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Chapter 1


What is Exit Planning?

An exit plan is the road map that addresses all aspects of transitioning your privately owned business when you are ready to sell, retire, or transition the business to someone else.

The exit plan addresses the business, personal, financial, legal, and tax issues involved in the exit process. Even if you are not thinking about retirement now, you still need an exit plan to document contingencies in case of an unfortunate life event – such as divorce, death, illness, or burnout.

Guy holding magnifying glass

3 Questions You Will Have to Answer When You Begin Your Exit Planning Strategy

  1. When Do You Want to Sell/Exit?

    When you exit is the one area that might change most often as outside influences can change the timing of an exit. Shifting market values, a pandemic, or revised personal objectives can modify your timelines. Getting into business is one thing but getting out of it takes planning and a group of trusted advisors.

  2. To Whom Do You Want to Sell or Transition To?

    Transitioning to family members working in the business in one opportunity. You have options to gift and/or sell shares to those family members. It's essential that you have family members work in the business before the transition because you will want to make sure they understand the business and have a vested interest in running it full time.

    Another option is transitioning to insiders such as your management team. Frequently there are management groups already in place that are more than capable of running the business. Further options are ESOPs (Employee Stock Ownership Plan), strategic buyer(s), or a competitor. When choosing who to sell to, it's crucial to align your objectives with those of the potential buyer.

  3. For What Price Do You Want to Sell Your Business For?

    The third objective in exit planning is how much you will sell your business for. That price is based on knowing the answer to how much your company is worth. There are multiple ways to value your business. It's not just looking at your bottom line or your assets and setting a price based on what you think it is worth. We will discuss more about the valuation process later in this guide.

Why is Having an Exit Plan Important?

Exit planning can be handled as soon as the day you start your business, but it should begin at least five years before you want to leave. If you put off your exit strategy until you're ready to get out, you may have seriously limited your options including who you can sell to, the value you'll receive, and how successful the transition goes.

You can also expect that your exit plan will need to be adapted because of circumstances beyond your control. This can include issues such as health, life changes, key employee departures, market conditions, or interest in your company by intended successors.

Though every entrepreneur has heard stories from people who sold their small company for a considerable sum of money, they tend to be the exception, not the rule.

woman with question marks floating around her

Chapter 2


Gather Your Exit Planning Team and Determine Your Timeline

List of the Types of Professionals You Need on Your Exit Planning Team

Start by creating your exit planning advisory team which includes professionals with experience in each aspect of the exit.

  • Attorney:

    Protects the owner's assets and processes all legal contracts and documents.

  • Financial Advisor:

    Develops a financial plan for growing and protecting your wealth.

  • Trust Advisor:

    Helps you determine the appropriate type of trust for your situation (if you use trusts in your estate planning).

  • Accountant:

    Develops a tax strategy to mitigate taxes, assists with the due diligence process, and discusses ways you can increase the value of your business.

  • Valuation Expert:

    Determines the current value of your business and ways you can improve that value if needed.

Exit Planning Timeline

Before you decide how to exit your business, you first need to consider how much you need to retire and when you want to leave. To get the best results from your exit strategy, planning is vital. We recommend planning 5-7 years in advance of your expected exit date.

The following chart provides a snapshot of the core activities involved in exit planning and a sample 7-year timeline. Of course, things can be adjusted based on your specific needs with an eye to the type of exit you are planning.

Chapter 3


Determine When You Plan to Sell or Transfer Your Business

The biggest mistake owners make is overestimating what their business is worth and underestimating what they need to live on after they exit the business.

A general rule of thumb for retirement income is to have 75% of current income available post-retirement.

retirement income breakdown chart in percentages

As a business owner, you need to take a close look at expenses currently going through the business that will not be post-exit. For example:

  • Car payments or leases

  • Gas

  • Car insurance

  • Travel expenses

  • Health and life insurance

Having more free time may mean you plan to travel a lot or purchase a second home.

Meeting with your financial planner is critical as you start your exit planning process. They will be able to help you develop your post-retirement income scenarios.

What is Your Asset Gap?

Current Company Value – Retirement Needs = Asset Gap

The asset gap occurs when there is a difference between the resources a business owner has and the resources they'll need for a comfortable business exit.

To determine whether there is an asset gap or not, you need to calculate the value of your company and then what your needs are in retirement. To close the asset gap, there are three options:

  1. Stay and Work – If you have a business where you receive a good salary, it's providing a good lifestyle, and you can't make up the asset gap, then you should continue to work until it makes financial sense to exit the business.

