A family’s interest in a privately held business ranks right up there with all things quintessentially American. And the hope of most founding owners is for the business to continue on in the hands of the next generation of family. But this isn’t a viable option for many businesses for many reasons. Here’s what you need to know about positioning your business interests — and yourself and your family — for the sale and for life after the business.
According to H. Arthur Graper, CFP®, senior relationship manager and managing director at CIBC Private Wealth, considerations for selling a privately held business often revolve around three factors: economics, emotion and need. “In addition,” says Graper, “wealth diversification for the founding owner is a key factor in the ownership-and-succession decision matrix. Sometimes continuing to own the business moves to second priority as the owner realizes that liquidity and diversification have become more important at a certain stage of life.”
When a family decides the right and best choice is to sell its interest in a business to a third party, the work begins in earnest — and so does the uncertainty.
Selling: A long-term process
Although it happens often with business owners, 6 months is most certainly not the ideal time frame for preparing to sell the business. The family should be thinking more in terms of a planning, preparation and implementation phase of at least 3 years.
“Certainly, the emotions of selling the business need to be worked through, which may take some time, but it is essential that the business itself be best positioned for sale,” says Graper. “First and foremost is to clean up the balance sheet. Often, there are expenses run through the business that really should not be, or loans to family members or other owners that have never been paid back. Receivables generally should be kept as current as possible or written off — bite the bullet and get rid of them. Most important is the structure of the business. Are there valuable strategic alliances and long-term contracts with suppliers or vendors? If so, they may need to be locked down. If the business requires real estate to operate, long-term leases may need to be in place. All of these things can add value to the business when the time comes to sell.”
The business also may need to secure agreements with essential employees and key management before a sale to third party. Retaining these nonrelated key employees can be critical.
The business owner must focus on supporting the employees who will be running the business after the sale. These employees are often in the best position to judge the worth of the company and are very motivated to ensure its continued survival and prosperity. A business can use bonus arrangements, nonqualified deferred compensation plans with long-term vesting requirements, stock option plans and employee stock ownership plans (ESOPs), all of which can tie the employees to the business long after the founding owner leaves. If certain key employees decide to end their relationship with the business, “key man” insurance can be used to fund a buyout, if necessary, and to train and hire replacement employees.
The founding owner also can consider contractual arrangements (such as a franchise agreement), professional licenses, or certifications (minority- or woman-owned business) that can be critical to the successful transition of the business. Caroline McKay, senior wealth strategist and managing director at CIBC Private Wealth, worked with a privately held business client, an engineering firm. The business had a wealth of organic knowledge, but no written processes and procedures.
Another of McKay’s clients, a 50-year family business, had dutifully recorded shares sold to family members and gifted to key employees — at least most of the time. “When it came time to sell, there was no accurate record of who owned what percentage,” says McKay. “Sometimes you have to really get down in the weeds and look closely for anything that could negatively affect selling and transitioning the business. We also worked with a privately held business that was contractually bound by a controlling distributorship agreement, under which the business could not transition in any way — either to the next generation of family or to an outside third party — without the distributor approving the sale.” Key point, says McKay: Selling to a third party requires the business to be “fully self-sustaining.”
A valuation firm will determine valuation in one of three ways: cost approach, using adjusted book value analysis; income approach, using discounted cash flow method; or market approach, using comparable company analysis. Valuation firms and investment bankers will dig deep to understand both the positive and negative attributes of your business. Positive ones include having repeat or recurring business, being a market leader, holding patents or a technological advantage, having a diversified customer base and being in middle-stage growth trajectory. Negative attributes can include discounting the value because of small size and the loss of the key person — the founding owner; being a cyclical business; having a commoditized and nonproprietary product or service; or being in late-stage growth trajectory.
“One major consideration that can be either positive or negative is your management team,” says McKay. “The market will pay more for a strong management team with a credible strategic plan to grow the business. If you are going to prepare your business for a successful sale, make sure you have a strong management team.”
Structuring the sale
There are numerous ways to structure the sale of a privately held business: a lump-sum sale, an installment sale, an earnout sale based on a percentage of future profits, or a sale to a charitable trust. A business owner may sell the business interest by transferring either the entire ownership interest — stock, partnership interest, membership interest — or just the assets of the business. The desired “end result” will help determine a sale’s structure.
