Exit Planning Tools for Business Owners

business

Employee Retention Before and After Your Exit

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In most businesses, employee retention is a material factor in valuation and transferability.

The ability of a buyer to assume control of a fully-functional organization has substantial influence on his or her perception of a company’s value. Any need to pay the seller for an extended period of training adds a redundant executive salary to the projected operating costs. Concern that key personnel may resign or be recruited away by a competitor adds a level of uncertainty to the transfer.

Of course, the basic premise of “The more you work in the business, the less it is worth.” always applies. Even if you’ve effectively delegated most of your operational responsibilities, however,  there remains the threat of an exodus of corporate knowledge.

Many exiting owners don’t believe that the problem is theirs. “These people work for me because I treat them well.” they say. “A new owner should have no problem if he or she does the same.”

True enough, but every buyer’s confidence level is greatly increased by a mechanism to support employee retention through the transfer process.

Stay Bonuses

Stay bonuses are so named (quite logically) because their purpose is to get key employees to stick around after a transfer of leadership. They can take a number of forms, but one of the most common is to escrow a portion of the sale proceeds for later payment if certain conditions are met.

The amount of the bonus can vary, but a general rule of thumb is about six months’ salary for two years of continued employment. Depending on the deal and the number of employees involved, this could be substantial. We suggest allocating about 5% of the sale price when planning such bonuses, but it could vary widely. Here are a few examples.

You sell your company for $5,000,000. Your four top executives each earn $200,000 a year. Six months of their salaries would be $200,000, or 4% of the sale.

On the other hand, if you have seven top executives at that level, $350,000 is 7% of your sale proceeds. That might be too rich a commission for your taste. The 5% guideline would make their bonuses about $35,000 or about 18% of salary.

Only you can decide whether the amount is motivational. Differing amounts based on position are normal. There is no requirement (such as in ERISA) that you apportion the funds by longevity or salary level.

Conditions of Payment

If you choose to make the bonus available, it only enhances the buyer’s confidence. Because the bonus is the seller’s liability, the new employer has no added financial motivation to keep or terminate any particular individual.

Bonuses are customarily forfeited upon resignation or termination for cause. Unlike other non-qualified deferred compensation plans, bonuses are typically not paid out in the event of the employee’s death or disability. This isn’t synthetic equity or a reward for general tenure. Qualification for payment is dependent on a specific condition being met at a specific time.

Also, unlike most NQDC plans, there is no buildup or gradual vesting of value. An employee who stays for 18 months isn’t eligible for three-quarters of a bonus. That should make stay bonuses free of claims in the event of an employee’s bankruptcy or divorce.

Employee Retention Alternatives

Employee retention is an issue in the transfer of any business with skilled personnel.  Only you can determine whether it is worth the investment of offering stay bonuses.

If you are confident in employees’ loyalty to the company, one alternative is to place some of the sale price into an escrow account, to be released if turnover remains below a certain percentage for a specific time. This still allows you to retain the entire proceeds, but transfers some of the financial risk of turnover (even for non employment-related causes) to you.

The other approach is to rely on inertia and security to maintain your workforce in place. Those are strong motivations, and are sufficient in most cases.

Regardless of a buyer’s demands, remember that no one gave you financial guarantees of loyalty. You earned it, and it isn’t unreasonable to expect a buyer to do the same.

Celebrating Mr. Fezziwig

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To celebrate the holiday, I’m reprinting a post from 2013 about the underappreciated boss of A Christmas Carol, Mr. Fezziwig. I hope that you enjoy it. Merry Christmas!

Last week was the 170th anniversary of the publication of Charles Dickens’ A Christmas Carol (December 17, 1843). The immortal words of Ebenezer Scrooge are ingrained in the memory of the entire English speaking world. I’d venture to guess that “Bah, Humbug!” can be correctly identified as to source and speaker by over 99% of those reading this.

The novella, serialized in five parts, was not a commercial success. Unhappy with the sales of his previous novel (Martin Chuzzlewit– no wonder!), he refused his normal fee from the publisher in favor of royalties on the proceeds, which proved disappointing. Critical reception was favorable, although it didn’t catch on in America until much later. The New York Times first published a review in 1863, 20 years after its publication in England.

Like most of Dickens’ work, A Christmas Carol clearly includes an indictment of the social inequalities of the Industrial Age; child labor, workhouses, and debtors’ prisons. It stands out, however, because of the lessons taught by its memorable ghosts, and the redemption of its main character in only 113 pages.

During the Protestant Reformation in England and Scotland, Christmas had become a period of penance and reflection. A Christmas Carol is credited by many for leading the return to a celebratory holiday, focused on appreciation and thanks for family and friends.

Modern Ebenezers

Modern filmmakers have returned to the straight-ahead plot and uplifting story line (not to mention the recurring revenues available year after year) with a frequency that helps stamp the legend in our psyche. Starting with the 1938 Reginald Owen version (originally released as “Scrooge”) and the 1951 Alistair Sim classic, the character of Ebenezer has been tackled by actors ranging from George C. Scott to Michael Caine (with the Muppets). Patrick Stewart, Kelsey Grammar and Rich Little (in various celebrity impersonations) have taken a shot, as have Mickey Mouse, Mr. Magoo, the Smurfs, Barbie, Dora the Explorer and the Flintstones.

