Exit or Succession Planning For Small Businesses

At some point in time in time every business owner will “exit” their business. In most cases, a small business represents a significant component of family wealth and the owner will be keenly interested in maximizing this value when the business is either sold to an outside 3rd party or key employee, or transferred through an orderly succession to a family member.

Unfortunately, most entrepreneurs are so immersed in the daily demands imposed in operating their company that they have neglected to properly plan for the inevitable transition of their business. The goal of this article is to briefly review the exit/succession planning process and highlight the importance that these plans have for every business owner. Whether the goal is to exit the business in six months or ten years, it is critical that a business owner recognize that succession planning is the single most important way to take control of the terms and conditions of exiting their business. Proper exit planning will reduce the variability of the business control transfer, and can secure a sound financial future for their family.

WHAT IS EXIT PLANNING?

Exit Planning, also commonly referred to as “business succession planning,” is a methodology that addresses three critical questions a business owner will face at some point in time:

1. What is the timetable the owner seeks to exit the business?
2. Who will succeed the owner when the business is transitioned or sold?
3. How much income is needed from the business transition/sale for retirement?

The Exit Plan becomes a written roadmap that is developed in conjunction with legal, accounting, and financial professionals and is designed to maximize the value an owner receives when exiting the business. Exit planning can be a fairly complex long-term process and take many years to properly implement. The process can be broken down into succinct action items and deliverables and should illustrate how value can be received at a very early stage. A professional team will bring efficiency to the process by implementing a basic structure of steps to be followed, and can insure that the experience will be a personally gratifying and financially rewarding endeavor for the owner.

The key steps involved in developing an Exit Plan include:

1. Establishing Exit Objectives

• Determining the retirement timetable, long term income needs, and financial requirements necessary to reach them.

2. Identify the key drivers of business value

• What is the fair market value of the business if it were sold today?

3. Plan to build & preserve business value and reduce risks

• Activities that can be implemented to leverage best practices and maximize the business value.

4. Transfer of ownership, management, & control

• Determine the anticipated buyer (outside 3rd party, key employee, family member) and develop the structure for ownership transfer that maximizes financial security while minimizing taxes.

5. Contingency Planning

• Protect the continuity of business operations should an unexpected event occur.

6. Wealth management/preservation

• Secure financial independence by developing a financial plan to manage the income from the business sale.

7. Successful Exit

While nearly all business owners will recognize the importance of having a formalized exit and succession strategy for their future and the future of their company, very few actually have a plan in place. What most business owners fail to recognize is that the process is fairly easy to initiate and can be done at a minimal expense. While many components of the Exit Planning process will require the expertise of a CPA, Attorney, and Wealth Manager, significant value and efficiency could be achieved by implementing this process through a competent Business Intermediary/Brokerage firm.

An experienced business intermediary firm will be able to streamline the exit planning process significantly by taking the lead in the planning framework and tapping the necessary resources (accounting, law, wealth management) over time as they are required. This team concept is very cost effective for the business owner as he is only paying for the specific services at the time of use. A business owner is now able to put a toe in the water and establish the framework for the exit plan at very little cost. By establishing the current market value of the business in conjunction with a determination of the owner’s exit timetable and the income needed for retirement, the Business Intermediary will have the essential elements for the foundation of the Exit Plan.

Implementation should be viewed as a process versus a one-time event, and the most successful and rewarding Exit Plans are those that are started years in advance of the business transition. Whether the planned exit is six months or ten years from now, an owner should be proactive. The longer that a business owner has to implement the Exit Plan, the greater the opportunities will be to maximize the business value, minimize tax liabilities, avoid key employee turnover, and eliminate emotionally charged family issues.

How to Build Business Credit Now and Later

People are always asking me for tips on how to build business credit. The joy of building credit for your business is there is no exact steps that need to be followed. Don’t get it twisted, though, because obtaining proper credit does require a process. Some steps need to be completed as soon as possible as others can be done at any time. You should be building credit at all times because you never know when you are going to need it.

Let’s take a look at how to build business credit now and later!

Create A Plan

The first thing I tell people when they ask me how to build credit is to make a marketing plan for credit for your business. That plan should be reviewed and revised on a monthly basis.

If monthly time frames do not work for you, try having a weekly plan instead. A good goal per week is to find one avenue in business that will build you credit. How to build business credit starts with an organized plan and finishes with you completing the plan.

Find Lines Of Credit That Work For You

You may feel that you are asking how to build business credit because of all the stories you heard. You are not sure what is right, wrong, legit, etc. My best piece of advice is to consider what you want you business to be about and go from there.

