How To Get What You Want When You Leave Your Business
Few
things are certain in business life, but there is one universal truth:
Be it a carefully planned decision or the result of fate?s swift hand,
someday you will leave your business.
Your exit is going to take place in one of two ways:
You
will transfer ownership of the business during your lifetime because
you?ve decided you want out. Without planning, this will probably mean
that you have to liquidate. With planning you will be able to sell the
business to a third party, to key employees or co-workers, or to family
members ? all at minimal tax rates.
You
will die or become totally disabled, and the business will have to be
liquidated unless some type of business continuity arrangements have
been planned and documented.
Most
owners measure their satisfaction with their business in terms of the
income, wealth, identity, challenge, stimulation, satisfaction and pride
that it provides to them. Consider another definition of success that
measures a business ? not only by how well it operates under your
ownership and by the benefits it provides -- but also by the rewards it
will bestow when you leave it. Because in the end, what you really want
and need from your business is the ability to leave it ? under the most
favorable conditions. The only way you as an owner can do this
successfully is to create an exit plan as early as possible and stick to
that plan as long as you maintain your business.
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Developing Your Exit Plan
What
exactly is an Exit Plan that will allow you to leave your business in
style and how do you create it? Despite the almost infinite variety of
businesses and business owners almost all exit plans contain common
elements or goals. Generally these goals fall into three broad
categories:
To create and preserve the value of the company;
To provide a means to exchange that value for money with the least tax consequence possible;
To
meet personal and family needs by providing security and continuity to
your business and for your family either upon your planned departure or
if disaster strikes ? upon your death or disability.
Creating and Preserving Value In Your Business
Most
entrepreneurs are so dedicated to the worthy purpose of making money
that they have little or no time to spend on creating and preserving
value for their business. You must find the time because?
First,
to exit the business in style, you will need cash. That source of cash
is the business. To determine the amount of cash you will receive, we
must know the value of the business.
Second,
if you intend to give the business to children, the business must be
valued and that value must be used for gift tax purposes.
Third,
the business typically comprises the great majority of an owner?s total
wealth. The IRS knows this just as surely as you do. Determining the
value now, allows you the opportunity to design an Exit Plan taking your
business into account with the goal of minimizing the IRS?s take.
Fourth,
well-designed key employee incentive compensation planning is central
to increasing business value. Business value is often used as a
measuring rod for such plans.
Fifth, if
an owner goes through this exercise well before the business is sold or
transferred, he or she will be able to pinpoint the factors that are
crucial to measuring and increasing (or decreasing) the worth of the
business.
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How Much Is Your Business Worth?
Determining The Value
Valuation
of your business is likely to be performed by your CPA or a business
appraiser using a methodology consistent with the approaches sanctioned
by the IRS. This valuation will determine a range of fair market values
for your business for purposes of gifting, estate taxation, and general
planning. Note that this fair market value is not the same as the sales
price for your business. To determine the sales price, the fair market
value is used as a hypothetical starting point and adjusted to
accommodate factors like timing of the sale and industry cycles, current
condition of the merger and acquisition market, interest rates, and
geographic location among others.
The
technical details of business valuation are beyond the scope of this
report. But one aspect worth noting is that estimating the value of your
business will be critically dependent on who the business will be
transferred to. If you are selling the business to an outside third
party, you will seek the highest possible value for your ownership
interest. If you are transferring ownership to your children, you must
make every effort to develop the lowest defensible value for your
ownership interest. This counter intuitive strategy is due to the huge
role the IRS plays in the transfer of your business.
If
you decide to sell to an outside third party, it will be for cash and
you?ll want all you can get via a high value. But your children, your
employees, your co-owner don?t have much of that green stuff. Their
source of money, or cash flow, is the same as yours ? the business. They
will need to earn money on the business and pay income tax on it (tax
#1) then pay the balance to you to buy the business ? at which time you
will pay a second tax on the gain (tax #2). The higher the business
value, the greater the purchase price. The greater the purchase price,
the greater the double tax bite.
