When imagining the future of their businesses, and possibly a future that involves different ownership at some point, owners may wonder if it’s really possible to consider “insiders” (employees, children, or co-owner) as viable successor owners. Insiders are often a great match for company culture, leadership style, and vision. But they may lack one very important element – money to buy the business. Is this a fatal flaw in planning for the transition of future ownership? Maybe, but maybe not.

First Things First

Before we dig deep into an insider’s ability to pay for ownership, it may be a good idea to take a step back and see whether that line of investigation is even worth pursuing. Start by laying out your goals and objectives for the future of the business in writing. You should be able to clearly define:

• How much longer do you want to own your business?
• What do you want your relationship with the business to be before, during, and after an ownership transition?
• What do you want your business to look like after you no longer own it?
• What must the business provide, on an after-tax basis, to complete your plan for financial security and independence?

Once you know the answers to these questions, you can start to evaluate possible outcomes for the future of your ownership interest by holding each scenario up against your goals to see how well they fit together.

Insiders Don’t Have Money

It is often the case that an insider, who would otherwise be an excellent successor owner, does not have enough money (or access to money) to support a purchase of the business. But this does not mean that a transfer of ownership to them should be off the table. The secret to success for an insider who is otherwise a strong owner candidate is cash flow. Cash flow can bring everything together.

The Definition of Cash Flow

What is “cash flow?” You’ve probably heard others say that your sale price might be a “multiple of cash flow”. Well, that all depends on the definition of “cash flow.” There are several definitions or measures of cash flow, each with a potentially significant and substantive difference. Typical measures of cash flow include:

• EBIT: Earnings Before Interest and Taxes.
• EBITDA: Earnings Before Interest, Taxes, Depreciation and Amortization.
• True Cash Flow: The amount of pre-tax money directed to owners via salary (above the value of their services), bonuses, distributions or dividends, and rental payments in excess of fair market rates for equipment or buildings.

Each of these measures of cash flow can produce a different cash flow amount. Which one makes sense for you may depend on the unique nature of your business.

How Cash Flow Supports the Sale Price to Insiders

Shaila Drexl, owner and manager of three commercial buildings, desired to sell each of her three property management operations to each of the three on-site building managers. She thought she’d retain ownership of the buildings themselves and separated her building ownership from the management businesses. She had heard that “six times cash flow” was a fair way to value her type of business and this method matched nicely with her idea of what she needed to meet her financial objectives.

Let’s assume that Shaila’s employees want to buy her business. Let’s also assume that these employees share a trait common to many employees: They don’t have any money. Since Shaila’s employees don’t have money of their own, and they have limited borrowing potential, the payments they make must come from business operations. Every dollar of cash flow that is created through operations will be taxed at ordinary income tax rates, because it will either get reported as company income or it will be paid or passed through to the employee, who will then report it as income. Each employee will only have an after-tax amount left to pay Shaila, who will then most likely owe capital gains tax because she is being paid for her ownership interest. That’s two bites at the apple for the IRS before each dollar makes its way to Shaila’s savings account.  So, it may take some time for Shaila to reach her after-tax financial goals if her only plan is to sell ownership to employees, because company cash flow is eroding on its way to Shaila’s pocket. Is there a faster way to help Shaila reach her financial targets?

Shaila did the math and decided that it would take too long for each employee to pay for their part of the business if they just used cash flow to pay for Shaila’s ownership using a generous multiple of cash flow as the company value. She called a meeting of her most trusted advisors and began to look at planning strategies that might work better. Her advisors were able to identify a variety of potential improvements to her plan, including revisiting company value, adding different types of payments to Shaila, and transitioning ownership over time rather than all at once. Through analysis and creative thinking, they were able to come up with several ways to use company cash flow more efficiently, all the while keeping an eye on Shaila’s stated goals. In the end, Shaila was pleased with her more comprehensive plan.

The Bottom Line

A sale of ownership to insiders can be fraught with danger if the overall picture, from company performance to individual tax consequences, is not taken into account. Comprehensive planning can take time or may require several perspectives, but the benefits can outweigh the costs for many owners.

Planning for a successful future isn’t homogenous. It simply can’t be. The needs that you and your business have are likely to be different from every other owner and business out there. So, the question you might ask about planning for future success isn’t, “How should I do this?” Instead, it should be, “Which process is the best for me?” Today, we’ll look at three different ways you can begin the process of planning for future success.

