Category: Mergers & Acquisitions
How to Develop an Exit Strategy to Sell Your Business for Maximum Value
Every business owner wants to realize the maximum value when they eventually sell their business. The question is what should you do now to prepare for the sale of your business and maximize business value?
As Middle Market Business Brokers we have sold hundreds of businesses ranging from manufacturing to technology, construction, and Healthcare plus other industries. While these businesses are in diverse industries, the companies that sold for premiums and sold quickly had several things in common. We have outlined the key elements in developing an Exit Strategy to prepare for the sale of your business and maximize the business value.
Developing an Exit Strategy for the Sale of Your Business
Here’s a 7 step outline, with details for each step below, for developing an Exit Strategy to maximize the value of your business. A good exit strategy will also make your business more marketable and reduce your time on market. Your Exit Strategy is essentially building your business to sell.
- Owner Dependency
- Customer Concentration
- Financial Statements and Tax Returns
- Tax Strategy to Minimize Taxes on the Business Sale
- Financial Performance
Buyers place a great deal of importance on the ease of stepping in and running the business. Replacement of the owner is a chief concern in every transaction.
If you have delegated well and have staff handling much of the day to day operations this makes your business more desirable to buyers. Conversely, if your business is highly dependent on your expertise and customer relationships and there are no staff members capable of taking on these responsibilities buyers worry about how to replace you and the transition. If you have delegated much of the day to day operations to staff you have built a business. If your business is completely dependent on you, you essentially have a job with helpers.
Your Exit Strategy should address Owner Dependency to minimize owner dependency as well as plan for the eventual ownership transition.
Staff is also important to buyers and a key factor in selling a business. Buyers like to see staff stability (long tenures), good experience, and in larger companies supervisors, foreman, and leads. If your company is large enough to have managers this is a big plus with prospective buyers.
We don’t recommend adding unnecessary staff as part of your Exit Strategy as this would reduce profitably and thereby business value. Rather, we recommend optimizing the staff you have to build a better business that is less dependent on you, has stability and is transferable.
For example; if you have experienced and long time employees capable of taking on more responsibility, such as becoming a supervisor, start developing them and give them more responsibility.
Likewise, focus on staff retention, especially for key employees.
Businesses with excellent systems, procedures, and a well trained staff operate more efficiently and also are more marketable when they are offered for sale. Buyers see businesses with systems and infrastructure as an easier acquisition and transition as compared to those where everything is in the owner’s head. This doesn’t mean you need to create reams of documents covering every minute detail of your operations, but the essential procedures and policies should be in place to cover day to day operations. The goal is to create a business where you are easy to replace and a new owner can step in without relying on you for an extended period of time.
If your company has a broad customer base that’s great as it minimizes the risk and financial impact of losing any one customer.
If your company has one or several customers that represent a substantial percentage of your business this increases risk and is a concern for prospective buyers. We have successfully sold companies with customer concentrations as high as 70% for one customer. It’s not an easy transaction when a single customer represents a very high percentage of the company’s annual sales and it can make the sale of the business take much longer as well as affecting business value.
If your company has high customer concentration there are essentially two actions you can take when developing your Exit Strategy.
- Development and implement a plan to diversify your customer base. This may involve simply developing new customers in your existing area and services or expanding your geographic area and services.
- Securing long term relationships. In some industries it may not be feasible to simply add more customers due to the company servicing a very narrow niche. Being a niche player has its pluses and minuses. On the positive side, niche suppliers often command better margins. On the negative side these markets are also often narrow and have limited customers which result in high customer concentration. If you have high customer concentration but have had long term relationships with these customers this can be dealt with in the sale with an experienced Business Broker. The key is to show the relationship is mature, secure, and most importantly transferable to a new owner.
Your company’s financial statements are absolutely critical in the successful sale of your business. The tax returns must be current and your P&L should closely match the tax returns (note there are commonly small differences).
Your company will be valued based on the tax returns and the Discretionary Earnings calculated from there. Discretionary Earnings are the Net Profit from the tax returns plus owner’s salary and all benefits/expenses.
Below we talk further about financial performance and Discretionary Earnings. Read more about calculating DE here.
In developing your Exit Strategy make sure you review your P&Ls and tax returns with your CPA and clean them up if necessary. After an offer is received you will have to prove the company financial performance in Due Diligence and this goes much easier with well organized financial statements.
Tax Strategy to Minimize Taxes on the Sale of the Business
There will be taxes on the sale of your business. The question is how much. There is no simple answer to what your tax liability will be. It depends on many factors including the type of sale, Stock or Asset Sale, the structure of the sale, the type of entity your company is and your past tax returns (depreciation, etc).
