by Allen Duck COO, Northstar Financial Companies, Inc.
In part two of this series, we discussed the basic outline for helping your business owner clients begin to plan and prepare an exit out of their firm. Once you’ve worked together to review the situation, define the runway, identify the outlook and select the appropriate method of sale comes the most critical part of the transition process – structuring the deal. Depending on whether or not an internal or external successor has been chosen, there are a number of factors that can impact the success (or failure) of the transaction. Once these are recognized comes the hard part of exit planning for many agents and advisors: following through with the deal and actually leaving the business to enjoy retirement.
WHO AND HOW
Let’s quickly take a minute to refresh our memories about the pros and cons of choosing to structure an internal or external buy-out. Many business owners looking for an internal sale, particularly those with small, independently owned firms, do so because they have family currently in the business or want to bring members in to keep the business in the bloodline. Those with children in particular make the sale exponentially more complex, yet these owners have more of a tendency to “trust” in the sale irrespective of objective information regarding the high failure rate of second and third generation business owners. If the family member doesn’t have command and a strong grasp of how to maintain the business, this can be the quickest way to disenfranchise loyal workers and create a period of decline. Often times, this leads to the owner having to leave retirement to rebuild the business and start the process all over again!
Other potential internal successors may be identified through performance reviews and internal relationships. Frequently it’s a department head that excels in a managerial role. Still, these individuals may not be multi-dimensional enough and the end result could be the same as mentioned above. A third-party buyer from outside the firm will have to fully understand the structure of the business and how it interacts, but will not have to contend with the task of actually learning how to run a business. As a seller though, it is crucial to ensure that an external buyer has a similar interest level in supporting the existing book of business or clientele through a similar philosophy, attitude and approach. After all, clients only work with individuals with whom they feel comfortable. In these cases, personality profiling can make all the difference.
STRUCTURES AND CONTRACTS
In most deal structures, internal or external, the vast majority of the payment will be deferred and carried by the seller. In essence, the buy is using the firm’s own money to pay the debt. In such a leverage buy-out, the value of the business should be set forth in the contract with suitable clauses that protect the seller and the buyer from egregious acts by either party. Often referred to as “clawbacks,” these provisions allow for a valuation review at certain points in time, at which any significant change in the firm’s value is adjusted and future payments owed are affected. These structures should equally recognize the seller if his or her continued participation creates value during the transition period. Clawbacks act as a mechanism for leveling risk and reward; without them, a seller is likely to have to acknowledge a greater percentage of the risk and discount the purchase price accordingly. Additionally, taking a reasonable approach to determining the true value of the business is critical in making the transition a success and ultimately from keeping people out of court.
Cash plus debt structures are the most traditional type of sale. In these instances, a down payment is made up front, and subsequent guaranteed payments with an earn-out are made over a three- to five-year basis. Pure debt deals are the most risky for the seller. In these cases, a financially unprepared successor (usually a family member or employee) would create a 100% deferred payment carried by the seller. An uninterrupted and consistent income stream is required for these deals to be successful, which may pose a challenge if the buyer isn’t prepared for the added responsibility. It is rare to see all-cash structured deals, yet, we are seeing an increase in recent years. Typically they involve large firms taking on assets as part of a “roll-up” strategy. These deals present the very least risk to a seller but are not always in the best interests of clients and/or current employees.
To determine what makes sense for a business owner client (and for your own exit plan), determine how the seller wants to get out. Is he or she willing to stick around while the new owner adapts, or would the owner prefer to take the money and exit quickly? With an external buyer, the business owner may need to hold one meeting with each major client to help ease the transition and maximize the retention, but will often be freed of responsibilities much sooner than with an internal deal. Corporate structure may need to be considered based on issues of taxes and liability. If a firm is a C Corp and time allows, it may be appropriate to revert to an S Corp creating the basis for an asset purchase over a stock purchase. A beneficial tax structure results for the seller without forcing a buyer to assume unlimited liability. A large percentage of the firm’s value can be allocated to goodwill creating the basis for capital gains treatment. Note that every situation is different, and bringing in strategic resources will help prevent unforeseen issues for the buyer and the seller.
ACTION AND ACCOUNTABILITY
Taking the time to develop a plan for an exit is only meaningful if action results. A plan has to be written to be real, and its author held accountable if it is to be beneficial. In order to protect your clients’ wealth (and your own!), dealing with succession is a must – it protects the firm’s value now and creates a path to successive increments in net worth. When an owner is serious about making the transition, he or she should nominate a mentor to help oversee the process and challenge the owner of the management of his or her last and most significant business project: a shift into retirement.
When you are ready to transition, consider looking to Creative Marketing, your family or a trusted colleague to keep you on track. If this person or group of people is equally committed to helping you thoroughly prepare to exit the business and maximize its value, you will be much more likely to walk away feeling good about the transaction and confident you got what you deserved from all your hard work. As an added bonus, you can doubly benefit from buying insurance on yourself and/or your business if you haven’t already.
FOR AGENT USE ONLY. NOT FOR USE WITH THE GENERAL PUBLIC. 12255 – 2012/4/2
This material has been prepared for informational and educational purposes only. It is not intended to provide, and should not be relied upon for, accounting, legal, tax or investment advice.