As Christopher M. Goodrich, partner with Crady Jewett McCulley & Houren LLP of Houston, points out, “in cash sales where the owner receives a lump sum of cash or property in exchange for all or a portion of his or her interest in the business, capital gain is generally recognized in the year of sale to the extent that the sales price exceeds the owner’s basis, although there are exceptions.”
The sale can also be an earnout. The purchase price of a business with an earnout agreement includes a contingent payment based on the company’s future performance or some other matrix. The contingent purchase price is generally “earned” if certain future benchmarks are reached during a specified period after closing. The price often includes a sliding scale on which the contingent payment will be made. “Earnouts are typically useful when there is a gap between a seller’s expectation of future profits and a conservative purchaser’s estimate of the value of the business without the business owner’s ongoing involvement,” Goodrich notes.
An installment sale can also be used, although Graper says that this type of sale is more frequently considered if the business is being sold within the family. “The big advantage is that it can provide regular cash flow to the departing founder,” says Graper. “But it is best used for the sale of a stable business so that the cash flow is available for the new owners to make the installment payments.”
McKay notes that there is a big difference, to both buyer and seller, between an asset sale and a stock sale. In an asset sale, the purchaser acquires part or all of the assets of the selling company and gets a step up in basis on the assets purchased. The selling company also keeps liabilities not assumed by the purchaser. As to the tax effect, the selling company recognizes gain or loss on the sale of assets. Tax results differ depending on whether the entity being sold is a C-corporation, S-corporation or an LLC. Taxes may be part ordinary income and part capital gain, depending upon the assets sold. Additionally, the owners of the selling company may incur a second level of tax when cash or consideration is eventually distributed from the selling entity.
In a stock sale, the buyer has purchased stock — not assets. Therefore, the buyer gets a carryover basis in the purchased capital assets. Although there is no gain or loss to the selling entity, the selling shareholders recognize capital gains on the difference between their stock basis and their pro-rata share of the purchase price. “Given the complexity of the different alternatives, it is imperative your team of advisors understands the structure and tax implications of your particular deal,” says McKay.
Finally, it is possible to sell ownership, but not control, of the business via a tax-free reorganization. The interests in the business are recapitalized into voting and nonvoting interests prior to the sale, and the owner may try to sell only the nonvoting interests for cash or a promissory note. This is not always appealing to potential buyers, but there are some circumstances where it can be worthwhile to explore.
Selling the business: A pros and cons checklist
A sale provides liquidity.
The investment portfolio is diversified away from concentrated wealth.
The estate planning process may be simplified.
It offers the owner the opportunity to separate from the business entirely.
The family usually loses control of the business.
The business may pursue a different direction than the founder envisioned.
The business may ultimately fail under new ownership.
The loss of jobs among family members and the potential for the family’s loss of identity are possible consequences.
Future appreciation of the business is lost.
Liquidity: The thrill, the terror, the “what next?”
Comfortable, controllable and concentrated. The founding owner of a privately held business may have spent decades in the business, and everything about it feels comfortable and controllable — the routine, the risks, the rewards. Even the fact that his or her individual wealth and, by extension, the family’s wealth, are concentrated in the business feels comfortable. And then one day the sale of the business is complete, and gone is the comfort, the control and the concentration of wealth.
“A large liquidity event is a major life development for business owners,” says David L. Donabedian, CFA, CIBC Private Wealth chief investment officer. “The initial stages of the transition can be disorienting. While they understand the advantage of diversifying their wealth away from one source, some are uncomfortable about their level of understanding of the markets, asset allocation and an investment portfolio with unfamiliar holdings over which they have no direct operating influence. Successful business owners are extremely astute people who understand the financial component of running a business, but that’s not the same as knowing whether to own one stock or another, or which hedge fund may be right, or on which area of emerging markets to focus. And so many things are now out of their own control.”
The segue is best viewed as a necessary mind shift, due to the liquidity event, from being a “business enterprise” to being a “family enterprise,” says McKay. “Along with issues of identity, there are new concerns about cash flow, investment portfolios, how family property is held and how to set up trusts, among other things. The new liquidity is an ‘enterprise’ that the family now needs to manage.”
