The Inman Company Blog

Friday, 07 March 2014 00:00

Chips off the table

As entrepreneurs, our largest asset is usually our business. Most owners dedicate years of blood, sweat and tears to build their company, often at the exclusion of diversification. We sometimes wrongly believe that our best chance of controlling our destiny is through managing our own business and reinvesting its earnings. In the process, we often take risks (for example personally guaranteeing business debt) with most of our personal net worth being at risk or "in the game".

Prudence dictates that we will eventually want to protect our assets which requires we take "Chips Off the Table". This can be accomplished in a number of ways:

• Sell the business to an outsider for cash. The preferred exit for many owners. Requires a buyer with deep pockets and synergies with the seller. Sellers seeking this option need to plan years in advance and understand the importance of timing.

• Sell the business to an outsider for a combination of cash and seller financing. An installment sale can be risky but can be attractive to a seller who remains with the Company after the sale. This can result in a higher selling price, lower taxes and a superior interest rate compared with alternative investments. Some sellers use a guaranteed structured installment sale, which guarantees that the seller gets their money but is not taxed until received.

• Sell the business to family/employees/management. Many firms are led by professional managers, including family members, who are attractive partners for private or strategic buyers/investors. Also, where appropriate, ESOPs (Employee Stock Option Plans) offer very attractive tax benefits for owners and employees.

• Merge with a public Company substituting shares in a private company for public securities. This alternative offers tax deferrals and is attractive where the public entity is well managed, has a long track record of growing value, and has a robust market for its shares.

• Recapitalizations make sense when values are high and where there are plenty of buyers (current conditions). Owners can sell a controlling or non-controlling interest for cash and keep ownership and management control. This presents the opportunity to withdraw value from the business and yet stay engaged and active without risk.

Additional Factors to consider:

• Income Tax Rates – Federal Capital Gain rates recently were increased to 20% from 15%, Ordinary rates on the taxable earnings from a business (reinvested or not) can be as

high as 40%. These differences can be significant over time and with Capital Gains rates expected to increase further, sellers may elect to move sooner rather than later.

• Interest Rates – There is a direct relationship between the cost of debt and capital and the price that can be paid for a business. When rates are higher, cash flow is lower; thus depressing value. Interest rates today remain at historically low levels. Most economists believe they will rise in the future.

• Market Conditions –As we learned in Basic Economics, supply and demand ultimately determine the value of any business. Today, the market is robust with a huge amount of money chasing fewer quality deals. The result is a sellers' market and an opportunity for business owners to get top dollar.

• Business Life Cycle – Businesses, like individuals have a life expectancy with growth, maturity and decline phases. Change can come quickly when we are least prepared. Very few family businesses survive longer than two generations. The time to sell is ALWAYS when the business is at its peak or close thereto and the owner is healthy and still active. Many great private companies have failed by holding on too long.

The decision of when to take "Chips Off the Table" is the ultimate decision we all make as business owners. It is a decision that can impact the seller and his/her heirs for generations. It needs to be made only after careful consideration, planning, and without emotion or bias.

Choose wisely.

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