ELITE ADVISOR BEST PRACTICES
Inside the Inside Sale
A record number of businesses will be coming up for sale as baby boomers steamroll toward retirement age. Here’s how advisors can shine when there aren’t enough viable buyers.
By Guy Baker
- A hidden axiom in business transition planning is that business owners tend to buy themselves out of their businesses—with their own money.
- Exit planning is a burgeoning opportunity for advisors as waves of boomers move toward retirement.
- Helping entrepreneurs transition their business will be a critical puzzle piece for estate planners and other financial advisors in the years ahead.
- The tax on the sale of a business can be one of the most burdensome to unwary entrepreneurs.
With baby boomers reaching age 65 at an unprecedented pace, there will soon be more and more business owners selling their companies—but to whom? That is the question of the next decade. The constant flow of businesses available for sale will likely saturate the capital markets and force the less profitable or less appealing companies to seek other solutions. An employee of a noted M&A firm told me that the firm actually pursues less than 5 percent of the companies it interviews. This would suggest that a large percentage of companies will be faced either with liquidation or having to sell to an inside buyer.
The problem is that the inside buyer usually has no money. But does that have to be a deal stopper? An unknown axiom in business transition planning is as follows: “Business owners always buy themselves out of their businesses with their own money.” The value of the business is the capitalized value of the cash flow. When a business sells, the new owners take the cash flow and give it BACK to the seller. Herein lies the opportunity.
Real-world case study
EDM, Inc., was such a company. It was a family-held manufacturing business started by Ralph, the father. Ralph’s son, Frank, had been working at the company for several years and wanted to buy the business from his dad. Ralph was ready to retire, and he was willing to sell the business to Frank; but, of course, Frank had no money.
Ralph owned the building and the equipment. All the inventory, administrative equipment and office furniture belonged to the corporation, along with the client list. Ralph wanted $1 million for his ownership, and he was willing to carryback the financing for his son. Working with the family CPA, it was determined that the son would buy the company stock for $1 million plus interest. There would be no money down, and the son would make monthly payments to Ralph. Dad would contribute the equipment to the business but would still keep the building and collect the rent.
The power of deferred compensation
However, after Frank started to do the math, he realized this arrangement was going to put a big strain on the business’s cash flow. Fortunately, Frank was introduced to our firm, and we presented an alternative solution. We suggested putting in a deferred compensation plan for the father, paying him $200,000 a year for five years. The cash flow was equivalent to what Ralph already took out of the business.
Because Ralph’s income would now be ordinary income, the corporation would gross up his salary to cover the tax cost differential that Ralph would have to pay if he agreed to the new terms of this sale.
The results were significant. Under the stock sale-capital gains approach, Ralph would receive $813,000 net proceeds based on the new capital gains taxes (both state and federal). But Frank would have to pay nearly $818,000 in corporate income taxes to make the payments to his dad. The total taxes for the entire transaction would have been $1,396,000, counting Ralph’s taxes on the capital gains. This would be 140 percent of the FMV for the company. Most people don’t know that the tax on the sale of a business (done the wrong way) is the most expensive transaction in the IRC.
Using our firm’s solution, we were able to save our client $802,000 in income taxes. That reduced the total cost as a percentage of the transaction to 73 percent—a significant savings. Ralph received $813,000 in net proceeds from the sale, the same as he would have received had Frank bought his stock. So for Ralph, it was a push. But for Frank, saving nearly $1 million in cash flow meant he could afford to buy out his father and had a reasonable chance at future financial success.
Exit planning will be a burgeoning opportunity in the years ahead, as more and more baby boomers move toward retirement. Having the ability to help business owners transition their business will be a critical puzzle piece for planners. Start learning how to help your clients now with this once-in-a-lifetime opportunity. Most business owners sell the business only once; they need to get it right.