When Doing Nothing Can Cost You Everything: Why You Need a Business Succession Plan

Thursday, February 11, 2016 @ 12:02 PM
Author: Peter Brehm

No business owner would deliberately risk the very enterprise that could help fund his or her retirement and prove to be a lasting legacy. Yet, an owner who has failed to plan for business-succession or exit upon retirement does exactly that. Here’s how to avoid the sometimes substantial cost of doing nothing.

“Albert” is the 63-year old owner of a profitable retail operation that boasts annual sales (revenue) of around $1 million. Since launching the business 20 years ago, Albert runs the day-to-day operations full time, and has been drawing an annual salary of about $60,000 in recent years. He also employs four part-timers to run the cash registers and stock shelves now and then. Currently, the entity holds about $125,000 worth of inventory (based on current purchase price of items) and around $100,000 in equipment. A quick estimation of the business’s value can be gauged by applying the rule-of-thumb similar businesses (ones selling the same product or service) use in his geographical area: calculate 50% of average annual sales over the past three tax-reporting years.

In Albert’s case, that would amount to a business worth roughly $500,000 (business value including equipment, good will, etc.).

The strain of working 12-hour days in retail is starting to take its toll on Albert’s health, however. Albert agrees that he can’t keep up his current pace much longer, but has procrastinated on actually coming up with a business-transition or succession plan, feeling confused and overwhelmed at the thought of it. “I’ll probably just work until I can’t anymore,” he laughs. When his friends ask what he’d actually do if he were unable to work, he scoffs, “That’ll never happen.” A few weeks later, a fall from a ladder puts Albert in the hospital for several weeks. With no one to take his place, Albert thinks it best to consider closing up for a while, if not permanently. “It had a good run,” he says, thinking that this outcome was probably inevitable.

An All-Too Familiar Story

As a member of the baby boomer generation, Albert has done what so many of his contemporaries are also doing, or more accurately, not doing: they are not planning for business exit and/or succession as retirement approaches. A brief look at current and significant demographic shifts tells the story.

In January 2014, the oldest of America’s baby boom generation crossed over the 65-year old mark. What’s more, as the generation that introduced tie-dye fabric, love beads and organic farming to the American mainstream got older, they did so in droves; Boomers are turning 65 at a rate of 10,000 a day – a trend that is estimated to last for the next 16 years. This amounts to more than 75 million people closing in on retirement in the next decade. At the same time, roughly two-thirds of all businesses with employees (nearly 4 million companies) are owned by these baby boomers.

A lot of people from that generation worked very hard and developed significant wealth through private-business ownership. Much of their success is due to their highly entrepreneurial and creative nature – a combination that has fueled innovative ventures which, in turn, has allowed them to provide for their families, and which, ideally, should provide for their retirement.

Baby boomers now corner the market on small-business ownership, and that has made many of them quite wealthy — studies show that 65 percent of households with at least $25 million in investable assets are business owners.

Unlike many of their parents, most of these baby-boomer business owners want to maximize the value of their life’s work. For many, their wealth is tied up in their businesses. If these owners don’t begin planning now, the end result could be disastrous to their financial future. With so many similarly situated owners approaching retirement at roughly the same time, we’re looking at a wave of boomers needing to sell or transition a business all at once. That glut of supply has the potential to make their situation worse.

In short, every 57 seconds, a baby boomer small-business owner is turning 65 – a trend that is poised to continue for the next 20 years. And chances are, like many wealthy individuals and families, that baby boomer has built a business that could be transitioned to supplement retirement income. The problem is, this may not come to fruition for many boomers due to their overall failure to plan.

Boomers: Graded “F” in Retirement and Business Succession Planning

Despite their best intentions to maximize and customize their business transitions, many baby boomer business owners are not being preemptive. It’s no secret that this segment of the American population is woefully ill-prepared for retirement. Across the board, boomers remain in trouble in terms of retirement planning, and depending on whether they are “early boomers” or late ones, may be on track to replace as little as half of their pre-retirement income once in retirement.

Consider these statistics on small-business ownership and the failure to plan:

• Over 50% of the owners of privately held businesses say they expect to have a change in ownership within the next 15 years.
• Business owners are expected to generate $10 trillion in personal liquidity over the next 15 years through business sales.
• Forty-three percent of business owners have no formal financial plan or exit strategy.
• More than 50% of regional family businesses do not have a buy/sell agreement.

While boomers have made an indelible mark on American culture and business, what they didn’t leave behind is just as significant. The boomer generation had far fewer children than their parents, so it’s unavoidable that these business owners will face succession, and liquidity, challenges later in life.

