Exit Planning Tools for Business Owners

selling a business

Investing in Your Own Business: Will It Pay Off?

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A few months ago a business owner asked me to evaluate an acquisition offer for his small business. It was from a larger company headquartered in a different region of the country. They had a branch operation in his city, and wanted to expand their presence by combining it with his.

For an opening offer, the deal seemed very reasonable to me. The purchase price was about four times EBITDA, with half in cash and half with interest over the next three years, and without any conditions attached. (note: That doesn’t mean conditions wouldn’t have come later.) He would receive a three-year employment agreement at a higher salary than he currently paid himself, with additional bonuses for growing the business plus all the benefits he currently enjoyed.

He was unhappy with my assessment, and announced his intention to counter-offer for double the proposed purchase price, with a perpetual employment agreement that would allow him to work for as long as he chose.

While any opening offer is subject to negotiation, I expressed my doubts about attaining a public-company or strategic-level multiple, especially when accompanied by an employment agreement that would make any labor attorney flip out. I asked him how he planned to justify his asking price.

empty wallet“It just isn’t enough to retire,” he said. “I’d have to keep working indefinitely, and I don’t want to have to go find another job if this doesn’t pan out.”

Please understand; presenting this story in the abbreviated way that I have makes this owner sound like he is clueless or ignorant. Neither is the case. He has run this business for years, and built it to several times the revenue and profitability of when he acquired it. He has sacrificed personally, putting in long hours and scrimping financially to reinvest in his company. He  qualifies as a successful small business owner by most measurements of small business success.

But as a mid-generation Boomer (late 50s) he is coming to the realization that it may not be enough. Like many others, he decided that investing in his own business was more controllable and would produce a higher return than the vagaries of stock markets and  mutual funds. His business is his retirement account, and like hundreds of thousands of others, he eventually came to believe his own claim. He expected his company to fund his retirement, without really looking at its objective value in the marketplace.

I asked him if doubling the price would achieve his retirement goal. He thought for a moment, and said “I don’t know, but I doubt it.”

There are roughly 5,500,000 Baby Boomer business owners entering, or already well into, their retirement windows. (The oldest Boomers turn 70 this year.) Many have the expectation that their company is their retirement plan, but there is no assurance that it’s true. If you are over 50 years old, I strongly recommend that you do three things:

  1. Download and read my eBook “Beating the Boomer Bust.” It’s a collection of ten blog posts  from this site with an overview of the challenges that are inevitable with the wave of retiring Boomer exits.. It’s short (45 pages) and its free.
  2. Get an objective valuation for your business. You don’t need a full appraisal. An opinion of value can range from free to a few thousand dollars, but it shouldn’t cost more than that. (You pretty much get what you pay for, though.) It is critical to understand where you are today.
  3. Get a realistic projection for how much you will need to maintain your target lifestyle in retirement. A Certified Financial Planner (CFP®) has the training and software to include inflation and tax assumptions. Again, many insurance agents and stockbrokers will provide this for free, but I prefer someone who does it without offering products for sale based on the result.

Disclosure: I offer exit consulting for business owners, but I do not provide valuation services, financial planning, wealth management, tax guidance or insurance. I’m just trying to have fewer conversations like the one above. Additional information, including a free, online self-assessment of your business, is at http://exitmap.com.

 

 A Note to My Readers

This January marks the start of my seventh full year of writing Awake at 2 o’clock on a weekly basis. I got serious with the publishing of “The Strategic Triple Threat” in January of 2009, which will probably stand forever as my most accurate piece of economic prognostication. :-)

Many thanks to the hundreds of you who have commented, and who come up to me at speaking events and say “I’ve been reading your blog for years.” If you read regularly and find yourself nodding in agreement or quoting a column, then I feel that I’m doing my job.

It’s a big, wide Internet out there. Like any blogger, I’m thrilled that I touch so many people with helpful information, but would always like to reach more. Please help by taking a few minutes to pass along a link to any business owners or advisors that you think might also enjoy an owner’s point of view.

