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Sep 18B2B CFO

Exit Plans, Buy-Sell Agreements, and Other Petards

Sep 18B2B CFO

A petard is an explosive device formerly used in warfare to blow in a door or gate, or blow a hole in a wall when breaching a fortification.  It was often placed in a tunnel with a gate or door at one end. Our quaint expression, “hoist with his own petard”, made popular by Hamlet, describes the case where the one who placed the petard was inadvertently sent flying by its explosion. Because it was poorly designed, improperly placed, or mistimed, there were unintended and injurious consequences.

For the typical owner of a small or medium sized business, their company is the largest financial asset they possess. The company can provide many things: income, fulfillment, self-esteem, community recognition, jobs, and countless headaches. However, in contrast to cash, stocks, bonds, and most other financial assets, a privately owned business is fundamentally illiquid. What it cannot readily provide is liquidity. The value, once created, is not easily realized. This is the reason many successful business owners have 85% or more of their net worth locked up in their company. While this may be acceptable for a period of time, eventually the owner will want to devise a strategy to extract the wealth he or she has created.

To Plan or Not to Plan

An exit plan, properly devised, written and executed, can result in the largest financial transaction of a business owner’s life. A solid exit plan should address various dimensions of the exit, including, among other things, exit goals, the readiness of the owner, the readiness of the business, the value of the business, the various exit options to consider, the timing of the exit, the tax consequences of the exit, and the owner’s post-exit financial situation. With so many facets to consider, the exit strategy should clearly be given serious thought. Sadly, one study found that the typical business owner spent eighty hours building a business plan and six hours creating an exit plan. You may spend more time planning a family vacation than planning the transfer of your business. Maybe you assume that your key managers will purchase the business from you. Or that your friendly competitor will invite you to lunch one day and make you a generous offer to buy your company. Without a clear, executable plan in place you are likely to be disappointed, and more importantly, your illiquid wealth may dissipate in  the process.

We Took Care of Our Buy-Sell Agreement Years Ago

Buy-sell agreements are standard documents for businesses with multiple owners. While intended to serve a valuable purpose, they are oftentimes poorly crafted or seriously outdated. The purpose of a buy-sell agreement is to equitably protect the interests of the various owners of the business. The agreements are set up to allow the buy-out of owners’ interests upon the occurrence of certain “triggering events”. Some refer to the three “D” triggers: death, disability, and divorce. A buy-sell agreement may not include disability or divorce as triggers. Or it may not define disability in a manner consistent with the insurance coverage purchased to fund the triggered buy-out. In addition, the buy-sell agreement may stipulate a valuation of the business that has little similarity with the company’s current value. A New Jersey court confirmed a buy-sell agreement that valued an interest in the business based on book value rather than current appraised value. The result was a $178 thousand buy-out, rather than $11 million! Such an outcome could have been avoided by a properly crafted buy-sell agreement that included provisions for regularly updated valuations of the business.

My Financial Reports Are Good Enough As Long As I Can Get My Taxes Done

Financial reporting can be the cause of either wealth preservation or destruction. David C. Vorhoff is a Managing Director of McColl Partners, investment bankers in Charlotte, North Carolina. At a presentation to business owners and advisors in November, 2011 he stated that financial reporting was the second biggest problem area for them when attempting to successfully complete merger and acquisition transactions. Audited financial statements and adequate internal controls help provide confidence for the buyers. The converse is also true. Mr. Vorhoff cited the transaction that fell from a $55 million price to a $45 million price. The sole reason given by the buyers was that the financial controls were so weak. Investing in the proper financial reporting and control environment, in advance of the exit process, would have had a profound effect on the financial position of the exiting owner.

As you consider your own company-encased wealth, and your inevitable transfer of the business to others, be sure that the petards you deploy are well-designed, precisely placed, and carefully timed. Find advisors that can help you through the process. Ones that have expertise in building and deploying those petards.

 

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