Every consultant will tell you that you can’t begin planning early enough. But even if you’ve made no move yet to create a plan, all hope is not lost. Though you can’t wake up and say, “I’m shutting down this afternoon”—unless you just want to liquidate and walk away—you can come up with a transition strategy that will work for you.
Don’t go in alone, though. Surround yourself with a team of professionals—business broker, accountant, banker, attorney, insurance agent—and create a “formal or informal board of advisers ... People who have bought or sold businesses and who may or may not be in your industry; people who will ask the tough questions,” says Lauren Owen, a principal at Redpoint Coaching, in Seattle.
Path FinderThere are a finite number of ways to transition out of your business. Leaving IPO creation and liquidation out of the mix, most remodeling company owners opt for sale to an outside third party or a transfer to someone inside. How do you know which strategy is right for you?
When Inc. editor-at-large Bo Burlingham spoke with business owners for his upcoming book about exiting one’s business (Finish Big comes out this summer), he researched the differences between happy and unhappy transitioners. It turns out money isn’t the No. 1 factor; people tend to underestimate the emotional side of leaving their business. “They don’t really know,” Burlingham says, “until they don’t have it anymore, what exactly it is they got out of their business,” which, after hundreds of interviews, he narrowed down to purpose, pride, and structure
Figuring out the best way to arrive at those three elements, developing a picture of yourself as a former company owner, and asking yourself “Who am I? What do I want and why?” will help you pick the best transition path. If there are immediate financial goals you have to meet, selling to an outside third party might be best. If you’re keen to have someone carry on your traditions, then transferring the business to a child or key employee is a good option. If yours is a large, profitable company and you want all your employees to benefit, then creating an ESOP (employee stock ownership plan) is the answer.
If there are immediate financial goals you must meet, selling to an outside third party might be best. If you’re keen to have someone carry on your traditions, transferring the business to a child or a key employee is a good option. If yours is a large, profitable company and you want your employees to benefit, an ESOP (employee stock ownership plan) is the answer.
“It’s a hard process no matter what exit strategy you choose,” says Barbara Taylor, co-founder of Synergy Business Services, in Bentonville, Ark. “You have to choose an option you’re confident about committing to.”
Undergoing a business valuation will also help you determine which path to take. For example, if you’re considering selling outright, the valuation will indicate whether you even have something someone would be interested in buying.
You could hire someone to complete a business valuation, but a good business broker can also do an affordable market-based appraisal. When Paul and Nina Winans sold their 27-year-old remodeling company to an outside party, they started by posting the sale on several online sites. “We got a lot of responses, but we bailed because we were freaked out,” Paul says, “We had never even bought a house without a real estate agent. We were never the kind of people who did anything without the help of professionals.” Eventually they found a business broker who showed them what made their business sellable and helped them come up with a value.
Goodbye and Good Luck
The outside, third-party sale: If your company is prepared, you have no children or key employees willing to take over, and you’re emotionally ready, an outright sale is appealing. But it’s an unlikely scenario for most small-business owners. According to Richard Parker, president of the Business Buyer Resource Center, it looks like:
- 90% of all people who begin the search to buy a business never complete a transaction.
- Just 20% of all businesses listed for sale ever sell.
- 50% of all transactions agreed to between the buyer and the seller fall apart during the due diligence stage and never close.
It’s especially difficult to sell a service-industry business such as a remodeling company. For one thing, many of these businesses are run like practices that revolve around the owner. “You should always shoot for operational irrelevance as the owner,” Taylor says. What made the Winanses’ business a good candidate for sale was that they had a systematized company with manuals for a number of different positions and processes. “Basically, we followed the E-Myth,” says Paul, referring to the best-selling book by Michael Gerber that encourages business owners to work on their businesses and not in them. “We ran the company as though we were going to franchise it.” The other factor that made their company attractive was that the Winanses owned the building that housed the business, making it easier for the buyer to get a loan.
The way that you structured your business in the first place—as an S-corp. or a C-corp., for example—also plays a role in its sale. “The worst way to get out of your business is if you’re a C-corp., and the best way is if you’re an S-corp.,” says Ken Stiefler, a certified exit planner and the president of Exits, in Denver. He’s referring to double taxation. Basically, with a C-corp. you never paid taxes over the years on all the intangibles of your business—the value of your location, your reputation, your client list—what’s referred to as “blue sky.” But those intangibles—those possibilities—are what help to increase your business’s value. Now the new owner will have to pay tax on the corporate level on the gain of those intangibles, and you’ll have to pay capital gains tax on what you receive.
In an S-corp., you may have paid more in taxes over the years, but you now avoid the corporate level of taxation (and you still make out better). Since the buyer doesn’t have that extra tax burden, it may make it less difficult for him or her to purchase your business. (For a more in-depth discussion on this topic, read Steifler's white paper about C-corp. vs. S-corp.)
It can take 12 to 24 months (or more) of planning and preparation to ready your business for sale, and then it might take a year to actually sell it, Taylor estimates. Once you do, you could get a good down payment, but then the rest of the sale will have to be financed. All-cash offers have become difficult in the banking climate of the last few years, Stiefler says. He saw many owners unable to exit. “They lost control and agreed to stay under an employment agreement for a couple of years,” he says. “But if they didn’t like working for others and started their business years ago because of that, they might not like working for someone else now.”
