Over the years I have worked with business owners transitioning out of their business and I have found common obstacles to a smooth process. Here, I share what can create roadblocks to the transition and then provide an action plan to mitigate against those roadblocks.
What does it mean to be ready to exit?
Nearly 6 million small to midsize businesses will be ready for transfer by 2035, according to Forbes‡. Being prepared is the first part of the sale process; are you and your family ready?
Being prepared and ready to exit your business may seem simple, but it is more complicated than most realize. Every business is different, and I have outlined two different business scenarios to help illustrate what I mean.
Scenario #1: Profitable business with little owner involvement
Some owners or company founders may not believe that an exit plan is necessary if their business is doing well and it takes little time of involvement on their end. “Why bother?” they may ask.
If the business is running smoothly and they are making money with little effort, a transition plan takes the back seat in priorities. However, a very real problem is the unknown. What if the owner/founder’s health declines, or they pass away? At that point, they leave their business with no idea how it is supposed to continue in terms of ownership structure and long-term planning. Because no contingent buy/sell agreements were drafted, and key employee compensation programs or stay bonuses are not outlined, businesses can quickly devolve into chaos.
The beneficiaries of the business are left with the complex task of the business transfer. This subjects the business to undue risk and can place stress on the employee base and/or the remaining family, which can further harm business value.
Scenario #2: Highly owner-dependent business
On the other end of the spectrum are businesses with highly involved owners/founders. If there is no transition plan in these scenarios, business value takes a significant hit. The more the business relies on a singular owner or key employee, the less valuable the business will be due to the associated risks related to that individual leaving the company.
When we have owner-dependent business operations, a plan is critical to helping the owner transfer specific operations through the delegation of the business processes over time. There needs to be a serious focus on transferring decision-making authority to other members of the leadership team. If there is not a leadership team, the owner must create one, with bonus points for those who include clear succession plans for key positions.
In this case, it is difficult to transition this business to anyone (internal, external, family) when so much of the intangible knowledge used to run the business is in the mind of the owner. Even if the business is profitable, in the eyes of the market, value discounts will occur if the owner leaves. The owner may be looking at a prolonged earn-out on the transfer of the business, which is an agreement that requires the company to reach certain financial milestones before the selling owner is paid.
Hidden risks of a family transition
There are five hidden risks unique to family businesses. Founders and owners need to work to mitigate these risks several years before the planned exit.
Lack of an organization chart – Business owners preparing for transition need to create roles and fill those roles with competent employees. Some key roles to have in place include:
- Chief financial officer
- Chief risk officer
- Chief operations office
- Head of human resources
- Chief technology officer
The organization chart needs to be adjusted to the size of the business. The big goal here is that the business has a leadership team capable of making day-to-day decisions and running the business. The leadership team is held accountable for their performance and key performance indicators (KPI) are tracked and discussed regularly.
Major customer concentration risk: When a significant portion of a company’s business and profit are tied to one client, it becomes a challenge to navigate the departure of the founder/owner. In my experience, I have seen this come up repeatedly. This is a tough conversation because the business has extreme risk of losing that client. Even if you are transferring ownership to family members, it is a transfer of risk not value because of the concentration of business.
Lack of liquidation strategy: Many owners are not clear on who they would like to sell the business to, or the person they want to sell it to is not qualified. A key employee earmarked for ownership may not actually want the business or the business/employee are not financeable for the liquidation value the owner is expecting to receive.
Family member is “in” the business, but not working: For family businesses, it is common to have several family members who are not involved in the day-to-day work of the company. However, this can become a problem if the non-working member is designated as the successor, and it could create an add-back valuation adjustment.
Many times, a family member is on the business payroll but has never actually worked at the company. This practice impairs the cash flow of the business and prevents the business from growing as well as possible. All family members on the company payroll should be providing equivalent value to the company for their pay.
Lack of formal governance: With a family-run company, often we have a lack of a formal governance structure, like a board of directors, a family charter, or any process by which the family and the business operate in harmony.
Family dynamics like rivalries can impact a sale, and I have seen it happen. If the founder/owner controls the company until death, what happens in these situations is a succession battle. It takes time, and it’s not necessarily fun, but business and family governance need to be addressed early on in the business lifecycle to assist in a smooth transition.
Business owners should consider risk exposure based on these common challenges and implement a plan to address them before a transition is needed or wanted.
Final notes
Founders should not wait to embark on a liquidation event a year from their retirement date. Whether you are three-years, five-years, or 10-years from your exit, you can begin the planning process now. I always say, “Be exit ready, always” and know the value destination you are working toward.
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Disclosures
Financial planning services are offered by UMB Private Wealth Management, a division within UMB Bank, n.a. that manages active portfolios for individuals, fiduciary accounts, employee benefit plans, endowments and foundations. UMB Bank, nab, is a subsidiary of UMB Financial Corporation.
This material is provided for informational purposes only and contains no investment advice or recommendations to buy or sell any specific securities or engage in any specific investment strategy. Statements in the presentation are based on the opinions of the author and are subject to change at any time without notice. You should not use this presentation as a substitute for your own judgment, and you should consult the appropriate financial professional before making any tax, legal, financial planning or investment decisions.
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NOT FDIC INSURED | NO BANK GUARANTEE | NOT A DEPOSIT | NOT INSURED BY ANY GOVERNMENT AGENCY | MAY LOSE VALUE
