Exit Planning Tools for Business Owners

small business

Transition Tribulations

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This article in Financier Worldwide of the United Kingdom quotes me extensively. I thought you might like to see it. (My spellings were changed to British standard.)

Transition tribulations: exiting a family-owned business

by Fraser Tennant

When the owner of a family business decides to call it a day in order to enjoy the fruits of his or her labour, the transfer of ownership can be a challenging process. What is more, in the US in particular, transitions of this nature are becoming ever more common.

Indeed, as highlighted in JC Jones and Associates LLC’s white paper, ‘Exit Planning for the Family Owned Business Owner’, more than 70 percent of privately owned businesses in the US will change hands in the next 20 years. At an estimated $10 trillion, it is the largest intergenerational transfer of wealth in history.

In terms of today’s retirement-minded family business owners, what is required is a well-conceived exit plan, one that sets clear and realistic objectives. “An exit plan is a strategic process detailing the financial, operational, management and ownership changes that will take place as leadership is transitioned,” states the report. “A well-thought-out plan is required to meet the personal goals and timeframes of owners and to monetise their business.”

Myriad issues

When the decision to depart a business is taken, there are myriad exit or succession planning (the primary emphasis of which is family) strategies to be considered and a multitude of questions to be answered. What will happen to the business when the owner moves on? Should the business be sold? Will the owner’s children want to carry on with the business, and, if so, is there a successor ready to assume the leadership? How can a maximum return from the business be ensured? These are just some of the key issues.

In many instances, a family business owner may have no choice but to pursue exit rather than succession, as there is no next-generation family member ready, willing or able to take the helm. That said, for those owners who do have the option of transferring ownership elsewhere in the family, statistics are not encouraging.

Stephen Pascarella, owner of Pascarella and Gill, PC, notes that less than one-third of family-owned businesses survive the transition from first generation ownership to second. According to Mr Pascarella, three main challenges are likely to arise. First, transferring when parents are not financially ready. This is a premature move which could be devastating to retirement planning and financial security, as retirement funding may draw from the business, impeding possible growth. Second, transferring to children who do not know how to run a business. Many business owners forget that new owners, most often their children, must possess the skills to run a business. Finally, attempting to give everyone equal shares. When multiple family members are involved, dividing a business equally may not be in the owner’s best interests. For business owners, it is crucial to remember that management and ownership are two separate issues.

Exit and succession strategies

When a business owner decides to make an exit and there are children employed in the business, a layer of complexity is added to the planning process. According to John Dini, president of MPN Inc, in this scenario there are three relationships between family members at work.

First, there is the blood relationship between parent and child. Second, there is the management relationship, not only where a child reports to a parent but when a child is, at least nominally, in charge of siblings or even the children of siblings. Third, there are the ownership relationships. Does ownership pass according to the blood relationship or in proportion to the management responsibility? Are children who are not working in the business included in ownership? What rights do they have to determine the course of the business? In today’s extended families, where these questions frequently encompass step-children and in-laws, it is a complicated business.

“A family successor should be ready, willing and able to run the company,” says Mr Dini. “However, if he or she is not, all may not be lost. There are a number of succession plans where employees who are key to successful operations are included in ownership or otherwise financially motivated to spend a lifetime within the business. There are numerous incentive plans, including stock appreciation rights, phantom equity or other forms of deferred remuneration that can compensate a critical employee based on company value, without actually issuing ownership.”

For Nadine Kammerlander, professor of family business at WHU – Otto Beisheim School of Management, the main challenge is to find the ‘right’ next owner and at the right time. “Family business owners often start thinking about their exit at too late a juncture and often have unrealistic expectations,” she suggests. “Moreover, they often underestimate the difficulties of finding an individual to take over a firm, overestimate the future potential of the firm as well as its value due to emotional attachment, neglect legal, regulatory or tax issues that might impede the sale, and can be reluctant to cede control.”

Whether it is a matter of unrealistic expectation, misplaced emotion or wasteful procrastination, the likely outcome is that the sale will not proceed as smoothly as intended, with the business owner forced to restart the process more than once. “When considering suitable strategies, family business owners first need to decide whether they want to pass on ownership and management to the same individuals or split them, for instance by giving the ownership shares to the children and hiring an external chief executive.”

