Buying and Selling a Business in a Changing Market

Buying and Selling a Business in a Changing Market

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Buying in changing market

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Buying and selling a business is a challenging and calculated process that is influenced greatly  by market conditions. On one hand, business buyers must consider the historical performance of the business they intend to purchase and gauge that against financing options and other acquisition challenges to make a judgment call on how the business would perform post-acquisition.  Business owners, on the other hand, must consider the money they are making now, and weigh that against a pay out and their need or desire to work less.

So what are the conditions in today’s market affecting business sales for buyers and owners?

Here in the middle of 2022 we have a stock market that is trending downward, with interest rates trending upwards. We have continued labor shortages. The cost of goods sold is spiking and supply chain challenges confound producers and consumers alike. We are a couple of years past the beginning of a pandemic which has resulted in a hangover effect within normal  business cycles disrupting them and taking a year or more to ripple through all levels of supply and demand.  Furthermore, the pandemic has had an “Etch-a-Sketch” effect on some markets, erasing what once worked and creating new opportunities and markets where none existed before.

Declining stock markets affect small business sales

While it’s relatively consistent over the long term, as investors consider the stock market as an asset class for investing, in the short term many agree it does not appear to be a viable option for investing due to economic and political uncertainty and other factors, resulting in a bear market. 

As a business intermediary serving business owners in the sale of their small businesses, we are seeing more inquiries for our businesses for sale from investors stating they would rather invest in a small business rather than the stock market because it’s a more controllable asset with higher return options. This is a good opportunity for small business owners seeking to sell their small businesses if they are priced appropriately.

But because businesses are generally valued on cash flow, business owners who command a purchase prices far in excess of what their peers are asking still see long periods of days on the market. And because small business investing continues to be a risky proposition, those which are priced appropriately are getting more buyer interest, and more offers as a result.

Rising Interest rates affect buying a business 

At the same time we’re seeing small business sale interest increasing due to the equity market asset class appearing less attractive, we are also seeing interest rates on the rise creating less attractive financing options for purchasers. 

Prior to and for most of the pandemic the availability of commercial and SBA loan financing at historically low rates for small business had greased the gears of business transactions.   When businesses are financed by third parties, there exists an opportunity to shift the risk of non-payment beyond the buyer and the seller. Most business owners prefer to get paid in full at closing and most business buyers would prefer not to pay the full amount at closing.

But as interest rates go up, financing options become less attractive through the banks as deals simply don’t pencil out as well as they did when interest rates were lower. Much like the real estate market, several points on a loan can make a difference on debt service of thousands of dollars a month on a multimillion-dollar loan. 

Furthermore, with SBA and commercial loan rates normally being adjustable, the fear of rising interest rates adds further instability and concern for using these types of financing vehicles. The result is often more offers which include seller financing, where the buyer asks the business owner to be the bank because traditional bank terms are now less attractive.

This market effect pushing towards seller financing is often less attractive for business owners seeking to sell their business, unless they are looking for an annuity of payments.  Most often they are seeking a lump sum to invest in their next business.  It also takes a great amount of trust and fit between the buyer and seller of the business when seller financing is involved.

Labor shortages and Increasing Cost of Goods Sold affect business transactions

Perhaps the greatest hangover effect of the pandemic in the 2022 business year has been the rise in shipping costs and the rise in the cost of goods sold plus the increased cost and lack of labor to run businesses. As a transaction agent for businesses I’ve never seen such a more pronounced effect on business than these two factors combined.  

Many very strong businesses cite one or both of these issues as  limiting factors for growth and the ability to sell because it’s a problem not just for the current owner, but one the next owner will have to deal with as well.

The Ibba and M&A source Q2 Market Pulse survey cites these factors as the most significant negative factors on transactions. While these issues probably will not last forever, they are having a significant effect on cash flow and reducing value in businesses.

On the flip side, those small business owners who have found solutions to supply chain issues and labor shortages have stood out and have increased their business’s value.  Such businesses are taking market share from those businesses in the majority who have failed in these categories. There’s certainly no shortage of demand for quality businesses that have teams of quality staff, and access to goods that are in demand. 

A final effect of the cost of goods challenge has been a surprising one: an oversupply of inventory for the strong businesses. 

Those businesses who have unprecedented demand and who have overcome supply chain issues are over ordering when they can.  Much like the toilet paper hoarding phenomenon early in the pandemic, there’s a natural tendency to order in advance especially when news reports highlight supply chain challenges. The consequences for a business sale is a complicated one. In general businesses are sold with a “normal” level of inventory, but when a business sells with excess inventory it must be financed on top of the business. 

Many banks and buyers are not comfortable with this added expense. 

Excess inventory can be a benefit for an established business that can navigate supply chain issues, but when it comes to selling a business it can appear as a poor return on equity. As a business intermediary we must look at working capital closely to determine the appropriate method to deal with excess inventory, as well as work in process issues that come up during business transactions as we navigate a changing marketplace.

In Conclusion

As we take a broader view on business transactions during a changing market, it’s clear  these current issues will work themselves out in time. 

The research indicates that multiples of cash flow and EBITDA don’t move more than a few points per quarter, and while the number of transactions goes up and down on a regular basis, business markets tend to be more stable and offer investors attractive outcomes.

What the Great Resignation Means to Your Business

What the Great Resignation Means to Your Business

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Great Resignation 2021

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If you’re a business owner who intends to ultimately sell your business, it’s wise to pay attention to the latest potential disruption to your business. And while it’s always been a factor if you intend to grow and sell a valuable business, the unexpected exit of valuable members of your workforce beginning mid-2021 has reached such epic proportions it’s been named the Great Resignation. I’m sure it’s a term you’ve heard before but it means everything if you care about the value of your business.

According to the U.S. Bureau of Labor Statistics Job Openings and Labor Turnover Survey conducted in December 2021, more than 24 million employees left their jobs in the six months between April and September, 2021. For blindsided business owners, understanding why employees walked away from their jobs – particularly after the worst of the pandemic was behind them – is important.

For the most part, the pandemic served as a reset button for the owners of nearly every business left standing. Revenues changed drastically. Certain businesses benefited greatly by winning more business due to demands that didn’t exist prior to the pandemic. Others lost. And it happened virtually overnight.

Since then, if the business survived and regardless of the direction of its revenue swing, it did so by changing its business model. Costs were cut, certain expenses increased or were added, employees were added and lost. And while all of these changes affected existing employees, very few business owners understood the nature of what was happening.

And that’s because one of the most important assets your business has to offer a buyer is its people. It’s the people in your business who ensure its other valuable assets are developed, nurtured, and preserved in order to consistently have a profitable business.

In simple terms, the assets in the physical and intellectual property form will not produce a profit without the human capital which drives them.

What is Causing Employee Resignations?

Recently, the MIT Sloan Management Review published a MIT Sloan Management Review research study that identified the top five predictors of attrition and the four short-term actions to take to address this huge problem.

What’s been reported in the mainstream media is mostly about employees walking away from their jobs in search of greener pastures – specifically for more money. While this may be true, the MIT study pointed to very specific reasons that had less to do with compensation and more to do with how employees were feeling.

According to the study, when compared to compensation the following issues are more likely to result in an employee’s departure from the company and are the top predictors of attrition during the Great Resignation:

  • A Toxic Corporate Culture – including failure to promote diversity, equity, and inclusion; workers feeling disrespected; and unethical behavior
  • Job Insecurity and Reorganization Issues – layoffs and restructuring
  • High Levels of Innovation – struggles with work-life balance due to unmanageable workloads
  • Failure to Recognize Employee Performance – especially so for high performers
  • Poor Response to the Covid-19 Pandemic

The Great Resignation Means a Reduction in Business Value

After reading this report, I recognized how similar these employee matters which cause millions of employees to exit their employment were to the topics we discuss with business investors and buyers as well as business owners when they are assessing the value of their business.