Why Not Plan?

The reasons boomers don’t plan for business succession or transition are many. Some may want to envision a business-transition plan for the future, but don’t know where to start, or, cannot fathom anyone wanting to buy their business. Others are enmeshed in unrealistic expectations from and about their own families and/or business partners. Others simply don’t have the time to devote to planning. These are hard working and incredibly busy people, and the fact is, while there are some simple fixes available, there are no ‘cookie-cutter’ solutions to this problem.

No Plan? Then Plan To Leave Money on the Table

Business owners should at least consider, and acknowledge, the potential losses that could occur if an owner fails to plan. Many owners don’t fully realize what they stand to lose by not planning for business sale or transition. Many businesses, even small operations, are worth more than the owners may realize, especially if they plan ahead.
As a result business owners should consider a business valuation expert to assess areas of value within the business, and determine at least a ballpark asking price. Many valuation experts work for a flat fee, which can be a small price to pay to learn the value of their single largest investment.

A quick look at “Albert” illustrates this point. Assuming that Albert engages a business valuation expert who confirms that his business is fairly valued at around $500,000. Albert successfully finds a buyer willing to pay his asking price of $500,000. If Albert’s financial goal is capital appreciation over time, he could invest the lump-sum proceeds in a vehicle that strives to deliver solid growth of principal. Assuming even a conservative annual rate of return of 3.5%, in just five years his investment would have grown to $593,843. If Albert can leave his principal investment intact for 10 years, it would have grown to $705,299, assuming still a 3.5% rate of return.

Now, if Albert is comfortable assuming more risk, he can venture into investment vehicles that are perceived to be more risky, such as alternative investments, lower-rated corporate bonds (even high-yield credit), or small- or mid-cap stocks, for example. If so, he might enjoy a slightly higher annualized rate of return, of, say, 5.5%. If that’s the case, Albert’s original $500,000 investment would grow to $653,480 in just five years, and $854,072 in a decade. That’s quite a lot of growth to leave on the table.

Suppose Albert instead prefers to invest the proceeds to create an immediate stream of income to replace the $60,000 annual salary he used to draw from the business. In that case, Albert’s main investment objective would include preservation of principal, and ideally, a guaranteed minimum rate of return so as to generate a somewhat predictable monthly income. While it may be difficult for Albert to fully replace his $60,000 salary solely through the sale proceeds, he can supplement other sources of income, such as social security payments or distributions from his IRAs or other self-funded retirement accounts. (Once Albert reaches age 70-1/2, he will have to take mandatory minimum distributions from his retirement accounts anyway.) In this case, an immediate annuity funded by the $500,000 sale proceeds, at an assumed growth rate of 5.5%, would deliver a monthly income stream of approximately $2,300 ($2,292), or about $27,500 annually—roughly half of his former salary.

Moving Toward a Solution

Given the potentially substantial “money left on the table” many business owners face absent a transition or succession plan, small business owners should consider the following steps:

1. Start by evaluating with your financial advisers exactly how much of your wealth is actually tied up in your business.

2. Determine your goals for the business. Aging is inevitable; wouldn’t you rather see your legacy continue in the way that aligns with your values? Options include:
• Keep the business in the family, if that’s what you want
• Keep the business alive for the employees
• Create a windfall of retirement assets that can serve as a source of regular, dependable retirement income

3. Hire a skilled, experienced business valuation expert to identify areas of transferable value within your business. These may include management, financial controls, systems, customer concentration, and even good will/name recognition in the community. Why? Not having an exit plan can undermine what is sometimes referred to as “legacy aspirations.” As an owner, you may have goals and values upon which you founded your enterprise, and you likely don’t want to see them discarded along with your potential income opportunities. Make sure you determine the best valuation method for your type of business.

4. Coordinate your “dream team” now. Speak with your tax, legal and exit-planning advisors sooner than later, and schedule time each week to be devoted to this effort.

5. Talk to an attorney well-versed in business transition, acquisition and sale. Explore all of the viable options for business succession/transition that may be appropriate for your business. These could include a buy-sell agreement (if you have business partners); outright sale; or transfer to a family member (seller is creditor to buyer, buyer pays off over time, creating income stream, etc.)
Above all, it is important that business owners take action. Even just making that call to your financial advisors to determine how much of your net worth is tied to the business can be eye-opening. Why risk losing the very enterprise you likely took years to build? The effort it takes build a plan is well worth preserving the legacy of your life’s work.

Peter C. Brehm

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