In terms of selling the business, a family owner has several choices, such as bequeathing to a family member, an employee via management-buy-out (MBO), another individual previously unconnected with the firm, via management-buy-in (MBI), or a competitor. “These strategies vary across the dimensions of sales price, professional management and continuance of firm tradition,” adds Ms Kammerlander.

Valuation

When it comes to assessing the value of a business there are a number of options to ensure valuation reflects both current worth and future potential. How this valuation is determined very much depends on the type of exit strategy the owner has chosen to pursue.

“While selling a business to a competitor will probably generate the highest value, it may lead to a loss of more than 25 percent of the business proceeds due to taxes and advisory fees,” says Mr Pascarella. “External transfers, such as a sale to a competitor or private equity group recapitalisation, use synergy value and investment value. In contrast, internal transfers, such as an employee stock ownership plan (ESOP) or gift or sale to family, use fair market value where discounts may apply.”

Choosing the exit option most conducive to maximising value is, therefore, critical, as is obtaining well-qualified and experienced assistance. “A qualified valuation professional will consider both historical and projected value,” affirms Mr Dini. “But in a family transfer other considerations often take precedence over fair market pricing. What are the retirement needs of the parents? Is the estate being ‘balanced’ between children active in the business and those who are not? Is stock being transferred via a more arms-length sale process? And is the focus more on tax-reduction strategies, such as gifting or trusts?”

The worth of a valuation expert is clear, but caution should be exercised when securing a specialist. “Given the importance and complexity of the process, experience and support is required,” agrees Ms Kammerlander. “However, there are a large number of so-called advisers that may lack the required competencies, experience and attitude. A careful selection is needed.”

Another issue is that owner-managed firms often lack proper documentation. “Such a lack of transparency makes it difficult for outsiders to recognise the real value of a firm and might lead to a lower-than-desired sale price,” adds Ms Kammerlander.

Reaping rewards

With the sale of a family business often the culmination of a lifetime’s work, departing owners want to make the right choices, avoid missteps, keep regret to a minimum, and reap the rewards of years of endeavour.

“Sometimes a business has served its purpose,” says Mr Dini. “If all the children have moved on and are successful in other pursuits, then the company should be sold to a third party. “Few owners are more unhappy than those forced to return to a family business out of a sense of obligation to their parents, regardless of any related financial success. Their misery might be exceeded only by those who spent a lifetime in the company, only to see it sold to strangers because parents thought it was the only way to monetise the fruits of their labour.”

It is important for owners to consider both financial and non-financial issues. As regards the former, owners need to start thinking about the manner of their exit sooner rather than later. The more time dedicated to the search for the ‘perfect’ successor, the more likely that search will be successful.

In terms of non-financial considerations, the owner needs to reflect upon his or her goals before entering the exit process. What is most important? Is it the sale price? Is it the continuation of the businesses’ name? “A clear answer to such questions helps the exiting owner to achieve a satisfactory solution,” believes Ms Kammerlander. “Communication with family and other stakeholders is also crucial. If a family business owner sells, unaware that his or her children were interested in taking over, there is a high potential for ongoing family conflicts.”

To make the transition from business owner to retiree as smooth as possible, Mr Pascarella’s advice is to follow a five-step process: (i) establish exit goals; (ii) measure financial and mental readiness; (iii) learn and choose the optimal exit option; (iv) understand the business value of the option chosen; and (v) execute the exit strategy plan to achieve exit goals.

Complex and emotional

Exiting a family business is clearly a complex and emotional undertaking – a process requiring careful advance planning and much resolve, especially when the business is the largest single asset in an estate.

Moreover, once the decision to depart has been taken, there should be no procrastination. “This can lead to disaster with a great deal of vicious, internecine squabbling,” warns Mr Dini. “If an owner wants his or her children to remain on speaking terms, they owe it to them to discuss and define what will happen as the business passes, or not, to the next generation.”

Ultimately though, family business owners want to harbour no regrets over the decisions they make when the time comes for them to pass over the reins and transition to the next stage of their lives.

