Critical Questions That You Need To Answer If You Own A Business!

Building a business is hard work. Protecting and preserving it is even harder and overlooked by business owners.

While many owners expect family members to take over the business (69%), very few have actually made plans to make sure their wishes are accomplished (26%), even though they realize the importance of estate and succession planning as is an integrated part of that planning.[i]

A succession plan is complex, time consuming and involves attention to details along with many hard questions which need to be answered for a comprehensive and effective succession plan.  It is also the key element in maximizing the return on the investment of your business. This is the big financial payout, the sale of your business.[ii]

SOME MAJOR QUESTIONS AND ISSUES TO ASK YOURSELF!

What if a shareholder wants to sell their interests?

  • Is there a right of refusal for the other owners?
  • What are the financing arrangements?
  • What are the recourses if you fund the buyout especially if the funding is over a long period of time?
  • What is the arrangement if the business fails, how will you get your money if you financed the sale?

 Who steps in your shoes if you want out? 

Not everyone has the luxury of leaving a business when and how they want to.  Things like death, disability, and situations are uncontrollable.

  • What are your contingency plans when a trigger occurs (death, health, non-voluntary situations)?
  • Do other members of the firm have access and authorization to use funds to keep the business going if there is such an event?
  • Does your family take on personal obligations for financial notes and loans you have signed personally to fund your business operation?
  • Do you have estate documents and health care directives, should you have a disability or become incapacitated?

Taxes- and the planning for them Continue reading “Critical Questions That You Need To Answer If You Own A Business!”

The Story! The Cost of Funding Your Buy and Sell Agreement! Options!

The Story! 

The Cost of Funding Your Buy and Sell Agreement! Options!

Over many years I have experienced many business owners in total denial about the cost of funding their buy and sell agreements, thinking they can come up with the liability when the trigger of death occurs.

The four listed ways are compared below.

  1. Cash
  2. Borrow
  3. Sinking Fund
  4. Life Insurance

Let’s take the one by one.

Cash: This is assuming the company has the cash at hand, idle. Rarely is this an option. Growing companies reinvest in their company and only keep enough cash reserve as needed.

Borrow: A company just lost a valuable member of the company. Most bankers would probably want to see how the company will fair after the death of a key person and would want to know how the liability which has just been created will affect the cash flow of the company before loaning more money. There probably is a good chance that outstanding line be pulled in by the bank (probably a covenant in the loan agreement).

Sinking Fund: Mostly just theory! In 48 years, I have never seen a company try to develop a sinking fund. If the company was putting money in the sinking fun, they are losing the opportunities this money could create by investing in the business rather than on the sidelines. Not reasonable as the actual amount of money needed is available should death occur prior to the target date of accumulation. The least appropriate method.

Life Insurance: At its simplest benefits, it is immediate, tax free and the funding level is immediately known. Also, the cost is only 17 cents on a dollar rather than the much higher costs of the other three options.

Summary: While we don’t know when a death or disabilitymay occur, the company should at least be prepared for this trigger. Today the price of life insurance is low-cost. There is no reason not to purchase at least temporary life insurance (10-30 years), such as term insurance. The cost of life insurance in the example is using cash value life insurance.  Increased Sales To Fund Cost: Another measure of effectiveness of funding the buy and sell is to measure how much more in sales the company has to do to pay for the funding method.

Costs:  Funding over 15 years. 

Cash; 1,039,464 Loan: 1,306,085. Sinking Fund: 901,613 Life Insurance:  171,512

Also, what do you need to have in sales to pay for the method: 

Example, with Life Insurance Cost, @20% profit, sales would be $857,560

With Cash: There would have to be $5,197,320

 

 

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Lifestyle and Enterprise Business

In John Brown’s June 2019  blog , the article discusses the difference between Lifestyle and Enterprise Business, he discusses that fact that many businesses are formed to accommodate the lifestyle of the owners without giving too much thought as to the long-term effect of the business value when it is sold.

While the business is up and running, it is doing exactly what the owner wants it to do, and that is to provide a steady and profitable income to carry the lifestyle of the owner and their family.  Again, this is  great for the business owner, their families and businesses in general.  However, the article discusses the problem when the owners are forced to sell, or just want to sell and exit the business.

Business owners may think they can run their businesses as a lifestyle business and still plan for an exit of their business for the highest potential value.  This is a myth, since the strategy of exit planning involves different philosophies and strategies used to grow the business best potential value.

Most business owners don’t really know what their businesses are worth.  Because of this, they never understand why they don’t receive the perceived value upon post exit.    Also, many business owners take for granted, the perks from the business as normal and ordinary.  These perks evaporate once they exit.  A double hit to the owner of a lifestyle business model.

The article emphasizes the fact that you can’t have it both ways if you wish to exit your company at the best possible price. Business owners who are running a lifestyle business, must turn that business into a business enterprise if they expect to exit their business at the highest possible price.

