By Joseph G. Milizio, Esq.
As an exit planner, I don’t start from the beginning. I start from the end.
Studies indicate that over 70% of former business owners are unhappy with the results of their exit plan. Why? A major part is insufficient proceeds. Without proper planning, you won’t know if the proceeds of sale will meet your financial needs. And those needs start with your objectives after leaving the business.
This requires an analysis of the business. Do you know what the business is worth? Will the cash flow be sufficient to support you and your family after you leave it? Do you know what you can expect to receive from your non-business investments?
The aim of a business succession plan is to increase value, over a period of time, so that when the exit takes place your objectives are met.
Although each exit plan is unique, they share common characteristics. There must be a written plan, so that progress can be measured. Exit planning is not a short-term process. It takes preparation and time to implement. Without a written plan, it may never be carried out and will certainly take longer to achieve.
Many business owners do not set clear objectives and, therefore, cannot put an exit plan into place. The following three questions are a good start:
- When do I want to move on from my business?
- What annual income will I need during retirement?
- Whom do I want to transfer my business to?
(The latter can include family members, key employees, co-owners, third parties, and employee stock ownership plans.)
Once the framework is put into writing, the focus will be on maintaining and increasing business value. There are many ways to maximize value, including increasing cash flow, implementing efficient systems and procedures, making sure that key employees are retained, and minimizing income tax liability.
The choice to sell to a third party or to transfer to insiders (whether co-owners, family members, or key employees) requires different planning. A sale to a third party will focus on maximizing value, since you’ll effectively be paid at the closing.
A transfer to insiders will focus on minimizing income tax consequences, to both you and the buyer, and minimize your risk of not being paid in full. Let’s face it—insiders will most likely not have the cash to purchase the business. You’ll be paid from earnings generated by the business. As such, you will be receiving installment and other payments from the company over an extended period of time. If there is an insufficient cash flow, your exit plan could fail.
Keep in mind that there will always be two income tax obligations on the sale of a business. The first is the income tax charged to the buyer, when they receive income from the business. The second is the capital gains tax assessed against the seller.
So the goal is to obtain the lowest defensible evaluation for the ownership interest in order to protect those hard-earned dollars from being subjected to double taxation. The best way to do that? Create unfunded obligations to yourself from the business long before the actual transfer takes place. These may consist of deferred compensation, leasing of real estate, and distribution of Subchapter S dividends.
The best way you can receive dividends and maintain control until you’re paid in full is to retain a controlling ownership interest in the business until financial security is assured. This may entail a purchase in phases, whereby insider third parties purchase a minority interest in the business until it satisfies its obligations to you. This method can also create valuation discounts, allowing insiders to buy-in at a lower price.
Of course, selling over time requires a contingency plan in the event of your death or disability. Otherwise, a business can be left with a sharp upswing in value, but also extremely vulnerable from a continuity perspective. As a business owner, you must have adequate agreements in place to protect the business from catastrophe. For example, a buy/sell agreement with a co-owner or incentive stock options.
Successful business owners often develop strategies based on experience, but the typical business owner cannot afford to learn from mistakes after they’ve already implemented their succession plan. A team of skilled and experienced advisors will help you prepare an exit plan that meets your objectives and allows you to have a successful business exit.
Joseph Milizio is the Managing Partner of Vishnick McGovern Milizio LLP. He leads the firm’s Business and Transactional Law, Mergers & Acquisitions, Real Estate, Exit & Succession Planning for Business Owners, and LGBTQ Representation practices. He can be reached at jmilizio@vmmlegal.com and 516.437.4385 x108.
