If you are an owner or partner in a closely held business, have you given serious thought to what would happen to your company if you were to die unexpectedly? Chances are, you probably haven’t.
“Most small business owners haven’t given succession planning any real thought beyond, ‘I ought to do something,’ ” says David Geller CEO of GV Financial Advisors. “It’s absolutely critical that owners think through what they would want to happen to their companies if they were to die unexpectedly. This means assessing your family’s financial needs and what you can realistically get for the business and then coming up with a formal, written succession plan and communicating this to your key employees and family members.”
Without proper planning, your business could quickly crumble under the weight of estate taxes and battling between the competing interests of heirs and surviving owners and shareholders. The failure to deal with succession planning openly and forthrightly can have disastrous consequences on a company and its shareholders, employees and other stakeholders.
It Can’t Happen to Me
The fact is, dealing head-on with succession planning is not a comfortable process for most owners. After all, who really wants to confront the issue of his or her own mortality — especially if you’re young, healthy and successful?
But if you think, “It can’t happen to me,” think again. According to actuarial tables, in a business with two partners both 35 years of age, the probability that one of them will die before age 65 is a whopping 47 percent! For partners who are both age 50, the probability drops only slightly to 40 percent.
One year ago, Stephen Miller, the 52-year old CEO of Inter-American Data, one of Catalyst magazine’s Top 50 Entrepreneurs in 2003 and also a licensed pilot, decided to go for a relaxing Saturday morning flight on the company plane. The plane never left the ground before crashing at the end of the runway and exploding, killing Miller instantly.
At the time, he and his partner, John Moran, were well into the process of selling Inter-American Data, a leading provider of software and related services to casino hotels and major resorts. “There was a tremendous amount of interest in the company from prospective buyers,” says Michael Jacobs, president of Jacobs Capital Management, whom Miller and Moran had engaged to sell the company. “In fact, we had two calls on the Friday before Stephen’s death with very interested buyers.
“I had to contact all of the potential buyers and tell them what had happened and ask that they be patient and not let this impact the process of the sale,” he explains. “Most importantly, I wanted to buy some time for John and Stephen’s widow, Bonnie, to let everything sink in and decide what they wanted to do.”
Moran and Bonnie Miller decided to go forward with the sale of the business. “We decided we didn’t want to do any kind of earn-out,” says Moran. “We wanted to either own the business and be actively involved or sell it and not have any ongoing involvement.” So they accepted an all-cash deal from Agilysys Inc., a publicly traded firm based in Cleveland, which enabled them to do just that. The sale of the company closed in February.
The key to everything going so smoothly in spite of Miller’s tragic death was early succession planning by the partners. “Stephen and John were both young and healthy, but they were extremely well prepared in case something were to ever happen to either of them,” says Jacobs. “They had gone to great lengths to establish the right legal structures and minimize the tax impact in case of an unexpected death.”
Most buy-sell agreements are funded with life insurance on the business owners. This provides a ready source of cash that enables surviving partners to buy the deceased partner’s interest, ensuring that the deceased’s heirs receive full value for their shares regardless of the continued success or failure of the business.
There are two types of buy-sell agreements:
“Nothing can overcome a lack of preparation when something like this happens,” says Moran. “For us, something tragic and unforeseen did happen, and if we hadn’t been prepared, I might still be running the company today.
“Even though Stephen’s death was a major unexpected hurdle, nothing came off track in selling the company,” he says.
The first thing to realize when it comes to ownership succession is that the primary value in most small businesses is in relationships. To maximize the value of the business, there must be a structured plan for transitioning those relationships — and this isn’t something that happens overnight.
Geller recommends that you identify key employees and make sure they’re on board with your plan. He recently helped the sole owner of a $15 million construction business in Atlanta form a succession plan. The business has two key employees — one on the client relations side and one on the operations side — and it has purchased key-man life insurance on each.
“We decided that if the owner were to die unexpectedly, the first thing we’d do is tell these employees that we would increase their salary and give them a percentage of the business when it sells if they would stay,” Geller explains. “Then we’d hire a business broker and try to sell the company quickly. This would enable us to keep the business going, while realizing that the business lost some value the moment the owner died, and might continue to lose value.”
