Even in the best of times, selling a business is a multifaceted process fraught with risk. In the current economic climate, what you don’t know could be fatal. Even so, there are techniques that can be employed to avoid many of the dangers. For many small and medium business owners, today’s economy may present an unprecedented opportunity to shore up your exit strategies and achieve maximum value for your most important asset. Here are some notable numbers:
- Recent estimates show that 63% of business owners do not have a formal exit plan.
- Over 90% of North American companies are privately held.
- According to the US Census Bureau, there were over 25 million US corporations in 2004, most of which were closely held sole proprietorships, partnerships, or LLCs.
This means nearly 16 million companies have no formal exit plan.
AICPA – Succession Planning Studj 35% of multi-owner businesses and 9% of sole proprietorships (sole proprietorships and sole proprietors) had a written succession plan in 2008, compared to just 25% of multi-owner businesses and 8% of sole proprietorships in 2004.*
Current status of succession planning Multi-owner companies Sole proprietors
Started the plan and will complete it soon. 35% 7%
Will start the process in the next year or two 32% 43%
Starts the process in about 5 years 10% 23%
Starts the process in about 10 years 3% 3%
Have a plan drafted but not officially approved 9% 3%
*The 2008 PCPS Succession Survey by AICPA
These undeniable numbers make a compelling case for aggressively pursuing the most advanced strategies and cutting-edge techniques to plan and execute exit strategies, estate/wealth preservation plans, and strategic plans for the 21st century.
As an entrepreneur in today’s economy, business growth (or lack thereof) and trying to manage day-to-day operations will dictate how you will spend the majority of your time. However, there is no more compelling reason than the current economic situation for you as a business owner to take steps to capitalize on trends and opportunities that result in better valuation, reduced tax consequences and smoother transitions when your liquidity event comes to fruition. Your future after you exit is also important. The earlier you plan for all contingencies, the better.
What are your options?
Traditionally, there are two main avenues you can choose: sell to an external third party or transfer to insiders such as your employees or family members. There are two main avenues entrepreneurs can take when they decide it’s time to move on to the next phase of life: selling the business to an outside party or transferring the business to “insiders” such as family members or Employee. Of course, one could also liquidate, but that is usually not the path taken, rather a forced or hardship path if no buyer turns up or other circumstances intervene.
Today, when selling to a third party, there are a few options that need to be carefully considered, including transferring 100% ownership or retaining a portion of the equity. While it may be tempting to walk away with a large chunk of cash, in the current state of our economy it may not be practical or in the seller’s best interest.
Given the current economic climate, this may not be the wisest strategy for owners in industries where valuations are negatively impacted by the economy. Sell 100% of their shares when the market value is at a record low.
Some examples are real estate related businesses, construction companies, automobile manufacture/sales and retail stores. Instead of a cash out, a second option is to sell just a portion of the equity and keep a portion. The retained equity can be either a minority or majority interest. In certain cases, a partial sale may be desirable as it allows the selling shareholder to take some of their net worth out of the business, allowing them to diversify some of their wealth while retaining some equity for potential future appreciation.
In uncertain economic times, the opportunity to free up some of your net worth can help the company grow and thereby increase the valuation of the retained interest in the company. More importantly, by selling a fractional interest in your business, you can share future business risks and opportunities with a partner.
Acme Corporation was valued at $10 million and owned by a single shareholder. However, given the current economic climate, the sole shareholder decides to sell 70% of its ownership to an outside party. The result is a liquidity event where the selling shareholder receives $7 million in committed equity. The seller negotiates an agreement to remain involved in running the company, with a new owner bringing a fresh perspective to the company’s management and operational structure. Retaining a significant minority equity interest and joining forces with the outside buyer will set the stage for the selling shareholder to participate in future growth when the economy recovers. This scenario also gives the buyer the certainty that the seller still has “skins in play”. This participation in the company is beneficial for both the buyer and the seller. With a carefully crafted plan, the seller is positioned so that the 30 percent stake could be worth significantly more than it was at the time of the original transaction.
Another approach is to implement a plan of transmission to insiders such as family members, management or employees. In the case of family succession, internal transfer can be used to reduce certain tax consequences. Because in today’s environment, the tax burden should decrease due to lower valuations. We’ve found that company valuations are generally lower than they were a year or two ago. The factors causing this range from low revenue, lower profits, tight credit, and lower valuation multiples.
The resulting lower valuations present exceptional opportunities to transfer ownership interests to family members through a variety of techniques that shield or defer tax events and achieve several other succession plan benefits. Since interest rates are still relatively low, these techniques continue to improve. Additionally, if your goal is to prepare the company for another sale to an outside party at a later date, the current climate is conducive to recapitalizations and intra-family transactions to shift ownership and save on taxes when the company goes to the outsider future is sold. A warning notice; Since there is a very real possibility that hyperinflation could devalue our currency, you should carefully consider where to invest the funds you receive at the time of transfer and hedge against any eventuality. In addition, such inflationary conditions could reduce or eliminate any gains you may have from the retained interest.
The current economic crisis can also favor a sale to your employees. You may want to sell through a management buyout to select key managers or through an employee stock option plan (ESOP). Again, lower ratings mean better economics for buyers and potential tax savings for sellers.
How should you proceed
Planning an orderly succession and achieving maximum liquidity from your final disposition of your business requires a team approach. By bringing together the combined experience of respected tax, legal, insurance and finance professionals, you get an integrated strategy that addresses the multiple facets of your exit plan.
Case study #1
John Smith, a 70 percent owner of ABC Manufacturing, LLC, wanted to plan his exit strategy. The value of his ownership interest in the company was $4 million and he wanted to retire in 5 years, but the question was how? Through the use of state of the art techniques, ABC Manufacturing, LLC has agreed to borrow $4 million over a 5 year period to fund the premiums of an indexed universal life insurance policy for John’s life. John could then start receiving life insurance payouts after he leaves the company. The end result – this approach exceeded John’s expectations and delivered over 249% of what John expected for the value of his property.
Retiring Owner: Male, 46 Expected value of owner’s shares: $2,500,000 Pension payouts begin at age 55 Annual pension payouts: $263,611 for 30 years Net death benefit: $659,700 Total benefits from this approach: $8,568,037 Share of the owner’s expected value achieved with this solution: 343%
Retiring Owner: Male, 43 Expected value of owner’s stock: $8,000,000 Pension payouts begin at age 50 Annual pension payouts: $760,125 for 20 years Net death benefit: $13,758,412 this solution: 362%
For these business owners, employing our recommended techniques have enabled the business owners to meet their business succession planning needs and provide funding for a smooth ownership transition while also providing potential tax-free retirement income.
For another example of a strategy that reflects current methods, read this Wall Street Journal article: Wall Street Journal Article
What is your exit plan?
If you’ve been procrastinating on planning or executing your exit strategies, now would be a good time to stop procrastinating and put your plan into action. The current atmosphere offers opportunities that we will not see for years to come, if at all. Now is the time for you to act. Just like death and taxes, you will eventually walk out of business. Will your exit be on your terms or someone else’s?
Stop rationalizing, stop stewing. Get out of your chair and start doing! DennisWaitley