Exit Planning Tools for Business Owners

selling a business

Addressing the Value Gap – Truth in Pricing

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Truth in pricing is a common issue when discussing the sale of a business.

The selling price of their company is a point of pride for any owner. When they are willing to share the price they were paid, they usually include everything that was listed in the purchase agreement. While there is nothing inherently dishonest about that, it’s often not exactly the truth either.

In our last article we saw Bob, the owner of Bob’s Widgets, came to the conclusion that he needed to sell his business for $6,000,000 in order to replace his current salary and the Seller’s Discretionary Earnings (SDE) such as the vehicle and health insurance that his business pays for.

He knows that his friend Edgar sold his widget company for $5,000,000. Both Bob and Edgar have about 40 employees. Bob thinks his newer manufacturing equipment allows him to operate more efficiently than Edgar. Edgar freely discloses that his revenues were $4,000,000 in the year prior to the sale. Bob’s sales were $7,000,000 last year.

We will ignore Bob’s EBITDA ($500,000) for this exercise. Whether his expectations are practical as a multiple of profits is a discussion for another time.

Is it unreasonable to presume that if a $4,000,000 revenue company in the same industry can sell for $5,000,000, then a $7,000,000 company should sell for $6,000,000? Bob figures that he is not only being reasonable, but perhaps he is shooting too low.

Truth in Pricing

To begin, let’s see what Edgar’s price consisted of.

Royalty payments on specialty widgets that Edgar patented were value at around $150,000 a year for the next ten years. That was $1,500,000 of his “selling price.” In addition, although Edgar’s equipment was old, it was paid for. His company was debt-free. He generated almost $1,000,000 in EBITDA annually.

truth in pricingEdgar’s buyer also wanted him to stick around for three years. Edgar calculated his salary of $150,000 a year as part of the “purchase price.” He also had an “earn out” of $500,000 a year for reaching certain sales goals in the next two years. In total, royalties, salary and conditional payments made up $2,950,000 of his $5,000,000 price, leaving only a bit more than $2,000,000 as “cash on the barrelhead.”

Did Edgar lie? Not in his own eyes. Given some time, effort and luck., he will eventually realize $5,000,000 in total pre-tax income related to his business. It’s his version fo truth in pricing.

Bob’s Price

First Bob has to consider what his price would include. He has about $350,000 left on the lease/purchase of his two newest widget manufacturing machines, which would have to be paid off by the buyer. He also owes about $300,000 on his revolving credit line.

Bob has always felt that vacation pay is earned, and never bothered to put a limit on its accrual by employees. He would be shocked to learn that his 40 employees, who average about $50,000 in salary, have about 240 weeks of unused vacation time. That’s another $230,000 plus the employer’s payroll taxes. Let’s call it a quarter million dollars. Edgar had a maximum one-week carryover. His liability was about $40,000. If Bob’s buyer is willing to pay a five (5x) multiple of EBITDA, the unrecognized vacation expense could drop the purchase price by nearly $1,000,000.

Bob is also anticipating a stock sale, with a tax burden of about $1,200,000 on his sale price. If it’s an asset sale (90% of small businesses are asset sales), he can expect that number to be much higher. In short, even if Bob could demand $6,000,000, his actual cash price might be more than a million and a half dollars less, and his tax burden almost a million dollars more. Suddenly Bob has the equivalent (in his eyes) of a $3,500,000 sale.

Closing the Value Gap

Welcome to the second part of the Value Gap. Now Bob realizes that not only will he need substantially more money to fund his post-exit lifestyle, but his company can’t currently provide the level of proceeds he was planning on for retirement.

It may seem surprising, but the answer to this problem for many owners is “I’ll just work longer.” The challenge of closing the Value Gap is too daunting to wrap their thinking around.

Some planning could help Bob. He can modify his benefit structures and pay off some debt, but let’s say that his $6,000,000 price is reasonable, and growing the value to $8,000,000 would meet his goals. Breaking that down on an annual basis renders a growth target of less than 6% annually over the next 5 years.

That may be a better solution than “just keep working.” Bob’s time frame may be longer or shorter. He may modify his target income. He may be able to economize in his business operations to increase cash flow. There are a number of options to consider, but they all require that Bob first understands his Value Gap and truth in pricing.

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.

