Planning for a Successful Business Transition
Many of my clients are baby boomers – people in their 60’s – who have built businesses and are now contemplating a transition of ownership (aka retirement). That transition is often difficult for many reasons, both financial and psychological.
These difficulties can be overcome with some guidance and forethought (and some effort). The following tips are offered to help you with this process.
Identify the New Owner
Perhaps the first step is to identify the choices a business owner has when transitioning ownership. In most cases, your choices are limited to one or more of the following:
(1) Children. Many businesses are family businesses. If one or more children are involved in business operations, and are ready and able to take the reins when their parent(s) retire, this is a viable option. More about children below.
(2) Employees. Some business owners are lucky to have long-time employees who are interested in purchasing the business and are able to do so. A transition of ownership to an employee, or group of employees, can provide a good exit for the business owner.
(3) ESOP. An “employee stock ownership plan” is a very specialized and complicated type of employee benefit plan that permits the company owner to sell the company to a trust. The trust is held for the benefit of the company employees and allocated over time to as a retirement benefit. ESOP’s have many advantages, but are a good fit for only a small percentage of business owners (there are roughly 7,000 ESOPs nationwide).
(4) Third Parties. A sale to a third party, in most cases a competitor, can often bring the best price and terms.
Start Early, Be Patient
Most businesses, especially smaller business, are operated in a manner that best fits the owner but may not necessarily present the business’ true worth. Owners may have company cars that aren’t critical to business operations, children who are non-key employees, excessive salaries, etc. In order to prepare the business for sale, these items need to be identified and adjusted so that the true profitability of the business is reflected. This process takes time, patience (and some expertise – see Assembling a Team, below).
I tell my clients that they should, at a minimum, start working on the marketability of their business a year in advance – two is even better.
Be Realistic
Business owners are notoriously unable to provide an accurate value of their businesses. The tendency is to overstate this value, although some owners are unnecessarily pessimistic. I advise my clients to obtain what I call a “thumbnail valuation,” which is a brief review by a business valuation expert of current financials, tax returns, etc. that leads to an estimate (not an appraisal) of the business’ value. This type of valuation can provide the owner with a solid basis on which to negotiate the transition of the business -- without incurring the cost of a full blown appraisal.
In addition to being realistic about value, owners also need to manage expectations. Obtaining full value for a business, negotiating the terms of the transition, and protecting the owner from undue risks all take time.
Beware of Being the Bank
When selling to a third party, children, or employees, an owner is often asked to finance some or all of the deal. In essence, the buyer is asking the owner to be the bank. This can be attractive to an owner because it expands the number of potential buyers who might not otherwise be financially able.
Be extremely cautious. Normally, the buyer is relying on the continued success of the company to pay the owner what is due. The owner is therefore subject to both the known risks of operating the business and the unknown risk of the buyer’s abilities. If the owner is going to act as a bank, he/she should retain the right to: (1) a security interest in the stock (or membership interests) of the company, (2) monitor the company’s operations (receipt of periodic financial statements), and (3) regain control of the company in the event of a default or the failure of the company to satisfy certain financial covenants.
Children! A special word about transitioning a company to children: it is easy to be informal, generous, etc. when transitioning a business to your children – it’s just human nature. But, if you are relying on payments from your children and/or the company to fuel your retirement, you should insist on the same types of protections that are prudent in a 3rd party sale. I’ve seen many parents hand over a business to a child, only to watch it being mismanaged – with the resulting loss of income for the owner during retirement.
Assemble a Professional Team
It can be attractive to try and transition your company without incurring the expense of hiring professionals to help you. Who wants to pay an attorney, CPA, business broker, etc. – especially if paying income taxes on the gain from a sale?
In making a decision about engaging professionals, remember that most business are sold on the basis of a multiple of earnings (often labeled EBITDA – earnings before interest, taxes, depreciation and amortization). The multiplier usually depends on the type of business. For example, a dental practice might sell for 4 x EBITDA; an insurance company, maybe 5 x EBITDA. The takeway is that for every dollar your professionals can add to the value of the company, the value to the owner is much more – which normally more than offsets the costs of such professionals.
I recommend to my clients that they assemble a “team.” An attorney to help with legal issues during the transition, including the drafting of key documents. A CPA to explain the taxation of the transition and to offer ways to minimize those taxes. A business broker if the company is to be marketed. And, a financial planner to help the owner invest and manage the proceeds from the sale.