Every business owner will eventually need to exit their business.
I am asked frequently by clients for the “best” way to plan for a business exit.
The answer is always the same: it depends on the owner’s goals.
Unlike publicly-traded companies where stock can freely be exchanged on a regulated market, changes in ownership and other financial interests in small, closely-held businesses are generally governed by a combination of internal stakeholder contracts, estate planning documents, and (in the absence of the foregoing) applicable state law. Risks are greater when it comes to the transition in ownership and operations for privately-held businesses, and particularly, in small, closely-held businesses.
After many years of advising business owners on succession planning, here are five of the most common mistakes I have seen. Note that in this article, “succession planning” does not include a sale of the entire business to an independent third-party buyer, but rather a transfer to co-owners or other individuals.
1. Failing to Account for Key Personnel
Too many people confuse the owners of a business with the key personnel of that business. The two are not necessarily the same.
When I ask clients who their “key personnel” are, I ask them to include all of the men and women (and sometimes even third-party contractors) who manage and oversee the operations of the business, drive revenue, and whose departure would materially impact the business.
Who is critical to finding the business’s customers/clients?
Who maintains important customer/client relationships on an ongoing basis?
Do the one or two back-office folks at a business have their own way of doing things that no one else knows how to do?
Would the departure of one owner lead to an exodus of key personnel?
These questions are important because the value that an owner assigns to an ongoing business (more on that below) generally rests on the presumption that the business can replicate its operations – and profits – in the future. The loss of a key salesperson who drives an outsized portion of the business’ sales, the departure of a well-respected and trusted manager who solves day-to-day operational problems, or the death or disability of the sole back-office manager who runs accounting and billing his or her “way” are the types of risks that are foreseeable.
With proper planning, these risks can be mitigated without having significant long-term impacts on a business. And, where business owners themselves are key personnel, the effect that their departure may have on the business directly ties into the value of the business (and their buyout amounts) in their absence.
2. Failing to Limit Who Can Purchase the Business Interest
It is common for businesses to have multiple owners with differing ages, health statuses, and economic interests.
If an older owner with a minority interest wants to retire and liquidate his or her interest, there may be no third-party buyer willing to purchase the minority interest, because the buyer would not control the business and would be largely subject to the whims of the majority owner(s). Likewise, the remaining owners may not want to be in business with a complete stranger in the future or subject to potential harassment or other bothersome “meddling” which they can avoid.
What if a partner dies, becomes permanently disabled, or just decides one day to stop working? Should there be a mechanism in place permitting or even requiring the other owners to buy them out? What effect will their departure have on the value of the business in the future?
Rather than permitting any and all transfers, many business owners will instead opt to enter into shareholder or ownership agreements expressly limiting transfers of ownership interests to (i) sales to the other owners, (ii) repurchases by the business itself, and/or (iii) transfers to a limited class of persons or heirs for estate planning purposes (and then, often without continuing voting or oversight rights).
3. Failing to Plan for Valuation
A shareholder or ownership agreement is excellent in theory.
In practice, the implementation of such an agreement is ripe for disputes between the owner seeking to exit (who will want the highest value for his or her ownership stake) and the remaining owners (who want to value the exiting partner’s stake as low as possible to be able to retain maximum value for themselves).
To avoid the costs – in time, energy, and of course money – of resolving potential disputes in the future, owners of closely-held businesses can and should try to agree on how their business and relative ownership stakes will be valued upon the occurrence of certain events.
This method of valuation can be included in the shareholder or ownership agreement itself.
Valuation can be tailored specifically for the applicable business and the owner’s role in the business.
For example, if an owner manages key client relationships, the valuation of the business (and the payments to ultimately be made to such owner upon his or her departure) may be made partially contingent on the successful maintenance/transfer of those relationships for a period of time into the future.
Or, where all owners are equally responsible for the business’ revenue-generation, the parties may be able to agree on a formula to value each’s interest based on the business’ trailing EBITDA, revenue, or other metrics.
Yet another alternative is for the owners to simply agree on the business’ value on a periodic basis (e.g. every year, or upon achieving certain financial benchmarks) which will thereafter be binding until a new value is agreed in the future.
And, if an owner’s departure is for a predetermined “bad act”—such as the breach of a key agreement with the business or the commission of a serious crime – the value of the exiting owner’s interest may be discounted or subject to different payment terms to take into account the potential harm to the business such owner has caused.
In all events, it is important for business owners to periodically review and assess the valuation method(s) and metrics chosen. As a business grows and changes, what was initially an appropriate valuation method may need to be reconsidered.
4. Failing to Have a Funding Plan
Even if business owners agree on the valuation of their interests, how will the purchase be funded?
Consider a rather common hypothetical:
- Widgets LLC is owned by two members, each with a 50% stake.
- Widgets LLC is valued at $10X, and for simplicity, each owner’s respective ownership interest is worth $5X.
- If one owner dies, or simply wants to “cash out” and retire, will the other owner (or the business itself) have sufficient funds available to be able to fund the purchase of $5X immediately? Even if the cash is immediately available to fund the purchase, would the payment of the full purchase price all at once leave the business in a position where it could not continue its operations as presently conducted without hardship?
- Are there tax-related reasons that both parties would want to stagger payments over time?
There are several ways to address these issues. In the case of the death of one owner, ensuring that the other owner (or, although generally less preferable, the business itself) maintains a life insurance policy on the deceased owner is a straightforward way to ensure that cash is available to fund the resulting purchase.
Owners can agree that all or a majority of the purchase price will be funded immediately from the proceeds of the life insurance policy. Similarly, businesses and their owners may also consider obtaining disability buyout (DBO) insurance to fund the purchase of an owner’s interest in the event of his or her permanent disability.
Where one owner simply wants to voluntarily exit the business and liquidate his or her interest at an agreed valuation, owners may consider staggering payments over a number of years (with or without interest accruing on the unpaid balance) to allow the discretionary cash flow from operations to fund the buyout without needing to cut costs or otherwise curtail regular business operations. The exiting owner may be able to receive the corresponding benefit of recognizing income (and paying associated taxes, potentially at reduced rates) over a period of years rather than all at once.
As with business valuations generally, this type of strategy should be revisited periodically during the business’s life cycle to ensure that the formula or metrics used when an agreement is first executed continue to make sense given any interim business growth or changes in operations.
5. Failing to Plan at All
The biggest mistake that I see business owners make is not having any succession planning in place.
The day-to-day life of a business owner can be frenzied, with little time to plan for the future. But it is inevitable that the business owner will one day need to exit. Deliberate planning over time will ensure that the owner’s exit will be harmonious, will not disrupt the operations of the business, and will preserve the owner’s legacy.
On the other hand, failing to plan can cause the quick ruin of the life’s work of the business owner.
Are you a business owner who wants to plan for these issues? Contact Tim Canney, chair of the Business and Tax Group at Bulman Dunie, at (301) 656-1177 x330 or tcanney@bulmandunie.com.
