How To Get What You Want When You Leave Your Business
When it comes to running a business, few things are certain. There is however, one universal truth. Be it a carefully planned decision or the result of fate's swift hand, someday you will leave your business.
Your exit is going to take place in one of two ways:
- You will transfer ownership of the business during your lifetime because you've decided you want out. Without planning, this will probably mean that you have to liquidate. With planning you will be able to sell the business to a third party, to key employees or co-workers, or to family members - all at minimal tax rates.
- You will die or become totally disabled, and the business will have to be liquidated unless some type of business continuity arrangements have been planned and documented.
Most owners measure their satisfaction with their business in terms of the income, wealth, identity, challenge, stimulation, satisfaction and pride that it provides to them, but consider another definition of success -- one that measures a business not only by how well it operates under your ownership and the benefits it provides, but also by the rewards it will bestow when you leave it. Because in the end, what you really want and need from your business is the ability to leave it under the most favorable conditions. The only way you as an owner can do this successfully is to create an exit plan as early as possible and stick to that plan as long as you maintain your business.
Developing Your Exit Plan
Despite the almost infinite variety of businesses and business owners almost all exit plans contain common elements or goals. Generally these goals fall into three broad categories:
- To create and preserve the value of the company;
- To provide a means to exchange that value for money with the least tax consequence possible;
- To meet personal and family needs by providing security and continuity to your business and for your family either upon your planned departure or if disaster strikes - upon your death or disability.
Creating and Preserving Value In Your Business
Most entrepreneurs are so dedicated to the worthy purpose of making money that they have little or no time to spend on creating and preserving value for their business. However, it's important to find time for several reasons:
First, to exit the business in style, you will need cash and the source of cash is the business itself. To determine the amount of cash you will receive, you must know the value of the business.
Second, if you intend to give the business to your children, the business must be valued because that value is the one used for gift tax purposes.
Third, a business typically comprises the great majority of an owner's total wealth. The IRS knows this just as surely as you do. Determining the value now, allows you the opportunity to design an Exit Plan that takes your business into account with the goal of minimizing the IRS's take.
Fourth, well-designed key employee incentive compensation planning is central to increasing business value. Business value is often used as a measuring rod for such plans.
Fifth, if an owner goes through this exercise well before the business is sold or transferred, he or she will be able to pinpoint the factors that are crucial to measuring and increasing (or decreasing) the worth of the business.
How Much Is Your Business Worth?
Determining The Value
Valuation of your business is likely to be performed by your CPA or a business appraiser using a methodology consistent with the approaches sanctioned by the IRS. This valuation will determine a range of fair market values for your business for purposes of gifting, estate taxation, and general planning. Note that this fair market value is not the same as the sales price for your business. To determine the sales price, the fair market value is used as a hypothetical starting point and adjusted to accommodate factors like timing of the sale and industry cycles, current condition of the merger and acquisition market, interest rates, and geographic location among others.
The technical details of business valuation are beyond the scope of this report. But one aspect worth noting is that estimating the value of your business will be critically dependent on whom the business will be transferred to. If you are selling the business to an outside third party, you will seek the highest possible value for your ownership interest. If you are transferring ownership to your children, you must make every effort to develop the lowest defensible value for your ownership interest. This counter intuitive strategy is due to the huge role the IRS plays in the transfer of your business.
If you decide to sell to an outside third party, it will be for cash and you'll want all you can get via a high value. But your children, your employees, or your co-owners don't always have cash on hand. Their source of money, or cash flow, is the same as yours - the business. They will need to earn money on the business and pay income tax on it (tax #1) then pay the balance to you to buy the business - at which time you will pay a second tax on the gain (tax #2). The higher the business value, the greater the purchase price. The greater the purchase price, the greater the double tax bite.
For example, if company earnings are distributed to the purchaser (let's say a key employee), it will be taxed as compensation--salary or bonus money--which will then be used to pay the after tax money to you (say 65 cents of the original dollar of earnings). You in turn pay a capital gains tax on the 65 cents received (assume little or no basis on your ownership interest, therefore a tax of about 25 percent). The net is less than 50 cents on each dollar earned and paid out by the company.
In other words, all purchasers, other than outside third parties, need to look to the earnings of the company for money to pay to you because they have no money of their own. This results in a double tax paid on the money received by you (taxed once as the employee/purchaser earns it and once when you receive it for your stock). The higher the business value, the higher the tax, the more difficult it is to accomplish a successful transfer, and the less likely that you will leave your business in style. Methods for avoiding this double taxation are rather complex and beyond the scope of this guide, but keep in mind that determining the value of your business will require you to decide early on how you wish to transfer it.
How To Motivate And Retain Key Employees Through Ownership
The one indispensable component of a valuable business is its top employees. Think about it: your top employees are even more valuable than you are for the purpose of creating value for your ownership interest. The more valuable you are to the business, the less valuable the business will be when you leave it. What you need to do is leave behind key employees who add significant value to the business for several important reasons:
- Properly motivated by a profit-based incentive plan, key employees do increase the value of your business.
- Key employees often become potential owners when you decide to retire or move on to another venture.
- If you decide to sell to a third party, the continued existence of a stable, motivated management team will increase the purchase price.
Key employees are not necessarily employees in key positions. Key employees think and act a lot like you and are eager to be given responsibilities and challenges. Like you, they want to see the business grow and prosper, and they want to grow and prosper along with it. They take pride in being identified with, and contributing to, a successful business. In short, they act like owners. Their continued presence in the business is necessary if the business is to thrive.
