In this session you will learn about:
- The most common exit strategy problems;
- Three things any owner can do right now to prepare for an exit;
- Three pre-sale tax and estate planning opportunities;
- Best way to discuss exit strategy with internal and external stakeholders; and
- Most common mistakes owners make when discussing an exit strategy with their executives.
About the GuestMr. Sorkin is the author of "Expensive Mistakes When Buying & Selling Companies." He is licensed to practice law in the District of Columbia. He is also a Certified Public Accountant. Mr. Sorkin received a B.S. in Accounting and Finance from American University and earned his law degree from the University of Miami. He earned a Masters of Law in Taxation from Georgetown University.
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Read the Full Transcript Here:Noah: Hi, this is Noah Rosenfarb. I'm here today with a great guest, Stuart Sorkin, not only an attorney, but also an accountant. The co-author of Expensive Mistakes. Stuart is an expert in getting businesses ready for sale. I'm really glad that he is able to join us today and provide you guys as listeners with some advice. So, Stuart, let's jump right into it and maybe you could tell our listeners, what some of the most common exit options are.
Stuart: Well, actually there are only 6 options to exit a business. You can sell it to family, you can sell it to employees or partners, you can sell it to a 3rd party, you can become an absentee owner, the business gets liquidated, or you die. If you don't choose one of those first 4, the last 2 happen automatically. Neither of those necessarily produces the best result for the family of the business owner.
Family transfers are a wonderful vehicle if, 1. Your family member has the desire to run the business, and knowledge to run the business, and has entrepreneurial spirit. Your child maybe a wonderful technician in one part of the business, but unless he has the entrepreneurial spirit, and the understanding where he needs help to run the business; it's not going to be successful.
When you are talking about acquisitions between partners or employees, you need to make sure that the employees have entrepreneurial spirit, and you also have to make sure that if you are doing this as a staged exit where you are giving equity, that you can get it back. I had one client who was in the midst of a transaction where he was going to transfer a significant percentage of his company to 3 employees, immediately prior to one of those, one of the employees was sexually harassing the other members of the firm. Obviously, not a good situation. Second person all of a sudden her husband decided to move and she left the business. So, using employees is a wonderful vehicle, but you got make sure that they are willing to stay, they understand the entrepreneurial risks and rewards of being a business owner.
Third party sales will generally work good deals. The problem you are going to have is that depending who your acquirer is, if you are being acquired by a larger company, they are going to be less willing to pay a significant amount of good will, because if there are a large successful business, they are looking at buying your client list probably assets in some of your key personnel. So, 3rd party purchasers, it might have a tendency to give you a lower price than what you might get otherwise if they are large acquirers. If they are small acquirer, that's probably the best route to tell.
And absentee ownership is wonderful, but the one thing I tell clients is, the day you know that you can walk out of your store and get hit by a truck and your business is viable, is the day your business is ready for sale. Because when you sell, the one major change is you are not going to be there. If the business doesn't run without you prior to sale, it's going to be harder to sell.
Noah: Yeah, great advice. How do you suggest owners get on to that path where they can leave their business, they can go on a vacation, they can . . .
Stuart: I think the first question that an owner when they are close thinking about this is, what is the number. What do they need to live on? Because there is no sense in trying to sell the business if you are not going to realize enough financial resources from the sale of the business to be able to do what you want to do when you sell the business. So, I think that's a key piece to figuring out, because by doing that, you then know, "well, if I'm sure, how am I going to get there?" You might get there by internal growth or am I going to look potentially if I have some time, at route to acquisition? Each of those has various risks and rewards of growth. So, once you have established a number, then at least you can say, okay, am I half the number or how much more do I have to get to get the number?
Another issue that I tell clients is, I don't care . . . you may have a timeframe for when you are going to sell the business, but when you are really going to sell your business is likely when a buyer wants to buy the business. In that sense, you need to be prepared. I tell clients regularly that one of the first things they should do once they start to think about this path is, they should get a due diligence checklist and do a preliminary putting together of all the due diligence. This is a critical one, because when you do that due diligence, it will provide the ability for you to hopefully document the price you think your business is worth.
