About the Host
Ryan is an entrepreneur, podcast host of the show Life After Business and the co-owner of Solidity Financial. Having personally experienced the hazards of selling a business, he joined up with his friend Brandon Wood to educate others on the process. Through their business (Solidity Financial), they provide a platform for entrepreneurs called The Value Advantage™ that helps in exit planning, value building and financial management.
About the Guest
Stuart Sorkin is a lawyer and CPA who spent many years working for large accounting firms before starting his own law practice. His broad range of experience allows him to see how tax, financial and estate planning are intertwined and become extremely important when selling a business. He took everything he learned working with large clients on business plans and estate planning and co-wrote a book called Expensive Mistakes When Buying and Selling Companies.
If you listen, you will learn:
- Top mistakes made when buying or selling a business
- The importance of exit and post-acquisition planning
- How estate planning and the sale of the business are intertwined
- What is a Monte Carlo Analysis and how it can help with exit planning
- How key employees can increase the value of the business
- Keeping an up-to-date due diligence library will make the sale and transition easier
- The six ways an entrepreneur can exit their business
Ryan Tansom: Welcome to Life After Business, the podcast, where I bring you all the information you need to exit your company and explore what life can be like on the other side. This is Ryan Tansom, your host, and I hope you enjoy this episode.
[00:00:30] Welcome back to the Life After Business Podcast. This is Ryan Tansom. Today's guest name is Stuart Sorkin. Stuart and I rallied back and forth on a lot of different things and it stems from his major experience over the last 30 years in M&A and his credentials and the book that he wrote. He's got his JD, LLM and CPA, so he comes at this topic from a lot of different angles.
[00:01:00] He wrote the book with a gentleman named Dick called Expensive Mistakes which, I'll tell you what, I really wish I would have read prior to us selling our company. So, we take a couple of the top mistakes that entrepreneurs make while they're selling or packaging up their business to sell. Then we dive into some really, really cool topics like due diligence and all the different parts of due diligence that are important. Ways that you can actually become an absentee owner and how being an absentee owner will actually give you more money on the actual sale of your company.
We talk about how your corporate structure, estate planning, tax planning and financial planning are all intertwined and looking at your structure in one big picture. In the show notes, I included links to Stuart's book and then I also included a due diligence checklist that shows you the span of topics that are covered based on the conversation that Stuart and I have.
[00:02:00] This episode of Life After Business is sponsored by the Value Advantage. The Value Advantage is a platform delivered via peer groups and/or one on one to help you build a valuable company that can thrive without you, while putting an exit plan in place, so you have the options to sell when you want to who you want for how much you want.
You're able to manage the business by the numbers work in the business as much or as little as you want, and you fully understand how the business impacts your personal financials. If you want to know more check out the show notes or the website.
Without further ado, here's my interview with Stuart.
[00:02:22] Good morning, Stuart. How are you doing today?
Stuart Sorkin: I'm doing great. How are you doing today, Ryan?
[00:02:30] Ryan Tansom:
I'm doing really good. I'm super excited for today because I got your book in part of my soul-searching after the aftermath of us selling our company and your book is called Expensive Mistakes. I want to—for the listeners' sake, if you can go back, you've got many decades of experience in the M&A space—but can you kind of give the general backdrop of your experience and what advice and what type of clients you normally work with?
[00:03:30] Sure. Well, I spent seven years in what was formerly the big eight—now, I guess, the big four—five of which in their national office where I started their tax application software group and worked with early incarnations of the PC to do early spreadsheet analysis. I left there, and went to work for a large firm in D.C. and spent the better part in 1987/88—spent the better part of two years buying banks (failing S&Ls and banks) down in Texas when the S&L crisis hit.
[00:03:55] That was probably my first major foray into it and then went to a boutique securities firm where I worked with small clients—small to mid-sized clients—on capital raising, putting together business plans for financing, et cetera. Then spent a chunk of time with a mid-sized firm doing mergers and acquisitions in estate planning, and the intertwine between estate planning and sale of business is something that's commonly missed between people. Met Dick Stieglitz, my co-author, in a Men's Communications Group and we decided to write the book basically as a 'give back' to small- and mid-sized companies who would not be exposed to the issues that his experience and my experience over the last 30 years had come together. It was published initially in January of 2010, which was the first year that baby boomers started hitting 65.
Ryan Tansom: When I was reading and I was like, "Well, yup, I can relate," because most of the listeners may or may not know on my show that my dad and I when we sold there was some things that we could have done that would have saved us almost $1.6 million. I want to get into that because I think that touches in a couple of the different mistakes and you've got like a total of 57 in this book.
[00:05:30] I want to go back to when you and Dick were starting to write this book. Did you start with how many mistakes you know that are possible or, like, where did kind of the book come into fruition?
