountant that most small businesses sell for about five times earnings.”

Q: “And how much would that be?”

A: “Well, I made about $150,000 in salary last year, and another $200,000 in profit. Add in my insurance policies and my car, my wife’s car and a few trips that combined business and pleasure. Say around $500,000 in total benefits. So I’d expect to get somewhere around $2,500,000 for the business.

Q: “What would that be after taxes?”

A: “I’d have to pay capital gains, so I’ll net in the area of $2 million.”

Simple, right? Let’s look at the reality.

abacusBob is calculating what the brokerage industry calls “Seller’s Discretionary Benefits” or SDE. While it is a legitimate way to look at the full value of business ownership, ball park valuations of 4-5 times pre-tax earnings don’t apply to that calculation. Cash flow expensed for benefits (rather than dropping to a taxable bottom line), isn’t included in those earnings multiples. The traditional multiple for a small business sale averages 2.5 time SDE, or half of what Bob is estimating. We are immediately reducing the likely price to something like $1,250,000.

Next, about 90% of small business sales are asset transactions. Only about 10% close as a transfer of stock ownership. Double that tax estimate from 20% capital gains to a 40% ordinary income rate.

Businesses transfer debt-free. So if Bob owes another $300,000 on his credit line, that comes off the top from the proceeds, but the tax is still payable on that $300,000.

So Bob’s $1,250,000 drops to $750,000 after taxes, and to $450,000 after debt repayment. He has lost three quarters of the amount he was planning on for retirement.

The problem is exacerbated when the planner dutifully enters $2,000,000 in his retirement software, assuming that the owner certainly knows the value of his business. That happens more often than I care to discuss.

These misunderstandings are just the tip of the iceberg. There are another half-dozen common mistakes when owners look at their value. In many cases it results in owners being highly insulted by legitimate offers from qualified buyers. I’ve also seen them renege on accepted offers when they finally have a CPA model the tax impact.

(NOTE: I do not perform valuations, give tax advice, or broker businesses. My recommendations here will not generate revenue for me.)

If you are like 85% of all owners and plan to sell your business to a third party, the first thing to do is engage a valuation professional. The second thing is to take that valuation to your accountant for tax modeling. Start your exit planning by embracing reality. You’ll be a lot happier in the long run.

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