Sep 11
19
Announcing October 5th Exit Planning Workshop Sponsored by the Beaverton Chamber of Commerce
Don’t Let the Door Hit you in the Butt – How to Exit your Business
Presented by Scott Spangenberg, MBA – Partner B2B CFO®
If you are like most business owners, you have devoted an immeasurable amount of work and resources into growing your company. With all that you have invested, doesn’t it make sense to plan an exit from that business that protects the wealth you have accumulated? After all, exiting your business will certainly be one of the most important financial events of your life. In reality, you will have ONE chance to get this right!
With this presentation you will be able to start thinking about options that are available to you and how to position your business for the best (and most) profitable exit. You will understand your “financial gap” to retirement and what you need to do to fill that gap. You will understand there is more than one option to realize your financial dreams.
You will learn:
The Six Step Exit Process to exiting your business
Determine what your goal is for exiting your business.
How to measure if you are financially and mentally ready to leave your business.
The five major options for exiting your business and how to understand which one is best for you.
Valuing the different options for your personal situation
Event Details:
Wednesday, October 5
7:30 – 9:00 AM
Beaverton Chamber Lower Conference Room
12655 SW Center Street, Suite 140 Beaverton, Oregon 97005 (map)
Pre-registration not required, just join us.
Pricing
Chamber Members: FREE
Guests: $10 at the door (Become a Chamber Member)
*OR purchase a Business Matters! Punch Card at the door for $30 for 6 Sessions (50% discount).
Creating an exit plan can be a difficult and emotional time for a business owner, but it doesn’t need to be. Many owners believe that their involvement in the company must end and they have to turn over the reins to someone else. This is not necessarily the case. Some may choose to transition out over time and gradually relinquish control when they feel the time is right.
One of things that can seem most daunting when thinking about an exit is starting the conversation with family members, business partners, employees, etc. about your future plans.
Start early – Exit planning is something should be constantly revisited during the life of your company and not left until the last minute. Oftentimes, proper preparation along appropriate timelines can help to lessen any issues that could arise in the event of an emergency exit.
Be prepared – Make sure that you have done your research and weighed all of your options before beginning the conversation. Being sure of yourself and your decisions can help mitigate arguments and resistance that could occur. Working with an exit planning professional, and having them present during important conversations, can be extremely helpful.
Listen to key stakeholders – As emotionally charged as the discussion can be for the exiting business owner, it can be equally so for those who may feel excluded from the conversation. It’s important to anticipate as many of their questions as possible, including time frame, motivation, and reasons behind your choices.
Some business owners prefer to discuss exit planning in progressive one-on-one situations, starting with close friends and family members and slowly working their way out to high-ranking company employees. Others start with their business partners. Some prefer to make an announcement to everyone at the same time. There’s no right or wrong way to do it, and the strategy should be tailored for each business owner.
Beginning a dialogue about an exit plan can be a challenge. I can help educate you, the owner, about your exit/transition options so you can plan in advance and minimize both the disruption and the intense emotions that can occur with abrupt or unplanned exits.
As a trusted advisor and partner, Scott Spangenberg will help you achieve your financial goals and make the most of the business you have worked so hard to build. Throughout his career, Scott has developed an outstanding reputation by providing exceptional consulting services to an array of industries throughout Oregon and southwest Washington.
Posted in Exit Planning Management by .
There are short-term and long-term needs for your business. When thinking about an exit, you are considering the long-term implications to your business and life, while simultaneously balancing the short-term needs of your business. The saying here is ‘not to take your eye of the ball’ while designing your optimal exit. The challenge is one of where to focus your attention – too much time spent focused on your exit and the business suffers. Too much time spent on your business and your exit is likely never to happen. This newsletter is intended to get you thinking about your exit while keeping an eye on your business.
Let’s begin with a basic statement about exits. You need to have a vision for how you will live your life beyond running your business. And, in order to establish that vision, it is recommended that you focus on how you will spend your time. And, very importantly, you should begin, in part, living that life so you can experience what your exit will actually feel like. How will it feel to spend your time on activities that inspire you the way that your business drove your needs for fulfillment and success? The best way to answer this question is to begin to experience this post-exit lifestyle. Owners with the most successful exits have something that they are ready to step into after their business. These time-filling activities transcend the hobbies and past-times such as golf, fishing, exercise, and leisure time. They are meaningful activities that fill your days.