Addressing the Value Gap – Living Expenses

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The Value Gap is one of the most used phrases in exit planning. Simply stated, it’s the difference between what a business owner would realize if he or she sold the company today, and what they need to embark on a financially secure “next act” after business ownership.

Both amounts can be determined with some accuracy by professionals. A qualified appraiser will analyze a company, its prospects, differentiation, markets, and comparative businesses and develop a value for the business. A good financial planner will look at savings, expected income, anticipated lifestyle expenses, life expectancy, and inflation and develop a scenario for the amount needed to fund those expectations.

Simple, right? Financial plan requirements minus net proceeds from the business transfer equals the value gap.

Testing the Value Gap

If it is so simple, why do so few business owners do it? Instead, they value their businesses by hearsay, misestimate their lifestyle needs by a substantial margin, and think “I’ll probably be fine.” In fact, fewer than one owner in five has even documented any plan for their transition.

Let’s take my favorite business owner, Bob of Bob’s Widgets Inc. Bob pays himself $120,000 a year and lives nicely on that amount. So he estimates that $10,000 a month should cover his lifestyle in retirement. To generate that, he needs $3,000,000 in savings with a 4% return. That means he has to sell his business for about $4,000,000, assuming 24% capital gains tax.  His company sold $7,000,000 in widgets last year, with a $500,000 pre-tax bottom line, so he is sure it’s worth at least $4,000,000. (We’ll discuss this valuation in my next column.)

But wait a minute. Is Bob really making $120,000 a year? He drives a Ford Super-Duty company truck that cost $85,000. The payment is about $1,500 a month. Insurance, maintenance and fuel are paid for by the company. Bob’s Widgets Inc. also pays for Bob’s $750 a month health insurance, his $1,200 monthly life insurance, and his $7,200 annual personal tax preparation bill.

“Sellers Discretionary Expenses”

Bob’s company expenses are not only common, but he doesn’t really take all that much in comparison to some owners. Any advisor can tell stories of company-paid second homes, family trips and other expenses far less business-related than Bob’s.

Without going beyond what would be considered “normal” owner perks, we can add about $58,000 a year in post-tax spending to Bob’s lifestyle. At his 4% return assumption, that adds another $1,450,000 in post-tax proceeds from the business to his need for a liquid asset base.

Even if Bob’s assumption of a lower capital gains rate is correct (which is not the case in 90% of small business sales) he actually needs a sale price of at least $6,000,000 just to maintain his current lifestyle.

Even Bob knows that his company can’t sell for $6,000,000. Without getting an appraisal or a formal financial plan, Bob has just had his first lesson in planning for the Value Gap.

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.

20 Red Flags to Look Out for When Buying a Business

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Magnifying glass focused on money

Buying a business is an opportunity to skip the growing pains of launching a startup. It’s a chance to start with a proven model with customers and cashflow. How can you tell if the prospective business is a genuine investment opportunity or a disguised escape route for a burnt-out owner?

The following is a list of the top five things to consider when prospecting a business purchase – and some red flags for each category so you can recognize trouble a long way away. This list is no way exhaustive and there are many other issues to consider when buying a business. However, nailing these will tip the odds of success in your favor. Here are 20 red flags for buying a business you should look out for.

1. Why the Business is For Sale

Before you fall in love with a business, make sure you understand why it’s for sale. You’ll want to interview the owner about their experience with ups and downs, their efforts to course-correct, and what tactics have been most successful.

Above all, you should be checking to see if you have what it takes to take the business to the next level and why hasn’t the previous ownership attempted this course. It’s not just about if the company could be a profitable investment– it’s about verifying the fit with your skills and resources.

Red flags:


The owner is burnt out or seems to be filling multiple roles
A toxic culture and/or high employee turnover
A poor business plan that can’t compete with costs or competition
An industry that is contracting or being disrupted by technology.

2. Perform Due Diligence

Due diligence will occur after your Letter of Intent has been accepted. It’s a comprehensive process, taking anywhere from 45 days to 9 months. This is the most critical step in the acquisition process. This is your chance to get “under the hood” and see how the business operates and to validate what you have heard from the owner in the prior discussions.