But, secondly is that once you go to letter of intent, most letters of intent are conditioned upon due diligence. If your due-diligence isn't done, you as a seller, are going to be spending a tremendous amount of time dealing with due-diligence. What does that mean? That means you are not working in the business. What happens to the value of the business if you are not working in the business? It possibly falls off. If due-diligence runs in a certain period of time, the buyer says, "Wait a minute, you project that you are going to do 20% higher in next quarter. You are down 5%." He is not going to buy off on the idea saying, "Oh, well, you were doing due-diligence. You weren't selling." He is going to say, "I want the price reduced."
So, if you don't do your due diligence in advance, and are prepared for it, you risk numbers, you risk spending time on a deal that may not close and you look like an amateur. If you look like an amateur, the buyer will try to take advantage of you.
The other issue is that if you think that the business is going to generate significantly more than the number, then there are ways to potentially transfer some of those proceeds effectively in a tax effective way to the next generation. And if you are going to do that, you need probably a couple of years before the sale to maximize the benefit.
So, those are probably the 3 ones that I would look at as key opportunities in preparing for an exit when you are going for it, and that is, as I said earlier, one of the keys in most businesses are employees. What have you done to go hand cuff your employee? What have you done to make sure that they will stay after the acquisition, so you can deliver that intact management team, because if you deliver an intact management team, you give the buyer more comfort that the deal will be successful and he knows that therefore tying that together and tying incentives to time management key employees in on sale is a very key issue.
Noah: Yeah, all great issues. You mentioned one about tax planning, right? If your proceeds are likely to exceed your needs that you got to do tax planning early on. Why don't you describe for our listeners some common strategies that you helped clients implement?
Stuart: The ones that I tend to use a fair amount is the setting up of an irrevocable trust which you then sell a portion of the equity to the trust for a note. There are several advantages of these types of transaction. 1, generally, you are going to sell less than control. If you sell at less than control, the IRS will allow discounts for lack of control, lack of marketability, etc. So, you could, depending on the level of risk you are willing to take, as well as the amount you are willing to spend on getting a good business valuation, anywhere from 20% to 40%, discount in the fair market value when you sell it to the trust. Since you are selling it for a note, there is no current income tax consequences to you if you have transferred in at a 30% discount. Then, you can get compound growth of 10%, let's say for the 3 to 5 years that it’s in this trust, you will shift it maybe 50% or more of the proceeds to the next generation and you have a choice if it is that your home run, you can cancel the note as a gift, or you can do other things to get rid of the note.
On the other side of the coin is that some clients say, "Well, what happens if it's not full homerun?" Well, by the size of the note, at least when the proceeds come in, you can tap that data. Within that framework, if the spouse it is not an owner in the business, the trust that we are talking about for the children might provide that the spouse is the first beneficiary. So, while you have given it away and you shifted some of the tax consequences, you haven't necessarily given up access to the asset. So, that is one of the ways I like to do income tax planning.
Obviously also with how you structure any incentive compensation and how that is going to be setup of whether it is going to be actual equity, which means basically you are giving away parts of sales proceed or whether it is some form of bonus or phantom equity plan which not only reduce the proceeds, but gives you a tax reduction the final year to reduce your tax liability. So, those are 2 of the probably key areas that's in the pre-planning session that you can do to potentially do some income taxes.
Additionally, one point I have to make is that businesses have this tendency to say, "Oh, I'm not putting it on the books." Well, let me say this, if you are not putting it on the books to minimize tax liability, then you better have a set of financial statements that show let's say the fringe benefits and other types of things that you are doing that strip reducing the income that won't be there when the acquirer purchases the business. Therefore, they can factor that in to the calculation of the purchase price.
Noah: Yeah, all great strategies. One of the things you talked about is incentive compensation for management team and I think that brings us to how do you introduce your executive team, your management team to the concept for preparing for an exit? What would you say is the either the best practice or maybe something to avoid?
Stuart: Well, let me say this, first off is there are different level of executives. There are those executives that they are needed, but they are probably someone that is going to require you, they are imminently replaceable. There are some, let's say like head of sales who is maybe very irreplaceable on a short term basis in a sale. So, one is you need to figure out who are the key employees that an acquirer is going to look at as being essential to the management team and therefore, want to know that they are going to have them there.
