Most people when they go into business do not consider an exit strategy (getting out of the business in the future), after all, they are just going into this exciting new business.
But as the years march on, business people start to think about an exit strategy. This can be prompted and even bought forward by a number of circumstances such a health issues, marriage split, business partner split, lack of business performance, or loss of interest. In many cases, these business people don't really know how to go about looking at their exit options, let alone planning so they can achieve the best possible result.
So first let’s list the main options available:
1 - Stay in the business until you can no longer work.
2 - Pass it or sell it to your children
3 - Sell it as a going concern
4 - Close the business down
Option 1 - Stay in business until you no longer can work
There are only three reasons why you would select this option:
A - You cannot afford to retire
B - The option of going to work is better than the option of not going to work
C - You cannot bear to see your life's work dismantled
In short, option 1 is very much driven by personal circumstances.
Option 2 - Pass it on to your children
This is probably the most difficult option to exercise as there are so many variables. I could write pages based on my experience of working with clients transitioning their business to their children. While on the face of it, it sounds like a simple option, the variables can be so complex, especially if there is more than one child in the family, or you are funding the sale to the child/children. Tax planning needs to be bought into play.
Business protection needs to be put in place to protect the business from the children's personal relationships failing. Children who are not in the business may need to have their share of your will protected, while at the same time not saddling the child in the business with non-business siblings.
Then there is the question of valuing the business. These considerations go on and on, making this option the most complex.
The starting point is to create a formula taking all aspects into account. Then apply the numbers. For example. You have three children, one being in the business since leaving school and two who are not interested in the business. Your business is worth $1,700,000. Your other assets are worth $1,000,000 so the total net worth is $2,700,000. If you were to split your assets equally upon your demise, each child will inherit assets worth $900,000. To achieve this, the child in the business would have to either borrow $800,000 to payout siblings or take them on as partners. On paper, this may seem fair but there is a problem. The child who had spent 30 years helping build the business is feeling he has shot himself in the foot as he helped double the net worth of the business over the years, and now has to pay for his efforts. The other two children feel it’s only fair they get a third of the parent's total assets because if the business is sold to a third party they would get their third. Now we have a family dispute that did not exist before the proposed sale. This is only one of a hundred possible scenarios families face when selling a business to a child.
Option 3 - Sell it as a going concern
This option is becoming a more difficult option to achieve as the rules on valuing the business have changed. The first decision is one of determining if you are selling the shares in your company or only selling the assets of the company. Not too far back in time, the sale was made up of three figures; 1 - inventory, 2 -plant, equipment, furniture, and fittings, plus 3 - goodwill. Reach a price on each of these and you had a selling price.
Today most businesses are valued on their return on investment. To arrive at this you must first determine what your Super Profits have been for the past three years. Super Profits are what the owners take from the business in cash and benefits, less what they would pay someone else to do their job.
What they take from the business includes salaries, drawings, distributions, personal travel, life insurance payments, superannuation, car leases, and the likes. For example, the owner takes a salary of $150,000, has a car lease of $10,000, travel of $20,000, other perks of say $30,000 a net profit before distribution of $100,000, totaling $310,000, less what you would pay a third party to do your job, say $80,000. This leaves a Super Profit of $230,000.
Now consider the risk of owning a jewelry store compared to other investments such as having money in the bank, stock market shares, property, and the like. It's well known the higher the risk, the higher the return required, which poses the question, what is the comparable risk of investing in a jewelry store. You could ask any of the hundreds of owners who have closed their doors in the past few years, but that would be depressing.
Due to the risk of investing in a jewelry store, the rates being used are in the range of 20% to 25% return on investment. This equates to a value for buying at 4 to 5 times the Super Profit. In the above example taking the super profit of $230,000 then the going value is $920,000 to $1,150,000.
Now, let’s examine another dimension of the same business, the value of the assets. Inventory worth $1,700,000, plant at the fire-sale value $30,000, and goodwill (worth next to nothing these days) but say $50,000 for this exercise, giving a total value of assets of $1,780,000.
Now you can see the problem here, you have $1,780,000 of assets which is only worth $920,000 to $1,150,000 based on the return on investment method.
Much has been written over the years about asset strippers (people who buy corporations at share value when the value of assets are somewhat more, then sell off the assets to make an instant profit).
To sell a business as a going concern requires grooming it for sale. This involves reducing the sale value by reducing the asset value. The obvious step is to reduce the inventory investment, which needs to be done in a controlled manner. Just stopping buying will result in lost sales, resulting in lost profit which reduces the value of the business.
In the above example, assuming it is a typical small business it will have at least $600,000 of its $1,700,000 inventory being excess inventory that has built up over the years. If the value of the assets is reduced by selling off this $600,000 excess inventory, and the selling price of the business of $1,150,000 is achieved then the owner will achieve a total cash value of $1,750,000, (the $600,000 stock sold off plus $1,150,000 sale price) which is the approximate value of the assets.
ARMS has assisted many clients to prepare their business for sale so they achieve the highest price that can be obtained while giving the incoming owners a healthy business to start with. A true win-win sale. This typically takes upwards 2 years of grooming.
Option 4 - Closing the business
In other words, being your own asset stripper. Apart from option 2 of selling within the family, this option is the most widely used over the past few years. To realize the most from your business assets means a strategy starting at least two years out from the close down date. ARMS has helped a number of its clients achieve the most from its business using the method.
There are of course many variants to the above options, but this article is designed to give you a broad overview of things to consider and timelines you will need to allow for when you plan an exit strategy.