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The Perfect Exit Strategy
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The Perfect Exit Strategy
for Owners of Closely Held Businesses
Contributed by Guy Baker, MBA,
MSFS, CFP, MSM
business owners will transition their business ownership in the next 10 years?
Based on the tsunami of Baby Boomers – quite a few. Baby boomers have
dramatically impacted markets as they have aged. First it was baby gear, then
overcrowding of schools. There was an impact on housing, the stock market and
ultimately, consumer spending which is keeping the economy afloat.
As these Boomers near retirement, this tidal wave of humanity is going to
impact social security, health care and retirement homes. What impact will they
have on the sale of a business?
Based on past
history, there will be a lot of businesses being put into play. – but will
there be enough buyers? Based upon simple economics - the Law of Supply and
Demand – it is likely a large number of businesses for sale will impact the
sale value. The price of businesses could fall precipitously as more and more
business owners try to sell into this buyer’s market.
owner shares one problem in common. They eventually want to capitalize on the
value they have created. They want
a liquidity event. As retirement nears, they will want to convert their equity
into passive income. It often comes as a shock that their capital can’t
produce the same income they were earning from the business. But that is the
subject of another paper.
event can only occur when the seller turns their business over to a new owner.
For most businesses, there are essentially only three prospective buyers
– a family member, an inside buyer or an outside buyer. The impact of these
factors is unpredictable, but there are two things which are certain – (1)
owners of businesses should secure a buyer as soon as possible and (2) they
should carefully consider any expansion plans.
Finding a Buyer
Let’s look at finding a buyer. Our experience has been that most sellers either sell to a family member or a key employee(s). When the seller rejects these options, then they start to look outside the business. The most common reason a family sale or internal sale fails to happen is the cost. These buyers can’t afford the price or the terms are unacceptable to the seller. When this happens, the seller seeks a business broker and begins a search for the “elusive” outside buyer.
the seller will discover their business is worth far less on the open market
than they had hoped. All of the warts and moles of the company are only too
apparent to a professional buyer. The cost of doing a makeover is too much to
consider, leaving the internal sale as the only good option.
entrepreneurs have been successful because they take risks. It is their nature.
They usually don’t possess strong management or business skills. We have found
there are two types of owners – the risk takers and the managers. The bridge
between risk and management is delegation.
The risk taker
is constantly expanding, looking for new markets and trying to find ways to grow
the value of their business. Often there is no eye towards an exit strategy.
They believe someone will always be willing to step in and buy the business.
This ultimate buyer is their escape route, yet they are often very cavalier in
their planning for this event.
intrepid risk taker expand into a buyer’s market. The Babyboomer entrepreneur
who is 50 – 55 may be thinking they can double or triple the value of their
business in the next ten years and really capitalize on the value they have
worked so hard to build. While this may be true, there is every likelihood they
will see very little of that value in a buyer’s market. Maybe they should take
some of the chips off the table and start planning now for their exit.
A Basic Business Rule
There is one
basic rule that governs every business transition.
Understanding this simple rule makes all the difference between a
successful and unsuccessful transaction. Here
is the rule – “There is no such thing as new money.”
It’s a simple rule really – it means that every business owner
eventually will buy themselves out of their own business with their
own money. At
first blush, this may seem ridiculous. Why would they ever do this? The buyer
writes a check for the value of the business. Whether it is a cash sale or a
term note, it is the buyer’s money.
While this is
true, to a point, don’t be fooled by the idea it is the buyer’s money. They
may front the money, but they would never purchase this business unless they
thought they were going to get it back, plus a handsome profit. Initially, this
is a difficult concept for most businessowners to grasp. In fact, it is often
puzzling to their advisors. But once this important concept sinks in, it becomes
the key to planning a successful transition. Again, it is important for the
seller to understand it is always their money that buys them out of their
business with their own money. Why?
The Basics of a Transaction
Let’s look at
the basic factors of a transaction to understand the interplay between buyer and
When an outside
buyer purchases the business – what money do they use to pay for the purchase?
They either borrow from a lender (seller financing or a bank) or they liquidate
their own assets, but ultimately they are going to look to the business income
stream to repay their investment. Most buyers want a 20-25% return – this
equates to payback in 4-5 years.
If our buyer
had never sold the business, he would have kept the income for himself. Once the
sale is completed, his income goes to the new buyers – along with the risk,
the headaches and the liabilities. So then, whose money bought the business?
It’s the seller’s money. As a result, if it is his own money – why not
have the buyer start planning his exit now.
In order to truly understand the implications of No New Money, every business owner and advisor needs to understand the tax principles in a business transition – we call it “The $1.82 Story.” Most people don’t know this, but the sale of a business is often the most heavily taxed transaction in the tax code.
The tax can approach 110% of the
sale price of the business.
Let me repeat
that – 110% of the SALE PRICE. If the FMV of the business is
$1,000,000, the taxes paid could be $1,100,000. Why? Let me show you. Suppose
you sell your business for $1x – how much will you net from the sale? If we
assume it is a capital gains transaction – the maximum capital gains tax rate
in many states will be between approximately 25- 28%.
