The moment arrives for every successful business owner: You start thinking about what it would be like to sell the business, name a successor and create a legacy that makes you proud.
According to data from Barlow Research, the median age of retirement for small-business owners was 67 at the start of the pandemic. Survey data from the Federal Reserve Bank of St. Louis, meanwhile, describes a retirement "boom" as 2021 began; Forbes notes that during the 2020-2021 period, 62 percent of business owners said they hadn't taken a vacation, and 45 percent said that running a business had a negative impact on their well-being.
The upshot? Even as economic conditions rebound and companies get back on their feet, many business owners find themselves wondering if it's time to make the move. Maybe it's as simple as taking a step back and letting someone else take charge. Maybe it means selling your business to a friend or family member, or maybe it means shuttering the company and selling off the assets. No matter the approach, however, there's a substantive distance between the notion of creating a legacy you're proud of and making this idea a reality.
In our three-part series "How to create a great legacy," we're taking a deep dive into the key steps to get you started, the common pitfalls to avoid, and the benefits of having trusted and experienced financial advisors on your side. First up? A step-by-step guide to selling your business and taking the first step toward your legacy.
Step 1: Calculating your business's worth
How much is your business worth? It's not an easy question to answer: While the number in your head reflects years of time, hard work, and perseverance, the market value of your business is largely dependent on external factors that fluctuate significantly over time.
Consider a recent post from the American Institute of CPAs (AICPA) which speaks to the impact of the Coronavirus Aid, Relief and Economic Security (CARES) Act. The post offers insight for CPAs conducting business valuations and recommends they take into account factors such as:
- Paycheck Protection Program (PPP) loans: Depending on the nature of the business and the timeline of a loan application, some companies may be eligible for PPP loan forgiveness, which in turn impacts their overall market valuation.
- SBA Debt Relief: As noted by the AICPA, the Small Business Association (SBA) covering six months' worth of Debt Relief Program payments has a direct impact on cash flow and net income, which may increase total valuation.
- Past and future financial results: While many businesses used CARES funds during the pandemic to remain in operation, some were already on the brink of collapse before COVID challenges made it impossible to stay open. As a result, evaluation of pre-pandemic financials and the use of CARES funds must be considered to determine the potential results of future operations and in turn the value of the business.
- Comparable business use of CARES Act provisions: The AICPA also recommends that accountants examine how comparable companies in the market benefitted from CARES provisions and how that impacted their bottom line. This provides a general benchmark for valuation to provide a more accurate market value.
Before getting in touch with CPAs to start a formal valuation process, however, it's worth doing some quick math yourself to get a general sense of your business value — and if it makes sense to start the sales process.
Three calculation methods are common.
1. The asset method
The most straightforward method of evaluating fair market value, the asset method calculates value by subtracting liabilities from assets. For example, if your business has $200,000 in assets and $50,000 in liabilities, its total value is $150,000.
Worth noting? The asset method effectively provides a point-in-time ballpark of business value. It doesn't take into consideration the ongoing nature of a profitable going-concern business, which has plans for continued, profitable operations that directly increase its value.
2. The income method
The income method is more complex. It requires calculating your business' potential future economic benefit, adjusting for factors such as growth rates and cost structures, and then working backward to create current value. While it may provide a more precise representation of market value, it depends on accurate forecasting assumptions and is best attempted with the help of a financial professional.
3. The market method
The market method is designed to be quick and easy, but it also provides a more accurate valuation than the asset method. As noted by Forbes, it relies on current market data about the average sale price of cash-flowing businesses in comparison to the seller's discretionary earnings (SDE). SDE is calculated by combining the net profit on your profit and loss statement with any personal expenses, such as the purchase of health or auto insurance paid for using business funds, along with any salary you pay yourself.
Here's an example: Say your business has a net profit of $150,000 per year. You pay yourself a salary of $60,000 and spend $40,000 on documented personal and family expenses. The result is an SDE of $250,000. If the average market multiple for SDE in your area for similar businesses is 2.0, you multiply your SDE by this value — $250,000 x 2.0 — to get an average market value of $500,000.
Equipped with a general idea of business value, you can make the first of many decisions regarding your legacy: Is it time to sell, or is it worth reducing debt and increasing valuation to boost your business value?
Step 2: Choosing your successor
What happens after your business is sold? Who takes over the reins, and why? Would you prefer to sell your business to a family member? An interested party with business savvy? A private equity firm? Each approach comes with pros and cons — which one works best for you depends on your financial and familial goals.