There are several incentive packages you can implement to retain and motivate key employees. These incentive packages help your key employees reach their financial and psychological goals - if they stay with you. As your key employees attain their goals, the design of these incentive packages should also help you to achieve your ownership goal of building business value (and eventually converting that value into money).
Take a hard look at your current employee benefit programs, especially those aimed at your key employees. Elements of your incentive program should include:
- Financially attractive awards that create a potential bonus of at least 10 percent of the key employee's annual compensation. Anything less than this will not be sufficiently attractive to motivate the key employee to modify his or her performance to make the company more valuable.
- Specifics; that is, determinable performance standards, such as the company reaching a certain net income or revenue level.
- Structure to increase the company's value such that, as the key employee reaches measurable objective standards, the net income of the company increases.
- Incentive reward vesting or "golden handcuffs" that link payment to tenure thus encouraging the employee to remain on the job in order to receive the reward.
- Face-to-face meetings with your key employees to discuss the plan and make sure the incentive arrangements are thoroughly understood and all questions answered.
Four Ways To Leave Your Business - Which One Is Right For You?
Selecting your business successor is a fundamental objective of planning an exit strategy and requires a careful assessment of what you want from the sale of your business and who can best give it to you.
There are only four ways to leave your business: transfer ownership to family members, Employee Stock Option Plan (ESOP), sale to a third party, and liquidation. The more you understand about each one, the better the chance is that you will leave your business on your terms and under the conditions you want. With that in mind, here's what you need to know about each one.
1. Transfer Ownership to Your Children
Transferring a business within the family fulfills many people's personal goals of keeping their business and family together, but while most business owners want to transfer their business to their children, few end up doing so for various reasons. As such, it's necessary to develop a contingency plan to convey your business to another type of buyer.
Transferring your business to your children can provide financial well-being for younger family members unable to earn comparable income from outside employment, as well as allow you to stay actively involved in the business with your children until you choose your departure date.
It also affords you the luxury of selling the business for whatever amount of money you need to live on, even if the value of the business does not justify that sum of money.
On the other hand, this option also holds the potential to increase family friction, discord, and feelings of unequal treatment among siblings. Parents often feel the need to treat all of their children equally. In reality, this is difficult to achieve. In most cases, one child will probably run or own the business at the perceived expense of the others.
At the same time, financial security also may be diminished, rather than enhanced, and the very existence of the business is at risk if it's transferred to a family member who can't or won't run it properly. In addition, family dynamics in general, may also significantly diminish your control over the business and its operations.
2. Employee Stock Option Plans (ESOP)
If your children have no interest or are unable to take over your business, there is another option to ensure the continued success of your business: the Employee Stock Ownership Plan (ESOP).
ESOPs are qualified retirement plans subject to the regulatory requirements of the Employee Retirement Income Security Act of 1974 (ERISA). There's one important difference however; the majority (more than half) of their investment must be derived from their own company stock.
Whether it's due to lack of interest from your children, an economic downturn or a high asking price that no one is willing to pay, what an ESOP does is create a third-party buyer (your employees) where none previously existed. After all, who more than your employees has a vested interest in your company?
ESOPs are set up as a trust (complete with trustees) into which either cash to buy company stock or newly issued stock is placed. Contributions the company makes to the trust are generally tax deductible, subject to certain limitations and because transactions are considered stock sales, the owner who is selling (you) can avoid paying capital gains. Shares are then distributed to employees (typically based on compensation levels) and grow tax free until distribution.
If your company is a stable, well-established one with steady, consistent earnings, then an ESOP might be just the ticket to creating a winning exit plan from your business.
If you have any questions about setting up an ESOP for your business, give us a call today.
3. Sale to a Third Party
In a retirement situation, a sale to a third party too often becomes a bargain sale--and the only alternative to liquidation. But if the business is well prepared for sale this option just might be your best way to cash out. In fact, you may find that this so called "last resort" strategy just happens to land you at the resort of your choice.
Although many owners don't realize it, most or all of your money should come from the business at closing. Therefore, the fundamental advantage of a third party sale is immediate cash or at least a substantial up front portion of the selling price. This ensures that you obtain your fundamental objectives of financial security and, perhaps, avoid risk as well.
If you do not receive the bulk of the purchase price in cash, at closing, however, your risk will suddenly become immense. You will place a substantial amount of the money you counted on receiving in the unpredictable hands of fate. The best way to avoid this risk is to get all of the money you are going to need at closing. This way any outstanding balance payable to you is "icing on the cake."
If there is no one to buy your business, you shut it down. In liquidation the owners sell off their assets, collect outstanding accounts receivable, pay off their bills, and keep what's left, if anything, for themselves.
The primary reason liquidation is considered as an exit plan is that a business lacks sufficient income-producing capacity apart from the owner's direct efforts and apart from the value of the assets themselves. For example, if the business can produce only $75,000 per year and the assets themselves are worth $1 million, no one would pay more for the business than the value of the assets.
Service businesses in particular are thought to have little value when the owner leaves the business. Since most service businesses have little "hard value" other than accounts receivable, liquidation produces the smallest return for the owner's lifelong commitment to the business. Smart owners guard against this. They plan ahead to ensure that they do not have to rely on this last ditch method to fund their retirement.
If you need assistance figuring out which exit strategy is best for you and your business, please don't hesitate to contact us. The sooner you start planning, the easier it will be.