From the May 2007 issue of Wealth Manager Web • Subscribe!

Exit Myths

As an advisor, you have a quiver full of legal and financial strategies to help clients disengage themselves from their closely held businesses. However, these strategies will miss their mark unless the business owner approaches exit planning with an informed and open mind. And that may mean debunking the five great myths associated with this important stage in your clients' lives. But before you can eliminate them, you have to thoroughly understand them. By going beyond the "conventional wisdom," you'll be able to work more effectively with business owners, and they'll buy into the process more readily.

Myth #1 - Owners Must Give Up Control

For many business owners, control of the business is an important part of their financial, emotional and psychological security. A 2004 study of several hundred closely held business owners conducted by Hannah Shaw Grove and Russ Alan Prince found that more than 98 percent identified the "desire to control their own lives" as an important benefit of being an owner. Weigh this against only 3 percent who identified "becoming wealthy" as an important motivator. Clearly, many owners equate exiting the business with stripping away their thickest, warmest security blanket.

Advisors can help such clients understand that it is possible to separate owning a business from controlling a business. Removing the control myth opens the door to greater willingness to plan--without fear or defensiveness. For example, we work with the 72-year-old founder of a business who has three adult children working for him. For years, his children tried without success to get their father to implement a succession strategy. Only after we helped the patriarch to understand that controlling his business was not the same as owning his business, were we able to implement a proper exit and family succession plan. We accomplished this by recapitalizing his C-corporation into voting and non-voting stock. The client then transferred all of the non-voting stock to his children, with the intention of retaining all voting stock until his death. While this strategy also has familiar estate planning benefits, this owner's intransigence had nothing to do with estate taxes. Once he understood the difference between owning and controlling his business, his previous resistance ended.

Myth #2 - All Value is Transferable

Many owners who intend to sell their businesses are under the mistaken impression that at retirement they can put out a "For Sale" sign and, within a reasonable time, a buyer will walk in, write a large check and happily escort them out the front door. Unfortunately, selling a company is a challenge, even on a good day. In many closely held businesses, much of the marketable value is tied up in the owner's relationships and talents. Buyers know this and are reluctant to pay if they believe that when the owner walks, the business will follow.

However, owners can make changes to their businesses to reduce that personal dependency and, potentially, increase transferable value. They need to:

o Hire and develop a strong management team;

o Implement long-term compensation incentives for top employees;

o Develop customers and other key relationships not exclusively tied to the owner;

o Pursue niche markets with high barriers to entry;

o Strive towards several consecutive years of strong financial results;

o Identify unique assets such as patents, copyrights and retainable contracts.

Helping an owner who intends to sell often requires a frank conversation about what the business is worth. You may have to ask, "What is the business worth without you in the picture?" Asking the question puts the current owner in a potential buyer's shoes and makes him or her more capable of objectively assessing transferable value.

Myth #3 - Buyers Bring in New Money

When it comes to selling his business, every owner's dream is an all-cash deal for a hefty premium without an earn-out. The now former business owner hits the golf course, never to worry about money--or the business--again. That dream is, well, a dream. In reality, buyers do not bring any new money to the closing table. All closely held business owners essentially buy themselves out. A rational buyer only pays cash because he expects his capital to be replaced with a desirable return. Where does the capital come from? The business profits. Who built the business to generate those profits? The outgoing owner. Buyers, even in an all-cash deal, bring no new money. Buyers only bring cash today in exchange for the cash the business will produce tomorrow.

In other words, owners may fall into the trap of believing that they do not have to actively plan for their financial needs at exit because the exit transaction itself will take care of those needs. They fall into this trap because of the myth that a buyer brings value that did not already exist. Whether a lump sum or installment sale, no new value, no new "money" is created by the exit transaction. Understanding this opens an owner's mind to the need for, and benefits of, planning in advance and implementing strategies that maximize results.

Debunking this myth gives a business owner access to strategies that put taxes and time to work on his behalf today for an exit that may not happen for many years. This is perhaps most evident for the owner who sells to key employees. Among the many strategies for owners who do this are ESOPs, "golden-handcuffs," salary continuation plans and leveraged buy-outs. Most of these strategies require owner funding in some manner. Don't be surprised to hear your client react with incredulity: "You want me to write a check now to help my employees buy me out later?" The answer may be "yes," and for sound reasons, potentially altering the terms or tax-treatment of the sale to favor the owner. But only after a business owner realizes that he ultimately buys himself out does an objective consideration of various exit-planning strategies become possible.