The next issues though I think with employees is, do they have the entrepreneurial spirit to become an owner? What I mean by that is, a lot of these incentive compensation plans can be setup where it's basically a zero sum game as far as bottom line tax liability to the employee. However, the employee is giving up actual powers to potentially get this equity. If the employee is not willing to give up something currently for this long ownership, then he may not be the right entrepreneur or have the entrepreneurial spirit to make it work.
Another point along those lines is when you are assessing the employee, you also need to have some idea of whether or not his family will support his becoming an owner. What I mean by that is this, I have seen several deals where employees were going to buy the business and they go to the bank, and the bank says, "Yeah, we'll finance it, not a problem. But oh, by the way, your wife will have to sign on the loan, because we want to be able to take your home if this deal falls through." Some spouses will never agree to that. There is no sense in pursuing down the road of employee ownership if your employees are not going to be willing or able to complete the purchase at a later date.
So, you want to assess their desire. You also have to asses something else and that is I view most businesses like a three-legged stool. There is the finance and accounting, there is a sale and marketing, and there is the delivery of products and services.
Most entrepreneur start doing all 3. Eventually, they are going to then successfully take partners or employees to make sure all 3 roles are filled. If you are going to bring in half the executives do it and they are only good with 2 out of the 3, you need to make sure that that 3rd leg is filled in some form before you try to execute the exit strategy.
Noah: And bring on those people, I guess as soon as you can afford it and as soon as you can pick a role for them?
Stuart: Right, exactly. I think that most people do not understand that except with public corporations, you can have equity that will do anything. So, you can give actual equity potentially to one employee that has a vesting valuation. Which means that they have to stay a certain period of time before they realize full value for becoming an owner. It has the advantages of getting the employee capital gains as the advantage of time and in more closely than using something like phantom stock or ordinary income. It doesn't have the negative tax consequences of ordinary income to the employee, but you need to make sure that once you have given this equity that they are going to be there and be there for the time you need until the exit strategy. The beauty of LLCs and C corps. is you can create an employment plans of equity that allows you to do that.
Noah: Let's talk about maybe the topic of your book, Expensive Mistakes, and give some examples kind of the expensive mistakes you have seen made and how an owner might go about correcting that situation if they see a bit of the story in a way their company exists today.
Stuart: Well, I think the one I have seen in multiple situations where not having that the owner is the ultimate bottle neck in the business, and you've got to get yourself out effectively. Because what happens is this, if you are an owner who has to make every decision, you end up with probably employees for the most part that are "yes men", which means that they may not be able to run the business when you are there and you probably are pushing out any employees who has any entrepreneurial piece because you are going to see that he is going to slapped down when he is taking executive decisions so, why stay? So, I think that is a common theme that I have seen.
I think there are a whole bunch of stories we can talk about with family sales for, true story. I had a client who ran a very successful business for 35 years. His son has been in the business for over 15 years. Son and father loved each other, but they had a completely business life. Then, at one point the son said, "Dad, either sell it to me or I'm leaving." Father decided to sell. Now, because he was selling for his son, he didn't really document the deal as he should have, because he was taking back paper from the seller as well as he was one of the landlord for where the facility was because he owns the building, because the son couldn't afford to buy both.
Well, what happen is that the son after he takes over the business decides he is going to go out and build a second location. Father didn't know about this at the time. Son had a million dollar over run on the new facility and end up putting both businesses in bankruptcy, which means the father lost the income from the note and the real estate was tied up in a bankruptcy court for 12 months where he couldn't rent it. Not a good situation. So, even if you are selling to a family member, you need to document the transaction.
Another issue is to hire quality professionals. Your lawyer or your CPA may be wonderful at reporting or doing the normal routine thing that you would do to handle your business. They may have very little experience in the area of buying and selling the business. There is this untold stories of clients entering into transactions based on a professional said, "Well, I read about this and maybe we should do this," without understanding what all of the options were to accomplish the goal. Therefore, hire professionals. Make sure that you have people involve who understand and know the M&A business and assume that the other side . . . if you are not going to assume, the other side probably have, and if you don't have it, if you don't have that professional expertise, it will probably cost you a lot of money.
As I said, the story I gave before about executives who are buying the business inside and find out the wives won't sign the deal.
