FACT: All business owners will exit their business eventually, and only half will do so according to their plans.
From the pages of In Business magazine.
Business owners, look around. If you and your business peers were gathered in a room today, half may not be there tomorrow, according to statistics cited by IB blogger Martha Sullivan, partner and succession planning practice leader at Honkamp Krueger & Co. in IB’s January finance feature, “Mistaken Value.”
Sullivan said 50 percent of business transitions or business exits will be forced by an unplanned event — death, disability, divorce, or disagreement.
And, as discussed in January, among the 70 percent of business owners who think about the value of their business, only 13 percent of companies have done an actual valuation to determine if the number will be sufficient enough to fit into their retirement strategy, according to Mass Mutual’s 2018 Business Owner Perspectives Study.
Too often, business owners work in their business rather than on it and fail to recognize that it probably is the largest part of their net worth.
Are you prepared? Whether you choose to retire or get hit by a bus tomorrow, could your business continue without you? More importantly, would you want it to?
We asked two attorneys and two CPAs who deal with this every day to chime in on the process. Our thanks to Joe Boucher, co-founder/shareholder, Neider & Boucher; Joe Bartol, member, Stroud, Willink & Howard; Bruce Hutler, partner, Baker Tilly; and Ellen McGuire, tax partner, Johnson Block CPAs for taking time to comment.
Whether a young entrepreneur or a seasoned veteran, business owners need to plan for the inevitable, and these are some questions to ask:
1. Why are you exiting? Do you want to fund your retirement? If so, what is the financial nut you need to crack? Is it reasonable?
“An owner often gets an idea in their head that they need to retire on a million dollars, but that may not be the real value,” notes Hutler of Baker Tilly. “It’s a pipedream.”
2. Can the business operate without you?
If so, great! Who is being groomed to replace you?
If not, what needs to be done to see that the transition goes smoothly?
Business owners must know who their successor or buyer will be. If it’s not someone currently on staff, does this person still need to be recruited? Will it be a family member? (Careful, not all are qualified.) Perhaps an executive wants to turn the company over to the employees. Businesses can even be gifted, in whole or in part, to a family member if estate tax laws are followed.
Or, are you hoping to sell to a third party?
3. Assemble your business allies, including a law firm, CPA firm, and wealth managers to work with you throughout the process.
“Professionals take the emotion out of the discussion,” notes Johnson Block’s McGuire. “It’s always good to know what the business is worth and what you need for retirement. If there’s a gap between the two, there are strategies that may help get to the value you need to sell it for.”
Professionals can also help prevent challenges the IRS might launch, particularly in gifting situations.
Tools for transitioning: The buy-sell agreement
The buy-sell agreement has been called a pre-nup for business partners, and in reality, it is. Business partnerships fail, just as many marriages fail, and divorce and family businesses can pose the greatest threats to the longevity of a business due to the emotions involved.
Drafting a buy-sell agreement counters emotion with a framework that everyone agrees to. It can be revisited and changed as directed by the agreement.
Business owners often refer to the buy-sell agreement when they’re getting ready to sell their business, but Bartol at Stroud, Willink & Howard defines a buy-sell as a set of provisions within a shareholder’s agreement for a corporation, or an operating agreement for a limited liability company. It directs multiple owners what to do at the time of an exit, which could include a sale.
The agreement determines what happens if one business owner dies or retires, and the remaining owners want to buy his or her interest in the business, Bartol explains. “A buy-sell will determine whether a surviving or remaining owner has to buy the exiting owner’s interest, how the price is determined, or whether the remaining owner has the right or option to buy the exiting owner’s interest in the business.” It will also lay out the terms of the arrangement should the remaining owner exercise that option.
A well-crafted agreement spells out everything from the owner’s plans to when and how often to appraise or value the business based on triggering events.
It can also detail how to handle a stalemate should one occur down the road. That’s why agreements should be completed as early as possible, when all partners or family members share the same vision and are more likely to agree to terms.
Other points to consider: If one or more partners exit early, how much would they get paid and how should that amount be determined?
Boucher, of Neider & Boucher, offers his opinion: “If I’m meeting with three or four people who are forming a new company, I usually tell them that within three years, one will be gone. They may look at me incredulously but there’s a high percentage this will be true, and they need to plan for that.”
He suggests a nominal payout for any partner exiting a new business within the first two years. “Often there’s no value in the first couple of years.”
