Finch Exit Strategies

Helping Business Owners Leave with More Money

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Way #5 Transferring your Business to Family

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I have saved the most common transition for businesses is to sell or transfer to family. The State of Owner Readiness Survey conducted by the Exit Planning Institute in 2013 indicated a whopping 32% of private businesses intended to transition the business to family members.

Did you know only 30% of family businesses make it to the second generation, and only 12% make it to the third generation?

What is good about a family transition?
Business legacy preservation – what was built can continue to be a livelihood for the next generation.

Planned – Conversations can, and should begin, long before it is time
to transition so the finances and leadership changes can be controlled and expected by customers, management, and employees.

Lower transaction costs – In theory, the “deal” can be made and then
committed to paper by an attorney, and the tax planning done by a CPA. This cuts out the need for brokers or investment bankers, which can usurp up to 15% of the sale price.

More control of sale and price – The agreement will be decided based on many factors, and not as likely to be based on a true valuation
of the business. While you may be able to save the significant cost of hiring a professional to formally value the business, you need
to be aware of special IRS considerations around a sale to family. Your CPA and attorney should be able to help you navigate these considerations
to ensure you are in compliance. Remember: the terms of the deal are even more important than the sale price because earn-outs and financing take valuable time.

Less disruption to the business – Typically, the style of the business continues so the transition is not a culture shock to customers and employees.

Higher buyer/seller motivation – It is not likely either side is walking away from this deal, nor are they shopping around for any other alternatives.

Negative factors to consider when selling to family:
Family dynamics – There are entire books about this subject, as well as an entire profession of “family advisers” who help smooth the
emotional and political side of negotiating business within a family setting. It is quite typical to be dealing with deep-seeded and ancient
histories of a myriad of issues:
• children deemed or actual favorites
• attempts to balance wealth distribution to children not
involved in the business
• sibling rivalry and bullying,
• birth order issues
• gender biases, and
• strong differences of opinion regarding business potential
and direction.
• addiction or mental health issues
• conflicts around spouses or significant others

I have seen many tears over Mom’s opinion versus Dad’s regarding which child should have majority ownership or a superior position, how to compensate the one child not involved in the business, how the children’s skill and effort compares to their compensation, and real doubts about the children’s preparedness to run a business of this caliber
should something happen to the parents overnight. This is a situation most likely to create issues and the more children, the more issues.

Lack of funds/illiquid buyers – This is the situation I run into most often. The next generation has no funds to buy the business, and they
do not wish to incur debt nor take a lifestyle decrease through payroll in order to buy out their parents so they rely on future, uncertain, profits to repay the debt. Many families fail to consider what may happen if the business does not do well and the impact that may have on parents reliant on that cash flow or children trapped by debt.

Complications around being indebted to family – The lender/borrower dynamic influences those in that relationship even when everything has gone according to plan. However, even after a deal is arranged, many second generation buyers fall short on the payments. If there was a plan made to pay out the parents through salaries and
benefits (see Way #26), it doesn’t take long for the buyer-children to start complaining that the parents “aren’t really doing much” and
wondering when they can take them off the payroll, or treating scheduled debt payments as “optional” and abuse the family relationship

Next generation not prepared for ownership responsibility – In most cases I see, the children feel entitled to the business because they
helped to build it. There appears to be a lack of appreciation for what sacrifices the older generation made in order to build the business to the comfortable and secure state it has attained. The grit and keen sense of entrepreneurship that has developed the strong infrastructure and processes into a well-oiled machine could be skills the next generation
has unfortunately not had a chance to develop. Much like a baby bird that has been helped out of its own shell, being spared the
struggle can sometimes fail to equip the children with the necessary skills to be successful. I am describing many, but not all situations
where the parents know the true sacrifice to build the business that cannot be conveyed to the next generation.

Lower sale price – If you are selling to your family, you are not likely to negotiate for the highest sale price because of emotional ties to the buyers.

Key employee flight risk – why would employees stick around if family members are the only senior executives or potential owners?

Tradition may outstrip good strategy – Sometimes new buyers bring new blood and new ideas, and there’s not always such a change when the business goes to the next generation.

Path of least resistance – but not always a path to growth or success. In many family businesses, the entire family has gotten used to working
together and avoided learning from the outside world in terms of personal interaction, management styles, working under a schedule
or other restraints, and living on a salary without the benefit of draw or additional bonuses.

