Most family businesses are either bought by outside parties for a fraction of what they are worth or shut down. This scenario caused me to once again look at how owners think about their businesses. Most see a small business as their personal investment. This kind of thinking creates both a problem and an opportunity for a closely held business.
Let’s say you own a landscaping business. Your business generates around $300,000 per year, and you have $500,000 worth of equipment. You estimate the business is worth $1 million. If you have $20,000 on hand, you opt to buy more equipment, instead of investing, for example, in a 401(k) plan. Ultimately, recurring revenue and used equipment are the only things you really have. To get the $1 million you think your company is worth, you have to make sure the business will remain a going concern and plan how you’ll exit the business.
Most small business owners that successfully transition from one proprietor to another (whether family members or not) essentially finance their own buyout. To do this, you need someone who’s capable of taking over the business and a way to do the buyout in the most tax-efficient way. If, for instance, an owner wanted to leave her business in 10 years, she might consider giving 10 percent of the business to a key employee each year for 10 years. The owner could pay premiums on a life insurance policy for the employee who would report it as bonus income. The employer’s payments would be tax deductible. The employee, in turn, would have a life insurance policy on the current owner because the owner is making payments toward the employee’s purchase of the business. After ten years, the employee can draw cash from the policy for a down payment on the purchase of the business. During the transition, the business stays healthy with the oversight of the original owner. If, however, you rely on a traditional account to stockpile cash, what happens if one of the parties dies? What if the company is sued? What if the market crashes? Life insurance is not an attachable asset; that means nobody or no entity can take its worth from you in one of the aforementioned scenarios.
If you want to make the most of your investment, plan a way to unlock the liquidity in your business before events overtake you. When owners fail to plan their exit, three scenarios usually occur:
· The owner taps the business for cash, until there’s essentially no business left.
· The owner works diligently until death, but there’s no succession plan; if the owner has built a very successful business, the family sometimes can’t afford the estate taxes without selling.
· The business owner slows down, grows tired of the endeavor or fails to maintain profitability and must shutter the company’s doors.
Whether you decide to transfer ownership to the next generation, sell to your managers or court an outside buyer, you want to make sure the company maintains its value. You can read our blog post “Thinking for Generations to Come” to learn how one company stayed in the family.
Have you planned how you’ll leave your business? Share your thoughts with me at [email protected], and I’ll consider writing about it in a future post.