There are actions you can take to minimize or defer your taxes on the sale of your business. Tax planning should be a key part of your Exit Strategy and you should meet with an expert. If your CPA says there’s not much you can do about it and you’ll just have to pay the taxes (yes, some of our sellers were told this) you should seek a CPA that is familiar with this type of tax planning and get some additional advice. There are several tax strategies available that can substantially reduce and defer your taxes. These strategies have a wide range in cost, complexity and savings. A CPA familiar with this type of tax planning can advise you on your options.
Your company bottom line, or in this case Discretionary Earnings, has a direct and proportional relationship to the value of your company. Broadly speaking, for every dollar added to your net profit, two to three dollars are added to the value of your business. So if you add say $10,000 to your bottom line or Discretionary Earnings your business value increases between $20,000 and $30,000.
A common mistake made by business owners is to focus on minimizing their annual tax liability and in doing so they often gut their net profit. As a result they are also gutting their business value. This doesn’t just impact the current year, it impacts your business value for as much as 3 years because a business is valued on the tax returns for the past 3 years.
Before we address how to preserve business value without paying excessive taxes, let’s discuss Discretionary Earnings aka DE. Businesses are not valued simply on the Net Profit shown on the tax returns because most businesses have a large amount of owner’s salary and benefits included in the expenses. Discretionary Earnings is used to value small and midsized businesses instead of Net Profit or EBITDA. DE is the total economic benefit the owner derives from the business. It is calculated by taking the tax return net profit and adding the owner’s salary plus all benefits and expenses run through the business.
As you can see, you can minimize the Net Profit and preserve the DE by tracking owner benefits and expenses on your tax returns. It is best to have owner benefits and expenses well identified in separate expense categories so they can be easily verified during Due Diligence and underwriting if SBA financing will be used.
Another, often overlooked, way to minimize taxes without reducing Discretionary Earnings and thereby business value is starting a retirement plan. The owner’s retirement contribution is added back as an owner’s benefit. Many business owners think the cost of a retirement plan such as a 401K or Defined Benefits Program is prohibitive because they would have to include employees in the plan. We have sold several businesses that had retirement plans. The owners were able to contribute substantial amounts into the plan and the costs of providing the plan to the employees was reasonable. Offering a retirement plan is also great for employee retention and recruitment.
Revenue and profit growth is obviously a key financial metric. Businesses showing steady growth often sell at a premium and businesses with declining revenue and profits are difficult to sell, often being discounted. Driving revenue and earnings growth should be a focal point of your Exit Strategy. It should be noted that businesses with steady or flat revenue and earnings are also very marketable. For buyers, the key here is minimizing risk and financial stability delivers this.
ADDITIONAL INFORMATION ON SELLING A BUSINESS
- Essential Steps in Preparing Your Business for Sale
- How to Confidentially Sell Your Business
- Pacific Business Sales Steps in Selling Your Business
- “Own Your Future, Straight Talk about How to Buy a Business and Build Your Future” by Bill Grunau
- Benefits of Stock vs Asset Sale in Sale of a Business
- FAQs Selling Your Business
Small Business Survival through COVID-19
COVID-19 has shut down businesses across the US and worldwide. In most US states non-essential businesses have been ordered or requested to close, employees have been told to work from home, and the general population has been told to stay home as much as possible. These are times no one has faced before and business owners are facing challenges no one could have anticipated or planned for. As a business owner you must plan carefully, think strategically, and above all else take action to ensure the survival of your business. Many people depend on you and your company; your employees, customers, and community all depend on small business owners like you.
Companies Providing Essential Services
Some companies are fortunate to provide essential services such as defense/military equipment and manufacturing, healthcare, essential construction services, financial services, etc. While the nature of their business requires these companies to stay open, which ensures their financial survival, they are facing unique challenges during this time that must be dealt with.
- Health and Safety of your Staff:
The health and safety of your staff should be of paramount concern. Since they are needed to work during this crisis it is critical to educate them in good health practices in the workplace and at home to minimize the risk of them becoming ill and potentially infecting others. If they suspect they are sick they should stay home and see a doctor if necessary. Ensure that your staff are taking this seriously.
- Maintaining a Safe Workplace:
- Implement Work from Home where possible
- Provide hand sanitizers and hand washing soap/sinks
- Maintain Social Distancing at the workplace
- Encourage the staff to wipe down workstations and clean the facility
- Keep Customers Informed:
Stay in touch with your customers and let them know your company is operating. Let your customers know what steps you have taken to maintain a safe workplace and a healthy staff. Keep them informed of schedule or delivery changes.
- Maintain Your Supply Chain:
Contact your suppliers to confirm they are open and your scheduled deliveries are on schedule. Consider looking into backup suppliers in case your supply chain is interrupted.
- Manage Cash Flow and Expenses:
Although you are fortunate enough to still be operating this is a turbulent time with business conditions changing constantly and quickly. Preserve your cash in case customers start paying more slowly and to cover unexpected expenses or interruptions in your cash flow. Likewise, now is a time to watch expenses carefully in order to maintain both cash and profitability. If cash becomes tight you can work with your vendors, creditors, bank and landlord.