[00:05:45] I think the book came into fruition... We sat around a table for a while and started thinking about the main—what we viewed as segregating the book into five main areas, which are, from the seller's side, developing your business and getting it ready for the sale; the buyer's side on the same token. Then looking at the transaction from the buyer's side and the seller's side. And finally the one that I think gets ignored significantly is the integration because closing is not necessarily success in a deal if you are an acquirer.
[00:06:30] The integration piece that I've seen many deals fall apart for failure to integrate properly, and then we started looking ... then we put together, started talking about common things that he and I had seen and we had probably more than the 57, but I think we tried to look at the ones that we thought would be most valuable to the small-, mid-sized business owners that were more on a practical side. I think the book was tries to look at things from a practical perspective—not just a legal, accounting or business perspective—but what are the practical considerations you need to look at.
[00:07:10] Yeah, and I loved it and I wish I would have read it prior to us selling because I mean you only do it once. Usually, if you're a business owner. And there are the serial entrepreneurs out there that will continue to do it. But for the general population of entrepreneurs, that's their one big asset that they end up selling and they don't know the mistakes until afterwards, like I alluded to in our situation.
There's a couple of mistakes and I want to highlight and kind of dive in on your thoughts, but before we even get into the narrower subjects of a specific mistake—when you're working on the buy side sell side with these entrepreneurs, is there a way that you can summarize the main problem or strategy or the lack of strategy in this whole situation?
Okay, you've hit on the sell side. It's really easy. It's lack of a plan. It's a failure to plan and that's where the integration comes in is the failure to plan. One, what's your target, what's your real number? Many entrepreneurs have an inflated view of the value of their business, but they also don't necessarily understand how that business integrates in their overall financial plan. It's really key in my mind that you figure that out.
[00:08:37] Secondly is, what are you going to do when you do sell the business? I think that is probably an area where—because as an example with Dick, he knew he could not continue to work for the business post-sale, because it was his baby and he knew himself well enough to know that he would only be frustrated watching someone else handling his baby going forward. I think another major issue on the sell side is, can you stay with the company? Should you stay with the company going forward?
[00:09:20] If you're not staying with the company, what are you going to do with the rest of your life? Because I've seen some very bad situations come up where people just don't really have a plan, a personal plan, post-acquisition.
[00:09:40] On the buy side, I think overestimation of how quickly you're going to be able to integrate, failure to necessarily understand the cultural issues that you may have [with them] if you're acquiring it—if the acquirer is going to then put it in with another, an existing business. The cultural issues—I've seen major disasters in that area.
Those probably are the two significant sets that I would see.
[00:10:12] Yeah, and I think you touched on a couple of big key points, too. Because it's just really having an awareness of all this and what are the different variables which I think you guys spelled out pretty—in a lot of detail in your book. The first of the exit or of the mistakes that I want to dive into, which you kind of just touched down, is the vague exit strategy.
You talked about, and before we go into it, you had mentioned that: can you stay with the business can you not? I think the vague exit strategy includes a lot of different things. If you can say, when you say vague exit strategy... is it timing? The exit options? What do you mean when you say that?
[00:11:00] Stuart Sorkin:
Okay, well vague exit strategy is one... have you... are you, if you're exiting, are you going to be financially secure for the rest of your life? That is why the first thing, if I start working with a client before I get handed an LOI (which is not the way I would prefer to work), but if I actually can develop a plan, the first thing I want my client—the client—to do is to meet with a financial planner, or their financial planner, and run a Monte Carlo analysis.
[00:11:40] For those who don't know what the Monte Carlo analysis is, it is an analysis that most brokerage houses can run that says, based on you providing them your income and expenses, they can tell you how much capital you need for the remainder of your life with a 90 to 95% certainty. The first question is to find out what the value, what you need to retire comfortably; or to do the next deal, whatever that is.
[00:12:15] Secondly is, then you can then look and do a real value of the business. Then you can compare the two. If it's a positive delta, meaning that the value of your business exceeds what you need, then you can do a lot of sophisticated planning in the tax area with regard to transferring to subsequent generations and charitable remainder trust and other types of vehicles where you can reduce the tax liability on the eventual sale.
[00:12:45] In one case, recently, I had a client who found out that he had a million positive delta and his view was that instead of selling it to a third party where he would have gotten that million, he was more interested in allowing his management to buy it because they would have had trouble meeting his what he thought his number needed to be. When he found out his number was lower, he could then sell it to his employees and preserve the legacy that he wanted to preserve.
[00:13:15] Knowing what you need and then knowing what the true value of the business is as a starting point is important. Then we can look at, especially if we have time: How do we add value to the business? Have we 'golden handcuffed' the employees?
