Business Strategies
Let's say you’ve built up a successful business – sales and profits are growing, you're accumulating cash in the bank and your customer base is growing nicely. But what's the point of this success if you can't figure out a way to translate this into personal wealth and ultimately a happy retirement. Find out how to avoid costly mistakes and plan for a successful transition of your business wealth to personal wealth.

After reviewing this material, feel free to email me with any of your questions or comments to: info@jonathanflawn.com. Be sure to review The 13 Worst Blunders Business Owners Make.


Succession Planning

Overview
Succession planning by business owners is tremendously neglected, and this can be extremely costly. Why do business owners so often neglect this important area? I can think of 2 main reasons. First, most business owners are so busy that they simply don’t have time (or think they don't). The second reason is that they probably don't realize how important it is. When your business is hurting because of a cyclical downturn, that's not a good time. When you have unexpected health issues, that’s not a good time either. And when you dead and buried, and your widow or partners have to deal with it, that's a really bad time. The best time to plan for succession is when your business is booming and your health is good.

Let's consider first of all the potential groups that can form part of business succession planning. Possible successors to your business are:
  1. Family
  2. Management
  3. External buyers or investors
Finding someone to take over your business can be a problem: family members may not be interested or may be unsuitable, management may not have enough capital or may not be interested and external buyers may be hard to find, may not have enough capital or they drive too hard a bargain.

You should commence succession planning 2 or more years prior to potential ownership succession. Professional advice is a must to avoid costly mistakes. You need financial, accounting, legal and tax advice. Having access to the right advice can help you increase shareholder value, increase the price you receive, improve the terms of the deal, and minimize taxes. Ideally, you need someone to act as quarterback to the entire process, integrating the advice from accountants, lawyers and financial advisors (that's where I come in).

There are a number of factors to be considered as part of each succession plan:
  • Complexity: In terms of complexity, family succession deals are the simplest, management succession deals are in the middle, and external buyer deals are the most complex. External buyers are generally going to want to do a lot more due diligence and their interests in terms of deal structure and tax issues are going to be the most divergent from yours.

  • Time requirements: For external buyers, the time requirements are greater while for family buyers, the time requirements are the shortest, with management buyers somewhere in the middle. Even if you have no immediate plans to sell or pass on your business, planning now makes sense because changing circumstances, like a sudden health issue, may force your hand.

  • Cost: In line with the complexity of each deal, external buyer deals will have the highest legal and accounting costs while family succession deals generally will have the lowest costs.

  • Risk: The risk of deal failure (failure to close) is higher with external buyers. There is also a higher risk of breach of confidential information with external buyers so this process must be managed carefully.

  • Deal structure or terms: This is an important component of any deal and must not be neglected. Generally family successions will have the most favourable terms and deal structure, while external buyers, who have the most divergent interests from yours, will have the least favourable terms and structure.

  • Valuation and pricing: The right external buyer can result in the best price for your company. For example, if the external is a competitor, the advantages to them of reducing competition or acquiring a customer base may result in a higher price for your company. Favourable factors like that are less likely for a family or management buyout.

  • Tax efficiency: Because you are dealing with family members with similar interests, family succession deals can be structured very tax efficiently. External buyers on the other hand will have very different views on the tax situation. A good example of this is that external buyers will often prefer to buy assets rather than a corporation because of both tax advantages and elimination of contingent liabilities.
In the end, all deals involve trade-offs between competing factors, and you will seldom get everything you want in a deal.

Timing
There are four factors that affect the timing of succession planning: company factors, environmental factors, operational structure factors, and personal factors.
  • Company factors: These involve things like: how dependent is your company on you, how long will it take to transition from you to new management, how ready for sale is your company (is it structured to facilitate a sale), and how has the company been performing. A company with a short track record or one with flat sales and profits will be much harder to sell than one with a history of steadily increasing sales and profits.

  • Environmental factors: Trying to sell your company in the middle of a recession or in the middle of a cyclical downturn of your business will likely slow down the sales process.

  • Operational structuring: Having a company where your management is secure, customers are tied down, you have a current up-to-date website, the books and records are current and well organized and with a flexible operating structure (e.g. without long-term commitments) will facilitate and speed the sales process.

  • Personal factors: Timing can be negatively affected if you are mentally unprepared to sell, or if family members are not ready to take over, or if income tax and estate planning is inadequate or deficient.

