Top Four Common Mistakes Business
Owners Make with Exit Planning.
Prepared by.
Richard Watson,
CFP, CHFC, CLU.
Senior Director of Planning,
Business Advisory Services.
Joe Fahey, CFA.
Senior Director of Planning,
Business Advisory Services.
In this white paper
1
Mistake #4: Not understanding after-tax cash flow needs for retirement
2
Mistake #3: Expecting an all-cash deal
2
Mistake #2: Only speaking with or seeking one prospective buyer
3
Mistake #1: Lack of preparation
5Conclusion
Top Four Common Mistakes Business
Owners Make with Exit Planning
At some point, every business owner faces a business
transition. As the business interest often represents the
single largest asset on many owners’ personal balance
sheets, its value can represent a lifetime of focus, energy,
and work. As such, for business owners making decisions
around their business transition and exit planning, this
time can often be charged with emotion and stress. Not
only are they having to manage the day-to-day operations
of their business, but they may also need to respond to
questions and concerns from stakeholders and prospective
buyers around due diligence, deal structure, and
financing, to name a few, often with short timeframes
during the transition or sale window.
While every owner, business, and transition is unique,
there are four common mistakes that we see business
owners make when trying to transition their business,
whether it’s a sale or passing on their business to family or
to employees. This paper will review these mistakes and
make possible suggestions for business owners to consider.
Mistake #4: Not understanding after-tax cash flow
needs for retirement.
When weighing the complex topic of transition and exit
planning, many owners focus more heavily on improving
diversification or receiving liquidity (or a headline
transaction value) as a result of the transition, but not
necessarily on how the timing of the transition or the
amount from the proceeds will impact their retirement
picture and long-term standard of living. This step can
be especially critical in some instances because after-tax
cash flow can actually decline post transition, particularly
for owners who have historically paid themselves a
handsome wage or significant dividends or distributions.
For example, Chart 1 depicts two business owners assessing
what their cash flow needs would be post-transition.
Business owner #1’s after-tax cash flow will be
approximately 90 percent of what it was pre-transition,
while owner #2’s after-tax cash flow will only be 40 percent
of what it was pre-transition. While both owners
anticipate a decline in cash flow post-transition, owner
#2’s cash flow declines by 60 percent post-transition,
which may have profound long-term retirement planning
implications. For this reason, owners would do well to
carefully consider the impact of their business transition
on their personal wealth plan as soon as possible—ideally
long before the business transition event.
Chart 1. Hypothetical Example of After-Tax Cash Flow Pre- and
Post-Transition
100%
80%
100%
10% decline
100%
90%
Pre-Transition
Post-Transition
60% decline
60%
40%
40%
20%
0%
Business Owner #1
Business Owner #2
Source: Wells Fargo Wealth Management, 06/14
Suggestion: Review your cash flow and retirement
income needs considering both pre- and
post-transition scenarios.
If you’re a business owner, gaining a clear understanding
of your personal balance sheet, sources and usage of
cash flow, income tax liability, as well as your risk and
liquidity profile—both on a pre- and post-transition
basis—can give you powerful insight as to when (or even
whether) you should keep or sell your business. This may
be particularly important when selling a business during
a strong economic or market cycle. Many owners plan to
invest their post-sale proceeds into a diversified portfolio
of stocks and bonds, yet many marketable securities may
be at all-time highs.
Especially when it comes to retirement planning, a
common mistake that business owners make is in not
planning adequately for their retirement. Only about
36 percent of business owners have Individual
Retirement Accounts (IRAs), less than two percent of
them own a Keogh plan, and only about 18 percent of
Top Four Common Mistakes Business Owners Make with Exit Planning
1
business owners participate in a 401(k) or qualified
retirement plan sponsored by their company. At other
times, money received from the transition or sale of a
business may be more than sufficient to satisfy long-term
retirement planning needs, though undertaking a
purposeful assessment can help to confirm the fact.
Owners may want to consider not only developing a
disciplined strategy and timeframe for an optimal asset
allocation for their retirement portfolio, but also
implementing more sophisticated estate, charitable, and
wealth transfer planning strategies during the pre-sale
window. This phase-in investment strategy may provide
business owners with the added luxury of not feeling
rushed to put their post-sale proceeds into marketable
securities all at once. It may be beneficial to have a
discussion with your relationship manager and legal and
tax advisors about how this liquidity will impact your
wealth plan.
Mistake #3: Expecting an all-cash deal.
Contrary to what many business owners may think,
business transitions are not typically all cash transactions.
The majority of transitions in fact involve seller
financing, earnouts, and escrow/holdback arrangements—
meaning that while an owner may receive some cash at
closing, he or she may also receive a significant portion
of the purchase price over time.
