Indianapolis Small Business - IndySmallbiz.com » T. Ray Phillips

Buying Out Your Partner

T. Ray Phillips — Thu, 26 Jan 2012 18:17:10 +0000

Presented by T. Ray Phillips

MMS, Inc., a computer service business, had survived recent industry turbulence through the persistent efforts of its owners, Ralph McMillan and Janet Shaw. In fact, MMS had enjoyed good cash flow for the past three years and its future looked rosy. Successfully meeting these challenges made Ralph (age 59) more anxious than ever to leave the business and Janet (age 48) more than ready for Ralph to leave. But neither owner had a clear idea of how to proceed, who to ask for guidance or even how to take the first step.

Janet and Ralph had to find the starting line before they could run the course to the successful dissolution of their partnership.

Ralph’s Tasks

First, Ralph must assess his income needs and timing of his exit. He must determine how much of the purchase price he needs (or wants) on the day he leaves and how much he is willing to receive after he leaves (a Retirement Needs analysis). This is a very different question from how much his interest is worth yet the questions are related because the cash Ralph needs must be attainable from the sale of his interest.

Second, Ralph must obtain an independent valuation of his ownership interest.

Note: Ralph is unwilling to leave unless he exits with full value for his ownership interest (hence the need for the valuation) and unless that value is enough to meet his retirement needs (hence the need for a retirement income needs analysis).

Janet’s Tasks

Janet wants to balance the risk/liability she and the business will assume in Ralph’s buy-out with the opportunity for continued growth in the value of business interest. Since Janet is likely to be unwilling to buy Ralph’s interest—if doing so puts her (or the business) at too great a financial risk—she must secure a professional’s projection of the company’s future cash flow.

This cash flow projection with enable Janet to determine if the business will likely have enough cash flow (after Ralph leaves) to finance the purchase of Ralph’s interest without stifling the growth and prosperity of the business.

Ralph’s Exit Plan Design

Ralph’s Exit Plan should be designed to:

Use the available cash flow in the most tax-efficient manner possible.
Plan the long-term ownership structure of the company.
For example, after Ralph is gone, what does Janet (the remaining owner) intend to do with the business? Does it not make sense to consider her future exit when Ralph’s exit is being designed and implemented?

Ralph’s Alternatives

As Ralph contemplates his exit, perhaps Janet should consider:

Selling all of the ownership to an outside party. To do so, the business must be marketable and Janet (and perhaps even Ralph) may need to remain for a year or more after the sale. In this scenario, Ralph has a better chance of receiving at least the bulk of the purchase price.
Selling Ralph’s interest to key (or all) employees. This strategy depends on the existence of motivated management willing to assume ownership. Often, a partial sale to a younger management group (keeping control firmly in the hands of the remaining principal owner) makes great sense. This strategy starts to pave the way for the eventual sale of the remaining owner’s interest to this group, can be a great motivation tool and handcuffs this management team to business.
Selling all (or just Ralph’s interest) to an Employee Stock Ownership Plan (ESOP). This design can potentially offer tax and cash flow savings for both Ralph and the buyers.
These are just a few of the many ways to design the exit of a co-owner.

Before any group of co-owners can create a successful exit plan they must employ professionals to:

Assess the departing owner’s needs (a retirement income needs analysis);
Secure an independent valuation of ownership interests; and
Assess the remaining owner’s risk tolerance (dependent on a cash flow projection).

To contact T. Ray Phillips Re: subject matter in this article, call
(317) 208-6312 OR e-mail trphillips@finsvcs.com

Please do not leave trade instructions over e-mail, as they cannot be processed.
Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS under circular 230, we inform you that any U.S. Federal tax advice contained in this communication, unless otherwise specifically stated, was not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing, or recommending to another party any matters addressed herein.

The Importance Of Time In An Employee Buy Out

T. Ray Phillips — Mon, 09 Jan 2012 16:07:39 +0000

Presented by T. Ray Phillips

Many, probably most, business owners would like to sell their businesses to their employees, but for one nagging problem: Their employees have no money.
The desire to sell to employees collides with the owner’s overarching need for financial security. Owners simply cannot risk selling a business to employees who have no cash.

Take James Johnson, the fictional owner of fictional company Johnson Consultants, Inc. James’s management team was capable and interested in buying the company. The business had little debt and good cash flow.
When James met with his advisors to discuss the topic, one of their first questions was, “When do you want to leave the business?”
If James answers, “Now!” a sale to employees who lack cash is fraught with risk. If James’s answer is, “I’d like to be out—and cashed out—of the business in five to eight years,” a well-designed exit plan can make that happen—if James starts today.