Let’s say you have a bad credit score for your business, you will probably want to look for credit specifically for people with poor credit. Obviously, regular credit cards will not work if lenders will not grant you one in fear you are not going to pay them back.

There are many types of credit lines that can work for your specific situation; take advantage of them. Do not be afraid to ask your lender for help in choosing the right type of credit for your business. It really will help you in the future.

How To Build Business Credit After Your Business Is Established

I have talked about how to build business credit from the beginning of your business. The most important thing is to register your business, and create a business address and phone number. However, you may be wondering how to build business credit after your business is established.

The easy answer, again, is talk to a lender. A lender will be able to tell you your business score, credit cards that are right for your business, loans that are right for your business, refer you to credible vendors, etc. They work with individualizing credit for business owners everyday. You can trust their suggestions.

The basic thing I tell business owners on how to build business credit is to never stop building it! You may read in a business magazine a year from now about a new topic in credit for a business. Give it a try! You may earn a little bit of credit from it, but isn’t it worth it?

So, instead of wondering how to build business credit, you should wonder how to always have enough credit in the case that you need it to keep your business going!

Structuring Small Business Sale Transactions

Selling a privately held business is often romanticized as face-to-face negotiations over business valuations and purchase price. Whether small or large, business transactions can be extremely complex and require a great deal of work behind the scenes. As the size and/or complexity of a transaction increases, the need for innovative structuring options also increases. Deal structure, financing, and tax management must be a proactive process that is addressed at an early stage. In many cases the Seller and Buyer often place all of the focus on the transaction price at the expense of the ‘net results’ of a business transaction. By carefully negotiating the terms and structure of the transaction, a business seller could walk away with a deal that provides a significantly larger economic benefit than a transaction that provides 100% of the proceeds at closing. For asset sale transactions, the ‘allocation of purchase price’ can become another area of negotiation after the price, terms and conditions of the sale have been agreed to by the buyer and seller. Each type of structure carries with it different tax consequences for the buyer and seller, having a material impact on the overall value of the transaction. The type of business entity owned by the seller (C-corporation, S-Corporation, LLC, Partnership, or Sole Proprietorship) in addition to whether the transaction becomes an asset sale or stock sale will have a major bearing on the decisions made in structuring the transaction to afford maximum economic benefits. The purpose of this communication is to advance a few of the techniques available in structuring small business sale transactions and to emphasize the value an experienced team brings in structuring the transaction. Asset sales of pass-through entities (LLC, S-Corp, & Partnerships) are handled very differently than stock-sales of C-Corps and it would be impossible to cover all of the structuring alternatives within this short document. Proper legal and tax counsel should be retained and the cost of these professionals is usually offset by the benefits they bring through their involvement in the transaction.

The following factors will be relevant in structuring the transaction:
1. Legal Business Entity

- LLC

- S-Corp

- C-Corp

- Partnership

- Sole Proprietorship

2. Type of Sale

- Asset Sale

- Stock Sale

3. What is being sold

- Entire business

- Partial Interest / Investment

- Inclusion of Real Estate

4. Installment Sale or component of Seller Financing

5. Who is the buyer

- Financial Buyer (Entrepreneur)

- Strategic Buyer

a. Corporation

b. Private Equity Group (PEG)

c. Family Member (Succession)

6. Plans after the sale (Short term/Intermediate/Long Term)

- Consulting Contract

- Employee Contract

- Covenant not to Compete

7. Personal Tax Situation

STRUCTURING THE TRANSACTION

1. Asset Sale / Stock Sale
Determining what is being sold, the individual assets of a business or the stock in a corporation, will be critical in determining the optimal structure of a transaction. The majority of small businesses that are sold each year are structured as an asset sale. An asset sale is when a buyer purchases all or a portion of the assets of a business (e.g., facilities, equipment, vehicles, real estate, etc) whereas a stock purchase is the purchase of the ownership shares/rights of the corporation – all assets and all liabilities of the entity are retained by the corporation and only a change in corporate ownership has occurred. The following highlights three notable differences between each method; there are many additional considerations so it is critical to consult professional advice to determine the most appropriate method.

Change in Legal/Tax Entity:
With an asset sale, the legal entity and tax identity do not transfer to the purchaser. The Buyer receives a stepped-up tax basis in the assets acquired equal to the FMV purchase price, the point from which new depreciation is started. Under a stock sale, the tax basis of the assets remains unchanged, and all of the tax attributes, including depreciation methods, tax year, corporate tax election, are preserved.

