How will you exit?

Editor’s note: The information provided is not intended to be legal, accounting, insurance or tax advice.

There are no guarantees when owning and managing your business except one: You will eventually exit.

But you may not realize your exit may be riskier and more complicated than you think. According to Deloitte,® London, 71% of small- and medium-sized business owners plan to exit their businesses within the next 10 years, and more than 90% of these owners will not be able to sell their businesses and meet their retirement cash requirements.

A 2008 study about internal family transfers conducted by Family Firm Institute, Boston, revealed 70% of companies fail to transfer or sell to the second generation and 90% of companies fail to transfer or sell to the third generation.

What is at stake?

What prompts an owner’s exit? In the best-case scenario, an owner will choose to voluntarily depart from his or her business, perhaps to enter retirement or start a new venture. However, an owner might involuntary depart due to death or disability. No matter the reason for an exit, planning for the inevitable is essential. The financial stakes are too high to ignore.

Statistically speaking, an estimated 75% of a business owner’s wealth is trapped in their nonliquid business, according to PricewaterhouseCoopers, London. It is common for private company owners to reinvest their capital back into their companies to be used for working capital or growth. The primary reason for planning is so an owner can realize that capital in a way that provides the owner with financial security, reduces tax liabilities and protects the wealth created.

An exit plan also protects other parties who rely on the business, such as employees and their families, and ensures a successful legacy for the business and the owner.

The exit plan

Transitioning a company’s management to new ownership, whether internally or externally, is challenging and can take years to complete. Exit planning can help an owner implement strategies that will increase the odds of success and allow owners to accurately envision their financial futures.

An exit plan asks an owner to outline the financial goals of the transaction. This generally involves the owner finding a way to monetize the business so his or her income can be replaced after leaving the business. The plan also asks owners to consider their future personal and business goals.

A properly written exit plan should include strategies and tools to manage financial risk and taxes, coordinate the owner’s goals with the necessary legal documents and protect the business from consequences such as predatory lawsuits or economic downturns.

An owner also should consider the various disciplines involved in the exiting process. During the execution of an exit, a team may consist of a corporate attorney, estate planning attorneys, accountants, tax specialists, financial planners, life insurance agents and business appraisers.

If an owner is looking into specialty transitions, such as an Employee Stock Ownership Plan, he or she may need additional advisers such as ESOP attorneys, business brokers and investment bankers. Without a coordinated plan, this can become quite expensive for the exiting owner.

Compiling a proper exit planning report can take a specialist about six months to a year or more to implement.

Transfer options

An owner has several options for transitioning a business to new ownership: He or she can sell externally to a strategic or investment-minded buyer or internally to an employee, family member or key member of the organization.

Because of the inherent risks associated with owning and operating a roofing company, the more common transition method is an internal sale to a family member, manager or employee, such as a management buyout or ESOP.

In an internal exit, the owner must find a way to transfer the business and prepare a new generation to ensure a successful exit that continues to meet the needs of the owner and employees.

Management buyout

Management buyouts are the most common exit strategies in the contracting industry. They give a selling owner the greatest flexibility and, if properly structured, can offer significant tax advantages.

The owner can sell a portion and continue to earn a salary and benefits. He or she can sell the rest of the company in the future or sell the entire company immediately. Because of this flexibility, a business owner can achieve great tax efficiency with the transaction.

A management buyout is a win for the buyer and the seller. The buyer has the opportunity to build significant personal wealth, and the owner benefits by cashing in on the investment made in the company.

However, management buyouts come with inherent risks. The largest obstacle in executing a management buyout is buyers often lack the financial ability to pay for the business. This requires a plan that will allow the business to pay for the transition over time.

Therefore, careful pre-planning and tax strategies should be implemented to leverage the many tools available to help achieve the best tax yield for the sale while minimizing the financial risk of getting paid for the business.

Another major obstacle is the risk the seller will not be paid. Starting a succession plan early prepares the new team for the buyout. The buyer’s senior management team’s performance can be tied to the cash flow that will pay the seller.

The plan also should focus on reducing or eliminating taxes, managing risk and protecting assets to ensure the best outcome for the buyer and seller. For example, reducing the company’s sales price is a common yet counterintuitive strategy in a management buyout. A lower sales price requires the company to generate less pre-tax income, ultimately leading to lower taxes.

ESOP

Another internal transfer option is an ESOP, which essentially is a retirement plan with a trust that buys corporate stock as opposed to other marketable securities typically found in more traditional retirement plans, such as profit-sharing and 401(k) plans.

Because the trust operates for the benefit of the employees’ retirement, the ESOP qualifies under the Employee Retirement Income Securities Act and is under the oversight of the Department of Labor and the IRS. An ESOP can be a tax-efficient tool for exiting a business.