Urgency Planning

Many owners like to approach their planning through the lens of urgency. Urgency planning means identifying goals or problems that are of the highest risk, ranking them by risk, and then tackling each element in order. This may seem straightforward, but there are some considerations.

1. How do you define risk?
2. Why do you think a certain aspect about your business is subject to risk?
3. Why do you think you must address this risk before or after others?

Determining why things are urgent guides the planning process. If tackling projects based on their criticality is what’s most comfortable for you, it’s important for you to know why those things are critical and how they affect the other critical things down the list. Pausing to understand your reasoning may also give you some insight into your more fundamental priorities.

From-the-Ground-Up Planning

When business owners first start thinking about planning for a successful future, from-the-ground-up planning is what they initially envision. (This might be a reason why owners sometimes find the concept overwhelming.) The process for from-the-ground-up planning often looks like this:

1. Getting internal affairs in order. This could be hiring the right and appropriate number of people, conducting quality control, or creating yearly goals for each team.
2. Develop management. Once the house is in order, the next step is to find or train managers who can run the company themselves. Developing a strong management team is critical to the success of from-the-ground-up planning because it’s the managers—rather than you—who will keep internal affairs in order and exceed expectations. This will give you time to move to the next step.
3. Designing your ownership transfer. Whether you stay in your business forever, transfer to insiders, or cashing out with an outside third party buyer, you’ll need to determine the appropriate amount of money you must have to achieve financial independence and how the business can support that need. Planning your future may include anything from installing programs to incentivize, retain, and/or reward key employees to creating a set of business continuity instructions in case you die or become incapacitated.

Hybrid Planning

Hybrid planning takes the two planning methods from above and mixes them together. Doing so lets you maintain a balanced momentum toward the things you’re excited about pursuing while still addressing the most daunting aspects of your planning process.

For example, you might be excited about building your company’s value but dread the idea of finding a next-level management team because you’ve never had one before. A hybrid method lets you combine your urgency planning (building value) with your from-the-ground-up method (installing next-level management) so that you aren’t disregarding the things you’d rather not do. Similarly, you might combine your urgent desire to install your kids as the next generation of owners and leaders, but you’ll also need to support the company documenting its internal systems and processes (a fundamental factor for business stability), which can help your children be more successful.

We can help business owners identify and prioritize their objectives with respect to their business, their employees, and their family. If you are ready to talk about your goals for the future and get insights into how you might achieve those goals, we’d be happy to sit down and talk with you. Please feel free to contact Peter Skelton at peter@kafl.com or 585-271-6400 x108.

As a business owner, you make decisions constantly that you believe will reduce your risk and/or improve your business outcomes. There are countless ways to do this. In this article, we’ll present ways to leverage your internal strengths to reduce risk and improve business outcomes. We’ll also show you how these strategies can affect your longer-term, post-business planning.

An effective strategy for reducing risk and improving outcomes is having a management team that can run the business in your stead. There are numerous benefits of having such a management team. First, it reduces your company’s reliance on you. This can give you more time to focus on the biggest goals you have for yourself, your family, and your business.

Second, it can act as a source of new ideas to improve the business in general. This is especially true if your management team has a diversity of experience. Different experiences can lead to different, sometimes unconsidered, strategies to improve business outcomes.

Third, it often increases the value of your business. Whether you hope to sell to a third party or an insider, or even work until you die, having people other than yourself who can keep the business humming makes it more attractive to potential buyers.

Having a strong management team also ties into your long-term, post-business planning. If you hope to eventually sell your business to insiders, the management team may end up being a qualified buyer, or they may be critical to supporting your children as they take over leadership. This can give you a head-start on bolstering future performance for a strong and healthy company, leading to a more successful transfer.

For example, incentive plans for your management team give them more responsibility, which lets you determine whether they’re fitting successors or high-level executives. Incentive plans also motivate the team to continuously improve the business because any rewards are contingent on achieving goals that contribute to your future success. This can allow you to wind down your responsibilities without giving up control while increasing your income, reducing your risk, and improving your outcomes.

To take it one step further, a common misinterpretation is that owners must transfer all of their ownership to insiders at once. This isn’t necessarily true. There are many ways to transfer portions of ownership over time, which are often tied to good incentive planning. This can keep you in control while you delegate more responsibilities to other people. It also gives you an out if your management team proves incapable of meeting or exceeding expectations, which protects you against risk.

