Business Owners’ Special Series #26
Tapping your professional network is a no brainer for things like recommendations of vendors, finding talented employees and getting general advice. However, relying solely on your professional network and not seeking professional support when planning a high-stakes business transaction and exit planning can be a costly mistake.
Let’s look at the case of Martin, who never engaged professional support to develop an early stage exit plan, because he thought his professional network provided sufficient free advice.
Fifteen years ago when Martin started his business, he had few assets and little money. After starting his business he dreamt of “someday selling it for a million dollars.” It was a huge dream at the time, but Martin was now on his way to exceeding that goal. His annual profit had reached $3 million for each of the past five years, and he decided it was a good time to sell his business.
Martin discussed his plan to sell the business with many friends in the industry, including one who recently sold a business of similar size. He received consistent advice: Businesses in this industry sell for five times its earnings.
Based on this advice, Martin was certain, considering the $3 million in profit his business was bringing in, he could sell his business for $15 million. He was ecstatic and could not wait to hold the $15 million check in his hand. His friend who recently sold his business introduced Martin to his buyer, and he was off to a profitable business exit. Or so he thought…
At the end of the day, Martin sold his business for $9 million, not $15 million. After taxes, Martin had $4.5 million. After paying off $2 million of business debts (a condition of sale from the buyer), Martin was left with $2.5 million. While $2.5 million is a nice chunk of change, it was not even close to the $15 million Martin anticipated after his peers mislead him to believe he could sell his business for five times its earnings.
Martin made a number of mistakes during the process of selling his business. First, he was not prepared for a sale. He lacked an exit strategy and the knowledge of what the exit process would entail, or that he could engage in a process to maximize the value of his business. He did not understand what the buyer’s due diligence process would include, nor did he understand how the buyer was valuing his business.
Second, Martin did not know what businesses in his industry sold for. The ‘five times its earnings’ prediction he received from his peers was actually just an average price for his industry. A professional advisor could have helped Martin determine the range of prices for his industry, based on recent industry transactions. This would have shown Martin that ‘best in class’ businesses in his industry had sold for six or seven times earnings, but ‘below average’ businesses had sold for only three or four times earnings.
Additionally, an advisor could have helped Martin develop an early stage exit plan that would examine Martin’s business from a buyer’s perspective and identify areas where Martin could have made strategic changes to enhance the value of his business. Martin had the potential to change his business from ‘below average’ to ‘best in class.’ He could have then sold for seven times its earnings, or $21 million, instead of $9 million. Ignorance, lack of planning and relying solely on the advice of peers cost Martin $12 million.
Thirdly, Martin’s friends advised him that he could save on taxes by allocating the purchase price to “intangible assets,” which would be taxed as capital gains rather than as ordinary income. Martin noted that advice very carefully and made certain that over 95% of the sale price was allocated to intangible assets, with a nominal amount allocated to equipment.
Martin paid the highest ordinary income tax rates on his business sale, and not the lower capital gains tax rates. His taxes were closer to 40% instead of 20%, doubling the amount Martin paid in taxes. Was the advice his peers gave him incorrect? “Allocate the price to intangible assets” was not wrong, it was just incomplete.
Almost all of the purchase price paid to Martin was allocated to a non-compete agreement and a consulting contract, both of which are taxed at ordinary income tax rates. Even worse, the consulting contract is subject to Social Security and Medicare taxes. Martin paid far more in taxes based on this advice, because he did not consult with a tax professional.
Finally, Martin did not solicit multiple offers for his business, he dealt exclusively with one buyer, the same buyer who purchased his friend’s business. Martin was not aware that there are many types of buyers and that different types of buyers pay different prices. He did not understand that having multiple buyers interested in his business would have created competition, which would have driven up the price he could sell for.
Martin could have walked away from the sale, once he realized he was not going to receive $15 million, but he was so consumed and overwhelmed by the sale and due diligence process that he took his eye off business operations and his business began to suffer. He felt compelled to sell the business before things got worse.
Over 70% of the businesses that go to market fail to sell, as many sellers walk away from the sale transaction when they realize their business is worth far less than they thought it was. This is not where you want to be as a business owner. An astute business owner is always preparing for sale, and always focusing on value. Savvy business owners are working on their exit strategy every day, especially when they are not ready to sell their business.
Too few owners take this long-term strategic approach to developing an exit plan focusing on building value. Do not make Martin’s same mistakes. Instead, start business exit planning now. Educate yourself on the process, learn about different types of buyers and see which type aligns with your exit plans. Learn how buyers view value in your business, or lack thereof. Most importantly, seek professional assistance and do not let peers and friends lead you to a DIY plan.
Rich Gunn leads BPM’s Value Acceleration Service Team, which helps with succession planning, transition business exit strategies and exit planning for business owners. Rich is a Certified Exit Planning Advisor and a member of the Exit Planning Institute.
The Business Owners’ Special Series (B.O.S.S.):
The Business Owners’ Special Series (B.O.S.S.) is a library of information for business owners who are proactively seeking guidance from experts on how to implement value acceleration in their business. Be sure to keep reading, if you desire to develop your business to its maximum potential value and gain an understanding of how and why beginning the process sooner results in building greater value.