Gifting

Gifting, as implied in the name, involves gifting stock to new owners and often is used in family transfers. It is not a monetizing method of transfer but rather a tax-efficient way to transfer wealth to a second generation or trust through valuation discounts.

Valuation discounts are applied in instances where the interest being sold is either nonmarketable (meaning it can’t be converted to cash in three days or less like publicly traded stock) or noncontrolling (meaning a minority interest holder cannot effectuate change in an organization).

Because the minority interest holder cannot expect to receive any benefit from the investment until it is sold, that interest typically would sell for a discounted value. Applying these discounts can substantially reduce the pro rata value of the underlying stock or equity being transferred, making it a great wealth transfer tool.

Gifting is not a typical transition option for an exiting owner dependent on the business’s sale to maintain his or her post-exit lifestyle. However, by gifting nonvoting stock, a business owner can maintain control of the company and continue receiving a salary and benefits until it is passed on to the recipient.

Private equity

An external transition option is to sell to a private equity firm. Private equity companies are investors who build value and sell later at a higher price. They invest and purchase controlling interest (usually 60-70%) and often need the owners to remain and manage their companies to increase value. These owners can later sell their remaining portion for a greater multiple and be wholly cashed out.

Private equity firms see the roofing industry as an attractive, profitable, stable market ripe for longer-term growth investors. This is an opportunity to provide an economy of scale and synergies for purchasing shared resources, best practices and bargaining power to be competitive in the roofing industry.

Private equity firms are attracted to profitable companies with strong margins more than 10% above earnings before interest, taxes and amortization; a continued pattern of growth; clean financial statements; a strong management team; unique niches; and free of potential liability.

Private equity firms also pay close attention to the owner’s management team. Team members understand the business’s relationships, systems and operations, so they are in a better position to manage the risk associated with maintaining and transferring profits to the new owners.

The pitfalls of exiting

Exiting a business presents numerous challenges, such as valuation, taxation, succession and contingency planning.

Business value

A business can have several values depending on the exit method selected, the ownership interest being sold and the economic climate in which the business operates. The business owner should understand the nuances of business value, including what adds and/or detracts value from the business.

Business owners often have unrealistic expectations of what their companies are worth. In the valuation world, a business is only worth what someone is willing to pay for it. A qualified business appraiser can help determine a business’s value.

Tax planning

Tax liabilities vary greatly depending on the type of exit an owner pursues. In certain instances, the effective tax rate on the sale of a business could exceed 55%, which means the government would receive 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 exits.

Succession planning

Succession planning often is a neglected discipline with exiting owners. It involves training key individuals within a company to eventually replace the owner and deals with changing disciplines, behaviors and attitudes in the management team. Depending on the level of planning that already has been employed, this process can take two to 10 years.

Neglecting to plan for business succession can affect an owner’s ability to exit his or her business successfully. For example, if an owner is selling to an outside party, the buyer wants to know a well-seasoned management team is in place to help support operations into the future. Not having this management team in place can make the business less attractive to buyers.

A lack of a strong succession plan also can negatively affect an internal transfer. The owner’s ability to get paid relies on the management team’s ability to continue to run the business successfully.

Contingency planning

Another common pitfall involves missteps in contingency planning, primarily improperly documented buy-sell agreements or improperly designated life insurance policies. These two items depend on each other for proper execution.

A buy-sell agreement is an agreement between existing shareholders that outlines the terms of a buyout in the event of death, disability, divorce, and voluntary and involuntary departure for cause. It should be drafted to support the owner’s intentions and leave little ambiguity.

Life insurance often is used as the funding mechanism for buy-sell agreements. If life insurance is not owned correctly or if the beneficiary is not properly designated, it could create a situation where a significant tax benefit is missed.

Exit planners

Managing the exit planning and execution process is critical to achieving success. All too often, advisers promote a one-size-fits-all approach to the process without considering the owner’s ultimate goals or other plans. On the other hand, an exit planner can assist in organizing and consulting the business owner regarding various strategies to envision the outcome well before the sale.

Think of an exit planner as an architect. An architect must understand the various disciplines involved in building a structure, such as the specifications of an electrician, plumber, carpenter and roofing contractor, and integrate the various disciplines in a comprehensive blueprint so the contractors can identify, evaluate and execute the plan.

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 the business owner may experience. The planner can then 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 incorporated into the plan. It is important the exit planner guides the process for the owner and he or she can evaluate and discuss key issues with other advisers on the team.

Plan early

Business owners are retiring at unprecedented rates. Although the common solution is to sell the business, many owners have not put in the time and effort to make the business saleable.

With the increased number of businesses that will be transitioning during the next 10 years, it is incumbent on business owners to plan for their eventual exits. It not only benefits them individually but also benefits their families, employees and, in some cases, their communities.

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KEVIN KENNEDY is co-owner and CEO of Beacon Exit Planning LLC, Dallas, and JOE BAZZANO is co-owner and chief operating officer of Beacon Exit Planning.