Exit Planning Tools for Business Owners

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Deal Momentum, Deal Fatigue, and Pre-Sale Diligence

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With the help of her Exit Planning Advisor, Betty has decided that selling to a third-party buyer would best accomplish all of her goals (financial, values-based, legacy).

Quantifying her business and personal resources with a financial gap analysis has been helpful to Betty in determining her departure date in six years. She now knows the current fair market value of her business and how much it will need to increase in value to attain her financial objectives at sale in six years.

Betty now also understands (again with the help of her Exit Planning Advisor) the importance of maintaining “deal momentum” when she eventually enters into a sale transaction.

Betty now knows that all too often, “deal fatigue” sets in and damages or destroys deal momentum experienced early in the process. She also understands that deal fatigue typically results from a difficult and lengthy due diligence process. Due diligence is defined as the process by which the buyer requests documents, data, and other information about the business they want to review to identify any potential liabilities or hindrances to a deal getting done. The process of due diligence involves setting up a digital “Data Room” where all requested information is deposited for review.

Person at a desk demonstrating: Deal Momentum, Fatigue and Diligence
A key component of Betty’s comprehensive exit plan is to do everything possible to ensure deal momentum and avoid deal fatigue when the time comes.

Betty also wants to be prepared if a serious and qualified buyer comes calling earlier than her six-year time frame. So, with the assistance of her Exit Planning Advisor, she is going to conduct “Pre-Sale Diligence” systematically over the next 12 months, including setting up a virtual data room that she will regularly review and update as needed. This preemptive approach will significantly increase her chances of deal momentum and a smooth transaction experience.

At that point in the future, when Betty is approached by a potential buyer or when she takes her business to market, having conducted Pre-Sale Diligence, she will be better prepared, more confident, and less stressed and anxious—all of which lend toward sustaining deal momentum and a successful transaction.

Pat Ennis is the President of ENNIS Legacy Partners. The mission of ELP is to help business owners build value and exit on their own terms and conditions.

The Power Of Strategic Exit Planning

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In today’s business landscape, having a strategic exit plan is not just a luxury—it’s essential. Effective exit planning involves setting clear goals, understanding your business’s value, and creating a detailed roadmap to achieve a smooth transition.

Starting early with your exit plan allows you to set precise objectives and assess your business’s value well in advance. This proactive approach provides the flexibility to adapt to changing market conditions and business performance, ensuring that your exit strategy remains relevant and achievable.

To maximise the return on your business, you must have a thorough understanding of its value. This goes beyond simple financial metrics and includes evaluating intangible assets such as brand equity, customer relationships, and intellectual property. Accurate valuation helps in setting realistic expectations and negotiating effectively with potential buyers.

Power of Strategic Exit PlanningA well-defined roadmap is crucial for guiding the exit process. This plan should detail every step, from preparing your business for sale to identifying potential buyers and managing legal and financial aspects. A structured approach ensures that all aspects of the transition are handled efficiently and with minimal disruption.

Enhancing your business’s value involves focusing on operational improvements, strategic growth, and strengthening your market position. By addressing these areas, you can increase your business’s attractiveness to buyers and achieve a higher sale price.

A smooth transition requires effective communication with all stakeholders, managing the emotional aspects of leaving the business, and providing support to the new owner to ensure continuity. A comprehensive transition plan helps in maintaining the business’s reputation and achieving a successful outcome.

Kerry Boulton, CEPA is Australia’s most respected exit strategy advisor. With over 20 years in business as an entrepreneur, transformative coach, consultant, sought after speaker and talented facilitator, Kerry has been helping business owners like you to overcome challenges while providing the steps needed to ensure that you find the financial freedom you deserve.

What is “Holistic” Planning?

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Financial planners use the term “holistic planning” frequently. It’s meant to indicate that they consider the client’s short- and long-term life goals and the future they visualize. According to Fidelity Investments Holistic Wealth Planning is continuous and considers two dozen aspects of client wealth objectives.

The Valuation Reality Gap

Only one of those aspects is ownership of a business. This raises the question “If a typical business owner has 50% of their net worth in a business, is it really just 1/24 of their planning?”

Of course not. I’m exaggerating for effect, but there is an uncomfortable truth about financial planning for business owners.

When we ask financial planners about their assumptions regarding business value, the great majority (almost all) reply that they use a value provided to them by the client. Unfortunately, most business advisors estimate that the average owner’s impression of their company’s value is at least 35% too high.

An owner is planning on a $3,000,000 nest egg in retirement. He estimates that $1,500,000 will come from the net proceeds (after paying capital gains tax) of selling his business for $2,000,000.

But 90% of businesses that size are sold on an asset basis. That could bump the tax rate from under 25% to something closer to 40%. If he has overvalued by the “average” of 35%, a $1,300,000 sale would net $780,000.