Here’s the challenge. At what point in time will you start to live this new life while gently letting go of the business that still needs your attention? Here are a few tips.
The best first thing that you can do that is not too distracting to your running of the business is to commit your goals to writing. If you can answer the following question you are taking a great step forward:
- What do you want to be doing twenty (20) years from now?
- What does your life look like?
- How do you fill your days?
The idea behind the twenty (20) year target is that it is far enough into the future to really challenge you to think through the types of things that you would really like to be doing. If you think that you don’t see yourself still running your businesses in twenty (20) years– which many owners cannot see – then the question is simple: What will you be doing?
Think about this question.
Stop reading and write the question down on a piece of paper.
Begin with the following as a guide to answer the question:
5:30 – 7:30 a.m. Follow typical wake up routine, i.e. coffee, exercise, breakfast,
shower . . .
Now that you’re dressed, refreshed and caffeinated where will you go?
What is going to fill your day?
7:30 a.m. – 6:00 p.m. ????
6:00 – 11:00 p.m. Follow typical evening routing, i.e. dinner, reading, television, a few phone calls, sleep.
You see, most owners cannot fill in this blank space during the day. And, as a result of not knowing what they will do, they revert to running their businesses. There is not necessarily anything wrong with running a business that you enjoy immensely. However, the reality is that this course of action is not sustainable indefinitely and your holding onto your role might not be the best thing for your business or for your personal life.
If you begin to fill too much of the day too quickly, on the other hand, you lose focus on your business and the overall value that you receive for your exit will most likely be reduced. How can we bridge this gap and make for a more successful overall exit?
Start Small, Build Over Time
Many exiting owners today are spending winter months in warm climates such as Arizona and Florida. They are looking at and purchasing real estate in today’s depressed market and beginning to build their post-exit lives in these new locations. This is an excellent first step towards developing your optimal post-exit life. The reason is that the trips ‘down south’ are min-vacations, allowing them to focus on work when they return.
Most owners know that they cannot spend all of their days on the golf course, but the purchase of the home puts them in a new community, most likely surrounded by folks in the same position that they are in. And, being in the company of others who are going through the same thing you are is a good way to advance your thinking and to join a community of folks who will be with you during those future hours.
Vocation Vacations
If you want to try something more unconventional you might consider using your vacation time to get the experience of living your dream job… perhaps with a view towards filling your days this way. From being a boat yard owner to a forensic pathologist, these multi-day mentorships put you in the actual role of a new career of your dreams. This type of creative activity is a great way for you to begin to take steps towards your future.
Hire a Coach
One of the best things that you can do to begin to focus on your post-exit goals without losing your grip on your business today is to hire a coach. At the very least you may recognize that change is difficult mostly because of the patterns and habits that we get into. Coaches help us set goals and stay on course towards achieving them. If your goal is to exit successfully, this is a great commitment that you can make to yourself to get the process started with some help.
Conclusion
So, although forming your post-exit vision can be a challenge, there are constructive ways to visualize spending your days without completely losing focus on the business that needs you. A separate topic of discussion is how you can make yourself operationally irrelevant. However, you may find it very helpful to take the first steps towards designing your post-exit lifestyle.
The politicians in Washington seem to be finally asking the right questions about job creation . . . i.e. how can small business begin to hire again. Well, amongst other reasons why small businesses are reluctant to begin staffing up again, one of the primary reasons is that lower costs means higher exit values. And with so many owners having a ‘value gap’ to fill, it is imperative that they protect and drive value through profitable bottom lines.
Let’s discuss the concept of a value gap. This begins with the amount of money that an owner needs to declare financial independence. Typically, an owner’s illiquid business is their primary asset so a liquidity event needs to take place to turn the business into cash. The value of that business, for the most part, will be driven by the company’s cash flows. And, lower expenses and higher, per-employee productivity is what makes a business valuable.
Now, the recession has increased the value gap for many owners as they realize that both their liquid and their business values have declined. Worse yet, owners were likely to have contributed personal assets into their businesses as credit tightened and these owners needed to capitalize their businesses. The answer, of course, was to reduce expenses by laying off employees – an unfortunate plan to enact but a necessary one for survival.
