How do you plan for business succession? What are the four different ways of selling or exiting a business? When should you sell a business and when should you not sell? What is a good deal when selling a business? Should I pass my business on to my child? Is an inside sale of a business a good idea?
By James L. Cunningham Jr., Esq.
I have a number of clients who have successfully founded and run businesses, small and large. Many are in their late fifties or sixties, but pretty much regardless of their age, when I ask them what’s in the future, I usually hear: “I’m going to retire in five years.” If I ask them five years later, they say again, “I’m going to retire in five years.” At a recent webinar, one client joked, “I’ve been retiring in five years for thirty years!”
Why five years? My friend and mentor, business advisor Lonnie Martin of Vistage International, says that answering “ten years” seems like too long, while “five years” is just long enough to sound, well, somewhat credible.
Now, all these good people are smart enough to know that without a runway of at least five years, it’s not easy for a founder/CEO to exit a business without some kind of catastrophe occurring, and it also probably takes that long to prepare for a high-value sale. But, of course, just saying “I’ll retire in five years” is not a plan. It’s the focused steps you take during that time that count.
Without a five-year plan, well, count on five years more.
After many years advising business owners in these issues, I would strongly suggest that even a fifty-year-old founder/CEO should start working toward an exit strategy—even if you’re planning to stay more than that five years.
Here at CunninghamLegal we work with founder/CEOs as they make the tough legal and financial decisions leading up to and following the sale of a business or the passing on of a business to a child—including the sticky tax and inheritance issues. We also help with our Family Office Services for high net-worth families involved in complex ownership matters. Contact us using the form at right, or call us at (866) 988-3956. You may also wish to view our webinar on business succession planning.
Exiting a Business Creates Both Financial & Personal Issues
In this article I focus on business and financial issues, but before I really get started, I do want to touch on some of the personal and psychological considerations you will face when you head for the door.
For example, exactly what will you do when you retire? Please don’t answer, “I’ll relax and figure that out when it happens.” Most people tell me they want an “active retirement,” but that only begs the question, what does that mean? Are you sure you really want to walk away entirely? If so, what will you do after that first wonderful three months out of the saddle?
Maybe you want to stay connected. But if so, can you spell out precisely what “staying connected” would mean?
Don’t be casual about the answers to these questions: they matter. The phrase “retirement planning” should describe a lot more than financial planning.
Start with a Gut Check: Do You Need the Business to Continue?
Professionally speaking, you should think about making a business-succession plan as carefully as you did the business plan you drew up when starting your company.
But start by giving yourself a gut check. How important is it for you to keep the business going? Many of my clients have invested, frankly, most of their adult life in their business, and they have a deep emotional connection to it, along with a connection to their long-term employees. They go to sleep each night with the sense of having created something of value that should not just disappear.
Ask yourself, “would it be okay if the business just folded without me?” Because for some businesses, just walking away may be the only option.
Consider the Outcomes You Could Live With
In my experience, the odds are high that even with careful planning, the concern will take some kind of significant dip when you leave. Why? Because you are quite likely the primary rainmaker bringing in new business. You quite likely have relationships with special suppliers and customers that will be difficult to pass to another party. The list goes on.
How will you feel if that significant dip occurs?
Say a prospective buyer comes in and says, “I don’t want your employees or facilities. All I want is your client list. I’m going to shut everything else down.” Is that something that would cause you grief? Or do you not, in the final analysis, really care?
In other words, you need to plan for business outcomes, personal financial outcomes, and emotional outcomes.
Four Paths of Business Succession
I once heard Patrick Ungaschick, CEO of Navix Consultants, which specializes in business sales, give a terrific talk in which he set forth the four different ways to sell, pass along, or wind down a business. His list:
- The “Outtie:” sell to a third party outside the business.
- The “Innie:” sell to a key employee or employees.
- The “Passer:” pass along the business, almost always to a family member, such as a child.
- The “Squeezer:” squeeze as much value out of the business as you can before shutting it down.
The “outtie” is usually the path that first comes to mind when thinking about leaving a business. It’s also potentially the most lucrative of the four paths.
If you want to look for an outside buyer, and you want to realize top dollar, you may well want to use a broker to introduce you to potential buyers and facilitate the sale.
A broker is, of course, not mandatory, but often only a broker will be able to dig up several prospective buyers and get an actual bidding war going. I’ve got to say that if I were selling my own business, I would prefer having a broker’s professional help. A truly skilled broker should not only be able to bring in more prospective buyers but help you ready the business for sale.