Option 1: Selling to a family member
If you have family members interested in running your business or have plans to keep the business under the auspices of your family at large, you may consider selling to a family member. This could be an adult child, a sibling, a niece or nephew, or even a cousin — what's more important than their relationship to you is their willingness and ability to manage the business.
For instance, if they've already been working with you and have demonstrated substantial business savvy, it may make sense to have them transition into your role over time. If they have other interests but you want the business to remain in the family, you may want to transfer ownership (with or without a sale), without transferring specific roles or responsibilities.
Option 2: Selling to an interested party
You may also choose to sell your business to an interested party. This could be a current employee or group of employees who plan to continue running the business as-is, or it could be a buyer looking to capitalize on your positive cash flow.
Option 3: Selling to a private-equity or investment firm
There's also the possibility of selling your business to a private-equity or investment firm. In this case, your business may be repurposed as part of a larger investment strategy. Or, it may be closed after the purchase if it directly competes with another company owned by the equity or investment firm.
Step 3: Creating a diverse financial portfolio
Before selling your business, it's critical to lay the framework for a diverse financial portfolio. Here's why: In the wake of your sale, your liquidity increases substantially, but the longer these assets remain in liquid form, the smaller the benefit for your legacy.
It makes sense, since uninvested money isn't paying dividends, and as the past two years have made abundantly clear, market forces could shift at any time. While it's possible to take a wait-and-see approach with your sale — to evaluate the market in the moment and decide where your money is best invested, this comes with the dual problems of cost and complexity.
Consider a recent analysis of active U.S. equity mutual funds during COVID-19 conducted by the National Bureau of Economic Research (NBER). The paper found that active investments during this time period underperformed benchmark expectations, in turn "contradicting the hypothesis that active funds outperform in recessions." Other funds also suffered during this time period, and while rebounds are underway, market stability is no longer a given.
The takeaway? It's critical to create an in-depth financial plan that prioritizes a diverse financial portfolio before you sell your business. This allows you to streamline the transfer of liquid assets into investments with stable performance; diversification, meanwhile, helps ensure that even if specific funds struggle, your overall portfolio remains positive. Needless to say, selling your business is likely the biggest financial / liquidity event of your life. It can get stressful. As you begin to exit the business, knowing you've got all the money-management bases covered will allow you (and your family) to sleep better at night.
As a business owner accustomed to steering the ship, it may be tempting to take on this type of portfolio planning on your own. But it's often beneficial to connect with trusted financial experts who know this territory well, understand your business and have your best interests in mind. Here at California Bank & Trust, our wealth planning specialists can help you develop a wealth management plan customized to your specific financing needs. Leveraging expert advice also reduces the time and effort required on your part during the sale, in turn letting you focus on what matters: Your legacy.
Step 4: Considering what comes next
Preparing to sell your business is a critical step in planning your legacy. From the timing of your sale to the diversification of your assets, it's no easy task — and it's worth taking your time to make sure everything goes to plan.
But it's also important to consider what comes next. While selling your business lays the groundwork for your legacy, well-performing investments alone aren't enough to ensure legacy goals are met. As a result, it's worth mapping out a long-term view of legacy goals along with a general sense of direction:
- How will you leverage assets to meet these goals?
- What types of trust and fund distribution frameworks make sense for any children or other family members who may benefit from your legacy?
- How much of your wealth will be donated to charitable causes?
- How do you determine the optimal timing for each of these steps?
This is the 'soft' side of succession planning, but it's also at the core of what your legacy is about, therefore it must be an integral part of your financial plan.
Consider the example of a trust created for your adult children and your adolescent grandchildren. First, it's worth establishing your overall goal: Is the plan to provide them with a lump sum of money at a specific time, or allow them discretionary access to funds with a cap each month or year? Or would you prefer a trust system that allows your children and their children to request funding for specific purposes — such as for healthcare needs, down payments on their homes, or to help put your grandchildren through college?
Moreover, what (if any) stipulations would you include? For example, you might require that your children have steady and gainful employment before they can access funds. Or you might create provisions for emergencies. No matter the approach, it's worth creating a well-designed trust, crafted from the ground up to meet your needs and cover foreseeable circumstances — along with leaving room for additional stipulations or modifications as needed.
Taking the first step
The first step in establishing your legacy? Mapping out a detailed plan to sell your business and find a successor. But this is just the beginning. To ensure the legacy you leave is the one you want — both for yourself and your family — it's critical to avoid common missteps and make sure you've got the right people in place to help you achieve your legacy goals.
Worried about where things might get off track? We've got you covered in Part 2 of our Creating a great legacy series: Avoiding Common Pitfalls.