Due diligence includes:

Verification of sales and cashflow
Key employees
Concentration risk – clients and key suppliers
Financial/Tax Review
Asset Consideration
Legal Review
Operational Efficiency
Company debt
Real Estate status – lease expiring, property owned by the owner.
Inventory – obsolescence, turnover
Environment Concerns

Red flags:


Findings are significantly different than similar companies
The business model is overly complicated
Report results seem unlikely
Cultural concerns

3. Financial Review

Although briefly discussed in the previous section on due diligence, this is where you will determine what the financial opportunity of acquiring this business will be. It’s critical to partner with an independent and qualified CPA / financial professional to ensure that the story the numbers are telling are accurate. It is your responsibility to verify the results being provided to you.

You’ll want to dig into:

Profit and Loss (P&L) Statements
Balance Sheet
Cash Flow Statements
Tax Returns
Accounts Payable
Accounts Receivable
Sales history

Red flags:


The owner claims that the company makes more than the books reflect
Customer concentration
Equipment will need to be replaced soon (significant early expenses)
Account receivable and Accounts payable aged past 90 days Lack of budget and rolling 13 week cash forecast.

4. Get Clear About the Industry’s Future

You’ll also need to research the future of your new company. Is growth likely? What are the barriers to entry? Competitive landscape? Is the industry fading in relevance, being disrupted by technology, requiring significant product development to stay alive?

Access to industry research and speaking with industry experts is important. Talk with future competitors under the guise that your are considering becoming an investor in the industry. Seek out recent transactions and what the multiples are. How have the new owners faired post-acquisition.

Red flags:


The owner claims to have little competition
Inability to adequately explain declines in sales or margins
The owner reports having a hard time keeping up with established competitors
The owner mentions continuous new competition
The industry isn’t flexible to modern innovations

5. Reputation Matters

A good reputation isn’t just nice to have– its value is measured in dollars. Companies with a good reputation benefit from higher profits, free marketing, and better hiring ability.

Clean branding has never been more critical in an age of consumer determination to buy socially, ethically, and environmentally friendly. With social media and reviews in the driver’s seat, it’s crucial to work with intact brands.

Remember, brands don’t get a redo just because ownership changed.

Red flags:

Poor social media or news coverage
Significant poor reviews
Mistrust in target consumer base

Joe Gitto, CEPA is an accomplished senior Finance, Sales and Operational Executive, Entrepreneur, Coach, Thought Leader, and Board Member with more than 25 years of success in various industries. He is the Managing Member of Blue Sky Exit Planning Services.

The House of Gucci Succession Plan

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By now, you may have seen the movie House of Gucci. Lady Gaga and Al Pacino star in the true depiction of the Gucci family.

The Gucci brand started with two brothers who own the family business equally. Each brother had a son, and each son was to inherit the empire. One of the sons was a ne’er-do-well, who always attracted and found trouble. Despite nobody ever giving him a chance, the viewer could tell his successor ownership was doomed. The other son married the woman who was played by Lady Gaga. The story progresses through time as one of the fathers die and the other goes to jail while the wife rises to power and greed. To complicate the succession plan, lavish lifestyles, poor business decisions, children and divorce ensue.

The Gucci brand has always been iconic, and it remains so today. The movie describes the struggle between the two brothers and their ideas on how to grow the brand. One brother wants to expand into shopping malls across the world, while the other brother believes the idea of having a Gucci store in a mall is despicable. The two brothers who have these opposing views show how difficult it is running a family business with 50-50 ownership.

The two sons are the on-again/off-again heir apparent to the fortune, and eventually they will run or have a hand in running Gucci. The ne’er-do-well son struggles and is really off-base with his ideas, which are very inconsistent with the brand, and he lacks any sense of training or sense of how to run a business. Subplots in the movie describe how the other stakeholders attempt to circumvent his ownership and ultimately the rest of the family.

The other brother is smart, but he has a blind spot in that he has never had to struggle financially. He has never had to know what it was like to lack resources. His approach to management and growth are flawed because of the company culture and his paradigm. The influence of his wife and others around him also taint the management and success of a family run business. He lives lavishly, incurring personal expenses that he funds through the company.

Subterfuge and infighting ultimately become the demise of the family. The business survived but it was sold off for pennies on the dollar and was turned into a publicly traded company and as a result, the family no longer owns the business.

Clearly, the Gucci’s would have benefited from a team of exit planning advisors to help them navigate these waters! Indeed, there was no training of the sons, there was no alignment by the brothers, there was no dealing with the other stakeholders in the family. There was no financial planning, nor personal planning. Other than the brand quality, there was no development of cultural consistency or business attractiveness. There was a lack of management succession, planning and delineation of who does what. Sadly, there are many family run businesses that much less well known, but who lack the kind of exit planning that is needed to successfully pass along the business to the next generation.