  2. Get What You Can – If you only get what you can get for your business, you will need to update your goals and change your lifestyle to shrink the asset gap.

  3. Build Value – Increase the value of your business pre-exit so your retirement goals are met. This takes time so it is imperative you start early.

Understanding the asset gap will inform the decisions you make going forward.

  • Do you have time to delay your exit to build more value in the company?

  • Are you transferring to family in a scenario where significant funds will remain in the business?

  • Do you know the real value of your business or just estimating its worth?

  • Are you planning to work elsewhere or are you relying on the business income to support your family going forward?

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Chapter 4


Six Options for Transferring Business Ownership Successfully

The biggest decision when planning your exit strategy is what option you will choose. There are six options, each with its own benefits and challenges.

people discussing at a table
  1. Pass Ownership to a Family Member

    You have built a legacy and now you're ready to pass it on to a younger sibling or the next generation of your family. This is often an entrepreneur's dream, providing for their family for generations into the future. However, it may not be your children’s dream and they could have no interest in taking over. Though you have the option of providing them the business as a gift, it does not deliver much or any value to you at the time, which can limit your retirement income if you have not made other arrangements.

    Statistically the success rate of transferring to family members is low. Various surveys indicate less than 30% of businesses survive to the second generation and only 13% of those make it to the third generation before they are sold, merged, or closed. The dream you have of transferring your business to family may not be the dream your family has in mind.

    Ask yourself these questions:

    • Are you willing to finance much of the sale value?

      Often family members do not have the capital to purchase the business, which means you will need to leave money in the business.

    • Why is a family transfer important to you?

      If you wish to continue the mission or culture of the business, as well as maintain community relations, a family transfer can be very appealing. It continues the legacy you have built.

    • Are your family members interested and experienced enough to take over?

      Consider if they demonstrate enthusiasm and have the ambition to take over the business. Future owners should work in the business for many years to truly gain the experience they need to take over leadership.

    • Are there conflicts or family issues that may make a transfer difficult?

      With family, there is typically conflict. If you have multiple family members, think about each of their strengths and weaknesses. Should you have a CEO from outside the company lead the organization? Will you still be involved in key decisions as a member of the board? Are there significant differences in how family members are involved – is one child heavily involved in day-to-day management, while another is more passively working in the business?

    • Is transferring the business the best way to provide for your family and your future needs?

      Depending on your financial position, keeping the business in the family may make financial sense. However, if you need to finance much of the transfer, how does that impact your future?

    When transferring to multiple children, fair is not always equal. If you have one child who works in the business and takes on a leadership role, and another who is less interested, how will you structure the sale to be in everyone's best interest? Family conflicts can be big hurdles in the process.

  2. Sell to Key Employee(s)

    Your next option is selling your company to key employees who are already experienced with your business. However, many employees will have limits to their financial resources or may not have the business acumen to be a good entrepreneur. You will spend time training the employee and may have to finance the deal personally or through your business, due to difficulty with bank financing. Is the risk one you are willing to take on or will your company's balance sheet work well with the debt and distributions needed for this type of transfer?

    The reason to transfer to key employees can be similar to why you want to transfer to family. This option gives the opportunity to turn the business over to known leadership. Your company will stay in the community, maintain the same culture, and your employees will be taken care of.

    So, what are the obstacles for this option? Employees may not have the funds to purchase the business, which again means you need to finance all or part of the transaction. This leaves you less cash as you move into retirement.

    There are several ways to fund an employee purchase:

    • Installment Sale:

      With an installment sale, you receive payments over a period of time at a reasonable interest rate and based on an agreed upon price. The success of this will be dependent on the future income of the business. If sales decline and expenses rise, it may be difficult for the new owners to make the required payments. However, if the business continues to grow and be successful, this can be an appealing option.

    • Leveraged Management Buyout:

      With this option, the management team gets financing to fund a portion of the transaction. They then secure a private-equity investor to back the deal. There is less risk to the departing owner with this option.

    • Modified Buyout:

      A modified buyout has two phases. There is the initial sale with a minority interest which can last three to seven years. The second phase is the sale of the balance of the company at the current market value. The challenge with this option is it takes longer to receive all the funds for the sale, but it does help key employees take over in a long-term solution.

