Exit Planning Tools for Business Owners

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Family Succession: Exiting a Small Business Part 3

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It’s time to discuss family succession. In Part One of this series we looked at exit strategies that aren’t really available to small businesses, and in Part Two we discussed selling to a third party. Now let’s talk about the issues when transferring to a family member or members.

Which Kids?

When passing the business to family, often the primary issue is inheritance. Small business owners frequently have 50%, 60% or as much as 80% of their personal net worth in their company. There is a temptation to treat the business like any other personal asset, and divide it among all the children.
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“After all,” (the logic goes,) “We built this for our family’s security. It isn’t fair that only the kids who work in the business should benefit.”Sometimes the non-active children have succeeded in lucrative careers, like medicine or law. That may make an asymmetrical legacy easier.

Other times the children outside the business have not been successful at all. They are the ones who most need support, and in fact may be on the payroll already (although not “active” in any meaningful sense.) Parents’ expect the same unconditional love they have for them from their siblings, but it just doesn’t work that way.

Splitting it “Fairly”

When the company is too valuable an asset to balance inheritance with other assets, we recommend passing some to the active children before your death. That can be via sale, bonus or gifting, but it recognizes the active children’s contribution to the business.

Upon death, you can divide the balance of the equity evenly, but with a contract that says the non-active children must immediately sell their shares to the active ones at Fair Market Value. This accomplishes several things:

  1. The value of the business at the parents’ death  is divided “evenly.”
  2. The non-active kids get the step-up in basis, and should have no tax on the sale.
  3. The active kids retain 100% of the benefits from their efforts going forward.

Its especially important to get spouse signatures on these agreements. Valuations and agreements between family are fine, but an outsider (especially an ex-spouse) may not be as amenable.

I have a comment that I use with parents who are deciding how to divide ownership among children. “In the long run, you want everyone to still have a nice Thanksgiving together.”

Securing Family Succession

This is the other big issue. The parent wants family ownership to be their legacy, but their child or children aren’t qualified to run it. There is capable management, but none of them have the same last name.

Remember, we are talking about small business in this series. Families named Cargill, Ford or Walton need not be too concerned  about non-family management.

But for a small company, you can’t put children in a position where the resignation of a key employee could sink the whole enterprise. That makes the children subject to blackmail. Key operating skills have to be retained with incentives.

You don’t need to make key employees into partners, but they should have a vested interest in growth and profitability. This can be as simple as bonuses for company performance, but long-term retention usually requires non-qualifed deferred compensation (NQDC) plans.

These are tied to the long-term growth and profitability of the business. “Non-qualified” simply means it isn’t an ERISA-qualified benefit (like an IRA or 401K) because it is discriminatory in nature.

There are a number of forms for NQDC, mostly involving virtual equity. Phantom stock, stiock options, stock appreciation rights and warrants are all avenues for such compensation. They allow an employee to amass an increasing nest egg over time, based on tenure and appreciation in the value of the business.

Da Plan! Da Plan!

Whether you are deciding how to apportion the business for your estate, securing continuation of a management team, or just minimizing taxes on the transfer, planning is the key. Determining your goals for family succession and working through your options well in advance (5 years or more before your planned retirement,) is the secret for the successful transfer of a family business.

Without planning, you are putting Thanksgiving at risk.

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Manage Activities; Lead for Results

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A few weeks ago I posted a comment in the Business Journals Leadership Trust Forum about a life lesson I learned. The difference between effort and outcomes – Manage Activities; Lead for Results.

They reached out and asked if I could expand my comments a bit. Those of you who know me won’t find it surprising that it grew into an article.

You can find it here. I hope you enjoy it. Remember, lead for results.

 
Invest 15 Minutes and take our FREE Exit Readiness Assessment. We do not request any confidential information.

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

Is Google Making Us Stoopid?

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As an Exit Planner, most of my engagements involve assessing a management team. They may be the intended buyers of the company, or else they are key factors in the saleability of the business.

The biggest and most frequent complaint I hear about managers is that they don’t know how to THINK. Business owners lament the inability of employees to discern critical paths, assess alternatives, or analyze complex problems.

Examples of Thinking Shortfalls

A CPA is doing a final review of a client’s tax returns, as prepared by an associate. As with many business owners, the client has two related entities, one acting as the management company for the other.

The reviewing partner notices the income from management fees in one entity, but no corresponding expense deduction in the other. The associate explains that the client’s books didn’t show the offsetting expense, so he ignored it.

The owner of an IT services company receives an irate call from a client. His technician has just spent two billable hours on the client’s PC, and it still won’t print his documents.

When the employee is asked for an explanation, he points out that the client said he needed updates to his printer drivers, and that is exactly what he (the technician) did. At no point did he try to determine whether updating the drivers would solve the customer’s problem, or even what that problem was.

The customer made a request, and the technician complied. He didn’t perceive the customer’s lack of technical knowledge as a factor.

As the adage goes, “When someone asks you for a drill, what he really wants is a hole.” If you are in any business where the customer expects you to be more knowledgeable than him (and why would he hire you otherwise?) thinking is a core competency.

I Can Look Up the Answer

Numerous educators and managers have related to me the effect of the Internet. Students resist rote learning. Employees refuse to train in procedures. Their answer is ubiquitous; “Why do I have to know that? I can look it up whenever I need it.”