So, where does the baby boomer owner go from here?
Well, with a business recovery under way, the owner’s are seeing recovery of their businesses and, with the help of technology, they are getting more done with fewer people. Moreover, as the owners begin to measure their value gaps, they see that they need to extract a high value in order to meet their personal needs.
Let’s look and an example. An owner lays off four (4) workers during the recession that reduces labor costs by $300,000. During the recovery, revenues are coming back and lower labor costs have this owner projecting higher profitability. Cash flow, or EBITDA (earnings before interest, taxes, depreciation, and amortization) improves by $300,000. And, as a typical business will be valued as a multiple of this cash flow – let’s assume a four (4) times cash flow in this example – this translates into an addition of $1,200,000 to the value of the company at the time of the owner’s exit, forecasted to occur in the next few years.
The owner is focused on the exit. And, the higher value substantially contributes to closing the value gap to meet their personal goals. The quick translation is that the owner will reduce their value with new hires, unless those new hires are immediately accretive to the business. And, after all, productivity can take time and cost additional dollars in training, benefits, vacation time, and the typical ramp-up as the new employee needs to integrate and assimilate in the business.
Is the owner thinking growth or exit? Will value be achieved through expansion or through high cash flow?
It is simply the case that no owner will forget this most recent Great Recession. This is where human nature kicks in. What is the motivation to hire when a successful exit is moved to the forefront of owner’s attention? Not too much. In fact, there are many owners who are enjoying this economic recovery but are more interested in not experiencing another recession. This means that they want to exit in the next few years and cash in and turn the business over to someone else.
Having a high cash flow is the shortest path to a higher value. New hires detract from that value. And, since many businesses have learned to live with less, it is hard to see where the jobs will come from. Bankers who would not extend credit over the past few years are now finding owners reluctant to take the credit that they are offering. The market has changed and it is not in favor of risk-taking and aggressive hiring.
This market change of risk taking should translate into your post exit future. Use the increased value of the business and cash flows to close your value gap and lay the framework for your exit.
It has been a struggle, to say the least, to get through this recession and not being financially prepared for your future when the next one hits is a risk not worth taking.
Posted in Exit Planning Management by .
We’ve all done it. We paid a consultant to assess our current situation and then did not follow through on the recommendations. The final product of the assessment and the written report, sits on a shelf. And, although the answers to many of our issues are provided within those pages and analysis, it just seems like we are too busy to focus on taking action on them. This, by the way, applies to many areas of our lives, including past attempts at:
- Personal investment planning
- Estate planning
- Business planning
- Retirement planning
- Insurance & risk management planning
- Succession planning
The reality is that accumulating wealth comes with certain responsibilities that take time to manage and execute properly. We could easily point the finger at the advisors who were complicit in not assisting us in the completion of these plans, but ultimately we are all responsible for our own planning. And, as time passes and situations change, the planning actually also needs to be updated to reflect the new circumstances.
The Exit Plan
Adding to the list above should be your written plans for an exit from your business. The exit plan should never be a static document. In fact, as the world, economy, your industry and your business changes, your plans for your exit should be re-evaluated. Is your company sustainable, valuable and transferable today? These are questions you need to know. Beyond that, who could own it, run it, and successfully leverage what you have already created after you no longer own it? If you don’t know the answer to these questions, you should really consider finding them because these too will change.
For example, your immediate family may expand to include grandchildren. Have they been included in your planning for your future and how will your wealth pass to them? This is sometimes a strong motivator as owners envision the potential that their future generations can have from the hard-work and success that they have achieved. Without a plan that includes constant updating, it is possible that your wealth will be diminished.
Check Ups
Do you go to the doctor once every five (5) years to check your health, assuming that the old reports apply to your current health?
Do you figure that the trips to the dentist are good for years and years?
Or here is an easier one . . . do you have the oil in your car changed every 3,000 or 5,000 miles?
Of course you change your oil because you want to avoid the expense, pain and overall embarrassment of having your engine cease because you did not take 20 minutes out of your day and spend the thirty dollars necessary for some routine maintenance.