Liability:
With an asset sale, the Buyer’s liability is limited. The Buyer is purchasing some or all of the assets and has the option to identify any liabilities they are interested in assuming. Under a stock sale, the Buyer purchases the stock of the company and assumes all liabilities (known, unknown, contingent or otherwise).

Assignment of Contracts:
Most businesses have contracts in one form or another. The most common are commercial real estate leases, contracts involving business relationships, and contracts with employees. An asset sale transaction involving the assignment of these contracts requires considerably more work and has a potentially a different outcome than a stock sale. Contracts need to be evaluated to determine if they permit an assignment without consent. Should they not permit assignment without consent, third party consent will need to be obtained. In stock sale transactions, the legal entity that is the party to the contract continues, and the general rule is that the contract remains in force between the original parties. (No consent to assignment is needed as assignment typically does not occur). There are exceptions, as some contracts stipulate that a change in ownership of the business will be considered an assignment of the contract. If such a ‘change of control’ clause exists in the contract, the same issues will arise as with an asset transaction. Performing due diligence and having legal counsel thoroughly review all of the company’s contracts will be critical to determine the available options.

2. Covenant Not to Compete (CNTC)
A covenant not to compete (CNTC) is a contractual condition by which the seller promises to refrain from conducting business or professional activities of a nature similar to those of the business being sold. In a contract for the sale of a business, a reasonable value can be allocated to a ‘covenant not to compete’ which is generally enforceable provided it is reasonable and limited as to time and territory. The buyer may amortize this amount over 15 years even though the actual term of the CNTC is usually much shorter. For this reason, buyers often prefer a larger amount be allocated to tangible assets or a consulting agreement with a shorter useful life. In order to be legally binding, it is recommended that some consideration is allocated to a CNTC.

3. Consulting Agreement
Depending upon the goals of the seller/buyer and the complexity of the business being sold, the seller could be retained as an independent consultant. The consulting agreement should specify the schedule of time (days or hours involved), type of training or services provided, the length of the agreement, and compensation. This is a popular structuring method which can benefit both the buyer and seller. For example, the sales price could be lowered in exchange for a lucrative consulting contract. The buyer benefits as they pay less money up front and have the ability to deduct the payments in the year made as a business expense. The seller could benefit by receiving the compensation over a period of several years, possibly reducing the tax impact. There are additional tax related issues to the seller, pertaining to the deductibility of business expenses incurred as a consultant and potential self employment taxes, and it is therefore recommended that proper tax counsel is obtained.

4. Seller Financing / Installment Sale
It is rare for a privately-held business to change hands for an all-cash price. More common in small business sales would be to have a component of seller financing as part of the deal structure. Seller financing is a mechanism where the business owner would fund the sale of their business and/or business assets with a promissory note helping the buyer finance all or a portion of the acquisition of the business and/or business assets, which is then paid back from the business’ cash flow. This type of deal can be very flexible – the seller can adjust the payment schedule, interest rate, loan period, or any other terms to reflect the seller’s needs, business cash flow, and the buyer’s financial situation.

There are several benefits to the business owner in providing seller financing:

Maximization of Transaction Value
Few areas offer more opportunity to negotiate successfully than when it comes to the details of the financing. Many sellers actively prefer to do the financing themselves as they can negotiate the highest transaction value when offering flexible owner-finance terms. In addition, the interest earned on the promissory note will add significantly to the actual selling price. Interest rates are currently hovering at their lowest level in years and sellers recognize that they can get a much higher rate from a buyer than they can get from any financial institution.

Tax Benefits
Seller financing could be a way for the owner to defer tax on the sale of the business. If the sale complies with the IRS installment method of reporting for tax purposes, capital gain taxes could be recognized when payments on the seller financed note are received versus 100% of the gain recognized upon closing the sale. It will be important to consult a tax professional as not all assets would qualify for deferred capital gains treatment. Typically, the assets that have depreciated beyond their original purchase price, such as real estate, are eligible for installment sales, as are intangibles (such as goodwill) that are established during the course of the business.

Completing the Transaction
Seller financing can be a useful tool to complete business sale transactions that need extra financing as part of their structure. The pool of qualified buyers increases exponentially when a portion of the transaction is financed by the seller. For some businesses, carrying back a note for some or all of the purchase price may be the only way to sell the company. The credit market, as a result of the sub-prime financial crisis, is still very tight. The plentiful, easily obtainable, flexible and inexpensive credit that flooded the market several years ago has changed dramatically. Many buyers will leverage bank financing to acquire a business and the majority of these lenders will require a component of seller financing to underwrite the loan. Seller financing, in the lender’s eyes, mitigates risk as they will have the additional confidence knowing that the seller has a vested interest in the business succeeding. The seller, in this instance, will be providing secondary financing to the bank’s acquisition loan (i.e. subordinated debt) for the remainder of the price.