For
example, if company earnings are distributed to the purchaser (let?s say
a key employee), it will be taxed to her as compensation ? salary or
bonus money. She will then pay the after tax money to you (say 65 cents
of the original dollar of earnings). You in turn pay a capital gains tax
on the 65 cents received (assume little or no basis on your ownership
interest, therefore a tax of about 25 percent). The net is less than 50
cents on each dollar earned and paid out by the company.
In
other words, all purchasers, other than outside third parties, need to
look to the earnings of the company for money to pay to you because they
have no money of their own. This results in a double tax paid on the
money received by you (taxed once as the employee/purchaser earns it and
once when you receive it for your stock). The higher the business
value, the higher the tax, the more difficult it is to accomplish a
successful transfer? the less likely you will leave your business in
style. Methods for avoiding this double taxation are rather complex for
our discussion here, but keep in mind that determining the value of your
business will require you to decide early on how you wish to transfer
it.
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How To Motivate And Retain Key Employees Through Ownership
The
one indispensable component of a valuable business is its top
employees. Think about it: your top employees are even more valuable
than you are for the purpose of creating value for your ownership
interest. The more valuable you are to the business, the less valuable
the business will be when you leave it. What you need to do is leave
behind key employees who add significant value to the business for
several important reasons:
Properly motivated by a profit-based incentive plan, key employees do increase the value of your business.
Key employees often become potential owners when you decide to retire or move on to another venture.
If
you decide to sell to a third party, the continued existence of a
stable, motivated management team will increase the purchase price.
Key
employees are not necessarily employees in key positions. Key employees
think and act a lot like you, they are eager to be given
responsibilities and challenges. Like you, they want to see the business
grow and prosper, and they want to grow and prosper along with it. They
take pride in being identified with, and contributing to, a successful
business. In short, they act like owners. Their continued presence in
the business is necessary if the business is to thrive.
There
are several incentive packages you can implement to retain and motivate
key employees. These incentive packages help your key employees reach
their financial and psychological goals ? if they stay with you. As your
key employees attain their goals, the design of these incentive
packages should also help you to achieve your ownership goal of building
business value (and eventually converting that value into money). Take a
hard look at your current employee benefit programs, especially those
aimed at your key employees. Elements of your incentive program should
include:
Financially attractive
awards that create a potential bonus of at least 10 percent of the key
employee?s annual compensation. Anything less than this will not be
sufficiently attractive to motivate the key employee to modify his or
her performance to make the company more valuable.
Specifics; that is, determinable performance standards, such as the company reaching a certain net income or revenue level.
Structure
to increase the company?s value such that, as the key employee reaches
measurable objective standards, the net income of the company increases.
Incentive
reward vesting or ?golden handcuffs? that link payment to tenure thus
encouraging the employee to remain on the job in order to receive the
reward.
Face-to-face meetings
with your key employees to discuss the plan and make sure the incentive
arrangements are thoroughly understood and all questions answered.
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Four Ways To Leave Your Business ? Which One Is Right For You?
Selecting
your successor is a fundamental objective that is decided early in the
Exit Planning process. Almost all owners want to transfer the business
to other family members, an employee or a co-owner; only about 5 percent
want to sell to an outside third party. Interestingly, however, most
persons first identified as successors do not usually end up as the
ultimate owners.
Choosing your successor
involves a careful assessment of what you want from the sale of your
business and who can best give it to you. There are only four ways to
leave your business. If you know these methods and decide in advance
which one you prefer, then you have a better chance of leaving your
business under terms and conditions you choose. Without planning you are
more likely to settle for terms and conditions beyond your control.
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1. Transfer of Ownership to Your Children
50
percent of typical business owners want to transfer their business to
their children. Fewer than one in three of these owners end up doing so.
Because this is the riskiest way to leave your business, you must
prepare for failure by developing a contingency plan to convey your
business to another type of buyer.
