How to Plan Now to Leave Your Business Later

Reprinted with permission from the Massachusetts Society of CPAs

MassCPAs – July 2021 Issue of SumNews

How to Plan Now to Leave Your Business Later

By Jack Finning, CPA, CGMA, CBEC

A significant part of my efforts leading AAFCPAs’ Transaction Advisory Services practice involves convincing business owner clients to plan for an exit well before they are actually ready to leave the business.

When asked when they should start planning their exit, I often reply, “the day you start your business.” Realistically, a meaningful strategy can be put in place three to five years out from a planned exit. This allows for adequate time to ensure success in all aspects of the transaction, including liquidity, tax structuring, asset protection, valuation, due diligence and profitable growth. Th e work is incredibly interesting because each owner and business is unique — each with their own individual set of facts, circumstances and goals for succession.

We kick off discussions by assessing readiness. There are two key questions to ask business owners to help determine if they are ready to exit:

Are you financially prepared for an exit, meaning are the proceeds from the business going to support your long-term retirement and legacy goals?
Are you mentally prepared for an exit? Ask clients if they are ready to walk away from the business, give up control and find new ways to fill their days.

The answers to these questions will help drive the development of a customized exit strategy.

Determine What the Client Needs to Exit

We encourage business owners to work with AAFCPAs Wealth Management, or their existing wealth adviser, to develop a detailed personal financial plan as a first step to developing an exit strategy. As part of this exercise, clients project their financial needs in retirement, including an estimate of the “short fall,” if any, of liquid assets needed to achieve retirement goals.

For many of our business owner clients, the business is their most significant asset. And in most cases, owners find that they have a short fall when they complete their personal financial plan. This short fall equates to the minimum after tax value they will need to receive from the business. The short fall does not equal the value of the business.

Determine the Current Value of the Business

Next, AAFCPAs introduces the client to members of our business valuation team so the owner(s) may gain an understanding of the current value of their business. If there is more than one owner, we encourage them to document a buy/sell agreement, which establishes a method for determining the value of a business and stipulates how a partner’s share of a business may be transferred in the event of unexpected events such as disability or death. We find the “value now” concept eliminates conflict down the road.

It is important to note, this valuation only provides a ballpark estimate of the value of the business. Privately held businesses do not have a single value. The value you receive for the business depends on who purchases it from you (or how you decide to gift it). When selling to an outsider, the goal is a high value. If gifting to a family member, a charity or employees, a lower value may be the goal.

Determine the Owner’s Succession Goals

There are many options for owners to consider beyond an outright sale when planning an exit. The best option is based on the owner’s goals for succession. An exit plan should be documented, addressing the owner’s goals related to timing, ownership and control.

We typically see four broad types of exiting owners:

Leave right away for the most money,
Want or need to grow the business,
Wealthy but want to continue to work, and
Wealthy and ready to leave.

Determine the Best Exit Option

The five major types of transactions owners may consider as the basis for their exit strategy are:

Gifting programs,
Management buyouts (MBOs),
Employee stock ownership plans (ESOPs),
Private equity group recapitalizations, and
Sale of the business.

Often, these transaction types may be combined. Let’s go through each option:

Gifting

Many clients opt to gift some or all ownership of the business to family members, employees or charity. A gifting strategy is often used when the owner has accumulated sufficient wealth and does not need cash from the business. These owners are also motivated to provide for their children and/or key employees.

In these cases, we bring in our tax consulting attorney, who specializes in estate plans, to evaluate tax implications and wealth preservation strategies. Timing for this transaction type may be crucial in 2021 as proposed legislation, if passed, will have a major impact on gifting and estate planning. Gifting is also often combined with other strategies such as ESOPs and MBOs.

Management Buyouts

In some cases, the owner may prefer to give the management team (which may include family members) an opportunity to buy the business rather than selling to outsiders. This is often the case when an owner has acquired sufficient wealth and has an affinity toward these loyal team members who helped grow the business and the owner’s wealth.

In most cases, these managers or key employees know the business and value may be maintained through continuity of business operations. Th is type of exit strategy allows the owner to maintain a level of involvement and control, as the transfer can occur over many years, providing a flexible deal structure.