Plan Goals Any buy-out plan must accomplish three goals:

1. Minimize the owner’s, the company’s and the employees’ risk, by keeping
the owner in control of the business and the sale process until the owner receives the entire purchase price.
2. Ensure that the owner receives full value for his or her ownership
interest.
3. Minimize the income taxes of both the owner and the employees.
Unless a buy-out plan meets these goals, owners would be wise to reconsider selling their companies to their employees. If, on the other hand, owners plan and begin to execute a transfer plan well in advance of their departures, they can achieve these three goals. Of course, special planning is required to meet the income tax minimization goal.

Two-Stage Plan Design

A plan to execute an employee buy out has two stages.

Stage 1: Each year employees buy small amounts of stock until they have purchased and paid for approximately 35% to 40% of the ownership (usually non-voting). Ordinarily, this stage takes five to eight years. At the end of this stage, key employees are in a position to approach a bank.

Stage 2: Assuming the business continues to be profitable, paid-up owners of 40 percent of a company are usually able to secure bank financing to purchase the remaining balance of the owner’s stock.

James’s buy-out plan kept him in full control of his business until he received all of his money. Because he maintained control, he significantly reduced the risk of not receiving full value. He successfully cashed out of his business because he did not wait to begin his exit planning until he was ready to leave. By starting before he was ready to leave he was able to choose his successor, exit on his timetable, and leave with the cash he wanted.

The two-stage plan outlined above is a very brief summary of a relatively involved buy-out plan. There are many additional design issues that owners should discuss with their advisors.

Caveats:
1. This plan does not work for all businesses, but can work well for
companies valued between $500,000 and $5 million.

2. Executing the plan takes time, usually at least five years to allow the
employees to purchase a significant chunk of the company.

3. This plan requires a cooperative bank aware of the owner’s intentions
well in advance of the transfer.

4. This plan requires a strong management team interested in owning a
company financially fit enough to allow most of the available cash flow to be used to pay off the purchase debt.

To contact T. Ray Phillips Re: subject matter in this article, call
(317) 208-6312 OR e-mail trphillips@finsvcs.com

Quantify Your Resources: The Ultimate Exit Test

T. Ray Phillips — Tue, 13 Dec 2011 16:00:47 +0000

Presented by T. Ray Phillips

In the first Step of The Seven Step Exit Planning Process™, you, as an owner, establish three primary exit objectives:

The date you wish to exit;

The amount of cash you want upon exit;

and Your choice of successor.

Today, let’s look carefully at that second objective: How much cash will you need from the sale of the company to enjoy a financially secure post-business life? For most owners this is a great starting point for determining when, or if, they can leave their businesses.

Peter Daniels was the 58-year old (fictional) owner of Daniels Food Processing, Inc. He had engaged his financial advisor to:

Set a realistic assumption for a rate of return on Peter’s investments;

Research actuarial information to determine average life expectancies for both he and his wife;

and Help him and his wife agree on and establish an acceptable post-exit annual income amount.
As part of this process, Peter and his advisor reached the critical question whose answer would determine Peter’s ability to retire on his terms: What must the value of Peter’s business be if Peter is to leave, as he desires, at age 63?

Like Peter, your resources are likely both in the business and outside of it. You need to know the value of both so you can determine if there is a gap between the amount of money you will need in the future and the amount you have today. This gap must be quantified and—to exit successfully—you must create and implement a plan to close that gap. Most owners retain an experienced financial planner to help with this project.

Peter and his advisor used the following process:

First: Peter and his wife (Pam) agreed on their future annual income needs. They believed that they could live on $200,000 per year (95% of their current income) and would require that level of income for approximately 30 years (based on their life expectancies).

Second: Peter and his advisor, using their agreed-upon estimate of a projected rate of return, calculated that Peter’s non-business investments assets would be worth approximately $500,000 in five years (Peter’s desired exit date).

Third: Peter’s advisor calculated that the amount of investment capital needed to pay Peter and his wife $200,000 per year for the duration of their lives (based upon current actuarial tables and assuming a seven percent investment return*) beginning five years hence is approximately $3,000,000. Thus the net (after tax) sale proceeds from the sale of the business must be $2,500,000, or between $3,000,000 and $3,500,000 pre-tax.

Fourth: The business is today worth between $1,000,000 and $1,500,000.

Bottom Line: The gap between what Peter has today and what he needs to retire on his terms is about $2,000,000. Therefore, Peter must increase the value of his company by at least $2,000,000 if he is to exit on his terms.

This is why Peter needs at least five years to plan and why he must start today.

Many of you can identify with Peter’s situation because you face the same challenges. Peter knows what he has to do and he’s found the motivation to start the planning and preparation necessary to leave his business in style. Have you?

For Peter, and perhaps for you, five years is a tick away. It’s time to get busy.

