When two streams of thought begin to converge, owners begin to take a serious look at exiting their business.
The first stream is feeling you want to do something besides go to work every day: either you would like to be someplace else—doing something else—or you simply feel it is time to move on.
The second stream is thinking you have reached or are close to reaching financial independence and/or could do so by selling your business
Ideally when these two streams converge for you, will your business be prepared for your exit when you want and on your own terms?
Like contingency planning, it is never too soon to start planning for your exit because doing so has an immediate and continuing positive impact on the success of your business.
The exit panning process described below originated over 20 years ago and it has been continuously refined by the experience of thousands of owners and their advisors. While each exit plan is as unique as the owner who creates it, properly crafted exit plans have several signature characteristics
- They are in writing so that all involved can measure their progress toward the owner’s goals
- They incorporate accountability by holding the owner and each advisor to deadlines for completing each task
- They increase business value both in the short term and long term
SUMMARY OF SEVEN STEPS
Before we dig into the details, here are the questions each step answers. It is often very valuable to think about how you’d answer each one.
Step 1: Set Exit Objectives / Goals.
Have you determined your primary planning objectives in leaving the business such as:
- Your desired departure date
- The income you need to achieve your financial objectives
- The person to whom you want to leave the business
Do you have secondary objectives such as taking care of certain employees or continuing the family legacy?
Step 2: Quantify Available Resources
Do you know how much your business is worth?
Do you know what the business’s cash flow is likely to be as and after you leave it?
Do you know the amount of income you can expect to receive from your non-business investments after you exit the business?
Step 3: Focus on Business Value
Do you know how to increase the value of your ownership interest?
Do you know how to protect the business value you’ve already created?
And do you know what actions are necessary to minimize income taxes not only today, but also when you transfer ownership?
Step 4: Sale to Third Party
Do you know how to sell your business to a third party in a way that will maximize your cash and minimize your risk and tax liability?
Step 5: Transfer to Insiders (co-owners, family members or key employees)
Do you know how to transfer your business to family members, co-owners, or employees:
- Without losing control of the business until you have all your cash in hand
- While paying the least possible taxes
Step 6: Develop a Contingency Plan for the Business
Have you done what it takes to ensure that the business continues if you do not?
Step 7: Develop a Contingency Plan for the Owner’s Family
Have you provided for your family’s financial wellbeing and continuity should you die or become incapacitated both before and after your ownership transfer?
THE SEVEN STEP EXIT PLANNING PROCESS
STEP 1: SET EXIT OBJECTIVES / GOALS
Seneca, a philosopher in ancient Rome said, “When a man does not know which harbour he is heading for, no wind is the right wind.”
This advice is as sound for business owners today as it was centuries ago. Yet, few owners heed or appreciate its warning and do not develop exit plans because:
- They are simply too busy working in the business
- And/or they find it too emotionally wrenching to contemplate separating from a business they have created, nurtured, lived with, suffered with, brought to maturity and in which they have totally immersed themselves
If these two statements ring true for you remember, it is never too soon to start planning for your exit because doing so has an immediate and continuing positive impact on the success of your business.
Where Do You Start?
It is difficult, if not impossible, for any planning professional to engage you in a planning process until you are emotionally prepared to begin planning. Decades of experience has proven the best way to become emotionally prepared is to base your exit planning on your goals.
The Romans believed that “Victory loves careful preparation” and we know that preparation starts with setting clear, simple exit objectives.
There are three straightforward exit-related goals that, once established, allow owners to cut through a lot of muddled thinking and accelerate their progress. They are:
- Setting a target date for your exit
- Deciding how much annual after-tax income you want/need during retirement (in today’s dollars)
- Choosing to whom you want to transfer the business, e.g.:
- Family
- Key employee(s)
- Co-owner
- Outside third party
- Employee Stock
- Ownership Plan (ESOP)
No owner can effectively begin planning (or acting in an efficient and coordinated manner) to leave his business without establishing these goals. Many owners set other goals as well, such as:
- Maintaining family harmony
- Providing for one or more employees
- Transferring wealth to family members
- Getting maximum value for the business
- Giving to charity
- Taking the business to the next level – with someone else’s money
- Living a life of significance
Remember, your goals direct all subsequent planning efforts and actions. You are the person primarily responsible for this step, but you need not work alone. We have decades of experience in creating and implementing exit plans for owners with varying goals, in a variety of industries, and at every stage in their ownership lifetime.