[00:13:45] One of the things that I think that many people miss today when they talk about golden handcuffing of employees is that, yes, you want to golden handcuff the employees to grow the value of the business; that's a wonderful thing. But if all of the sudden your top sales guy gets a big check the day at closing, what's the likelihood he is going to stay? The idea here is—the building a golden handcuff strategy— that effectively creates a stay bonus for the employee, for your key employees. Because if you can deliver an intact management team for 12 to 24 months post-acquisition, you will add anywhere from 25 to 100 basis points to your EBITDA multiplier.
[00:14:30] Looking at how you can golden handcuff your employees and how to make it a win-win for them. Looking at things like, are you a mile wide and an inch deep, which would make your acquisition issues? Are you—in my area in Washington, we have a lot of government contractors and the government contracting range—do you have full and open contracts, or are they my are they set-asides based on a particular status that you have, which is going to affect the value of the business?
By looking at those things then we can look at how we can increase the value of the business. I work on a simple philosophy of business is like a three-legged stool. There's the accounting and finance. There's the sales and marketing. And there's product delivery.
[00:15:15] All entrepreneurs start by doing all three. The smart ones figure out what they're not good at or what they're not as good at or what they don't want to do, and they bring in either a key employee or partner to handle those things to balance out the value of the business. Looking at those areas.
[00:15:45] Yeah, and I love how you touched on a couple of really good things about—I think there's a constant challenge behind how do you actually structure the deals of key executives. How do you get them? Just writing a check is usually not aligning them with incentives and everything and that's part of ...
[00:16:10] We follow the value builder system by John Warrillow, not sure if you're familiar with that or not, but he's got the eight key drivers. This whole concept of value building I think is newer in the last few years because it's a conscious effort to increase, like you had said, that multiplier on your pre-tax or your EBITDA. If you've got a delta or even a positive delta, you've got the ability to increase the value of your company. But then there's also ways that you can increase your net proceeds. So they kind of go back to when you're talking about how you structure everything where... the net proceeds is what you're concerned about in cash flow.
Stuart Sorkin: Correct.
[00:16:45] You've got the multiplier in the value of the company which is your gross dollar amount, but how that turns into your actual proceeds is two different kinds of thing. I don't know if we can separate those and how you distinguish the two or the different things that you advise people on how to approach different role—
[00:17:00] I think that there are probably a couple of different things. One of the things that I look at is the idea of tying your employees in has to be a win-win. In order to make it a win-win, you've got to make it that— hopefully that—the value of locking these key employees up in the company will increase your sales proceeds by more than what you're giving away to them.
[00:17:45] I think that some people don't really necessarily look at how that plays in and that's why as I said the idea of saying, "Okay, I'm going to sell the company and you're going to have your stock options and you're going to get ordinary income and nothing to lock you in post."
[00:18:08] Yes, you've helped me build the value of the business but you haven't necessarily added to your EBITDA multiplier. The way to add to the EBITDA multiplier is, the idea is, that creating payouts, as an example that I typically use would be, that you might with LLCs or C-Corps—because you can have multiple classes of equity—you create an employee class equity which has vesting valuation because equity in a private company is basically wallpaper until a change in control.
[00:19:00] The idea of saying, of creating something that says you actually own this equity, but if you leave you're only going to get bought out on a portion of it based on how long you've been there. The other thing that I think is key about why I like the equity piece, Ryan, is the idea is that I don't believe in necessarily giving equity. I like the idea of saying to an employee, "You're going to buy the equity out of after-tax bonuses that I'm going to pay you."
[00:19:30] The reason why I want to do that is that this helped ... There are two types of employees in the world. There are those who were there for a paycheck and there are those who have some entrepreneurial spirit. If someone is unwilling to forego the opportunity cost of the bonus versus actually buying your equity, then they are probably not the right person in your management team because they are there for a paycheck not to help you grow the business.
Ryan Tansom: Right, they see that paycheck as a missing boat if they buy the equity.
[00:20:00] Exactly. Therefore, so it's a way to test. But then saying to them, "Well, with this equity class, you're going to get 10% or 15% of that as a capital gain rather than ordinary income." So the point is that I'm also, by having you buy this, I'm saving you 20% or more in taxes when you sell the company. When I sell the company the employee now doesn't have ordinary income they get capital gains.
[00:20:45] In exchange for that, it says: you're going to get 10%, 15%, 20% of closing; you're going to get let's say 50% or 60% at the earlier of one year after acquisition or 30 days after constructive termination. If they mess around and try to transfer you, if they try to cut your salary you get paid; but the employee as long—basically it says as long as the new acquirer comes in and doesn't mess with your compensation or your duties et cetera, you're going to stay a year.
