By Maurie Cashman
We work every day with owners to build value in their companies. Some of these owners build value so their companies can be more profitable, others build value with an eye on growth, while still others want to use systems that build value to become more organized.
All of these are great reasons to build value, but we look at building value a little differently because in ownership transition planning, we take a longer view and help business owners prepare to transition their companies when they choose, and for the amount of cash they desire.
So building value is not ownership transition planning, but building value is a necessary and principal part of every Ownership Transition Plan. Ownership Transition Planning provides the context for building value. Building value serves many masters, the most important of which is to enable owners to reach their ultimate goal of converting their livesâ€™ work into the post-business lives they desire.
When we talk about building value in the context of Ownership Transition Planning we ask:
- What is the companyâ€™s current value?
- What value must the company achieve to enable its owner to reach their lifetime income and other ownership transition objectives?
- What tactics can be employed to close a gap between todayâ€™s business value and the value you need upon ownership transition?
- How can you transfer business value most efficiently?
Letâ€™s look at the case of fictional owner Jack Klompus.
- Age 58 married to Pam, also age 58.
- Sole owner of Klompus Distribution, Inc.
- Salary of $250,000.
- Ownership transition Objectives: 1) Ownership transition at age 63 (five years from today); 2) Post-ownership transition income of $200,000 for 30 years. (Owners consistently underestimate the future amount of annual income they will want and need, setting themselves up for future disappointment. Use a Financial Planner to arrive at a realistic income goal.); and 3) No specific successor in mind.
Klompus Distribution, Inc.
- Annual cash flow of $250,000.
- Estimated value today: $1,000,000 to $1,250,000 as calculated by a business appraiser.
- To finance the Danielsâ€™ post-ownership transition income needs, given the number of years they want income and their assumed rate of investment return (7%), Jack needs to sell his company for between $3M and $3.5M to net $2.5M.
- Jack must increase the value of his company by at least $2M if he is to retire on his terms.
In Jackâ€™s case, the Two Million Dollar Question is: How can he increase the value of his company by $2,000,000 over the next five years and close the gap between the business value he has and the business value he needs?
1. What is the companyâ€™s current value?
Based on an industry rule of thumb, Jack thought he knew the current value of his company. Because in Ownership Transition Planning the companyâ€™s current value is a fundamental cornerstone of the work to follow, guesses and assumptions about value are not sufficient. Owners must retain valuation experts to establish what their company is really worth.
2. What value must the company achieve to enable its owner to reach their lifetime income and other ownership transition objectives?
In creating an Ownership Transition Plan, owners quantify the amount they will need to support the post-ownership transition lifestyle they desire. Usually, they work with a financial planning professional to establish the â€œWorking Assumptionsâ€ Jack established above (life expectancy, the future value of non-business assets, and rates of return on investments). Owners must also ask and answer hard questions about their post-ownership lifestyles. Without an accurate and realistic assessment of where you are and where you want to be, it is difficult to develop a plan.
3. What tactics will you employ to close the gap between current business value and the value you need upon retirement?
Only after you have determined the size of the gap between current and desired business value, does it make sense to decide what needs to be done to close it.
Understanding how far you have to go within a specific time frame provides the context for achieving your goals. Without a timeframe, most owners do not take the sustained action to accomplish what is needed and instead pledge to plan â€œright after this major project,â€ â€œthis crisis,â€ or â€œthis season.â€ These pledges are rarely kept.
The timeframe inherent in the gap analysis creates responsibility: it requires self-discipline and each small step is subject to the accountability we fail to practice when it comes to Ownership transition Planning, even though we preach it every day to our employees.
Using the gap analysis as its foundation, owners can then identify and implement specific actions that will increase the value of their companies. While there are many value-building actions from which owners can choose, the most critical are those that enable a business to operate successfully without its ownerâ€™s involvement. These include the creation of a stable and highly-skilled management team, understanding and using current financial information to track and alter company performance and the installation of sustainable, organization-wide systems.
An Ownership transition Plan should also include collecting, interpreting and using the data necessary to track progress toward your goal. Tracking may include monthly, quarterly and annual cash flow projections, as well as the creation of an annual business plan. It is critical that the strategies within the Annual Business Plan and any Long Term Business Plan mesh with the Ownership Transition Plan so that they are not working against one another. In essence, the two should become one.
4. How can you transfer business value most efficiently (tax and otherwise)?
Good Ownership Transition Plans view value-building and all other activities through an income tax lens. Owners use every legal strategy and tactic to minimize taxes while they earn money, grow value and transfer that value. Because taxes simply skim off the value it takes decades to create, it is far more effective to act with a grasp of current and future tax consequences. Use knowledgeable advisors years in advance of the eventual transfer of your company in a way that limits the tax burden on both the owner and the buyer.
Ownership Transition Planningâ€™s value-building tools can close the gap between a companyâ€™s current and desired values.