Look at your exit planning in contrast to your car. Let’s assume that your car is worth $30,000 and your business is worth $3 million. If you drive 12,000 miles this year you might spend an hour and a half getting the oil changed and approximately $100. Given that your business is worth 100 times what your car is worth, doesn’t it make sense to invest time and money into planning for this valuable asset? Measuring an equal amount of time to protect your business as you do to maintain your car, you would spend about 2 ½ weeks a year working on your business, exit, and other planning and probably $10,000. That’s a pretty good return on investment if you save hundreds of thousands in taxes at exit, and/or increase the value of your business by a high multiple of that number.
This newsletter is the blinking light on your dashboard telling you to update your plans.
So remember that a commitment to consistent, strategic-level thinking is critical to your success as an owner.
Posted in Exit Planning Management by .
To Share Stock or Not to Share Stock
That is A Question for Many Exiting Owners
A number of business owners who enter the exit planning process have a management team who helped them bring the business to where it is today.
These owners want to see their management team take the same sense of urgency towards the business that the owner has taken to make it successful. In fact, owners fear that without this proactive approach, the management team will not succeed with either a new buyer (external transfer) or as future owners of the business (internal transfer).
As an owner begins to think about the future of the business, a natural reaction is to make the management team owners of stock in the business to align their interests and motivate better behavior. The theory here is that whether the owner sells to the managers or to an outsider, this management team will be vital to the businesses’ future success. In addition, these owners begin to think in terms of solidifying this leadership team and taking a step towards a new form of ownership in the future. The question that needs to answered, therefore, is whether or not sharing equity is the best solution for the succession and exit planning issues?
Let’s first look at the positive aspects of sharing equity in your business. On the one hand, the managers may feel appreciated and pay more attention to the business if they ‘own’ a piece of it. In addition, the granting of stock has a symbolic gesture that accompanies the event – the idea that the manager’s participation in the business is highly valued and their status is sought to be elevated in the eyes of the owner. In fact, these are some of the driving forces that cause stock grants to be undertaken.
But, there are some downsides to sharing ownership of stock. Let’s look at a few.
What it Means to Own Stock
When someone else owns stock in your company it puts a burden on you, the primary shareholder, to meet certain obligations. Minority shareholders have rights – mostly under the laws of the state of incorporation – which require the owner to be mindful of how these shareholders are treated. It is helpful to know these rights because if the original intention of sharing stock is to motivate behavior, it is often the unintended consequence of this action that owners end up with obligations that they do not expect.
Will Stock Ownership Motivate?
So, if you are going to suffer the burdens of making your employees owners of the stock in your business, it is best to first examine whether or not stock ownership will truly motivate behavior. As a business owner, you are most likely aware that behavior is motivated by many factors. Some employees want to strive to do the best they can, some are looking for recognition for their efforts, while others are simply motivated by the size of their current take-home pay. Be careful not to apply the wrong remedy to the issue. In other words, stock ownership in the company can sometimes be a fleeting gesture that many employees do not value as much as you want them to.
Is a Grant of Stock Valuable / Meaningful
Two (2) reasons that granting stock to your managers can be tricky business are (i) the amount and value of the stock many not be meaningful to them, and (ii) without a future liquidity event envisioned, will these managers see the opportunity to turn the stock into cash?
Is the Grant Meaningful?
The issue of whether or not a stock grant is meaningful goes to the manager’s total compensation and how much value the stock holds on a relative basis. In other words, if your business is worth $8 million and you grant 1% of stock to your manager, will they see the value in an $80,000 ownership of stock? Well, if your manager earns $175,000 per year and has $500,000 saved for their retirement, they might not view the ownership in your company as a meaningful contributor to their total financial situation – at least not enough to cause them to stay permanently or to change their behavior entirely.
Can the Managers Achieve Liquidity?
Beyond the question of whether the amount is meaningful, an owner also needs to consider whether or not the manager will be able to cash in this stock. If you think it through, these managers will now be facing the same issue that you are facing, i.e. how do they cash in their ownership into a form of currency that they can use to pay for certain expenses? Illiquid stock only becomes liquid when someone else is willing to buy it. The larger problem for your managers is that their minority stake interest (a discount for which was not taken into account with the simple, prior valuation formula) is illiquid and essentially non-transferrable.
Knowing now about the meaningful and liquidity issues, do you still think that granting stock is the best motivator?
