Planning for retirement can be complicated for anyone, but business owners have even more to consider.
Most retirement planning articles for business owners focus on their retirement plan options, which are essential components to maximizing the tax-efficiency of savings and deserve substantial attention on their own. My colleagues previously provided an overview of retirement plans for small businesses in general and for solo entrepreneurs in particular.
Yet for business owners, another major consideration is important. Your retirement often means ending your income stream at the same time that you are selling potentially your largest asset: the business. Taking steps to make the company more desirable before a sale can help you start retirement in the best position possible.
When developing an exit strategy from the business, first you should identify and prioritize your objectives. While it will not maximize the company’s value, you may want to wind up operations completely if you don’t wish the company to extend beyond your involvement. Alternatively, you might choose to transfer the business to key employees, family members, or someone else you know. In this case, you may sacrifice some monetary value in pursuit of other goals for your business’s future. Discussing these issues with a financial planner can help crystalize the impact of these decisions on your post-retirement lifestyle and may also help uncover hidden value in your business.
Like most financial questions, the right answer to how to maximize your business’s value will depend on your specific situation. Yet certain universal principles can lead you down the right track. At the most basic level, if you want to sell your business, create a desirable company that can exist without your involvement.
Make The Owner Obsolete
The first, and arguably most important, step in maximizing your business’s value to a potential buyer is to plan to make yourself obsolete. Many businesses rely on the skills, relationships and expertise of their founder. But a business that can thrive after he or she departs requires a path forward without those intangible assets.
You should establish thorough processes and routines that will allow the business to function smoothly without you. Then test those processes. A well-constructed system will ensure that clients, vendors and employees have a consistent experience, regardless of how much or little you contribute to the relationship.
While some owners feel that they need to be the company’s focal point, potential buyers prefer to see a well-balanced team. Your exit plan should involve determining who will take over key tasks and when they will do so. Also consider whether you might better outsource or automate some of your current responsibilities. A strong team with a demonstrated track record of success will not only help your business grow in the short term, but a new owner will value a business more highly if he or she can rely on the existing management team. Because retaining key employees benefits your business, you should also be able to show potential buyers that you have taken steps to encourage those staff members to stay on after your departure.
Understand The Owner’s Value
Many small business owners have a skewed sense of their business’s value because they don’t understand how a buyer thinks. A buyer will not pay for things you are taking with you when you leave. This includes the services you provide to the business, whether you compensate yourself for them or not. Therefore, you should take compensation for those services before you leave.
Say a boutique earns $100,000 per year in profit but the owner takes no salary. The company could be virtually worthless if the buyer would need to pay someone close to that amount to provide the functions the current owner fulfills. Conversely, if the business owner pays herself an above-market rate salary, buyers should recognize that they can make additional profit by buying the business and hiring a less-expensive employee.
Depending on the business, buyers might price a company based on the “seller’s discretionary compensation,” which is all the income that an owner receives. Or potential buyers may adjust the financial statements, and their pricing, to reflect a fair market salary for the owner’s services.
With this in mind, you should feel comfortable paying yourself any amount that leaves the business with enough cash to operate. Any paid compensation shouldn’t have a material impact on the value of the company. Stay mindful, however, that the amount of unpaid work you do might cause buyers to lower their purchase price.
Tidy Your Books
Potential buyers need to have confidence in their analysis when buying a business. Providing them with as organized, complete and accurate a picture of the company’s finances as possible will help. All your financial data should be easy for a potential buyer to review. Sloppy financial reporting often serves as a red flag for buyers. Inaccurate or incomplete records can hurt the company’s value, since buyers will view it as a more risky acquisition. Buyers compensate for higher risks by lowering their offered price. Paying an outside firm to review – or better yet, audit – your financial statements will help increase your company’s value.
Many owner-run companies aren’t designed to maximize reported profit, because maximizing reported profit means higher taxes. When preparing for a sale, it is important to remove any personal expenses from the business and cut unnecessary spending. Trying to minimize taxes in the short term can result in material reductions in your business’s market value.
