Published on WealthManagement.com on August 27, 2024 | Authored by Guy Baker
My last article about business transitions examined the most important issues for owners to consider pre-sale when planning to exit their businesses. Here, we examine six key considerations that can make or break a successful transition.
Sell or Transfer the Business?
In many ways, an owner’s business is like a family member. Deciding to sell the business to a third party (rather than transferring it to a child or key employee) can feel like getting divorced or kicking a wayward child out of the house. An outside sale is often the best option to maximize proceeds and eliminate family rancor, but without proper planning, an outside sale can wreak havoc on family dynamics and cause significant turnover among employees.
In addition to determining the best deal terms and timing, you should help owners figure out the best way to invest the windfall before the funds come in. You’re also in a great position to help them think about how they’ll spend their newfound tsunami of free time, plan their legacy and give to causes they care about most.
As the old saying goes: “Good judgment comes from experience, and experience comes from bad judgment.”
Entity Structure
Many owners are surprised to learn that the entity structure that has served them so well while starting and growing the business may not be the best structure for selling it. For instance, C corporations (C corps) have many advantages for ongoing enterprises but can cause tax challenges during a sale, such as “trapped gains.” Due to poor planning, C corps often own real estate and have significant accumulated earnings from those assets that will be double-taxed when the corporation is liquidated. The corporation must first recognize (and pay tax on) gains associated with the sale of real estate. If the business owner sells the company’s assets, there will be a large second tax on these trapped gains.
Also, the business’s accumulated earnings (which have already been taxed at the corporate level) will be taxed as ordinary income when distributed to shareholders, including the owner. The only way to avoid double taxation is to sell stock. But most buyers want to restart the depreciation clock as soon as possible to benefit from the tax savings. They also want to eliminate any hidden liabilities in the corporation. That’s why they insist on buying assets. Resolving this problem can derail the sale of the business, however, because of conflicting economic interests.
One solution is to switch the entity from a C corp to an S corporation (S corp). It takes five years for the built-in gains inside the C corp to be converted to S corp taxation. However, once the assets can be disgorged without a second level of tax, the asset sale can proceed. That’s why you want to add a qualified CPA or tax attorney—preferably those with business transaction experience—to your client’s planning team. Often, the client’s longtime accountant or attorney doesn’t have the necessary transaction experience and important issues get missed. As your client’s quarterback, however, you’re in an excellent position to build the right team, smooth out bruised egos and have all the experts working harmoniously.
Walkaway Money vs. Sale Price
Another challenge facing business owners is that the after-tax proceeds from the sale may not be enough to support the lifestyle to which they’ve become accustomed. Assume the owner has been paying themself $600,000 annually (in addition to other perks such as a car, country club and entertainment expenses). It would take about $15 million at 4% interest to produce $600,000 in annual pre-tax. Your client’s company may have fetched a $20 million offer, but the owner might net $12 million after tax. That’s a $480,000 annual income, which may not be enough, especially when they must start paying out of pocket for all the perks that used to be run through the business.
Whether the outcome reduces taxes or has significant trapped gains, it’s important to model the sale correctly to show the owner what they can expect to net. The tax consequences of different exit strategies can be highly complex and will significantly impact the seller’s net proceeds—that is, their “walkaway money.”
Advisors’ Industry Knowledge
Each industry has unique considerations that can affect valuation, who might be potential buyers and deal structure. Understanding these considerations is important when deciding to sell or not to sell. An important question is to ask whether the owner’s advisors are knowledgeable about the industry. Do they have deal experience within the industry to know what’s reasonable and customary? If not, they could be rubbing potential buyers the wrong way or causing your client to leave significant money on the table.
Family Dynamics
Eventually, every owner must start thinking about who will take over their business. In some cases, they may have competent children already working in the business who have been well-trained and who understand the nuances of the business. But if the owner has no family members interested in (or capable of) taking over the reins, they must look for outside buyers. This adds a layer of complexity because the owner must start updating the books, documenting business processes and addressing unresolved business problems or the sale won’t go through.
Deal Structure
You can add significant value by helping your business owner client decide among an all-cash offer, an installment sale or a stock swap. Each has pros and cons. It starts with helping the owner clarify their goals. Do they want to take some chips off the table, or do they want to parlay their value into a larger nest egg or eliminate risk and diversify market share?
The specifics of how a deal is structured (for example, earnouts and seller financing) can have major implications that may only be fully appreciated with mergers and acquisitions experience. Ultimately, the owner wants flexibility and income. They may want to stay involved in the business and sometimes retain partial control. These are important considerations to iron out before the sales process begins. It’s best to start planning several years before a potential sale date. I’ve soon too many owners (and their advisors) underestimate this timeline.
As the wealth advisor, you want to help clients create the optimal portfolio for investing their post-sale proceeds to replace the family income they have enjoyed for many years. But you need to tread carefully around each specialist on the team who believes they are the most trusted advisor to the owner. You might also want to bring in an organizational behavior counselor to help longtime employees deal with an ownership transition and a family counselor to help family members deal with the loss of the family piggybank and resentment from being passed over to assume the reins.
Dr. Guy Baker is the founder of Wealth Teams Alliance (Irvine, CA).