It must be said, however, that the larger the business, the more likely an outsider will be interested. It also must be said that an outie sale may be the least tax efficient way of exiting a business. Never forget that Uncle Sam is a joint tenant on every major transaction in your life, including this one. Far too few otherwise savvy business advisors are savvy about tax efficiencies in a sale.
Advanced Tax Planning is another key service offered by our firm, and should really take place before you get too far down the road of selling your business.
The Inside Sale of a Business
The “innie” involves a sale to one or more key employees. Unfortunately, many times employers don’t have key employees with the capability or interest in owning and having the final responsibility for running the business. This can be a tough truth to face, but you owe it to yourself to be realistic about the capabilities of your team members. Will they actually be able to keep the business going on their own long enough to finish paying you off; and do they have a burning desire to do so?
Indeed, part of your five-year plan may be bringing in a new person capable of eventually taking over the business.
Generally, in both an outtie and an innie sale, at least in California, you can expect to pay 50 percent in taxes. Partly for this reason, outtie sales may become interesting to a business owner only at or above the $5 to $10 million level, which leaves $2.5 to $5 million in after-tax profit – without any tax planning.
An innie sale, however, can often be structured with built-in tax advantages to avoid those big tax hits—if you know what you are doing. This may involve an ESOP, an employee stock ownership plan spread out over time, or a buy-out built around the seller’s well-constructed retirement account, or both. You definitely need expert legal advice in creating a deal that leverages these kind of tax efficiencies.
Passing on a Business to a Child
The “passer” involves passing your business on to a family member, whether the family member pays fair market value, a reduced value or you just hand over the keys to the business without receiving anything in return. Here, you’re turning your business into a family business. Some businesses are more appropriate for this sort of arrangement and others aren’t. The question, of course, is whether you have a child who would be interested both in what your business does and in running it.
If you make a passer sale that also involves payment to you from the next generation, it’s really more of an innie sale. And like an innie sale, a passer can be set up with certain tax advantages, assuming that a high level of trust has been developed within the family.
For tax purposes, you may want to pass along a business to a child when it has a low valuation, the sole exception to the general rule, which is that you want to get top dollar. Making the transfer as a gift can also realize a number of tax advantages. However, if you sell your business at a 90% discount, that discounted 90% likely will have to be reported to Uncle Sam as a gift on an IRS Form 709.
Again, because of the complex estate planning, tax planning, and asset protection issues the passer might involve, you should engage legal help early in the process.
Closing a Business Down Entirely
The “squeezer” may be an appropriate exit strategy for sole proprietorships in particular. Say you’re a CPA with a profitable business serving a select clientele, few of whom may be interested in working with your potential successor when you retire. They’ll choose their own successor CPAs, of which there are many who would be happy to be interviewed.
In such a case, your retirement plan may be simply to squeeze every dollar you can from the business until you close it down.
There is absolutely no shame in shutting a sole proprietorship or other small business down after squeezing as much revenue as you can from it. It’s a perfectly legitimate way to wind down a business. Just as an outtie sale is more appropriate the larger the business, the smaller the business, the more appropriate a squeezer might be. It’s simply a choice you make.
Establishing Long-Term Viability and Value of a Business
What specific steps should you take to prepare your business for an inside sale, an outside sale, or to pass it on to a child—in other words, what steps do you need to take to keep the business going long enough for an insider to pay you off, for an outsider to be interested, or for your child to have a solid chance of success?
Let’s assume for now that 1) you want to realize the maximum value from the business when you retire, and that 2) you want the business to thrive without you.
You have to start with an essential emotional paradox for you as the owner: Everyone wants to be needed, but you need to get yourself into a position where the business won’t need you anymore. The way you build value and create a business that’s more likely to survive, or to sell for a higher price, is to resist the impulse to make yourself irreplaceable.
Most business owners know this intellectually, but accepting it emotionally can be very hard for a founder/CEO who built a business up from scratch and remains key to, well, everything.
Start With the Question of “Who” Will Help You Sell
Realizing that “who” decisions are of utmost importance in both business and life, always focus on building the strongest possible management team and involve them in your succession planning. In fact, the biggest mistake business owners make in succession planning is not engaging with their “A-team” early on. In this case, the senior-management A-team might also include external consultants such as corporate, tax-planning, and M&A attorneys, as well as regulatory advisors, appraisers, and so on—especially for a larger business.
Importantly, you need to be open to advisors who have special knowledge that your current team doesn’t necessarily have. You may have a great CFO and CPA, but they may not be able to deal with some of the larger or more complex issues being raised during succession planning.