[00:21:20] Now, the last piece of this is something else that people, in my opinion, tend to miss. And that is I put a portion to a funded covenant not to compete, because a covenant not to compete is a license to sue. It is not anything else. But if all of a sudden I'm saying that the dovetail portion of 10% or 20% is going to be paid out on a monthly basis starting at month 13 after acquisition as long as you don't compete, but If you do compete, the money gets paid into escrow and the employee has a choice of saying, "I'm going to forfeit it because I am competing," or suing and saying, "No, I'm not competing." Since the agreement provides prevailing parties gets their fees paid, it keeps both sides honest, but you've also now delivered and locked up your management team for the acquirer for two years—which will maximize, which I believe will significantly maximize your multiplier when someone comes in.
It's because, I like the word transferable value. It's how easy with the least amount of risk can someone come in and take over your operations. The reason that someone is willing to give more money or more basis points is because there's less risk that all of the top people in the company are just going to walk away because there's usually going to be impact of profit if they do.
[00:22:45] Ryan, the other point is this: by locking up your employees before you're in an acquisition mode, you also increase the likelihood of success. And because, as you're probably aware, probably close to 60% of the deals that go to LOI do not close. A percentage of those deals are that you haven't locked up your key employees. The acquirer wants this key employee and the key employee now knows he's got you over the barrel, and either interposes themselves in the negotiations—which could have negative consequences—or wants more money, or says, "If I don't get it, I'm leaving," and you can't lock that person in. The acquisition fails. So by locking up your key employees prior to starting the actual exit, you increase your likelihood of success of closing as well as increasing the potential net proceeds.
[00:24:00] One other point I will make is that the—if you look at these "bonuses" that are being paid out to by the equity, they're really advantaged to the owner because what happens is most of these employees are in a lower tax bracket. If you bonus out the money and you say, "Okay, everything after the tax number goes back to pay for the stock. Well the payment of the stock, if it's issued by the company, is a nontaxable transaction. So therefore the CEO/owner is maybe reducing his compensation by the amount of these bonuses, but he then gets back a larger after tax amount which can be distributed to them in the form of a dividend. During this period of time, you can reduce—the note is outstanding, you can actually increase the owner's cash flow.
Ryan Tansom: Interesting, I like it. With the 60% that fail of the deals—which by the way, I mean that that's an astronomical amount and I wouldn't be surprised that it continues to go up with the amount of companies that are going to market over the next few years—but other than some of the key employee issues ... I mean I know there's a lot of these different mistakes that you've—-
The biggest mistake is we relay a quick story to you that I attended a seminar a couple of years ago where the head of Blackstone Acquisitions was talking and he put a question out the audience and said, "When are you going to sell your business?" From the audience: one year, five years. He says, "You're all wrong. You're going to sell it when someone wants to buy it." Therefore, you always have to be ready for sale and the biggest reason why deals fail in LOI is not being prepared for due diligence and not being ready. One of the things I also am a strong believer in is that once you are starting to think about this, spend the time to build your due diligence library, and then update it quarterly or semiannually because a number of the deals that I have seen fail were due diligence ran long because they weren't prepared. The person who's responsible for the due diligence is usually the owner entrepreneur who is usually the principal rainmaker. What happens when he's spending three to six months doing due diligence? He's not out there selling, and he's not out there selling and due diligence runs three to six months, he blows his projections because he's not getting these revenue figures he says, and either at that point in time the inquirer comes back and says, "Hey guy, you haven't made projections. We want to haircut your purchase price." At that point he's got a real problem. He either accepts it, or he walks away knowing he spent a ton on transactional fees and knowing that he has probably hurt the business significantly because employees don't like to be in an insecure position, and a company that fails on acquisition may lose employees at that point. Therefore, it takes you a period of time to rebuild the business at post-acquisition.
[00:27:45] Yeah, I honestly could not agree with you more. With our situation—I don't want to dive into your due diligence thoughts—but my little two cents is when all of a sudden you have to gather all this— my dad and I have the luxury of being able to kind of volley the leadership back and forth for our employees and the selling and gathering the data—it is a very intense amount of work because of the requirements and the questions that are being asked of you. I totally agree that having the ability to do that and not impact operations is huge. But then also the thing is your employees get wigged out if it's not a normal operation to have that stuff. They're like, "Why do we need this information?" All of a sudden like, for us I got a VP of sales who's got 15 employees or sales people reporting to them, and all of a sudden you're asking for the profitability or top contracts and like the diversity of the customer is, and he's going, "Why are you doing that?" That alone is almost more scary as an owner than the actual time it takes to get the information.