In the event of a default by the buyer on the seller financing note, the seller would have a number of options for recourse and the specifics will vary per transaction based upon the involvement of a primary (1st position) lender, the extent of collateralized assets, in addition to personal guarantee’s made by the buyer. The specific rights will be detailed in the security agreement that is associated with the promissory note and can involve a number of stipulations including restricting the new owner’s sale of assets, acquisitions, and expansions until the note is paid off in addition to specifying the receipt of quarterly financial statements to enable the seller to keep tabs on the business. Having an experienced transaction attorney involved in the drafting of the promissory note will be essential.

5. Earn-Outs
An earn-out provision is an excellent structuring vehicle to bridge the gap on a valuation difference between what the seller expects to receive from a sale and what the buyer thinks a business is worth. Earn-outs are contractual contingent payments in which the purchase price is stated in terms of a minimum, but the seller will be entitled to additional compensation if the business reaches certain financial benchmarks in the future. Although the benchmarks can be calculated as a percentage of sales, gross profit, net profit or other figure, an earn-out is most often based on sales (not profits) and is typically tied to increasing revenue over historical levels. An earn-out is a good way to maximize the total selling price of the business, especially if the seller is confident of future sales and the new owner’s management ability. It is not uncommon to establish a floor or ceiling for the earn-out, and in a down economy, a seller can use an earn-out provision to obtain a value closer to what the business is worth in a healthy economic climate. Earn-outs are favorable to both the buyer and seller. The seller recognizes earn-outs as payment of money predicated on the future performance of the business and is therefore in a position to potentially obtain a higher value for their business than what would be afforded in a traditional sale in the current market. Buyers, on the other hand, are attracted to earn-outs as they pay less money at the time of sale but compensate the seller based upon the future success of the business. Buyers are protected against overpaying for a business that doesn’t meet the projections or growth that the original owners expected. Furthermore, Buyer’s recognize the vested interest the earn-out creates with the seller and the shared goal in the continued success of the enterprise. Most successful earn-outs are achieved when they are limited to one or two variables based upon a solid 3-5 year sales forecast. Earn-out provisions require a greater degree of involvement by the seller, and are most often implemented in conjunction with a seller employment or consulting agreement where the seller is positioned to ensure that all of the steps are being taken to reach the goals. Furthermore, it is also important to specify in the contract the person or firm that will be responsible for managing or reviewing the books and verifying the business’s performance.

ASSET ALLOCATION
In a small business sale, the owner is selling a collection of assets, some tangible (such as inventory, vehicles, buildings, and FF&E) and some intangible (such as software, customer lists, trade names, trained & assembled workforce, patents, non-compete agreements, and goodwill). Unless the entity is a C-Corp and stock is being sold, the total transaction price is allocated sequentially based on the fair market value of the acquired assets. The Tax Code shows that assets fall into 7 different categories (asset classes) based on IRC section 1060 (Form 8594), and requires that the buyer and seller adopt and maintain a consistent purchase price allocation method for tax future calculations that will determine both the buyer’s basis in the assets and the seller’s gain or loss. In most cases, the tax impact on the individual assets sold are measurably different for the buyer and seller and therefore the negotiation of the dollar amounts allocated to each of the 7 categories becomes an important element of the business transaction.

Class I – Cash
Class II – Marketable Securities
Class III – Market to Market Assets & Accounts Receivable
Class IV – Inventory
Class V – Assets Not Otherwise Classified
Class VI – Section 197 Intangibles other than Goodwill and Going Concern
Class VII – Goodwill and Going Concern Value (Residual)

Minimizing taxes plays a major role in structuring and negotiating a business transaction. Many promising deals have fallen through because the buyer and seller couldn’t agree on how to structure the deal to minimize taxes. Typically, the seller seeks to have as much money as possible allocated to assets that would be taxed as capital gains versus assets that would be treated as ordinary income. The buyer on the other hand strives to have a larger weight allocated to assets that are currently deductible or where stepped-up assets could be depreciated quickly under IRS regulations. Particular attention should be paid to the identification and valuation of the “intangible” assets as they can be significant in negotiating terms. While Buyers are often indifferent to an allocation between goodwill and a CNTC, because Sec. 197 allows a buyer to amortize goodwill or a CNTC over the same 15-year period, they will often prefer a larger allocation to a consulting agreement which is able to be expensed in the year paid. Sellers, however, prefer goodwill & going concern allocations (capital gain treatment) over a CNTC or a Consulting Agreement (ordinary income treatment).