*In today’s market, few financial advisors are comfortable projecting a seven percent investment return and few owners can tolerate the risk involved in achieving that rate. If half that rate of return is a more realistic figure, then the owner’s principal (in this case business sale price) must almost double to yield the same amount of income.

To contact T. Ray Phillips Re: subject matter in this article, call (317) 208-6312 OR e-mail trphillips@finsvcs.com

Please do not leave trade instructions over e-mail, as they cannot be processed.
Circular 230 Disclosure: To ensure compliance with requirements imposed
by the IRS under circular 230, we inform you that any U.S. Federal tax
advice contained in this communication, unless otherwise specifically
stated, was not intended or written to be used, and cannot be used, for
the purpose of (1) avoiding penalties under the Internal Revenue Code or
(2) promoting, marketing, or recommending to another party any matters
addressed herein.

Preparing For Your Exit: Planning For Your Inevitable Business Exit

T. Ray Phillips — Fri, 25 Nov 2011 15:00:35 +0000

With over half of today’s 9.5 million owners of established businesses reaching the retirement age of 50 years old or older it is likely that many of you will be ready to leave your business within the next decade or so1. What have you done to plan for that day?

What are you waiting for? How could planning for the biggest financial event of your life not be worth your time and effort?

Given that most retirees live on 95 percent or more of their pre-retirement income there’s good reason to get busy creating an Exit Plan that enables you to help achieve your financial and lifestyle objectives after you leave your business2.

If you aren’t sure how to begin preparing for your voluntary – and inevitable exit – because you don’t understand the process or even know whom to turn to for help, you are not alone. There is a methodical, adaptable and customized Exit Planning Process that business owners and their advisors have used for years that is designed to help owners leave their businesses on their own terms and on their schedules.

Exit Planning is not mysterious, time-consuming, nor just a clever way to sell you another product. It is, however, a means to help you achieve your financial and lifestyle objectives:

1. Leaving on the date you choose.
2. Receiving the amount of cash you want.
3. Choosing your successor.
4. What exactly is the Exit Plan that will allow you to leave your business in style? How do you create yours? Just as there is an almost infinite variety of businesses and business owners, so too are there many different Exit Plans.

Yet all plans contain several common elements. Let’s begin with the basic seven issues that most owners understand best when we phrase them as questions.

1. Do you know your primary planning objectives for leaving the business, such as:
Departure date?

2. Income needed to achieve financial goals?

3. To whom you want to leave the business?

4. Do you know how much your business is worth?

5. Do you know how to increase the value of your ownership interest through enhancing the most valuable asset of the company – the employees?

6. Do you know the best way to sell your business to a third party, with the goal of increasing your cash, decreasing your tax liability and reducing your risk?

7. Do you know how to transfer your business to family members, co-owners or employees, while paying lower taxes and achieving your financial goals?

8. Have you implemented all necessary steps to ensure that the business continues if you don’t?

9. Have you provided for your family’s security and continuity if you die or become incapacitated?

If you can answer “yes” to all of the questions, then you are well on your way to developing a successful Exit Plan. If you are like the vast majority of business owners; however, your answers highlight areas where you need to focus your Exit Planning efforts. As you work through your Exit Plan, however, you will be able to say, “Yes” to each and every one of the questions listed above.

1 Feldman, Dr. Stanley J. and Winsby, Roger, “Financial Service Needs of Established Business Owners: The Size and Demographics of a Wealthy Underserved Market,” Axiom Valuation Solutions, formerly bizownerHQ.

2 The Wall Street Journal, “The Retirement Lies We Tell Ourselves,” December 11, 2006.

DISCLAIMER: The information contained in this article is general in
nature and is not legal advice. For information regarding your
particular situation, contact an attorney or tax advisor. This
newsletter is believed to provide accurate and authoritative information
related to the subject matter. The accuracy of the information is not
guaranteed and is provided with the understanding that none of the
providers of this newsletter, including Business Enterprise Institute,
Inc., is rendering legal, accounting or tax advice. In specific cases,
clients should consult their legal, accounting or tax advisors.
The example provided is hypothetical and for illustrative purposes only.
It includes fictitious names and does not represent any particular
person or entity.
To contact T. Ray Phillips Re: subject matter in this article, call (317) 208-6312 OR e-mail trphillips@finsvcs.com
Please do not leave trade instructions over e-mail, as they cannot be processed.
Circular 230 Disclosure: To ensure compliance with requirements imposed
by the IRS under circular 230, we inform you that any U.S. Federal tax
advice contained in this communication, unless otherwise specifically
stated, was not intended or written to be used, and cannot be used, for
the purpose of (1) avoiding penalties under the Internal Revenue Code or
(2) promoting, marketing, or recommending to another party any matters
addressed herein.