Chart 2. Percentage of Deals that Involve Seller Financing, Earnout or
a Escrow/Holdbank Arrangement
100%
89%
80%
60%
40%
20%
0%
39%
30%
Seller Financing
Earnout
Escrow/Holdback
Sources: 2014 Capital Markets Report, Pepperdine University Graziadio
School of Business and Management; 2013 Private Target M&A Deal Points
Study, American Bar Association
2
Suggestion: Engage an advisor who can help
determine what deal terms can be achieved
realistically in the current market environment.
This can have important retirement planning and risk
management implications for business owners who are
not receiving full liquidity at closing. It’s also possible
that many owners will not have any wage income from
the business post-transition unless an employment or
consulting agreement is being contemplated as part of
the deal’s terms. This means that business owners may
carry a level of risk until the terms of the promissory
note or earnout are completed since future payments
may be at risk if the acquiring company faces a financial
reversal or downturn. An after-tax cash flow analysis, such
as the one just discussed, can help to better position
owners as they negotiate the timing, amount, and
security of contingent consideration in a deal. In some
instances, it may even save an owner from entering into
a deal that may have had calamitous long-term
retirement planning implications. We recommend
working with your relationship manager to understand
how this event will impact your personal wealth plan.
Mistake #2: Only speaking with or seeking one
prospective buyer.
At one time or another, many owners receive unsolicited
offers from competitors, strategic buyers or private
equity groups. These offers may come through at various
times throughout the year, leading to a scenario where
an owner is essentially evaluating one offer at a time.
For example, an owner might receive an unsolicited offer
from a competitor or prospective buyer and pursue it for
several months, only to discover that after due diligence,
the purchase price or terms were not satisfactory for both
parties. Months later, the owner may receive another
unsolicited offer from a different source, leading to a
repeat of the process, but with the same result. These
failed attempts at business transitions can result in great
frustration, increased transaction costs (i.e., expenses to
perform due diligence with multiple sequential buyers),
and consume precious time that the owner could be
spending to manage and grow the business.
Then, even if an unsolicited offer ultimately leads to a
sale, the business owner may not know with certainty
whether the purchase price and the terms of the deal
were truly the most optimal since the transaction would
lack the context and comparative view provided by a
disciplined sale process.
Top Four Common Mistakes Business Owners Make with Exit Planning
Lack of a cultural or strategic fit between selling firms
and their financial, strategic or industry buyout candidates
also present a significant issue for some firms.
Chart 3. Example of a Disciplined Sales Process with Potential
Multiple Bidders*
$80
75.3
$75
Chart 4. Percentage of Deals Not Closing
$70
65.0
$65
$60
58.0
54.0 55.0 55.0 55.0 55.0
$55
49.0
$50
$45
$40
45.0
47.5
50.0 50.0
53.0 52.8
60.0
60.0
62.0
62.5
65.0
30%
65.3
Not Closed
58.0
54.0
54.0 54.0
52.0
70%
Closed
56.0 56.0
55.0
53.0
50.0 50.0
Source: 2014 Capital Markets Report, Pepperdine University Graziadio
School of Business and Management
42.5
A B C D E F G H I J K L M N O P Q R S T U
Potential Acquiror
Source: Wells Fargo Wealth Management, 06/14
* It is important to note that results may differ and depend on a company’s
positioning in the industry and current market conditions.
Chart 3 reflects a hypothetical scenario where a business
owner receives 21 different offers from prospective
buyers. Each prospective buyer is represented as a letter
on the chart’s horizontal axis and their respective
purchase price ranges are represented on the vertical
axis. While all the prospective buyers received the same
information at the same time, each had a differing view
on what the company was worth. As you can see, the
offers ranged from a low of $42.5 million to a high of
$75.3 million for the same company. The low end of each
blue bar represents where that prospective bidder’s first
offer started, while the high end of each bar represents
its best and final offer.
In addition, the terms of the offer may differ for each
deal. Some buyers may offer more cash as a part of the
transaction, while others may offer larger non-cash terms
(such as seller financing, an earnout or acquiring
company stock in lieu of cash). Approaching multiple
bidders with a coordinated, disciplined process, as
opposed to one buyer at time, may entice all bidders to
put their best foot forward or risk losing the deal.
Further, companies that have prepared to go to market—
and do find a buyer—do not always close the deal. One of
the biggest reasons given for deals not closing is the
inability of the selling owner and the prospective buyer
to overcome differences in how each party viewed what
the business was worth (i.e., the expected purchase price).
Suggestion: Keep all your transition options open
and know what your business is worth.