Why? Again, it’s competent and positive employees that drive the value of a business up. Because without them, all other business assets are less valuable. And so is the business.

When we speak with Private Equity investors and buyers who want to acquire valuable businesses, they ask about the business’ corporate culture and then they verify what they learn! I can’t count the number of deals that have fallen through because of a culture clash between the buyer and the business being sold. I’d be willing to bet it’s the number one reason for unsigned LOIs and failed deals.

Savvy buyers will spend much time during the acquisition process due diligence phase and the post-acquisition planning phase helping employees on both sides of the transaction to feel less insecure due to the inevitable changes that will take place. It’s very important in the long run to get this part of the deal right.

As for work-life balance issues for the employees of highly-innovative businesses, care must be given to improve workload expectations. Again, for the team of employees working on a sale transaction, there is a tremendous amount of work to be done. Not only do the employees on both sides of the deal have to do the work to get the closing behind them, they have to do their day jobs too!

Business buyers and Private Equity investors alike are quick to identify the high performers. They know if a long-term incentive program such as a deferred compensation or phantom stock plan isn’t part of a key employee’s compensation package, many will depart for greener pastures before the deal is done. The absence of such financial incentives for the high performers contributes to a less valuable business. Much less valuable.

Employees who feel the business owners and leaders have their back, especially when things do not go well, are ultimately happy and loyal employees. So it’s not surprising to assume that if an employee feels Covid-19 issues were not handled well, it’s likely they won’t believe the business owners and other leaders will successfully handle the inevitable disruptions created when the business is sold.

There are no shortcuts – you need your employees and they need to be treated well if you desire to build a valuable business.

The MIT Sloan Management study also identified several other interesting facts about the Great Resignation. Certain industries had a much higher attrition rate than others. They included Apparel Retail, Management Consulting, Internet, and Enterprise Software- an interesting mix of both blue and white collar industries.

How to Improve Employee Retention

For many business owners, they believe all they need to do is to provide their employees with competitive or additional compensation to keep attrition to a minimum. Apparently, they are wrong.

The study uncovered four things that are more important to employees than compensation and they include:

Providing employees with Lateral Career Opportunities – especially for those employees who do not want additional responsibilities, however desire to keep learning and contributing to the success of the business

  • Allowing Employees to Work Remotely
  • Holding Company-Sponsored Social Events
  • Arranging for Predictable Work Schedules for All Employees

There is a lesson here for all business owners in the study’s findings. The similarities are remarkable between the reasons behind the Great Resignation and the employee retention issues valuable businesses regularly navigate. The pandemic simply magnified them.

For those business owners who managed to survive, and in some cases thrive despite the pandemic, it’s time to focus on your most important business asset – your employees. Now that you know what the important employee attrition issues are as well as what you can do about them in the short-term, you have a roadmap to help you build a more valuable business.

What is Exit Planning?

What is Exit Planning?

by | Exit Planning | 10 Questions

Business Owner’s Family in the Exit Planning Process

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According to Wikipedia, Exit Planning is the process of preparation for the exit of an entrepreneur from his company while maximizing enterprise value, and thus his shareholder value, during the mergers and acquisitions transaction.

Other non-financial objectives may be pursued including the transition of the company to the next generation, sale to employees or management, or other altruistic, non-financial objectives.

In simple terms, exit planning is a three phase process undertaken by a business owner as he considers transferring ownership to another business or individual(s).

A variety of terms are used by professionals and business owners alike to describe business exit planning.  They may include:  transition planning, exit strategy, and succession planning.  None of these terms define or encompass the full business exit planning process.  Instead, each is a phase or component of the business exit planning process.

Let’s break down its three parts:

1. What is Transition Planning?

In the first phase of an exit plan, the business owner initially devotes resources to improving the value of his business in the eyes of a prospective buyer or new owner.  It is logical to believe a prospective buyer or new owner will pay more for a business if it is profitable over time.  Accordingly, growing the business and increasing its profitability in the three-to-five years preceding its sale makes good financial sense.  Various measures of profitability are used in the transition planning process including: EBITDA, EBIT, and Enterprise Value.  These measures are also used when the business is sold or transferred to a new owner.

Proactively preparing the business for buyer’s due diligence during the sale process is also part of the transition planning process.  Likewise, taking steps to protect the relationships a business has with its customers, employees, and suppliers is necessary during the transition planning process.

A thorough transition plan for most businesses takes one-to-two years to accomplish.  In phase two of the exit planning process, the entrepreneur’s exit strategy should be developed.

2. What is an Exit Strategy Plan?

In order to develop an exit strategy, the entrepreneur must consider his own personal objectives which may include financial goals, business culture, and/or matters of legacy.  Each entrepreneur wants to keep his exit promise on his own terms.  So the development of the entrepreneur’s exit strategy involves matching the “right fit’ new owner with these objectives.

There are a variety of paths to exit business ownership and they include:

  • Sale to a Third Party
  • Sale to Co-Shareholder, Partner or Co-Member
  • Sale or Transfer to Insiders or Management Buyout
  • ESOP – Employee Stock Ownership Plan
  • Sale or Transfer to Family Members
  • Investment from Venture Capital Firm
  • Investment from or Sale to Private Equity Firm
  • Investment from Mezzanine – Convertible Debt and/or Equity
  • Liquidation
  • Bankruptcy

Each of the exit paths noted above have different tax consequences and all may be structured in a variety of ways.  Estate and tax planning is imperative during this phase of the exit planning process.

There are times when the business owner’s personal and business objectives are at odds.  For example, if the business owner wants the new owner to keep the business in its present location while receiving top dollar for its sale, discussions with an international buyer willing to pay a higher price and with intentions of plant relocation would not be a ‘right fit’.  In this example, the top dollar sales price objective conflicts with the desire to keep the business in the same town post sale.

The development of various exit strategy scenarios allows an entrepreneur to begin thinking realistically about   potential buyers or new owners in the context of his personal objectives, before the selling process commences.  This effort saves precious time and resources when the business ultimately is put up for sale or is transferred.

3. What is Succession Planning?

This third, and very important phase in the exit planning process, addresses the need to replace any owners and/or management team members who may exit the business after the sale or transfer occurs.

It also should include business continuity planning or contingency planning in case something tragic happens to the business owners and leaders before a business is sold or transferred to new owners.

Succession planning is vital for the longevity and long term financial success of the buyer.  Replacing executive-level talent is not as simple as hiring new employees.  In many cases, the business owners and executives hold extensive knowledge and, without proper succession planning and its careful execution, the business may ultimately fail.

What is Exit Planning — FAQ’s

When Should I Develop My Business Exit Plan?

As odd as this may sound, you should begin your exit plan when you start your business.  The first part of the exit planning process involves growing a profitable business that would be attractive to potential buyers or new owners.  Growing a profitable business from day one means you are always in a position to exit your business.  Likewise, developing business habits that make your business due diligence proof and protect your valuable business relationships contribute to having a healthy business.

Having said that, if the exit plan has not been started a three-to-five year period is an ideal time frame to start the exit planning process to sell or transfer to a new owner.

How Do I Know I am Ready to Exit my Business?

You don’t know.  And that’s the problem.  Exiting a business may not be optional.  You may suffer an accident or debilitating illness and be forced to exit.  There’s no time like the present to begin the business exit planning process.

Who Do I Need for Business Exit Planning?

Just as It Takes a Village to Sell a Business, it takes various resources to create and sustain an exit plan.  A few of the resources needed include:

  • Business Transaction Attorney – to offer advice regarding tax and estate planning matters and to prepare critical documents
  • Certified Public Accountant – to calculate business tax basis, prepare financial and tax projections
  • Financial Planner – to prepare cash flow projections for personal budget/needs post sale or transfer
  • C.F.O – to assist with business budgeting, projections, and financial reporting
  • Exit Planner – to educate, guide and facilitate the Transition Planning phase; to develop the Exit Strategies; and to  develop a Succession Planning Roadmap to keep all of the above professionals heading in the same direction!