What’s more likely: You will have to hold a portion of the purchase price. “But this way, you’re playing banker with someone you don’t know, and there’s a certain amount of risk,” warns Josh Patrick, principal of Stage2 Planning Partners, in South Burlington, Vt.
Transferring ownership to a child or a key employee(s): Every year you should sit down to discuss what everyone in the family wants to do, Owen says. “Sometimes Mom and Dad are certain that their kid wants to buy the business, but the kid isn’t sure. Or the kid thinks that Mom and Dad will sell to him, but they actually want to sell to a third party.”
Ken Moeslein, former owner of Legacy Remodeling, in Pittsburgh, has two sons. Before transitioning ownership, he discovered that his younger son had no interest in the business, and his older son worked in the business for seven years or so before deciding that he wanted a future in it. Once that decision was made, it was then a five-year transition, Moeslein says, adding, “We took our time nurturing and training him.”
And there are emotional issues to deal with. How difficult will it be to work alongside or to work for a son or a daughter (or a former employee)? How important is it to keep the traditions you created? The company culture? You even have to decide if you want to give the business to your children or to sell it to them.
“In my experience,” Patrick says, “if you don’t sell the business, the children don’t value it.” On the other hand, purchasing the business can be a stumbling block that a parent might not want to put in front of the new owner.
But pre-tax dollars can be used to purchase the business, and you can hold a promissory note that the new owners will pay back over time.
All Hands on Deck
The employee stock ownership plan (ESOP): Not many remodeling companies would take this on—for one thing, the ESOP needs to be done in a profitable business with at least 15 employees—but Iris Harrell, a 30-year veteran of the industry and soon-to-be former owner of Harrell Remodeling, in Mountain View, Calif., has always been daring.
Years before it became popular to do so, Harrell was offering 401(k) plans with a matching component as well as health insurance for her employees. Harrell is highly principled and believes in the legacy she has created and in the value of her employees. “When I realized that I couldn’t carry this load forever,” she says, “we had about 30 employees and we wondered what would happen to them. They were talented. We wanted to find a way to pass on the legacy of the business.”
An ESOP fit her company culture, in which all employees already felt empowered. “And once you make the transfer and really set it up, people start acting like owners. Little things changed. People picked up trash in front of the building. Everyone needed to contribute their best at all times and we couldn’t tolerate weak players,” Harrell says.
In an ESOP, a company sets up a trust for company stock, which is funded by the company from tax-deductible pre-tax earnings. Owners can defer taxation on gains by reinvesting in other securities. Owners can sell all at once or in installments, and they have the option to define their future role. “It’s a great way to spread capitalism,” Harrell points out. “Employees earn ownership by becoming fully vested after three years of successfully working in the company.”
Stocks come from company profits “so we have to have enough profit to pay everyone their salary and to pay our bills. We have a goal for retained earnings since it takes a lot of capital for cash flow. Above that we have to have enough for capital improvements,” Harrell says. Profits go to the employee owners based on their salary. The higher earners, since they contribute more to the company, get more stock.
“The 21st century requires collaborative leadership,” Harrell says. “Everyone has an observation that is important, no matter where they are in the company.”
Regardless of how you end up structuring an exit strategy, all the sources we spoke with for this article agree that you can’t fund your retirement though the sale of your business. Think about diversifying now—purchasing real estate, starting a consulting firm—and having other retirement options so you can say, like McAdams does, “If the business fails and three years from now we want to shut this down, my wife and I will be OK.”
The Happy Transitioner
As Inc. editor-at-large Bo Burlingham discusses in his new book, Finish Big, those who are happiest after transitioning out of their businesses are those who:
- Look back with pride on what they accomplished while they had the business.
- Feel OK about the process they went through and what happened to the people who had been on this journey with them.
- Feel comfortable that the rewards received for their business were fair.
- Have moved on and are engaged with something else that may also fulfill their needs as their previous business had done.
The Experts Weigh In
Putting a Number to It
“It’s such a low multiple for construction-related businesses because they are perceived as having a low barrier to entry and they tend not to have recurring revenue because a lot of them have a bid process, which drives the value down,” says Barbara Taylor, co-founder of Synergy Business Services in Bentonville, Ark. The broker for Paul and Nina Winans considered “owner irrelevancy” (can the business survive without the owner?) along with owners’ compensation plus benefits plus net profit and then subtracted the amount of money that would have to be paid to employees to do the things Nina and Paul were doing. The broker then added three years’ worth of information, divided that total by three, and picked a multiplier to come up with a final figure. -—Paul Winans
Work for It: The Earn OutWashington state remodeler Len McAdams founded McAdams Remodeling & Design, in Kirkland, 40 years ago and began thinking about transitioning out of his business 10 years ago. After deciding to sell his company to an inside employee, he is just now beginning the “earn out” phase.
Here’s how it works: The buyer obtains shares for monies that come out of future earnings that he will pay back to the seller over several years. The seller gets the share of the company profits while the buyer is buying step-by-step until, at the end of the earn-out period, the seller is out and the buyer is in. McAdams’ earn out will take 10 years. In Year 1, the buyer pays his 10% of the net asset value of the existing company—everything but intangibles. At the end of Year 1, the business distributes 10% of its profits to the new buyer and 90% to the seller since he still owns 90% of the shares of the new entity. On that same date, the buyer is obligated to buy his next 10% of shares. This process repeats each year until the new owner has 100% of the shares and 100% of the profits. —Len McAdams