The same goes for your legal advisors. A corporate attorney with whom you have developed a long-term relationship may not be the “deal attorney” with expertise in these kinds of transactions you now need.
Too frequently, business owners fail to have sufficient tax planning professionals on the A-Team. M&A lawyers aren’t tax lawyers, and CPAs are too-often focused on how much tax you should pay, instead of how to avoid it in the first place.
“Who” also includes your clients. Buyers are looking for a solid client or customer base. They’ll look askance at too heavy a dependency on a single or small number of clients. The more clients, ideally repeat clients, the better. That’s one reason larger businesses are easier to sell than smaller ones.
The Tahiti Test for a Founder’s Departure
You’ll also need to ensure that your company’s business processes are in place and fully documented—often a rarity. Businesses often rely on their founder/CEO to “fill in the gaps” and ensure things are running smoothly and as intended. But buyers are looking for businesses that will run smoothly after the founder has departed with his or her special understanding of how all the pieces fit together.
Here’s a good test of this I give my clients. I ask, if you went to spend three months in Tahiti, would your business be able to get along with only occasional written communication with you? Or would you be inundated with calls and Zooms? If so, your company is not yet ready to realize maximum value in a sale, and if you want to sell, you have lots more work to do.
Five Keys to Maximizing the Value of a Business
Beyond the issue of replacing yourself, let me suggest five keys to maximizing returns when it comes time to sell a business:
- Consider joining a peer group.
- Practice basic business hygiene.
- Know the difference between a good and a bad deal.
- Pay attention to both macroeconomic and microeconomic factors.
- Realize that timing is crucial.
Let’s look at each in turn.
Consultants, Coaches, and Peer Groups for Selling a Business
This will probably be the first time you’ve tried to sell a business. As a first-timer, it’s critical to realize that you don’t know what you don’t know.
There are a number of ways to get help. Two involve hiring a coach or a consultant to sit beside you on the ride. What’s the difference between these roles? A consultant is an often-costly specialist or technician brought in to assist on specific projects. A coach is someone with whom you have an ongoing relationship.
Say, for instance, that you want to implement a new CRM system. It might help to get a consultant to take you through the process. When they’re done, they’re done. A consulting group like Patrick Ungaschick’s Navix might be similarly useful in implementing certain processes that will assist in the sale of your business once you know when you want to exit.
If, on the other hand, you’re really conflicted about what you’re going to do after you let go of the business and retire, working with a coach may be appropriate. This is something you need to figure out, and it is often helpful to have a sounding board on this and other major life issues.
Why Peer Groups Can Help with Business Succession Planning
CEO peer groups are an important, perhaps vital resource for any founder/owner to consider. The advantage of such a group is hearing a number of different experiences and perspectives that you really couldn’t come up with on your own. A group can also serve an ongoing coaching function.
Most owner/CEOs spend almost all their time involved in the fray of their business operations and transactions. This is as it should be. But for major strategic decisions such as succession planning, they need to be able to step back and step out of their own echo chamber. That’s what a peer group is really about: stepping back in a learning environment, not just for succession planning, but across a broad spectrum of business issues.
If you engage fully, a CEO peer group can serve as a fruitful incubator at every step along the way—and one of a peer group’s other great advantages is the ability to hold members accountable for implementing what they’ve learned from the group.
There are peer groups that focus on certain verticals and others that are industry-agnostic. Both can be useful, depending on specific situations. Established groups have fees that range from $5000 to $30,000 annually, with vertical-specific group fees tending to be higher.
Industry-agnostic groups include Vistage, EO, CEO Alliance, and Renaissance. I’m a member of a Vistage peer group chaired by my friend Lonnie Martin. Lonnie worked for many, many years in the telecom industry and has bought and sold businesses several times. Both the group and Lonnie have been incredibly helpful to members in building viable businesses, that may eventually be saleable at an advantageous price.
Just remember that any business sale requires a five-to-ten-year runway—that means engaging with a peer group now, not when you’re burned out and ready to bail.
Business Hygiene Before a Business Sale
Cultivating business hygiene essentially means running your business like a business, not like a personal fiefdom—which can happen even in large corporations.
If you’re looking to sell, you need to clean up your books and document your processes. You also have to make sure everything that can be nailed down gets nailed down. Do all employees, particularly upper management, have confidentiality and non-compete clauses? Is all the company’s IP, whether it be copyright, trademarks, or patents, properly secured? Are lease agreements appropriate? Credit issues resolved? These and a hundred other questions specific to your business should be under control before you try to sell.
