Three Questions Every Business Owner Must Answer
Start preparing your business for eventual transition now
Nathan Corbitt, CPA, CFA, CFP®, CExP™
Partner | Wealth Advisor
Business owners spend years, possibly decades, pouring their heart, soul and much of their wealth into making their business successful. Unfortunately, most business owners haven’t spent much time planning to capture the value they’ve created. That is, they probably don’t know how they’re going to sell their business.
In the United States, approximately 6 million business owners will attempt to sell their business in the next decade1. Most of these owners expect to be able to simply sell their business when they are ready much like they would sell a house. As a result, they haven’t spent adequate time planning for their exit and data shows that less than one-third of these owners will be successful. Unfortunately, most will leave millions of dollars on the table when they choose to sell.
Over the years, we’ve met with scores of owners and have experienced first-hand why some owners are tremendously successful at exiting their business, and on their terms. Sadly, not all owners share this success, and most often, the factors driving failure are both predictable and controllable. In fact, we’ve found these patterns to be so predictable, that before we help business owners develop a plan to sell their business, we require them to answer three simple, yet revealing questions.
Question #1: How Much Do I Need to Sell My Business For?
The first question, is “How much do I need to sell my business for?” In other words, business owners must know how much money they will need in retirement to be financially independent. Answering this question requires both an understanding of the owner’s annual expenses as well as how much wealth they’ll need to cover these expenses throughout their retirement.
Many years ago, I met an owner who netted enough from the sale of his business so that his family could comfortably spend about $100,000 per year for the rest of their life. The problem was that his family was accustomed to spending about three times that amount each year. Unfortunately, this entrepreneur’s advisors didn’t realize this before the transaction was finalized, and as a result, the owner spent the next decade starting another business to close this gap.
Spending often changes when a business owner retires, but it is ill-advised to assume spending will dramatically decrease. Being successful requires business owners to do the math and fully understand what their annual spending needs really are, including travel, taxes, lifetime goals such as a second home, and even inflation. Once these amounts are clear, they’ll need to calculate the amount of investment assets they’ll require to support this lifestyle. This process can be complicated and including a skilled financial planner in this conversation is a wise decision.
What are My Outside Investment Assets?
The next step to answering the first question is understanding the value of any investments the business owner has outside of the business such as a stock portfolio or real estate. This piece of information is vital since the greater their assets outside of the business are, the less they’ll need from the sale to be financially independent in retirement.
This information is also critical because, outside investment assets afford greater leverage while negotiating the sale. For example, a business owner with $5 million invested in stocks, bonds and real estate has more leverage during negotiations than an owner whose only investment asset is their business. Inevitably, having this additional flexibility increases the value you will receive from the sale.
As an example, let’s assume an owner has half of their required assets in investments outside of the business, and they receive two offers from prospective buyers.
The first offer is on the lower end of their projected price range, but the buyer is willing to pay all cash. The second buyer, however, is willing to pay a significantly higher price. But this offer is a combination of cash, owner financing at above market rates and a small continuing equity interest in the business.
Even though the price is lower, without the necessary outside investment assets, the owner would almost certainly have to take the first offer because the cash is guaranteed. Without the outside investment assets, the second would unwisely put the financial health of the owner’s retirement in a company they no longer control. But by having significant assets outside of the business, this owner now has the flexibility to consider the second offer, and the higher price, because it no longer generates unmanageable retirement risk.
What is My Business Worth?
The final step in answering this first question is knowing what the business is currently worth. Most owners believe they have a general idea of their business’s value based on stories they’ve heard about the sale price of a “similar” business. However, they don’t consider business specific factors such as the experience and independence of their management team or the diversification of their cash flows. These factors (and others) will significantly impact a business’s value.
Others base their ideas on a price multiple of their current earnings but don’t understand that their valuation will be based on a range of multiples. For example, if businesses in their industry are valued at between 3- and 6-times earnings, and their current earnings are about $5 million, they should expect a sales price to be between $15 million and $30 million. But whether their sales price is at the top or bottom end of that range, will largely be determined by the quality of their earnings and the risk of future cash flows to a prospective buyer.
