Are the Myths Your Clients Believe about Value Hurting Their Family Business?
Your clients are savvy business owners. But are some of the beliefs they have about the value of their operations holding them back? See if these sound familiar.
Myth 1: My business operates to support my family’s lifestyle, so value isn’t important.
Operating a business for lifestyle purposes is different from operating for growth. However, this approach has consequences when the owner is ready to transition the business to the next set of leaders.
- The Pros and Cons of a Lifestyle Business
The primary goal for lifestyle business owners is to provide income and cash flow. This allows them to enjoy a desired way of living without sacrificing a work/life balance. These businesses generally aren’t sustainable or scalable without the owner. That makes transitioning or selling them a significant challenge.
In addition, funding for these businesses comes from the owner, not outside investors. As a result, capital-intensive businesses—such as manufacturing—are difficult to launch and sustain on a lifestyle basis. Many become hard to transition without continued support.
Lifestyle businesses can become growth businesses. They can be valued and transitioned or sold apart from their founder/owner. This is a difficult process, because it requires some significant changes to make a successful shift. The business’s key value drivers must be examined to determine how to enhance its worth and make it transferable or saleable. This will alter the company’s dynamics—and the reasons the owner started it.
- The Pros and Cons of a Growth Business
These operations exist to create value, which also provides a reasonable income for the owners and other stakeholders. The company may have professional management and often is wholly or partially owned by investors, families, or one or more individuals.
While profits are important, increasing the growth and value of these businesses is the primary goal. This means cash and earnings are reinvested to support the company’s expansion, which reduces the funds available to finance the family’s lifestyle. While the family can still maintain a good quality of life, that’s not the primary focus of the business.
- Advice to Clients: Know who you are and what you want
When it comes to establishing and running a business, clients should be clear on what to expect from it. If your client wants the operation to fund the life he or she envisions, then the lifestyle business is a better fit. If your client wishes to create a company that will support himself, herself and others, and ultimately continue to succeeding generations—while providing some recompense for the founder’s contributions—then a growth business is a better goal. Either way, clients should make a conscious choice.
Myth 2: Our family business runs like a well-oiled machine. I don’t believe we need to do anything for the next generation of leadership to be successful.
No matter what your client hopes and wishes, statistics show the success rate on transitions for family-owned or controlled businesses is dismal! This situation can improve significantly through proper planning and taking action early to provide the infrastructure to support this change.
- Many Owners Are Ill Prepared for a Business Transition
According to the 2013 Ownership Readiness Survey (performed by the Exit Planning Institute, PNC Bank and Kent State University) 83% of business owners either do not have a transition plan, only have one in their heads, or haven’t communicated their plan to stakeholders.
The negative impact of not having a written transition plan is staggering for business owners, their families, employees, customers and suppliers. That is compounded by the number of owners between the ages of 50 and 75, who expect to transition their business in the next five to 15 years.
If your client is thinking about selling or transitioning the family business, he or she needs to develop a well thought-out and documented plan. It should include these items: 1) a comprehensive enterprise valuation assessment—what the company is worth today, 2) the steps needed to improve its value, 3) a comprehensive legal and personal financial plan, and 4) a plan for life after the transition.
A transition plan considers transfers among family members, sales to a third party, or transfers to others within the company. It’s designed to help owners move away from a business on their own terms—not those dictated by someone else—while maximizing the after-tax dollars in their pockets.
Transition planning is not an event but a process. The most successful ones follow very specific steps and reach milestones in a particular order. Even if your client is not considering a transition, it’s important that the family be prepared in the event of a forced change such as the owner’s sudden disability or death.
Myth 3: I don’t need to be concerned about the value of my business other than for estate and gift tax purposes, transfers to spouses and children, and sales under a buy-sell agreement or transfer by any other legal document.
The business is usually the largest asset on the family’s balance sheet—and not a liquid one. Owners are often unaware of their company’s value, beyond understanding they need to produce cash flow to support the family.
Business owners usually seek to improve cash flow by increasing revenues, decreasing expenses, or buying another business. However, these initiatives seldom raise the enterprise value without significant additional risk. Owners frequently don’t realize that value and cash flow can be created by evaluating and improving the qualitative factors of a business.
A mini-case: How Planning makes a $6 Million Difference
Here’s a good example. John was at the country club talking with Tom, a new member. He was surprised to learn that Tom had just completed a transition of his company to the next generation of leadership. John knew about the business, because it was a competitor. Tom’s company was an ordinary but steadily profitable operation. Its product line, historical sales and earnings were identical to John’s. Both companies were in a highly competitive but expanding industry, with plenty of room for growth, innovation and higher value.
Tom had a valuation assessment and written transition plan for his company. He implemented a strategic value enhancement initiative. This increased cash flow and the company’s enterprise value to more than $10 million. That meant it would support his lifestyle throughout retirement.
John also had a family member who was interested in and qualified to lead his company. However, he had no written transition plan, and his company was still operating primarily to support John’s lifestyle. In addition, he discovered his business’s enterprise value was $4 million, which wouldn’t fund his lifestyle in retirement. John was shocked to discover Tom’s company was performing better and worth so much more!
John asked Tom what he had done to make such a big difference. Tom explained that he and his management team had worked with an advisor to develop a comprehensive written transition strategy for how the company would prepare the next generation of leaders and capitalize on growth and value enhancement opportunities—long before the transition. John realized he needed to do the same.
Whether your client wants to transition the business next year—or a decade from now—it’s never too soon to start planning. These actions will improve the company’s performance now, in addition to the long term.
In developing a comprehensive written transition strategy, determining the family company’s enterprise value is only the starting point. It is just as important to explore how the company rates on the value drivers typical in every business. This process starts with analyzing past and projected financial results. Next, the owner and management team need to have a detailed discussion about the quality of the organization. This includes examining the eight main value categories of how your organization functions:
That evaluation allows you and your client to create a roadmap for maximizing the company’s value, cash flow, and the basis for prioritizing and planning improvements. In other words, understanding what the family has, and then deciding how to enhance it.
The second part of preparing a comprehensive written transition strategy is exploring the goals for the owner and the family. The family financial planner and/or advisor should determine if there is a gap between what the business could generate now and what is needed to meet personal financial goals after a transition, such as:
Staying involved in the business Enjoying more leisure time
Maintaining a community presence Creating a family legacy
Clarifying philanthropic interests Funding retirement lifestyle
Chances are that your client already has a number of good advisors: accountant, financial planner, legal advisors, money managers and others. Adding an objective third party who is skilled at identifying the hidden value in the business that is waiting to be tapped and who knows how to help you prepare the company—and the family—for the inevitable transition may create a plan that adds millions in cash flow to support your family in the near term, fund retirement lifestyles, and keep the company viable for the long term. Talk about value!
About the contributor:
Barry Goodman is the managing director of Birkdale Transition Partners LLC, which is an objective source for those considering any business transition. He can be reached at [email protected].