Thank you

If you would like a printable pdf of this column or any other, please let me know at jdini@mpninc.com.

Key Man Policies May Not Cover a Buy/Sell Agreement

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Over the last few weeks, I’ve had a number of conversations with clients about key man insurance. Let me say at the outset that I don’t sell insurance, and have no financial stake in whether any client has coverage or not. The use of such policies, however, may not always fit their intended purpose, especially in smaller companies.

The most common intended purpose of a key man policy is to fund a buy/sell agreement. The benefit payment goes to the company, which in turn uses the proceeds to purchase ownership from the family or estate of the deceased. If it works that way, it’s an excellent planning tool for your family’s security, but there are a number of things that can get in the way.

To begin, the company probably needs the money. If they are scrambling to replace you in the business, partners may be reluctant to part with a cash windfall that can keep them going. In most cases, the insurance company’s responsibility ends when payment is made. The buy/sell is a separate agreement, and enforcing it may require legal action by the bereaved family. In the meantime, the cash is being used elsewhere.

Surprisingly, some policies are in place to buy out a sole owner. A company can’t own all of it’s own stock. Someone else has to have at least minimum ownership, since treasury stock (repurchased by the company) has no voting power. If the buy/sell was put in place for former partners, you may want to revisit both the shareholder agreement and the policy.

DominosFinally, there is the small matter of company debt. The absence of the principle credit guarantor (which applies to most majority owners) will trigger repayment clauses. Lenders are in the business of mitigating loan risk, and credit agreements likely give them first call on any available funds. Unless the company remains on a strong footing, with another guarantor who can step into the primary role, the insurance payout might not be available to either the heirs or the business.

There’s one additional area where the objectives of a key man policy and a buy/sell agreement may not meet. That is in long-term disability. Because most buy/sells lump repurchase terms for death and disability together, many owners forget that the insurance only pays in the first event, and has nothing to do with the second.

There are many approaches to obtaining coverage to secure your family’s financial well-being and/or the sustainability of your business. Although I’m an exit planner, that world of split premiums, whole and universal life, insurance trusts and other, far more arcane structures makes my head spin. All I can advise is if your current broker advertises “auto/home/life” he is not likely the kind of specialist you need. Find someone who is experienced in reviewing shareholder or partnership agreements, and who can tailor a product for your requirements.

Thanks to all the readers who responsed to last week’s survey on energy costs. Just under 69% said either “Falling energy prices are good for my business” or “rising energy prices are bad for my business.”  Of course, 14% said the opposite, which just proves my point.

What is Your Company Worth? II

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Last week we discussed how business owners frequently use hearsay or incomplete information to estimate the value of their companies. They give the number to their financial planner, or include it on a personal financial statement for their banker, neither of whom bat an eyelash at the estimate. Having the amount “accepted” by financial experts, the owner starts to treat it as fact. How do you know whether it is realistic or achievable?

alchemistValuation of a small business is a combination of art and science. No two small companies are alike. A multiple of profits or cash flow is only the starting point. Take two small companies, each with $4,000,000 in revenues and $500,000 in profits. Each pays the same salary and benefits to the owner. One does it by having systems that control most day to day activities, recurring revenue from contracts, and long-term employees who are incented by profit sharing. The other does it with an owner who works 70 hours a week, hasn’t had a two week vacation in ten years, and makes every new sale personally. Which business would you pay more to own?

Beauty lies in the eye of the beholder. The multiples paid for businesses depend on the type of buyers they attract. Commonly, those that sell for less than $2,000,000 are considered “Main Street.” Their target buyers are individuals who are purchasing an income. They intend to work in the business, and to earn a regular paycheck by running it.

