Do you have a plan in place that dictates your exit from business ownership?
Most do not.
According to the Exit Planning Institute, more than 80 percent of small business owners lack a written plan, and nearly half have completed no planning at all.
When it comes to crafting a proper exit plan, there is no archetype. Some owners elect to pass the business to a family member through succession. Others opt to move the business through a third-party sale. Another group will offer employees a stake of the business through an employee stock ownership plan (ESOP).
Regardless which path an owner picks, his or her exit will likely be the largest transaction he or she will ever conduct — one that should be handled with extreme care.
Here are some tips from a group of advisors who are well-versed in helping HVACR distributors make crucial business decisions, including exit planning.
While many HVACR distributors opt to pass their businesses down from generation to generation, Leon LaBrecque, managing partner and CEO, LJPR Financial Advisors, Troy, Michigan, said owners should proceed with caution when considering this transaction.
“The question is, ‘Is this the best use of your kid’s time and your time?’” said LaBrecque, who boasts more than 30 years of financial planning experience. “Simply because your children share your DNA doesn’t mean they’re automatically qualified to run your business.”
LaBrecque encouraged owners to remove a child’s name from a résumé and ask if they’d hire him or her based solely on his or her career accomplishments.
“If the answer is no, perhaps you should find another role for your child,” he said. “Monetize your business in another way and use the money to help the family outside of the business’s future.”
Mike Marks, co-founder and managing partner of Indian River Consulting Group, a consulting firm to distributors and manufacturers, said when considering promoting a child to owner, an owner must carve out time to pass on the critical, proprietary knowledge necessary to operate the business.
“Don’t confuse transition of ownership with transition of management,” he said. “If you expect a son, daughter, or other relative to be more than an owner, make sure they have experience with multiple facets of your business. Also define the level of performance you expect and always have a plan B in case they don’t meet those expectations.”
Another concern arises when an owner must decide how to allocate funds when one kid works in the business and another does not.
“The child who works in the business is more than likely going to be better economically taken care of than the other one. How do you account for that? How does your second child get a cut of the action? Does he or she get shares? Those solutions are all over the map. I’ve seen clients equalize all beneficiaries in the estate plan. I’ve seen owners insist the child working in the business has to buy in, and then he’s responsible for paying his sibling’s portion. There are many solutions.”
When it comes to planning a family’s future, LaBrecque suggests getting all parties involved.
“Let’s say I have a $10 million company, and I want to pass it on to one of my kids, but none are qualified,” LaBrecque said. “One way to acclimate the kids into the business is to set up a family board of directors. Appoint your son as a member and tell him you want him to have some say in the company’s direction. Encourage him to sit in on meetings with lawyers, CPAs, and community leaders.”
Marks recommends an outside board concept.
“A board of directors is a good idea even if you’re not creating a succession plan, because the board can hold management accountable and provide an outside perspective,” he said. “And if company leadership, including you, becomes ill or incapacitated, a board can provide direction and implement the CEO’s wishes.”
When sold to the right buyer, a third-party sale can be a much more lucrative endeavor than handing the business down through the family.
A sale outside of the family is often an easier process as well because it lacks a great deal of the internal tension surrounding a generational transaction, LaBrecque said.
“If you sell to an outside entity, you’re talking about transforming your $1s into $5s,” LaBrecque said. “You should always be thinking about making money on your money.”
LaBrecque said there are two general options worth considering.
“The first is to sell the business to employees gradually under a buy-and-sell agreement, where you give key employees some kind of valuation on the stock,” he said. “You either bonus them the money to buy the stock or gift them the stock. Then, you have a buy-and-sell agreement that establishes a date when the employees fully buy you out.”
The second arrangement is a bit more sophisticated, LaBrecque said.
“An ESOP, where you sell your company to the 401(k) plan and the employees own it outright, is also an option,” he said. “In this arrangement, the owner gets a note that allows him or her to get valued out pretty quickly. An ESOP can actually monetize faster, and it gives full ownership to the employees quicker. Additionally, it’s fairly lucrative for the owner, who can earn 10-11 percent on such a note.”
An Exit Can Be Taxing
An owner’s exit can be complex on a financial and emotional level.
“An owner cannot spend 30-40 years of his or her life building a business without a strong attachment,” said Kevin Kennedy, president of Beacon Exit Planning LLC. “Business is not just what you do, but who you are. This complex process requires specialized advice from an accountant, business appraiser, tax advisor, corporate attorney, estate planner, financial advisor, and insurance advisor, among others.”
Coordinating and understanding such often disjointed advice can be overwhelming to a business owner who is not familiar with these concepts and terms.
“An exit is taxing from a financial perspective, where an owner can surrender more than 50 percent of the harvest to taxes on the state and federal levels,” continued Kennedy. “In addition, each path has a different value, tax consequence, and financial compromise. Taxes can be reduced or eliminated by properly structuring, aligning, and positioning the company in order to meet complicated regulations. In this situation, time can be your best friend, so plan early.”
Marks identified numerous steps a business owner should consider before selling a company.
After deciding whether to sell the business, pass it down, gift it to employees, etc., an owner should have the business appraised.
“An appraisal will help establish your company’s worth and overcome the myth that a business’s worth is directly connected to the number of years an owner has invested into it,” Marks said. “Getting everyone to agree on this will create a baseline for determining your business’s value going forward.”
Marks insisted an owner should explore if the company’s achieved — or whether he or she wants it to achieve — platform status.
“If you want to avoid the planning, financial considerations, and thorny issue of choosing between family members, or if you just want to reap the reward of your hard work while you can still enjoy it, plan now to maximize your business’s worth by investing to become a platform company,” he said. “A platform company typically grows at two to three times industry growth. They grow intentionally, have scalable infrastructure, are a critical link in their supply chain, have desirable customers, and partner with leading suppliers. This may mean investing in initiatives to improve operating scale, processes, or productivity.”
Our experts insist a well-established exit plan adequately protects an owner’s hard-earned wealth and helps him or her institute a lasting legacy.
Kennedy said distributors should recognize that exit planning takes time.
“A flexible plan may take several months to write and several years to execute,” he said. “Depending on the readiness of a company’s management and the type of exit and current payout, a succession plan may last from three to 10 years. That said, if the business is systematized and has clear financials with mature management in place, and the owner can take a six-week vacation, the company could be ‘sale-ready’ in less than two years.”
Marks said the risks are too great not to do whatever it takes to protect a business’s legacy.
“Making plans to put the business you’ve built and devoted your working life to into someone else’s hands is never easy,” he said. “When distribution company owners don’t plan ahead for succession, it can lead to anything from financial disarray to family-member infighting when they step down, or – worse – die unexpectedly.”
Five years before owners are set to exit the business, LaBrecque suggests they spend some time with a private equity firm.
“Once you see how serious buyers think and learn some of the things they’re looking for, you’ll start to run your business differently,” he said. “If your goal is to sell, it’s advantageous to focus on the aspects that buyers find attractive before you put the place up for sale.”
Publication date: 10/29/18