Business owners should understand that throughout the due diligence process, buyers will adjust earnings and reduce the price as they perceive risk in future cash flows. If an owner does not have sound financial statements based on Generally Accepted Accounting Principles (GAAP) or if they are managing their financial statements primarily for tax purposes, they can expect to receive a price based on a lower earnings multiple. If they have a concentrated customer base or if their management team is inexperienced or constantly turning over, their multiple will go down again. However, if they have quality earnings supported by audited financial statements, a strong management team, and a diverse customer base, the buyer’s risk to future cash flows will be significantly reduced. This owner will likely receive both a higher price and better terms at closing. As mentioned earlier, most of the factors that drive valuation are controllable and will determine the earnings multiple the owner will be able to demand. And even small increases in this multiple can add millions in value to the ultimate sales price.
Question #2: Who do I want to sell my business to?
The second key question is, “Who do I want to sell my business to?” This question is critical because it helps business owners identify the likely target buyer while both guiding transition planning and helping the seller understand the likely terms of the eventual transaction. Broadly speaking, there are two types of potential buyers. The first group is an outside third party, such as another business or private equity, while the second group consists of insiders, such as family members or key employees.
Studies have shown that approximately 60 percent of owners identify a third party as their preferred target buyer, and there are several good reasons for this. First, it generally poses less risk for an owner because third-party buyers tend to pay more cash than insider sales, which tend to involve more owner financing.These transactions often incorporate many competing buyers which tends to result in a higher price. And finally, third-party transactions tend to be much faster (usually 12 to 18 months) than insider transactions which sometimes require several years to successfully complete.
Understand the Terms, Just Not the Price
But selling the business to a third party can also have expensive pitfalls for business owners. The first pitfall is when owners hyper-focus on the sales price and lose focus on the other terms of the deal. These terms may include (but are by no means limited to):
- Earn-out Provisions where the owner receives additional compensation that is contingent on the company’s achieving future financial goals.
- Reps and warranties that determine the assertions made by the buyer and seller during the sale agreement.
- Indemnification clauses that describe how one party will compensate the other for any harm, liability or loss arising as a result of the sale.
- Tax liabilities that result from the sale
- Working capital agreements where the seller agrees to leave enough “working capital” in the business so that the buyer can continue to operate the business through the transition period.
Deal terms have significant implications for the ultimate value the seller receives. Neglecting these details can have a dramatic impact on the success or even cause the failure of the deal.
Buyers Have Sophisticated Teams
Another problem for business owners is that most third-party buyers are much larger than the company they are acquiring. As such, they have highly experienced deal teams negotiating on their behalf. Business owners who have never experienced the transaction process are thus at a distinct disadvantage, and to succeed, they must acquire an equally experienced team to represent them through the process.
Recently, I worked with a business owner whose business was expanding rapidly, and because of this growth, the owner was exploring his options for selling. Since the most attractive option was a sale to a large public company, one of our first recommendations was to build out the deal team to ensure his goals were achieved. In this case, we added an Attorney, a CPA and an investment banker to the team; all of whom had substantial deal experience.
The CPA and the Attorney were able to structure the business and the transaction to smooth the sale process and to minimize taxes; saving the owner millions in extra costs. The investment banker, who had significant experience in that market, understood the motivations of the buyer and was able to negotiate a price that was 20% higher than what the owner was anticipating. In addition, their negotiations relative to the working capital adjustment added nearly $500,000 to the owner’s net proceeds! That’s the value of a great team!
Selling to Family Members and/or Key Employees
Selling to insiders such as family members or key employees can prove far more treacherous than most business owners anticipate. In my experience, one of the more common obstacles for an owner trying to sell to family members or key employees is the lack of effective communication.
For example, I recently worked with an owner who is the family patriarch. He built the business, owned it for over 30 years and wanted to sell it to his children who worked in the business. However, in discussing the potential sale, he learned his adult children had no desire to be in business together once their father retired.
In another instance, I worked with an owner who wanted to sell to a trusted manager he had worked with for decades, only to learn that she had no desire to own a business. In both instances, the owners had to change the course of their exit planning which ultimately slowed their ability to successfully exit their business.
Another important note for these owners is to treat insider transactions the same as third-party transactions and bring in transaction experts, such as transaction CPAs and Attorneys, early. Employing these professionals in structuring and communicating the transfer will help to ensure that issues such as taxation, control of the company, and who each person is accountable to, are appropriately addressed. In doing so, both delays and hurt feelings can be avoided.