Main Street businesses are valued by a multiple of Seller’s Discretionary Earnings (SDE). The value of the business is based on the sum of the financial benefits resulting from ownership. That includes profits, salary, benefits and any of a long list of possible perquisites like a company car, travel, or insurance. (For more on calculating your SDE and selling a business in general, you can read my book, 11 Things You Absolutely Need to Know about Selling Your Business.)

Main Street pricing is typically between 2.1 and 2.8 times SDE. It is based on simple arithmetic. The closer you come to 3 times SDE, the less able a buyer is to pay both the bank and himself. You can run your own numbers here, to see how it works (registration required).

For larger companies, those that attract financial and industry acquirers, the multiples are higher, but the multiplier is lower. Those buyers anticipate paying for professional management, so the owner’s compensation is less of a consideration. They look at EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) to calculate available cash after all the expenses of running the business (including executive talent) are paid.

Competitors will calculate the savings they might realize from consolidation, but are usually reluctant to multiply those savings in a purchase price. Private Equity Groups (there are 7,000 in the US) and the acquisition arms of large companies seldom look at businesses with earnings of less than $1,000,000. As amazing as it seems to a small business owner, their due diligence and legal processes are too expensive to make smaller acquisitions worthwhile.

Private Equity Groups pay an average between 4.7 and 5.2 times EBITDA, year in and year out. That makes sense, because they are financial buyers with a targeted Return On Investment (ROI). Large company acquisitions of smaller businesses can range from 4 times EBITA up to around 7 or 8, although in a few cases strategic considerations (competition, exclusive contracts, proprietary methods) can drive that up substantially .

All of these are real numbers, based on actual sales data and industry surveys. Sellers often confuse the terms revenue and income, or apply EBITDA multiples to SDE. They are greatly disappointed and angry when legitimate offers fall far below their expectations. Just because your planner or your banker didn’t challenge your valuation estimate doesn’t make it fact.

My new book, Hunting in a Farmer’s World: Celebrating the Mind of an Entrepreneur, is now available on Amazon in paperback, hardcover and Kindle. It is an ownership book, not a management book, and is illustrated with the stories of real entrepreneurs who faced challenges that apply to us all.

Ready…Set…Exit! Part II

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Last week we discussed the tsunami of Baby Boomer retirement, and how we will reach a peak of nearly 500 unsold businesses a day within the next 5 years. The statistics are immutable. The birthrates of the last century are fixed in stone. (If you haven’t read my e-book Beating the Boomer Bust you can get it for free here. Use the download code “Woodstock”.)

Once you understand the inevitability of competing to sell your business in a buyer’s market,  you have five choices.  The first  is to simply ignore it and hope for the best. For any owner who holds most of his or her net worth in the company, that’s not a great option.

The second is to watch, and wait for an opening. That requires following small business sales for favorable trends, and a flexible retirement plan that can take advantage of market conditions or an unexpected opportunity.

The third is planned liquidation. If you can achieve your financial goals by running the business a while longer, and you choose not to invest in building a company that runs without you, this is a viable strategy, albeit without the satisfaction of a large final payday.

The fourth is to build a business suitable for sale in a highly competitive environment. Such a company must have strong systems, dependable revenues, accomplished management (not including you), and profitability greater than most other companies a buyer might consider, whether those are in your industry or not.

handoffThe fifth strategy is to build your own internal exit plan, and execute it without many of the unknowns involved when taking your business to the market. It requires choosing an insider (family or employee) who understands the business, and is happy to have the opportunity to own it. Of course, that person should also have the ability to run it successfully, or at least the potential to learn those skills.

But wait. Didn’t I just write last week that selling the company to employees for a note was a terrible exit plan? I did, and it is. Selling the company to insiders doesn’t require that you bet your retirement on their continued success. With time and careful planning, it can be done in a way that minimizes or eliminates your risk.

First, any owner has to accept the fact that the company’s cash flow is the only means of payment for a purchase. Whether a buyer gives a note to you, borrows the price from a third-party lender, or invests cash with the expectation of a return on investment, the profits of the company are the source of repayment.