If you intend to sell to a third party or work until you die, you can set up different kinds of incentive plans to make your desired path and tenure easier. You might consider a “Stay Bonus” structure in your incentive plan. It rewards managers who stay with the business through and after you transition out of it. This reduces the risk that important players will abandon ship and negatively affect your company’s value.

How can you know whether you have a management team that can reduce risks and improve outcomes? A good indicator is how the business operates in your absence. If you’ve ever taken extended time off only to find yourself addressing business issues on your time off, it’s likely you don’t have a strong management team (the same applies if you feel like you can’t ever take extended time off). If you aren’t confident that your management team can run the business well without you, you may want to consider finding managers that can.

To reduce risk and improve outcomes, you’ll likely need to look outside of yourself. But this can be extremely beneficial to yourself, your family, and your business. However, leveraging your internal strengths (or finding strong external managers to join your company) can take time. This means that it’s likely in your best interest to start this planning now, before you absolutely need it, rather than when you need it.

If you’d like help in working through the ways you might reduce risk and improve outcomes in your business, please contact Peter Skelton today at peter@kafl.com.

What’s your New Year’s Resolution?

Communicating better and more effectively is in the top three of my resolution list, along with exercising more and losing weight.  One of the challenges I find with communicating with clients is a reason to reach out in a way that’s meaningful and with relevant information.

One of the groups that many advisors find challenging are business owners.  Few things are bigger and more important to business owners than planning for their future success, both inside and outside the business. It’s a huge planning process, and owners need help from advisors to plan effectively. Shockingly, business owners are reporting that when they need their advisors most, they’re nowhere to be found.

According to a Ycharts survey, as reported by Caleb Smith and Irene Huhulea of Investopedia, “[T]he majority of advisory services clients are under-engaged when it comes to their relationships with advisors. In fact, 63% of survey respondents said that they were contacted by their advisors ‘infrequently’ or ‘very infrequently,’ including nearly half of clients with $500,000 or more in AUM.” Additionally, “The survey also found that 62% of respondents said more frequent or more personalized contact would give them more confidence in their financial plan and 85% would consider the frequency and style of communication when deciding to retain services.”

So, advisory services clients, including business owners, want more communication from their advisors, would feel better about their planning with more personalized contact, decide whether to retain an advisor’s services based on how well they communicate, and still feel like their advisors aren’t in contact with them enough. What can and should advisors do to address these communication breakdowns?

As an outside advisor, it’s easy to view a business primarily as an asset. To business owners, the business is often so much more. Yes, it’s important to business owners for the business to be worth as much as possible. But there’s more to business ownership than just maximizing value.  Unless advisors understand what, other than money, owners care about, it’s impossible for them to work in their clients’ best interest.

Understanding what drives business owners outside of money is much more challenging than it seems. The advent of analytical technology has made it much easier for advisors to be more indirect with their clients. They can more easily crunch numbers and create projections, sometimes without ever contacting their clients directly. This isn’t to say that this technology is inherently bad: It certainly makes planning processes more efficient. But none of these technologies can replicate the human element of planning for a successful future.

Bluntly speaking, unless advisors know how to appeal to the emotional side of planning, they cannot truly provide the advice business owners seek. The planning process is far too emotional to rely solely on cold logic, algorithms, and projections. This isn’t something that advisors can simply discount. Recall that 85% of advisory services clients consider whether to retain an advisor’s services based on how and how often that advisor communicates with them. Proper communication is what owners want, yet many advisors aren’t delivering it.

We are investing in being a leader in helping you communicate with your business owners about planning for their successful futures.

So what are some of the takeaways?

• Advisory services clients, including business owners, feel that their advisors don’t contact them frequently enough, and will make decisions regarding whether to retain their services based on the frequency and quality of their communication.
• Advisors to business owners must know how to communicate with their clients and prospects in ways that reveal what matters to them. Once they find out what matters most, they must do everything they can to address those matters.

If you would like to discuss how we can help you open up some conversations with your business owner clients, contact me and let’s talk!

Peter Skelton
CEO
KAFL Insurance Resources
www.kafl.com
585-955-6224 Direct
800-272-6488
585-271-5050 Fax