It may be years before you sell your business, but it’s time to plan your exit strategy
Dec 07, 2018 11:42AM
By Kathleen Maris
By Donald L. Reichert
President, The Reichert Company
What’s your business worth? You’ve probably heard the question posed to you before or even pondered it yourself.
If you’re a business owner, your business more than likely represents a lifetime of effort and has provided you and your family with a comfortable living. Most business owners depend on their business—or the proceeds from its sale—to provide for a comfortable retirement as well. So why is knowing your businesses value important, particularly if you have no plans of leaving the business for years?
Before you scratch “business valuation” off your to-do list, consider five important reasons to put getting an “estimate of value” at the top of that list. An estimate of value:
1. Establishes your starting line and distance to the finish.
2. Tests your exit objectives.
3. Provides important tax information.
4. Gives you a critical litmus test.
5. Provides owners and employees with an objective basis for incentive plans.
You might be thinking, “Why spend the money? I have no plans to leave anytime soon and I know the value of my company better than any expert.” Consider the following points about just what this estimate of value would provide you:
- It’s not a full-blown opinion of value that you will need anyway prior to transferring your business;
- It costs only about half as much as a formal standard opinion of value;
- It forms the basis for the later complete valuation; and
- It’s primarily used for planning purposes—your planning. It cannot be relied upon for tax purposes.
Reason 1: Establishes your starting line and distance to the finish
Business exit planning, properly executed, should follow a specific path and generally involves at least six distinct steps. All business exit plans should be able to answer three critical questions in specific terms: What date do you want to leave? To whom do you want to sell it? And what do you want or need for it to ensure a comfortable post-exit life?
Few business owners are comfortable relying on averages or rules of thumb. Informal yardsticks rarely take into account variations in revenue, cash flow, proprietary technology, and other factors that can have a significant effect on the value of their business. What do you think the odds are that a sophisticated buyer would be willing to acquire your business without first determining its worth? Why shouldn’t you?
Reason 2: Test your exit objectives
Your business exit objectives will likely center around one critical question: “How much am I going to need from the sale of my company to maintain the lifestyle I’ve enjoyed and want to continue for myself and my family during retirement?” A relevant companion question should be, “Is the business worth enough on an after-tax basis to support those needs?” An estimate of value will tell you if the distance between today’s value and the finish line is too great to reach within your specified exit-time horizon.
Reason 3: Provides important tax information
As alternative exit paths are considered, it’s important to recognize that a sale to a third-party versus a sale or transfer to insiders could have vastly different tax implications. Without appropriate tax planning, taxes can take a huge bite out of the business sale proceeds. Whereas there are a variety of strategies that can be used to mitigate the erosion of sale proceeds due to taxes, they often take years to implement.
Sales or transfers to insiders or family often involve the transfers of minority interests at a discounted value. Rest assured that if challenged by an IRS audit, the typical “rule of thumb valuation” that business owners too often rely upon (because they did not want to spend the money for a professional valuation) will not fly with the IRS in justifying the discount. An independent valuation specialist is in a better position to defend the position before the IRS.
Reason 4: Gives you a critical litmus test
Many business owners are surprised to find that business value is relative, not fixed. In the case of a third-party sale, business value is not only dependent on a company’s intrinsic value, but also on the market cycle of the merger-and-acquisition marketplace. Value can also vary significantly based on the choice of successor. In companies with multiple owners, unless value is periodically updated for buy-sell purposes, one owner may receive too much or too little upon the death, disability, or unexpected departure of another owner.
A business owner looking to ultimately exit and monetize his or her business needs to know if there is a “gap” between the amount ultimately needed to ensure financial security and the value of the business today. The resulting “gap amount” tells the owner how much value they will need to meet their exit objectives, as well as where time and effort need to be concentrated to close that gap should there be one.
Reason 5: Provides owners and employees with objective basis for incentive plans
Whether plans are to sell to insiders (in many cases key employees) or to outside third parties, it’s important to motivate and keep key employees and management intact. To accomplish this, owners often use incentive programs that both motivate and “handcuff” employees to the company. These plans are typically based on some formula related to the growth of business value. Any participating key personnel are justifiably interested in knowing how the business value is established, the metrics used to monitor its growth, and whether the value is fair. If a transfer to key employees is in consideration, would you expect your employees to accept an unsupported valuation? Would you not be concerned about leaving money on the table with too low a value?
Getting a handle on the value of your company well in advance of your exit point is generally well worth the money spent. The cost of an estimate of value can vary significantly from as little as $1,500 for a “calculation” to as much as $25,000 for a full-blown appraisal and is largely driven by the size and complexity of the company being valued. It is advisable to use a credentialed valuation expert. Common certification designations are CVA (Certified Valuation Analyst), ASA (American Society of Appraisers), ABV (Accredited in Business Valuation), and CBA (Certified Business Appraiser).
The exit from your company is likely to be the largest financial transaction of your life. Doesn’t it make sense to understand what your business is worth and what the value drivers are that make it one of your most valuable assets?