The fundamental concept that newly liquid former business owners need to embrace, says Donabedian, is that “when it comes to assets, concentration creates the wealth, but diversification can preserve it. Many business owners are ready to make the transition to that mindset; for others, it’s a much longer process. We start with two general scenarios: wealth concentrated in a single asset or only a couple of assets vs. a more diversified portfolio. As you might expect, the best possible return in a perfect world comes from a concentrated position. But often, that potential reward has already been realized — the business itself. Conversely, the downside risks are greatest with the concentrated position. Part of the evolving discussion is for the business owner to recognize that phase one — a concentration creating significant wealth — has already been accomplished. Our job now is to preserve wealth in the most prudent ways.”
The preservation conversation naturally addresses the issue of risk. What are the potential risks and rewards of equities, bonds and alternative investments — on both an individual basis and when combined in a diversified portfolio? In many ways, the selling business owner is learning to recalculate his or her definition of risk. “When they have run an operating business, or even owned and managed commercial real estate, they have a much more tangible feel for what the risk is,” says Donabedian. “They are able to define clearly what a bad year or a bad outcome looks like. Figuring out risk on a diversified portfolio is not as simple. We are evaluating the risk characteristics of each asset class, and then putting all that together. A business owner’s definition of a ‘good return’ may also need a reset. A well-diversified portfolio designed to earn 8% a year over the long term may look very acceptable for most investors, but the successful business owner may think: ‘I started with $10,000 and just sold my business for $200 million — for me, that’s a good rate of return.’”
On the positive side, because most business owners are accustomed to working with and understanding spreadsheets, income statements and balance sheets, they’re comfortable with numbers. The CIBC advising team’s scenarios include a lot of numbers: various types of portfolios over 10 and 20 years, assumptions about inflation, the owner’s income needs, the tax implications of each scenario, and best-case and worst-case scenarios. Essentially, it’s this: what might the future look like in terms of your wealth? In addition, the team must account for other illiquid assets, such as real estate owned, often creating a staged, multiyear process toward more complete diversification.
For members of a family who have been running a family business, the evolution from a “business family” into a “financial family” can feel daunting. Becoming a successful “financial family” requires more structure, more delegation and a different type of management, such as working with a new team of advisors focused on wealth preservation.
For many business owners, the transition to managing wealth involves a major shift in mindsets. Entrepreneurs who have sold their business enter an environment for which they are largely unprepared. While they often have high financial and business literacy, they often lack what might be called “wealth literacy.” They feel vulnerable in a world of advisors who speak an entirely new language. Beyond that, the rules of this new landscape are complex, and it is difficult to know whom to trust. They are expected to understand the complex investment concepts and discern effectively among investment alternatives, understand byzantine fee structures, and effectively calibrate risks that they don’t truly understand. On top of that, families must also navigate estate planning, new tax rules and risk management strategies in very different ways than they have before.
In the face of this uncertainty, says Donabedian, it is important to keep in mind that successful business owners have always surrounded themselves with expertise. “This is no different,” he says. “Our relationship with clients who experience a liquidity event includes expertise in the broad issues of multi-generational wealth strategies, all the way to expertise in narrowly focused segments of investments that represent emerging opportunities. While the transition may be a long-term process, there are many steps along the way to help ease business owners into their new status as former business owners who created and realized substantial wealth.”
Beyond these technical considerations of wealth management, former business owners often face substantial questions about how to adapt to their new lifestyle, how to raise their children, and how to navigate the personal, familial and social complexities wealth creates. The move from business owner to wealth holder often involves a substantial change in identity. As one former CEO put it, “Last month, I was the guy who had his emails answered in 15 minutes. Now I’m the third guy in line at Starbucks.”
Just as the former owner is coping with this new reality, the owner’s family is undergoing substantial change as well. The transition can put stress on a marriage and other family relationships. Indeed, one major concern parents face is how to prepare the children to ensure that they will not be stunted by inheritance but will grow to become wise stewards of the wealth. Here, too, CIBC can help. We have worked with many families to help them sort out not merely the quantitative issues of wealth management, but also the qualitative issues of intergenerational success. Through education, conferences, growing internal capability and our extensive connections with outside resources, we can help families navigate the complex realities of wealth and succession.