STEP 2: QUANTIFY AVAILABLE RESOURCES
A universal ownership objective is to secure the income stream that you (the owner) and your family will need to support a future lifestyle. Three elements constitute your financial resources:
- Business value
- Non-business sources of income
- Projected business cash flow
A Word About Business Value
Knowing the value of the business is critical to developing a successful exit plan because for most owners their businesses constitute their most valuable asset. Accomplishing your financial goals depends on converting that asset to cash. Based on an owner’s knowledge of the current value of the business, owners and their advisors can determine:
- If an owner’s financial objective scan be met at present through a conversion of business value to cash
- Or how much the business value must grow to reach the owner’s financial objectives
- And how quickly the business value must grow in order to meet the owner’s desired exit timeline
(If you want more information about business valuation, ask us for our Business Valuation White Paper.)
STEP 3: FOCUS ON BUSINESS VALUE
There are three parts to focusing on business value:
- Increase the value of your business
- Protect its existing value
- Minimize current tax liability as well as liability when you transfer ownership
Increase Business Value
An inevitable by-product of a well-run business is consistently increasing value. There are numerous actions an owner can and should take to maximize value including:
- Maintaining and consistently increasing cash flow
- Creating, using, and continuously refining efficient and effective processes, systems, and technology
- Documenting the sustainability of earnings
- Motivating and retaining key employees
This step goes to the heart of a successful business and to the essence of your role within the business: to enhance value. And it clearly illustrates how exit planning has an immediate and continuing positive impact on the success of your business.
Minimize Risk
A future buyer may not even consider purchasing your company if there’s a risk its value will decrease. Have you taken steps to make sure your key employees stay with a new owner after you exit?
(We have White Papers regarding key employee incentive plans and other Value Drivers. Just ask.)
Minimize Tax Liability
There are several tax-minimizing techniques owners employ as they work toward their exit. Charitable Remainder Trusts, Employee Stock Ownership Plans, Defined Benefit Plans, and lowest defensible value are examples of tools we use to minimize taxes.
It is important to know that it can takes years to reap the benefits from most tax-planning strategies. This is another reason why it is never too soon to start planning for exiting your business.
Given that both income and business tax rates are likely to increase, can you afford to wait to investigate various tax-saving strategies?
STEP 4: SALE TO A THIRD PARTY
There are a variety of ways to market a business for sale, but if your company is worth at least $5 million, one of the best ways to reap top dollar is to have an investment banking firm orchestrate a competitive (or controlled) auction.
In a competitive auction, multiple qualified buyers come to the negotiating table at the same time, all with the same information, and all prepared to make an offer for the company. This process maximizes sellers’ leverage and enables them to select the sale price, deal structure, and on-going operating philosophy that are most attractive.
Key to the success of this process is the ability to bring many qualified buyers to the table at the same time.
Of course, competitive auctions don’t just happen. They take careful preparation, marketing, and execution. If you are considering a sale to a third party as your exit route, we suggest you read “Cash Out Move On— Get Top Dollar and More Selling Your Business” by John H. Brown and Kevin M. Short. It shows you how to prepare for and stay in control of the process.
If your company is worth less than $5 million, you may be able to retain the services of an investment banker skilled in competitive auctions, but more likely you will use the services of a business broker and engage in a negotiated sale. Again, a key to success is using the most capable broker available.
STEP 5: TRANSFER TO INSIDERS (COOWNERS, FAMILY MEMBERS OR KEY EMPLOYEES).
Owners who wish to transfer their businesses to family, co-owners or key employees must:
- • Minimize the income tax consequences of the transfer to both the seller and the buyer
- • Minimize the departing owner’s risk of not being paid the entire purchase price by having the owner stay in control until he or she is fully paid
The reason we emphasize these two conditions is simple: the buyer(s) (children, co-owners or key employees) have no cash.
Minimize Taxes
The only way you (as the owner/seller) will receive your purchase price is to receive installment and other payments (directly from the company) over an extended period. All the money you receive will come from the income the business earns after you depart.
That’s why it is imperative that your exit plan minimizes tax consequences to the business and to the buyer in order to preserve a greater part of the company’s cash flow for the departing owner. There are several techniques we can use to accomplish this.
Minimizing Ownership Value of the Business.
The lower the price paid for the ownership interest, the fewer dollars are subject to the double-tax whammy. The first whammy is the income tax charged to the buyer (key employee, co-owner or family member) and the second whammy is the capital gains tax assessed against the seller (the departing owner).