Lack of Financing Can Often Derail Insider Sales
Most often, owners are trying to sell to family members and key employees who are younger and substantially less financially established than the owner. These buyers simply don’t have enough assets to buy or finance the purchase of a multi-million-dollar business. This reason alone accounts for many businesses failing to transfer from the original owner to the next generation.
The good news is that this obstacle can be overcome with time and effective planning. For example, I recently worked with a company that has been actively transferring ownership to younger key employees for the past decade. Consequently, when the owner is ready to exit the business, these next generation owners will have the financial resources to purchase the remaining company at full value.
Question #3: When Do I Want to Sell My Business?
The Exit Planning Institute’s 2013 Readiness Survey shows that 75 percent of business owners are unhappy within a year of selling their business. In my experience, this unhappiness is rooted in failing to plan for the transition and a lack of vision for what life will be like after a sale. On the other hand, owners that plan well for a sale and life after business can manage and even dictate the terms of their exit. As a result, they are more likely to be satisfied afterward. For this reason, business owners should understand how the question of “when” will impact their success.
Loss of Control
Unfortunately, some owners will be forced to sell their business for reasons they cannot control. It could be the sudden death of a partner, a divorce, a physical disability, a competitive business environment, or simply the loss of passion for the business. For these owners to pass the business on to their heirs, a partner or even a key employee, they must plan accordingly.
Appropriate planning can help identify the risks the owner and the business face. In addition, planning can mitigate the financial and emotional tolls that come with catastrophic events. This is why having a contingency plan in place to handle the most critical aspects of the business is so important. At a minimum, the plan should include:
- How to handle key customer and vendor relationships;
- Ensuring the company’s financial position and investments are maintained during any transition;
- An updated buy/sell agreement for anyone that is part of a multi-owner organization, and;
- Making certain key employees stay focused on their job and remain with the company during the transition to a new owner.
Finally, transition plans must be communicated well to both employees and other vital company relationships.
Even with planning, outside forces will affect the timing of any sale. For better or for worse, the general economy, the business cycle in a specific industry, and even the cycle for mergers and acquisitions (M&A) will all impact, an owner’s ability to sell and demand a premium price. For example, a 55-year-old owner who wants to sell within five years must anticipate where the business cycle will be at that time. If the industry’s business cycle is slowing, that will likely impact both cash flows and the sale price they’ll receive. To receive a premium price, a better option may be to speed up your exit planning or possibly even wait for the business cycle to recover before entering the sales process. Another factor to consider is the strength of the M&A cycle. This cycle tends to mirror capital market liquidity and run for five to seven years before slowing. And as it slows, so do the options of selling for a premium price. So, if the M&A market is strong, waiting three more years before selling could cause an owner to leave money on the table if the market slows.
In one example, I worked with a business owner who planned to work for another decade before selling the business. However, the market environment began shifting away from their traditional business model. After assessing the strength of their business cycle and the strength of the M&A cycle, he made the strategic decision to sell the majority of the business’ assets. In doing so, he not only was able to fully fund his retirement, but also managed to keep the operational side of the business (and the cash flow it generated) fully intact.
Vision for Life After
As business owners consider when they want to sell their business, they should envision their life after the sale takes place. It’s not enough to be at peace with leaving a business they’ve built. They must be clear about the direction of their life going forward.
After all, most business owners are “doers” and not particularly fond of a slower pace. Thus, it’s difficult to go from the constant adrenalin rush of running a business, to a more modest pace. But these are not the only options available. Rather than ceasing passionate endeavors, many business owners can successfully redirect them.
This re-direction may involve travel, contributions and volunteer time with charities, more time with their family and grandchildren, or simply exploring new things. The point is that having a plan for the next phase of life will help determine when it’s time to sell. Ultimately, this vision will solidify the success of their transition out of their business and ease the transition into the rest of their life.
Who Is Brightworth?
Brightworth is a nationally recognized, fee-only wealth management firm with offices in Atlanta, GA and Charlotte, NC. The wealth advisors at Brightworth have deep expertise across the financial disciplines, allowing us to provide ongoing, comprehensive financial advice to families across the country.
This information is provided as a guide to assist you in your financial planning. The examples are provided for illustrative purposes only and are not intended to be specific financial planning recommendations or tax advice. Please consult with a professional for specific questions regarding your particular situation.
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1Study Shows Why Many Business Owners Can’t Sell When They Want To, Forbes.com, February 5, 2017