I think you hit the issue is that if when you're dealing with the "employees" not the guys who exceed beyond a paycheck. Acquisitions are scary, and therefore it's like—typically you see, in an LOI as an example, "Well, we want to talk to your key personnel." My comment is, "You only talk, in my LOIs, you will only talk to my key personnel and you will only talk to my clusters once you've cleared every one of the other due diligence items." Only if there's a problem with my employee or a customer, are you walking away.
[00:29:45] Let's dive into your due diligence thoughts because—and like what do they consist of—because I think you've got a couple of different points in your book that talk about it, but going through it, it feels like a full colonoscopy. I mean you're going down, man. It is like everything you could think of and more, so I don't know if you can do with a light brush stroke touch on the different kinds of things and need to be ready.
[00:30:00] Sure. Obviously, all of your corporate records. If you are a corporation, have you done all your annual minutes, is your stock registered correctly. I've seen a lot of deals where the stock register isn't right and they've got stock that supposedly been redeemed that they don't have, or there's a stockholder that's out there that they haven't talked to in 10 years, and then he comes out of the acquisition.Your stock records, your corporate records. I also believe you need to do a financial statement clean up. There are certain things that if you look at your financials there may be things that you can do to make your financials look better. I have one client who had a very unique way of recognizing revenue that when they got a purchase order, they recognized the revenue even though the purchase may not generate a profit, and so what they would have is $15 million in sales and $6 million of bad debt write off because they were recognizing the profit on the PO even though they hadn't actually... there was no guarantee. So by changing that, it made financing also easier in the future for them, but the idea of looking at your financial statements. Also, planning is important; you should be doing rolling two to three year projections out. Again, a lot of this stuff once you do the corporate records, once it's not that difficult to do the annual up to know you need to do the annual update or if you only own one annual update. If you've been updating your ... If you have done the things looked at your financials, are you presenting things right away? Do you have the right people in the right places?
It's the documentation too, so I think a lot of entrepreneurs come in for a fight and a fight. I can relate totally where you're, I think you actually in your book you called it the Doo-Doo machine where you're doing things constantly. When we sold a couple of our branches or we went through our deal. A lot of entrepreneurs or business owners can answer all these questions, but it's like, "Okay, then show me."
[00:33:00] Then, it's like, "Oh shit, we've got to find our employment contracts, find and dig up our contracts with our customers and then they may or may not be consistent," where are all of these things? I think that is almost more—
[00:33:30] Well, that's what I'm saying by building a library and it doesn't take once, you've hit the real issue is that most doctors are spending 99% working in their business and 1% on their business. The idea here is, for some period of time, you need prior to deal, prior to ID, prior to setting price to have a secure computer where you've created a due diligence library, where all of the standard contracts are kept. Then on a quarterly or semiannual basis you'll review that thing, and say, "Oh we got to put, we've got a new contract type here. We need to get that in."
[00:34:30] Having that discipline will make the sale go a lot smoother because you just hit the other point, Ryan. Most of the things are in the entrepreneurs' hat. It is not doing data dumps to the acquirer and his consultants, what does he not doing? He's not working in the business. That's why doing that data dump prior to it, so you can, yes, you're going to be tied up a percentage of the time in the acquisition anyway but to the extent that you have done this planning at least you can continue to run your business at a reasonable level during the acquisition process until you have to reveal it to the employees.
[00:35:00] It is crazy amounts of work. Like we were office equipment distributor, so we wrapped Canon, Lexmark, Samsung, Dell, HP so it was like reseller agreements and those update there was like different discounts in the cash backs that we'd have with ... I mean you have to like literally prove everything out. Depending on the buyer, the buyers are usually more sophisticated so they know what they're asking for too.
[00:35:30] You put the other when you mention the ... The point is if you start doing this now before you're in acquisition mode you say, "Hey, every quarter or every six months I want you to update your particular section Mr. Employee." They are not going to think that's out of the ordinary when you're in the due diligence month, because this was part of the new procedures that we're putting in is that we want to standardize, we want to make sure everything's all the records are good.
[00:36:00] In this way, you don't have to involve that you can keep the number of employees who know what's happening with regard to the acquisition down to a minimum. In my opinion that's the key because rumors are not a good thing in acquisition mode.
Ryan Tansom: No, on time becomes your worst enemy.
Stuart Sorkin: Exactly.
Ryan Tansom: I want to jump into your mistake number 19, which I thought was really interesting because it's the financing options and what's available out there. I've got a keynote presentation that I've done where it's, I think there's a lot of misperceptions and so I would say the statement that a lot of people think there's two options.
[00:36:30] One, where they bring it to market and they get a big check and then they walk away or two they have some long drawn out non-profitable family transition, but there's a plethora of options in between. Can you kind of just give some ...?
