Published: CSA Journal 29, December 2005
IMPORTANCE OF OWNERS HAVING A TRANSFER PLAN
By Edward W. Towers, CSA and CBI
CSA’s commonly counsel seniors on health, tax, financial planning, estate planning, investments, and insurance matters. One frequently ignored area is transfer planning (A.K.A. exit planning) for seniors who own companies. An exit plan considers the various alternatives for an owner to transfer ownership and puts in writing the desired plan (with a timetable) on how to turn over the company to the new owner. It is like an estate plan but it is for the company. By recommending the development of an exit plan for clients in need of one, a CSA can be of great service. The opportunity to be of help in this area is more beneficial, possibly more important than having a will. This situation occurs more frequently than most CSA’s realize.
Citizens over 55 years of age own thirty-one percent of businesses in the U.S. We estimate that only fifteen percent of company owners have exit plans. In portfolio management, personal financial planners advise paying attention to diversification across the various classes (e.g. stocks, bonds, cash, etc.). A study by Vanguard has shown that asset allocation is the most important factor in investing (more than the actual selection of individual stocks!). Although diversification receives the majority of the publicity, a business owner’s largest investment, his company, surprisingly is often ignored. Commonly, three quarters of an owner’s net worth are tied up in his company. Having so much equity tied up in one investment is very risky – especially for senior citizens. Furthermore, it is worse that most business owners don’t have any plan for transferring or exiting.
Reasons For An Exit
Developing an exit or transfer plan by the owner of a business is crucial for seven reasons. Frequently the decision to sell a company is the biggest financial decision made by an owner. It is even more important for owners who are senior citizens for additional reasons.
As you know in real estate, the importance centers on location, location, location. In exit planning it is timing, timing, timing. Timing is everything in M&A (mergers and acquisitions). The ideal time to sell a company is when interest rates are low, the SIC (Standard Industrial Code) industry is hot, and there are more buyers than sellers. All three of these will change over time and are cyclical. Interest rates are now low, relative to historic averages. When an industry gets hot, all companies in it benefit. The saying is “A rising tide lifts all boats”. Currently demand for small and midsize companies is greater than supply. EBITDA (Earnings Before Interest Tax Depreciation and Amortization) multiples have risen to 7.3 times for companies between $25 million and $200 million. The EBITDA multiple for reported strategic acquisitions less than $100 million for January 2003 was only 6.5 times. The timing is excellent now to implement an exit plan.
Another reason to develop an exit plan is to evaluate the risk the owner takes on by holding. There are five types of risks assessed by the owner:
- A material change in the company such as a loss of key personnel, a major vendor, or a large customer.
- A change in the owner’s personal circumstances like divorce, death of a spouse, illness, stroke, or heart attack.
- A fundamental change in the specific industry caused by a competitive sea change
(e.g. imports from China) or governmental regulatory rulings.
- A change in the economy such as inflation, tax, recession, interest rate, and/or stock market.
- A natural disaster like a flood, hurricane, tornado, or earthquake.
All of these risks need to be weighed against the potential incremental return for not exiting.
Allowing for proper preparation in order to exit is a third reason for an exit plan. There are a number of steps an owner can take to position a company to sell. Here are some of the more significant steps in positioning:
Optimize the EBITDA
Transfer the real estate title to the owner (if currently owned by the company)
Change the organization to a pass through entity such as a S corporation
Perform a valuation on the company
Appraise the real estate
Audit the financials
The fourth reason for exit planning is knowing the time it takes to implement the process. It takes longer than you might expect. The U.S. national average now is 224 days to sell a company. You do not want to be under a time constraint. If you are under duress, the price goes down. Furthermore to sell a company for the right price and terms, the timing for the sale will not be set by the owner – but by the buyer.
An interesting reason for exit planning is that there frequently are side benefits in the short run. The very exercise of gathering information and questioning your future almost always uncovers things that can be put to use immediately. Commonly, long range plans have aspects that are incorporated with current plans. Frequently, the owner is really too close to the trees to visualize that he is deep into the forest.
Avoiding the common dilemma is the sixth reason for exit plans. In reality, to our chagrin, the M&A business is “event driven”. Most owners do not plan to transfer their company in advance. Sadly, the exit is then caused by events (usually negative) such as the “Dismal D’s”: death, divorce, disability, or declining market. The event that causes the decision to be made usually results in a reduction in the value of the company. Most companies are sold too late; few are sold too early.
The final reason why an owner should prepare an exit plan is to be able to fully explore the myriad of exit alternatives. An owner should not presuppose that the best case is the outright sale of the company. Perhaps the owner should acquire another company, pick up synergies with integration, and then sell a much larger, valuable company in two years. Reasons Why Owners Frequently Do Not Have An Exit Plan
There are a number of excuses that owners use for rationalizing why they don’t have an exit plan. An owner may say he is too busy running the day to day operations to have any time for an “academic exercise”. In actuality an exit plan is usually very practical. Postponing does not address the need. Will the owner really have more time one year from now?
Sometimes the owner genuinely does not know where to receive the required advice. A Certified Business Intermediary (CBI) is specifically trained and qualified to assist an owner through this process. To find a CBI in your area, go to the web site of the International Business Brokers Association at HYPERLINK “http://www.IBBA.org” www.IBBA.org . If you would like a copy of “Alternatives for Transferring a Company”, written by this author in the Journal of Personal Finance (Volume 4, 3rd Issue), contact TIGER Brokerage Group.
Many brokers and intermediaries will pay a referral fee to a CSA who passes along a senior client to them. There is also an opportunity to have a reciprocal relationship, as brokers sell companies owned by seniors who need help offered by CSA’s.
An owner may resist change – so he avoids planning for the change. Clinging onto the status quo almost always results in a declining situation. As M&A intermediaries, we see owners who don’t want to do anything now because they need another year to get their EBITDA up to where they can get the money that they want for the company. Then one year later the same owner says he doesn’t want to sell now because all is well and there is no reason to sell now. There is always an excuse available if you look for one.
Certainly, emotion frequently is a reason why an exit plan isn’t prepared. Selling a company can be very emotional and it can involve many family members. Handholding is not an insignificant aspect of what I do for owners as an intermediary.
Tax may also be a factor. Sometimes an owner will procrastinate because he doesn’t want to come to grips with the fact that ownership capital gain transfer will almost always be taxed in some way (estate or gift). Minimizing tax is preferable, but tax should not be the main driver for such an important decision. This is particularly critical for a plan that has timing as such an critical element.
Possibly, the owner may not have a qualified successor, or the presumed successor may really not be interested. Even if the successor is qualified and willing, he has to be trained. This requires time and planning.
The most common real reason for not having an exit plan has to do with the FUD factor: Fear, Uncertainty, and Doubt. It is among fear, uncertainty, or doubt (or a combination) that are the reasons most decisions are not made. Consequently, major decisions like how to exit your company get put on the back burner – until some event happens that forces the issue.
United States Census Bureau, December 31, 2002 Vanguard Investment Counseling and Research 2003. The study looked at performance of 420 actively managed balanced mutual funds the U.S. with at least five years of history between 1962 and 2001. How a fund’s portfolio was divided (between stocks, bonds, and cash) accounts for 76.6% of the variability of a fund’s monthly return. The Deal, February 13, 2005, from Thomson Financial Securities Data Corp. The Deal February 10, 2003, from Standard & Poor’s LCD. 2004 Business Reference Guide by Tom West.