Over my years of practice, I have found that many of my estate planning clients have owned one or more business interests — these interests have been actual, operating commercial businesses, a professional practice or even an investment partnership. In the past few years, as baby boomers have reached retirement age, the number of businesses that need to be transitioned has grown substantially. However, many owners either have not started or have not completed plans for that transition.
In a recent survey1 conducted by the Exit Planning Institute in the Twin Cities metro area, 91 percent of respondents felt it was important to have a transition strategy; however, 79 percent of those respondents acknowledged that they had no written transition plan in place, despite the fact that many owners’ wealth is tied up in their business.
So, what exactly makes up an effective business transition strategy? First, consider that many, but not necessarily all, of these businesses may be deemed micro (under $5 million in sales) or small (under $25 million in sales) in size. These businesses may end up transitioning to family members, current management, employees or outside third parties; in some cases, they may just liquidate and dissolve. However, regardless of size, effective transitions of these privately held businesses have a number of factors in common.
- Assembly of a competent team of professionals: Depending on the circumstances, owners need to rely on a team of professionals when planning to transition their businesses. This team will likely consist of a transactional and estate planning attorney, certified public accountant (CPA), financial planner, valuation expert, investment banker or business broker (to identify possible buyers), investment advisor (to manage the proceeds resulting from a sale of the business) and possibly other consultants, including those skilled in improving business profits.
- An analysis of the owner’s circumstances: For many owners, most of their wealth (often 70 percent or more) is tied up in their business. Why? When surveying a cross section of my business clients, the answers are simple: Whether they bought or started their business from scratch, many of my clients needed to use their own capital, didn’t want partners and firmly believed that their business brought them the best return on their investment. With the majority of their wealth tied up in their business, the sale or other transition of that wealth is needed to fund their lifestyle in retirement, family or charitable legacies, or a combination thereof.
- An analysis of the owner’s retirement needs: To coordinate and complete an effective transition of their business, it is vital for owners to have a full understanding of their financial needs in retirement and other available resources. This often requires the assistance of a qualified financial planner.
- Determination of the current value of the business in the marketplace: Determining what the business will actually sell for in the marketplace calls for a qualified valuation consultant. Without digging into all of the details involved in such a valuation, the process needs to account for the EBITDA2 generated by the business over the past several years (to determine the trends, if any), and identify excess compensation and expenses taken by the owners that intentionally reduced profits, and thus taxes. While the valuation process is underway, the owner and advisors have an opportunity to clean up both financial and governance records and to develop a “due diligence room”, a secure online space where anticipated information generally required by buyers and their advisors can be easily accessed.
- Comparison of the owner’s needs to the real value of the business, as determined by the valuation expert: There is often a significant difference between the owner’s opinion of the business’s value and that of the valuation expert. Understanding that difference should motivate the owner to consider what steps need to be taken to improve profitability, or what I refer to as the “profit delta.” This will require the owner to examine the business from a variety of angles, including sources of revenue, expenses that could be reduced, improvements that could result in greater efficiency, new lines of business or the potential for dropping current lines of business. The owner may need to bring in a strategic or tactical planner, or both, to complete this process.
- Identification of potential buyers: Potential buyers include family members (whether or not they have been previously involved in the business), current management, employees or third parties (individuals, competitors, strategic buyers or private equity investors). To identify a buyer, the owner may need to seek out an investment banker, business broker or a merger and acquisition advisor. Finding several interested buyers can produce a bidding scenario that may well improve price to the owner. If the owner is expected to carry any part of the purchase price, the owner’s advisors should expect to conduct due diligence on the buyer.
- An updated estate plan: The owner’s estate plan needs to be consistent and aligned with the transition plan, as well as with federal and state tax issues. Most importantly, if the plan provides for some, but not all, of the owner’s children to participate in the ownership of the business, owners are well-advised to find ways to compensate those children who won’t be participating.
- Development of a contingency plan: Not all businesses sell or transition successfully. If the liquidity from a sale or transition of the business is necessary to support those who survive the owner, then the plan may necessitate the use of life and disability insurance. Using an irrevocable life insurance trust (ILIT) plan as part of the owner’s estate plan can provide the substitute liquidity needed to support his or her family. Many business owners may find it easier and more profitable to liquidate and dissolve their business than to complete a sale or other transition.
Planning for the transition of a business is clearly not an event, but a process that can take several years to complete successfully. The key concept is planning.
1. “2017 Twin Cities Metro Area State of Owner Readiness Report.” conducted by the Exit Planning Institute, accessed March 2017.
2. Earnings before interest tax, depreciation and amortization (EBITDA) is a measure of a company’s operating performance. Essentially, it’s a way to evaluate a company’s performance without having to factor in financing decisions, accounting decisions or tax environments.