Stuart Sorkin: Well, let's put it this way every entrepreneur exits his business the one of six ways, he sells it to family, he sells it to management, he sells it to a third party, he becomes an SP owner, it gets liquidated or he dies.
[00:37:30] If you don't choose one of the first or the last two become the obvious choice, and within that framework you have to look at with management sales. The biggest issue you have to look at is and this is the first one of the first questions I asked my clients in looking at when you talk about financing is, "Okay, Mr. Entrepreneur, if you would drop dead tomorrow what is the ability for this company to get to look at bank loans?"
Oh, back to that, "Well don't you think the since in probably 70% of the acquisitions you're going to take back paper from this company that you would like to improve your credit risk now?"
Ryan Tansom: No.
So that again goes to the employee how important employees are is how do you improve your credit risk that you're going to get paid once you sell? Some of the financing pieces on sale depending on this one issue of one of the other chapters called the unemployable salary, because the fact is earn outs and earn outs are a wonderful vehicle as long as you are capable of saying, "This is no longer your baby and someone else is raising your baby and you may not agree with their decisions," but you have to sit there and say it's their baby now.
[00:39:00] That so, earn outs and I think the key also in earn outs is they have to be written in a way that is clear understandable and relatively easy to calculate. I've seen some litigation over what does the earn out mean, and how is it calculated? It needs to be extremely specific when you get into actual writing of the documents of how the earn out is going to be calculated.
[00:39:30] Well, making sure that if you're the seller that you can control your numbers that the earn outs based on, because I mean I've heard, if it's a profitability earn out based on net profit or something where all of a sudden your "new boss" decides to buy a bunch of new trucks and that hits your profitability you no longer hear.
No, because they decided to cap X, at the end of the quarter.
[00:40:30] In fact, I just had one recently where it was going to be in that and we fought and wanted to change it to a gross profit, because it was we had a situation where we knew that the seller wasn't going to be very happy, but the fact is, they had not spent a lot on infrastructure in the last couple of years and there was going to be a major hit to EBITDA. In this case, it was important to keep this person happy, so we went to a gross profit to avoid them taking as big a hit, in some cases depending on how much you want to penalize that, that would be a case where you would probably lay out in advance saying, "Hey, you haven't bought computers for any of your staff in three years."
[00:41:00] That's $100,000 is going to go to EBITDA, you understand that it's going to hit your earn out number and making sure that if you're going to do and or not based on that, if there's either control or at least some understanding of what the GNA increase or decrease is going to be at that point.
Ryan Tansom: Well, and making sure, just a little note on that too is to not I've seen people where they play the games where they're not investing in their infrastructure trying to increase their profits, so that way they can get a bigger number on because it's a bigger multiplier.
The multiplier is a bigger number because they've been profitable more, but then people look at that stuff and they say, "It's going to need this much," so they end up paying for it one way or the other.
Well, you've also you also hit another issue that I think is S Corporations are not the best vehicles for acquisitions, for being sold in some ways, because the problem is. If you get an LOI towards at the end of the third quarter and you're not going to close until after the first quarter.
[00:42:30] I've seen banks go through absolute hysterics because the owner is doing all his tax plan, because it's an S Corp to minimize their income. They're looking at three quarter, three quarter is a very profitable, and all of a sudden fourth quarter the numbers drop like a stone because he's doing tax plan. That's another thing that people have to be concerned at least consider is, that if you are going to sell in a period it's going to go over your year end and you are an S or an LLC where you're doing tax planning.
You have to consider what that may do to your finding to the acquirers financing because they're look at three quarters and all of the sudden they don't understand why your revenue has dropped, or your profitability has dropped dramatically. You're doing it for tax planning and so that's another thing to consider is that you may have to not do as much tax planning in that here a sale.
You've touched on this term of tax planning, so I want to get your two cents. I find that there's a lot of misperceptions out there that tax planning is one bucket. You've got a estate planning which is one bucket. Financial planning which is one bucket and then like your corporate structure is another bucket. The reality is, it's like one big a Rubik's Cube and that's some of the problems where we ran into that, we could have had a lot more money in that because we should have looked at it all holistically. Tax planning while you're just doing the normal year end like you had said is way different than how like what your structure is, and estate planning is not just having a power of attorney and a trust. Whipped up for 10 grand.
Can you explain how all of these impact the net proceeds as?
As I said, I think the first thing is that the entrepreneur needs, now what the net proceeds needs to be to achieve whatever their next step is. That's financial planning comes in is, how much you need to do whatever you're going to do for the rest of your life or also with the net framework, is this your last rodeo or are you going to potentially do another deal? Because if you're going to do another deal part of tax planning and expenses, maybe using troughs to take some of the chips off the table that the next deal doesn't work you have protected them.