The next step, says Geller, would be for these key employees to identify the firm’s top clients and meet with them ASAP after the death. “They would need to emphasize that the clients’ relationships are not just with one person, but with the company,” he says.
Usually, the right amount of insurance and the deceased owner’s salary will provide enough money to hire a replacement and at least keep the business going, Geller says. “Term insurance is very cheap right now, so why not spend some money on this and give yourself a financial cushion? It’s when you’re under the financial gun,” he suggests, “that you have to make very difficult decisions quickly and under very stressful circumstances.”
With very small, service oriented companies, when the owner dies, the company usually dies too. “What many of these entrepreneurs have done is build themselves a job, and when they’re gone, so is the job and the company,” says Geller. “I’ve worked with a number of them who wondered if there was any value in their companies besides themselves and often there isn’t. They need to accept this reality and accurately assess who does what in the business and whether there’s any ongoing viability to the business without them.”
Partnerships create a different set of challenges. Aside from the issues involved in keeping the business going, there are some serious potential conflicts of interest between a deceased owner’s heirs and the surviving partners. The partners would likely hope to continue growing the business and maintaining a long-term outlook and they may not welcome the involvement of a surviving spouse who knows little about the company. The heirs, meanwhile, might not share this long-term outlook or they may just want to sell their interest for top dollar.
A formal, written agreement between partners that spells out specific plans in the event of an owner’s sudden death is the best way to avoid conflicts, and possibly even litigation, between heirs and surviving owners. The best vehicle for accomplishing this is a buy-sell agreement. This is a legal document that helps ensure the orderly transfer of an owner’s interest upon his or her death and it helps provide a smooth transition of complete control and ownership to the parties most able to keep the business going.
A buy-sell agreement establishes a mutually agreed-upon sale price for the deceased owner’s interest ahead of time. It also spells out the terms of the payment and places a value on the business that is binding on the IRS for federal estate tax purposes. Just as importantly, it provides much-needed stability for employees, customers, creditors and investors and it allows surviving partners to maintain control of the business.
Get Professional Help
Creating a formal succession plan will require a significant investment of time and effort and you’ll need the assistance and guidance of experienced estate and business planning experts as you work through the myriad issues involved. But as the real-life story of Inter-American Data so vividly illustrates, it’s a process you really can’t afford to neglect.
“It’s simply unfair to employees, partners and family if unexpected death and business succession haven’t been thought through and planned for,” says Geller. “Dealing with the death of a loved one or business associate is already overwhelming, but for heirs and surviving owners to have to deal with a business that is ill-prepared is a recipe for disaster.”
Every once in a while, as busy executives focused on the day to day, we need to be reminded of our mortality. Recently, for me, the story of the two Darlington students who drowned on a spring break kayaking trip in Florida hit close to home. The two boys were friends and classmates of my oldest son and they were on a trip, led by his English teacher, that he had considered going on. No matter what your age, and regardless of how healthy you are, you need to have a plan in place in the event that your transition from your job is to another world. This is especially true if you are a shareholder in a private company.
If something happens to you tomorrow, who is going to take over your responsibilities in the business? Have you communicated your views on this to anyone? Exactly how much will your estate taxes be? How will they be paid? Who will purchase your shares if those you have willed them to would prefer a more liquid investment? If you have a partner who dies, who is your new partner going to be? Where are the answers to all these annoying questions written down so that your wishes can be carried out?
According to estate planning experts, most private companies are ill-prepared to deal with the loss of a significant shareholder. It is not uncommon for a business to have to be sold to pay estate taxes. Nor is it uncommon for a founder’s legacy to fall apart once he or she departs unexpectedly. And it is routine for there to be total chaos while those left behind try to figure out what to do, even if there is a plan in place, because it was not effectively communicated. All too often, business owners adopt the attitude that these concerns are not their problem; they will be singing with the angels. But that is a selfish attitude, especially when addressing these matters takes relatively little time and money.
