The Great Escape
How to Develop and Effectively Execute an Exit Strategy
There’s a common question on the minds of entrepreneurs when they think about retirement: ‘how can I eventually get out of my business and not lose my shirt?’ The answer is simple: Develop an exit strategy a few years before your desired retirement, and simply execute it.
Take the case of Chuck, a 65-year-old-going-on-21, life-of-the-party type of guy. He sported a big smile, and joked with everyone. But he was plagued by a gnawing question: “in 10 years, I want to exit my business, take care of my employees, have enough money to live out my retirement dreams, and guarantee that my daughter inherits everything if something happens to me. Some people may want to get every dime they can when they sell, but these are the most important things to me. How do I pull this off?”
Chuck had been an entrepreneur for his entire life and, about 20 years before, started his current business from scratch. Due to his insatiable appetite for nonstop improvement, his business blossomed into one of the largest in Southeast Florida.
Chuck felt a great deal of loyalty to his employees, and wanted to develop a plan to sell the business to his general manager, Carlos. Since Carlos was a young person with a family, he didn’t have many financial assets. Chuck needed to develop a plan that would make the buyout process affordable for Carlos, while simultaneously assuring that his daughter would get fair value if anything happened to him.
To develop a quality exit strategy, business owners like Chuck need to follow some important steps. They are:
Step One: Create a financial plan. In Chuck’s case, the plan helped identify how much income he would need after retirement to fulfill his dreams. This number determined how much money Chuck would need in his retirement savings, and from the sale of the business on the day that he retires.
Step Two: Maximize retirement savings now. Over the next several months, Chuck consulted with his financial advisors and developed a comprehensive financial plan. A thorough analysis revealed that Chuck needed to put $5,000 per month into a retirement savings plan. Since IRAs and 401(k)s allow limited funding, a defined benefit pension plan was a good choice for the company. These plans work best with an older owner who has younger employees — in Chuck’s case, a perfect match. This plan allowed Chuck to put $60,000 a year into savings, all of which was tax deductible. The tax savings alone helped fund a portion of the plan: a true win-win.
Step 3: Determine the company’s worth. Chuck didn’t want the expense of hiring a valuation analyst to compute his company’s worth. To come up with an approximate value, Chuck and his financial advisors went through an exercise to determine the amount of net cash from the business to Chuck in the previous year. A good rule of thumb to use is three to five times that number equals the value.
Step 4: Establish a transfer strategy for the business to the buyer. Because Carlos didn’t have much money or assets, he would not be able to simply go to the bank and get a loan to pay for the business. To solve this challenge, annual performance incentives were created for the company. If the business met those performance incentives, Carlos, as general manager, would be gifted 5% of the stock of the company at the end of each year until he reached 49% ownership in year 10. At that point, Carlos would be a 49% owner with a 10-year track record, and a bank would likely be willing to loan him half of the business’ value to complete the buyout of Chuck’s interest.
Step 5: Get it in writing. Now Chuck needed to sit down with an attorney and get all this in writing. Since his advisors had done most of the legwork already, they were able to specifically tell the attorney what was needed, which saved a considerable sum in legal fees. The attorney drafted a stock purchase agreement for Chuck and Carlos. The agreement laid out the performance incentives and where the stock would be held, stipulated that the shares would be non-voting, and required Carlos to buy Chuck out at the end of the 10-year period. The attorney also created a trust, which laid out the transfer of Chuck’s assets to his daughter in case he died.
This type of buyout strategy is useful when the owner wants to sell to an employee or family member. The key element that allows these plans to succeed is time. The greater the amount of time the business owner plans for the exit of his business, the greater his chance of success. If Chuck simply woke up one day and said, “I can’t take it anymore,” there’s no way that Carlos could buy him out. Everyone knows a business owner who’s had health problems or unexpectedly passed away, causing the business and all its value to go down the tubes. This could have been avoided in almost every case by taking the time to create an exit plan.
Another key element in making your exit strategy succeed is to work with advisors who have extensive experience with this type of planning. Many quality CPAs and attorneys don’t fall into this category, yet they’re smart enough to bring in an outside advisor who does. Also, it’s important that the advisors work as a team, so that everyone is on the same page, working toward the business owner’s goals.
Chuck’s plan was enacted five years ago, and all has gone exactly as planned. Chuck’s still the life of the party, and loves seeing his vision turned into reality. Financial peace of mind hasn’t changed him one bit — when his friends get together, they all smile, shake their heads and marvel at the character everyone knows as Chuck.