Editor’s Note: This is part two of a two-part series that features the first chapter of the book, “The Contractor’s 60 Minute Exit Plan – How to Cash Out, Eliminate Taxes and Retire Comfortably.” For part one, see our December 2019 issue.
Exiting a business presents numerous pitfalls and challenges. Most owners — 70 percent — don’t manage to successfully transition the business to new ownership. The question then becomes: Why is it so hard to transition a business?
Several key issues make exiting a business difficult: valuation, taxation, succession and contingency planning.
What is the value of the business and how is it set? The business valuation world is complex, and a qualified business appraiser should be utilized to assist the owner in determining the value. A business can have several different values associated with it depending on the exit method selected, the ownership interest being sold and economic climate the business operates. The business owner should understand the nuances of business value, including what adds value and what detracts value from the business.
Business owners often have unrealistic expectations of what the company is worth. In the valuation world remember one thing; the business is only worth what someone is willing to pay for it. It is incumbent on the owner to make it saleable.
Business owners are familiar with consulting accountants to determine the potential tax obligation on the upcoming profits for the year. Some business owners may also have a plan for estate tax. But how many have actually run through the process of identifying the various exiting alternatives and studying the tax ramifications when selling the business?
The tax liabilities vary greatly depending on the type of exit an owner pursues. In certain instances, the effective tax rate in the sale of a business could exceed 50 percent. That would mean the government would get more than the owner in the transaction.
Exit planning can help owners better understand the taxation associated with each type of transfer and make better financial decisions during their exit.
The process of succession planning involves training key individuals within a company to eventually replace the owner. This is an often-overlooked process until it’s too late. A succession plan deals with changing behaviors and attitudes in the business. This process can take from two years to 10 years depending on the level of planning that has already been employed.
Neglecting to plan for business succession can affect an owner’s ability to successfully exit their business. For example, if an owner is selling to an outside party, the buyer wants to know that a well-seasoned management team is in place to help support operations into the future. Not having this management team in place makes the business less attractive to buyers.
The lack of a strong succession plan can also negatively affect an internal transfer. For example, transferring ownership to a management team generally requires that the management team gradually payout the exiting owner over time. In other words, the ability for the owner to get paid relies on the ability of the management team to continue to run the business successfully. An exiting owner wants to make sure the check clears the bank, and this requires a capable and well-trained management team.
The final common pitfall involves missteps in contingency planning, primarily improperly documented buy/sell agreements or improperly designated life insurance policies. These two items go hand-in-hand and are dependent on each other for proper utilization.
A buy/sell agreement is an agreement between existing shareholders that outlines the terms of a buyout in the event
of several triggering events, such as death, disability, divorce, and both voluntary and involuntary departure for cause. It should be drafted in a form that supports the owners’ intentions and leaves very little ambiguity in what is most often very difficult times.
The life insurance is often used as the funding mechanism for the buy/sell agreement. If not properly owned, or if the beneficiary is not properly designated, it could create a situation where a significant tax benefit is missed.
Managing the exit planning and execution process is critical in achieving success. All too often, advisors promote a one-size-fits-all approach to the process without considering the owner’s ultimate goals or considering other aspects of planning in the business owner’s world. An exit planner, on the other hand, can assist a business owner in organizing and consulting the business owner on the various strategies available to them.
Think of an exit planner like an architect. An architect must know and understand the various disciplines that go into building a house or structure. He or she must understand the specifications of an electrician, plumber, carpenter and roofer and integrate the various disciplines in a comprehensive easy to follow blueprint so that the contractors can identify, evaluate and execute.
An exit planner works much in the same way during an owner’s exit. The exit planner understands tax, accounting, valuation, financial planning and to some extent legal issues that confront a business owner during this process. From that knowledge, the planner can create a comprehensive plan that can be the source for the owner’s exiting strategy.
In addition, the exit planner should have a thorough knowledge of the various disciplines that are incorporated into the plan. It is not only important that the exit planner guide and direct the process for the owner, but it is critical that the planner can evaluate and discuss key issues with other advisors on the team. Read further in our book to discover the exit planning process and learn more information on setting goals for a comprehensive exit planning process from discovery to design.