"Seven Steps to Leaving Your Business in Style"
By By Josh Patrick, CFP
Vistage Speaker | Founding principal of Stage 2 Planning Partners
When I ask private business owners aged 50 and older when they want to leave their business, they usually answer, "In five years." If I ask the business owner the same question two or even five years later, the answer will likely be the same. I call this the "perma-five syndrome."
Owners often say five years because they know they're not quite financially ready to retire. They believe that in five years they can fix those financial issues. The reason we get the same five year answer when we go back to the owner years later, is that they either didn't understand the full scope of the financial issues that need to be solved or they weren't able to solve the issues.
For those considering selling their business in the next five years, here are seven specific steps that will prepare you to actually leave your business in time and in style.
1. Calculate future expenses and income.
Use your current financial inventory to project your retirement needs. The numbers you get will tell if you can afford to leave now. If you can't, you'll know specifically what targets you need to reach. To take your inventory:
- Categorize all expenditures over the past year. Quicken or a similar program makes this task easy.
- Look at all of the personal assets that you own and want to continue to own.
- List all personal assets you would like to own in the future, but don't yet own.
- Calculate an annual dollar value of your company benefits (car allowance, vacations, dinners, medical, etc.).
- Calculate what you'll owe in taxes during retirement.
Once you have these numbers, you'll get an idea of what you'll need to retire. Next, assume that your investments will return 4% yearly on an inflation-protected, after-tax basis. Then add all the income you'll receive from other sources such as pension plans, rents from real estate, Social Security or other programs.
Adding these numbers together will help you understand how much income you will generate after leaving your business. If the income is higher than your expenses, you may be financially ready to retire. If it's the other way around, you may need to continue working.
2. Determine the current value of your business.
Ultimately, your business is worth what someone else is willing to pay for it, and buyer's motives are the final arbitrator in the selling price. In most cases, either the actual cash flow of your business or the potential value of your operation is your greatest pricing leverage. In either case, your ability to communicate the cash flow or potential value is paramount to getting your best price.
When offering cash flow projections to potential buyers, be sure to include capital reinvestment numbers and other major expenses. Otherwise, you'll lose credibility quickly. If you're selling to a third party, expect to produce numerous financial statements for the evaluation of your business. If making an inside sale (selling to family or to managers within the company) don't oversell the potential cash flow, as you will most likely have to play the role of bank for the new owners, and you will want to make sure you get paid.
Additionally, consider the buyer's taxes--the more you can help the buyer limit their taxes, the more the buyer can afford to pay you for your business. For example, if you're selling your business for $1,000,000, the buyer will have to earn $1,800,000 to pay you. This is because most of the time buyers will purchase a business with after-tax dollars.
If you're able to structure the transaction so that you're paid in mostly ordinary income (income that income taxes are paid on), you'll be able to save your buyer a huge amount of taxes and net more in the sale. This type of planning works well when you transfer your business to your children or managers in your company, but it doesn't often work to your advantage when selling to outside buyers.
3. Increase the value of your business.
Here are four things you can do to add value to your business:
- Install a deferred compensation program, so the new owners can purchase your business interest using pre-tax dollars.
- Quantify your most and least profitable customers, then start marketing to the most profitable segment.
- Leverage intelligently-get a positive return from the money that you borrow.
- Know the key financial indicators of your business
Adding value three-five years before you plan to sell your business can net a large return on investment.
4. Decide how to leave.
The four ways you can leave your business are:
- Sell to an outsider.
- Sell to your managers.
- Sell to family members.
- Liquidate.
Each option has different benefits, though liquidation is always the least attractive because it squanders the good will in your business. If you don't like the future of the business or if you want to be uninvolved in its future operations, an outside sale is advisable. If you believe in the future of your business and don't mind remaining attached to it, then an inside sale may be advantageous.
As you decide how to leave you should engage the services of intermediary. I recommend engaging a broker, lawyer, and financial planner.
5. Incentivize your key people.
Your current management team should be a value driver (not a value reducer) when it comes to selling your business. Make sure that your management team is willing to stay for a period of time during the ownership transition. Consider instituting a stay bonus for your key managers, especially those who do not have ownership stake. Usually stay bonuses have a deferred payment schedule tied to trigger or benchmark events. Stay incentives for key people will allow you to get more money for your business, from both outside or inside buyers.
6. Protect your asset.
If you're selling your company and holding a note (often done in an inside sale) you should have agreements in place for reclaiming the business should you have to do so. Additionally, your selling contract should limit your personal liability for what happens in the business after you pass control to a new owner.
Most business transfers have some element of deferred payments attached to them. Make sure your agreement protects you with legal remedies should your buyers be unable to meet those deferred payments.
The primary goal in asset protection is to make sure you first get the cash for your business and then protect the cash from those who might want to take it away.
7. Invest the proceeds.
Taking risks in your business is a day-to-day occurrence. Once you have a liquidity event and you're sitting on significant cash, acting financially conservative should become the rule of the day.
When you sell your business, you're converting a cash production system that you control into a pile of cash that you invest in entities out of your control. It takes time to get comfortable with this reality. My advice: use a financial planner who's well versed in risk management. Protecting your capital should be the first goal, maximizing your returns, the second.
Conclusion
Usually business owners spend three to five years preparing a business for its sale. This preparation may take the form of increasing cash flow, upgrading the management team or adopting new strategies. One overlooked aspect of preparation is to ask yourself the question: What will you do with your life once it's no longer tied to the business? Take time to plot how and what you want to do after you leave your business. It's time well spent.
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