A business enterprise has transferable value.  It needs to be worth something to the purchaser, for example an equity group, as lifestyle value means nothing to a private equity group compared to the business owner of a lifestyle business as they both have different philosophies of business purpose.

Turning a business into a business enterprise is basically creating a business that is worth something to people or entities beyond the owner.  Brown suggests the transforming of a lifestyle business to an enterprise business is a challenge mostly because of the owner’s emotional attachment to the business, and limited owner resources. 

It has given him and his family a nice lifestyle, freedom and pride.   “Why should he change anything?” The owner created this baby, loved it, invested in it and build it.  Consequently, it is not only a physical transition but a psychological transition. 

When you look through the eyes of an outside investor, they are looking for other aspects about the business, mostly  flaws  of the business, inefficient  areas of the business, management, potential return on investment, cash flow, potential growth and  a host of elements needed to make a future profit from the purchase and sales of the business, not lifestyle to the owner. 

Continue reading “Lifestyle and Enterprise Business”

Disadvantages Of The Buy And Sell Agreement! [i]

Certainly, having a Buy and Sell Agreement (BSA) has many advantages, many of which I have discussed in our past posts (May 2019, Advantages of Buy and Sell Agreements).  However, I would like to go over the disadvantages of a BSA.

RESTRICTIONS ON ESTATE PLANNING

BSA can restrict ownership transfers and consequently management duties. These restrictions can be applied to you also. The restrictions could limit your personal planning by limiting your options for the ownership interests during your lifetime or at death. It may prohibit you from making gifts of your ownership interest to your family. Depending on your planning, your BSA could limit your plans to leave ownership interest to your family. The BSA may require your ownership interest to be sold at your death.

RESTRICTIONS ON FINANCIAL PLANNING 

A BSA can restrict the persons to whom you could sell your ownership interest to and restrict when you can sell it.  An example would be in a situation that you need to sell your interest because you’re in a financial bind. The BSA may require you to sell to your entity or your co-owners, who may not want to buy.

Special election to the defer federal state tax of deceased owners

This could limit an estate owner from using Code Section 6166 which is a way of paying your estate tax over a period of time, giving you the option of paying over a 15-year period, five years of deferral and a ten-year payout.  A purchase from your estate could cause the loss of the right to defer the estate taxes.

A sale of Corporate interests may result in a loss of the entities corporate structure

This could limit the entities right to use its own loss carry back and carry forward losses on a significant change in ownership, which is possible without a well throughout BSA.

The cost of putting together a BSA

It takes time and money to put together a solid buy and sell agreement, Of course this is a disadvantage and it can be expensive, however, in order to have an optimal BSA, you will need to invest time and money.  You will also need a competent council to prepare the necessary documents.  This incurs costs.  Being educated in this strategy is to your advantage when designing your BSA.

A poorly drafted buy sell agreement can be costly:  By failing to carefully work out the terms of buy-sell agreement or by having mismatches between triggering events and the identity of the purchaser versus the funding source, a real mess could be created.

[i] Buy -Sell Agreements for Baby Boomer Business Owners Z. Christopher Mercer, ASA, CFA, ABAR

Alternatives To Buy And Sell Agreements – Different Documents To Put Buy Sell Agreement Language In!

  1. Governance documents– Articles of incorporation, partnership, organization, bylaws or operating agreements frequently have Buy And Sell Provisions (BSP). Is critical that you change your agreement within these documents should you update to a formal BSA, so the language is consistent.
  2. Compensation based plans: Such as consulting agreements and salary continuation plans.
  3. Entity recapitalization: It is possible to recapitalize the ownership interests of the entity which could create differences and ownership interests.
  4. Gifts of ownership interest: this could change the ownership and voting rights.
  5. Charitable gift of ownership interest. Same as #5.
  6. Private annuities: You could transfer ownership of your interest to someone else in exchange for a promise to make payments for you for the rest of your life
  7. ESOP’s: EMPLOYER STOCK OPTION PLANS.
  8. Non-qualified deferred compensation plans.
  9. Qualifying for section 6166 deferral.
  10. Division of an entity.
  11. Confidentiality and non-competition agreements; In conjunction with a buy and sell buyout , the former owner could be paid to not compete with the entity and to keep secret all confidential trade secrets, customer lists, and other private proprietary information of the entity.
  12. Installment sales: The owner simply wishes to retire and sells the stock in exchange for promissory note that is payable overtime.
  13. Sale to outsiders.
  14. Public offering.
  15. New generation opening a similar type of business: This is where senior generation winds down and a new generation may open a similar business preferable to allow younger generations to open a new look but similar to the identical business of the old. The dying on the vine concept.

*A good read would be “Buy and Sell Agreements (US Legal Series); Paul L. Hood Jr.  Also, I have included a link to article from Ed Partesi, ASA,CM&AA of UHY Advisors “Covering the bases:  “The Need for Effective Buy -Sell Agreements”. Effective Buy and Sell Agreement!