Beyond Motivation, Where Can Ownership Go Wrong
An important issue to consider is what would happen when your employee – who is now a stockholder – leaves the company to go to work for a competitor and wants to be cashed out. Or, worse yet, has ownership in your business but works for a competitor. Adding insult to your company’s injury, you may be in a position of having to redeem those shares and, in effect, pay this manager to leave your company and compete with you.
A Way to Resolve this Dilemma
As you can see, sharing stock in your business can be a risky proposition and may not achieve the results that you intend. Therefore, a few steps may be helpful towards your ultimate decision to begin the exit planning process.
- Take careful measure of whether you are using stock grants as a motivator, as a retention tool, or as a means to effectively transition ownership.
- Carefully evaluate the anticipated behavior of the recipient of the stock.
- Have multiple and detailed conversations with your managers about the future of the company, their relative contribution and your desire to align their interests with yours, and,
- Most importantly, do not make the mistake of substituting equity ownership for the need to provide leadership in your organization.
Alternatives to Equity Ownership
You should know that there are more than a few alternatives to sharing the actual stock in your business. These alternatives offer more flexibility in structuring benefits but also come with the burden of some complexity. In all cases, these tools should be examined as a substitute for actual stock ownership. A short list of these items include:
- Phantom stock plans.
- Stock appreciation rights plans.
- REBA plans.
- Profit-sharing plan (with vesting schedules).
- Stock Option plans (which should be carefully evaluated for their meaning and liquidity).
- Non-voting stock grants (a different version of stock grants).
- Non-financial incentives, including leadership roles and more authority in the business.
These alternatives are too vast to cover in detail in this newsletter but look for future newsletters that provide details on these plans and talk to your advisors about options that are best for your situation.
For now, I hope that this newsletter helped you think through the implications of offering stock to your managers. We also hope that you take the complexity of these decisions as a motivator to develop a comprehensive exit plan for your business. Being proactive in this area of planning could be your best, first step towards the successful exit from your business.
Posted in Banking Exit Planning Lending Management Uncategorized by .
One of my clients owns an office building in the Portland metro area. After completing a preliminary analysis I was able to show the business owner the expected tax savings as well as the fixed cost performing a Cost Segregation Study. The study resulted in an initial increase in depreciation expense of $215,000 or an increased after tax cash flow of $75,000. More tax savings will accrue in 2011 and beyond.
Cost Segregation is an IRS-approved application by which commercial property owners can accelerate depreciation and reduce the amount of taxes owed. Cost segregation is the approved method of re-classifying components and improvements of your commercial building from real property to personal property. This process allows the assets to be depreciated on a 5, 7, or 15-year schedule instead of the traditional 27.5 or 39-year depreciation schedule of real property. Thus your current taxable income will be greatly reduced and your cash flow will increase. This savings generated may be used to reinvest in the business, purchase more property, pay bonuses etc.
It’s simple, legal and recommended in the August 2004 issue of the Journal of Accountancy for CPAs.
The good news is that you can still complete a cost segregation study in 2011 and claim the benefits in your 2010 tax return!
If you are the owner of commercial properties valued at $300,000 or greater, contact me to determine if a cost segregation study can save you taxes and increase your cash flow. There is no charge or obligation for this analysis. I can quickly let you know the expected benefit you can expect as well as the total cost of performing the study.
Posted in Banking Lending Management Uncategorized by .
Many owners know in their hearts that they built their businesses to create a legacy. Their companies do important work in a unique way with a team that they hand-picked and groomed over many years. These business owners take a parental view of the business, caring for it and the employees, always building upon the strengths and core values of the company. The business provides a nice lifestyle for these owners as well as a strong identity in their community. To say that the business provides much more than simply surplus cash flow would be an understatement.
For these owners it is somewhat inconceivable that an outsider would own their business. Therefore, these owners spend time giving careful consideration to the internal transfers that are available to them and how to empower their managers with future ownership.
There are three (3) primary methods of transferring a business internally. First is a management buyout, next is an employee stock ownership plan (ESOP). And finally, there is the option of gifting ownership to family and others, which this newsletter will not cover as gifting strategies do not generate a ‘buyer’ for company shares.
This post reviews the pros and cons of each of these internal transfers, providing insights into what details owners should focus on when considering a transfer to their current employees (and/or family).