Myth #4 - The Gross Price Matters

Owners selling their business often focus on the gross sale price and pay attention to little else. "My business is worth $5 million, and it is a waste of time to talk to anybody for less than that," is a common sentiment. Whatever the number is, the gross price means little. Helping owners realize that the net result is what matters clears the way for a more creative approach to exit planning.

Typically the biggest culprit eroding the gross value is taxes. The purchase and sale of a business is among the most heavily taxed transactions. Principal paid by the buyer to the seller uses after-tax dollars. For every dollar of principal, under a 35 percent effective income tax rate, the buyer must earn $1.53 and pay 53 cents in taxes to net that one dollar. Buyers may enjoy some tax planning opportunities such as depreciation, but depreciation takes time to recover, and the up-front tax burden on the buyer remains high. For a $10 million business, under the same tax assumptions, the buyer pays about $5.3 million in income taxes. Many business owners, business buyers and tax advisors do not appreciate the tax treatment because it is hard to see. The buyer usually will not earn the $15.3 million in a single year, so there is no income tax return showing $5.3 million in taxes. But if the business in this example was purchased in 10 equal installments without interest, each year the buyer would have to earn $1.53 million and pay about $530,000 in taxes to write the seller a check for $1 million.

Eventually the seller will owe taxes, preferably at long-term capital gains rates. (It is possible that the seller could have basis that would reduce capital gains taxes; it is also possible that some portion of the sale proceeds could be taxed at higher ordinary income rates.) At a current federal rate of 15 percent, each dollar the seller receives is reduced to 85 cents. Combine the buyer's taxes of 53 cents-per-dollar, and the seller's taxes of 15 cents-per-dollar, and you'll see that 68 cents of every dollar of business value goes to taxes. The combined federal income tax rate on the purchase and sale of the closely held business may be 69 percent of the business value or higher. Without your advice, the business owner who suffers from the myth that the gross price is paramount likely will gloss over these issues.

Myth #5 - The "Five-year Plan"

Most successful owners stay so busy meeting immediate needs that long-term projects often get postponed, especially if it appears no harm will come from the delay. Exit planning is one of the items that frequently ends up on the back burner. In fact, many owners and advisors suggest serious planning can wait until as late as five years before the owner expects to be ready to retire. This is a serious error. In his best-selling book The Seven Habits of Highly Successful People, Stephen Covey advises "begin with the end in mind"--sound advice for business owners.

The fact is that many exit-planning strategies and tactics are problematic or even unavailable unless the owner has many years--far more than five--to plan ahead. For example:

o Selecting the ideal legal business entity is an important exit-planning consideration. Less time, however, restricts an owner's options. For instance, owners of C corporations may avoid double taxation at sale by having converted to S corporation status. However, the tax benefits may be lost if, subsequently, the company is sold within a 10-year holding period after conversion. The "five-year myth" leaves an owner in this situation with little recourse.

o Preferably, an owner seeking to sell times the sale to ideal market conditions, a favorable interest rate environment and a healthy industry. But many business cycles can take years to complete. Committing to a sale within a shorter time period may limit the owner's ability to achieve the most favorable climate.

o Family business succession planning often involves gifting assets using the annual gift tax exclusion and other tax-free transfers. If the outgoing generation wants to exit within a few years, little time is available to maximize the effectiveness of annual gifts and other strategies.

o Many exit strategies benefit from the effect of compound growth on invested assets. For example, funding a retirement plan creates future income outside the business as well as current year income tax deductions. Fewer years to implement this strategy greatly stunts growth in a retirement plan or other accumulation strategy.

In a recent example, we witnessed the sole owner of a successful business announce to his son and two other key employees that he was tired and wanted to be bought out "in three years." The main problem this owner and his management team faced was not money, common goals or good motives. It was the lack of time. The buy-out eventually occurred, but only after strained negotiations and broken family ties. More time would have permitted a happier ending

These five commonly held myths are, in fact, roadblocks to sound exit planning. Once the advisor helps to remove them, the emotional and financial rewards for owners, employees and families can be enormous.

Patrick A. Ungashick, CLU, ChFC, CFS, a partner with White Horse Advisors, LLC, in Atlanta, specializes in succession planning. He can be reached at patrick.ungashick@whitehorseadvisors.com.

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