Seven Pitfalls of a Business Exit
Editor's Note: This is the last in a series on exit planning and succession that Window & Door began publishing in the May issue. The series is adapted from that which ran in Glass Magazine, our sister publication. If you have a succession story to share or are beginning the process and want to share your experience, email firstname.lastname@example.org.
Business owners intuitively understand and manage their everyday risks in a measurable manner, but most owners have never exited a business and are unaware that the odds are against them. Beacon Exit Planning LLC, and Beacon Merger & Acquisitions Advisors LLC, has identified seven recurring minefields that can derail owners from successfully navigating their inevitable exit. Identifying and understanding these common problems, risks and concerns can help business owners prepare for and manage their own future exits.
It is essential for those who have invested their life and time into building a successful business, and who have more than 70 percent of their illiquid wealth trapped inside the business, to create a strong exit plan to help overcome the odds. Find more details from the series.
1 - Lack of planning
“At any given time, 40 percent of U.S. businesses are facing the transfer of ownership issue. The primary cause for failure … is the lack of planning,” according to the U.S. Small Business Administration, sba.gov. Most owners are just too busy running their business to take time to plan for their exit. They probably have completed a will, some estate planning and a Buy-Sell Agreement, but not a clear exit plan. Procrastinating owners often wait too long, only to be forced to liquidate their business for pennies on the dollar, leaving an irresponsible legacy for their spouse, family and community.
2 - Risk exposure in Buy-Sell Agreements
Early in Beacon’s process when working with clients, there is a review of personal and business documents, primarily the Buy-Sell Agreement. In many cases, we have uncovered provisions and structures that could be devastating to the business owner, the company and the family. The risks often expose millions of dollars in unnecessary tax liabilities or structures that don’t support the owners’ intentions. This exposure is unrecognized by existing advisers and must be confronted immediately before we even begin to draft the exit plan.
Common risks include:
- An underfunded or unfunded Buy-Sell Agreement.
- Improper valuation formulas and definitions that can create ambiguities and confusion when the need to implement arises.
- Insurance policies that are improperly coordinated, creating potentially significant tax consequences.
- Buy-Sell Agreements that do not allow the remaining owner to take advantage of stock basis adjustments, a provision that could save millions of tax dollars.
3- Outliving money in retirement
The number one fear for affluent Americans over 55 is running out of money in retirement, according to the results of Bank of America’s latest Merrill Edge Report. While most business owners are considered affluent, industry studies show that their largest segment of wealth (in our experience, more than 70 percent) is trapped in their illiquid business.
The owner’s challenge is how to live independently from the business, cash out without being clobbered by taxes, retire and not outlive their money.
Developing a financial plan as part of the overall exit plan can help an owner ensure they have sufficient income replacement after departing the business.
4 - Facing the odds of an external sale
Fewer than 20 percent of the companies brought to market actually sell, according to the U.S. Chamber of Commerce, uschamber.com. This figure is closer to 10 percent with construction companies, according to FMI Corp., fminet.com.
To increase the odds of a successful external sale (a sale to a consolidator or competitor), an owner should:
- Find an experienced and proven mergers and acquisition professional and get the company sale-ready in order to receive the highest possible price.
- Plan to market the business to several competitive bidders (once the company is sale-ready). This may increase the odds for achieving the highest price and financial independence from the business. Don’t wait until a buyer approaches for a one-on-one negotiation.
- Obtain the advice of a certified valuation adviser to determine the actual synergy value so the owner has a realistic understanding of the company’s justifiable value going into the negotiation.
5 - Facing the odds of an internal sale
Fewer than 30 percent of family businesses will transfer to the second generation, and only 10 percent will transfer to the third generation, according to Family Firm Institute.
The vast majority of private business sales in the lower to mid-level markets ($5 million to $60 million) will be an internal sale, transferring via an Employee Stock Ownership Plan, a Management Buy Out or through gifting. The good news is, if the internal sale is structured properly, the after-tax results can often exceed an external sale.