If you are a business owner, the first step is to figure out how the company would operate in your absence. If there is more than one option, be sure that you have decided who your replacement will be. Write it down somewhere (even if in a sealed envelope) and let someone you trust know where that document is located. If you have already done this, have you updated it lately? Your view on the subject may change over time.
According to Atlanta estate planning attorney, Allen Altman of Greenberg Traurig, if you have partners, be sure there is an agreement in place that provides for the shares of the deceased party to be purchased by the remaining shareholders, not the company. Share buybacks are typically funded with insurance policies owned by the company. If your company is bonded or borrows money from the bank, there are outside parties who would have a say in whether those insurance proceeds could actually be used for their intended purpose. Altman recommends that the partners individually hold policies on each other.
The buyback agreement should stipulate a formula for how to value the stock or provide for an independent valuation to be performed. If you choose a formula, it needs to be updated periodically, as the proper multiples or valuation methodology will change over time as the company grows and as financial markets change. A company worth six times pre-tax earnings one day could be worth eight times or four times a couple years later. Business owners rarely allow the purchase price to be established by an independent valuation. In most cases, this would be the most equitable solution. But, as many private company owners are control freaks, they don’t trust anyone but themselves to establish how the price will be established.
If the deceased individual’s shares are not automatically purchased by the remaining stockholders, the surviving owners need to be certain that the individual who inherits their partner’s shares is someone they can live with as a partner. I have a client who has a 50/50 partner whom he brags will work until he is one foot from the grave because his wife is such a witch (I am paraphrasing). But when I asked him who would be the other 50 percent shareholder in the event his hard-working partner was hit by a truck, his smile suddenly dropped. Guess who?
While everyone in the tax world has his or her own prediction for what is going to happen to estate taxes, it would be wise to follow Washington’s moving tax target and continuously update your estate plan to assure that an untimely death does not force the liquidation of the company at an inopportune time. Chris Dardaman, partner in Atlanta-based Polstra & Dardaman, points out that if there is insufficient liquidity in your estate to cover the estate tax burden, there often is no other option than to sell the company. And right on the heels of the death of a key executive may not be the best time. Moreover, the market could be poor for business sales at the time.
When you are preparing an estate plan, you should always have an independent valuation performed on your company by someone familiar with how the IRS values companies. Your homemade formula for a buy/sell agreement, or your belief that you can value the business at book value in the event of a death, may be off by several orders of magnitude from the opinion of the IRS. And in this case, the IRS’s opinion does matter.
Even when business owners invest the time to prepare estate and succession plans, which their survivors greatly appreciate, they sometimes store the information somewhere that no one can find it. In writing this article, I realized that while I have documents stored in a safe in my house, no one other than me knows the combination.
Dardaman recommends that every one of his clients establish a notebook that contains all of the financial information that would be relevant to those who have to carry on after you depart. At a minimum, the notebook should contain:
Dardaman also recommends including instructions on any matters of importance to you that are not spelled out in one of the above documents.
If you don’t want anyone to know the contents of your notebook while you are alive, give it to someone you can trust or store it in a secure location and give the key or combination to someone you trust.
It will only take you a matter of hours, or at most a few days, to get your affairs in order. But it is the best going away present you can leave your partners and family members. After all, you want them to be toasting you after the funeral, not exasperated trying to sort out the mess you left behind.
Uncle Sam has provided a generous tax subsidy (that is not utilized nearly as often as it should be) to business owners who are exiting their businesses. It is a complex program that is not well understood and frequently used inappropriately.
About a year ago I wrote a high-level article on the subject, but I have since been asked to elaborate on this topic, which I will do with a case study involving a deal I am currently working on.
Recently I was hired to sell a company that had two principal shareholders: the founder, who owned 51 percent of the stock, and the CEO, who owned 40 percent of the stock. The 49-year-old founder, who was no longer actively involved in the business, wanted to cash in his controlling ownership position and go into the ministry full time.
The 58-year-old CEO, on the other hand, was not ready to hang up his spurs. However, the CEO, who had been displaced twice as a result of buyouts of the companies he had worked for, was terrified that if a private equity firm or a strategic buyer took control of the business he would lose his job the first quarter the company failed to meet its projections.