What do the Exit Planner Designations for Advisors mean?

There are several organizations associated with the exit planning profession.  For many business owners, the organizations’ respective designations and membership acronyms are confusing.  So, it may be helpful to clarify further:

The Business Enterprise Institute (BEI) offers advisors training, marketing support, planning software and a network of like-minded advisors for collaboration purposes.  An advisor in the BEI organization may participate at any level they desire and do not need to attend training or be tested for competency to be a member of the organization.  The BEI organization also offers advanced exit planning training course where the advisor may earn his or her CExP designation, which stands for Certified Exit Planner.

The Exit Planning Institute offers advisors two levels of membership once they’ve taken the 5-day course and passed their CEPA (Certified Exit Planning Advisor) designation test.  The basic membership covers the CEPA designation where the second lever offers its members additional tools for marketing and professional development.

The Exit Planning Exchange is a member-based organization of multi-disciplinary professional advisors.  The XPX organization has various groups of advisors who meet in local chapters across the United States.  This organization does not offer its members training or certification.  Instead, its focus is on member networking.

Conclusion

Unfortunately, the business exit planning process and profession can be quite confusing — to both business owners and the professional advisors.  That’s in part because the profession is relatively new so the terms, exit planning steps, and designations are not clearly defined.

If you are searching for an exit planner for your business, ask every advisor your meet, whether they hold a certification as a business exit advisor or not, about their experience in the field.  What have they actually done with real business owners?  Have any of their clients sold or transferred their business to new owners and how did the work they did with the client influence their outcome?  Ask for specifics.

A well-seasoned, successful exit planner will have many examples to share with you and be willing to provide you with their names as a reference!

 

4 Things To Do to Prepare to Sell Your Business

4 Things To Do to Prepare to Sell Your Business

by | Exit Planning | 4 Questions

how do I prepare to sell my business

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As I speak with business owners considering the sale of their businesses in the near future, it’s obvious most are overwhelmingly unprepared to do so.  

The onset of the pandemic has presented an uncertain future for business owners, whether they are hoping to sell their businesses soon or are in the startup or growth stage.  Very few businesses enjoyed an increase in revenue over the past few years.

Unfortunately, shrinking revenue during the most recent year that precedes marketing the sale of a business is problematic.  At best.

With the pandemic in full swing across the globe, coupled with business’ revenue contraction, there are very few owners in a position to put their businesses up for sale.  But even if they do, buyers acquire businesses with a purchase price, terms and conditions based almost completely on the risks associated with the economy, industry and the business itself.

As these risks increase, the offer price shrinks and less favorable terms and conditions are negotiated.  It’s just the way it works.  

While many feel the pandemic has caused business owners to stall out on their plans to sell, I contend it’s presenting business owners with the gift of time to better prepare for a sale and to ultimately achieve a better outcome.

So, what should a business owner do to prepare to sell his or her business some time in the near future?

Aside from right-sizing the business’s overhead costs to line up with its current level of revenue, and looking for opportunities the pandemic may be presenting, there are four things a business owner can do now to prepare to sell.  And more importantly, doing these four things will mean that when a Letter of Intent is received from a buyer, the business will be very well-prepared to survive the due diligence stage of the sale.  

 

1. Organize the Business’ Contracts and Agreements

The first part of this task is to find the contracts and agreements the business has drawn with other parties.  Please understand, doing so is no small feat.

Ideally, each contract and agreement should be scanned into a PDF format so ultimately it may be provided to the buyer.  More on that topic in a bit.  

Then either your attorney or someone on your staff with an eye for details should identify every significant term in the contract or agreement and list them in a summary document.  Terms such as when the contract starts, when it terminates, whether it auto-renews or not, and if advance notification is necessary to terminate the contract or agreement are important.  Assignment clauses are also very important in any contract when a business is sold to a third party as well.  

All of the contracts and agreements should be summarized in a master list which can be sorted by its terms.  Setting this up now will save a tremendous amount of time and will highlight for business owners where certain contracts and agreements may be unnecessary, redundant, or simply need to be renegotiated.  

Undertaking this detailed exercise in advance of a sale almost always results in monetary savings for the business owner — either now and/or when they sell.

Unfortunately, if this step is not done before the business is put on the market, it will be necessary during the due diligence phase of the business sale.  When that happens, the business owner risks the buyer negotiating down the offer price, or the deal not closing due to a problematic discovery in a contract or agreement by the buyer.

 

2. Start Building Your Dataroom

When your business goes on the market, your representative will need to electronically warehouse all of the documents the buyers will be examining.  For many business owners, gathering these important documents is an exhausting and overwhelming process.  

It doesn’t have to be so.  And it’s not a good way for the business owner to start out when they go to market.  It’s a long enough road to travel without adding this stress at the beginning of the journey.

So take stock of the typical documents a business broker or intermediary will request and start to build your own, internal data room.  It doesn’t have to be all that sophisticated.  Just earmark a set of folders on your hard drive, or in the cloud if that is your preference, make certain it’s secure, and begin to gather the documentation.  You will be glad you did so.  I promise.

 

3. Clean Up Your CRM

Having a Customer Relationship Management software system is necessary to succeed in today’s business environment.  Establishing one for the business is typically a game-changer.  However, many business owners agree that without constant efforts to keep the data in the CRM clean, the CRM can be a challenge when buyers take a peek under its hood.

Whether it’s duplicate contacts and companies, inactive customers, very old ghosted prospects, or sloppy documentation management practices, almost every CRM needs attention in order to perform as a valuable asset to the business and to survive the buyer’s due diligence.

During the due diligence phase of the sale, most buyers will want to spend as much time as the seller will allow them to poke around in the business’ CRM.  There’s a lot of information in the CRM and buyers know it.  So, clean it up and put in place the resources to keep it in top shape.  

 

4. Audited Financial Statements

Buyers love audited financial statements because it saves them time during the acquisition process.  But that’s not the only reason I recommend having your financials audited by your CPA firm for the two years before you sell your business.  It’s also because having a CPA audit your financial statements will result in a higher purchase price.  

Most buyers will spend less time during due diligence if the financials are audited.  For example, they won’t worry if something that should have been recorded as liability was incorrectly recorded on the Income Statement as income.  CPAs know better, whereas your bookkeeper may not. 

During the two years preceding the sale of your business, your CPA will have cleaned up the books.  He or she will have removed the business owner’s personal expenses from the Income Statement and recorded the payments to you as either a dividend, distribution or partner draw, depending on your business entity structure.  Doing so, will mean there will be fewer conversations between the buyer and business owner about the necessity to add back expenses to EBITDA or not.  Such conversations force the buyer to ask more questions and slow down negotiations which is rarely good for the seller.

As odd as it may sound, for the business owner intending to sell soon, the pandemic has provided a good opportunity to better prepare for a successful sale.

ESOP as an Alternative Exit Strategy

ESOP as an Alternative Exit Strategy

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When thinking about ways to sell your business, you are likely familiar with the most common strategies proposed by business advisors: selling to a third-party such as a private equity firm or a competitor, or selling to your family.  What your business transition advisor may not have discussed with you is instead selling your business to an Employee Stock Ownership Plan (an “ESOP”).

What is an ESOP?

What is an ESOP?  An ESOP is a type of a retirement plan that Congress created by providing very generous tax incentives to explicitly encourage business owners to sell some or all of their business for the benefit of their employees.

