Aging, pandemic fatigue, labor shortages, supply chain disruptions and fear of a rising capital gains tax have taken the joy out of running a business for many owners. It’s tempting to sell with a glut of private equity (PE) money seeking deals. But millions of baby boomer business owners still haven’t been able to pull the trigger and ride off into the sunset – with a financial windfall for you to help them manage.
What gives? Quite simply, too many owners haven’t taken the steps to make their businesses sellable. As a trusted advisor, you have a unique opportunity to create value here.
Owner Value Versus Market Value
My friend Rob Slee, founder and managing partner of the middle market investment banking firm Roberston & Foley, told me that 90% of boomer business owners are “trapped in their businesses” because they haven’t created enough value to sell to a third party. I too have seen way many owners treat their businesses as personal piggy banks rather than as sellable assets. When a business is so owner-centric, it’s hard to create enterprise value. While owners think it’s all about earnings before interest, taxes, depreciation and amortization, private equity (PE) firms pay close attention to the “Owner’s Addback” line on the balance sheet. This is where you find all the cars, vacations, Costco bills and other non-business expenses the owners are running through the business. And that’s part of what depresses multiples.
“Almost every owner I've ever met thinks their business is worth about twice what the market is willing to pay,” observed Slee, who wrote the book, Private Capital Markets: Valuation, Capitalization, and Transfer of Private Business Interests. Owners tend think in terms of what they need the business to be worth after taxes. Unfortunately, the market is looking for value and “could care less what owners need their business to be worth,” added Slee.
Too Much Money/Too Few Good Deals
With nearly 5,000 PE firms in the United States holding nearly $2 trillion in committed, but unallocated dry powder globally, Slee said the amount of money looking to buy companies is “10 times what it was 20 years ago.” However, he said PE is only able to act on 2% of boomer businesses because the owners haven’t structured them to be saleable.
From where I sit, the paradox of too much money chasing too few deals could be exacerbated in 2022 as investors are looking to alternatives to the volatile stock and bond markets – but I don’t see a surge of private business suddenly becoming transaction-ready. Again, this is a ripe opportunity for advisors to help their clients unlock enterprise value. Here are some of the main challenges we see and strategies for overcoming them.
According to Slee, fewer private businesses are transferring to owners’ adult children because the kids see the toll that the business took on their boomer parents. “They want the money, but they don't want to do what it takes to build the business,” observed Slee. “Of the last 25 family businesses I've sold, not one was bought by the owner’s children,” added Slee. In my own experience, I’ve seen the founder’s kids typically stay on for three or four years under the new ownership, but again, they have no intention of taking over the reins. They just want a paycheck. That’s not contributing value to the business.
Another challenge is that boomer business owners think that as soon as they start talking about exiting their company, “it's the first step toward the elephant graveyard,” observed Slee. That’s ironic, because the better the business can run without them, the more it’s worth to a potential buyer. More on that in a minute. “They really don't want to talk about it until somebody knocks on the door with an offer,” added Slee. But, by that point, it’s too late to implement many of the good planning opportunities.
Charitable Giving Shortfall
At the start of every conversation about selling a boomer business, Slee said there are two things he hears:
- “I want to take care of my employees.”
- “I want to give a large amount of money to establish a charitable foundation.”
But once owners see what’s left of their proceeds after taxes and transaction costs, those good intentions often take a back seat. There's not enough money left to follow the charitable aspirations, Slee noted. Also, by the time owners get to Slee for help, they already have letters of intent signed. Legally, it's too late to do things like set up a charitable remainder trust or some other charitable structure.
Ten-Year Business Transfer Cycle
Over the past 150 years of U.S. business history, Slee said there’s been a consistent business cycle every 10 years or so. Business conditions tend to be tough in the early part of the decade, get a little more buoyant through the middle part of the decade and then become exuberant – sometimes irrationally exuberant – at the end of the decade. That’s the best time to sell.
“Normally our transfer cycle would have ended at the top of every decade, but because of COVID and $10 trillion of federal investment in pandemic relief have extended the transfer cycle a few years into this decade,” said Slee. “Soon, though, that window will close and then boomer owners will be trapped for another six or eight years, until the next the next decade,” he added. Don’t let that happen to your clients.
Waiting for a Better Offer
Owners get cash offers and don’t sell, which they often live to regret. “Every time I've had an owner pass up a market value deal cash or cash market value deal, within 24 months, that business either went bankrupt or the owner was dead,” observed Slee. “The market is a jungle. Either you go willingly, or the jungle takes you out. The competition will run you out of business.” If your clients get a fair deal today, Slee said they would be wise to take it and not get greedy.
When to Start Planning
Slee said owners typically haven’t considered how they're going to construct their exit transaction for maximum value or how they'll manage the money afterwards. “It’s purely an afterthought.” In a perfect world, people like Rob and I would be called in three to five years in advance of the sale. One of the first things we’d do is focus on the business’s enterprise value, and that means making the owner irrelevant to the business. The owner must learn to create a smooth-functioning sustainable business that can run just fine with them. Without that, they don’t really have a business, they just have a job.
Both types of trusts provide an upfront income tax deduction and avoidance of capital gains tax. What’s more, the trust generates an income stream for the remainder of the business owner’s lifetime, their spouse’s lifetime and, in the case of a PIF, it might allow for an income stream for their children’s lifetime. The owners might also want to transfer some of their wealth to future generations to reduce the size of their taxable estate. They might also want to ensure there’s enough liquidity in the event of a premature death. Typically, this is accomplished by acquiring life insurance and, further, with comprehensive estate planning.
Get Needed Liquidity
For many successful entrepreneurs, a business represents 80% to 90% of the value of their estate. But it’s illiquid. If the owners die suddenly, their estate will likely owe tax and probably won’t have enough money to pay it. With enough time to plan, you can craft tax-efficient ways to create the necessary liquidity for your client’s estate. The $24 million estate exemption is set to sunset at the end of 2025. That’s less than three years away, and many expect it to be cut in half. The time to start planning is now. That’s where you come in.