[00:45:00] The idea of also, the estate planning has some significant issue potentially in family business scenarios because some of the biggest fights I've ever seen in my practice have been where you have one or two children in the business, and one and two children out of the business and then you decide who's going to leave equal shares to the four kids. Having non-work operating working children in a business and operating children they have completely different goals, and I have seen families destroyed over that issue.
[00:45:30] I look at it as party or state plan you should be looking at that if you have a family that's not in the business, how you're going to equalize the estate and keep the children out of the business? Or how you're going to minimize that in a way that is not going to harm the business? I mean, that's part of the estate planning.
[00:46:30] Within the estate planning also though is with the higher exemptions and so on, a estate planning from a tax perspective is less important than some ways of, it's not what you leave your kids, it's how you leave it to your kids. The idea is it's an example that I'm working on and I'm working on a project now with the client. Their biggest assets, they are own vineyards. Their biggest asset is the real estate, but the real estate doesn't generate cash for liquidity purposes for the state taxes.
[00:47:00] The idea of doing transfers currently or over time into trust that will not be subject to tax again for a number of generations. Makes sense. You have to look at what are the composition of the assets and how they play in. With regard to tax planning on the sale, you also don't want the tax tail to wag the dog. We may or may not have the tax bill this year. If we do have a tax bill this year, or maybe be certain clips that will come, it could come in at a certain period of time.
[00:47:30] Sending our artificial deadlines for taxes can hurts you and net proceeds because the acquirer knows you have that deadline, and if you have a deadline they have a lot more control over the transaction. You have to integrate the income tax, the long run income tax, short run income tax, the estate tax issues. What you're going to do afterwards, all the part of your financial plan is one.
[00:48:30] Obviously your corporate structure is important because I'll give one other piece. In family transactions if they are not service corps probably the best and most efficient way to potentially do it by out of the senior generation is through a corporate redemption and being a C Corp, because the first $100,000 of taxable income in the C Corp is tax at $22,000, which is considerably less than taking $100,000 out in excess of your normal income and then giving it to your dad, well you're paying 40% on it. The idea here is this is also some tax plan with regard to ...
[00:49:00] A lot of times in the family deals, some second generation will buy a small portion of the stock and then the corporation will redeem the stock at a more favorable tax rate.
[00:49:30] I think, I mean there are so many different ways and that's why I love the Rubik's cube analogy, because depending on what your goal is you get to back from the goal because I've heard even horror stories. Actually I was talking to this gentleman, he's a friend of mine. He's had a firm similar to mine down in Texas. Worked for the minimum of net worth of $25 million families, and this family is worth like 400 million or something like that. They sold 60% of their, his big huge, that the retail chain to a trust that all these different tax things, but then all of a sudden the company blew up I guess and they did really well.
The dad could not afford to pay the tax bill even though his kids got rich because they were the beneficiaries of this ...
Yeah, and that's another point that I'm going to make to you is that clients need the choice of your business entity well in fact the type of trust that you use, because GRATs spreads the rental retained interest trust are okay for S Corps and LLC's and the owner, and they work because what happens is you make the gift and you get depreciation out, but the senior generation is paying the income taxes.
If you have a C Corp that is only going, and the reason why that's important is do they trust reaches the top tax bracket at about $14,000 of ordinary income, so you do not want a lot of ordinary income running through in irrevocable trust.
[00:51:00] Flow through entities don't work with the irrevocable trust unless they are GRATs or other types of Grantor Retained Interest Trust where the grantor was willing to pay the taxes on the other side. The point is, if you have a C Corporation then why would you ever use it GRAT, you would be ... because the irrevocable trust gets to pay the same pay for capital gains treatment as an individual.
[00:51:30] Why would you want to grantor to pay tax at capital gains taxes on the sales proceeds when that could be paid by the trust at the same rate?
Ryan Tansom: It's just one big huge jigsaw puzzle.
[00:52:00] Well, and here's another thing that I think people should also consider is, in some cases the entrepreneur are still supporting the parents, is now supporting the parents. One of the things that I've been using recently is setting up the selling maybe your contribution to a charitable remainder trust for the benefit of parents to supplement their income and getting a significant charitable deduction to reduce the tax liability in the year of sale.
[00:52:30] Yup, there's just so many and this is a huge long technical rabbit hole that I know that you and I could probably volley back and forth for a long time. I think the biggest takeaway. I mean it is so intertwined and all has to do with your goals, your timing, and even like you I think you've alluded to it in your book where depending on whether you sell it, of one of the six ways each way that you're planning on exiting will determine all the ways that you're back and technically from this.
I think making sure that you understand the correlation between your exit options and goals versus all this technical stuff.