Holistic Planning Man

Impact on Retirement Goals

Now his nest egg is $720,000 short of goal. Retiring on $2.3 million isn’t exactly poverty, but it would require substantial changes to the anticipated goals.

That is why financial planning for business owners can’t be holistic if it doesn’t include the value of their business. That value should be confirmed by a third party.

Exit planning is the critical final component of a business owner’s wealth strategy. A business requires different tax strategies, risk management and timing assumptions from simply calculating around a pension. Even an appraised value can range widely between different transition strategies.

Holistic Planning in Exit Considerations

How is estate planning affected by the disposal of the business? Does it employ one or more children? Just as importantly, does it not employ one or more children? How can the business value in the estate be balanced between fair and equal? In the most extreme case, will the business be passed down as part of the estate? In that case its value may not be included as part of the owner’s wealth at all.

Will the business be sold to a third party, or as part of a management buyout or ESOP? The proceeds may be realized all at once, or over a long period of time. Is there value for any real estate involved? (A new owner may or may not wish to purchase the real property.)

Holistic planning for a business owner is far more complex than for an employed individual. It’s almost like having a second client in the room. If the planning doesn’t consider the myriad of complexities surrounding monetization of an illiquid asset (the company), it may not be considering the biggest single factor in the client’s financial future.

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.

Top 3 Tips for Small Business Buyers

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We review over a hundred small business transactions each year. Buying a business can be a complicated process, especially for a first-time business owner. Entrepreneurship through acquisition “ETA” has become increasingly popular, but we wanted to share some insights to assist buyers in negotiating a fair price.

1. Add-backs

Seller add-backs for personal or discretionary spending is a murky area. An an appraiser, some add backs make sense and others do not.

We’ve seen a cattle business expensed through an HVAC company.

We’ve seen a lease for a Porsche and a leadership meeting in Hawaii.

We’ve a dozen Rolex watches purchased using business funds.

It is important to scrutinize and verify all of these add-backs. Sellers may try to add back marketing expenses which we would argue likely contributed to sales for the period. Also, ensure that the add-backs line up with the financials statements. If a seller is trying to add-back $30,000 in travel expenses, but the travel expense account only had $10,000 in expenses, something is off.

There is also a school of thought that a seller shouldn’t get the benefit of reporting lower taxable income for years only to recoup the benefit through add-backs at the time of sale. As the proverb goes, it is “having your cake and eating it too.” This idea is unpopular amongst sellers and brokers, but we wanted to raise awareness.

Verify add-backs and if you get any push-back, consider it a red flag or deal killer.

2. Financial reportingtop 3 tops for small business buyers graph

Financial statements for small businesses are notoriously suspect.

Before digging into the numbers, ask about the financial reporting process. Who sends out invoices and who receives payment? How frequently are invoices sent out? How are business expenses handled? Are there any controls in the place? Who does the bookkeeping and with what frequency? Does the CPA clean up the financials or simply record the data on a tax form?

We’ve seen some broker memos that simply list “Seller represented financials” with no further financial statements upon request. Red flag and deal killer.

When analyzing the financial statements, look for customer concentrations and consider the transferrability of the relationships. Is the chart of accounts consistent year after year or does it change frequently? Are there expense items that seem inconsistent with historical periods or industry benchmarks?

Part of the risk in the quality of earnings is in the process of recording the transactions. It is important to understand how the numbers come together. Through this process, you may even identify opportunities to boost cash flow under new leadership through more efficient collection and disbursement procedures.

3. Working Capital

Working capital is defined as Current Assets – Current Liabilities from an accounting perspective. In M&A, we’re really talking about Accounts Receivable, Inventory, and Accounts Payable.

A business broker will tell you that working capital is not typically included in small business transactions. An appraiser will tell you that working capital is an integral part of the value of a business.

There seems to be a magical threshold in which working capital becomes part of the transaction, usually around $750,000 or $1,000,000 in enterprise value. There is no logical explanation for why working capital is not included at smaller levels other than buyers not requesting it.

Liquor stores are commonly sold as a multiple of SDE plus inventory. SDE, or Seller’s Discretionary Earnings, is defined as net income + owner compensation + personal/discretionary expenses. For context, most businesses are listed for 2 or 3 times SDE. We push back on the suggestion that inventory is separate and distinct from the value of the business.

What is a liquor store without beer, wine, and liquor?

What is a bike shop without bicycles?

Answer: A vacant space.

For businesses to be marketed and traded using a multiple of cash flow (SDE) without the underlying source of that cash flow (inventory) is illogical. Buyers would be double-paying for the asset. Do not do this.

Working capital also includes accounts receivable. Accounts receivable are generated when you provide a good or service to a customer and agree that the customer will pay you later (typically 30 or 60 days). Accounts receivable can strain cash flow in a business if not monitored properly. A business is incurring expenses up front and waiting 30-60 days to receive payment. Payroll is every two weeks or twice a month, and your employees must be paid. Suppliers must be paid.

