Top Four Common Mistakes Business Owners Make with Exit Planning.

Top Four Common Mistakes Business Owners Make with Exit Planning. Prepared by. Richard Watson, CFP, CHFC, CLU. Senior Director of Planning, Business Advisory Services. Joe Fahey, CFA. Senior Director of Planning, Business Advisory Services. In this white paper 1 Mistake #4: Not understanding after-tax cash flow needs for retirement 2 Mistake #3: Expecting an all-cash deal 2 Mistake #2: Only speaking with or seeking one prospective buyer 3 Mistake #1: Lack of preparation 5 Conclusion

Top Four Common Mistakes Business Owners Make with Exit Planning At some point, every business owner faces a business transition. As the business interest often represents the single largest asset on many owners personal balance sheets, its value can represent a lifetime of focus, energy, and work. As such, for business owners making decisions around their business transition and exit planning, this time can often be charged with emotion and stress. Not only are they having to manage the day-to-day operations of their business, but they may also need to respond to questions and concerns from stakeholders and prospective buyers around due diligence, deal structure, and financing, to name a few, often with short timeframes during the transition or sale window. implications. For this reason, owners would do well to carefully consider the impact of their business transition on their personal wealth plan as soon as possible ideally long before the business transition event. Chart 1. Hypothetical Example of After-Tax Cash Flow Pre- and Post-Transition 100% 80% 60% 100% 10% decline 100% 90% Pre-Transition Post-Transition 60% decline While every owner, business, and transition is unique, there are four common mistakes that we see business owners make when trying to transition their business, whether it s a sale or passing on their business to family or to employees. This paper will review these mistakes and make possible suggestions for business owners to consider. 40% 20% 0% Business Owner #1 40% Business Owner #2 Mistake #4: Not understanding after-tax cash flow needs for retirement. When weighing the complex topic of transition and exit planning, many owners focus more heavily on improving diversification or receiving liquidity (or a headline transaction value) as a result of the transition, but not necessarily on how the timing of the transition or the amount from the proceeds will impact their retirement picture and long-term standard of living. This step can be especially critical in some instances because after-tax cash flow can actually decline post transition, particularly for owners who have historically paid themselves a handsome wage or significant dividends or distributions. For example, Chart 1 depicts two business owners assessing what their cash flow needs would be post-transition. Business owner #1 s after-tax cash flow will be approximately 90 percent of what it was pre-transition, while owner #2 s after-tax cash flow will only be 40 percent of what it was pre-transition. While both owners anticipate a decline in cash flow post-transition, owner #2 s cash flow declines by 60 percent post-transition, which may have profound long-term retirement planning Source: Wells Fargo Wealth Management, 06/14 Suggestion: Review your cash flow and retirement income needs considering both pre- and post-transition scenarios. If you re a business owner, gaining a clear understanding of your personal balance sheet, sources and usage of cash flow, income tax liability, as well as your risk and liquidity profile both on a pre- and post-transition basis can give you powerful insight as to when (or even whether) you should keep or sell your business. This may be particularly important when selling a business during a strong economic or market cycle. Many owners plan to invest their post-sale proceeds into a diversified portfolio of stocks and bonds, yet many marketable securities may be at all-time highs. Especially when it comes to retirement planning, a common mistake that business owners make is in not planning adequately for their retirement. Only about 36 percent of business owners have Individual Retirement Accounts (IRAs), less than two percent of them own a Keogh plan, and only about 18 percent of Top Four Common Mistakes Business Owners Make with Exit Planning 1