ESOP Exit Strategy

Like a sale to a third-party, a sale to an ESOP permits an owner to receive fair value for the sale of their stock.  Unlike a sale to a third-party, an ESOP provides several ancillary benefits:

  • Maintain the current culture in the business
  • Benefit the larger community by keeping ownership and the business in the local        community
  • Material shareholder and corporate tax benefits
  • Provide a meaningful benefit for your employees that is effectively funded by operations and tax benefits
  • Flexibility to sell only the portion you desire so you can maintain control of the business if that is your desire

If any of these ancillary benefits appeal to you, an ESOP should be explored as a viable alternative transition mechanism.  You can learn more about ESOPs and read some real case studies on sesesop.com.

You can also see real-life experiences of business owners who had the pleasure of sharing the news of an ESOP with their employees:  

NCC Surprise Announcement

Commonwealth Fire Protection Company ESOP Announcement

In later articles we will explore some additional themes, such as:

  •   Tax benefits for the selling shareholder and the company
  •   Different structures for how to structure an ESOP transaction
  •   Valuation and debt capacity for ESOPs
  •   How ESOPs benefit employees

Stay tuned!

What is Exit Planning?

How to Prepare and Include the Business Owner’s Family in the Exit Planning Process

by | Exit Planning | 2 Questions

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Preparing your business for sale involves many parties if done properly. Sometimes the business owner chooses to involve his or her spouse/significant other in the planning process.  And in certain cases, additional family members are also part of this important process and conversation.

 

For the business owner who desires a great outcome, the inclusion of his or her family in the exit planning process, as well as the decision to sell, is vital.

 

Today, I sat down with one of our Featured Advisors, Paul Visokey, to learn about his perspective on how to prepare for the business’ sale and how they include the business owner’s family in the exit planning process.  Paul is a Business Broker with extensive experience working with business owners who undergo exit value planning.

 

Paul shares his insights and advice with me on this important, and often overlooked, topic:

How do you find the inclusion of the business owners’ family members in your planning process most beneficial?

 

Paul points out that It is very important for the spouse especially to be involved in the decision to sell the business.

 

If it is a family business with multiple family members they will all have some input. In some cases with multiple family members having a financial stake I will recommend a business/family psychologist.

 

When working with a business owner and his or her spouse, significant other or family members, and they are seriously considering the sale of their business, what do you find to be the issues that present the most difficulty for them?

 

Paul suggests that the two primary issues include:

 

1) after transition what will the majority owner and CEO be doing for maintaining his “mental” health; and

 

2) what are the financial interests of the family members and do they support the decision.

 

When these issues are raised, what are a few of the steps you recommend to business owners and their families to take?

 

Paul emphasizes that communication is key. Everyone should be heard.

 

Many business owners begin to think about selling their businesses many years in advance of actually doing so.  When should the steps you’ve identified be taken?

 

Paul questions the predicate that many business owners think about selling many years in advance. Business owners should engage trusted advisors such as their attorney and accountant and an expert in exit planning to help them prepare. It is a multiyear process.

 

When a business owner chooses to exclude their spouse, significant other or family in the exit planning process, what typically happens when the business is sold?  Do you see a recurring issue surfacing?

 

This issue is unpredictable comments Paul. The exit planning process should include the spouse and family members to at least set expectations on the timeline. If the process is a surprise to them it can cause an unhappy conclusion to the owner’s career.

 

How do you (or your firm) assist business owners with some of the soft or non-financial issues a business owner faces when planning to sell?  Issues such as the challenge to fill the business owner’s calendar after the business is sold with something to do comes to mind.

 

The question of what the owner plans to do in the future is a critical early question in the process. Just like it can take years to prepare the business for exiting it can take years to prepare the owner for exiting. Paul notes that the financial aspect should be discussed with their financial advisor.

It’s likely you’ve been brought in to work with a business owner who is actively selling his or her business and no exit or business transition planning work has been previously done.  What are a few of the challenges this situation presents?

 

The primary challenge when there has been no exit or business transition planning is achieving the desired equity from the business. When a business owner fails to prepare the business for exit, there is usually a value gap between what the business is worth and what the owner wants.

 

Also, Paul points out that it takes much longer to find the right buyer and ultimately close the deal because the due diligence process becomes a business interrupter.

 

Conclusion:

I wholeheartedly agree with the insights Paul shared with me about the importance of including the spouse and certain family members in the exit planning process.  

 

And unfortunately for the business owner who chooses to skip the exit planning process altogether, he or she will likely bear a financial and emotional cost.  They may not realize this reality until it’s too late.

3 Things to Know About Preparing Your SBA Business for Sale

3 Things to Know About Preparing Your SBA Business for Sale

by | Exit Planning | No Q&A Yet

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If you own a business and decide to sell, you would hope that sale becomes your big exit.  You know what I mean. The exit that allows you to hire a driver, gardener, and of course, someone like Alice from the Brady Bunch (side note: Don’t feel bad if you like that show.  I’d still watch it every single day if I could!).

Before you begin using hundred-dollar bills to light your cigars, let’s talk about three very important facts you need to know as you prepare your SBA business for sale.

Your Buyer Will Have To Get Their Own Financing

I’ve had my fair share of calls from sellers who are in the midst of negotiating a deal for their SBA business who want to know the answer to this popular question:  “Can a buyer take over my loan payments?” And while it would be ideal to simply pass your business loan along to the buyer, in most cases it doesn’t happen.

The reason it doesn’t happen is pretty simple.  Most small business loans focus on BOTH the finances of the business AND the individual guarantor.  In case you didn’t know, bankers are pretty conservative people. Nothing is ever easy with banks, and they always want to examine every situation in excruciating detail in order to be sure they don’t make a mistake.

When it comes to a new business owner assuming the debt of the old business owner, it will be essentially  like applying for the loan all over again. And guess what will happen if the new owner isn’t as financially desirable as the old owner?  They won’t allow the new owner to assume the debt. And guess what will happen if the bank feels the business isn’t performing well? Again, it won’t be allowed.

This is why in most cases the buyer should be trying to line up his or her own financing.  As a seller, you don’t want your deal to be solely in the hands of your lender. If it works out, great.  But the buyer should be looking at other options just in case.

In a worst case scenario, if your buyer can’t get financing, I’ve seen business owners take the risk of staying on the loan as a guarantor and hoping that the new business owner makes the payments.  The risk there is that if the buyer fails to make the payments to you, your neck is on the line and will be the one the bank is breathing down.

Short Sales Are Possible When Selling Your Business

People associate short sales with residential homes, but it happens with businesses as well.  In case you don’t know what a short sale is, it means selling the business for less than what’s owed on it.  If you sell your business for $100,000, but you owe $200,000, you have a short sale.

While a short sale is never anyone’s first choice, they are fairly routine in my world.  Not ideal, but still a workable situation. There are a couple of things you need to know about short selling your business:

Your Bank Will Need To Approve The Sale If You Come Up Short

The majority of business loans are secured by the asset of the business.  This means if you want to sell your business for less than the full balance, you will need the lender’s permission to sell their collateral.  It may seem like a minor thing, but it’s a HUGE deal to lenders. The SBA considers the sale of collateral without bank permission to be a fraudulent transfer of assets.  In other words, even if it’s for a nominal amount, selling your business could sink any chance to settle a deficiency. This is especially true for SBA loans.

Your Bank Will Need To See The Offer In Writing

Many borrowers want to get approval to sell their business before they ever have an offer.  In other words, they want hypothetical approvals. “If I get an offer for $100,000, will the bank take it?” is the type of question I often get.  The answer is that I have no idea. In order for the bank to consider the sale, they want something in writing. It can be a Letter of Intent or Sale Agreement, or whatever boilerplate document  you want to use. The key is to have it outline the price and specifically what’s included (or excluded) from the sale.

You Will Still Be Personally Liable For Any Remaining SBA Loan Balance

If you still owe money after the sale, you will need to either repay it or negotiate a settlement on the balance.  Keep in mind that when it comes to SBA loans, proceeds from the sale of the business will not be a credit towards a settlement.  Any settlement cash would have to come from personal sources, not business assets.

