Even in the best of times, the disposition of a business is a multifaceted process fraught with peril. With the current state of the economy what you don’t know could be fatal. Even so, there are techniques which can be employed to avoid many of the hazards. For many small to medium sized business owners, today’s economy may be providing an unprecedented opportunity to shore up your exit strategies and receive the maximum value for your most important asset. Here are some numbers worthy of note:
- Recent estimates show that 63% of business owners do not have a formal exit plan.
- Over 90% of North American businesses are privately held.
- According to the U.S. Census Bureau in 2004, there were over 25 million U.S. businesses the majority of which were closely held sole-proprietorships, partnerships, or LLCs.
This means nearly 16 million businesses are without any formal exit plan.
AICPA – Succession Planning Study 35% of multi-owner firms and 9% of sole proprietors (sole owner firms and sole practitioners) had a written succession plan in place in 2008, compared to just 25% of multi-owner firms and 8% of sole proprietors in 2004.*
Current Status of Succession Planning Multi-Owner Firms Sole Proprietors
Have started the plan and will soon complete it. 35% 7%
Will start the process in the next year or two 32% 43%
Will start the process in about 5 years 10% 23%
Will start the process in about 10 years 3% 3%
Have a plan drafted, but it has not been formally approved 9% 3%
*The 2008 PCPS Succession Survey by AICPA
These undeniable figures are compelling arguments for aggressive pursuit of the most advanced strategies and state of the art techniques to plan and implement 21st Century exit strategies, estate/wealth preservation plans and strategic plans.
As a business owner in today’s economy, business growth (or lack thereof) and trying to manage day-to-day operations dictate how you will spend the majority of your time. However, there is no more compelling reason than the current economic situation for you as a business owner to take steps to take advantage of trends and opportunities which will result in better valuation, lower tax consequences and smoother transitions when your liquidity event comes to fruition. Your future after your exit is also of concern. The sooner you plan for all the eventualities the better.
What are Your Options?
Traditionally there are two main paths you might choose: Selling to an outside third party or Transferring to insiders like your employees or family members. There are essentially two paths that business owners can take when they decide it’s time to transition to the next phase of life: selling the business to an outside party or transferring the business to “insiders,” such as family members or employees. Of course you could also liquidate, but this is not usually the chosen path, rather a forced or hardship route when no buyer emerges or other circumstances intervene.
Today, when selling to outside parties, some options which need to be carefully considered include whether to transfer 100% ownership or retain some equity. Although it might be tempting to try to walk away with a big chunk of cash, it may not be practical or in the seller’s best interest in the current state of our economy.
In light of the current economic climate it might not be the smartest strategy for owners in industries where valuations are negatively affected by the economy.Selling 100% of their interest when the market value is at a record low.
Some examples are real estate related businesses, construction companies, automobile manufacturing/sales and retail stores. Instead of cashing out, a second option is to sell only a share of the equity and retain a share. The retained equity could be either a minority or majority ownership interest. In certain cases, a partial sale might be desirable as it enables the selling stakeholder to take a portion of their net worth out of the business so they may diversify a portion of their assets, while retaining some equity with a view to possible future appreciation.
In uncertain economic times, the ability to liberate a portion of your net worth may help the business to grow, thereby increasing the valuation of the retained stake in the company. More to the point, selling a partial stake of your business allows you to share future business risks and opportunities with a partner.
Acme Corporation was valued at $10 million and owned by a single shareholder. However, in light of current economic climate, the sole shareholder decides to sell 70% of his ownership to an outside party. The result is a liquidity event where the selling shareholder obtains $7 million of locked up equity. The seller negotiates an agreement to stay involved in running the business, with a new owner introducing a fresh perspective to the management and operational structure of the company. By retaining a significant minority position in the equity and combining forces with the outside buyer the stage is set for the selling shareholder to participate in future growth as the economy recovers. This scenario also gives the buyer assurance that the seller still has “skins in the game”. This vested interest in the company is beneficial to both buyer and seller. With a carefully crafted plan the seller is positioned such that the 30% equity holding could be worth significantly more than at the time of the initial transaction.
Another approach is to implement a plan to transfer to insiders, such as family members, management or employees. In cases of family succession, the internal transfer can be utilized to reduce certain tax consequences. This is because in today’s environment the tax liability is likely to be reduced as a result of lower valuations. We have observed that business valuations are by and large lower than they were just a year or two ago. The factors causing this range from depressed revenues, lower profits, tight credit and lower valuation multiples.
The resulting lower valuations present exceptional options to transfer ownership interests to family members through a variety of techniques which shelter or defer tax events and accomplish several other succession plan benefits. Because interest rates are still relatively low, these techniques are enhanced further. Plus, if your objective is to prepare the business for another sale to an outside party at some future date, the present climate is conducive to recapitalization and intra-family transactions to shift ownership and save taxes when the business is sold to the outsider in the future. One cautionary note; because there is a very real probability that hyper-inflation could devalue our currency, you should carefully consider where to invest the funds you receive at the time of transfer, hedging against the eventuality. In addition, such inflationary conditions could diminish or erase any gains you might enjoy from the retained equity stake.
The current depressed state of the economy may also favor a sale to your employees. You might want to sell via a management buy-out to select key managers, or through the use of an employee stock ownership plan (ESOP). Again, lower valuations equal better economics for buyers and potential tax savings for sellers.
How Should You Proceed
Planning for an orderly succession & obtaining the maximum liquidity from your ultimate disposition of your business demands a team approach. By bringing together the combined experience of distinguished tax, legal, insurance and financial professionals, you will obtain an integrated strategy which addresses the multiple facets of your exit plan.
Case Study #1
John Smith, a 70% owner of ABC Manufacturing, LLC, wanted to plan his exit strategy. The value of his ownership percentage in the company was $4 million and he wanted to retire in 5 years, but the question was, how? By utilizing state of the art techniques, ABC Manufacturing, LLC agreed to borrow $4 million over 5 years to fund the premiums of an Indexed Universal Life Insurance policy on John’s life. John could then begin to receive distributions from the life insurance policy after he left the company. The end result — this approach exceeded John’s expectations and provided over 249% of what John was expecting to receive for the value of his ownership.
Exiting Owner: Male, age 46 Owner’s expected value of business interest: $2,500,000 Retirement distributions to begin at age 55 Annual retirement distributions: $263,611 for 30 years Net death benefit: $659,700 Total benefits resulting from this approach: $8,568,037 Portion of owner’s expected value obtained with this solution: 343%
Exiting Owner: Male, age 43 Owner’s expected value of business interest: $8,000,000 Retirement distributions to begin at age 50 Annual retirement distributions: $760,125 for 20 years Net death benefit: $13,758,412 Total benefits resulting from this approach: $28,960,918 Portion of owner’s expected value obtained by this solution: 362%
For these business owners, utilizing our recommended techniques the business owners were able to fulfill their business succession planning needs and enabled funding for a smooth transition of ownership while providing for potential tax-free retirement income.
To see yet another example of a strategy which reflects current methods see this article from the Wall Street Journal: Wall Street Journal Article
What’s Your Exit Plan?
If you’ve been putting off planning or implementing your exit strategies now would be a good time to stop procrastinating and put your plan in motion. The current atmosphere is presenting opportunities we may not see again for many years to come, if ever. Now is the time to for you to take action. Just like death and taxes, you will exit the business eventually. Will your departure be on your terms or someone else’s?
Stop rationalizing, stop stewing. Get up out of your chair and start doing! Denis Waitley