    Having a solid management team that understands all the aspects of running a business is imperative. You might have a great employee who is enthusiastic and great at his job but does not have the business acumen needed to handle all the nuances of being an owner.

    On the other hand, you might have an employee who knows the financial aspects of the business but does not understand how to deal with employees and customers. Defining who is interested and aligning their skills with the needs of the business will give you the best results for this opportunity.

    happy group of people
  3. Add an Employee Stock Ownership Plan (ESOP)

    To gain value while keeping your business going, an ESOP facilitates your plans but can have issues with bonding. As an ESOP, the owners are not always willing to give a personal guarantee, and there is the question of who is running the company. Is your management team flexible enough to work in this type of culture?

    Much like a 401(k) or profit-sharing plan, ESOPs are considered a tax-qualified retirement plan subject to the Employee Retirement Income Security Act of 1974 (ERISA) requirements. The biggest difference between an ESOP and another tax-qualified retirement plan is that an ESOP must invest in the business's stock. It provides the owner a great option for rewarding employees who have been loyal while transferring ownership to them.

    The ESOP trust must be formed by the business with a trustee who is typically independent of the company. All or a portion of the company is purchased by the ESOP from the owner(s) following an appraisal. In many cases, money must be borrowed from an outside lender by the business, with the proceeds from the loan immediately distributed to the ESOP as an internal loan. This allows the ESOP to immediately purchase the interest or shares in the business. This must happen in a two-step process so that your outside lender can avoid compliance issues with loan requirements under ERISA.

    There are many considerations to review to ensure the ESOP you create will work well for your business. These include:

    • Continuity of management

    • Evaluations of preexisting debt

    • Willingness of the owner to accept appraised fair market value for their shares

    • Legal limitations on how much can be contributed to the ESOP every year

    This opportunity is becoming more popular and requires significant time to establish before your exit.

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  4. Sell to an Outside Individual/Third Party

    Though selling to an outside party can provide you with a great value, the opportunities to do so may be limited, especially in industries that are not seeing rapid growth. They may also come from a small pool, limiting your sales options, or they could have limits on their financial resources, making it difficult to raise the capital needed to buy. The economy and type of business you own will impact the options you have for a third-party sale.

    A sale to an outside third party allows you to receive the bulk of the purchase price when you sell. This option is the quickest and easiest way to exit.

    What are the advantages?

    • The time frame is typically less than a year to complete the sale and receive your funds.

    • The sale can be structured so proceeds are only subject to long-term capital gains tax.

    • The time margin is quicker as once the sale closes, you no longer have responsibilities to the company. That is assuming the new owner does not require you to stay on for a period of time in an advisory capacity.

    • The outside sale alleviates the family issues of ensuring you are fair and equal to all children. If selling to a larger company, key employees may have more opportunities for advancement.

    What are the disadvantages?

    • With the sale of the company, you lose all control. If you do not receive the full purchase price at closing, you are at risk of declining payouts based on future company performance.

    • Buyers may ask for the seller to continue employment for a period of time as a condition of the sale.

    • Without proper planning, there could be significant tax consequences. If you're a C corporation, you could be at risk of taxation at both the corporate and individual level.

    • Once you are out of the business, there is no guarantee that your value-based goals will continue. The new owners may bring radical changes to the culture of your business.

    Proper planning will help you succeed with an outside sale. Do your due diligence, get a valuation, and put in place tax planning before you start the sales process. Be ready to let go of the emotional aspects of the business, as it may not continue with the same priorities you had as the owner.

  5. Accept a Merger with Another Company

    Merging with a competitor or selling to a private equity group can also provide good value, but you will find limited opportunities, unless your company has something the other business wants such as territory, key employees, customer relationships, or technology. At the same time of a merger, private equity firms want recurring revenue streams such as service contracts. This option is again heavily reliant on the type of business you own, your customer base, and the uniqueness of your products or services.

    The opportunity to merge with another company really depends on your products and services. If you have customers who rely on what you offer, this can be an effective strategy. Companies typically merge to expand market share, diversify products, minimize risk, reduce competition, and increase their profits.

    A merger means two companies will become one and there will be a need to cut redundancies. This could mean staff, product lines, service areas, and physical locations.

    What is the difference between a merger and an acquisition?

    A merger is when two companies combine to form one new company, while an acquisition is when one company buys out and controls another company.

    There are five main types of company mergers:

    • Conglomerate mergers

    • Horizontal mergers

    • Vertical mergers

    • Market extension mergers

    • Product extension mergers

    What are the advantages and disadvantages?