This strategy isn’t without challenge. The owner’s relationship with managers will change from employer/employee to partners. They will have to negotiate with people who work for them. Conflicts often arise when management realizes the owner still wants to maintain some control. Additionally, employees may not have liquidity or wealth to pay the owner up front, thus the owner may receive deferred payments over time.

In these cases, owners typically require management to pledge the business assets as collateral.

Employee Stock Ownership Plans

ESOPs may be an excellent vehicle for owners who have prudently saved for their personal financial security and are thinking about exiting the business but are not yet mentally ready to retire. ESOPs are when a company’s employees own shares in that company. Such plans may be selective or all-employee plans. Selective plans are typically only made available to senior executives.

ESOPs are often used in combination with gifting and/or MBOs. ESOPs have been in existence for over 40 years, and there are currently more over 11,000 ESOPs nationwide. Establishing an ESOP is not a simple process. An ESOP is a qualified retirement plan that is permitted to buy a company’s stock. Set-up requires an investment in advisory fees, a valuation (likely lower than the valuation that may be achieved with the sale of the business), and an ongoing obligation for the business to one day repurchase the ESOP shares, effectively cashing out the employees who retire or leave the company.

There are several benefits to an ESOP:

Creates a market for the purchase of shares,
Offers flexibility to sell any number of shares to the ESOP at a timing of the owner’s choice,
Offers the ability to sell the entire company at a later date,
Has the potential to reduce taxable income of the business through annual elective ESOP contributions, and
Other tax advantages based on the owner’s facts and circumstances.

The cash to purchase shares may come from several sources:

The company makes cash contributions (tax deductible) to the ESOP trust. The trust then buys the shares,
The owner sells shares to the trust and takes back a note. Cash contributions to the trust are then used to pay down the note, and/or
The trust borrows money to fund the purchase of shares. Contributions are then used to pay down the note.

Private Equity Group Recapitalizations

In cases where the owner is not mentally or financially prepared to leave the business, we advise them to focus on reducing company risks (as a buyer would perceive it) and on increasing profitability. This combination will increase the ultimate value. As appropriate, we consult on increasing the value of the business given the time horizon to retirement. Th is often includes engaging our in-house consulting CFOs.

In cases where owners need liquidity today, we advise them to consider a private equity (PE) recapitalization. PE groups aggregate the investments of individuals and institutions and invest those monies into private businesses that may provide better returns than other investment choices.

PE groups typically do not invest in companies that have historical profits of less than $1 million or a valuation of under $10 million. Thus, this strategy is best suited for owners who meet these criteria and who have an interest in staying on as an employee for an additional three to five years. At that point, they may be better positioned to sell the remaining ownership.

Sale of the Business

For owners who are mentally and financially ready to leave the business, an outright sale to an interested buyer may be the best option. Once the owner is equipped with the knowledge of the current value of the business and their needs for retirement, they know the minimum they are willing to accept. The goal then is to find a buyer interested and willing to pay that price.

There are essentially two methods to sell a business: negotiated transactions and auctions.

In negotiated transactions, the owner generally knows people in the industry and identifies and contacts a limited number of potential buyers.

Owners may be able to execute the sale without the support of an intermediary transactional adviser, although we discourage clients from going it alone. A transactional adviser can expand the market of interested buyers, maximize the value in the transaction, take the pain out of the process and minimize the distraction of the transaction from the demands of the day-to-day business. They perform analysis and understand the owner’s positioning, market the business to a targeted pool or a broader database, screen interested buyers, negotiate the terms, and assist in due diligence and closing. Transactional advisers are typically paid a “success fee” based on a percentage of the selling price.

The auction method of marketing allows the business owner to contact a broader spectrum of potential buyers, create a competitive bidding atmosphere and, in most cases, speed up the sale of the business. In these situations, I always recommend that the owner hire a transactional adviser.

To help your clients create a successful exit strategy, it is important to start with a solid understanding of the client’s circumstances and goals, which are personal, unique and in progress. Each plan should be customized and thoughtful, with a multi-disciplinary team involved.

MassCPAs member Jack Finning, CPA, CGMA, CBEC, is a partner at AAFCPAs and a past MassCPAs Board chair. Contact him at jfinning@aafcpa.com.