Let’s begin with the idea that your managers will buy the business from you.
Management Buyout
So you look to your management team and think that your transition out of the business may best be handled internally and privately by selling to your managers. You are willing to give the managers a fair shake so long as they can behave like owners and make their payments to you. After all, you got these employees to help you grow the business successfully, why not just reshape your coaching and get them excited about buying you out?
Three (3) Big Benefits to Internal Transfers
There are three (3) major benefits.
First, you provide an opportunity to the people closest to you to own and run your business into the future.
Second, by transferring internally to your managers, you get to avoid the incredible disruption that often accompanies a sale to an outsider.
And, third, you get the flexibility to structure a transaction that is tailored to your personal timing, needs and, perhaps, has a high degree of tax efficiency.
All of these benefits sound wonderful but they come with a very large assumption – namely, the fact that the business will continue profitably without you.
The Cons of an Internal Transfer
What price might you pay for this internal transfer? Well, it all depends upon whether your managers will step into their role as leaders for your organization.
In order to navigate today’s complex business world, your managers need to switch from a manager’s mindset to an entrepreneur’s mindset. This is of paramount importance because you need to have a high degree of confidence they will continue to run a successful company (here we are assuming that the managers don’t have a financial sponsor and that your financial readiness is such that you are depending upon the proceeds of this exit for your post-exit lifestyle).
The Hidden Dangers
If you make it past the idea that your managers will act responsibly as owners, you then need to ask another series of questions that could be potential negatives to this transaction:
- Will you be able to come to a price and terms agreement for the sale?
- Will the managers want to sign personally for credit lines and take other risks like you did?
o A subset of this question is whether the manager’s spouses’ will be comfortable with taking these risks.
- Will the managers see this sale objectively or will they think that you overcharged them for the business?
If you have difficulty answering these questions, a large negative to this transaction includes the fact that a failed transaction may cause irreparable damage to the relationship with your managers.
So, many owners will consider these issues and then take a first step towards a future management buyout by initially selling some stock to an employee stock ownership plan, or ESOP.
Employee Stock Ownership Plans (ESOP)
An employee stock ownership plan or ESOP is best seen – at least in the context of this newsletter – as a first step towards an internal transfer. An ESOP [trust] can be created to purchase shares from an exiting owner and, like the management buyout, the cash flows of the business will make the payments to fund the purchase. Like a management buyout, the ESOP is an ‘internal’ transaction. However, unlike a management buyout there are potentially great tax benefits to an ESOP.
The Pros
ESOPs are far too complex and applicable to too many situations to completely list the benefits here. However, some of the key features are:
- The creation of a buyer for shares of stock,
- An internal transaction – privacy is maintained,
- Tax deductions are available (which can be very meaningful),
- It can be a first step towards liquidity and future ownership of the business by the manager.
An ESOP can serve as a great tool to begin your succession and exit planning . . . but there are pitfalls to watch out for.
Like all transactions the ESOP is not without its limits and downsides. Some of the key areas to watch out for include:
- A leveraged ESOP puts non-productive debt on the company,
- A liability is created for the future purchase of shares from retiring employees (this needs to be accounted for over many years by the company),
- There are annual costs and maintenance costs to having an ESOP, and
- The initial fees for setting up the plan can be a bit costly.
So, if you can get comfortable with the pros and cons of an ESOP, it is likely that you will find it a valuable tool for the start of your internal transfer of your business.
Concluding Thoughts
Remember that all exits are challenging and you are not alone with making these tough choices. The best place to turn for advice in this area is to a trained, experienced and trusted advisor. In doing so, you can engage in the detailed conversation regarding the best exit option for your situation. Remember that there is no panacea when it comes to an exit, only choices that are the best fit for your situation.
Do you think of your exit in terms of selling a home where the house is cleaned and painted, the value is relative to other sales in your neighborhood, buyers arrive, papers are signed, proceeds are exchanged, and each party moves into a new and better situation?
Well, the exit from a business is rarely that clean and easy. And, as you investigate the different options for exit, you will quickly see that no exit is a panacea. In other words, the detachment from a business is an event that is both financial and emotional and both elements can last for quite some time . . . no matter how you structure your exit.