    Many small businesses may have the opportunity to be acquired by a larger company that considers the unique value of what they wish to acquire. If you are in a competitive market, you may be able to get more for the business, depending on the interest level of purchasers. It can be easier to negotiate a higher price compared to selling to employees or family.

    One disadvantage is the purchasing company may reduce redundancy in staff and services, affecting the welfare of your employees.

  6. Sell Your Assets and Liquidate

    This is often the easiest way to get out of a business, but it also provides the lowest value for the owner. This involves selling off equipment, liquidating assets and real estate, collecting your receivables, paying off any liabilities, and similar options. Because people know that you are doing these things to get out of the business, you're unlikely to make a lot of money in the process.

    This option is the least favorable and typically a last resort. Closing and liquidating the business turns your assets into cash. When selling off assets, they are not worth the same as what the business is worth. You will sell all equipment, operational assets, and property. However, you receive no value for the customer base you have accumulated, and your employees are released. Furthermore, creditors will be paid before you receive any cash from the sale.

    After the hard work put into growing your business, this is not a favorable exit plan and used only as a last resort. Therefore, planning matters. Plan far enough ahead so you don't get into a no-option scenario.

    man and woman looking at charts on a computer

Whatever option you proceed with, the selling price needs to make it easy for the seller and buyer to have success. Let's delve into each option a bit more.

Chapter 5


How to Determine a Selling Price for Your Business

What is a Business Valuation?

A business valuation is the formal process of determining the overall value, as well as the fair market value, of your business. There are many reasons you may need a business valuation including preparing for a future sale, establishing value for owners/partnerships, and taxation.

The significance of a business valuation lies in the formal processes of knowing what the financials look like, what the historical trends are, and projecting what the financials might look like in the future. A valuation helps to understand a business's trends, strengths, weaknesses, as well as how it is fairing against peers and competitors.

What Factors Does a Business Valuation Look At?

Factors a valuation looks at include:

  • Costs

  • Net assets

  • Management structure

  • Cash flow generated by the business

It also considers what other businesses in your industry are selling for. Keep in mind that even though the valuation uses historical data, it is the forward-looking data and projections that are most important.

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization)

EBITDA can also help determine business value. EBITDA is a historical number that looks back at historical financial statements. However, it is important to note that oftentimes business owners just take their financial statements and calculate EBITDA without taking into consideration the items to normalize that number.

(Download Video Transcript)

Examples of normalizing EBITDA are if you are paying above or below fair market value for rent, if your owner compensation is higher or lower than comparable owners in your industry, etc. It is important to take the historical information and spend some time with the financial statements to dig into what should be the "normal" number.

It is not as easy as taking your EBITDA number and applying it to a multiple because that number may be inflated or too low. You must be very cautious on the numbers you are calculating and how you are really deriving the value of your business.

ebitda example chart

The example below shows how you can impact the sales price by improving the value in the business or modifying the multiple.

how ebitda affects business value chart

When Should a Business Owner Perform a Valuation?

An owner should perform a business valuation in stages.

First, you need to gather enough information to have a good understanding of your value. Then you can decide if you want to sell it for that value. If it is not enough for retirement, then it is not the right time to sell.

Next, if the value is not at the level you want, you have the opportunity to make changes and increase the value over the duration before you sell the business.

Performing a business valuation at the beginning of the entire exit planning process provides you the framework on what you should do in the next 2-5 years until the time you sell. This is the prime opportunity for you to make the necessary changes that will enhance your business value.

In terms of the valuation component, if you are selling to a related party, you need to sell it at fair market value. You cannot sell it at a deep discount because at that point the IRS will get involved. The IRS will look at it as a gifting component to the transaction because you did not sell it at fair market value. Therefore, you will need a business valuation to substantiate that you are selling it at fair market value, or if there's a gifting component, you need a business valuation in order to support that gift.

What Can Owners Do to Increase the Value of their Business?

There is plenty an owner can do to increase the value of their business. It does not necessarily have to only be about sales or expenses. Managing processes and procedures can also have a substantial influence on business value.

To increase business value, owners need to look at the sustainability and accuracy of their financial information. For instance, in the due diligence phase, potential buyers will start to poke holes in the business's financial information, so owners need to shore up their processes and procedures as well as their financial reporting.