I work on a very simple philosophy. Exit strategy begins the day you start your business. Because if you do not know where you are going, how are you going to get there? How do you know when you have reached the goal? This goes to the concept we have talked about of figuring out what your number is. You need know what that number is so you can develop your business and get it to where you can get the number. Unless you are planning on dying with your boots on.
Noah: Unfortunately, some people do. They plan as if . . .
Stuart: Or the business gets liquidated. I have seen that scenario more than once as well.
Noah: Yeah. Well, how about this Stuart, before we wrap up our interview for today, why don't you kind of share a recounting of maybe your best success story? What is the type of work that an owner will . . .
Stuart: Well, actually one of my best success stories is probably with my co-author. Stieglitz has run a government contracting business for 20 plus years, decided he wanted to cut back and wanted to sell. What we did was in that particular case, is we did have some time, we setup an irrevocable trust for the benefit of his children. They became the owners of the equity using the trust. He also avoided the situation where one of his children can be in the way regarding the sale of the business because he could effectively control the trustee. Then basically, the trust, the majority owner of that was one of the majority owners of the company when it was sold. We were able through what was then called a private annuity transaction, able to defer the capital gains for a number of years on the sale even though the money came and unfortunately the IRS has now used private annuity in that way. So, that saving isn't there. That's another issue that I want point out that is really important.
As the seller, decide whether or not you have the will at all to stay with the company or not after. In some cases, you may need to stay for some period of time, but I will tell you that the longer that you stay, the more frustrated you will likely be because the issue is that for 20 or 30 years, this has been your baby and you believe that no one else knows how to run it better, and the issue you have at that point is you don't like the . . . it's very frustrating to go into work every day where you feel being hurt. It also can have negative implications to the acquirer, because human nature being what it is, you might say things about which you will do differently which will cause employment issues or morale issues for the buyer. So, you have to be careful in knowing whether or not you have to have the need, desire, and the personality to stay with the business for a length of time after sale.
I generally counter against more than a year for the seller to stay on afterwards. I'm sure it will be better.
Noah: Yeah, and I guess getting sellers to a point where they can actually make transition takes a lot of planning, right?
Stuart: Exactly. It's a lot of planning. As I say, in my general view, it's a 3 to 5 year process to do it right. Even those 3 to 5-year process, if the idea is that you need to have a 5-year plan in the mind of where you want your business to go. That's what I mean when I say exit strategy begins the day you start your business, because you need to be thinking about, okay 5 years from now where do I want this business to be? So, you have milestones in your own mind of what you are trying to achieve. Now, that may change 3 years into the transaction, and then you will do another 5 year plan. But that's really what you are trying to do here is do a plan. It's going to help grow your business to where you want it to be or better, and taking the steps along the way to do that.
Noah: What else would you want to share with our listeners before we wrap up our call?
Stuart: One comment about attorneys. Don't let your attorneys negotiate business deals. I have seen scenarios where attorneys have said to their long term plan, I think you should sell your business for 5 million dollars. That should be your price. Without any support, due-diligence or anything else. On the same token is, as transaction layers its way through from letter of intent to definitive agreement, generally what is going to happen is when the purchaser who usually prepares the acquisition documents tend to draft to the seller's lawyer, there are going to be both business issues and legal issue, generally. Lawyers should not be discussing the business issues. The purpose of the lawyer at that point in time should be to point him out to the businessman and say, "Before we spend time and money on doing a finishing up this document, let's make sure we can agree on the business points, because a percentage of deals die during the definitive document. And if it turns out to be a significant business point that comes up in the document that can't be agreed on, better to stop it then than to spend a whole bunch of legal work when they don't work on a business format.
Noah: Yeah, good advice. So, sort of if our listeners want to get in touch with you, what's the best way to catch you?
Stuart: The best way would be, they can contact, go to my website which is Stuartsorkin.com or they can contact my office. I am located in Washington DC, but I do, do this all over the country. Right now, I am actually in New Orleans giving a seminar on this area, at 301-320-1152.
Noah: Great. Well, Stuart Sorkin, an attorney and accountant, co-author of Expensive Mistakes and an expert in getting businesses ready for sale. Thanks so much for joining us. To our listeners, you can find more information about Stuart on our website. Stuart, thanks again for joining us today and sharing your advice and expertise.
Stuart: Thank you for the opportunity.