Understand your books and be sure that they tell the story you want a potential buyer to see. If your business recently experienced one-time expenses or changes in revenue that might distort its value, be ready to explain the circumstances.
Identify And Improve Key Metrics
The value of any business is what someone else is willing to pay for it. Buyers determine what they are willing to pay in several ways, but a common technique is to look at comparable transactions involving similar companies. Buyers may evaluate key metrics from similar companies at the time they sold and extrapolate a value for your business by comparison. They may price the company based on multiples of assets, revenue, net income, and earnings before interest, taxes, depreciation and amortization (EBITDA). The relevant multiples change by industry and get more esoteric for companies that are not making a profit. Once you identify the key metrics for your particular industry, you can focus on optimizing these numbers for your business.
Buyers also pay more for companies that are trending in the right direction. Even incremental improvements can serve as a sign of business health. Although buyers largely dismiss an owner’s specific projections, you still should have a formal long-term growth strategy. That strategy can help you to justify the target value for your exit by illustrating the business’s overall momentum.
A company demonstrates more value when it can boast both a diversified customer base and a diversified revenue stream. Buyers will want to see that no single client accounts for too much of total sales – generally, no more than 10%. Otherwise, if one or two major customers abandon the company after you leave, it could cripple the business. Losing major clients right before a sale is also a problem, especially if those clients represent a disproportionate level of revenue. Instead, your customer base should be balanced and, ideally, growing.
One way to reach new customers, as well as secure the return business of existing customers, is to explore new products or services. Your revenue stream should demonstrate that it is sustainable and should come with a backlog that the new owners can rely on. This is why recurring revenue sources are especially important. You can exhibit more potential value, too, if it is clear why your product or service stands out from competitors.
Identifying and strengthening what makes your business unique will also help you to make your business more marketable. Market research can help you to answer the question of what sets your offerings apart, as well as identifying any potential barriers to competitive entry. In other words, how easy is it for new competitors to get off the ground and create a similar business? The harder it is, the more valuable your business will be to a buyer.
Structure The Business To Be Scalable
When you try to maximize a business’s value, you should work to ensure it can grow. A scalable business is one in which profit margins increase even as revenues increase. This is easier in some industries than others. Developing an app costs the same amount, whether you sell hundreds of thousands of copies or only a few dozen. A law firm can only offer clients so many billable hours without hiring more lawyers. But within these limits, business owners can take steps that will make it easier for a company to scale. Make sure your technology is up-to-date and works well for its intended purposes. Ensure a clear path for expanding existing processes and work flow.
Plan For After The Sale
It is a good idea to approach a sale with a clear sense of your ideal exit path. Will you stay on as a consultant or in a diminished capacity for some transition period following the sale? If so, when do you plan to leave for good? Including an agreement not to compete with the business after you sell can increase its value, and may be of no cost to you if you plan to retire. Or you might maximize your total proceeds from the company sale by agreeing to an earn-out of future revenue. As with each choice in this process, the right decision will depend on your specific circumstances and risk tolerance.
Finally, don’t forget to consider the tax consequences of a deal’s terms. Sometimes you can structure a deal to treat more of the sale proceeds as long-term capital gains, rather than ordinary income. Or you can spread the proceeds over multiple tax years. Both strategies can increase the deal’s net proceeds. You should work with your accountant to make sure that you prepare all necessary filings and structure the sale in a way that works for you.
Throughout all the work to maximize your company’s value, it is important to stay realistic. Like homeowners, business owners sometimes overvalue their own offering because of a personal emotional attachment. This why it’s important to seriously consider a third-party valuation before a sale. A valuation expert can give you an objective, independent sense of what your business is worth. This can help you to set a realistic asking price and to make sound retirement planning choices.
Spending time on maximizing your business’s value ahead of a sale may mean a longer exit path. But you will have many years to enjoy the benefits of getting the best price you can in exchange for your hard work.