Documenting processes is far from the most interesting or engaging of tasks. Think of all the important things you could do instead of documenting a process! Nevertheless, any business, regardless of the owner’s succession plans, ultimately depends on efficient knowledge transfer, formal or informal. If you’re looking to sell, make your transfer protocols as formal as possible, because buyers know that a well-documented business is probably going to be a well-run business.
They will definitely ask, “where is all this written down?”
What Is a Good Deal for a Seller vs. the Buyer of a Business?
At the end of the day, you want a good deal, not a bad one. Obvious? Maybe. Nothing is entirely obvious in a negotiation between two parties with frequently opposing interests.
A good deal for a founder/CEO is a big check and no contingencies or strings attached. You likely want to separate yourself from the business, go home, and do something else—or at least, have the freedom to do something else, regardless of the level of involvement you may wish to retain.
A would-be buyer, on the other hand, will want to make a deal with a low or no down payment and a protracted payment plan. They also would like you to stick around and continue to work hard for as long as possible before actually retiring, to ensure a smooth transition and continued relationships with clients and suppliers. They may even want things like “earn-outs” tied to certain business goals. They may want to build in contingencies for “claw-backs” if everything isn’t as wonderful as you claim it to be.
This article cannot cover all the ifs, ands, and buts in a business purchase agreement. That’s why you need those professional advisors. But basically, the issue is this: What is most likely to make a buyer willing to write a big check that can be cashed as soon as possible?
Start with the stuff we already discussed: the right management team, a large number of recurring customers, and robust, documented business systems, t’s crossed and i’s dotted.
But there’s more…
Macroeconomic and Microeconomic Factors in Business Sales
Timing may not be everything, but it’s certainly crucial to a business sale. Part of that timing is the state of your company, part of it is the state of your industry, and part of it is the overall macroeconomic atmosphere. In general, if the economy is on the upswing, company sales will be more profitable.
It’s important to take note of economic trends not only in determining the best time to put a company on the market, but in knowing when to be bold in your asking price and when to settle for less. Waiting a while may be the appropriate response to a down cycle—but depending on individual circumstances, it may not. One size doesn’t fit all, but do not neglect the macroeconomic picture in your timing, especially in your own vertical.
On a smaller scale, you have to think about how you can demonstrate to a potential buyer that your company is differentiated from your competitors—and if it’s not, you need to do the work to create that differentiation as part of your five-year plan. Think, “How can I create an edge that I can sell to someone else, long-term?” And “How can I prove that it’s difficult for competitors to enter my space? How can I show that the value I’m offering customers won’t be usurped by an Amazon or other major player entering my space?”
Making a Good Deal Means Selling the Future, Not the Present
Fundamentally, when you try to sell, your business needs to perceived as continuing to grow and to have a real competitive advantage in its market as it heads into the future.
That may be hard to prove. You’ve got a good sense of where the business has been in the past. After all, you’ve spent twenty or thirty years building it up. Certainly, all that time and effort must be worth something?
Not necessarily. Never forget that it’s the future the buyer is purchasing. A business has to look like it has a bright future at the moment of sale, and a smart buyer will examine every possible indicator for evidence of that bright future. It’s not the best time to try to sell when your sales have been flat for the last 12 months. It’s best to sell when the curve is rising nicely.
What’s the Worst Time to Sell a Business?
Frankly, most people think of selling when business is down. They’re depressed and want to get out. But this simply isn’t the best time to sell. The time to sell is when everything is a plus, ten out of ten, and looking bright on the road ahead.
Unfortunately, of course, people often don’t want to sell during the bright moments, because things are going so well.
It’s counter-intuitive emotionally, but you actually should consider selling when you’re being successful and the future is looking especially rosy. That’s when you can realize maximum value for the business you’ve worked so long and hard to create.
This can be a tough mental shift, but you have to make it.
Next Steps
What next? Clearly, if you are considering selling or transferring your business over the next five to ten years, you’ve got a lot of work to do—carefully, in incremental steps, and keeping your ultimate goal in mind.
Even if this is something you could do on your own, I don’t advise it. You are an expert in your business, not in selling your business. Indeed, I’d say that almost by definition, you don’t have the legal and other expertise required to get the best deal possible. Get those advisors. Join that peer group. Start down the runway.
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We look forward to working with you!
Best, Jim
James L. Cunningham Jr., Esq.
Founder, CunninghamLegal
At CunninghamLegal, we guide savvy, caring families in the protection and transfer of multi-generational wealth.