Financial structuring
Prior to commencing the sales process, your company should be re-structured to remove redundant or surplus assets. Working capital needs to be managed to increase value. For example, non-current accounts receivable can be collected, or written off. It might be tempting to cut expenses to temporarily boost profitability, but care must be taken – sophisticated buyers will take notice if they see dramatic reductions in advertising or marketing costs to boost profit artificially.

Income tax and estate planning
There are a number of ways that income taxes can be minimized when selling your company. For example, the life time capital gains exemption of $750,000 can be crystallized and often other family members can enjoy the full exemption too – careful planning is required. Holding companies can be used to defer taxes and also protect against creditors. Individual pension plans (IPP) can be used to maximize tax sheltered retirement assets.


Business Valuation

Knowing what your business is worth is a fundamental part of good succession planning and it helps make you a better negotiator when it comes time to sell the business. All of the methods base the value on the ability of the business to generate future cash flow. There a number of methods of valuing a business, but I will confine myself to describing the 3 main methods (in order of increasing sophistication):
  1. The Rule of Thumb Method
  2. The Multiple of EBITDA Method
  3. The Discounted Cash Flow Method

The Rule of Thumb Method
Some businesses have well established rules of thumb for value. Typically these would be businesses where most of the revenue is in the form of recurring revenue. A good example of this would be the alarm monitoring business. Alarm monitoring companies have customers that pay a monthly or annual fee to have their home or business monitored. The revenue tends to be pretty steady. Someone wanting to purchase such a business might use a rule of thumb such as paying 2 to 3 times annual recurring revenue adjusted for things like the amount and quality of other kinds of revenue, historical attrition rates, the type of equipment at the customer have and the type of equipment at the alarm monitoring station and so on. The financial services business is another example of recurring revenue. Here the rule of thumb might be the amount of recurring fee or service revenue (trailers) or the quantum of assets under administration or both.

The Multiple of EBITDA Method
This method uses a multiple of "operating cash flow" or EBITDA to establish value. EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization. Generally we use 3 to 5 years of historical operating results or for a cyclical business, one normal business cycle. The EBITDA is then adjusted for things like excess bonuses and unusual items to come up with a normalized EBITDA. We apply the multiple and then deduct the interest bearing debt to come up with the shareholder value.

The multiple used will reflect the buyers assessment of risk – the lower the multiple the higher the perceived risk and vice versa. Other factors affecting the multiple are revenue stability, customer barriers to exit (like contracts), proprietary products or services, market conditions etc.

The advantage of this method is that it is simple and easy to understand. The disadvantage is that it ignores required capital expenditures, incremental working capital needs and the impact of future income taxes (these items are basically factored into the multiple).

The Discounted Cash Flow Method
This is a more sophisticated valuation method and is preferred because it captures all the variables. Basically what we are doing is taking projected cash flows for a reasonable period (generally 3 to 5 years), discounting these back to the present value using a discount factor. We then determine a termination value for the cash flow beyond our forecast period, capitalize that and then discount this amount back to the present using the same discount factor. Adding the two together gives us the enterprise value. As in the Multiple of EBITDA Method, we then deduct the interest bearing debt to arrive at the shareholder value.

The discount rate is the required rate of return for a given period of time and a given perceived risk. Generally we use the nominal rate which includes inflation. A typical range is 10 to 15%, which is greater than we see from the stock market, which makes sense given the higher risk of investing in small enterprises. The capitalization rate is the discount rate less the growth rate (generally 2 to 5%).

The process for selling a business
  1. Pre-sale planning and preparation
  2. Search for and identify buyers
  3. Preliminary due diligence by buyer(s)
  4. Deal structuring
  5. Negotiations
  6. Closing

Key business valuation concepts
  1. Value is based on ability to generate future cash flow.
  2. Valuation multiples and discount/capitalization rates are a function of a companies risk profile, growth prospects and the degree of optimism by potential buyers in the forecasted cash flows.
  3. Business owners should periodically conduct business valuations and succession planning.
  4. Business owners should create barriers to exit for customers (through high service levels, happy customers or customer contracts).
  5. Business owners should manage their balance sheets as well as their income statements to maximize perceived value.

If you have any questions or comments, feel free to email me at info@jonathanflawn.com.
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