The founder’s primary goal in the deal was to stash away sufficient money to allow him to live the rest of his life off the income from his investments. The CEO’s hot button was job security for another five years before he was ready to cash out.
After many months of effort, we secured several fair offers from private equity groups to purchase the founder’s shares, but both the founder and CEO had reservations. If a controlling stake was sold to a private equity group, an unknown entity would control the fate of the CEO. And while the founder recognized that the offers were fair, the tax bite on the sale of his stock would barely leave him enough money to generate his required level of current income given today’s low interest rates.
I proposed a solution that addressed both their concerns, with a little icing on top for the rest of the employees, which made both the founder and the CEO happy.
Through a leveraged ESOP (employee stock ownership plan) the founder could defer his taxes on the proceeds of the sale and thus have 20 percent more invested to generate an income. And the CEO would not be working for an unknown private equity firm or corporate boss.
The controlling stake in the company would be voted by the trustees of the ESOP, which would include the founder and a couple of other employees. This made the CEO feel much more secure. A few added benefits made the decision a no-brainer:
The workers who had built the company would receive, at no cost to them, valuable stock which they never could have afforded to buy;
The pressure on the CEO to deliver future profits was eased because pre-tax earnings could be used to pay back much of the principal on the loan; and
When it comes time for the 58-year-old CEO to cash out his shares, he will have a ready buyer — the ESOP.
Sound too good to be true? It’s not. So, why aren’t these deals more common? Leveraged ESOPs are the Rodney Dangerfield of corporate finance. They get no respect.
Essentially an ESOP is a trust, set up for the benefit of the company’s employees, that can borrow money based on the assets and cash flow of the company. Technically, an ESOP is an employee benefit plan, so it is regulated by the U.S. Department of Labor. And with more than eight million workers owning shares in their employer through an ESOP, the ESOP lobby has strong political clout, as I quickly learned when I was running corporate finance policy for Bush senior.
ESOPs were established by Democrats as an incentive to promote employee ownership, but they are embraced by Republicans because they are equally beneficial to business owners. The primary attraction to the business owner is that if he or she sells at least 30 percent of the shares of the company to an ESOP, he or she can invest the proceeds in income-producing securities and indefinitely defer taxes due on the sale of their stock. Assuming a 15 percent federal capital gains tax, an 8.25 percent state income tax (this was a North Carolina company), and the sale of $10 million in stock, rather than having less than $8 million of after-tax proceeds earning interest, an owner would have $10 million generating income off which to live.
Another advantage is that of the money used to retire the debt, an amount equal to up to 25 percent of the annual payroll is tax deductible each year. If the company borrowed $10 million to buy the owners’ stock and the loan amortized in five equal annual installments, in addition to covering its interest payments, the company would have to earn about $3.2 million a year to cover the $2 million principal amortization (assuming a 40 percent effective corporate tax rate). With a properly structured ESOP, the company would only have to earn $2 million a year to repay the principal.
All told, using the leveraged ESOP could result in up to $6 million in saved corporate taxes plus $2 million in deferred personal taxes on a $10 million transaction. Where else can you fund such a subsidy?
As the loan is repaid, the shares acquired by the ESOP are allocated to the employees (who have been with the company the designated time period) on a pro rata basis according to their income. On most matters, the shares may still be voted by the trustee. When an employee leaves the company, the ESOP repurchases the shares from him or her based upon the current market value of the stock, so workers not only receive free stock, they get the profit from the appreciation in the stock, which serves as a tremendous incentive to the workforce. The ESOP can stretch out payment for repurchased shares over several years, which is a good idea if it is still paying back the ESOP debt.
A leveraged ESOP also works for an owner who wants to take some chips off the table but remain involved in running the business. He or she could sell part of their shares to an ESOP, invest the proceeds on a tax-deferred basis, serve as a trustee voting those shares and later sell the entire company (or just their remaining shares). Not only has the owner diversified his or her assets, they have created an opportunity for the employees to benefit from the ultimate sale and an incentive to work toward it. The one catch is that if the entire company is subsequently sold it needs to be at least three years after the ESOP was established to avoid an onerous excise tax.