© Financier Worldwide

Your Transition Advisor Team

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Nothing impacts the success of your business transition more than the advisor team. Let’s say you receive a free pass to play in the Super Bowl. You will be playing against the New England Patriots, but you can choose any NFL player not on their roster for your team. Who would you pick?

There are a multitude of opinions about who is the best quarterback, wide receiver or free safety. One thing is pretty certain. You wouldn’t choose the guys you grew up playing touch football with. At least, not if you wanted to win.

Owners feel loyalty to the trusted advisors they already have relationships with. “He’s the attorney who handles all my legal problems,” is a bit like saying “He’s the doctor I always go to when I feel sick.” That is fine, but what if you needed a heart transplant?

Professionals are Specialists

All physicians went to medical school. In residency, they took rotations in surgery, obstetrics, pediatrics and infectious diseases. That doesn’t mean that twenty years down the road you want someone delivering your newborn child unless he’s practiced it a lot.

Just as there are many physicians, there are many attorneys and CPAs. They all have some training in all aspects of law or accounting. It is required to pass the bar or to get certified. But if your attorney spent the last twenty years doing real estate closings, or your CPA spends most of his time preparing tax returns, he or she may not be the right advisor for the biggest financial transaction of your life.

Business transitions aren’t simple. Even the asset sale of a small business has tax pitfalls that can easily trap those who don’t know what to look for. I recently heard a story about an owner who sold the stock of his company. He was ecstatic about getting the lower capital gains tax rate, and put that money aside for when he filed his return.

Unfortunately, neither his attorney nor his CPA thought to include a prohibition against the buyer declaring a Section 338 (h) 10 election. While not common, it allows a buyer to recast the transaction as an asset purchase. The seller has little say in the matter. Over a year after the closing the seller saw his capital gains turned largely into ordinary income. At that time, it meant a tax bite for about 20% more of his proceeds.

Choosing an Advisor Team isn’t Disloyal

Your traditional CPA can continue to do your tax returns. Your traditional attorney can still take care of your normal business and personal legal needs. For a transaction, however, you want someone who deals with the sale and transfer of companies on a very regular basis.

Unfortunately, some practitioners are insecure. They are afraid if another  professional is called in they will lose a long-time client. Their usual claim is something like “I haven’t done many (or any) of those, but they are pretty straightforward. I’m sure I can handle it.”

Those who are more confident in your relationship, or more successful in their specialty, will say “I don’t do enough of those to be fully confident of doing the best job for you. Let me recommend someone who has more expertise than me.”

The other issue is often cost. I’m regularly dismayed when I ask why someone uses a particular professional, and the owner answers “Because he’s cheap.”  Would you pick a physician using that criteria? Good help costs money.

Selling your company is your financial Super Bowl. You want to put together the best advisor team possible for that one game. Afterwards, you can go have a beer with your buddy from the sandlot. You’ll still be friends, and he will (or should) understand.

 

 

Selling Your Business – the Buyer’s Eyes

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Selling your business is much like selling a house. In order to realize the highest price possible, you want it to look its best.

The other day I passed an independent gas station/convenience store. The marquee at the curb advertised  their price for “unlead” gas. Really? Unleaded fuel has been required for new cars since 1975. Lead was completely banned as an additive 22 years ago. That means anyone who has bought a new car in the last 40-plus years, and every driver under 40 years old, has never purchased anything but unleaded gas.

What does that indicate about the maintenance of the business? If it has been decades since they updated their sign, what have they done with their refrigeration, roof, and other, more costly items of the infrastructure? Their P&L and cash flow are suspect, and due diligence will be more extensive. All because the first thing you see is an outdated sign.

First Impressions Count

In Steve Martin’s “LA Story” his girlfriend (Marilu Henner) checks her wardrobe by closing her eyes, spinning around in front of the mirror, opening her eyes, and removing the first thing she notices.

Very early in my working career I was in retail. My training manager taught me the same technique. Each day I walked out to the edge of the street in front of the business. I stood with my back to the business and my eyes closed. “Pretend you’ve never done business with us before,” he told me, “Then turn around, open your eyes, and see how our business looks to a new customer.”

