Why exit planning is becoming more critical than ever
Currently there are about 28 million small businesses in the U.S.—those employing 500 or fewer employees. Of these, about 19 million have zero or one additional employee. Of the remaining 9 million, 3.5 million are owned by persons younger than 50 or older than 70. Therefore, 5.5 million businesses are owned by the Boomer Generation. Boomers are 25% of the population but own 60% of small businesses with a total value variously estimated at $10–$15 trillion.
During the last 10 years, early Boomers have been selling primarily to late Boomers. From here on in, Generation Xers, now entering their forties will be the prime business buying group. Beginning in 2013, for the first time, and every year thereafter, the primary motivation for business sales has been Boomer retirements (Pepperdine University, Market Pulse Survey 2013).
The story of the Gen Xers is well known. They famously don’t define who they are by what they do. Life outside of work defines them. They want limited work commitments, flexibility in work schedules, benefit portability, and convenient technology so that they can work away from the office. Xers don’t get this lifestyle by owning businesses. I recently had the opportunity to address a large group of business owners—about 60% were Boomers, with most of the rest Xers with a smattering of Millennials. I asked the following question: Would you pursue an opportunity that required working 55 hours per week? Virtually all the Boomers said yes while the Xers for the most part wouldn’t consider it regardless of the amount of money they could earn. Xers are simply much less likely to invest the sweat and make the commitment required to own and run a business.
Retiring boomers are plagued by uncertainty: Will I have enough money to retire particularly considering my long post-retirement life expectancy? Can I maintain my lifestyle? What about healthcare? About 70% of business owners over 50 plan on selling in the next 5 years and 85% of owners over 60 plan on doing so. The Boomer business owner fantasy is “I’ll find a young buyer just like me who will pay me all the money I need to retire.” Unfortunately, there are far fewer buyers for Boomer businesses than there are sellers. Boomers have been building businesses that Xers don’t want.
If that weren’t enough of a problem, the exiting Boomer faces 2 additional headwinds. 1) Tax rates are going up so that net proceeds from a sale are diminished and there will be a higher tax burden on investment income. 2) We face a future of diminishing investment returns. It was not so long ago that a retiree could expect an annual return of 5%–7% on a conservatively managed retirement portfolio. In an era of 1% CDs, 4% investment grade corporate bonds and 2% 10-year Treasury bonds those expectations have become dramatically reduced.
The seller’s world over the next 10 years looks like this: a flood of businesses coming to market, many of which will not find buyers. So Boomer business owners face the perfect storm: a diminished pool of buyers and a reduced investment return on the after-tax sale proceeds. As we see it, the Boomer business owner has 5 options.
1) Ignore the problem. Every business owner eventually leaves his or her business—voluntarily or involuntarily. Let’s just see what happens.
2) Wait and watch. You know what is coming but your competition doesn’t. Keep track of financial indicators, follow closely the trends in your industry and in the broader Mergers & Acquisitions market. Listen hard if you receive unsolicited offers.
3) Execute an orderly liquidation. In order for a business to be saleable, it must have transferable value. If the business can’t run without you, it will be very difficult to sell. If realistically you can’t sell your business, focus on accumulating savings and develop a nest egg outside the business.
4) Prepare for a sale. The good news is that high-performing companies are in high demand. There is a tremendous amount of cash from pension plans, family offices, and private investors looking for a home in the acquisition of high quality private companies. This type of investment is attractive because it offers a much higher rate of return than can be found in the stock market. Such a company must be ready to go to market. It should have a minimum of a 3-year history of steadily increasing revenue and profits, financial metrics (such as gross and net margins, return on assets and return on equity) in the top quartile of its industry, a solid management team, and processes in place that will allow a new owner to continue to generate superior returns. Such a company will attract buyers willing to pay high multiples. Buyers today would prefer to pay 7 times earnings for top quality companies rather than 4 times earnings for mediocre companies. But make sure you sell before the next recession.
5) Hire your buyer. The best opportunity for many companies is a sale to a key employee. If that person is not currently in your organization, go out and find her, groom her for leadership, and then prepare a plan to sell to that key employee. That plan should include a transition of management responsibilities, an initial sale of a minority interest—typically 10%–20%—followed by a sale of the remaining interest, preferably using outside financing. In order to obtain outside financing, your key employee/buyer must show a proven capacity to manage the business as well as have an equity stake.
The more attractive of these options—especially 4 and 5—require significant planning. Even an orderly liquidation will typically require at least a year to plan. Preparing a company for sale requires at a minimum a pre-sale due diligence review and establishing incentives to keep key employees in place after the sale. The planning here will take on the order of 18–24 months. A sale to a key employee is likely to be the option of choice for most Boomer businesses and presents the most planning challenges. Management transitions take a minimum of 2–3 years, longer if you need to hire your successor. Planning and time are required to get ownership interests to the key employee(s)/buyer(s) and cash to the owner in a tax efficient manner.
Boomers are not doing the planning necessary to achieve a successful exit from their companies. As we noted above, most Boomers are planning on exiting their businesses in the next 5 years but according to a recent survey by the Business Enterprise Institute, only about one-third have even had a conversation with a professional advisor about planning for that event. We venture to guess that fewer than 15% of business owners over 55 have developed any sort of plan for exiting. Most business owners don’t know the value of their companies and don’t have any idea whether their business is saleable. This is a recipe for disaster. We are entering an environment in which planning is becoming increasingly important but Boomers are very slow to begin that planning. The longer you wait the more difficult it will be to plan a successful exit.
Published in Business2Business magazine, April 2016