The following article first appeared in the April 2016 edition of Wealth Planning Update, published by Wells Fargo Bank. We think it is worth reprinting for our readers.
At some point, nearly every business owner faces a business transition.
As the business often represents the single largest asset on many owners’ personal balance sheets, its value can represent a lifetime of focus, energy, and work. While every owner, business, and transition is unique, there are four common mistakes that we see business owners make when trying to transition their business, whether it’s a sale or passing it on to family or to employees.
Mistake #1: Not understanding after-tax cash flow needs for retirement
When weighing the complex topic of transition and exit planning, many owners focus more heavily on receiving liquidity (or a headline transaction value) as a result of the transition, but not necessarily on how the timing of the transition or the amount from the proceeds will impact their retirement picture and long-term standard of living. This step can be especially critical in some instances because after-tax cash flow can actually decline post transition, particularly for owners who have historically paid themselves a handsome wage or significant dividends or distributions.
As a business owner, gaining a clear understanding of your personal balance sheet, sources and usage of cash flow, income tax liability, as well as your risk and liquidity profile—both on a pre- and post-transition basis—can give you powerful insight as to when (or whether) you should keep or sell your business. This understanding goes beyond an overview; a decision this significant should be based on well-developed projections of the sale on your personal wealth and cash flow as it is key to evaluating your transition timing and options. This may be particularly important when selling a business during a strong economic or market cycle. Many owners plan to invest their post-sale proceeds into a diversified portfolio of stocks and bonds, yet many marketable securities may be at all-time highs. Work with your advisor to prepare a sensitivity analysis—does your post-sale wealth plan meet your needs if you invest at the peak of the market and it subsequently declines?
Suggestion: Review your cash flow and retirement income needs considering both pre- and post-transition scenarios
Mistake #2: Expecting an all-cash deal
Contrary to what many business owners may think, business transitions are not typically conducted as all cash transactions. The majority of business transitions in fact involve seller financing, earn-outs, and escrow/holdback arrangements—meaning that while an owner may receive some cash at closing, he or she may also receive a significant portion of the purchase price over time.
These different approaches to a business sale can have important retirement planning and risk management implications for business owners who are not receiving a full payout at closing. Business owners may carry a level of risk until the terms of the promissory note or earn-out are completed, since future payments may be at risk if the acquiring company faces a financial reversal or downturn. An after-tax cash flow analysis, such as the one discussed above, can help to better position owners as they negotiate the timing, amount, and security of contingent consideration in a deal. In some instances, such an analysis may even save an owner from entering into a deal that may have had calamitous long-term retirement planning implications. We recommend working with your relationship manager to understand how the sale or transition of your business likely will impact your personal wealth plan.
Suggestion: Engage an advisor who can help determine what deal terms can be achieved realistically in the current market environment
Mistake #3: Only speaking with or seeking one prospective buyer
At one time or another, many owners receive unsolicited offers from competitors, strategic buyers, or private equity groups. These offers may materialize at various times throughout the year, leading to a scenario where an owner is essentially evaluating one offer at a time. Furthermore, it can be tempting to take a “do it yourself” approach to a sale as business owners know their business well; such an approach provides control, plus the possibility of fee savings. Adopting this approach however (even if an unsolicited offer ultimately leads to a sale), may create uncertainty regarding whether they maximized the amount of money they could have received for their business. Rarely does a single buyer offer the highest purchase price or most advantageous terms to the seller, simply because there isn’t a need. Absent a disciplined and broad marketing approach led by a Mergers and Acquisition professional, the buyer does not have to compete with other buyers for the business. The result is often a sub-optimized process and transaction.
Further, companies that have prepared to go to market—and do find a buyer—do not always close the deal. One of the biggest reasons given for deals not closing is the inability of the selling owner and the prospective buyer to overcome differences in how each party viewed what the business was worth (i.e., the expected purchase price). Lack of a cultural or strategic fit, which is often discovered during due diligence, between a selling company and their strategic or financial buyer also may present a significant impediment to consummating a deal.
Just as business owners should not limit themselves to considering only one prospective buyer, they also should not consider only one transition option. Many owners, in fact, face a predictable set of strategic alternatives for the transition of their business. In addition to multi-generational family business transfers, businesses can also be transferred in other ways:
- Selling to management (management buyout)
- Selling to an employee stock ownership plan (ESOP)
- Selling to a financial buyer
- Selling to a strategic buyer
- Going through an initial public offering (IPO)
When appropriate, pursuing a sale through a disciplined auction environment, whereby multiple prospective bidders all review the same information at the same time, may help enhance the probability of finding the right cultural and strategic fit for the company at a purchase price and terms that may best meet the owner’s long¬term transition (and retirement) planning goals and objectives.
Suggestion: Keep all your transition options open and know what your business is worth Mistake #4: Lack of preparation
Mistake #4: Lack of preparation
Finally, business owners should honestly assess the readiness and attractiveness of the business prior to going to market. A helpful step in this process can be deliberately “thinking like a buyer,” which entails appraising the company’s strategic positioning, weaknesses, and business risks across the competitive landscape, much in the same way that a prospective buyer would when evaluating an acquisition target. Owners also could conduct preliminary operational, financial, and cultural due diligence on their company, perhaps engaging a business consultant or a transition advisor to provide an objective evaluation.
Irrespective of whether business owners intend to keep the business in the family or position it for a sale to a third party, this exercise often results in improved company performance pre-transition, better positioning the company for an internal buyout, or a more favorable price and terms in an external sale.
Finally, a comprehensive review provides business owners time, during the pre-sale window, to resolve any business or legal issues that might arise during the actual sale process, helping owners to not only determine a realistic timeline to go to market, but also increasing the probability of a deal’s closing, and transition success.
Suggestion: Conduct preliminary due diligence on your company
Mindful of these four business exit planning potential mistakes, business owners may be able to achieve the following benefits with advance planning and preparation:
- Identify, assess, and compare multiple transition options at the same time to achieve a higher sale price
- Position the company for a successful transition
- Minimize or resolve negative issues that may arise during due diligence
- Enhance the probability of a closing
- Improve performance leading to a more attractive sales price
While planning for business transitions can be complex, following a disciplined process can help owners confidently plan and execute a successful business transition and maximize outcomes for all stakeholders.
About the authors:
Jeff Haines, National Director of Business Owner Planning, Wells Fargo Private Bank
Tracey Gillespie, Senior Wealth Planning Strategist, Wells Fargo Private Bank