House of Gucci illustrates how important it is for families to pay attention to succession and exit planning. I give this movie two thumbs up for the entertainment value of the movie, but two thumbs down on exit planning!

Mark Hegstrom is Certified Exit Planning Advisor and helps business owners to plan for what may be their single largest lifetime transaction: the transfer of their business. Get started by completing an exit readiness Assessment for yourself. Mark is Managing Partner at Business Owner Succession Strategies (BOSS). He currently serves as President of the Exit Planning Institute -Twin Cities Chapter.
 

Why You Can’t Sell Your Business Overnight

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So why can’t you just sell your business in a couple of months?

Business owners are often told they need to get ready to sell their business, why can’t they just up and sell it? The short answer is that they are unlikely to sell it. Listing the business may be easy, getting someone to buy it, that’s the hard part. According to the Exit Planning Institute, only some 20-30% of businesses sell today.

You might be asking yourself, what actually makes a business part of this group who does sell?

Of course, there may be many answers to this question, but I think the biggest reason can be summed up in a single word: Risk. A business buyer is going to look at several factors when determining if they will buy. These factors lead them to conclude a risk level and they compare that with their tolerance for accepting risk. The higher the perceived risk, often there is a direct correlation with a lower multiple of EBITDA, and thus a lower selling price. In some cases, the risk perception may be so high that the buyer decides there is no price they would pay to accept that risk.

What are some of these perceived risks?

I think for a lot of small and lower middle market businesses, the challenges for a successful sale to an outside party are greater than for larger companies. Larger companies are larger because they sell more products – they need more inputs to sell a larger amount of their product. They need people, processes and management. Usually in a larger organization, the owner is not participating directly in the production or sales of the product, they have an organization that does this. Contrast this image with a smaller company where the owner is directly involved in the production of the product or sales – the greater this involvement, the greater the perceived reliance on the owner. We call this “owner centricity.” The higher the owner centricity, the riskier the proposition is to an outside buyer.

If the current owner is deeply active in production, sales or the management of the firm, then an outside buyer will have to replace those functions – they may conclude they will have to do these activities, and there is the rub. They may or may not want to do them, but perhaps more important, they may not perceive that they are able to do those functions. An owner who knows all his customers, an owner who is a gregarious personality and is responsible for attracting new business, an owner who has been at it for decades and knows the industry, the suppliers, the competition – those are all critical owner functions – the problem is that a new owner may not be able to see themselves doing those activities with the same success as someone who has done it for years. If the prospective buyer can’t see themselves as being able to do these functions as well, then they will question whether the business can repeat the sales and profits earned by the original owner. The degree to which this idea is challenged is risk.

A way to reduce this risk might be to reduce the level of owner centricity. To reduce the level of owner centricity, an owner would assess the critical functions of the business and measure the extent of their involvement. Once measured, the owner would undertake the process of implementing a management succession plan to develop written procedures, systems and policies, and begin the methodical process of handing over or delegating the owner’s responsibilities.

I like to think of a business as a mental model that fits inside of a shoebox. The box has systems, policies and procedures, that runs itself. It produces a repeatable process of making money. Imagine that one could reach inside that box and pulls the owner out! Now the owner owns the box that produces the repeatable product and earns a predictable profit. I recently met with a business owner client who shared that he had taken our advice and told his staff that he is no longer coming into the office. (His words were “only call me if someone dies”!) What he found was that the business ran without him, it produced recurring and repeatable revenue and profit streams. A new buyer might perceive that they can own that box, and they may then perceive it as less risky.

Exit, succession and continuity planning is about this process. Reducing owner centricity is one thing an owner can do to prepare for a sale or exit. This is not a quick fix, this takes time. Those who develop and implement an exit and succession plan over time may be able to reduce the perceived risks to a new buyer. You might say, those with a plan have a better chance of selling their business than those without a plan.

Mark Hegstrom is Certified Exit Planning Advisor and helps business owners to plan for what may be their single largest lifetime transaction: the transfer of their business. Get started by completing an exit readiness Assessment for yourself. Mark is Managing Partner at Business Owner Succession Strategies (BOSS). He currently serves as President of the Exit Planning Institute -Twin Cities Chapter.