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Planning That Lets Business Owners Exit 'In Style'

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The term “business continuation” is often used to describe succession planning. We find, however, that what the closely-held business owner really wants to know is, “How can I leave my business in style?”

The answer to this question is more than the identification of a successor owner or creation and funding of an agreement. It involves business, personal, and family issues–both financial and psychological. When the life underwriter orchestrates a process to help the owner answer his or her fundamental question, both the owner and the life underwriter benefit.

The owner/client receives the guidance necessary to develop and execute an exit plan. The life underwriter becomes a key player on the owner’s planning team, establishes a deeper relationship with the owner, and is positioned to reap greater financial rewards.

Consider the “typical” successful business owners situation. As the business (and its owner) matures, the owner reaches a point at which he or she would like to slow down, but thoughts of leaving the business speed up. Even the most thoughtful and successful owner is at a complete loss when it comes to planning his or her exit.

At a minimum, the owner needs to determine: 1) how much money is needed from the sale of this company; 2) when he or she wishes to leave; and 3) to whom does the owner want to transfer the company.

These and many other questions–all unanswered–serve to frustrate and stall the owner’s efforts to move forward. Family issues can be particularly vexing. In focus groups held by the Principal Financial Group, we observed family business owners delaying succession planning because they feared angering children when deciding who gets what. These parents are classic examples of owners who build successful businesses, but arent sure how to leave them.

We suggest that life underwriters use a methodical seven-step exit planning process, proven to be effective with thousands of business owners, to help their clients.

Each step of the exit planning process can be framed as a question. As the owner works toward an affirmative answer to each question–with the close involvement and guidance of advisors–he or she creates a workable, customized exit plan.

1. Do you know your exact retirement goals and what it will take–in cash–to reach them?

2. Do you know how much your business is worth today, in cash? Beyond what you provide the banker or the IRS, do you really know the economic value of your business?

3. Do you know the best way to maximize the income stream generated by your ownership interest and do you know how to increase the value of your interest?

4. Do you know the best way to sell your business to a third party that will maximize your cash and minimize your tax liability?

5. Do you know how to transfer your business to family members, co-owners, or employees while paying the least possible taxes and enjoying maximum financial security?

6. Do you have a continuity plan for your business if the unexpected happens to you?

7. Do you have a plan to secure financial independence for your family if the unexpected happens to you?

Answering these questions affirmatively requires thought and action on the part of both advisor and business owner. Lets use question five as an example of the need to think outside the business continuation box.

The successful transfer of a company to a child, key employee or co-owner depends on four elements:

–The ability and dedication of the prospective new owners;

–A company with strong, consistent cash flow and little debt;

?–A transaction structure that prevents income taxes from eroding the cash flow available to the seller; and

–Insurance protection for both buyer and seller in the event either dies before the transaction is complete.

Income taxes have a corrosive effect on the sale of a business to “insiders”–children, key employees, or co-owners. Few insiders have enough cash–especially after taxes–to buy out owners.

Therefore, sales to insiders take years to complete–a potentially risky prospect. Further, all of the cash used to purchase ownership must come from the future cash flow of the business after the owner has left it. If not properly planned, cash flow will be taxed twice. It is this double tax, which spells disaster for most internal transfers. Consider the following hypothetical situation.

Karl, a business owner, agreed to sell his company to a key employee, Sharon, for $1,000,000. This value was based on the company’s annual $250,000 cash flow, which Karl historically took in the form of salary. While Karl understood that Sharon could not pay $1,000,000 he thought she could buy the company over a five- or six-year period using the company’s available cash flow.

Karl’s calculations were wrong. The time needed for a buy out was at least 10 years. Why? Taxes.

Under Karl’s plan:

1. Sharon receives the cash flow ($250,000 per year) and is taxed at a 40% rate.

2. Sharon pays $100,000 in taxes (40% of $250,000). This is the first tax on the business’s cash flow.

3. Sharon pays the remaining $150,000 (net after tax) to Karl.

4. Karl pays a 20% capital gains tax ($30,000) on the $150,000 he receives for the sale of his ownership interest. This is the second tax on the original stream of business income.

So, what’s the end result? The company distributed $250,000 of its cash flow but Karl pockets only $120,000.

As you can see, without proper tax planning, an owner pays an effective tax rate in excess of 50% on the company’s available cash flow used to fund his or her own buyout. Taxes alone can prevent the consummation of a sale of a business.

What can an owner do to avoid disaster, minimize taxes and maximize the opportunity for success?

1. Put a plan in place that yields the owner a greater after-tax amount for the sale of the company. Since the cash flow of the company will not change, the key is to allow the IRS a smaller bite of the available cash flow.

2. Use an experienced team of financial professionals, usually consisting of an attorney, CPA, and financial representative. Each must understand the effect of taxes on both seller and buyer in order to make more money available to the owner.

3. Use a modest but defensible valuation for the company. A lower value for the purchase price reduces tax cost. The difference between what the owner will receive from the sale of the business (at a lower price) and what the owner wants to be paid after leaving the business can be made up using a number of techniques that extract cash from the company. (For example, a bonus or deferred compensation plan).

Similar challenges face owners in every step of exit planning. Knowing how to guide owners through the exit process is one of a life underwriter’s most valuable tools.

Life underwriters who offer a comprehensive approach to exit planning help their business owner clients achieve their most important goal: leaving their businesses in style.

Reproduced from National Underwriter Life & Health/Financial Services Edition, February 11, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.

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