Editor's Note: This article and the feature of Salem Flat Glass & Mirror mark the sixth and final installment of Glass Magazine’s Exit Planning and Succession series.
Search this website for "exit planning", to see all articles from this series.
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. Fewer than 20 percent of the companies brought to market actually sell, and fewer than 30 percent of family businesses will transfer to the second generation.
For business owners 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, creating a strong exit plan to help overcome those odds is essential. Beacon Exit Planning LLC and Beacon Merger & Acquisitions Advisors LLC, has identified seven recurring pitfalls that can derail owners from successfully navigating their inevitable exit. Identifying and understanding these common problems, risks and concerns of exiting a business can help business owners prepare for and manage their own future exits.
One - 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.
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.
For details on how to develop an exit plan, see “Part I: A Successful Exit,” on pages 38-44 of the January/February issue, and “Part II: Eight Disciplines of a Successful Exit,” on pages 22-27 of the April issue.
Two - 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. Most business owners are considered affluent. Their business pays them generously, supports their lifestyle, travel, autos and entertainment. However, 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. For more information, see “Part II: Eight Disciplines of a Successful Exit.”
Three - 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.
For more information on the Buy-Sell Agreement, see “Part IV: The Internal Sale,” on pages 52-54 of the June issue.
Four - The odds of an external sale
As mentioned previously, fewer than 20 percent of the companies brought to market actually sell, according to the U.S. Chamber of Commerce. This figure is closer to 10 percent with construction companies, according to FMI Corp. To increase the odds of a successful external sale (a sale to a consolidator or competitor), an owner should:
- Not wait until a buyer approaches for a one-on-one negotiation. Once the company is sale-ready, the owner should plan to market the business to several competitive bidders, which may increase the odds for achieving the highest price and financial independence from the business.
- Find an experienced and proven mergers and acquisition professional, and get the company sale-ready in order to receive the highest possible price.
- 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.
For more detailed guidance on navigating an external sale, see “Part III: The External Sale,” on pages 46-48 of the May issue.
Five - 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. Another way of saying this is that 70 percent of family businesses will fail to transfer to the second generation and 90 percent will fail to transfer to the third generation.
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.
For more detailed guidance on navigating an internal sale, see “Part IV: The Internal Sale,” on pages 52-54 of the June issue.
Six - Inefficient taxation
Each exit path has a different tax implication that can range from 0 percent 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, in the majority of instances 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 in order to make the transaction much more tax efficient.
Parts I through IV of this series offer insights on tax planning and advice on ensuring the most efficient tax implication during an exit.
Seven - 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. Imagine working for 20, 30 or 40 years and losing everything in a lawsuit. 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.