In other words, for the seller to receive money for his ownership interest, the company must first earn the cash that the buyer pays tax on when he or she receives it. The buyer then pays that after-tax amount to the seller as partial payment for the ownership interest and the seller (owner) pays a capital gains tax upon receiving that money. Hence, there is a double tax on each dollar of cash flow earned by the business that is used to pay for the departing owner’s interest in the company.
Create Unfunded Obligations
The best way to protect the business’s cash flow from the double tax is to create unfunded obligations to the owner from the business long before the actual transfer.
These obligations include:
- Non-qualified deferred compensation for the owner
- Leasing obligations between the owner and the business such as a building or equipment
- Indemnification fees
- Licensing and royalty fees
Reduce Risk by Maintaining Control
The best way to minimize a departing owner’s risk of not receiving the full purchase price is to keep that owner in control until he or she receives every dollar. To accomplish this, your exit plan might include one or more of the following techniques:
- Securing personal guarantees from the buyer, including business and personal assets
- Holding a controlling interest in your company until financial security is assured (One technique is to use a two-phase process in which the insiders purchase a minority interest in the business)
- Remaining involved in the company until you are satisfied that the cash flow will continue without you
Transferring a business to children, co-owners or key employees is a high-risk venture. The ace in the owner’s pocket is usually the option to sell to an outside party if the insider/buyers are unable to fulfill their obligations.
STEP 6: DEVELOP A CONTINGENCY PLAN FOR THE BUSINESS
One of the benefits of developing an overall exit strategy is that you quickly appreciate how contingency planning is an integral part of it.
Taking prudent measures so that your business continues if you don’t is a natural part of the planning process. In the ideal situation, business continuity needs (upon the death or incapacity of an owner) can be met by a business continuity agreement with a co-owner. Most businesses, however, are solely owned.
If sole owners do nothing else, they have a duty to their families and to their businesses to create written plans that answer the following questions:
- In my absence, who can be given the responsibility to continue and supervise:
- Business operations?
- Financial decisions?
- Internal administration?
- How will these people be compensated for their time and, most importantly, for their commitment to continue working until the company is transferred or liquidated?
- What should happen to the business at my death or permanent incapacity?
When owners make the decision to begin transferring their businesses, the last thing they are likely to consider is the need for adequate planning to protect the business if they should suddenly die or become incapacitated. Yet this is precisely the point when the business is most vulnerable: it has peaked in value, but the event creating liquidity (the sale of the business) is likely years away.
The remedy is usually straightforward: adequate legal documentation in the form of a buy-sell agreement or a stay bonus program for important employees with adequate funding.
STEP 7: DEVELOP A CONTINGENCY PLAN FOR THE OWNER’S FAMILY
With this final step, the exit planning process comes full circle. Review your financial objectives established in Step One: if you don’t survive until your business exit, what financial resources will your family need and where will they come from? What actions can you take to minimize or avoid estate taxes?
As a business owner, your estate plan is another part of your overall exit plan. Unlike some of your lifetime objectives (e.g.: financial security), estate planning objectives and business continuity objectives are relatively easy to meet upon your death or incapacity. To acquire the liquidity sufficient to meet your financial objective, consider the purchase of life insurance and disability insurance. Using insurance, you may be surprised at how easy it is to meet death objectives.
Once owners complete the first two steps of the process (Setting Objectives and Quantifying Available Resources) they often jump to preparing appropriate estate planning documents and funding of financial needs by insurance. By minimizing the financial impact their death would have on their families and their companies’ ability to survive, owners find greater confidence to continue doing the essential work ahead.
CONCLUSION
All of the techniques that produce operational business success (learning from mistakes, developing business strategies based upon experience, trial and error, and conducting business efficiently and effectively) do not guarantee a successful business departure.
Sadly, the valuable experience owners develop over the course of their business lives does not equip them to leave their businesses successfully. Experience, learning and “trial and error” all require time—a luxury most business owners do not enjoy as they approach the end of their ownership lives.
If all this planning sounds complex and time consuming, it need not be. We can help create a written and comprehensive exit plan that achieves your goals in a time and cost-efficient manner. Our exit planning process:
- Is based on your objectives
- Includes all seven steps summarized in this article
- Holds you (the owner) and all advisors accountable
- Provides a means of measuring your progress toward a successful exit
- Imposes deadlines to ensure you and your advisors act in a timely manner
Armed with a written exit plan, a team of skilled and experienced advisors, and with (ideally) several years before you exit, you can optimize your ability to leave your business in style.
This article contains an overview of the Exit Planning Process. We have other articles describing, in detail, many of its elements. Please contact Keith Brown if you’d like additional information about how we can help you create an exit plan to meet your specific objectives.