Let’s not forget the variants; Bill Murray in “Scrooged”, or Boris Karloff and Jim Carrey in versions of “How the Grinch Stole Christmas.” In all, IMDB lists almost 200 filmed variants of the story.

Unfortunately, the characterization of Scrooge has become ingrained in the minds of many as a stereotype of all bosses who dare to focus on margins and profit. How many employees identify their bosses with Fezziwig, who took pride in making his employees a happy group, even though Scrooge dismissed it as “only a little thing?”

FezziwigInstead of focusing on  the things that allow Fezziwig to spend lavishly on his employees (a motivated workforce, honesty, doing what’s right, profitability), we prefer to fantasize about a boss who expresses sudden enlightenment by unexpectedly bestowing gifts and extra days off. Fezziwig is relegated to an afterthought, an overweight doting uncle with no visible reason for his success.

Most of us are far more Fezziwigs than Scrooges. Oddly, if we celebrated the season of giving by handing our employees a list of all the extra things we’ve done for them during the year, we’d be considered more akin to Ebenezer. We bow to the popular myth, give even more at the holidays, and hope it has some carryover of appreciation into the New Year.

Just remember to remind your employees when you are being Fezziwig the rest of the year. A Christmas turkey for Tiny Tim isn’t as important as being a good boss.

Exit Planning – Maintaining Control

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For many owners, their biggest concern in an exit plan is maintaining control.  Whether they seek to sell to employees, family or a third-party, there is a fear that, once started, the process will have its own rules and momentum.

My colleague John Warrillow, author of Built to Sell and The Automatic Customer, has written an excellent white paper on the types of people who own businesses. John previously owned a data-driven marketing company, and always backs up his opinions with solid research.

I’ll leave the indicators of the entrepreneurial types to John, since it is his material. His conclusion, however, is that 2% of owners are Mountain Climbers. They are focused entirely on the next goal (usually growing the business.) Another 24% are Freedom Fighters; those who are in business for themselves as a way to control their lives. The remaining 74% are Craftspeople. They run their own business as a job, focusing on doing much of the work themselves to maintain the best quality.

Craftspeople aren’t prime candidates for exit planning. Their owner-centric approach to the business leaves them little value to sell to another entrepreneur. Mountain Climbers are almost certainly planning an exit, but their objective is probably to reach a level that attracts financial and strategic acquirers.

That leaves Freedom Fighters as about 92% of the owners who will benefit from a planned transition. Maintaining control is their very reason for owning a business. They have no intention of surrendering the outcome to someone else.

Sharing Control with a Buyer

Ironically, the majority of these owners say that they plan to sell their companies to a third party. By definition, they will be sharing the timing, price and transfer mechanisms with a stranger. The buyer will have his or her own ideas about the process and how much the company is worth.

Combining Warrillow’s  work with my own research on the number of Boomer employers (5 or more employees) in the U.S., and we can estimate that somewhere between 750,000 and 1,500,000 of these businesses are owned by Freedom Fighters over 55 years old. If you’ve read my latest book or visit this column regularly, you already know that the intermediary community (brokers and investment bankers), accounts for about 10,000 third-party sales annually.

These owners don’t have a century or more to stand on line waiting for a buyer. That’s why so many are choosing to sell their businesses to employees.

“But my employees have no money!” That first objection is usually true, but if they have the skills to run the business, the financial mechanisms can often be arranged. A Leveraged Buyout (LBO) or an Employee Stock Ownership Plan (ESOP) can be structured over a few years so that the owner remains in control of the business until he or she leaves with the full value of the company in his or her pocket.

Of course, you can always finance the transaction yourself, and sell to employees for a note. That, however, is the antithesis of maintaining control.

 

 

Internal Transfers: Legacy vs. Lucre

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Lifestyle vs. Legacy

Why would I refer to the results of an internal transfer as “lifestyle vs. lucre?” Lucre is a pejorative term. While it is technically just a synonym for money, most dictionaries draw the parallel to its use in “filthy lucre;” money that is ill-gotten or otherwise dishonorably obtained.

I was honored to present at the Exit Planning Summit this past weekend. One of the things I discussed was the need to help business owners determine whether their personal vision for their company’s future was based on lifestyle or legacy. That’s how I normally term it, and there is no negative connotation attached to either term.

That “lifestyle vs. legacy” decision, however, usually designates the difference between selling to a third party for full market value (lifestyle) and selling to employees in order to preserve the culture and quality of the organization (legacy.)

Legacy vs. Lucre

“Legacy vs. lucre” is my term for the differing motivations in an internal transfer, and it is fully intended to be pejorative.

For a business owner, the greatest appeal of an internal transfer is control. He or she gets to pick the new owners, their timeframe for taking over the company, and how much they will have to pay.