One of the reasons more business owners do not travel this route is that the firms that promote ESOPs often lack the investment banking skills to finance the deal creatively. They simply go to a bank that will use the owner’s proceeds from the sale of their stock to serve as the collateral for the ESOP loan. In that case the owner really hasn’t completely sold the shares because the proceeds are not fully theirs until the loan is paid off. With some creative financing, as we used in this deal, this dilemma can be resolved.
Another reason leveraged ESOPs have a mixed reputation is that they are often installed in companies that lack the profile to succeed with significant leverage. A successful ESOP company should be a successful company. Companies with inconsistent cash flows, those already burdened with debt, or in a declining market generally encounter difficulty repaying the loans. Moreover, companies that lack competent management or are not prepared to run effectively without the services of departing shareholders are a recipe for disaster if sold to an ESOP.
In other cases, the owners’ shares are sold to the ESOP at above market prices, placing an undue burden on the company to repay the debt. Although the Department of Labor requires a professional business valuation stating the price is fair, most valuation firms are not in the M&A business and their theoretical analysis may be far removed from market realities.
Finally, ESOP companies often fail to take advantage of derivative securities such as interest rate caps or swaps to limit the potential risks of rising interest rates. So ESOPs get a bad wrap because of user error, not because they are a defective concept.
A leveraged ESOP is an incredible opportunity for the right company at the right time. They benefit owners and workers alike, all at the expense of Uncle Sam. But they need to be established with a great deal of consideration given to financial and strategic concerns, not just the legal and accounting requirements.
Most business people have heard of Employee Stock Ownership Plans, commonly referred to as ESOPs, but not too many of us fully understand them. This is not surprising; they are very complicated. The typical reaction from a business owner when the subject comes up is that they have heard that ESOPs are not a good idea, but when asked to explain why they are at a loss. Yet there are more than 10,000 ESOPs in place and more than 8 million workers own shares in their employer’s success through an ESOP. An ESOP, like a lot of other financial tools, is right for some companies and not for others.
ESOPs are the byproduct of Sen. Russell Long’s efforts to establish a federal program to promote the ownership of company stock by employees. But today they are often used by company owners as a corporate finance tool to accomplish personal objectives. Technically, an ESOP is a qualified, defined contribution employee benefit plan that invests primarily in the stock of the company establishing the plan. Consequently, though ESOPs are often used as a financial tool, they are regulated by the Department of Labor as an employee benefit plan. Companies ranging in size from a small consulting firm to United Airlines have established ESOPs.
An ESOP is “tax-qualified” in that the sponsoring company receives certain tax benefits in exchange for meeting specific rules that protect the interests of the participants, i.e., employees. Private company owners who sell shares to an ESOP also receive favorable tax treatment if they invest the proceeds of their sale in a certain manner. ESOPs are also categorized as “defined contribution” plans in that the company agrees to contribute a pre-defined amount to the plan on an annual basis, but doesn’t guarantee what the benefit, i.e., the company’s stock, will be worth when the employee leaves the company and is cashed out.
From the business owner’s perspective, ESOPs are a mechanism to gain liquidity for their shares when there are no obvious buyers for the company. They are also a vehicle to transition ownership without paying capital gains taxes, which is a principal reason private company owners institute ESOPs.
To establish an ESOP, the company sets up a trust on behalf of the employees. The trust acquires shares in the company and allocates those shares to the employees over time. The trust secures the funds to buy the shares from one of three sources: 1.) the shares can be given to the trust at no charge, in which case no financing is required; 2.) the company contributes cash to buy the shares; or 3.) the trust borrows money to acquire the shares. The final approach, called a “leveraged ESOP,” is the one that permits ESOPs to be used as a corporate finance tool, thus the one I will focus on.
Owners can sell part or all of their shares to the ESOP. If the owner wants to maintain control, he or she can sell a minority interest, but the price per share will be lower. In practice, however, it is possible to retain control of the company even when selling a majority interest. Because the ESOP is a trust, the voting of its stock is controlled by a trustee, a role typically filled by a committee of employees and managers and chaired by the business owner or a suitable puppet.