You’ll Probably Need To Hold A Seller Note

This is particularly true of an SBA business for sale.  If your buyer takes an SBA loan, it’s a standard feature that the seller will have to hold a note.  Not ideal, but if the choice is to take a seller note for 10% of the price (or whatever the bank is requiring) or not close the deal, you might not have an option.

To add insult to injury, the seller note is usually subordinated to the bank loan.  In some cases, I’ve even seen banks require no payments on the seller note for a period of time.  And if the borrower defaults on their SBA loan, the SBA can write it into the agreement that you (the seller) cannot take any action until the lender authorizes it.

How to Prepare for Due Diligence When Selling a Business

How to Prepare for Due Diligence When Selling a Business

by | Exit Planning | No Q&A Yet

The business owner selling his or her business often finds it surprising to learn how much  time, money, and energy it takes to endure the buyer’s due diligence process.

This process can be particularly difficult because it’s the last step in a very long journey, one which introduces new emotions to the seller, and in many cases, their spouse or significant other.

due diligence when selling a business

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Today, I asked a two of our Featured Advisors a few questions during our online roundtable session to help business owners considering the sale of their businesses prepare for due diligence.

Mark Fazio is an attorney who specializes in M&A transactions and Neal Isaacs is a business broker in North Carolina.  There’s great wisdom in their advice:

From your perspective, what is most difficult for business owners when they are in the due diligence phase of selling their business?  And how can a business owner prepare for it?

Mark Fazio comments that the due diligence phase of selling a business can really be a test of a business owner’s patience.  Depending on the nature of their business, the due diligence phase can really be a long, grueling process.

Business owners are faced with request after request, and question after question. Contracts, claims, or practices that were seemingly never an issue before (and probably never will be) are examined and questioned by a potential buyer, and business owners often start wondering whether the buyer is stalling or playing games.  But a prudent buyer will not want to leave any stone unturned – just because something has not affected the business to date does not mean that it won’t result in liability down the road!

To prepare for the due diligence phase, a business owner should get all of his/her ducks in a row.  Pull all documents, scan them and set up a data room. If your accountant or lawyer keep records for you, obtain them as well (except for documents that may be subject to attorney-client privilege). Track down answers to obvious questions, such as whether you are still operating under contracts that may be expired by their terms.  Cross every “T” and dot every “I”.

Finally, it may seem cost-efficient to wait to engage your business lawyer until you are more certain that you have a deal, but a good business lawyer can really add value and help you during the due diligence phase to make your business more attractive to potential buyers.  Many issues that come up during the due diligence phase could have been an easy fix if discovered previously, but instead sometime result in a deduction to the purchase price.

Neal Isaacs adds that business owners often feel annoyed or frustrated at the demands of due diligence. It includes a lot of document wrangling for files they may not have thought about others reviewing, or they may have challenges finding them altogether. Having a good system for organizing documents, preferably virtual, for items such as tax returns, employee records, policies & procedures, sales/employee tax filings, and the like will not only make running their business easier, it will also keep them compliant in the event of an audit, and prepare them for the demands of due diligence.

When advising your business owners during the selling process, what do you see as a common misunderstanding about due diligence?  

 

The most common thing  business owners fail to understand is that just because something hasn’t become a major issue to date doesn’t guarantee that it won’t become a major issue in the future, warns Mark.  And for that reason, a prudent buyer has to dig in and get the full picture surrounding the issue.

For example, an employee may have been let go a month ago and never threatened to sue.  But absent a signed release, a potential buyer will want to understand the facts surrounding the termination to evaluate whether the terminated employee may have a potential claim.  

Another common example involves contractual relationships:  how binding is a contract to a third party, and how may a sale of the business impact future business with such third party?

Neal indicates that most owners are understandably concerned about what will be shared early. Neal finds that explaining the process in detail helps them feel more comfortable with this.

Specifically, explaining the length at which buyers must be screened before receiving confidential information, and the fact that they only get to see the intimate documents of the business in due diligence after they have submitted an offer that’s accepted by the buyer.

 

How do you advise your business owners with regard to the other advisors they need when selling their business — especially those advisors who are needed during the due diligence phase?

Mark suggests that a business owner needs (i) an experienced financial expert/representative who can help find potential buyers and get the maximum value for the business and (ii) an experienced business lawyer who can negotiate the best terms of the sale of the business.  In both cases, the advisor can add the most value if they are given full access to the business and the opportunity to gain a full understanding of the business prior to entering into negotiations with potential buyers.

Without good financial representation, a business owner may get 70-80% of what the business is truly worth  . Without good legal representation, a business owner may be giving back 50% of purchase price proceeds to the buyer after the sale for indemnity claims, etc.  Many people dabble in these areas but are not truly experts – a business owner wants a financial expert and a business lawyer whose bread and butter is M&A.

Neal asks his clients to communicate closely with their accountants/bookkeepers regarding the necessary documents needed, and to authorize him or her to communicate with others assisting the business owner. Often a broker can save an owner a lot of time and stress by allowing a business broker to go to the source for the documents needed for due diligence. Similarly, the client’s business attorney should review the due diligence list to ensure that the items being shared don’t violate any laws, especially payroll documents which could include employee’s personal information.

How much control do you exert over the documents which are released to the buyer during due diligence and how do you do this?

Everything should go through a business owner’s lawyer before being released to the buyer, says Mark.  The last thing a business owner wants is the buyer learning about or discovering an issue before his/her own lawyer does.  As stated above, a good business lawyer may be able to jump out in front of an issue and deal with it before presenting it to the buyer.  ‘

A business owner must remember that, during the due diligence phase, even though he/she may have an LOI with the buyer, nothing is a done deal.  If smoking guns are released to the buyer without being properly addressed then it could really shake the buyer’s confidence in the business owner and make them question how the business owner has been running the business.  

 More importantly, timing and presentation of an issue could make the difference between the buyer dismissing the issue or asking for a purchase price reduction and/or special indemnity from the business owner relating to the issue.  

Neal adds that the due diligence should enable the buyer to see the flow of money from the client through the business into the bank accounts and ultimately reported to the federal government. There are many ways to prove this, and often buyers ask for everything because they don’t know what to ask for.

Sharing reports from third parties that support the advertised representation and explaining to them how the business makes money should be enough to overcome document request overload with a reasonable buyer. Furthermore, documents that owners have invested money in such as attorney reviewed Policies and Procedures, employee manuals, and the like can be sampled or watermarked until after the closing, and customer lists should always be converted to a format that reveals qualities of the list without giving away the actual list; a chart of the percentage of customers by county is an example of this.

Is there a common issue discovered during due diligence that inevitably kills the deal?  If so, what is it and how could it be avoided?

Mark cautions that most issues can be dealt with if discovered in time, whether it be through merely getting the buyer comfortable with the issue, allocating the risk surrounding the issue or through an escrow or holdback.  In some cases, an adjustment to the purchase price may be inevitable. The most common “big ticket” issues involve litigation claims, tax defaults or non-compliance, ERISA non-compliance or contracts with key customers or vendors.

Anytime there’s a discovery that the business could be run in a manner that is not legal, it presents a major issue warns Neal. Examples may include when payroll taxes aren’t commensurate with wages paid, independent contractors are treated as W2 employees, or employees lack proper documentation. All of these type of issues should be mitigated before a business is taken to market and should not be discovered in due diligence. One of the major roles of a business broker is to anticipate challenges that an owner will have before the business is taken to market.

If you were in the shoes of your client who is selling their business, what is the single most important thing they should understand about the due diligence process?

Mark comments that business owners must always remember that the due diligence phase is like a courtship – a business owner really need to focus on getting the buyer comfortable with the business and the risks surrounding it.  So even though it can be a long, grueling process – and at times it may seem like the buyer is beating a dead horse – it is well worth the time and patience!