Business owners also need to answer the question, "How important am I as the owner of the business?" If you say you are important, then that's a problem. Unless you are going to work for another five years or more, you need to have key management in place that can run your business without you. It is important to note that this takes time. You will not be able to get your management team up to speed that quickly.

8 Key Drivers for Building Business Value

As you grow your business into a valuable asset for the future, the first step is to assess the value using the 8 key drivers of business value. Each of these value drivers are used to evaluate where your business stands today and outline areas to improve for the future.

(Download Video Transcript)

  1. Financial Performance

    This value driver does not mean you need to have an audited financial statement or even a reviewed financial statement, but what it does mean is you need to have accurate financial information. It is important that when a potential buyer starts the due diligence phase on your organization, they don't lack trust in the numbers and those numbers are accurate. A potential buyer will want to look at some successful results and they are going to focus on top-line revenue and bottom-line income.

  2. Growth Potential

    When addressing growth potential, it comes down to capacity. A company that is already at capacity is not going to be worth as much as a company that has capacity. When someone looks at buying your business, they want to buy it because they want to take the business to the next level. Key areas of growth potential are through revenue expansion and earnings predictability.

  3. The Switzerland Structure

    Independence is the theme for this value driver. It is important to not be reliant exclusively on a single customer. A business also should not be reliant on a single vendor, a single supplier, or even just your employees. Just like Switzerland, a company should be neutral to its customers, vendors, and employees so there is not a reliance on just one single source. Being too reliant on one customer, vendor, or employee can impact the business's value.

    meeting with woman pointing at graph
  4. Working Capital

    Working capital is basically your company's cash flow – it is the difference between receivables and inventory compared to accounts payable. One might think it is wise to pay all vendor invoices at once so there are no payables, but that’s not necessarily good from a cash flow standpoint.

    You do not necessarily want to have more receivables than payables on your financial statements because then you are paying out more than you are bringing in. It is a very important balancing act to have the right receivables and inventory to payables because when you are getting ready to sell and a buyer looks at those numbers, it can affect the value and ultimate sales price.

  5. Repeat Sales (Recurring Revenue)

    Often companies chase the work that they are getting. If you can find a way to have recurring revenue come into your business automatically, the more the value of your business will increase. To have a steady recurring revenue stream, determine what you can do with your business and what you can sell that can automatically repeat again and again.

    Service can be an option in terms of service contracts. For example, a customer may buy a product and then they also purchase a year's worth of service that could be automatically billed monthly, with annual renewals. Whatever it might be, you want to create a way to automatically have your revenue reoccur, so you don't have to chase it as much. It also gives you predictability so you can look at your sales in the future and budget appropriately.

    Recurring revenue is something that increases your multiple quite a bit when you are looking at valuing your business.

  6. The Monopoly of Control

    This value driver has to do with finding ways to differentiate yourself from other businesses. What can you do to really set yourself apart from your competition? The answer is to look at what your customers' needs are. Every organization should challenge themselves to do this. If you do, you will have more ability to have pricing strength because you're offering something that no one else offers.

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  7. Loyalty (Customer Satisfaction)

    It is important to measure your customer loyalty and your customer satisfaction. One way to do this is with the Net Promoter Score (NPS). This survey is one question which states: On a scale of 1 to 10, how likely are you to refer someone to this business? Then based on the score, you can tell how well your customers are satisfied with your business:

    • Score of 9 or 10 are the attractors. These customers are the ones who are actively promoting your business, sending referrals your way, and telling people that they need to buy your products.

    • Score of 7 or 8 are considered passive customers. They come to you when they need something, but they are not actively promoting your business to other consumers.

    • Score of 1 to 6 are the detractors. These customers are not loyal to you. They might buy from you if it is convenient but they're not actively trying to come to your business.

    Your Net Promoter Score is calculated by subtracting the percentage of detractors from the percentage of promoters (the percentage of passives is not used in the formula). For example, if 10% of respondents are detractors, 20% are passives, and 70% are promoters, your NPS score would be 70 – 10 = 60.

    One recommendation when implementing the Net Promoter Score is to add an optional question that asks why. People by nature tend to want to tell you if they are dissatisfied with something or they're unhappy. It is important to always add this optional question because this will give you some insight into areas to focus on if you do get a low score. Then resurvey your customers within approximately 9 to 12 months to see if you have gained some better scores.

  8. Management Depth (Hub & Spoke)

    This raises the question – do you have a management team in place or is the business solely reliant on you? This area is about changing the owner's mindset from needing to be all in on the company details to one being focused more on the high-level areas and being able to plan for the future.