Let’s assume the tax is 28% for our purposes. This means our business owner will pay $.28 in tax and net $.72 for his efforts. We call that the Seller’s tax and most people are familiar with those. But what about the buyer? What taxes did the buyer have to pay? Buyer’s tax? Come on, the Buyer doesn’t pay a tax, does he?
Is there a Buyer’s Tax?
Whether I am
working with a buyer or a seller - I always ask this question – “Does the
Buyer have to pay a tax?” This is where it gets interesting because virtually
everyone will say – “No – how could there be a buyer’s tax?”
So, how would
you answer? Most will say the same thing – “Buyers don’t pay tax.” And
while this is absolutely true – in theory - it is not
true in operation. Here is why.
How Does the Buyer Repay or Replenish their Capital?
When the buyer
writes a check – where does the money come from to pay the seller? Remember,
the money came from either a loan or the liquidation of other investments. The
purchase price either comes from accumulated capital or from financing. In
either case, the buyer purchases the business using an earnings multiplier.
Remember, they are expecting to recover their investment in 5 years (a 20%
return). Does this happen by magic? Of course not, they recover their investment
from taxable business income.
Focus on this
business income. In a 45% corporate
tax bracket - how much income does the business have to earn to net $1.00 to the
owners? (So they can recover their $1.00 of capital)
Most say, 45% tax bracket – it must be $1.45. But is it?
and see. If you earn $1.45, and pay a 45% tax, the tax is $.65 and you net $.80
- but $.80 is not $1.00. So how
much do you have to earn to net $1.00? You
have to earn $1.82. That’s why we call it “The $1.82 Story.” You pay $.82
of tax and net $1.00 income.
Why is this
important? Remember I mentioned the purchase of a business is the most heavily
taxed transaction in the code? Look at the taxes.
The seller had to pay $.28 and then the buyer has to pay $.82 – so, add
them up – that’s $1.10 total taxes to transition a business worth $1.00.
This is truly double taxation. The IRS taxes the income from the business and
then taxes the purchase price of the stock.
must understand the price tag of this transaction. Business decisions are all
about price tags and
alternatives. The price tag of a business transaction is - $1.10.
How to Reduce the Tax Cost
We can reduce
the pricetag of the transaction by restructuring the financial statement of the
business. To do this, we must convert Capital gains to ordinary income. What?
Convert capital gains to ordinary income, that is ridiculous. But is it? Most
would say- why? That is intuitively
impossible to accept. Yet, by doing so, we dramatically impact the cost of the
sale to the buyer. The FMV of a company is usually determined by the book value
plus any goodwill. By converting goodwill to tax deductible compensation, we
convert double tax dollars to tax deductible dollars. Be
careful, a lot of accountants have never thought about doing this – and may
balk at the idea. Business brokers are often not interested in adding any
complication to the transaction and will fight against doing this.
The key to
selling a business is tax efficiency. It has to be good for both the buyer and
the seller. So, you might still be thinking – “Why, would we ever convert
capital gains to ordinary income?” By doing so, we are able to deduct a
significant portion of the selling price. “But this causes the seller to pay
more tax.” Right, but if the seller NETS the same amount, what
does it matter if he paid more tax? – especially since the overall transaction
cost will be significantly less.
Here is the
fact - most sellers find it difficult to sell their business for top dollar.
Professional buyers always out negotiate amateur sellers. Sellers usually are
selling for the first time. Professional buyers make an art out of buyer low.
But by restructuring the capitalization of the company, you can make the
ultimate cost to the buyer less which can result in the seller getting MORE.
Selling to the Inside Buyer
situations, the sale should be to an inside buyer.
So, why doesn’t this happen more often? For one reason, the inside
buyer has no MONEY. The Seller has to finance the purchase with additional
salary to the inside buyer. The seller increases the insider buyer’s
compensation so the inside buyer can pay income taxes on the additional income
and then turn around and pay it back to the seller as taxable capital gains.
This is what we call the “double tax buy-sell.”
– if I could show you how to sell your business to your key man for top dollar
and avoid the “double tax buy-sell” – would you be interested?” This can
be done by restructuring the Seller’s compensation instead of the Buyer’s.
If the Seller
takes cash from the business as compensation – he would have to pay tax on it
anyway. By setting up a deferred compensation plan – for himself or for the
inside buyer - to offset the goodwill – he does two things.
First he establishes a substantial wealth accumulation program from
himself. But equally important –
he ties the inside buyer to the business.
rule – sellers are always bought out with their own money. By showing Sellers
how to make some or most of the business tax deductible and at the same time -
tie the inside buyer to the business in order to increase the value of the
business over time, the Seller assures himself of the price he requires. In the
final analysis, the Buyer will purchase the business for a significantly lower
cost than if he borrows from the bank or liquidates other money.
In the coming years, Sellers will be looking to find unique ways to fund the purchase of their business. The $1.82 story is a story they must hear if they are going to make the most of this transaction.
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