Neal adds that the due diligence process is the buyer saying, “I want to buy your business; I just need to confirm that you really do own it and that it actually makes the money you represented.” They have to check because they’re writing you a really big check and validating these things gives them the confidence they need to sign it!  

Can I Sell My Business For Less Than I Owe the Bank?

Can I Sell My Business For Less Than I Owe the Bank?

by | Exit Planning | 40 Questions

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For many businesses, the ultimate goal is to sell the business.  Can you picture it? Walk away from the daily stress and aggravation with a fat pile of cash.  Hop a plane to your favorite tropical destination and spend the rest of your days lounging a white sandy beach, sipping pina coladas out of a coconut, without a care in the world.

Well, friends, the above scenario is the ideal scenario.  I like sipping cold drinks on a beach as much as the next guy, and I hope that happens for you. But if you clicked on this article, you may be looking at a much different scenario.

And that’s what this article is going to cover: the less-than-ideal scenario.

I spend my days helping borrowers who can’t repay their SBA loans, but this advice is applicable to many types of small business loans.  So let’s set the table with an example:

When you bought your widget business, you took a loan from XYZ Bank for $400,000.  Three years later, you’ve had enough, and decide to sell. To your disappointment, your business broker can only elicit offers for $200,000, and you’ve only paid your SBA loan

Your Bank Likely Has A Security Interest In Business Assets

SBA Loan DefaultRemember when you took your business loan and signed that huge stack of papers? One of them was likely a security agreement. In that agreement, the bank took a security interest in all the business assets  Furniture, fixtures, equipment, inventory, intangibles, etc.

The basic idea of the security agreement is that it’s the bank collateral.  If you close the business, the bank has the right to sell the equipment to recover their money.  The bank also has the right to keep their security interest intact until the loan get repaid in full.

So if the bank gets to keep their security interest on your assets until they get paid in full, how does one sell their business for less than what’s owed?  It’s simple: you need to get the banks permission.

This is an important point to stress.  Ignoring it could be disastrous. I’ve gotten lots of calls over the years from business owners who sold their business without getting bank permission.  In addition to jeopardizing any chance to settle, selling the assets that are pledged is could be viewed as a fraudulent conveyance.  In a situation like that, the bank could seek to repossess the assets from the buyer, and obviously cause you a huge problem.  Double it if you pocketed the sales proceeds or used them to pay other creditors.

The bottom line: if the sale price won’t cover the entire loan balance, you need to get your bank’s permission.

Buyers Will Require Clean Title To The Assets

Selling a business is similar to selling a home in many ways.  When you sold your house, your buyer (or their attorney or title company) made sure that they took “clean title” to the property.  This means that there are no liens or encumbrances other than the mortgage you take to purchase the home.

In other words, the BUYER requires that the assets come to them free and clear.  And guess what? Same deal when it comes to business assets. The reason why this matters is that a buyer only wants the asset, not the accompanying liability.  The last thing a restaurant owner would want is to pay $1000 for a commercial pizza oven, only to learn it has a $350K lien against it.

Selling The Business Without Bank Permission Can Kill A Settlement

When a buyer seeks to “short sell” their business, the bank immediately asks: “how are you going to repay the remaining balance?”.  That’s where the settlement comes in, or in SBA terms, Offer In Compromise.

But here’s the thing.  In order to settle an SBA loan, the SBA specifically states that there must be no fraud or misrepresentation.  Selling assets that your bank has a security interest in can surely be interpreted as fraud or misrepresentation.  Your bank won’t like it, the SBA won’t like, and your buyer won’t like it.

Since the end goal is walk away with no further liability, you’re best bet is do everything by the book.  That means submitting any offer to the bank once you have one, and ensuring that all the funds from the sale are transferred to the bank in the matter they see fit.  Some banks are fine with you getting paid directly, then sending a check to them. Other banks want checks made out to them directly to avoid any chance of the funds going anywhere but to them.  If you are unsure, ask! Always err on the side of caution.

Conclusion

Yes, it’s possible to sell your business for less than you owe to your small business lender.  If you find yourself in this situation be sure to clear any sale of business assets that is not part of normal operations with your lender first.  Assuming there is a deficiency that you can’t afford to repay, you’ll want to consider an Offer In Compromise (i.e. a settlement). If your lender thinks you tried to pull some shady maneuvers, that will make the settlement process considerably harder.

Selling A Business: How to Prepare for the Exit

Selling A Business: How to Prepare for the Exit

by | Exit Planning | No Q&A Yet

selling a businessJim Beach, author and serial entrepreneur, interviewed Exit Promise founder Holly Magister on his radio show School for Startups Radio.

We want to share some of the insights from that interview here on the blog. This is the third post in this series, and Holly discusses the steps business owners should take to prepare their business for sale.

Jim: So I’m up and running, I’ve had 5 years of success now and my business is doing really well and throwing off a really good income. Maybe I have some employees and a partner. What do I do to start getting ready to exit? I’ve decided I’m either getting close to burnout and I just want to get rid of the thing and move on, or I’m 63 and I want to sell it before I retire at 65. What are some of the things that I can do to get my business ready for an exit, whatever that looks like?

Well there are probably 25 different things that you could do, but for your listeners I think the takeaway for them should be to get your financial health in order. And what I mean by that is make sure that your financials are properly prepared. Make sure your CPA is completely on top of what it is that you’re doing, which means you should be meeting with them more than once a year.

There are three levels of financial preparation that a CPA can offer you: one is a compilation, the next level is a review, and the third level is an audit. If you’re not doing a compilation, start one. Have your CPA do a compilation. I would recommend doing a review, which is the second level of preparation. The third is an audit, and again depending on the circumstances – who you intend to sell your business to, the size of your business, which implies how much money you have to spend on this – then you should consider doing an audit.

A buyer is going to want to see three years of financial statements. Yes, they’ll look at your tax returns, but if you have a review done, which is where I would highly recommend starting, they’re going to be much happier with that. And likewise you can take that next step up and have an audit done.

But don’t go out there and try to think you can sell your business when your brother in law (no offense to anybody!) is doing the tax returns as a side gig, and there’s no consistency and you’re running all of your personal lifestyle through your books. You’re going to have a hard time selling a business. Again, there’s probably another couple dozen things that you can do, and it does take several years to properly prepare your business for sale, but that’s the main issue that most business owners loathe, and they pay for it in terms of their angst they go through and ultimately how much cash they end up putting in their own checkbook.

Listen to the full interview here. For the second post in this series, click here.

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Exit Planning Starts When You Launch Your Startup

Exit Planning Starts When You Launch Your Startup

by | Exit Planning | No Q&A Yet

exit planning for entrepreneursJim Beach, author and serial entrepreneur, interviewed Exit Promise founder Holly Magister on his radio show School for Startups Radio.

We want to share some of the insights from that interview here on the blog. First, read about how Holly recommends entrepreneurs can plan for the exit from the very beginning.

Thinking About the Sale of Your Business When Launching Your Startup

Jim Beach: How, at month one, can we think about the exit? What are some of the concerns both from a tax strategy and planning wise that we should be thinking about? What, at day zero, should we be including in our thoughts for 10 years into the future?

Well, it actually should occur before month one even begins. And what I mean by that is if you are able to properly plan for the structure of your business – how the business is formed, whether it’s an LLC, a partnership, or a corporation, and the various ways that tax elections can be made – if you’re able to do that before you actually start your business, the selling of your business becomes much easier.

It’s one of those old sayings, “Start with the end in mind.” If you do intend to sell your business at some point, that should be an important factor regarding how you choose to form your business entity.

So as an example, if you started a catering business and you have a family that loves to cook, you’ve been doing this for years and years as a hobby, and it’s something that you bring your family together around the table and do, you may not have any intention of selling your business. You may intend instead to pass it onto your children and your grandchildren. That may be a different decision that’s made or needs to be made as opposed to someone who’s building an IT company like you did, Jim. If you build an IT company, chances are pretty good you’re not likely going to pass it onto your children and grandchildren, so you may want to consider some of the other alternatives, whether it’s an LLC, or a C corp, or an S corp.