business owners participate in a 401(k) or qualified retirement plan sponsored by their company. At other times, money received from the transition or sale of a business may be more than sufficient to satisfy long-term retirement planning needs, though undertaking a purposeful assessment can help to confirm the fact. Owners may want to consider not only developing a disciplined strategy and timeframe for an optimal asset allocation for their retirement portfolio, but also implementing more sophisticated estate, charitable, and wealth transfer planning strategies during the pre-sale window. This phase-in investment strategy may provide business owners with the added luxury of not feeling rushed to put their post-sale proceeds into marketable securities all at once. It may be beneficial to have a discussion with your relationship manager and legal and tax advisors about how this liquidity will impact your wealth plan. Mistake #3: Expecting an all-cash deal. Contrary to what many business owners may think, business transitions are not typically all cash transactions. The majority of transitions in fact involve seller financing, earnouts, and escrow/holdback arrangements meaning that while an owner may receive some cash at closing, he or she may also receive a significant portion of the purchase price over time. Chart 2. Percentage of Deals that Involve Seller Financing, Earnout or a Escrow/Holdbank Arrangement 100% 80% 60% 40% 20% 0% 30% 39% 89% Seller Financing Earnout Escrow/Holdback Sources: 2014 Capital Markets Report, Pepperdine University Graziadio School of Business and Management; 2013 Private Target M&A Deal Points Study, American Bar Association Suggestion: Engage an advisor who can help determine what deal terms can be achieved realistically in the current market environment. This can have important retirement planning and risk management implications for business owners who are not receiving full liquidity at closing. It s also possible that many owners will not have any wage income from the business post-transition unless an employment or consulting agreement is being contemplated as part of the deal s terms. This means that business owners may carry a level of risk until the terms of the promissory note or earnout are completed since future payments may be at risk if the acquiring company faces a financial reversal or downturn. An after-tax cash flow analysis, such as the one just discussed, can help to better position owners as they negotiate the timing, amount, and security of contingent consideration in a deal. In some instances, it may even save an owner from entering into a deal that may have had calamitous long-term retirement planning implications. We recommend working with your relationship manager to understand how this event will impact your personal wealth plan. Mistake #2: Only speaking with or seeking one prospective buyer. At one time or another, many owners receive unsolicited offers from competitors, strategic buyers or private equity groups. These offers may come through at various times throughout the year, leading to a scenario where an owner is essentially evaluating one offer at a time. For example, an owner might receive an unsolicited offer from a competitor or prospective buyer and pursue it for several months, only to discover that after due diligence, the purchase price or terms were not satisfactory for both parties. Months later, the owner may receive another unsolicited offer from a different source, leading to a repeat of the process, but with the same result. These failed attempts at business transitions can result in great frustration, increased transaction costs (i.e., expenses to perform due diligence with multiple sequential buyers), and consume precious time that the owner could be spending to manage and grow the business. Then, even if an unsolicited offer ultimately leads to a sale, the business owner may not know with certainty whether the purchase price and the terms of the deal were truly the most optimal since the transaction would lack the context and comparative view provided by a disciplined sale process. 2 Top Four Common Mistakes Business Owners Make with Exit Planning

Chart 3. Example of a Disciplined Sales Process with Potential Multiple Bidders* $80 $75 75.3 Lack of a cultural or strategic fit between selling firms and their financial, strategic or industry buyout candidates also present a significant issue for some firms. Chart 4. Percentage of Deals Not Closing $70 $65 $60 $55 $50 $45 65.0 65.0 60.0 62.0 62.5 65.3 60.0 58.0 58.0 54.0 55.0 55.0 55.0 55.0 56.0 56.0 50.0 50.0 53.0 49.0 52.8 54.0 55.0 54.0 54.0 53.0 52.0 45.0 47.5 50.0 50.0 30% Not Closed 70% Closed Source: 2014 Capital Markets Report, Pepperdine University Graziadio School of Business and Management $40 A 42.5 B C D E F G H I J K L M N O P Q R S T U Potential Acquiror Source: Wells Fargo Wealth Management, 06/14 * It is important to note that results may differ and depend on a company s positioning in the industry and current market conditions. Chart 3 reflects a hypothetical scenario where a business owner receives 21 different offers from prospective buyers. Each prospective buyer is represented as a letter on the chart s horizontal axis and their respective purchase price ranges are represented on the vertical axis. While all the prospective buyers received the same information at the same time, each had a differing view on what the company was worth. As you can see, the offers ranged from a low of $42.5 million to a high of $75.3 million for the same company. The low end of each blue bar represents where that prospective bidder s first offer started, while the high end of each bar represents its best and final offer. In addition, the terms of the offer may differ for each deal. Some buyers may offer more cash as a part of the transaction, while others may offer larger non-cash terms (such as seller financing, an earnout or acquiring company stock in lieu of cash). Approaching multiple bidders with a coordinated, disciplined process, as opposed to one buyer at time, may entice all bidders to put their best foot forward or risk losing the deal. Further, companies that have prepared to go to market and do find a buyer do not always close the deal. One of the biggest reasons given for deals not closing is the inability of the selling owner and the prospective buyer to overcome differences in how each party viewed what the business was worth (i.e., the expected purchase price). Suggestion: Keep all your transition options open and know what your business is worth. Just as business owners should not limit themselves to just one prospective buyer, they also should not consider just one transition option. Many owners, in fact, face a predictable set of strategic alternatives for the transition of their business. In addition to multi-generational family business transfers, businesses also can be transferred in other ways: n Selling to management (management buyout) n Selling to an employee stock ownership plan (ESOP) n Selling to a financial buyer n Selling to a strategic buyer n Going through an initial public offering (IPO) Each of these options has distinct advantages and considerations. The most appropriate type of business transition may depend on an owner s near- and long-term transition planning objectives, the company s current performance and position in the industry, and prevailing market conditions, among other factors. When appropriate, pursuing a sale through a disciplined auction environment, whereby multiple prospective bidders all review the same information at the same time, may help enhance the probability of finding the right cultural and strategic fit for the company at a purchase price and terms that may best meet the owner s long-term transition (and retirement) planning goals and objectives. Mistake #1: Lack of preparation. Finally, business owners should honestly assess the readiness and attractiveness of the business prior to going out to market. A helpful step in this process can be Top Four Common Mistakes Business Owners Make with Exit Planning 3