Transferring
a business within the family fulfills many people?s personal goals of
keeping their business and family together. It can provide financial
well-being for younger family members unable to earn comparable income
from outside employment, as well as allow you to stay actively involved
in the business with your children until you choose your departure date.
Transferring your business to your children will also afford you the
luxury of selling the business for what you need to live on, even if the
value of the business does not justify that sum of money. You will
determine how much you need or want, rather than be told how much you
will get.
On the other hand this option
also holds great potential to increase family friction, discord, and
feelings of unequal treatment among siblings. The normal objective of
treating all children equally is difficult to achieve because one child
will probably run or own the business at the perceived expense of the
others. At the same time financial security is normally diminished
rather than enhanced and the very existence of the business is at risk
if it's transferred to a family member who can?t or won?t run it
properly. In addition the vagaries of family dynamics may also
significantly diminish your control over the business and its
operations.
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2. Sale to Other Owners or Employees
One
of the great advantages of having other owners in your business is that
they can be your means to retirement. Especially with smaller
businesses, a common retirement planning technique is to have a younger
individual buy into your business while you are still active. Upon your
retirement, the younger owner will purchase your remaining stock.
This
plan can be advantageous because the younger person learns the business
? its structure, employees, customers, operation, and management ?
under your tutelage. More important for you, the younger person?s
capabilities (as well as his weaknesses) are known to you, so you have a
pretty good idea of how your business will be run after you leave. And
most important of all, the business can be sold to a market you create
and control. You structure the deal ahead of time to suit your
particular needs and objectives.
Disadvantages
in this plan are that there is no cash up front, unless you as the
owner have pre-funded the sale, but even then, you have probably
pre-funded with money that was yours anyway. A great risk also exists in
the fact that the buyout money comes from the future earnings of the
business after you leave it. Employees are often employees because they
don?t have an owner ?mindset.? They?re not entrepreneurs and they don?t
respond well to the challenges and pressures of ownership. These
disadvantages apply especially to businesses worth more than $2 million.
The owner simply has too much money and financial independence at risk,
and the price will be too high for an employee to afford.
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3. Sell It To A Third Party
In
a retirement situation, a sale to a third party too often becomes a
bargain sale ? the only alternative to liquidation. But if the business
is well prepared for sale this option just might be your best way to
cash out. In fact you may find that this so called ?last resort?
strategy just happens to land you at the resort of your choice.
Although
many owners don't realize it, you should get most or all of your money
from the business at closing. Therefore, the fundamental advantage of a
third party sale is immediate cash or at least a substantial up front
portion of the selling price. This ensures that you obtain your
fundamental objectives of financial security and, perhaps, avoid risk as
well. A second unanticipated advantage in selling to a third party is
the ability to frequently receive substantially more cash than your CPA
or other business appraiser anticipated because the market place is
?hot.? Finally, this may be the best option for a business that is to
valuable to be purchased by anyone other than someone who has access to a
considerable source of money.
If you do
not receive the bulk of the purchase price in cash, at closing,
however, your risk will suddenly become immense. You will place a
substantial amount of the money you counted on receiving in the
unpredictable hands of fate. The best way to avoid this risk is to get
all of the money you are going to need at closing. This way any
outstanding balance payable to you is ?icing on the cake.?
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4. Liquidate It
If
there is no one to buy your business, you shut it down. In a
liquidation the owners sell off their assets, collect outstanding
accounts receivable, pay off their bills, and keep what?s left, if
anything, for themselves.
The primary
reason liquidation is considered is that a business lacks sufficient
income-producing capacity apart from the owner?s direct efforts and
apart from the value of the assets themselves. For example if the
business can produce only $75,000 per year and the assets themselves are
worth $1 million, no one would pay more for the business than the value
of the assets.
Service businesses in
particular are thought to have little value when the owner leaves the
business. Since most service businesses have little ?hard value? other
than accounts receivable, liquidation produces the smallest return for
the owner?s lifelong commitment to the business. Smart owners guard
against this. They plan ahead to ensure that they do not have to rely on
this last ditch method to fund their retirement.
Friday, February 12, 2016