In some circles, gaining “knowledge” is a game of speed and skill. Participants in a conversation whip out their electronic lozenges upon any reference to a historical fact, person or thing name, geography question, et al, ad infinitum. (Don’t know Latin? No problem. Google it.)

What is eroding is the concept that an answer may not be the best answer, or even a good answer. It’s just an answer.

Life isn’t “Fill In the Blanks”

Getting an answer doesn’t mean you’ve solved a problem. What we are losing is the ability for critical thinking. For saying “Wait a minute. That is one approach, but might there be others? Is there a better answer?”

We used to have to work through that step by step in our brains. Now we are becoming conditioned to accepting the answer on a little screen as the final word.  It’s great for learning how to change a faucet, but maybe not so hot for solving a customer complaint.

Your management team is the most important factor in realizing value for your business.  If you are planning a fully controlled (time, method, and proceeds) internal transition, they are your buyers and the guarantors of any financing you may underwrite. If you are selling to an external buyer, he or she wants to see a business capable of running (and making good decisions) without you.

Either way, you need to teach them how to think.

Invest 15 Minutes and take our FREE Exit Readiness Assessment. We do not request any confidential information.

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

Subordinated Debt in an Exit Plan

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Subordinated debt can be a key consideration in any sale transaction. Whether you are contemplating a sale to a third party or an internal transfer to employees, the topic of taking second place to a lender will likely come up.

If an outside buyer is financing the purchase, seller notes can be considered as part of a down payment, but any bank will require it to hold second priority to their loan. If the Small Business Administration is involved, they will usually demand that the seller assume some of the risk with a secondary loan. In an internal sale, that will be a requirement.

Risk vs. Reward

As a business owner, you make decisions about good risk and bad risk every day. You extend credit to customers, and spend money on marketing or expansion based on your projection of a future payoff. Subordinated debt is just another risk/reward consideration.

It may allow you to get a higher price (eventually) than demanding an all-cash deal. It can also be the deciding factor in qualifying a buyer for outside financing for the majority of the purchase.

In an internal sale, subordinated debt is frequently a trade-off for time. An exit date may be your choice, or driven by outside factors such as health, family needs or increased competition.

When your target departure date is close, especially if it is two years or less, it is difficult to transfer enough equity to employees for them to qualify for 100% outside financing. The percentage of  the risk that you are willing to bear has a direct impact on what another lender will do.

If you need to leave in less than a year, financing the entire transaction might be your only choice.

Qualifying Subordinated Debt

Some brokers tout the tax advantages of installment sales with 100% seller financing as the best way to sell a business. In my experience, it is more likely to attract unqualified buyers. No reduction in tax rates comes close to the advantages of cash in your pocket.

It’s true that unsecured loans usually carry a higher interest rate due to the lack of security. That might be tempting, but no interest rate is attractive if you don’t get paid.

As a lender, you have the same interest in choosing a qualified buyer as the bank. Using subordinated debt to serve your purposes is a valid tactic. Using it simply because you are the lender of last recourse is probably not.

 

Death, Taxes and Exit Planning

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(This post was published in the Sageworks/ProfitCents blog earlier this week)

Understanding the Post-Ownership Void

As advisors, we understand that our business clients should be preparing for the biggest financial event of their lives – the sale of their business. However, when we ask, “How are you exit planning for your retirement from the business?” we seldom get a straight answer.

Instead, we get any number of comments like: “I still enjoy my business, I’m not thinking about it right now.” “I have a good company. I can sell it whenever I choose.” “Everything is available for the right price. I just haven’t heard it yet.”

These are all ways of evading the fact that they haven’t thought about their life after the sale of their business, and they don’t want to. Why is having the exit planning discussion so challenging? Because, like planning one’s own funeral or purchasing life insurance, it is frightening to contemplate the end of one’s professional career.

What I Do is Who I Am

Most business owners, particularly founders, find it difficult to separate their business from their own identity. The business is who they are. At family gatherings they overhear, “There’s Bob. He owns his own business, you know.”

The ownership of their business permeates their relationships. They are, “Bob Smith, the owner of Smith Manufacturing.” Not only in their business circles, but also at their church, in their children’s schools and their friendships. The business is their persona.

Contemplating life after ownership is scary. Who am I if I’m not me? Will I be treated the same? Can I command the same respect if I don’t have employees? Will my opinion still matter? Will others see me as successful without the trappings of a company around me?

Some owners have the confidence to leave a business with no concern about how others will perceive them. Most, however, associate retirement on some level with failure. While owning their business, they got a small shot of adrenalin every time they were asked to make a decision, which was usually many times a day. They fear a life without those little rewards, albeit unconsciously.

Understanding this reluctance to explore the void that retirement creates is a vital part of an advisor’s ability to serve their business clients. It’s easy to say, “Okay, I’ll be here whenever you want to talk about it.” But this alone is a disservice. Planning the most important financial event of a client’s life should be a priority, not an afterthought.

Have a Safety Net

When a client avoids the exit planning question, have a safety net. Selling a business is a competitive endeavor. No smart owner would enter a new market without knowing what his competition looks like. Just because someone isn’t thinking about an exit doesn’t mean that he or she shouldn’t do anything today. Getting the conversation started is one of the most valuable services you can offer.