    If you are trying to sell your company and it’s solely reliant on you to bring in the business, it will be hard for someone to take over when you're the one who is doing most of the work. As the business owner, you need to plan and build your company's value. Your management team should be relied upon to run the day-to-day operations so they can transition with a new buyer when the time comes.

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Chapter 6


The Value of Due Diligence in Exit Planning

What is Due Diligence?

Due diligence is a comprehensive appraisal of a business, undertaken by a prospective buyer, to specifically establish its assets and liabilities and evaluate its commercial potential. It is the process of a buyer confirming the accuracy of financial statements, income, revenue, unrecorded liabilities, etc.

There are several components of the due diligence phase besides financial due diligence. There is also a legal due diligence where, for example, a buyer will examine leases, customer contracts, and vendor contracts. Insurance due diligence will look at insurance coverage and any outstanding claims.

Why Do Buyers Perform Due Diligence?

On a case-by-case basis, a buyer will conduct due diligence on whatever aspect of the business they are trying to validate. For example, in a transaction where assets are being purchased, the buyer will perform the due diligence process to make sure the seller owns all assets free and clear. If a buyer is purchasing the stock of a company, they are more interested in whether there are substantial liabilities in the business.

There are a variety of different items the buyer will look at during the due diligence process, but it is really to make sure the assets they want to procure are good.

meeting with man pointing at chart

What Can You as a Seller Do to Prepare for Due Diligence?

If you have enough time to prepare in advance for the due diligence phase, you're going to get the best value for your business. Pre-planning due diligence on yourself is important because not only do you get to understand your strengths and you get to sell your strengths, but you also get to understand your weaknesses and rectify those weaknesses if you are able to.

During the due diligence process, the buyer will receive financial and non-financial information. They will look at every contract and probably even some contracts you did not even know you had. They will really look and make sure there are no undisclosed liabilities and that you have all your ducks in a row.

Before due diligence starts, when you're working with a buyer, you can really control what information you give to them, and in the format you want to give to them. But once due diligence starts, then what they ask for you must provide, within some limit. You have a lot less control over what your information looks like and what you are going to provide during the process.

If you know what your information looks like and you have had the opportunity to make any changes or tidy up some things along the way, you will experience a smoother due diligence process and you are looking to get the best value for your business.

Even if you are a business owner who plans to sell your company to a family member, the due diligence phase and a proper business valuation are still important. As far as due diligence is concerned, you don't want to hand over liabilities to your family members. Also, it depends on how closely your family member is working in the business. How much do they know, or not know, about the owner-type responsibilities of the business? They will still need to undergo the due diligence process.

Chapter 7


How to Understand Buy-Sell Agreements

What is a Buy-Sell Agreement?

A buy-and-sell agreement is a legally binding contract that stipulates how a partner's share of a business may be reassigned if that partner dies or otherwise leaves the business. Most often, the buy-and-sell agreement stipulates that the available shares be sold to the remaining partners or to the partnership.

The buy-and-sell agreement is also known as a buy-sell agreement, a buyout agreement, a business will, or a business prenup.

various people working and talking

Solutions to 7 Potential Buy-Sell Agreement Problems

These agreements safeguard your business and have provisions that clarify how situations will be treated. As with all contracts, they have definitions of triggering events, payouts, and valuations. Oftentimes these agreements are created with the idea that they will likely not be needed. Now is the time to look at your buy-sell agreements and measure them against these seven potential problems.

seven-common-buy-sell-agreement-problems
  1. Ignores Threats to Business Continuity

    Most buy-sell agreements don't address the challenges that the business, surviving owners, and deceased owner's family will face after an owner exits. They only address the transfer of ownership upon an owner's death or permanent incapacitation.

    For example, if the surviving owner does not have enough assets to satisfy the personal guarantees previously made by the deceased owner, once that financing is pulled, the business may not be able to continue. Likewise, if the deceased owner was the company's rainmaker or COO and no one is able to step into those roles, the business may be unable to survive.

    At best, a buy-sell agreement dealing with the transfer of ownership at death (and sometimes permanent incapacitation) only ensures that (a) the surviving owners own all of the company and (b) the deceased owner's estate receives fair value, in cash, for the transfer of ownership. It leaves other major issues unaddressed.