deliberately thinking like a buyer, which entails appraising the company s strategic positioning, weaknesses, and business risks across the competitive landscape, much in the same way that a prospective buyer would during the sale process. This provides business owners time, during the pre-sale window, to resolve any business or legal issues that might arise during the actual sale process, helping owners to not only determine a realistic timeline to go to market, but also maximize the business value to prospective bidders, possibly increasing the probability of a deal s closing. Not doing so could result in taking the company out to market too early. Allowing a group of bidders (or the industry) to know the company is for sale, for example, can expose the company to added risk, particularly with key employee retention and opportunistic competitors who may exploit this information with the company s customers and suppliers. For owners personally, it also risks the possibility of not completing a transaction on their own terms, often as a result of purchase price adjustments or concessions that occur in the heat of the sale process due to issues arising during due diligence. Chart 5. Possible Exit Planning Transition Options. Alternatives. Rationale. Practical Issues. Status Quo. n Continue growth and build scale. n Enhance competitive position. n Maintain ownership/control value creation. n No incremental risk introduced. n Difficult to fund increased growth. n Lack of wealth diversification. n Postpones liquidity/future value uncertain. n Business execution risk. n Does not address needs of junior partners. Management Buyout. ESOP. Majority/Partial Sale to Financial Partner. Strategic Sale. IPO. n Capitalizes on experience of existing management team. n Provides key managers with the potential for a significant financial return. n Key managers may be able to preserve their present job and income stream. n Management can utilize leverage to finance the purchase. n Company financial position can support an ESOP transaction. n Opportunity to benefit all employees. n Equity ownership motivates employees and increases commitment level to the company. n Potential tax benefits deductible contributions, section 1042 tax deferral. n Liquidity event for selling shareholder(s). n Limited voting rights to plan participants. n May provide liquidity while preserving some upside. n Provides additional financial/strategic resources. n Desired liquidity can be varied. n Helps to equalize junior partners and founders. n Addresses key shareholder goals. n Complete liquidity event; potential spike valuation. n Opportunity to combine with a larger, well-capitalized player. n May increase access to clients and accelerate growth. n Reduces business execution risk. n Headline transaction. n Partial liquidity. n Stock value established on a daily basis. n Access to long-term capital. n Public awareness of company. n Management team may not have skills to effectively manage the business. n Owner retains business execution risk to the extent he/she finances the transaction. n Liquidity available to owner depends on the financial position of management. n Leverage may impair financial flexibility. n Possible loss of control. n Feasibility study needed. n Owner s desire to benefit all employees. n Administrative costs associated with an ESOP. n C-corporation vs. S-corporation tax issues. n Qualified plan subject to ERISA rules. n Repurchase obligation with respect to departing employees. n Selling shareholder typically retains business execution risk. n Leverage may impair financial flexibility. n Valuation discount to outright sale. n Significant involvement from investors in company post-transaction. n Possible loss of control. n Modest leverage increases financial risk. n Market valuation. n Loss of control. n Management roles post-closing. n Transaction execution risk. n Lack of operating confidentiality. n Loss of management control. n Pressure for short-term performance. n Ongoing costs of being public, including Sarbanes-Oxley compliance costs. n Potential undervaluation. Source: Wells Fargo Wealth Management. 4 Top Four Common Mistakes Business Owners Make with Exit Planning

