Today’s newsletter is written to address an important topic in planning for an owner’s transition, namely, ‘how to get to the equity in your business?’ We’ll look at how business owners view their companies and then offer some planning-based suggestions as to how to draw the equity out of your business over time, assuming that you are not selling to an outsider. We hope that this newsletter content inspires you to begin planning for how you too will get to the equity in your business.
Getting to Income vs. Equity
There are two very different aspects to getting the money out of your business. On the first hand, there is the income that you draw from the company in terms of salary, personal/business expenses, and bonuses that you pay to yourself and/or retirement plan savings. All of this constitutes money that’s coming to you from the cash flow of the business going towards the lifestyle that you have built for yourself. The second and potentially much more critical aspect is getting to the equity – the illiquid part – of your business. The equity is your ‘owner’s value’, the reward for growing your enterprise and taking the risk as a shareholder and investor.
Leading with Personal Planning, Measuring the Value Gap
As part of tapping into your equity value, it is helpful to first know your Value Gap – i.e., how much money you need to extract from the business to maintain your lifestyle without the business. The chart below helps to illustrate this point.
We see that Bill Brown has $1,000,000 saved for retirement but needs $7,000,000 to maintain his lifestyle. Bill’s Value Gap is $6,000,000. The question becomes, ‘How can Bill get to the equity in his business in order to close this Value Gap?’
Like most business owners, Bill is focused on running and growing his business. Bill has some money saved for retirement. However, as we can see, it is nearly impossible for Bill to extract enough ‘income’ from his business, at his age, to meet his personal financial goals – Bill needs to get to the equity in his business. The question that Bill is looking to answer is, ‘how can I plan to tap into my business equity, over a long enough time period, to draw it out to meet my personal goals (without hurting my company’s cash flow)?’
The Many Paths to Harvesting Equity Value
The first step is to realize that there are many ways to get to the equity in your business. You can find a buyer, groom a successor, or even create a buyer for the shares of your company’s stock. The most important part of this planning process is to recognize that any one of these options requires a process.
The natural inclination is for a business owner to sell the company to someone else – i.e., to pull the equity out all at once through a sale transaction. As an owner, you need to know that options other than selling the business are available but may require some creativity in designing.
So, in Bill’s example, he needs to achieve a net amount of approximately $6,000,000 for the equity in his business to meet his personal exit goals. If Bill were to sell the business, he would need to get an asking price in excess of $6,000,000 because taxes (both federal and state) are going to be owed, and advisory fees are going to be a part of the difference between what Bill ‘gets’ for his business sale and what he keeps. However, Bill may want to look at alternative ways of getting to the equity in his business.
Internal Options for Getting to Equity
Bill may look at the option of selling a portion of the equity in his business to an Employee Stock Ownership Plan (ESOP). By selling a piece of the equity today, Bill can bolster his current savings (i.e., increase his financial readiness) while continuing to own a majority of the stock in his company. Although Bill may get a lower value for the shares through an ESOP sale, he can begin to diversify himself away from the business and, potentially receive important tax benefits that go along with the ESOP sale. This is a controllable way of getting to the equity in your business.
Bill may also look to his management team to assist him in extracting the equity from his business. Bill’s management team has the potential to continue to run the business in Bill’s absence. Bill should recognize that there are ‘higher level’ conversations that he can be having with his managers today which would make the company stronger, while also positioning those managers as potential successors to the business. When measured against what Bill needs to extract from his business, it may turn out that having his managers pay him out over time is his best option and he can build a stronger company in the meantime.
In conclusion, whether you’re looking to your managers to help you pull the equity out of your business, or you’re looking to sell to an ESOP, or looking for an outside buyer to acquire your company, it is important to have a concept of equity beyond just the cash that flows from your business to you. And from this very important concept and realization, you can begin to think of your business as the investment that it is and begin to create your exit plan to get to that equity and achieve your personal exit planning goals.