The Art of Selling Your Business to Fund the Life of Your Dreams
By Jeff Ruderman
Capital Group Private Client Services
Wealth Advisory Manager
When the moment finally comes to sell a company you’ve spent years building, the first question most entrepreneurs ask is: “What is the best price I can get in today’s market?” Although that’s a sensible starting point, focusing solely on obtaining the highest possible dollar amount can be counterproductive.
That’s because many factors, ranging from unfavorable market conditions to unrealistic expectations, can get in the way of a hoped-for valuation. Instead of fixating on what you think the business is worth, a more constructive approach is to determine how much you must walk away with in order to fund your lifestyle now and in the future. After all, the ultimate goal of a sale is to allow for a smooth transition to the next stage of life, especially if you are nearing retirement and want to turn long-planned dreams into reality.
Thus, it’s essential to calculate the cost of each item on your personal wish list. This is the money that forms the “core” of your portfolio — the total amount of investment assets needed to comfortably generate a desired annual income for the rest of your life. The precise figure differs from one person to the next based on such factors as age, risk tolerance and post-transaction spending plans. As a result, each analysis must be tailored to your unique financial circumstances.
Once we know the amount needed for your core requirements, we compare it to your total resources. This reveals your “funded status.” For goals that you are not on track to fully fund, we specify the shortfall amount and make clear how much more is needed. If you do not have enough capital to fund everything, you may need to postpone selling, reduce your spending expectations or find another creative solution for exiting the business.
Offers that are structured in similar financial terms can be relatively easy to understand and compare. The process becomes more difficult when different deal structures are on the table. Our approach is to thoroughly evaluate each offer to help you fully understand the trade-offs involved. Because we assess each offer in terms of its ability to fund your goals, the offers can be compared on a level playing field.
Below, we explore three options for generating liquidity, along with the pros and cons of each. Two options involve selling the business, while the third is an interim step should you need to pull money out of the company in advance of an eventual sale.
All-cash deals offer the greatest degree of certainty.
Assuming the market price equals or exceeds your core needs, an all-cash sale may be your best option. Unlike some other types of transactions, a straight sale generally allows you to leave the business after a set period of time with money in hand and no strings attached. On the downside, cash deals eliminate the possibility of deriving future income from the company or benefiting financially if the enterprise prospers. Still, if the sale offer satisfies your core requirements, it should be strongly considered. Though they may not offer the greatest financial upside compared with some other options, all-cash deals can often be completed quickly and efficiently.
Earnouts may not always pay off.
One alternative to a cash sale is an earnout, in which you sell the business to a third party but retain some financial exposure to it. This structure requires you to “earn” a certain portion of the purchase price through the future performance of the company. The better the performance, the bigger the potential payment. Earnouts are often used when buyers and sellers disagree about the sales price, especially regarding the company’s future prospects. This arrangement provides buyers with peace of mind that they have not overpaid, while giving sellers the opportunity to receive additional payouts if earnings growth is strong.
In this arrangement, sellers are typically paid in three ways. The first is an up-front amount representing a portion of the total sales price. In many cases, sellers receive a salary because they are often contractually obligated to stay on as consultants during a transitional period. The final payment is the earnout itself. For tax purposes, the initial payout is considered a long-term capital gain. Both the salary from consulting work and the earnout are typically taxed as compensation. Of course, you should always consult with a tax professional for your specific situation.
For sellers, the risks associated with earnouts have increased in recent years. Earnout periods, which historically have lasted from one to three years, sometimes now extend even longer. That extra time increases the risk of an economic downturn or business-specific setback eating into or eliminating an expected earnout. Beyond that, these post-transaction payments represent a growing portion of the total sales price, especially when selling to sophisticated investors such as private equity funds.
One risk is that tension will develop between entrepreneurs who are accustomed to calling the shots and the new owners to whom they suddenly answer. In other cases, earnouts are missed for reasons that are difficult for an entrepreneur to anticipate or avoid. Earnout provisions can be tied to a range of metrics but should be flexible enough to reflect the realistic prospects of a company and its industry.
Leveraged recaps help entrepreneurs diversify their wealth.
If you’re seeking some liquidity but uncertain about whether to sell a business entirely, a leveraged recapitalization (“recap”) may be an attractive option. Under this structure, you add debt to the company in order to take a distribution with the proceeds. Typically, financing comes from either a private equity firm in the form of an investment or from a bank as a loan. If you’ve built up significant value in the enterprise, a recap can provide a quick cash infusion to improve personal liquidity and diversification. In other words, you can take some chips off the table without exiting the business entirely.
Among other benefits, a leveraged recap provides time and flexibility if you either can’t or don’t want to sell right away. Often, recaps are an interim step toward an eventual sale, allowing you to retain ownership until a transaction can be completed. The degree of leverage depends on several factors, including the prospects for the business and the overall industry outlook. Of course, any gross proceeds from an eventual sale would be reduced by the amount of leverage on the balance sheet.
There are several points to keep in mind when contemplating a leveraged recap. First, you typically must remain involved in the company for at least several years, so this is not an option if you’re seeking a quick exit. Also, recaps add more risk. Though you stand to reap the financial upside if the company fares well, you may fall short of core capital if the company or the economy falters. And in some cases, you could be personally liable for repaying all or a portion of the debt. Therefore, it’s essential to confirm that the company will be able to shoulder the debt burden, especially during challenging economic periods.
Naturally, selling a business is complex, and it is important to work with a team of specialists (including investment banking, accounting and legal professionals) to help guide you through the process. On an emotional level, parting with a business can be both exhilarating and daunting. The process involves a variety of decisions that depend on your financial needs and personal objectives. In general, it’s advisable to plan early. Our team can work with you and your Investment Counselor to evaluate offers in the context of your goals, helping to provide peace of mind and a smooth transition to the next stage of life.