This newsletter examines the pros and cons of ‘external’ transfers, reserving discussion of ‘internal’ transfers for another writing.
Although there are two primary exit options for an external transfer, i.e. a sale to either an industry player or an investor (or investment group),
each has its pros and cons and it is likely that neither option will fulfill all of your needs and be ideal for your situation. Let’s begin with the most obvious and intuitive exit option – the sale of your business.
Selling your business
The most obvious exit option for many business owners is the sale of the business to another buyer, perhaps someone in the same industry. The immediate vision that forms is that someone else is going to take care of the problems that you currently face and they are going to pay you handsomely for the privilege of owning your business while you celebrate and dream of spending days in an idle manner, fulfilling the desires that you did not have time for previously.
Let’s take a look at a more realistic picture and why a sale may not be a panacea. Two (2) primary questions arise. First, will the business sale be successful? And, next, what will you do with your time?
Take note that only a small percentage of businesses, less than 20%, successfully sell to an outside buyer. That is an 80% failure rate. So if you do not know if your business is saleable, you may want to hold off on dreaming for right now.
However, even if you discover that you are one of the lucky owners who can successfully sell their business, realize that many business owners find it difficult to see their business being taken over by someone else – sometimes by someone they consider the ‘competition’. And, even if it isn’t a competitor who buys the company, it can be hard to step away and see changes that were not in line with how you ran the company or the goals you had planned for it. Unlike your home, your business is a direct reflection of your life’s work and the relationships that you built within it. It is worthwhile to give consideration to what your business means to you and, moreover, what it means to be the owner of a successful business.
This leads to the larger issue of what you will do with your time if you are not staying with the business after the sale. Sure you have a large investment portfolio and some financial security now that you have sold the business, but how will you replace the feelings of accomplishment and community status when you are no longer in charge of major – or any – decisions at your company.
Private Equity Group Recapitalization
So, if you think that you might want to cash in a majority of the business today and continue working, you may think of bringing in a financial partner – an investor or an investment group such as a private equity group. You might even begin to think that this type of partnership will allow you to continue to grow your business while you stay actively involved as a minority owner in the business.
But here’s the flip-side to that coin. And it begins with a simple question . . . do you think that you can work comfortably as someone else’s employee? Further, do you think you can do so as your new owner makes changes to the business that you disagree with?
Private equity groups typically hold investments – by the way, that is how they look at your company, as an investment – for five to seven years before they look to sell to a larger entity. So, if you stay with the business after the transaction, you need to ask yourself if this period of time will liberate your business to a higher level of accomplishment or will it serve as a period of time more akin to an occupation of it – and of you?
Will you be comfortable with the cultural changes that a recapitalization imposes on your business? Will you be comfortable reporting to a board of directors? Did you really build a business independently so that you could sell a majority stake and work for someone else?
Now, in terms of the financial ‘scoreboard’, you did cash in a majority of your shares for a large sum of money. However, you also exchanged your autonomy for an employment agreement that could be highly disagreeable to your day-to-day running of the business.
There is One Way Out
There is one way out of this dilemma but, if it applied to you, it is unlikely that you would be reading this newsletter. The way out – and when a successful sale does become a panacea – can be when the following apply:
1. You are dispassionate about your business and who owns it in the future,
2. You build a company that is completely saleable to many different buyers,
3. You have the flexibility to work with any type of partners, and
4. You have a definite plan for how you will spend your time after the business sale, and
5. You have an equal amount of dispassion for satisfying the need for success and achievement that the business provides to you.
Once again, this is a rare type of exiting owner and it is unlikely that this applies to you.
How to Choose the Best Exit Path
An exit plan is rarely the process of discovering the right answer to your problem. Rather, it is a calculation of which of the options head you towards achieving the highest percentage of your desired outcomes.
Are you ready to work for someone else? Can you live without the thrill of running your business day-to-day? Which of these options seems best for you? It is your ability to answer these questions that will be the best guide for your future exit decisions and whether or not an external transfer is right and which one is best for you.
Remember that there are trained professionals who can assist you with the process of determining which exit option is right for you. It is highly advised that if this newsletter got you thinking about which option is best for you, then you consult with a trained and experienced advisor to see which options best suit your personal situation. This is known as ‘exit planning’.