Additionally, if you sell at least 30 percent of your shares to an ESOP, capital gains taxes can be deferred on any proceeds reinvested in stocks, bonds or other securities of domestic public companies until those securities are ultimately sold. ESOPs are a tax efficient way for private company owners to diversify their assets, which is why they are so popular.
The way a typical leveraged ESOP works is that the trust borrows the money to purchase the shares using the company’s assets as collateral. The shares are allocated to the employees as the principal on the loan is paid off. Each year the company makes a tax-deductible contribution to the ESOP to amortize the debt. When an employee leaves the company, the shares they were allocated are purchased from them by the trust at the prevailing market price.
The Department of Labor requires the trust to have an annual independent business valuation performed to determine the fair market value of the shares. In the event that the company is worth more than the amount a bank will lend to the company (imagine that), the owner will be required to pledge some of the securities they purchase with their proceeds as collateral for the loan. Then, as the loan is repaid, the collateral is released by the bank.
There are three common reasons business owners choose to sell to an ESOP:
There are downsides to ESOPs, however, that need to be considered. The first is that a company has to be a certain size to make an ESOP practical. Mike Hartman, who serves on the board of Governors of the ESOP Association, believes that the minimum annual revenues before considering an ESOP should be $5 million. That eliminates most small businesses. The reasons for this are several, including the significant legal and administrative costs required to establish and administer an ESOP. Like any government-sponsored program, there is a lot of bureaucratic red tape involved with ESOPs. Just the legal fees to establish an ESOP typically run at least $50,000.
Businesses that do not have a large number of employees relative to the company’s value are not good candidates for ESOPs either. The annual contribution limit for a leveraged ESOP is 25 percent of payroll, so if the payroll is small compared to the company’s value, the trust can’t amortize the loan quickly enough. Also, companies lacking a strong management team capable of running the business after the owner retires are unlikely candidates for an ESOP.
First of all, the banks are rightfully leery of such companies and unlikely to fund the ESOP. Secondly, what owner wants to risk the proceeds of selling their company by collateralizing a loan that can only be paid back with future profits if the successor management team’s ability to deliver the profits is in question? For similar reasons, companies that already have significant debt or are in highly cyclical industries are not good candidates for ESOPs.
Finally, if an owner sells to an ESOP, and within three years a buyer for the company appears, the company has to pay an onerous excise tax if it is sold. This is the government’s way of preventing ESOPs from being used simply to dodge taxes. And if that buyer does come along, the upside of selling the company goes to the employees, not the business owner, unless he or she has maintained a significant interest. For that reason, estate planning lawyer Tony Turner of Mazursky and Dunaway believes that in most cases business owners who use ESOPs are giving their company away.
So, as is often the case with financial tools, ESOPs are the perfect solution for some companies, and they are not well suited for others. The quotient of ESOP knowledge to ESOP conversation is extremely low among many business owners and a surprising number of CPAs. Therefore, if you are considering an ESOP, you should consult an expert in ESOPs and talk to business owners who have implemented them to hear first hand about their experiences before heading down that path.
There is a popular saying that the two happiest days in the life of a boat owner are the day they buy their boat and the day they sell their boat. In between are countless unanticipated frustrations. The same could be said for business owners. Yet rarely do entrepreneurs, like boat owners, think about their exit strategy when they start the company.
Instead, they often wait until they are bored, frustrated or too old to enjoy it any more before they plan an ownership transition. These are generally not optimal times to pass the baton, particularly when your life savings and professional legacy are involved. And even business owners who put the requisite forethought into transition planning often make avoidable mistakes.
This is understandable, since few have ever made this transition successfully. Determining when and how to exit a company is the single most important decision a business owner will make. It deserves more attention than it usually receives.
Business owners often assume that their children or their senior management team will step up to the plate at just the right time and send them riding off into the sunset with trumpets blaring and saddle bags full of cash. Yet less than one-third of privately held businesses survive the owner’s retirement intact.