- Preserve and Expand Lines of Credit:
Your credit lines may be needed if cash gets tight. You can explore the possibility of getting higher limits on your credit lines and credit cards in case you need them later.
Companies facing temporary shut down
Many companies such as restaurants, hospitality, retail, and consumer service businesses will have no choice but to shut down during this crisis. The duration of these shutdowns is unknown and as a business owner you have no way of knowing what the economy will look like when your business emerges and reopens. Below are some steps to take to ensure your survival and plan for your re-emergence.
- SBA Disaster Loan:
The SBA has a special disaster loan program for COVID-19 affected businesses. You can apply online but be aware the website is running slow from the flood of applications. There is an 800 number for help, but it is flooded as well and wait times are very long. The process requires a lot of paperwork (listed below), but you can complete it on your own with some patience. NOTE: you can save your work on the application if you don’t have everything you need at the time and come back to complete it later.
SBA COVID-19 Disaster Loan – Economic Injury Disaster Loans link: disasterloan.sba.gov/ela
- Loans up to $2 million
- Loans are for substantial economic injury where the business is unable to meet its obligations
- Required Documentation
- Disaster Loan Application – 3 pages completed online
- IRS 4506T transcript authorization (you can fill this out online and submit it)
- Company/Corporate Tax Returns (you can upload or email separately)
- SBA form 413 Personal Financial Statement (you can complete online)
- If 2019 taxes have not been filed, 2019 Year End P&L is sufficient
- Year to Date P&L and Balance Sheet
- SBA form 1368 monthly sales (you can complete online and email separately)
- NOTE – if you have problems uploading your documents you can email to firstname.lastname@example.org or fax to the SBA at 202-275-5852
- City & State Small Business Relief Programs:
Several cities and states have launched small business emergency loans ranging from microloans in the $5,000 range to loans up to $200,000. You can do a Google Search for your city and state and also see the list below from Forbes.
List of Small Business Relief Program, Forbes
List of Banks Offering Relief to Customers Affected by COVID-19, Forbes
- Manage Lines of Credit:
If you have lines of credit you are likely going to have to tap into them. View these as your safety net and do your best to minimize the use of these, you will likely need these credit lines when it’s time to reopen.
- Control Expenses & Cash:
Even though you are shut down there are still expenses rolling in. Work with your vendors, landlord, creditors and bank to minimize your payments until you reopen.
Check your insurance policies to see if you have business interruption insurance. If so you may be covered for some of your lost revenue.
- Helping Your Staff:
If your business is shut down you likely have had to lay off your staff. Every business owner dreads laying off their staff. If you are in a financial position to help them in any way or offer them some form of work during the shutdown that’s great, if not, you can help them with unemployment insurance through the state. Make sure you keep them informed about the status of the company and when you may be able to reopen.
- Keep Customers Informed:
Make sure you keep your customers informed along the way through email, social media, and your website. They will be essential to your re-emergence from this.
- Planning & Re-Emerging:
Start planning now for reopening and rebuilding now. COVID-19 will pass and while this is a very difficult time, your business can survive and re-emerge. Planning for reopening now will make the process go smoother and faster, plus it will be a productive distraction while you are shut down.
Does a Bear Market Affect Business Values and Sales?
A Bear Market can be created on Wall Street by economic forecasts, increasing interest rates, slowing earnings growth, world events, and government economic policies. Small business values are driven by earnings, more specifically the Discretionary Earnings or EBITDA of the business. That’s it, earnings drive value for SMBs. Because the stocks of publicly traded companies are liquid and easily bought and sold, they are susceptible to speculation and when the economic winds shift, they become volatile. Privately held SMBs are not subject to speculation and are held for long term investment by the owners, thus their values are not driven by speculation. They do not experience meteoric growth in a Bull Market, nor do they plummet in a Bear Market. In fact, the only time the value of a privately held business is of any real concern is when the owners are contemplating selling the business.
What Does Affect the Value of a Small-Midsize Business?
Earnings are the primary determinant and driver of small business value and the earnings of a business can be affected by internal and external forces. Internal forces (things within the control of the management) such as management, product life cycles (obsolescence), quality, and pricing can cause the revenue and/or earnings of a business to decline. External forces (things outside the control of management) such as the economy, competition, and commodity/materials prices, to name a few, can also cause the revenue and earnings of a business to decline.
Thus, if the economy is weak or other external forces affect the sales and earnings of a business the value of that business will be directly affected. In this sense small business values can follow Wall Street values if the economic factors also affect directly the business and its earnings. While external forces cause the stock market to swing wildly and seemingly instantaneously, changes in the values of privately held businesses are only detectable when an owner is preparing to sell the business or perhaps obtain new bank financing.