Often, sellers will try to negotiate all rights to accounts receivable, leaving the buyer with a cash crunch right from the start. Again, this is illogical. A buyer and seller should agree upon a “peg balance” of working capital based on current working capital levels and seasonality. SBA lenders will often try to step in and fill this void with additional working capital financing. However, it shouldn’t be necessary. The value of the business is incumbent upon cash flow, and working capital and access to cash flows are the vital. If working capital is not included, the purchase price of the business should be reduced accordingly.

Small business buyers often miss this point, but rest assured private equity firms do not. Require working capital in the deal, if applicable.

Conclusion:

There are infinite risks to buying and managing a small business. It is likely you understand that fact if you’ve read through this entire article. Until the transaction is closed, however, that risk belongs to the seller. We encourage buyers to be thorough in their research, be confident in their requests for information, and don’t overpay for inventory or working capital.

Multiples of SDE or EBITDA can be helpful to gain a rough understanding of value, but, in the end they are just arbitrary numbers based on previous transactions that may be unrelated to your target acquisition. We recommend creating projections based on how the business would operate under your ownership. Determine what the expected operating income would be (Revenue less COGS less Operating Expenses) and multiply this number by 4. Then, multiply it by 5. This will give you a good range of value for the business. This is the same process used by appraisers when we discount cash flows to present value at discount rates of 20-25%. The math is roughly the same.

Mark Ahern started Amp Business Valuations in late 2020. He has a background in financial services and a passion for helping small businesses. Mark was formally trained in commercial real estate and C&I credit. He also held posts in retail banking, retail mortgage, and loan operations. Mark earned an MBA from DePaul University and teaches Business Finance at Regis University.

Cash Flow Normalization

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Cash flow normalization is done with the intention of identifying Earnings Before Interest Taxes Depreciation and Amortization (EBITDA) or Seller’s Discretionary Earnings (SDE). These differing measures are not interchangeable, but are used by different classes of buyers for different categories of acquisition.

Free cash flow is an important measure when calculating the value and price for any business. It is the amount theoretically available for servicing acquisition debt, working capital, return on investment for any cash outlay in the acquisition, and future expansion.

Cash Flow Measures

EBITDA establishes free cash flow as a measurement for most mid-market businesses. It evens out the differences in earnings caused by various tax jurisdictions. In the United States, there is federal income tax at the corporate level, but many states have additional income taxes, and in some cases, even smaller jurisdictions like cities may have their own income tax. These obviously impact the profitability of a company and could distort a buyer’s impression of its profitability.
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EBITDA calculations do not include the owner’s earnings, since the companies being examined are more likely to be acquired by investors who would replace the owner with a management executive.

SDE is the measurement used to illustrate the sum total of financial benefits available to the owner-operator of a business. It assumes that the owner is running the company on a day-to-day basis. SDE encompasses not only salary, bonuses, and distributions, but includes insurance and other benefits such as a company-paid vehicle.

A simple way to put it is that EBITDA is the cash flow available for a return on investment. SDE is the cash flow available for a return on the owner’s labor.

Making Adjustments

2 businessmen fishing for money from a boatIn the SDE calculations, there are two places where there is often an adjustment of expenses to market. The first is for a family member employed in the business or partners who intend to leave simultaneously with the principal owner.

In many instances, family members are paid according to their needs or the needs of the business instead of at a market rate for the position. With family members who are “underpaid” adjusting to the market rate will have the effect of reducing the cash flow available in the business. This reflects the fact that the family member or partner will have to be replaced by someone who is unlikely to work for a below-market salary.

The opposite is of course true for family members or partners who are overpaid. Reducing their compensation to a fair market rate will add to the discretionary cash flow of the business.

A second area of adjustment is when the owner of the company also owns the real estate that the company operates in. Again, the rents paid on the real estate often reflect the owner’s objectives more than they do the practical reality of the local real estate market.
A company that is underpaying rent is having its bottom line shored up by the reduced income to the real estate entity.

Overpayment of rent requires the owner to make a decision. If they expect the same rent from a new tenant, the profitability of the business as presented to a prospective buyer will be lower. Considering that most transactions involve a multiple of cash flows, you can usually point out to the owner that trying to maintain a higher rent is not in their interest as the seller of the company. Adjusting the rent to a market rate increases the cash flow of the company and presumably the basis for an evaluation multiple.

Which Cash Flow is “Right?

The decision of whether to use EBITDA or SDE when calculating cash flow is dependent largely on the size of the client’s business. If the company has cash flow in excess of $1 million annually or is large enough to be a likely target for professional buyers, EBITDA is the appropriate measurement for cash flow.

If the company is going to be purchased by family members, employees, or another entrepreneur and has a cash flow of less than $700,000, SDE is almost always a more appropriate measurement.

Which cash flow is used is a situational decision and may change if different classes of buyers are being engaged.

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.