In parts one, two and three of this series, I laid out the challenges facing business-builder clients that advisors who take the initiative to add value to a client’s company can use to help them increase profits, lifestyle and their level of happiness almost immediately, offered some tips on how to get the exit planning ball rolling and discussed dealing with one of the most common impediments to a successful transition: your client. In this final installment, we'll address the impact of de-risking the business and family enterprise and ensuring the client is left on financially solid ground post sale.
Risk identification and mitigation are a constant focal point for each of the exit planners we interviewed. In Sean Hutchinson's, a partner at RFN Global with a CEPA and CMAA background, view, there are five general categories of risk that apply to businesses, their ownership and their leadership teams: strategic, operational, financial, regulatory and reputational. Each requires thoughtful consideration in planning for an exit.
When I asked him to provide his thoughts about risks that are evaluated in a typical exit plan, he passionately described his concerns. “Most companies don’t really have a good strategic planning function. They just kind of do it, almost reluctantly, like ‘do we really need to have a strategy?’ Yes, you really do. Done well, it’s not an inconvenience—it’s empowering. And it generates enterprise value.”
Read the Full Series: Part 1 | Part 2 | Part 3 | Part 4
While strategic risks are externally focused on the competitive landscape for example, operational risks (including technology) are internal and almost completely in the control of the leadership team. Training and succession problems can be solved, as can a lack of process documentation. To one degree or another, these kinds of risks are always present and must be constantly monitored and managed.
Sean points out that operational risks are tangible. “We can point to a department in a company for instance, and we can say that it just doesn’t seem to be working as well as other lines of business. We’ll ask to focus our time there and try to figure out what’s going on. Of the operational risks, recruiting and retention of great employees is front and center right now, but not all companies can afford the best in a highly competitive market for talent. So, productivity is a key measure. Are key people failing to meet reasonable expectations? Is it an isolated or shared risk? Are they receiving the best training? Is the client seeing a lot of turnovers? If so, why? Is the compensation and benefits package out of kilter with the rest of the market, and are their people getting poached?”
In a related category of risk, there is a sea of regulatory and compliance exposures wed to Human Resources, such as nondiscrimination, OSHA, etc. Each of these must be understood and minimized before optimum value can be created for the seller.
Sean continues, “Let’s look at leadership team risk. Losing key employees now can be super expensive because you pay more to get people to fill in an empty seat, and then you’ve got to train them … Today’s employees don’t want ‘just a job.’ They want to know that they have a future with their employer. Look, companies struggle with that. I’ve seen companies encourage people indirectly to not be ambitious, right? Well, it’s the ambitious people that help you beat the competition. You don’t win the World Series without great players. When you say to someone, ‘Hey, pump the brakes—we’re not comfortable with you actually wanting to move up,’ that’s more insecurity than true management. Become the ‘employer of choice’ in a client’s industry. Be the talk of the town who everybody wants to work for. That’s how you win.”
While risks related to human capital are ageless, exit planners also need to help their clients prepare for modern dangers.
For example, far too many midsize companies who are looking for a buyer have only moderately protected themselves from cyber risk. While a large acquiring firm can efficiently up-level the cybersecurity of an acquisition, they will also use the same facts to leverage down the sales price. It’s important a client’s exit planning team challenges a client’s leadership team to demonstrate that they are competitive in each category of risk. In some cases, risk can be transferred to another party through insurance, but it will have a financial impact. On this point, Sean added, “There are a lot of companies that are not carrying sufficient cybersecurity coverage. It used to be cheap; now it’s not.”
The fifth category of risk is reputational. Reputational risks are more than simply those of the marketplace. They can range from business payment histories to vendors, to ecological reputation, and to workplace culture. Today’s websites, postings and even inter-office communication are exposed to immediate public feedback. There are cases where a single sentence that was taken out of context was ruinous for a business. Postings by disgruntled employees can grievously affect the way a client’s company may be viewed by other employees, customers and inquiring firms. If you’re facing this problem, what are you doing about it?
The Tax Man Cometh
When selling a business, EBITDA is rarely taken at face value but is far more often “re-casted.” By this I mean that you and your client’s potential buyer will enter a process where a buyer will add back or take away ordinary or nonordinary sales-related expenses, and certain types of bonuses.
When you re-cast a client’s EBITDA, you better understand how decisions may impact a client’s sales and margins, and whether, so to speak, the juice is worth the squeeze. You’ll also get a better understanding of the vibe of a client’s business in the eyes of a potential buyer. Regardless of where your client ends up, if they sell their business it will be likely sold for some multiple of EBITDA. And when it’s sold, tax will be due.
Many entrepreneurs intend on selling their business, but later discover that the requisite cash flow to maintain their lifestyle cannot be achieved with the after-tax sales value.
Here is an example based on a recent study:
According to the study, the average business owner has 70% of their wealth tied up in his or her business. With this as a background, envision a sixty-five-year-old business owner who is ready to retire.
- He presently has $2,000,000 in after-tax cash and securities.
- He has $4,000,000 in qualified plan assets, which are exposed to federal, state, Obamacare, and possibly federal and state estate taxes.
- Given his lifestyle needs, along with inflation, longevity in his family and the likelihood of higher taxes in the future, his financial planning team projects that he needs at least $600,000 a year of pretax and inflation-adjusted income.
- To achieve this over the next 30 to 35 years he likely needs a current after-tax investment portfolio of $15 million to $20 million to achieve his goals.
If he is like most other business owners, he will need to sell for at least $20 million pretax to net $13 million and retire comfortably without fear of running out of money.
Is your client’s business going to sell for $20 million or more? If not, have they developed enough other assets to meet their retirement income needs? If so, is your client concerned with the erosion of their wealth from capital gains, income and estate tax?
Help your clients envision how much more wealth they would have if they were able to keep a third more of the tax they might blindly pay when their business sells. The difference between blindly calculating the tax bill and paying it, versus cutting the tax costs by 20% through comprehensive pretax planning may be enormous for your client and their family. Cutting taxes in a meaningful way can enable a business owner to sell for notably less and still retire just as comfortably as if he or she sold for a higher number but paid unmitigated taxes that proper planning might reduce.
The problem often is that most business owners don’t develop plans to minimize tax on the sale of their business until they are ready to sell at a maximum price, and then they pay the maximum amount of tax. Waiting to begin planning can severely limit the opportunities that might otherwise have been available.
The most efficient way to build net value in a business often includes pre-exit-tax planning. If restructuring business ownership can generate millions worth of compliant tax savings, why do business owners fail to do so? It is usually because the business owner’s advisory team doesn’t know that advanced solutions exist. Sometimes business advisors will naysay advanced tax planning because it is outside of their purview, and they are afraid of losing client control (and therefore, future commissions and fees).
There are a variety of solutions that can be utilized to reduce the impact of federal and state taxes at the sale of the business, and on retirement assets. Most of these solutions require preplanning through experienced tax counsel, well in advance of the sale. A skilled exit planner will include an advisor (typically a specialized consultant working with a highly respected tax law firm) as part of their team.
Whatever your client’s dreams, help them harness their entrepreneurial capabilities to act now. Empowering a client, their leadership team and any family members who are involved in their business is more than just numbers. It can be immensely personally rewarding for advisors as well.
Brad Barros is the co-founder and a director of Private Risk Capital Development Advisor LLC and Private Risk Partners LLC.