  2. Ignores Common Lifetime Exits

    Does the agreement cover an owner's lifetime exit? An owner's incapacitation, divorce, bankruptcy, termination of employment, or retirement, along with business disputes among owners, can trigger the need to transfer ownership and are more likely to occur than the death of an owner. Most buy-sell agreements fail to consider these conditions.

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  3. Neglects the Decedents' Family

    Most buy-sell agreements focus exclusively on the benefits they provide to the surviving owner rather than on providing for the needs of the decedent's family. Even if the deceased (or incapacitated) owner's family receives buy-sell proceeds for the full value of their loved one's business interest, that amount is rarely enough to support the family at the same level as did their loved one's lifetime income. The fundamental exit goal for every business owner (i.e., maintaining financial security after exiting the business) is rarely achieved from the proceeds received via a buy-sell agreement.

    The financial shortfall for the deceased owner's family is caused by the transfer of ownership (and with it the right to a continued stream of income from the business) and the loss of the deceased owner's compensation. Buy-sell agreements are not designed to address these problems. In fact, they can cause more problems because the decedent's income rights end after the ownership transfer. The question that advisors must ask and help owners resolve is, "If you die, what will replace your income stream for your family?" There are many possible answers to this question that may involve restructuring the buy-sell agreement.

  4. Isn't Up to Task (Too Simple)

    Many buy-sell agreements are too simplistic to manage the personal complexities of the individual owners who sign them and their relationships with each other. For example, companies with multiple owners often do not want to treat all owners similarly, or one owner subject to the agreement may be uninsurable. In family businesses, non-business considerations may affect the design of buy-sell agreements.

    men and women working
  5. Cookie-Cutter Valuation Formula

    A valuation methodology (e.g., agreed-on value or book value) can be too simplistic. While such a formula may be adequate when a business first forms, it does not adjust sufficiently to account for business growth.

  6. Outdated

    Buy-sell agreements may not have sell-by dates, but they should. When they lie at the bottom of dark drawers, unreviewed in the context of current business circumstances and the changing desires of owners, they can yield ugly surprises. Owners rely on buy-sell agreements to manage emotionally charged situations, and if those agreements do not account for changes in the business, they cause huge problems for everyone involved.

  7. Poorly Implemented

    If insurance funding is lacking or insufficient, or information about the beneficiary and ownership of insurance is incorrect, there is no way the agreement can serve its purpose.

Chapter 8


Planning for a Tax-Efficient Transfer

The tax expense is only one component when calculating the net proceeds from the sale of a business. Other components are debt, working capital, and transaction expenses. So how you structure the transaction can have an impact on how much you pocket from the sale of your most valuable asset.

4 Important Factors That Impact the Tax Liability in the Sale of a Business

  1. Structure of the Deal (asset or stock):

    • Sellers typically prefer a stock sale for the capital gains treatment and to avoid double taxation (and because some tax of an asset sale is at ordinary rates due to recapture rules).

    • Buyers generally want an asset sale to maximize future depreciation write-offs via the ability to write-up tax basis in assets.

    • The seller should consider seeking a gross-up payment from the buyer for additional tax costs.

  2. Structure of the Business Affects the Tax Implications (C-Corp or S-Corp (pass-through)):

    • C-Corp (asset): Gain subject to entity-level corporate income tax and shareholder-level (dividend/capital gain).

    • C-Corp (stock): May qualify for 1202 gain exclusion and/or long-term capital gain exclusion (requirements).

    • S-Corp (asset): Gain passes through to seller subject to one layer of tax.

    • S-Corp (stock): 338(h)(10) election available to treat as a deemed asset sale.

    mean and women at a conference table working
  3. Structure of the Purchase Price Allocation:

    • In an asset sale or deemed asset sale, the purchase price allocation can have big tax consequences for both parties.

    • Both parties submit matching allocations of purchase price across different classes of assets. This affects how the seller determines gain/loss and depreciable basis in assets for the buyer (any write-up for buyer results in some depreciation recapture to seller).

  4. Installment Sale:

    • A sale might be structured as an installment sale if the buyer lacks sufficient cash or pays a contingent amount based on the business's performance. An installment sale also may make sense if the seller wishes to spread the gain over a number of years — which could be especially beneficial if it would allow the seller to stay under the thresholds for triggering the 3.8% NIIT (Net Investment Income Tax) or the 20% long-term capital gains rate.

    • Be aware of potential unintended consequences of an installment sale such as an increase in tax rates, portion of proceeds not eligible, or default.

