Unlocking Your Biggest Business Pay Day
Businesses pay their owners in three ways:
- Salary for labor performed for the business;
- Profits for risk capital invested in the business; and
- Equity Appreciation for creating or growing the business.
Equity appreciation typically provides the biggest pay day for business owners. Unlike real estate or publicly traded stock, a business owner can create substantial equity appreciation by building and growing a high performing profitable business.
Goodwill and Equity Appreciation.
As a general rule, a business is worth the greater of:
- A multiple of the cash flow it produces in excess of costs (including owner labor);
- The liquidation value of the business assets.
If a business generates enough cash through operations, it is worth more than the sum of the assets used in the business. This ‘extra’ value is called . Goodwill is created as the owner builds business revenue and profitability. For high performing businesses, goodwill value far exceeds asset value.
All things being equal, business value and owner equity value increase as goodwill increases. Maximizing business goodwill maximizes equity appreciation.
But, realizing maximum equity appreciation requires a well implemented business succession plan designed to preserve or enhance goodwill.
A business succession plan is what the business owner plans to do with the business when she will no longer be the owner. For most owners, it is the process to convert the business equity into cash.
There are basically four business succession planning options:
- Die at Your Desk;
- Internal Transfer; or
- External Transfer.
Let’s take a look at each option and its impact on the ability for the owner to realize maximum equity appreciation.
. With this option the owner operates the business until he dies. This is the default method when the owner doesn’t do any business succession planning.
The advantages of this option are that no planning is required and the profit and, potentially labor income from the business may continue until the owner dies.
The disadvantages are many, however. First, the owner never actually benefits from any equity appreciation. Because the work of the business stops suddenly, it is likely to result in the loss of most or all of the business goodwill. Employees are out of work, and customers are left with partially completed work. And, because all or part of the goodwill is lost, the owner’s heirs don’t realize the value of the owner’s work. The capital asset appreciation from the business essentially vanishes.
This option is also problematic because a business owner never truly can be sure if she can work until the end. It is possible (and perhaps maybe even likely) that physical or mental limitations could cause the owner to stop work long before her death. If the owner’s decline occurs over time, the value of the business could slowly evaporate. In that case the owner will have neither the equity appreciation or the income from the business.
What About Hiring a Manager?
I’ve heard business owners suggest that hiring a manager to run the business after the owner pulls back from day-to-day involvement is a good option. They posit that, given the return on investment likely to be achieved from the investment of the realized value of equity appreciation, there’s no benefit to succession.
While I agree that return on cash invested in public markets is low, my experience suggests that very few owners are able to make a small business into a passive investment. A manager employee will simply not have the experience or drive of the owner.
And if the manager does not work out and causes the business performance to suffer, moving to an alternative succession plan may be difficult or impossible. At a minimum, it will destroy some of the goodwill and business value.
This view also falls to take into account the time and cost of transferring small business equity compared with that of transferring publicly traded investments. Cashing out equity appreciation takes months and has a significant cost.
In short, Die at Your Desk does not maximize the equity appreciation, destroys goodwill, causes problems for customers, employees and heirs, and should generally be avoided.
. With this option the owner picks an end date, closes the doors, liquidates the assets and pays the creditors. If there’s anything left over once creditors are paid – most often there isn’t – it goes to the owner.
The advantage of this method is its simplicity. Though some planning is required to ensure lease terminations are coordinated with the liquidation, shutting down a business and selling the assets can usually be done in a fairly short period of time. After that the owner is free from the business.
The disadvantages are similar to the Die at Your Desk option. The major disadvantage is the loss of business goodwill resulting in the loss of most of the equity appreciation for the owner. And while Employees have to secure new work, they can be notified well in advance, and customer work can be completed prior to liquidating.
The way I see it, liquidating a well performing business because the owner is retiring, is similar to burning down your home after the kids move out. You’re taking a valuable asset and destroying it for no good reason
Unfortunately, . A business owner on the eve of retirement may try to sell only to find out they haven’t created a salable business.
In fact, only 10% to 15% of all businesses listed for sale actually sell.
While there are many reasons for this, with sufficient advance planning it is possible to make almost any business into a salable business.
As was the case with Die at Your Desk, Liquidation causes a great loss of value and should, generally, be avoided.
. With the internal transfer option for succession, the owner sells his equity to a partner or an employee.
This can work well for the owner and the transferee. Because of the existing relationship, the owner can better evaluate the transferee to determine the likelihood of a successful transfer. And with the experience with the business, the transferee may have a better ability to secure outside financing to complete the purchase, and to complete a smooth transition of ownership. An internal transfer can also be completed more quickly, with the use of a business lawyer and the current accountant for the business, and less cost payable to an intermediary to market the business.
Most importantly, though, from the owner’s financial perspective, the owner will likely be paid fair market value for the equity and thereby realize the value he created in the business.
The downside is that this is an all eggs in one basket strategy. If the transaction does not work, the owner is faced with additional time before retiring to restore the business and find another buyer. And the negative effect of a failed transfer on business performance and employees can’t be understated.