I’ve used that exercise ever since. When I was actively brokering businesses, I remained acutely aware of first impressions. A parking lot with weeds in all the cracks or sidewalk seams. A front office with stacks of unfiled invoices on top of the cabinets. A conference room with six month old notes on the whiteboard. An owner’s office that doubled as storage for samples.

My favorite is the “Employee of the Month” board that was last updated years ago.

Staging for a Sale

Most small business owners seeking to sell ask “What can I do to get the best price?” Surprisingly, many pushed back on my staging suggestions. “I’m selling a profitable business, not a parking lot.” “Those invoices show that we are busy shipping product instead of filing.” “If a new owner wants to reinstate the employee of the month, the board is there and ready.”

Selling your business isn’t a joking matter. I want to do the best job I can for the client. If the first suggestions I make are shrugged off, what will happen when the client has to execute the more difficult tasks like preparing due diligence information?

Fortunately there were other brokers who would gladly list any business, in any condition. I was happy to let these brokers put in the effort. My time was too valuable to invest in a client who refused to see his business through the eyes of a buyer.

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.

 

Business Buyers and Disintermediation

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In the last post, we discussed the reluctance of many prospective business buyers to deal with the regulatory burden of being an employer or service provider. You may be among the lucky few whose profession doesn’t require licensing. Even better, you may have qualified employees who are able to run the business without you.

There are other issues that concern younger buyers, however. One of these is the threat of disintermediation. That’s a trendy word for what we used to call “bypassing the middle man,” but it applies to many businesses that are being made obsolete by technology.

Disintermediated Businesses

How many business people still rent cars to attend a couple of meetings in a city? With Lyft and Uber, it is frequently easier to call a ride than leave a car in the (expensive) hotel parking for 90% of a visit. I’d be very skeptical of buying a car rental business today.

What happens when (not if) autonomous vehicles become part of daily life? Long-haul trucking will move to non-peak traffic hours, reducing the need for drivers, training schools, highway expansion, truck stops, and perhaps the number of trucks themselves.

Service businesses where the middleman lends expertise (easily duplicated by Internet research) or access to vendors are feeling the crunch already. The warning bell is sounding for mortgage companies, real estate agents, insurance and benefit brokers, employment agencies, printers, publishers, and travel agents.

These businesses won’t go away, but there will be fewer of them, and their margins are eroding.

The rise of robotics and artificial intelligence threatens even the most skilled professions. Legal databases, automated interpretation of medical imaging and free online tax filing are a few examples.

This quote is from a  February 21 essay by Rob Kaplan, President of the Federal Reserve Bank of Dallas.

As I have been discussing for the past two years, technology-enabled disruption means workers increasingly being replaced by technology. It also means that existing business models are being supplanted by new models, often technology-enabled, for more efficiently selling or distributing goods and services. In addition, consumers are increasingly being able to use technology to shop for goods and services at lower prices with greater convenience—having the impact of reducing the pricing power of businesses which has, in turn, caused them to further intensify their focus on creating greater operational efficiencies. These trends appear to be accelerating.

The Impact on Sellers

The overview of the business seller’s marketplace is straightforward. As I’ve been proselytizing for over a decade in my “Boomer Bust” presentations and books, selling a business will be more challenging, but that doesn’t mean any particular business is unsellable.

As with any other competition, the response is to create differentiation from the rest of the pack. There are a few key factors that top the list of appealing differentiators for business buyers.

  1. Build a business that can run without you. The more you work in your business, the less it is worth.
  2. Train effective management. Employees who understand how to run a profitable business are highly appealing to any prospective buyer. In addition, they can provide you with an alternative to a third-party sale.
  3. Upgrade the value-added component of your offering. If the only benefit you offer to a customer is time and place utility, you are probably toast.

There is another factor that may sound counterintuitive. Design your business so that it requires more expensive employees. If low wage workers are the backbone of what you do, you risk losing the technology arms race with larger competitors. I’ll expand on this in my next post.

The population of business buyers is younger, more technologically savvy, and less inclined to long hours than the generation that is selling. Winning in a competitive marketplace demands that you offer what business buyers want.