Suggestion: Conduct preliminary due diligence on your company. One way to help minimize this result, as well as to work toward positioning the company for a successful transition or sale, is to conduct preliminary operational, financial, and cultural due diligence on your company. Irrespective of whether business owners intend to keep the business in the family or position it for a sale to a third party, this exercise can help owners address any issues that might have proven to have been a nuisance or challenge (or resulted in a price adjustment or concession) during the implementation of the transition or sale. Table 1 illustrates several common areas of consideration for prospective buyers. These areas of consideration should be reviewed in advance and resolved, if necessary, in an effort to put the company in the best light prior to the transition. Conclusion. Mindful of these four business exit planning potential minefields, business owners may be able to achieve the following benefits with advance planning and preparation: n Identify, assess, and compare multiple transition options at the same time n Position the company for a transition n Minimize or resolve negatives issues that may arise during due diligence n Enhance the probability of a closing n Remain focused on running the business While planning for business transitions can be complex, following a disciplined process can help owners confidently plan and execute a successful business transition and maximize outcomes for all stakeholders. To learn more about business exit planning, please consult with a Wells Fargo relationship manager today. End notes. 1 Saving for Retirement: A Look at Small Business Owners, Office of Advocacy, U.S. Small Business Administration http://www.sba.gov/sites/ default/files/rs362tot_2.pdf 2 2014 Capital Markets Report, Pepperdine University Graziadio School of Business and Management 3 2014 Capital Markets Report, Pepperdine University Graziadio School of Business and Management Table 1. Common Issues of Consideration for Prospective Buyers Preliminary Diligence Area. Management Structure. Business Plan and Budgeting. Industry, Market, and Competitive Information. Marketing and Sales. Production/Manufacturing. Research and Development. Employee Relations and Benefits. Information Systems. Legal. How well positioned is the company for a transition? Prospective Buyer s Consideration. How deep is the management team? How are they compensated? Do employment contracts and incentive compensation programs exist? A prospective buyer may also want to identify the age, experience, and responsibilities of key management personnel. How are financial controls exercised in the company and by whom? Does the company have a written business plan, with budgeting, or is it more decentralized? Does the management team use forecasts and projections to manage the business, and, if so, how? Has it met or failed to meet its forecasts/projections historically? Does the company have compiled, reviewed or audited financials? Typically, a buyer will want to understand the industry and the company s competition as this information is critical to assessing the company s future performance. Who are the company s competitors (by product line and by geographic region)? What is the basis of the competition (price, quality, service, relationship, and location)? What are the competitive advantages and disadvantages of the company s products and services? How are the company s marketing and sales functions organized? How is the sales team compensated (salary or commission)? A prospective buyer may also want to understand the company s sales policies, prices, discounts, service, and returns. What production methods and processes are employed by the company? A buyer may want to confirm the present utilization of the available capacity, personnel, and space factors to assess the company s current and potential future productive capacity. How critical has developing new and unique products been to the company s historical success? If significant, a buyer may want to evaluate the company s R&D effort and pipeline over the past three to five years, as well as the company s ability to develop new products. Avoiding the loss of key employees after a purchase is often a critical concern for prospective buyers. They will want to understand the make-up of the existing work force (size, skilled or unskilled, union or nonunion), how they are compensated (salary and employee benefits), and which employees are critical to maintaining current levels of operations and profits. In what condition is the company s information technology, and is it readily upgradeable? How much of the software is customized? How concentrated is the knowledge base of the software and other IT functions in a few individuals? Does documentation of IT procedures exist? A buyer will want to confirm legal title to all major company assets, verify disclosed liabilities, search for unknown liabilities, and determine if key contracts are assignable. Typical areas of review include possible royalty and licensing, warranty service contract, environmental, patent and trademark infringement, employee discrimination and harassment, product liability obligations, etc. Both sides will also want to know what corporate and shareholder approvals will be necessary for a transition. If new senior debt will be added as part of a transition plan, will the company have the financial strength to service the new debt? Will the company have sufficient liquid assets to cover its operating costs during the transition period? Will the management team be flexible enough to adapt to a change of ownership? How will change management be communicated and implemented post-transition? Top Four Common Mistakes Business Owners Make with Exit Planning 5

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