Over the years I have witnessed entrepreneurs facing the transition of their businesses make
several common mistakes. The first is that many owners delude themselves into thinking that they will sell “at the top.” However, it is virtually impossible to know when “the top” has arrived. When the company is performing at its best, the market may not be favorable and vice versa.
Markets rise and fall. And business owners are no more adept than stockbrokers at predicting market cycles. Most of the time, professional market timers — investment managers whose careers depend on knowledge of how to buy low and sell high — under-perform the market as a group. The day I learned that none of us really knows what is going to happen to the market was in October of 1989, while sitting in the office of the Secretary of the Treasury debating what to tell the country after the stock market had “crashed” for the second time in two years.
My view was that leveraged buyouts had buoyed the market for years, and when the United Airlines LBO failed to get financed that day, investors saw this as a sign that there was a limit to lenders’ willingness to provide leverage. Yet the Treasury’s chief economist blamed it all on macroeconomic variables. Regardless of who was right, neither of us had the foresight to predict the plunge that day. Scores of private and public company sales were aborted that week, forcing business owners and shareholders to wait years in some cases to execute a transition strategy that had been carefully planned and executed.
Lesson number one, therefore, is for business owners to plan to exit their business when it is right for them personally; don’t try to second-guess markets you have no control over. An owner should modify his or her desired timetable only in the event of extreme market conditions, such the immediate aftermath of the Internet bubble burst a couple years ago, which caused the precipitous drop in the NASDAQ, or immediately after 9/11. If your desire is to check out when the youngest child heads off to college, when you turn 65, or when the company’s value reaches a certain milestone, focus on that objective. Chances are, market conditions will allow a graceful exit within a year or two of your desired transition.
The second lesson is that owners almost always underestimate the time required to execute a successful transition. You need to begin the process at least three years before you expect to be sipping mint juleps on Sea Island. A span of nine to 12 months usually passes from the time you decide to sell the company to the moment you reach the closing table. And if you don’t want to leave a lot of chips on the table, the buyer will generally require a one- to three-year transition period during which the owner must continue to manage the business, or at least be available as a consultant. In virtually every private company the owner possesses invaluable relationships with customers, unique technical knowledge or some other attribute that allows the business to produce the results it does. In most cases, assuming that you can sell your company based on the profits your business has generated with you at the helm, and that you will check out the day of the closing, is folly.
Third, prepare yourself emotionally. Most private company owners’ identities are inextricably linked to that of their company. No matter how intellectually committed you are to passing the baton, doing so can be traumatic. An aborted sale is a colossal waste of time and money and extremely disruptive to the business. Last year, one of my clients hired me with the assurance that if I could get him $10 million for his company (his magic number to retire comfortably) I would have to chain him down as he ran for the exits. After nearly a year of marketing the business, I secured him an offer of $14.5 million. Facing the reality of letting go of a company that he and his father had founded 20years earlier, my client, who had not taken a week off in more than a decade, confronted the reality of no longer being the big cheese in a small town. He recoiled and decided not to sell. By that time his employees, customers and competitors had all caught wind of rumors that his business was for sale.
Another common impediment to a successful transition is owners’ failure to keep their egos in check. Clearly, if you have built a company into a successful enterprise you have personal pride in what you have accomplished. But when someone else gazes upon your masterpiece, they invariably see blemishes. It is akin to having children: no one else sees them quite the same way you do. I recently represented a regional homebuilder who thought every major homebuilder in the nation would love to acquire his company. I personally spoke with every major homebuilder in the nation, and only one of them wanted to own his company. My client’s holy grail was $15 million. Yet when I presented him an offer for$16.5million, he got cocky. He demanded$20 million. Today he has no offer and he has missed what most would say is an unprecedented window to sell a company in the homebuilding sector.
Finally, too many owners simply wait until someone calls out of the blue with an offer to buy their company. You are guaranteed to leave money on the table if you don’t actively market your company. Moreover, if a buyer knows you are not represented they will never offer their best price.
The decision of when and how to transition the ownership of a business is much too important to make the sort of mistakes most entrepreneurs make. It deserves the same degree of planning and commitment that was invested when the company was started or acquired.
Reprinted with permission from Catalyst magazine, July 2003 issue.