Dan Reiter, CFP®, CPA
Abraham Lincoln famously once said, “Give me six hours to chop down a tree and I will spend the first four sharpening the axe”. For the small business owner, selling or transferring a business is likely the most important financial event in their lives. Unfortunately, few owners dedicate the time and resources necessary to first “sharpen the axe” in preparation for the sale. One survey of business owners uncovered that only about 20% have a written plan to transfer their business.[1] As a result, some owners end up taking a few wild swings with an exit strategy that lacks optimal depth. Others end up with an unsuccessful attempt at making any cut at all.
A key first step in preparation of exiting a business is considering the options on to whom the business may be transferred. Once the path is identified, it is helpful to understand some of the common mistakes that others have experienced that have traveled it first. Although not an exhaustive list of options, three paths are discussed below in selling a business:
To a Key Employee (or Group)
To Family Members
To A Third Party
A Survey of Owners’ Expected Exit Paths[2]
Selling To Key Employee(s)
Common Mistakes
Not Assessing Aptitude and Desire
Retaining Too Much Risk
Waiting Too Long to Plan
In a sale to key employees, first, the owner must make an honest assessment of each successor employee’s skill, ability, and desire to be owners of a business. A critical note - both skill and desire must be present for a successful transition. Skill as an employee often does not translate into being a skilled business owner. Communicating early and often with potential buyers is the key to success. In those communications, current owners (and their advisory team!) should be clear with successors on all the potential risks for buyers and how they can be minimized.
Second, insiders rarely have the cash necessary to complete an outright purchase of the business. As a result, careful planning must be undertaken to help the owner sell for the most value and least amount of risk possible. Most banks will not write loans to purchase the goodwill of a business (meaning any value not directly tied to physical assets). The Small Business Association will write such loans, but they usually require that the successor owner put 10-20% of the selling price down or already have a 10-20% equity stake. Without a plan to get equity in the hands of successors, owners are often forced to be the bank through an owner financed deal. The problem? The realization of the business value is still tied to the business risk, even once the owner retires and loses control!
The main key to success is to start early. A two-phase sale approach, for example, may afford a high degree of flexibility: (1) the owner agrees to sell a significant (but minority!) portion to the key employees, and (2) the final transition of shares. Upon completion of phase one, the owner has more options to choose from. For example, they can retain the right to sell to a third-party, cash out through insider obtainment of outside financing, or maintain ownership into the future. To gain the maximum flexibility in these options, however, the two-phase approach often takes several years to complete successfully. Owners should work with an experienced tax and financial advisor (with the help of an attorney) to develop the most effective plan to maximize the after-tax dollars received.
Selling To Family Member(s)
Common Mistakes
Not Assessing Aptitude and Desire
Ignoring Equality Concerns of Non-Business Children & Family Members
Not Incentivizing Non-Family Key Employees
The importance of assessing skill and desire is as important, if not more so, for sales to family members. Studies reflect that more than 60% of U.S. family-owned businesses do not transition to the second generation.[3] Often, struggles related to transitions are due to an ill-equipped second generation. Owners should take great care in assessing the skill and desire of their second generation as much as they would any non-family successor. Similarly, communication early and often on the risks and expectations of ownership are keys to success.
For most owners of family-owned businesses, maintaining harmony at the Thanksgiving table is one of their primary goals. Both business and non-business active children have very different perspectives that likely require reconciliation. For example, business active children may believe that they deserve to receive a share of the business in return for their “sweat equity” and may be demotivated if they find themselves in partnership with their siblings that do not work in the business. Conversely, non-business active children may perceive favoritism if they feel they are being cut out. Careful communication and estate planning can help alleviate some of these conflicts. For example, real estate and other non-business assets may be segregated for the benefit of non-business active children. Working with a qualified estate attorney and exit planning advisor experienced in family businesses is a critical step for any owner of a family business.
Third, failing to consider the contributions to the business of non-family key employees may lead to severe consequences in business profitability and value. Key employees that are often loyal to the parents may be less so toward the children. Development of plans for retaining and incentivizing key employees is a critical to any successful transition. For example, owners may consider implementing a non-qualified deferred compensation plan with requirements of continued employment for a specified period of time following the business transition to earn additional compensation (called a vesting requirement). There are many options available to retain and reward key employees, the loss of which may result in significant decline in profitability, customer base, and value to the next generation.
Selling to a Third Party
Common Mistakes
Not Understanding (and Building) Your Business Value
Not Prepared for Buyer Due Diligence.
Waiting Too Long to Plan For Taxes
What makes third-party business buyers pay top dollar for a business? The value of any business is built upon two very critical foundations: future expected cash flows and the risk associated with achieving them. Therefore, prospective buyers pay top dollar for businesses that have high expected cash flows with high perceived probability of receipt. A company’s value drivers are those qualities that drive the selling price of a business upward, or traits that reduce risk and better the odds to achieving expected financial results. We categorize value drivers into eight broad categories:
Planning
Leadership
Sales
Marketing
People
Finance
Operations
Legal
As part of our Prosperity Business Blueprint process, we walk business owners through an assessment of each of these areas and provide specific recommendations on how to improve from the perspective of a third-party buyer. Owners are often too emotionally invested in their businesses to view them through the eyes of a prospective buyer. The failure to do so, however, often results in leaving a huge amount of value on the table.
The second common mistake made by owners seeking a third-party sale is not being prepared for the buyer’s due diligence process. A buyer’s due diligence includes a review of the financials, inventory, fixed assets, contracts, policies, among other items for unknown risks. Additional risks identified may serve to either result in renegotiated terms or even result in the buyer walking away. Being prepared to go through a due diligence process ahead of time will allow for both a better sale process as well as identifying factors that may be of concern to a buyer before they do. Two acts may serve to better prepare a seller for due diligence: (1) having financial statements reviewed by an independent CPA firm, and (2) getting a qualified valuation. Both a valuation and independent review mirror many procedures and serve as a good “practice run” for the buyer’s due diligence process.
Finally, tax planning is a continuous process that should be started well before any terms of a sale are negotiated. Many sellers make the mistake of only starting to consider tax consequences once they have an offer from a buyer on the table. Unfortunately, at that time many tax planning opportunities may have already been missed. For example, making an S-corporation election may result in substantial tax savings by eliminating the double taxation faced by C-corporation owners at the time of sale. However, such an election must be made at least five years before the business sale to avoid the built in gains tax. Further, many points of negotiation during a sale have either beneficial or harmful tax consequences. Working with a tax advisor that understands and can advise on such points may help serve to significantly increase the after-tax sale dollars.
Mistakes Common to All Paths
There are two critical mistakes often made for all sale options. These mistakes are not understanding what amount the seller needs to be financially independent, and not building the right business and exit planning team to get there. If a business owner understands both what their business is worth today as well as what value they need from the business (after also considering all non-business assets), they can solve for their “gap”, or the amount of business value growth or future income still needed. All successful roads traveled begin by first appropriately assessing the destination.
Once the necessary destination is identified, the business owner should also have the right team in their corner. At a minimum, owners should have a good comprehensive (and fiduciary) financial advisor, estate attorney, business attorney, and tax expert well versed in business sales. Working in the role of financial and exit advisor, we often help clients establish the right team and serve as the “quarterback” to ensure better communications and efficiency by eliminating overlap in responsibilities. An experienced team working in collaboration for the business owner leads to better synergies, which means more time and better outcomes for owners.