Just as business owners should not limit themselves to
just one prospective buyer, they also should not consider
just one transition option. Many owners, in fact, face a
predictable set of strategic alternatives for the transition
of their business. In addition to multi-generational
family business transfers, businesses also can be
transferred in other ways:
n
Selling to management (management buyout)
n
Selling to an employee stock ownership plan (ESOP)
n
Selling to a financial buyer
n
Selling to a strategic buyer
n
Going through an initial public offering (IPO)
Each of these options has distinct advantages and
considerations. The most appropriate type of business
transition may depend on an owner’s near- and long-term
transition planning objectives, the company’s current
performance and position in the industry, and prevailing
market conditions, among other factors. When appropriate,
pursuing a sale through a disciplined auction
environment, whereby multiple prospective bidders all
review the same information at the same time, may help
enhance the probability of finding the right cultural
and strategic fit for the company at a purchase price
and terms that may best meet the owner’s long-term
transition (and retirement) planning goals and objectives.
Mistake #1: Lack of preparation.
Finally, business owners should honestly assess the
readiness and attractiveness of the business prior to
going out to market. A helpful step in this process can be
Top Four Common Mistakes Business Owners Make with Exit Planning
3
deliberately “thinking like a buyer,” which entails
appraising the company’s strategic positioning,
weaknesses, and business risks across the competitive
landscape, much in the same way that a prospective
buyer would during the sale process. This provides
business owners time, during the pre-sale window, to
resolve any business or legal issues that might arise
during the actual sale process, helping owners to not
only determine a realistic timeline to go to market, but
also maximize the business’ value to prospective bidders,
possibly increasing the probability of a deal’s closing.
Not doing so could result in taking the company out to
market too early. Allowing a group of bidders (or the
industry) to know the company is for sale, for example,
can expose the company to added risk, particularly with
key employee retention and opportunistic competitors
who may exploit this information with the company’s
customers and suppliers. For owners personally, it also
risks the possibility of not completing a transaction on
their own terms, often as a result of purchase price
adjustments or concessions that occur in the heat of the
sale process due to issues arising during due diligence.
Chart 5. Possible Exit Planning Transition Options.
Alternatives.
Rationale.
Status Quo.
n
n
n
n
Management
Buyout.
ESOP.
Continue growth and build scale.
Enhance competitive position.
n Maintain ownership/control value creation.
n No incremental risk introduced.
Capitalizes on experience of existing management team.
Provides key managers with the potential for a significant
financial return.
n Key managers may be able to preserve their present job and
income stream.
n Management can utilize leverage to finance the purchase.
IPO.
Management team may not have skills to effectively manage the business.
Owner retains business execution risk to the extent he/she finances
the transaction.
n Liquidity available to owner depends on the financial position of
management.
n Leverage may impair financial flexibility.
n Possible loss of control.
n
n
n
Company financial position can support an ESOP transaction.
Opportunity to benefit all employees.
n Equity ownership motivates employees and increases commitment
level to the company.
n Potential tax benefits–deductible contributions,
section 1042 tax deferral.
n Liquidity event for selling shareholder(s).
n Limited voting rights to plan participants.
Feasibility study needed.
Owner’s desire to benefit all employees.
n Administrative costs associated with an ESOP.
n C-corporation vs. S-corporation tax issues.
n Qualified plan subject to ERISA rules.
n Repurchase obligation with respect to departing employees.
n Selling shareholder typically retains business execution risk.
n Leverage may impair financial flexibility.
n
Strategic Sale.
Difficult to fund increased growth.
Lack of wealth diversification.
n Postpones liquidity/future value uncertain.
n Business execution risk.
n Does not address needs of junior partners.
n
n
Majority/Partial
Sale to Financial
Partner.
Practical Issues.
May provide liquidity while preserving some upside.
Provides additional financial/strategic resources.
n Desired liquidity can be varied.
n Helps to equalize junior partners and founders.
n Addresses key shareholder goals.
n
n
Valuation discount to outright sale.
Significant involvement from investors in company post-transaction.
n Possible loss of control.
n Modest leverage increases financial risk.
n
n
n
n
Complete liquidity event; potential “spike” valuation.
Opportunity to combine with a larger, well-capitalized player.
n May increase access to clients and accelerate growth.
n Reduces business execution risk.
Market valuation.
Loss of control.
n Management roles post-closing.
n Transaction execution risk.
n
n
n
n
Headline transaction.
Partial liquidity.
n Stock value established on a daily basis.
n Access to long-term capital.
n Public awareness of company.
Lack of operating confidentiality.