Other disadvantages include:
- The transferee may not have the assets to make a down payment or credit to secure a loan. Without cash or financing, or both, an internal transfer simply makes no sense and is too risky for most owners. Would you be willing to sell your business to a buyer with no skin in the game?
- The transferee may not be qualified to run the business. Training an employee to be an owner is a long and involved process that could take years to complete. And some transferees may never make the leap, resulting in the ultimate failure of the internal transfer years down the road.
- A limited pool of transferees may result in a lower price (i.e., not achieving all of the equity appreciation). If there’s only one deal to be had, it won’t be favorable to the party who wants or needs the deal the most.
- The transferee may not have the same view of the value of the business as the owner.
The Next Generation Transfer.
Even a brief discussion about internal transfers wouldn’t be complete without a mention about inter-family transfers. According to the Family Business Institute, 88% of business owners believe that their children are an option as a transferee of the business. However, only 30% of businesses are actually transferred to the next generation. And only 12% of those are transferred to the third generation.
These statistics show that forcing a transfer on your children or grandchildren can be a disaster for you, for them and for the business and its stakeholders.
You should consider long and hard whether an internal transfer to children is likely to result in the best outcome for each of the interested parties. The statistics suggest that the majority don’t.
. With the external transfer option, the business is sold to an unrelated third party.
This option usually results in the owner realizing maximum equity appreciation. Though the owner will typically be expected to stay on with the business for a few months or a year, the owner will have a known end date and be able to cleanly move into retirement or the next venture.
Another advantage are the professional advisors. Because the owner has advisors working on his behalf, he can focus on keeping the business growing. This benefit cannot be understated. If the owner loses focus and the revenues or profitability falter, equity value will be lost. Keeping the business on the track it’s been on will lead to greater business purchase price and maximum equity appreciation.
There are disadvantages to an external transfer too.
- Riding the Wave. Owners notoriously ride the growth of the business up and wait until things plateau or begin to decline before thinking of selling. Once revenue plateaus, it’s to get maximum value. Buyers want increasing revenue. If a decline happens, it can require two or three additional years to show the decrease was only an anomaly.
- Costs of Transfer. The cost incurred by the seller in making an external transfer will, on the surface, be the higher than the other options. They will include the broker-intermediary commission, and fees paid to a business lawyer and an accountant.
But, actual costs (being benefit minus expense) may be lower. The International Business Brokers Association (IBBA) reports that owners realize approximately 20% more for a business when an IBBA Certified Business Intermediary (CBI) is involved in a transaction. If the owner receives twenty percent more, the benefit of the increased purchase price would far exceed the costs of transfer.
- Time. The typical time to sell a business through external transfer is 9 to 12 months. If the business needs to be improved to maximize equity appreciation, then additional time will be needed. An external transfer is not an overnight process and requires upfront planning.
- Negotiation and Stress. Negotiations associated with a sale can be extremely stressful. Sale transactions can run the gamut from simple straight forward purchases to intricate transactions filled with hours and hours of negotiation. Using an experienced CBI and lawyer will minimize the stress through experiential knowledge and strategy, but it cannot be eliminated.
The bottom line is that, with an external transfer, the owner typically realizes the maximum equity appreciation.
Unlocking the equity appreciation payday requires preserving goodwill through business succession planning to transfer the owner’s business interest in the most efficient manner. For owners interested in maximizing the value of their business, business succession planning leads to a transfer, whether internal or external.
As always, if you have a question on this article, business succession planning in general, or any other matter related to business law, give us a call. We’d be glad to help you however we can.
Suzan Abramson, a securities and corporate lawyer with 33 years’ experience, recently joined the firm as a partner. Suzan and I have known each other since 1994 (I actually replaced her when she left a firm in the early 90’s). We previously practiced together at two firms in town. She brings a wealth of knowledge and experience and I am looking forward to working with her on many transactions.
We also recently welcomed Kim Tupper to the firm as a legal assistant and “designated hitter.” Kim comes to us with many years of experience working in law firms, is very organized and great with clients. We are very happy to have her as part of the team.
And last, but not least, Brittany Alexander also joined the firm as a paralegal / law clerk. Brittany clerked for Judge Blackwell in the spring, is in the top 5% of her class, and is on law review. She will finish law school in December.
With summer winding down we recently held the first (annual?) Entrepreneurship Law Firm Bioluminescence Kayak Tour. Bioluminescence is a natural phenomenon created by the dinoflagellate in the coastal waters near Central Florida that causes the water to glow when disturbed.
Our tour was on the Banana River in Brevard County near Cape Canaveral. Whether it’s the paddle churning the water during a stroke, the bow wave from the kayak or a fish shooting through the water, each disturbance leads to a glowing light that looks like a natural fireworks show. Of course, the effect is most noticeable when it is darkest around you.
At one point our group came through a school of mullet. When disturbed mullet will jump out of the water. With the bioluminescence effect you could see the trails from each fish, where it left the water and when it returned to the water.
While kayaking at night is quite different – I’d never done it before and was surprised how big waves look in the dark compared with the light – it was an absolute blast and I’m looking to go again.
If you’re interested in giving it a try, let me know.
Thanks for reading,