Ryan, let me add two quick points on what you just said. One is, well I said there's six ways to sell your business. If that's the way to sell your business is when you're an absentee owner, so you should be, every entrepreneur should be striving to be an absentee owner because that's when the business is most valuable because the one thing that's going to happen after the acquisition generally is the owner wasn't going to be there.
[00:54:00] Striving to become an absentee owner and the other thing that I've raises that you have to make sure that your professionals, the problem today with large firms is, the large firms have become highly specialized and with that high specialization one of two things happen in either something that leader have five different partners who are going to learn, who are going to have to learn about your transaction to make sure it's all covered or something is going to get missed.
That's why it's really important to have someone who is going to be the quarterback and make sure that the right people are involved at the right time. That's where the value ad is to make sure that you have the right people in the right place and the right questions are being answered.
I sat in that exact position right, where we had a CPA from a large firm in town with an attorney from a large firm in town. As an entrepreneur who was the guy, we know how to sell the hell out of IT services and your office equipment all that stuff. You sit across from all of these suits thinking that they should know all this stuff, and you don't realize that your attorney isn't specialized in M&A that they're actually specialized in employment law.
[00:55:00] Exactly, and the thing is or you're smart you've worked with the same attorney for 30 years, and he's a great attorney but he's not an M&A specialist.
Ryan Tansom: Oh such a huge deal.
Stuart Sorkin: This is the biggest sale in your life other than the real estate, you need to have someone who actually knows how these deals run.
[00:55:30] Well, and I know how they run and the interesting comment that I heard from the gentleman who was on our show back in January, so he said it impacts the continuing ed. If you're a CPA that doesn't do M&A for a living, why would you stay up on all of the stuff that we talked about because it's not important because you've only done one in your entire life versus the person that's done 10 this year.
Stuart Sorkin: Right, exactly.
[00:56:00] As we're run low on time here, I was just you ... You hit on a huge thing because I was actually gonna ask it to you, and I think you already answered it, which is striving to be the absentee owner. If most entrepreneurs are in the duty machine where they're doing doing, doing, which is 90% of the time and they're only working on the business 1% of the time striving to be the absentee owner should be their goal.
[00:56:30] And there are two ... When they say, there are a couple ... First off is this, if you don't do that you become the biggest backup in the business. If you are the biggest back up in the business what ends up happening, those that are entrepreneurial. If you have to, if the entrepreneur has to make every decision you're going to alienate those people in your management team who have entrepreneurial spirit because they're going to figure they can't do. They can't make any decisions, and all you're going to end up with yet, then, or you're going to end up with this, yes, man in management. Therefore, if you're not there the business falls apart.
[00:57:00] Yeah, and I think it's like the best gift on earth which is your sole goal is to work yourself out of a job.
Stuart Sorkin: Exactly.
Ryan Tansom: Your company is worth more because you did it.
Stuart Sorkin: Exactly.
Ryan Tansom: That's it. I don't know if you are familiar with the book Snowball by Warren Buffett?
Stuart Sorkin: Yes.
Ryan Tansom: I mean that's what Warren does. That's what Berkshire Hathaway is where he goes in there he understands it and then he delegates until all he has to do is read the financials.
Stuart Sorkin: Yeah, agree.
[00:57:30] I don't know if there's anything we haven't covered that you want to make sure that you know we reiterate or there's one thing you want to highlight before we kind of wrap up?
[00:58:00] I think the reiteration is this needs to be planned. If you wait and just say, "Okay," and then someone comes to you with an LOI, you're going to get a lot less proceeds and as I analogize it, one of the statements I make the client says, "Until you get the LOI, you are like the prom queen and everyone wants to date you."
[00:58:30] The minute you sign the LOI, the shoe is on the other foot and the acquirer will do everything they can to potentially reduce the price. You need to make sure that when you do the LOI that you've got someone ... If I see a two-page LOI I'm concerned. LOI needs to specify and also another point within that specification.
I'm a big believer that if you have a formal that's been used to calculate the purchase price that you use the formula in the LOI. In case there is something that hiccups in due diligence regarding revenue, you don't get into a fight at that point over what the new number is.
[00:59:00] That to the extent you can be a specific, you can build things that have flexibility with regard to where the wheel can fall apart in the LOI and prevent you'll have a more, a larger chance of closing taking the LOI closing if it's built as a flexible document but detailed.
Ryan Tansom: Great advice. Absolutely love it. Stuart, what is the best way our listeners can get in touch with them?
Well, they can contact me through my website which is stuartsorkin.com, or they can reach me by e-mail at [email protected]
Ryan Tansom: Stuart, thank you so much for coming on the show.
Stuart Sorkin: My pleasure.