Again, those decisions depend on who you intend to sell the business to. So those are things that really should be given some consideration. ‘

Frankly, what I find happens is most business owners, they just say “I’m going to start a business entity.” They think, “Well my friend, he’s got an LLC, so that’s what I’m going to do, too.” And they do a little bit of Googling, and they figure out what an LLC is, and they may even find that they can form that on their own on a website online. They don’t even have to call an attorney. So they had no advice about what forming an LLC means, and they have absolutely no clue what the tax consequences will be or the fact that they can actually make certain tax elections if they form an LLC.

They don’t have any idea what that means when they go to sell their business, not to mention all the steps along the way – compliance with the tax laws, compensation, how that’s handled – it all differs according to the business entity.

So to answer your question, the decisions that will impact the sale of their business really should occur before they even start their business.

Listen to the full interview on exit planning and more here.

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ESOP vs. 401K Plan – Definition and Benefits to Business Owners and Employees

ESOP vs. 401K Plan – Definition and Benefits to Business Owners and Employees

by | Exit Planning | 58 Questions

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 ESOP

 

The method chosen to transfer ownership of a business for sale is one of the most important factors to consider as a business owner. And the reason for its importance is related to the wide differences in the amount of cash received (net of taxes) by the business owner across the various methods of transfer or sale.

An ESOP or Employee Stock Ownership Plan is one method of ownership transfer or sale business owners consider when they decide it’s time to retire. That said, let’s explore the ESOP as a potential method of transfer or sale from both the business owner’s and employees’ perspectives.

How Does an ESOP Work?

When a company wants to set up an ESOP, it establishes a trust fund. The company then contributes new shares of stock or cash to buy existing shares. The shares are divided among employee accounts within the trust. Vesting schedules vary between individual plans, but employees must receive vested benefits on either a cliff vesting schedule, which is 100% vested after 3 years or less, or on a graded vesting schedule, which provides 20% vesting every year after the second year of employment.

Employers pay ESOP distributions when employees leave the company. The employee is given the stock they have accrued, and the company must buy back the shares at a fair market value if there is no public market for them.

How Does an ESOP Get Funded?

There are three main ways ESOPs get funded.

1.  The business can put new shares directly into the ESOP trust fund.

2.  The business can put cash into the fund to buy existing shares.

3.  The ESOP can be used to borrow money to buy the business’ stock shares.

All company contributions to the fund are tax-deductible.

Is an ESOP a Qualified Retirement Plan?

ESOPs are qualified retirement plans, meaning they satisfy requirements laid out in Internal Revenue Code Section 401(a).

Despite this, employees should not depend on an ESOP as the sole method of financing their retirement.

For instance, if the company stock fails to increase in value or decreases, the employee’s benefit remains flat or loses value.

If the company closes completely, the employee will lose their benefits entirely.

And while varied investment options exist after an employee has participated in the ESOP for 10 years and has reached 55 years of age, ESOPs can lack essential diversification.

The ESOP vs 401K Plan

Both ESOPs and 401(k) plans are retirement accounts offered by employers.

With a 401(k), the employer’s contributions are tax-deferred, meaning that the money is taken out of each paycheck before taxes, and those wages are not taxed until withdrawal.

Whereas with an ESOP, employees also do not pay taxes on the shares in their account until distribution.

In both situations, employers may offer matching contributions.

 

Selling Your Business to a Competitor

 

How is an ESOP Beneficial to a Business Owner?

ESOPs are beneficial to business owners in several ways.

1.  The owner can sell part or all of their shares to their employees, while still retaining control of the business operations.

2.  Establishing the ESOP trust also ensures there is a market for the owner’s shares.

3.  Transfers to an ESOP allow the business owner to defer or bypass capital gains taxes.

4.  ESOPs come with even more tax benefits:

a.  contributions of stock and cash are both tax-deductible.

b.  when the ESOP is used to borrow money, both the loan repayments and interest are also tax-deductible.

5.  Allowing employees to own part of the company can also result in increased loyalty and productivity, as they have the ability to  impact the value of the stock directly.

How an ESOP may be Beneficial to Employees

If the company has done well, an ESOP account may have performed better than typical investments in an index fund.

Contributions to the ESOP are also permitted to grow tax-free until the distributions are paid. When employees receive their ESOP distributions, they have the option to roll them over into an IRA or other retirement plan and avoid paying taxes until the money is withdrawn for retirement.

Exit Planners: Help Business Owners Make Companies More Profitable

Exit Planners: Help Business Owners Make Companies More Profitable

by | Exit Planning | 2 Questions

exit plannersMy business partner, the author Jack Beauregard, and I recently had breakfast with Lorraine McGregor from Vancouver, BC Canada. Lorraine is the author of books on Exit Planning and Entrepreneurship, as well as an experienced business consultant. We were all discussing why so many business owners were delaying (the inevitable) transition planning from their businesses.

A lot of talking

Lorraine talked about how she had spent 3 years speaking about the need for exit planning, hired a person to call major trade organizations in an effort to reach business owners and had countless conversations with owners (and other advisors). Not much changed. One day she said enough, this isn’t working; but what will?

It’s about profits, stupid

Lorraine then said something prophetic. Because business owners who have consistently profitable businesses have more exit options, those in the exit planning community should start talking about helping business owners make their companies consistently more profitable. Sounds simple, and yet I see too few advisors doing so, or even talking about it.

In her typical fashion, Lorraine didn’t just say this over a nice meal along the Charles River in Cambridge, MA. She changed her model to focus on what business owners really wanted to hear. Guess what? It’s working now. But then she did something else. She recently wrote a book about it, How to Increase the Value of Your Business Before You Sell… and Make it Profitable Now! It’s a quick and solid read for a business owner of any age, and advisors would do well to read it too (it’s available everywhere).

Toughen up and get a framework

In her book Lorraine instructs exit planners to ask tough questions along the lines of “Do you still have the fire to move forward, to make the business become more profitable?” If not, she added, your exit options will be much, much fewer. She describes what a saleable company is, and asks you to compare yourself. If you are lacking in many areas, it is better to know now than when you want to sell. Other topics include what dealmakers look for in a company, as another benchmark to measure your company. She then talks about a four step framework that any business owners can set up.

You are not so special

She did research on businesses and business deals with Capital IQ in Canada (but I am sure they correlate to the US and beyond):

  • There are 3.6 million businesses
  • 70% wanted to sell in the past five years
  • 199,474 actually got a deal done
  • 7 million Owners who wanted to sell are STILL running their unsellable companies today or have CLOSED. These owners are (or were) unaware of what it took to become a sellable business
  • There is $10 Trillion in wealth looking for saleable businesses

I hope, I hope, I hope

I couldn’t agree more with Lorraine’s main points. I really hope more advisors get the message and start collaborating with others who can help the owners make their businesses into saleable companies, before they talk about exit planning. I hope business owners also get the message that they can’t do it alone – but that there are really great people such as Lorraine and her husband Rob, who will help them drive up the value of their companies, so they can retire to better lives. I hope owners see that a profitable company is one part of a better life, and that they need to create plans for a new life after they leave the business, or they risk ending up with more money but a less meaningful life, which truly would be a shame.

 

How to Calculate Customer Concentration Risk

How to Calculate Customer Concentration Risk

by | Exit Planning | 3 Questions

Customer Concentration Business owners should be aware of the relative size of their top customers (or clients) sales revenue to their business’ total revenue.

All it takes is a simple division computation to reveal a customer’s relative size in terms of gross revenue.  If calculated properly, a customer concentration may be confirmed.

The business may have a customer concentration risk if one or more of its customer’s total revenue for the year represents 8% or more of all its customers’ revenue for the same year.  To many business owners, this concept may sound counter intuitive.