Business owners who are looking to their managers and employees to fund the buyout of their ownership in the business most often count on the ongoing, future cash flows of the business to make those payments. Unfortunately, many of these owners do not consider the two layers of taxation that these payments suffer, making the government one of the largest beneficiaries of this lack of exit planning.
Let’s take a look at the mistakes that most owners in this situation make.
The first thoughts that most owners have towards their managers owning their business are consumed with whether or not the managers can run the business without them. The next level of concern addresses the negotiation over a price and terms by which the business will be purchased. In most cases, the vast majority of the money that you will receive for the sale will be paid in the future from the
business cash flows. After all, if your employees and managers had the money to buy your business they probably would not be working for you! Now, assuming that all goes well, your managers will continue to run the business and generate enough cash flow to support the business and make the payments that are owed to you. So far, this all seems simple enough and if you have made it this far, you probably feel pretty good about the transaction overall.
But, let’s take a moment to look at the additional weight that is placed on the business cash flows because no advanced planning was put in place.
Two Layers of Tax
The first thing to recognize about the business cash flow is that all payments to you, the [former] owner are made on an after-tax basis. In other words, the business cannot take a tax deduction for the payments made for the purchase of your stock. Therefore, each dollar that is paid to you is a dollar that was taxed at the corporate rate. Let’s look at an example to make this point:
In order for manager Phil to make a note payment to owner Jim for the amount due for the purchase of Jim’s shares of stock by Phil, the business, Acme, needs to earn approximately $1.50 for every dollar paid to Jim. So, assuming that 1/3rd of every dollar is taxed at the corporate level (the actual corporate rate is 35% but I am rounding down to keep the math simple) we see that Phil and Acme need to generate $1.50 in profits to net $1.00 to pay to Phil.
A Second Layer of Tax
Now, once the payment is received by Jim, assuming that Jim sold his stock to Phil, the proceeds of that sale will be subject to a 2nd level of tax – a capital gains taxation (assuming that the payments are characterized as such) – which is currently an additional 15%. Therefore, when Jim receives the payment of $1.00 he only keeps $.85. Note that this only includes the Federal level of taxation and does not account for the additional Oregon taxes (9+%) or other taxes that may apply to the receipt of this income.
What is left for Jim?
What did the Government Keep?
Using our round numbers, the government kept 50 cents on the first round of taxes at the corporate earnings level and another 15 cents of tax for the income to Phil when he received the payment. This rough and conservative estimate of the
government’s take in this transaction is .65 cents of every $1.50.
A simple equation gives us the relevant percentage:
$0. 65/$ 1.50 = 43.3% of every dollar
Another way of looking at this is to see that Acme needs to earn $1.50 for Jim to end up with $.85 in his pocket (again, excluding Oregon and other taxes).
Back to our management team . . . this structure imposes an additional weight on the earnings and cash flow of Acme for the managers for the duration of time that these payments are being made to Jim. Therefore, Jim has, in many respects, made the difficult job of running Acme without him even more challenging by burdening his payments from the managers with two (2) levels of taxation.
Potential for Other Problems
Now, assuming that the managers make the payments to Jim, he may be indifferent because he may be thinking that he will keep the same amount of money no matter who the buyer is. But that may not be the case.
First, we can easily imagine that the managers are not able to withstand all of these tax payments and are unable to make the payments to Phil. This scenario would be every owner’s nightmare who enters into such an arrangement with the management team as the lack of ability to make these payments may likely destroy Jim’s post-exit plans and lifestyle.
Next, we can be proactive about this situation and, with some advanced planning, actually work to reduce the tax burden over time, providing either the managers with more cash flow, or, alternatively, providing Phil with a higher price which is, in effect subsidized by the tax savings. These advanced planning techniques are available and require the input and advice of your advisors to implement for your company.
Concluding Thoughts
Whether you want to benefit the business and managers that you are leaving behind or you want to use these planning concepts to achieve a higher selling price, there are ways to reduce the government’s take and plan ahead to have a more successful exit transaction. Unfortunately, the government will be the largest beneficiary of your lack of planning. There are techniques to reduce this tax burden and it is highly recommended that you check with your advisors on ways to reduce the government’s participation in your exit transaction.
Posted in Banking Exit Planning Lending Management Uncategorized by .
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