By Linda Schmid
A significant number of builder/contractors are considering exiting their businesses in the next 5-7 years according to a study by the Construction Financial Management Association in mid 2020. Further, 2/3 of these business owners plan to pass the business to family, employees, or both.
For many owners, their business is like their baby. They have invested a lot of blood, stress, and tears in birthing, nurturing, and growing it into a fully functioning entity. The last thing they want is to see their hard work demolished by their own exit, which can happen even when transitioning the business to family. This is why you need an exit strategy.
One of the most important aspects of an exit strategy is planning. That is not only developing a plan, but having the time to properly execute it according to ABC Supply.
Putting a Succession Plan In Place
The first thing to consider is human resources. Strengthening the management team and the culture are two of the most important things an owner can do to prepare the company for their exit. If everyone pulls together and feels they have a stake in the whole team winning, the company has a very good chance of successfully withstanding the change. The owner is important in developing company culture; hopefully from day one a tone has been set of team building, but it’s never too late to start.
According to Steve Ryan of Prairie Capital Advisers, those “who embrace the concept of teaching employees to think and act like owners enable their current owner to delegate responsibilities, thus beginning the ownership transition process.”
One of the first things that must be decided is who should carry on which functions when the owner is gone? Once there is a plan, people can begin to learn their new or expanded roles. ABC Supply advises that this plan be thoroughly documented, for the owner transitioning and for everyone on the team who will be involved. Keep notes about progress and every detail that comes up. This will only make everything easier for everyone.
The Financial Aspect
Before you can sell your business, you need to know what you have. Be sure that you have documents that are correct and up-to-date. This means that every asset needs to be accounted for. Land, buildings, equipment, accounts receivable including pending payments, and investments all need to be accounted for, both for your own benefit in making wise financial decisions, but also to make the transition smoother for everyone.
Once you understand what you have, you can begin to consider how to transfer it. Ryan provides a short list of considerations, while acknowledging there may be many others:
• Financing. Does the planned successor have the means to purchase the company?
• Risk. How comfortable are you with risk? What level of risk is any given offer? Do you expect the business to become more or less valuable over time?
• Value Expectations. What price are you willing to accept for your business? What do you need to get from the transaction? Are you counting on retirement income from the sale? How much do you need? Do you need immediate liquidity or will long-term liquidity work?
On top of these questions, there are options to think about regarding what you want to sell. For instance, you can choose to retain your interest in certain property, such as office space which can be leased out for profit, while transitioning the remainder. Or you could choose to retain certain assets in order to liquidate them in a separate transaction.
Another consideration may be what to do about the business name. If you do not have control over the business, do you still want your name on the door? If your business name is Best Homes, then that may not be your concern, but if it’s Hutton’s Best Homes, that may be another story. Further, your business name may have blue sky value, especially if you have worked hard to build up the reputation and/or traffic online. In that case you may wish to retain the name to resell, but either way it should be something you think through.
Legal Transition Alternatives
After consideration of the financial situation, transitioning to a family member may not seem viable if they do not have the cash and/or financing. However, before you give up your plan to keep your business in the family, there may be ways to accomplish such a transition besides traditional business financing.
According to Josh Lefcowitz of Cohen & Company, an accounting and advisory firm, the common ways of doing this are:
1. Gift the business to the new owners.
A gift of an ownership stake can transfer all or part of a company, either directly or through a trust, allowing the transition to bypass probate (when you pass away) which can be a lengthy – and public – process. Be sure to check what the lifetime gift tax exemption is because it can change from year to year.
Many people choose “revocable” trusts because they can be changed by the creator as long as they are of sound mind. This provides the opportunity to add or detract beneficiaries, add more assets to the trust, or sell trust property. In this case a successor trustee should be named, someone who is bound to follow the terms of the trust document to disperse the assets in case of the trust owners’ death. At that point the trust becomes irrevocable which means that it can’t be changed without the agreement of all beneficiaries or a judge’s approval.
An “irrevocable” trust has benefits that revocable trusts are missing. Irrevocable trusts are immune from estate taxes, creditor claims, and lawsuits against the grantor. This means that you must carefully weigh control over the trust against the benefits of protection of part of the trust’s worth in order to decide between a revocable and irrevocable trust.
2. Finance the new owners through an Installment Note.
The company stocks can be purchased through an Installment
Note at the IRS minimum rate. The minimum rate is changeable over time and depends on the note’s term. The new owners can use company income to pay down the note over time providing you with the income you need. Note that this is not a tax strategy; capital gains taxes will still be due. To avoid gift taxes you have to sell your business at fair market value with market interest rates.
The risk is that the buyer will be unable to make all the payments. You can provide yourself with some protection with a default plan. Retain a secured interest in business property or receivables; consider loan covenants to restrict certain activities by the buyer, borrowing for example; require life insurance to ensure re-payment in case of the buyer’s death.
3. Gift Shares to a Grantor Retained Annuity Trust (GRAT).
This option allows you to transfer assets to a trust which pays you annuities. Usually it is set up to return 100% of the value to you. The annuity continues to be drawn until you have reached the set term. A mandated interest rate is charged, and after the payments are complete, any value remaining in the trust goes to the beneficiaries and gift taxes are avoided.
You could choose to combine any of the above alternatives with any of these opportunities: a management buyout, sale to employees through an Employee Stock Ownership Plan (“ESOP”), leveraged recapitalization, sale to a third party. For example, you might gift 50% to family and create an ESOP with the other 50%.
The transition process can have a great impact on future success. The most important thing is to think it through, make a strong plan, and leave time to bring it to fruition. RB