For many feel the more business done with one customer the better.

While it is generally good for customers to increase their purchases of goods and services with a business, unless the remaining customers do so in similar fashion, the growing concentration of revenue from one (or more) customer(s) creates risk for the business owner.

How to calculate customer concentration

  1. Divide the revenue from your top customer for the last twelve months (or calendar year) by the total gross revenue of your business for the last twelve months (or calendar year).
  2. If this amount from 1 above is less than eight percent (0.08), you do not have a customer concentration risk.  You can relax!
  3. If this amount is equal to or greater than eight percent (0.08), you have a customer concentration risk with this customer.
  4. Repeat the calculation with each of your customers using their gross revenue one-by-one from the greatest to least gross revenue in a given year until the calculation is less than eight percent (0.08).
  5. Every customer with gross revenue which exceeds eight percent (0.08) of your business’ total gross revenue represents a customer concentration risk for your business.

Business owners should also look at the top customers/clients that represent the majority of its revenue to determine if there is an industry concentration.  If more than 25 % of a business’ income comes from a single industry, this can be problematic as well.

Should that industry fall into hard times or out of favor, the business could suffer.  And that’s true even if no single customer represents a large portion of the business’ revenue.

Determining if a customer concentration and industry concentration exists in a business is an important part of the exit planning process for one very simple reason.  When selling a business, the savvy business buyer will determine if one or more customer or industry concentration risks exists and if so, they will most likely reduce their offer price or possibly walk away altogether.

Learn more about how to manage the risks associated with customer concentration.

Key Questions When Transferring Your Family’s Business

Key Questions When Transferring Your Family’s Business

by | Exit Planning | No Q&A Yet

Family BusinessAnyone who owns a family business is intimately familiar with the blood, sweat, and tears associated with building and then keeping the business viable.  It’s very hard work. 

Nevertheless, it is not unusual for the business owner to postpone consideration of various issues involved in transferring the business to the next generation, including determining the value of the business.

This lack of preparation is often one of the reasons the risk of failure increases as family businesses are transferred to succeeding generations and a business exit startegy is not formulated.

As an analogy, think of selling a business in much the same way as selling your home. The time to address issues is not on the cusp of a sale, as this reduces bargaining power. Rather, prepare the home before you list it for sale. Similarly, you must prepare with family business succession planning if it is to occur successfully. In anticipation of this most important event, here are a number of points to ponder.

  • What is the value of the business?

    Determining the value of the business is essential to an effective exit plan, even if that plan involves giving the business away at death. Unless an owner has a realistic understanding of value, it is impossible to understand the tax implications of the transfer.

    Just as important, if the business will be transferred to certain family members, excluding others, knowing the value of the business is imperative if you are attempting to treat family members fairly. That’s why utilizing the services of a professional appraiser is essential and need not be cost prohibitive.

  • To whom should the business be transferred?

    While the fair minded business owner would certainly like to treat each of his or her heirs equally, unless all of the heirs work in the business, it’s utopic to think that transferring a business in this fashion. Generally, this situation can breed resentment, especially if certain heirs work for the business and draw a salary, while the rest of the heirs contributed no effort to grow the business and/or receive little if any benefit from their ownership.

    If the entrepreneur does not wish to leave the family business equally to his or her heirs, then are there other assets that can be used effectively to make non-business gifts to other heirs? But if the business’s value is substantially larger than the balance of the individual’s other assets, this type of distribution may not be possible, particularly following the payment of death taxes.

  • Have you Considered the Impact of the Family Business State on Inheritance and/or Estate Taxes?

    In this vein, how much federal estate tax and potentially state inheritance and/or estate tax will be payable at the death of the business owner?

    In 2022, only those estates in excess of $12.06 million will be subject to federal estate tax.  For most business owners, having an estate at death worth more than the current taxable amount, especially if married and able to double this exemption amount to $24.12 million, would be a great problem to have! 

For those who do, careful consideration should be given to determine if there will be other available funds to pay those taxes? And if so, will those funds be depleted to the point where parity no longer exists between those intended to receive business versus non-business assets?

Or, if an estate plan is structured so that the estate taxes attributable to the business interests are to be paid by the recipients of those interests, will those individuals have their own money to pay the taxes?

business valuation reportIf a business is the entrepreneur’s largest asset in her estate, taking action during his or her lifetime may be the only way to ensure success in transferring the business to the next generation, including minimizing what can be an unmanageable estate tax at death.

Such action may include a thoughtful lifetime gifting program, or a partial sale of stock to those individuals. Some form of a valuation discount may apply to the sale of some stock, particularly a minority interest, may be subject to some form of valuation discount, thereby enabling the transfer of a greater percentage of the company to the intended recipients. A sale of stock may also increase the pool of funds that ultimately will be utilized to pay estate taxes, or make gifts of non-business interests.

 

 

 

 

 

 

 

 

The Importance of a Buy-Sell Agreement

The Importance of a Buy-Sell Agreement

by | Exit Planning | 2 Questions

Buy Sell AgreementFor every entrepreneur, a smooth transition of business ownership will be of importance at some future point. The Buy Sell Agreement deals with a specific exit strategy case. An agreement by and between business owners, it establishes a mechanism for the purchase of ownership interests following the departure of an owner due to a triggering event (i.e., death, divorce, disability, retirement, etc.).

The primary purpose of a buy-sell agreement is to maintain ownership and operations within the existing management/ownership group; avoid interference from the exiting owner’s family; provide liquidity to pay estate taxes/retirement; avoid disputes with the exiting owner’s family regarding succession and value; and provide for a smooth transition to the next generation.

The two most common types of buy-sell agreements include:

  • Cross-Purchase Agreement: Agreements where the remaining owners buy out the interest of the withdrawing owners.
  • Entity-Purchase Agreement: Agreements where the company buys out the interest of the withdrawing owners.

Negotiating Offers and Terms When Selling Your Business

Once the type of buy-sell agreement has been determined, the next step is to determine the valuation mechanism to be included in the buy-sell agreement. While there are a variety of valuation mechanisms to choose from, the following three mechanisms are most often utilized:

  • Fixed Price Agreement: The price of future purchases are set at a specific dollar amount by stating a value for the equity of the company.
    Advantages: All owners agree to a price and know what the buy-sell price will be.
    Disadvantages: (1) The fixed price becomes outdated due the constant evolution of a business; (2) Owners seldom know the true value of a business and set unrealistic prices; and (3) Different triggering events may cause different values (i.e., death of an owner, retirement of an owner, removal of an owner, etc.).
  • Formula Agreement: Establish value by providing a specific formula based on a multiple of the company’s operations.
    Advantages: Once the formula is selected, the specific calculations necessary to determine the buy-sell price are known.
    Disadvantages: (1) No formula selected at a given time can provide reasonable and realistic valuations over time; and (2) Depending on the timing of the triggering event, the value of the interest may be unrealistic.
  • Business Valuation Agreement: Outlines a process by which future transactions will be priced (i.e., they define the valuation process). These agreements call upon the use of one or more business appraisers to determining the price at which contemplated future transactions will occur.business valuation report
    Advantages:     (1) Provide a defined structure or process for determining the price at which future transactions will occur; (2) All parties agree what the process will entail; (3) Owners obtain a qualified independent expert opinion rather than determining the value themselves; and (4) Attorneys are familiar with the business valuation process.
    Disadvantages: (1) The price is not determined now; (2) Can become costly; (3) Uncertainty over final value in the process can be stressful; (4) Owner uncertainty over what will happen when a triggering event occurs.

Based on the above, it is strongly suggested that owners consider the use of a business valuation as the appropriate valuation mechanism within the buy-sell agreement. Due to the complex nature and importance of selecting the appropriate type of buy-sell agreement and valuation mechanism, it is strongly recommended that legal counsel be engaged to assist in the process of selling a business.

 

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