Why Business Owners Need Exit Plans Years in Advance
Most business owners dream of a buyout that funds a comfortable retirement with plenty of time for travel, hobbies and family and no financial worries. The problem is that most owners don’t have a formal exit plan in place. So, when they finally receive an offer for their business, they tell themselves, “Wow. I could easily retire on that,” and rush to accept.
Then they call us at the last minute to help negotiate final details and make sure they’re not being taken advantage of. Unfortunately, there’s only so much we can do if the pre-planning hasn’t been done.
Real World Example
A client owned a very profitable laundry business in the northeast. The enterprise allowed him to live in Florida for most of the year and still earn over $500,000 a year while the company hummed along without him. However, the stress of overseeing the company remotely was wearing on him.
Still, his investment advisor and I were surprised when he told us he was planning to sell the business. When we asked if he wanted us to help him with the sale, he declined. We learned he had already hired a broker and was under contract for a sales price of $2 million. Further, the broker had recommended a different transactional attorney to prepare the sales documents, rather than my client’s longtime business planning attorney.
The owner was thrilled to be retiring until we explained that $2 million would only net him about $1.5 million after taxes and transaction fees or about $75,000 a year to live on. “Well, I can’t live on that,” he replied angrily. But since he was already under contract, it was too late, and the deal went through. Sure enough, the sale didn’t produce enough income for the owner and his family to enjoy retirement. A few years later, they lost everything and had to file for bankruptcy. Like many owners, my client would have been better off continuing to run the business and investing its proceeds in a conservative stock and bond portfolio.
Too often, deals for independently owned small businesses (under $20 million) are driven by buyers’ and brokers’ interests, not the seller’s. They often catch the seller off guard with a seemingly attractive number. If the seller is represented only by a broker, not an attorney, the buyer has most of the leverage.
Exit Planning Institute data shows that only 20% to 30% of businesses that come to market actually sell, and only one in eight sellers (12%) are happy with the outcome. It shouldn’t be that way, and that’s where you come in.
Letter of Intent Can be Misleading
Many times, sellers call us after they’ve already signed—or been pressured to sign—a hastily drawn letter of intent or a boilerplate purchase agreement provided by the broker. An LOI is a non-binding document that confirms each party’s preliminary commitment to transact. Many sellers believe signing one is required to show they’re serious.
Not true.
With enough time, we can draft a comprehensive LOI for the seller up front. It’s important to have a comprehensive LOI because the buyer can leave important terms out of the LOI and introduce them later in the purchase agreement, when the seller has already fallen in love with the offer price and is feeling pinched. The original offer price is frequently adjusted downward just before closing, or the buyer may require holdbacks of 12 to 36 months, which allow them to chip away at the proceeds. Sellers may also be required to hold a promissory note at a low interest rate that they can’t collect on if an SBA loan is involved.
Possible Maneuvers
If the owner is selling a business with a proprietary product, we can try to stipulate in the LOI that the buyer can’t change key pricing, ingredients or structure until the seller-financed loan is paid off. This issue comes up frequently in restaurant sales, where new owners immediately want to substitute cheaper ingredients, change the menu or even the famous recipe, which directly impacts business performance.
Sophisticated buyers don’t want a comprehensive LOI. They want the seller to get hooked on the upfront number and sign quickly. Don’t let that happen to your clients.
You’ll also want to ensure that the LOI and purchase agreement address the management team and employees. Buyers often promise that staff will remain intact and the business will continue unchanged under new ownership. In practice, new owners typically restructure, change the service model and replace executive leadership within 24 months.
These issues are nearly impossible to negotiate when a client is rushing to close. Earnout payments may never materialize if the new ownership struggles.
The Golden Standard
Begin income tax and estate tax planning three to five years before a planned exit. With sufficient lead time, you can address the full picture: How involved will the owner need to be post-sale? What will the net sheet look like after a sale? What will the quality of life look like with the net proceeds? What will their employment agreement look like, including restrictive covenants? What about non-competes?
In nearly every deal I’ve advised on, the buyer withholds employment and non-compete agreements until the 11th hour, knowing the seller will sign just to get the deal done. If a seller is being relieved of responsibilities over a 2- or 3-year transition period and must also sign a 3-year non-compete, the buyer should compensate them accordingly, since they effectively can’t work in their own industry.
For holdbacks, I want to know upfront whether it’s a percentage or a fixed dollar amount, and when the seller receives it. I try to negotiate a structured installment sale with a portion of the proceeds returned at six months, another at 12 months, etc. I work hard to avoid the situation in which I’m waiting until the 24th month and then being told there’s nothing coming back.
Charitable and Legacy Planning
With three to five years of runway, your client can accomplish far more than simply receiving sale proceeds and writing a check to charity afterward. With advance planning, they can gift shares of the business, real estate the business owns or fully depreciated assets to a charity, including a donor-advised fund, prior to the sale. In doing so, they may avoid income taxes on recapture and capital gains, because the charity generally pays no tax on the sale of property.
For gifts to children or grandchildren, a third-party appraisal is required and must be attached to a gift tax return filed with the Internal Revenue Service. The IRS then generally has three years to audit the return and valuation. If that pre-planning is completed well in advance of a sale, you’ve already cleared the bar on estate and income tax planning.
However, when owners call us with less than 12 months until close, any gifting we do, including transfers into trusts, may be reported in the same tax year as the windfall from the sale. That may reduce the opportunity for valuation discounting on any family transfers prior to the sale.
I’ll discuss pre- and post-exit gifting strategies in more detail in my next article.Exit planning isn’t something to tackle when a buyer comes knocking. Encourage your business owner clients to start the process years in advance to protect their financial future, their employees, their retirement purpose and their legacy.