Sometimes, that avenue to exit is chosen because the owner knows he or she can’t get a satisfactory price in the open market. The company just isn’t worth what he wants for it.

So selling to employees becomes a vehicle to get more than fair market value. Of course, no third-party lender will touch a deal for more than the business is worth, so almost by definition such transactions have to be seller-financed.

That is one of the reasons we hear horror stories about selling a business to employees for a note, and having to take it back when they default. Their failure may have been due to a lack of training to run the business, or an unsupportable price. Either way, they were set up for failure by an owner who was more interested in getting a check than in what happened down the road.

Legacy Requires Win-Win

Selling to a third party is an arms-length transaction. Both parties have their own agenda and advisor team. The buyer is perfectly cognizant of Caveat Emptor. The seller wishes to maximize the proceeds, the buyer to minimize his cost. The result is usually something in between.

When selling to employees, the playing field isn’t even. The employees have followed the seller’s direction for a long time. They are accustomed to doing what he says. It’s when the owner takes unfair advantage of his status that legacy turns into lucre.

 

“Read” my new book in 12 minutes!

Your Exit Map, Navigating the Boomer Bust is now available on Amazon, Barnes & Noble and wherever books are sold. It was ranked the #1 new release in its category on Amazon, and is supplemented by free tools and educational materials at www.YourExitMap.com.

Now, we have a really cool 12 minute animated video from our friends at readitfor.me that summarizes the book, and helps you understand why it is so different from “how to” exit planning tomes. Take some time to check it out here. Thanks!

The Right Price for Your Business

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“If someone offered me the right price, I’d sell in a minute!” Exit planners and business brokers hear it all the time. “Anything is for sale if the price is right!”

What is the “right” price? Of course, you can fantasize about a windfall from a buyer who has far more money than brains. Some of the fast-talking “business brokers” (the ones who get more revenue from preparing offering books than actually selling companies), will pitch their secret list of buyers in Europe and Asia who routinely overpay for businesses.

In case you didn’t know, the largest advisory firms in Europe and Asia are the same ones we have here. The same accountants, the same attorneys, the same investment bankers and the same consultants. It’s unlikely that they give their wealthy overseas clients lesser quality advice than the ones in North America.

Barring purchase by a lunatic, your business is likely to be priced around Fair Market Value; the arms-length amount that an independent buyer will pay an independent seller.

Beauty is in the Eye of the Beholder

You are the seller, and your company is what it is. Buyers, however, come in a variety of sizes and flavors. Understanding why companies have different values to differing buyers is critical if you plan to maximize your proceeds.

Here is a 2 1/2 -minute video on valuation from our website of free tools for business owners at www.YourExitMap.com.

These are the typical ranges for “fair market value.”

If you are earning less than $500,000 in total salary, profits and benefits from the business, your likely price is between 2.5 and 3.5 times the SDE (Seller’s Discretionary Earnings.) These are “Main Street” businesses; typically sold to individuals.

Once you exceed $1,000,000 in Earnings before Interest, Taxes, Depreciation and Amortization, or EBITDA (but not counting your personal salary and benefits) you are a target for professional investors. These include private equity groups and family offices. In this market, valuations between 4 and 6 times earnings are common. If your EBITDA is over $2,000,000 it could be substantially higher.

Strategic and industry buyers (who may be the same) could pay more, but those transactions are very specific to the situation. In simple terms, the right price is whatever you can get. If the acquirer has a plan to plug your business into an existing customer base and grow it substantially, earnings often become a secondary issue.

The Neutral Zone

The “neutral zone” contains those companies who earn more than $500,000 (SDE) but generate less than $1,000,000 EBITDA. This is a fairly broad range.

Let’s use an illustration. An owner takes a $400,000 salary along with another $250,000 in benefits, and shows a pre-tax profit of $700,000. Clearly that is a healthy small business. In the “Main Street” market the company could value at between $4 and $5 million.

An individual buyer would need at least 25% down ($1,000,000 cash) plus working capital, and be able to guarantee loan payments of about $500,000 a year. That’s well beyond the range of most individuals.

Yet unless this business has a unique product or intellectual property, it is likely of no interest to professional, industry or strategic buyers.

Many of these companies are choosing a staged sale to their management teams. Others choose to kick growth into a higher gear in order to reach the next stratum of buyers and valuation. Either approach will usually take at least five years.

Controlling the Right Price

Some owners are choosing both approaches. They use ownership as a management incentive to achieve growth targets. If the company makes the leap into a buyer market with higher valuations, both the owner and the management team win.

If the company doesn’t attract the target buyers, the owner still has a solid exit strategy from a more valuable company. Getting the right price requires the right plan.

“Read” my new book in 12 minutes!

Your Exit Map, Navigating the Boomer Bust is now available on Amazon, Barnes & Noble and wherever books are sold. It was ranked the #1 new release in its category on Amazon, and is supplemented by free tools and educational materials at www.YourExitMap.com.

Now, we have a really cool 12 minute animated video from our friends at readitfor.me that summarizes the book, and helps you understand why it is so different from “how to” exit planning tomes. Take some time to check it out here. Thanks!