How are assets valued? If real estate is involved, should appraisals be conducted, and if so, how often? “Just to say they’ll have their business appraised is really deficient,” notes Bartol, who strongly advises speaking with an appraiser ahead of a valuation. “I have learned that the instructions you give an appraiser determines whether the value will be higher or lower.”
Another consideration business owners need to consider is payout. “How long after a triggering event do I have to buy you out?” Bartol asks, “and once we close, when is the purchase price due? Will it be all in cash at closing, or due over five years?” These are matters that should be revisited regularly to make sure they make sense.
The reasoning is simple, he explains. It allows a new owner time to prepare, get their finances in order, and secure funding if need be.
“But if we have to close within three months of your death, that could put a real financial burden on the surviving owner and perhaps even break the company, which nobody wants.”
Exit strategy is all about planning for the what if, what if, what if, Bartol stresses, whether the parties are related or not, to avoid disagreements and conflict down the road. Get agreements in writing as clearly — and as early — as possible. Nobody wants ambiguity.
“Litigation is sometimes the only way to resolve a dispute, but it’s seldom the most efficient way.”
Valuing your business
Again, the buy-sell agreement should dictate when and how often business valuations are done, what triggers them, and when and how often appraisers should be called in. Most experts agree that businesses should be “periodically” valued, which could mean every two or three years, yet too often it’s a one and done event, says Hutler. “Often a valuation hasn’t been looked at since the owners first signed it years earlier, and that’s problematic.”
Business valuation is a critical component to an exit strategy and more complicated than people may realize. “It is not just looking at average earnings and multiples,” Hutler insists. “It’s so much more complex.” Potential buyers want real numbers, not “phantom” earnings, so demonstrating the true cash flow puts the owner in a much better position to sell.
McGuire says experts look at historical and projected income and make adjustments accordingly. Is an owner paying themselves no salary or an excessive salary, for example? “We adjust that to what a new owner would likely pay someone else to do that person’s job.”
Business owners should not assume they know their business’ value. Often they don’t consider things like bank debt, for example, which can impact value.
Are there discretionary expenses, such as charitable contributions, that benefit an organization or the community but are not necessary to run the business? Are insurance policies in place to ensure the company will have enough money to buy out a deceased owner’s family? Tax implications could apply depending on who owns the policy.
Valuation professionals also study entire industries both historically and in terms of future potential. “Some industries have trouble finding employees,” McGuire says, “and that can negatively impact a company’s value.”
It’s never too early to devise a plan. “The minute you start a business, you have to think about how to get out of your business because things are happening so fast,” notes Boucher.
If the owner intends to sell a company rather than transfer it to a management team, he or she should begin serious planning three to five years out because they should never assume that a business will be sold quickly.
Whether the intention is to gift a business to family or transfer or sell to the management team or outside buyers, Hutler describes the current marketplace as robust. “Interest rates are low, so there’s a lot more opportunity for an owner to exit a business as opposed to 10 years ago or so.”
The question nobody can answer is: What will it look like tomorrow?
Exit planning can be equally if not more important for sole proprietors looking to one day transition out of their businesses, particularly with a sale. As that day approaches, Bartol urges small business owners to put themselves in a buyer’s shoes.
Turn the tables: If you were buying your business today, what you would want to see?
Assess the following:
- Financial statements from the past three to five years, including tax returns, profit-and-loss statements, and balance sheets. How do they look? Are they impressive or embarrassing in both format and substance?
- Financing. Are there business loans that will come due before selling that need to be refinanced before an anticipated sale date? What about prepayment penalties on those loans that might make closing more expensive?
- Real estate. If you own property, should you consider having an environmental assessment conducted to alert you to any potential concerns and allow time to resolve them? “It’s better to know now rather than letting the buyer discover any issues, which could terminate a deal or delay a closing.”
- Title. Does the real estate title have any blemishes on it? Again, better to know now, especially if the property has been in the family or around for a long time.
Business owners often try to lower their income to minimize their tax liability, but that may not be the most appealing to a potential buyer looking for cash flow numbers. Is that something you might want to change prior to selling?
Bartol urges parties not to overlook the psychological component. An exit strategy is more than legal documents, the purchase price, or the money. He learned that lesson years ago as a young attorney.
“I didn’t realize that this particular business wasn’t just an asset [my clients] were selling, it was their life. It was how they identified themselves and how the community related to them.”
That’s another benefit to getting the transition plan in writing early on, Bartol emphasizes. Thinking about exiting five years or so in advance helps owners begin distancing themselves and preparing for life beyond the business.
“It should be a great thing, but it can also be very sad.”
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