Lastly,  a very good book to read about the future of the selling your business,  “Your Exit Map”   by  John Dini;  This gives you a great insight as to the next generation of buyers and the market place for selling your business.  

 

Be An All-Star Employer and Build Future Value In Your Business!

When you go into your own business, do you have a place to go, a paycheck, and a position?  You basically have a job.   However, when entrepreneurs go into business, they look for the big payday, the selling of their business.    Would it be nice to sell your business for 10 or 20 times your annual salary?

Building a business is not easy.  If you are going to put your efforts into building a business, build a business with a great foundation.  It is easier to build value in a business with a good foundation.  Let’s assume you have systems in place and a business presence.  What is needed for real growth once you get through the systems and organization formats, is to create and develop a business culture!

By having a business culture, marketing and recruiting get easier and less expensive as people are more attracted to your company.  Long –term employees get to know the business, your customers you’re your suppliers.  They become more efficient and become the “team”.   You will attract better quality candidates to hire.  You can become more selective and create the right roles for your employees.

Go to Trader Joe’s and ask the employees how they like working there.  You will soon find out that there is little stress, a lot of fun, and the employees want to be there working side by side with each other.

When employees are happy and like their jobs, they stay, they learn, and they attract investors and future purchasers.  This culture promotes profitability and consistency, which is how you maximize your potential profitability of the company.  Consumers like consistency and the added value of having a company that is easy to work with.  I like to call this the “Amazon Factor”.  Who doesn’t like ordering from Amazon? They make it easy for many reasons.

Having this type of environment doesn’t automatically happen.  You need to invest in it to create it, however, it will pay off in the future.  They key is to start early creating the vision you have for your company long-term. Create the vision of being the “All-Star Employer”, and you will attract the best, like minded employees, and create a great business that people will want to work at.

 

Advantages Of A Buy Sell Agreement And Some Dynamics Of The Agreement!

It’s important to understand that every Buy and Sell Agreement (BSA) is different and has a separate purpose when put together and implemented. Because of the vast differences in BSA’s, using a standard form of BSA rarely accomplishes the needs and wants of the parties involved.

Each participant in the agreement has different purposes and objectives and looks at the transactions very differently. Neither party knows when the agreement will actually be needed, and what the triggering event will be. A triggering event could be death, disability, divorce, termination,  bankruptcy, and other defined events.   One thing that can is consistent in most cases is that when a triggering event happens, then each party becomes visionless to the other parties’ best interests, and only focuses on their own and best interests.

The two participants in a BSA are a seller and a buyer. They come in different forms, as individuals, trusts, or estates. Usually their purposes and objectives are very different, and there usually is a conflict between the parties.

While creating the BSA  the parties tend to be very fair before a triggering event. This is because everybody is in the same position and no one knows who will suffer the future triggering event. This is a positive viewpoint, as the parties are reasonable and objective about the possible and various scenarios. Everyone’s objectives are personal, and range from financial, tax, to personal protection for their families.  Having a designed BSA can offer the owners some satisfaction that their needs are documented and witnessed.

Objectives of BSA

  • To provide a predetermined roadmap for the business based on a triggering event which may call for the sale of a participant’s ownership interest.
  • To provide a guaranteed buyer for the owner’s business interest and to create a market for that interest.
  • If funded through life insurance or some other means, the BSA will provide liquidity for the payment of the business interest and help the estate pay for the estate taxes and other settlement costs of the deceased owner’s estate.
  • Can avoid an impasse between the parties in the event of a triggering event.
  • To protect the company and surviving shareholder from subsequent competition, should a terminated owner wish to sell to a 3rd
  • To avoid potential conflicts between the surviving owners and the deceased owners’ heirs, by creating a roadmap through the agreement at the owner’s death.
  • Can level the playing field for the estate or deceased owner’s as the agreement gives the deceased owner a say on how settlement of their interest will be to their heirs and estate. Especially, when the surviving family have little knowledge of the business entity.
  • Establishing the price and method of valuing the interest, establishing the terms of payments, and providing a method of funding for the payment of that purchase price.
  • Can create job stability for minority owners and key non-owner employees.
  • Can establish the value of the entity for tax purposes.
  • Can preclude owners from selling their interest without the consent of others thus avoiding the third-party ownership or voting percentages.
  • The agreement can restrict ownership to people who are actively engaged with the entity of full-time basis.
  • Can improve the credit worthiness of the entity.
  • Can avoid transfer violations/Licensing requirements.
  • Avoid transfers to individuals that would terminate the S corporation status.
  • Can dictate discounts for lack of marketability (minority interest discounts).
  • Can provide for voting agreements where necessary.
  • Can dictate what happens to in force life insurance policies on the terminated or surviving owners.

These are only a few of the many reasons for a buy and sell agreement, and the advantages of funding the agreement.