Loss of management control.
n Pressure for short-term performance.
n Ongoing costs of being public, including Sarbanes-Oxley compliance costs.
n Potential undervaluation.
n
n
n
n
Source: Wells Fargo Wealth Management.
4
Top Four Common Mistakes Business Owners Make with Exit Planning
Suggestion: Conduct preliminary due diligence
on your company.
One way to help minimize this result, as well as to work
toward positioning the company for a successful transition
or sale, is to conduct preliminary operational, financial,
and cultural due diligence on your company. Irrespective
of whether business owners intend to keep the business
in the family or position it for a sale to a third party, this
exercise can help owners address any issues that might
have proven to have been a nuisance or challenge (or
resulted in a price adjustment or concession) during the
implementation of the transition or sale.
Table 1 illustrates several common areas of consideration
for prospective buyers. These areas of consideration
should be reviewed in advance and resolved, if necessary,
in an effort to put the company in the best light prior to
the transition.
Conclusion.
Mindful of these four business exit planning potential
minefields, business owners may be able to achieve the
following benefits with advance planning and preparation:
n
Identify, assess, and compare multiple transition
options at the same time
n
Position the company for a transition
n
Minimize or resolve negatives issues that may arise
during due diligence
n
Enhance the probability of a closing
n
Remain focused on running the business
While planning for business transitions can be complex,
following a disciplined process can help owners
confidently plan and execute a successful business
transition and maximize outcomes for all stakeholders.
To learn more about business exit planning, please
consult with a Wells Fargo relationship manager today.
End notes.
1
Saving for Retirement: A Look at Small Business Owners, Office of
Advocacy, U.S. Small Business Administration http://www.sba.gov/sites/
default/files/rs362tot_2.pdf
2
2014 Capital Markets Report, Pepperdine University Graziadio School of
Business and Management
3
2014 Capital Markets Report, Pepperdine University Graziadio School of
Business and Management
Table 1. Common Issues of Consideration for Prospective Buyers
Preliminary Diligence Area. Prospective Buyer’s Consideration.
Management Structure.
How deep is the management team? How are they compensated? Do employment contracts and incentive compensation programs exist? A prospective
buyer may also want to identify the age, experience, and responsibilities of key management personnel.
Business Plan and
Budgeting.
How are financial controls exercised in the company and by whom? Does the company have a written business plan, with budgeting, or is it more
decentralized? Does the management team use forecasts and projections to manage the business, and, if so, how? Has it met or failed to meet its
forecasts/projections historically? Does the company have compiled, reviewed or audited financials?
Industry, Market, and
Competitive Information.
Typically, a buyer will want to understand the industry and the company’s competition as this information is critical to assessing the company’s future
performance. Who are the company’s competitors (by product line and by geographic region)? What is the basis of the competition (price, quality,
service, relationship, and location)? What are the competitive advantages and disadvantages of the company’s products and services?
Marketing and Sales.
How are the company’s marketing and sales functions organized? How is the sales team compensated (salary or commission)? A prospective buyer may
also want to understand the company’s sales policies, prices, discounts, service, and returns.
Production/Manufacturing.
What production methods and processes are employed by the company? A buyer may want to confirm the present utilization of the available capacity,
personnel, and space factors to assess the company’s current and potential future productive capacity.
Research and Development.
How critical has developing new and unique products been to the company’s historical success? If significant, a buyer may want to evaluate the
company’s R&D effort and pipeline over the past three to five years, as well as the company’s ability to develop new products.
Employee Relations
and Benefits.
Avoiding the loss of key employees after a purchase is often a critical concern for prospective buyers. They will want to understand the make-up of the
existing work force (size, skilled or unskilled, union or nonunion), how they are compensated (salary and employee benefits), and which employees are
critical to maintaining current levels of operations and profits.
Information Systems.
In what condition is the company’s information technology, and is it readily upgradeable? How much of the software is customized? How concentrated
is the knowledge base of the software and other IT functions in a few individuals? Does documentation of IT procedures exist?
Legal.
A buyer will want to confirm legal title to all major company assets, verify disclosed liabilities, search for unknown liabilities, and determine if key
contracts are assignable. Typical areas of review include possible royalty and licensing, warranty service contract, environmental, patent and trademark
infringement, employee discrimination and harassment, product liability obligations, etc. Both sides will also want to know what corporate and
shareholder approvals will be necessary for a transition.
How well positioned is the
company for a transition?
If new senior debt will be added as part of a transition plan, will the company have the financial strength to service the new debt? Will the company
have sufficient liquid assets to cover its operating costs during the transition period? Will the management team be flexible enough to adapt to a
change of ownership? How will change management be communicated and implemented post-transition?
Top Four Common Mistakes Business Owners Make with Exit Planning
5
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