Growth in revenue and earnings also affect the value of a business. Businesses that are growing steadily or rapidly generally get a premium, and businesses with declining sales and earnings are discounted. The industry type (e.g. distribution, e-commerce, healthcare, manufacturing, construction, B2B or B2C services, retail, etc.) drives the earnings multiple for that business, however, the multiple is a constant and does not generally vary much although it can be discounted due to factors such as lower earnings within each industry, dependence on owner for day-to-day operations (little to no employees) and/or poor books and records.
How is the Value of a Small Business (SMB) Calculated?
When a small business owner is considering the sale of their business and wants to establish the market value, the first step would be to contact a professional business broker and ask for a Market Value Analysis. At Pacific Business Sales we offer a free Market Value Analysis for our prospective clients and also offer formal third-party valuations for a fee for clients in need of a full appraisal.
To establish the value of a business, the first step of course is to obtain copies of the last three years tax returns, year to date Profit and Loss Statement and balance sheet. The next step is to recast the financial statements to calculate the Discretionary Earnings, or DE, of the business. Simply put, DE is the total economic benefit or total income the owner realizes from the business. Recasting the financial statements involves reviewing the expenses shown on the tax returns and P&Ls and adding back owner’s benefits and non-essential expenses that are discretionary to the owner. The tricky or complicated part of recasting financial statements is that only expenses shown on the tax returns can be added back and any owner’s expense must tie to an expense line item on the tax returns.
When the recasting is complete the business broker or valuation analyst will use a valuation program to calculate the market value of the business based on comparable sales (comps) data and often a valuation method such as the income approach. At Pacific Business Sales we use the Peercomps valuation program and comps database along with other comps databases to calculate the market value of our client’s business.
Knowing the Market Value of your business is a critical first step in preparing to sell your business. If you would like to meet with us to discuss the prospective sale of your business and the Market Value of your business please use the button below to contact us.
How to Minimize Taxes on the Sale of Your Business
First, let’s look at what happens if you do nothing and just sell your business. Depending on the structure of the sale of your business your taxes capital gains tax could be as low as 15% to 20% if the business is sold as a Stock Sale and if the business is sold as an Asset Sale a portion of the proceeds could be taxed as ordinary income (ouch!). Exactly how your proceeds will be taxed unfortunately is not a simple question and you will have to review this with your CPA or tax advisor to determine exactly what your taxes would be. Regardless, when you sell your business, you will be paying significant taxes unless you take action in advance and implement a tax strategy.
Now let’s look at what you can do to minimize the tax liability when you sell your business. Before we dig into what works, a word of caution, there are a number of “tax strategies” that have been created and the IRS has recently ruled that several are not legal or valid. For the sellers that used these now overruled strategies they are facing the full taxes on the sale of the business plus penalties and it is now too late to implement another tax structure. So it is critical that if you chose to use a tax strategy you review with your CPA or tax advisor. There are two tax strategies to minimize taxes on the sale of a business that have survived IRS scrutiny over the years, one is the Charitable Remainder Trust (aka CRT) and the other is the Deferred Sales TrustTM (DST). Our experience with the CRT is that it is complicated as well as expensive to implement and maintain. The DST on the other hand is more straightforward and much less expense to implement and maintain while offering the same tax savings. Here’s how the DST works.
The DST defers the proceeds of the sale of your business by putting the cash into a trust. Thus you do not pay taxes on the full amount of the sale and only pay taxes as the proceeds are taken out of the trust. You can choose how much you take out of the trust each year and the term of the trust to fit your needs. The structure of this is much like a Seller Note or Installment Sale where with the DST the seller transfers the assets of the business to the Trust before the close of escrow and the Trust issues a Note to the Seller for the purchase price of the business. The Buyer then purchases the business from the Trust and the cash is sent to the Trust (no taxable event has occurred for the Seller). The Seller has complete control of the funds in the Trust and can direct the financial advisor to structure the investments as they wish. The Seller can also determine how much cash is taken out of the Trust, the timeline for these payments and can change the payment schedule if they wish. Taxes are paid as the funds are taken out of the Trust.
The diagram below illustrates how the DST works.
We mentioned above that several tax strategies have recently been overruled by the IRS. The DST has been in use for nearly 20 years and in 2009 the IRS issued a Private Letter Ruling on the DST which validates this tax strategy.
For more information on the DST you can use our DST calculator to estimate tax savings on your own and request a complimentary analysis and consultation with the financial advisor we work with, James Peters at Grace Wealth Management.
For Deferred Sales Trust Information Contact us or James Peters
Grace Wealth Management
Pacific Business Sales, it’s Broker and Agents are not financial advisors and are not providing financial or tax advice in this informational blog. Before implementing any tax strategy or tax planning you should obtain the advice of your CPA or tax advisor.