At a recent presentation to business owners, an owner told me the following: Despite the economy, his business hasn’t lost a beat. The company is doing better than ever. Yet he had a business appraisal done and his business is worth less than it used to be. How can that happen?
This business owner is the victim of a buyer’s market. The recent economic downturn has not only hurt the profitability of many companies; it has also limited the number of viable buyers for businesses. Less liquidity, less financing and less demand translates into lower values and fewer parties able and willing to buy businesses.
Private business owners, whether selling internally or externally, must act now to review their business values and buy-sell plans, and to adjust their exit plans. Failure to do so can mean delayed retirement, unfulfilled estate plans and unnecessary business failures.
The current economy can be a two-edged sword of opportunity for owners who get ahead of this issue and a potential disaster for those who don’t. One potentially effective way to get ahead of the issue is to perform a buy-sell review.
What is a buy-sell review?
A buy-sell review entails more than having an attorney review the language of a buy-sell agreement. There are 3 key elements to a review. First, the business must be valued. Second, there should be a review of existing agreements that involve the disposition of the business. Finally, a review needs to be made of the funding for the exit plan.
The object is to determine if the designated business value is accurate in this changed economy. The agreement is reflective of the intended exit plan and the funding is in place to make the plan actually viable. Failure of any one of these elements can mean failure of the entire exit strategy.
In an environment where business and asset values are lower than in past years, a buy-sell review can be a particularly important business planning step. The economy-driven changes in valuations can cause unwanted outcomes such as:
? Overpaying for a partner’s ownership interest;
? Inability to buy an interest because of reduced credit lines
? Insurance that is misaligned to the buy-sell terms.
Further, as exemplified by the business owner quandary mentioned above, the economic conditions may have changed an otherwise valid valuation or buy-sell agreement. For example, consider a business owner who had a $5 million estate when she set up her estate plan 3 years ago. On the advice of her attorney, she set up a bypass trust for which the federal estate tax exemption ($2 million at the time) would pass to her children; the remainder would pass to her husband.
The increased federal estate tax exemption and a lowered business value may cause this well crafted plan to fail under current conditions. Assume that her business (and estate) is now only worth $3.5 million and the federal exemption has risen to $3.5 million. If she were to die this year, all of her estate would go to her children, disinheriting her husband. This is an unintended outcome, in part caused by a significant change in the value of her business. A buy-sell review can help avert this outcome.
Kick-starting the exit plan