This is where you need to bring in an accountant who is experienced in the sale or transfer of a business. They will look at your specific situation and create the strategy that minimizes your tax burden.

Chapter 9


Combine Your Exit Planning and Estate Planning Strategies

Where Does Exit Planning Intersect with Estate Planning?

  • Exit planning develops the roadmap on how you will exit the business and determines the business assets you have now vs. any after-tax monetized value. It also establishes how those assets will support your post-transition.

  • This income stream planning should not be limited to when you transition out of the business.

  • An essential part of planning is determining the income stream your family will have if the unexpected happens and you do not survive until you exit the business.

By creating both plans (estate and exit) together, you can leverage the time and money spent on exit planning when you design your estate plan. Both have similar goals and strategies and therefore should be coordinated in joint efforts with you and your advisory team.

A valuation of your business by a valuation expert will set realistic expectations of the potential proceeds when you sell/transition the business. It also will help you determine if you need a plan to grow and/or protect the business value through value-building strategies.

If you have an estate plan in place, revisiting that plan and aligning it to your exit plan will give you a comprehensive strategy for your future income.

Exit planning and estate planning should also cover what will happen with the business and your estate upon your incapacity or death, especially if you are still active in the company. Proactive planning will keep the business running and meet your family's financial needs if the unexpected happens.

How Does an Estate Plan Help During Exit Planning?

  • Determines the income stream for your family and provides for financial security.

  • Directs who the business will transfer to in your family. If your family is not the successor of your business, your estate plan documents should reflect the plans for your business.

  • Protects your assets from creditor attacks and minimizes tax consequences.

  • Ensures your charitable goals are met.

man with question marks around him

Additionally, an estate plan should not be considered as your exit plan. However, implementation of your estate plan should take place well in advance of any exit, just as exit planning should take place years in advance of any exit.

Oftentimes, asset protection planning and estate/income tax minimization planning involve trusts or other entities and strategies that, if not implemented well in advance of an exit, may have limiting effects on achieving your goals and objectives.

Popular Estate Planning Technique: Intentionally Defective Grantor Trust (IDGT)

If you are considering transferring your business interests to a family member, how you structure the transaction can have a meaningful impact on the success of the transfer. Making a transfer in trust can reduce many risks and concerns that the person making the transfer may have. A popular technique to implement in this situation is an Intentionally Defective Grantor Trust (IDGT).

An IDGT is an irrevocable trust that is structured so that any transfer into the trust is excluded from the grantor's estate for estate tax purposes because the transfer is treated as a completed gift. Therefore, the business owner is able to pass ownership to the family while, at the time of the transfer, "freezing" the value of the ownership interest that was transferred and passing it outside of his/her estate for estate tax purposes.

The IDGT then holds the business ownership interest in trust, according to the terms of the trust instrument, for the benefit of the designated beneficiaries. Generally, the grantor makes an initial transfer of an up-front "seed" gift. Then the IDGT and the grantor enter into an agreement through which the grantor sells all or a portion of the ownership of the business to the IDGT, with the remainder of the payments evidenced by a promissory note given to the grantor.

Next Steps

An estate plan is not an exit plan, but an exit plan is not complete without an estate plan. Even if you take 5% of your time and spend it on the business, instead of 100% in the business, you will be better off for it. You will monetarily reap the rewards on the transaction and in your estate plan if you do that as part of your business planning.

Measurable Results.® SVA's Tax, Estate, and Succession Planning Benefits J. Henry & Sons

 

Chapter 10


Are You Ready to Get Started?

This is just a sampling of all the areas that need to be addressed when planning your exit strategy. There are many more examples, scenarios, and considerations based on your specific business and personal goals. Gathering a team of professionals who are experienced will net you the best results.

Download Exit Planning Checklist

Remember this:

  • Talk openly and honestly about your business operations and personal goals.
  • Look at all the options and how they impact your bottom line.
  • Before you opt for a family or employee transfer, be sure there is genuine interest in running the business.
  • Be realistic about the timelines. Start early. Plan ahead. Be prepared for shifts in your strategy.
  • Talk to your family about your goals before you get started.
  • Wait for the right opportunity.
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SVA Can Help

SVA has the expertise and resources you need to tackle your exit planning. We know as a business owner you are busy running the day-to-day of your business. The transition of your business might not be top of mind today. We will help you develop a plan to exit your business when you want, with the income you need, and transfer to the successor of your choosing.

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