Uncertainty around financing
As Thomas William Deans describes in the book Every Family’s Business, the best thing you can do if there’s any question at all about
financing is to sell the family business to someone else, give the children a nice bonus, and everyone move on with the fruits of your labor to
retire or start the next chapter. I know, this sounds harsh because so many parents want to continue the family legacy, but it can cause much
more dissension than good if (a) Mom and Dad cannot retire with any dignity because of lack of funds, (b) the payments aren’t being made
as agreed, or (c) the company is suffering because of making the payments. This doesn’t make for a fun Thanksgiving dinner table.

Consider that selling the family business4 can be the greatest success, rather than the failure it is usually considered to be. Imagine pooling
the generational effort to build the business to its greatest value, sell it at a premium, and have everyone ride off into the sunset with a great deal of cash in their pockets to begin their next adventures. How could that be considered failure? At the very least, have some critically honest conversations on a regular basis.  I suggest you read “Every Family’s Business” by Thomas William Deans for greater insight into this topic.

{Excerpted from 50 Ways to Leave Your Business by Sandra Finch, on Amazon soon in print and e-book format}

 

Way #43 Poor Estate Planning (A bad way to exit your business)

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The old adage goes: “Failing to Plan is Planning to Fail.” If you want something specific to happen with your estate you need to have it in writing. While we all know this, it is easy to put off, but the consequences can be extreme, especially for the loved ones of business owners.

Let me tell you about my client Patricia. Long before I knew her, she had married a man who owned a car dealership. During their marriage, Patricia had helped Frank build the company to 5 times its  original size and they had sold it to a private equity group that owned other dealerships.

Within a year, the company was barely profitable and so Patricia and Frank bought it back per the terms of their original sale agreement. For the next 5 years, Frank was not interested in the dealership any more and rarely went to work, but Patricia went in every day and built the company back to better than it had been before. She worked hard to cultivate good management, hire great employees, and build strong customer relationships.

Meanwhile, Frank was working with his attorney on an estate plan. He was planning to leave the entire company to Patricia, whereas his previous will left 67% of the company to his daughter Priscilla, a 30 year old who had never stepped foot into the dealership.

And then, one night Frank had a stomachache and was having trouble breathing. Patricia rushed him to the hospital, but he died within the hour.

The estate planning had not been completed, and so 67% of the company belonged to Priscilla and only 33% belonged to Patricia.

After several company valuation fees, some lengthy court battles, and a myriad of other dysfunctional interactions, Patricia owed Priscilla $1.32 Million for 67% of a company she had built and worked in every day. She is still paying off the note with after tax dollars every month.

The “way” Frank exited his company was ugly and not at all what he intended for his dear wife Patricia.

Is it hard to find time to meet with attorneys? Is it unpleasant to think of your demise and how you would want your assets divided? Are there a million things to do every day that seem more important that getting your estate planning signed, notarized, and witnessed? Yes, yes, and yes. But you simply must plan and plan NOW.

“The afternoon knows what the morning never suspected.”
-Robert Frost

{Excerpted from 50 Ways to Leave Your Business by Sandra Finch, on Amazon soon in print and e-book format}

When selling your business, BASIS IS A CRITICAL NUMBER

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Basis is a term that represents the financial investment you have in your business. This is important because, similar to other investments, you are taxed on the growth, not on what was invested. Your basis gets deducted from the sale price when you sell the business. For example if you sell the stock of your business for $1 million, but your basis is $200,000, you will only pay tax on the difference, the $800,000.

How is basis calculated?

• Take the original amount you invested in the business
• Add all amounts passed through to you (if S Corp or Partnership) as taxable income
• Subtract all deductions passed through to you (if S Corp or Partnership), even if they were not deductible
• Subtract all draws/distributions you have taken
• The result is your basis in the business.

Example: You start the business in 2010, by investing $50,000 into it. Let’s assume this is an S Corporation. Every year, the business has net income of $100,000, but you take $40,000 per year in draws (in addition to your salary). So, every year, your basis goes up another $60,000 because you add the $100K net income but subtract the $40K you took out. Let’s say you do this for 10 years. Your basis is $50,000 original investment, plus $60,000 times 10 years or $600,000. At this point, you find a buyer for your business for $2 million. Subtract your basis of $650,000 and when you sell the business for $2,000,000, you will only pay tax on the difference or $1.35 Million. How much tax can vary greatly as we will see later in this book. In general, you can expect your tax bill to be at least 15% of the sale above your basis, – unless you use one of the tax-minimizing ways in my book, 50 Ways To Leave Your Business, coming soon to Amazon in print and e-book form.