Selling to an insider is  a process where you take a note from the buyer before you leave, while you are still in control of the business. The buyer’s right to purchase is predicated on improving performance. You surrender some immediate income in return for incentive triggers that make your total sale price equal to or higher than what you would currently realize.

Once your internal buyer accumulates sufficient equity to qualify, he obtains a loan for the balance of your ownership. You receive 80% or more of your target price on the day you retire, and walk away with minimum ongoing liability. (I say 80% because most financial institutions like to see some incentive for the former owner to watch and advise for a few years. It can be up to 100%, depending on the lender and the company.)

With the right plan and the right people, the business transfers at a fair price with minimal cost and lower risk. The buyer(s) (whether one person or a management team) are incented to keep growing the business to qualify for ownership. While they are doing that, they are also assuming the management duties from you as a prerequisite for ownership.

Most important, you maintain control of the business until you are paid. For most owners, that is the most influential argument of all.

This is a column about the general issues of business ownership. I discuss exiting regularly because it is an important issue, but it isn’t the only aspect of ownership we discuss here. To receive my biweekly newsletter on exit strategies and issues, please subscribe here.

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Ready…Set…Exit! Part I

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For the last six years I’ve been writing and speaking around the country to business owners about the coming tsunami of retiring Baby Boomer business owners. My e-book “Beating the Boomer Bust” details the  statistics (For a free download, go here and enter the seminar attendee password “Woodstock”), but the numbers are inescapable.

According to www.bizbuysell.com the brokerage industry reports the sale of less than 8,000 small (under 500 employees) companies each year. There are between five million and six million such businesses in the USA that are owned by Boomers between 48 and 68 years old. That makes business owners about 7% of the Boomer generation (78,000,000).

By 2018, Boomers will be reaching their 65th birthday at a rate of 8,000 a day. That pencils out to over 550 business a day reaching  a logical point of sale. At current volumes, the brokerage industry can handle from January 1st almost through January 15th of every year. The other eleven and a half months you are on your own.

There are hurricanes, super storms, and perfect storms. The arrival on the ownership scene of GenX and the Millennials, who have less money and less enthusiasm for 60-hour work weeks, makes the wave of retiring owners a super storm. The need of big businesses to replace their retiring Boomers by offering higher salaries, better benefits and more flexibility make it into a perfect storm.

out the doorOf course, business brokers and the burgeoning industry of exit planning professionals (disclosure: I am certified in both) intend to cash in on the wave of sellers by vastly increasing their businesses. Even with a shortage of buyers, I’m sure they can double or triple their number of successful sales. Tripling would reduce the number of unsold businesses to only 485 per day. That’s 20 small companies with employees unsold hourly… 24/7/365. Do the math.

Of course, not all of the companies that change hands sell through business brokers. Some are passed on to families. Many are acquired privately, with accountants or attorneys facilitating the transactions. Others are sold to employees.

For small business owners, the third option, selling to employees, is too often the option of last resort. Owners ask their legal and financial advisors what to do. They prepare their company for sale (for a really solid new book on getting your company ready for a third-party sale check out The Exit Strategy Handbook by Jerry L. Mills). They list the business on the Internet or with a broker.

For any number of reasons, the business doesn’t sell. Perhaps they don’t have enough time because  the owner is burned out or ill. Their return on assets is too low, or their industry outlook is poor. The financial markets are tight, or there are just too many other businesses available for a limited number of buyers.

Finally, in desperation, they “sell” the business to employees for an installment note. In some ways these transactions often resemble the subprime mortgage market. The employees really aren’t qualified to grow the business. They need a job, and the terms can be stretched to any length to fit the cash flow available, so they are willing to sign whatever looks sustainable. If they don’t make the payments, the only recourse is for the owner to take back a company that he doesn’t want, and whose value has declined.

It’s a bad way to get rid of a company, but for many owners it is the only one they have left. It doesn’t have to be that way. We will talk about the alternatives next week.

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