6 - Inefficient taxation
Each exit path has a different tax implication that can range from zero to more than 55 percent. Many factors come into play, such as entity structure, tax history and characteristics, and the deal structure itself.
An external sale, if not properly structured, could come with a tax yield of 55 percent or greater. The external sale might generate the highest sales price, but it could leave an owner with the fewest dollars. The bottom line for owners—it is not how much you get, but how much you keep.
An internal sale may have a smaller tax consequence for the owner. However, the majority of these deals are structured in a way that creates more of a tax burden for the seller and the buyer. Owners should investigate strategies that can be implemented to make the transaction much more tax efficient.
7 - Risk of predators and creditors
Businesses are natural targets for lawsuits because of their perceived wealth and deep pockets. An owner can be blindsided and targeted by creditors or sued for events in which he or she did not ever participate. A successful exit plan should protect what an owner has earned from litigation, so it is there when he or she eventually exits.
Exit planning should utilize strategies such as asset insulation to structure a business, making it less attractive to litigation. Asset insulation positions assets and finances so that it’s difficult for a creditor to reach those assets, thereby reducing the chance of litigating and providing the owner with an added layer of protection against creditors and predators.
- Renders a potential defendant unattractive to litigate by removing the financial gain incentive
- Insulates major assets from predatory lawsuits and other creditors
- Promotes settlement, thereby leveling the playing field
- Integrates with estate planning and tax minimization objective without gifting assets or losing control of those assets.
Keys to Preparing Staff for Succession
Establish a clear direction and focus
The beginning of the succession process is a time for the senior management team to revisit the strategic plan, vision and mission, to work as a team and establish a stake in the company’s future.
It will be the management team’s responsibility to take the reins and engage the company in this plan, and to communicate and ensure the plan’s implementation. The direction begins at the top, and this exercise will help the team to begin seeing their future.
Consider EQ when choosing future leaders
Emotional Quotient, or EQ—which some researches argue is more important than IQ in the workplace—is a way to measure non-cognitive skills. Psychologist Daniel Goleman, author of “Emotional Intelligence,” states that emotional intelligence is reflected in behavior, from self-awareness, to how one uses gut feeling, self-control of emotions, empathy, and the ability to inspire and influence others.
Develop management succession
Management succession is more than the replacement of talent; it is the development of talent. This is a time for the new team to reexamine and improve performance of the company’s systems in a process of continuous improvement for the company’s productivity and profitability. The new management team should lead this process and educational effort for the entire company. It is a time for the owner to coach and stretch managers into champions, and to help them to start thinking like owners.
Train future leaders
Once a new management team is chosen, the owner must help them grow into leaders. Strong managers lead the company to meet deadlines and corporate goals. Those managers must now rise to a higher level of leadership to set a corporate direction and build consensus. An owner will need to work with those managers to change their behavior and build self-awareness, while still maintaining their spirit. Methods such as peer evaluation and personal coaching may prove helpful as managers move into the next level of leadership.
Start training early
Succession and behavioral change take time. The sooner training begins, the better the results will be. There are three parts to this training: education, coaching and stretching. The key is to leave 70 percent of their time for the stretching process. This is where managers are field-tested, and asked to apply their learning, make mistakes, adapt and mature. This is the most important aspect of the training process.
Coach the new CEO
Every CEO must realize that their role with the new successor is to make sure he or she is prepared to lead the company. The owner and successor should collaboratively decide the process, timeline and curriculum. The exiting owner’s role is to teach, coach and ensure the company’s future success. An exiting owner should let the new CEO find his or her own path unless they see a disaster in the making.
Prepare to be a lame duck
While the succession process will be different for every CEO, in almost all cases, the exiting owner will feel like a lame duck. Eventually, their phone will stop ringing, managers will move directly to the new CEO, and the exiting owner will be out of the loop. The good news is that this means the process is working as it was designed to do, and the exiting owner has succeeded where most CEOs fail. As I tell owners who are finalizing their exit, “Congratulations, and welcome to the Lame Duck Club.”