Too often, business owners fail to get the structure right when they think they’re ready to cash out and retire. UBS Wealth Management’s James Lipari assesses some of the potential pitfalls.
Q: Before they even consider a potential sale, do business owners need to think about how to be properly positioned for the process?
“Sometimes, those deals don’t always work out, and at the end of the day, it’s not 10x multiple, it’s a 3.”— JAMES LIPARI, SENIOR VICE PRESIDENT UBS WEALTH MANAGEMENT
A: From a deal-structure standpoint, it’s a question of what do they need, based on their personal expectations. Obviously, cash, but anything else, there’s a risk in how it would affect their ﬁnancial plan. Any deal can get a high multiple if the terms are all on the back side of the deal. That, plus taxes, is another thing we focus on.
Q: So how do you begin the process of advising them on deﬁning their post-sale expectation?
A: Let’s understand ﬁrst what you need to get out of the deal to maintain the lifestyle you want. For a long time, the owner has been using his or her business as a source of cash ﬂow to live a certain lifestyle. Basically, they have been monetizing that lifestyle at this point. They’ve got to understand what they need to get out of it to maintain that lifestyle. That would be the first thing we want them to understand. If it’s a deal where, say, the business has a valuation of $10 million, and the person needed to monetize $3 million of that net taxes, clearly, he or she is well over that number. But what if the valu- ation is only $3-$4 million? That would be the ﬁrst question: What do you need?
Q: Do those conversations often reveal that an owner isn’t ready to sell?
A: Yes. If the same person needs $11 million and we value the business at $10 million, we may actually suggest that person not sell yet. The conversation is now quite a bit different. If there’s no way they can replace what they are receiving out of the business, maybe they need to be going back to work. In a realistic situation, let’s ﬁnd and replace your day to day work with someone who can do it for you. It might be that you can draw more out of the business than you can sell it for. Now instead of structuring a deal, you’re structuring something with an HR or executive-search company. Then you can structure the deal down the road.
Q: Is it your experience that own- ers enter this process understanding what they’ll need in retirement?
A: No. There’s a real art to get people to open up and understand that conversation. Most think they will be good with $3-$4-$5 million out of the sale, but they don’t know how much they spend on an annual basis. They’ve got to understand what it takes to truly maintain the lifestyle they have, especially the wealthier clients.
Q: What are the parameters of that conversation?
A: That’s part of the financial planning. It’s hard, if you ask someone for a budget, for their monthly living expenses, most people can’t tell you the answer. It’s really more of a process of going through bank statements, looking backwards, itemizing things and creating a budget.
Q: That sounds a little counter-intuitive, given that we’re talking about owners who may be used to managing multiple millions of dollars in budgets every year. Are you saying that a lot of people tend to have tunnel vision on the business ﬁnances, but not on the personal side?
A: Yes, no one manages their per- sonal finances like they manage the business. There’s some history round this. Predominantly, most of the businesses out there are managed by men. I would say nine out of 10. But in those same households, the household spending is managed by the woman. The female is writing the checks, paying the bills, and the male isn’t and doesn’t pay attention to what’s happening at home as long as it is happening.
Q: So when you get them together to talk about their long-term need, how does that shape the conversation?
A: Males tend to think big picture and strategy: If I get enough in the sale, we’ll have enough for what we need. There’s a lot of research around this. A man may think ‘if I get $12 million, I should have enough to live on for the rest of my life. But they are not thinking about what that means. The female, she understands where bills are coming from and how the checks are written, she understands exactly what it takes to run a monthly budget, but often doesn’t think about how it gets there. With the male, it’s “if I bring enough in” and often doesn’t think past that.
Q: That has to create some tough conversations.
A: The danger there is that this same male will go to the country club, talk to his buddies after a round of golf, and somebody who already sold his company will tell him you should get a 12x multiple. Maybe you will, but you may not be able to get that in cash. Nobody talks about the terms of the multiple; they talk about what the multiple is. The terms are a big effect on that.
Q: How so?
A: In a lot of deals, 30, or 40 or 50 percent of the terms are not up front. Say you have a valuation of $10 million as an owner, but the customer base is a little iffy, or the buyer says “we don’t understand your payables, receivables or your CapEx. We’ll give $2 million up front, and a salary for next three years of $500,000, and if we hit those numbers, you’ll get an earnout for the next 5-10 years” or whatever. Then the new management steps in, this fellow loses control of the situation, there are potential competing interests going forward. Sometimes, those deals don’t always work out, and at the end of the day, it’s not a 10x multiple, it’s a 3.”
Q: Surely that’s not a common occurrence, is it?
A: I’d say it happens closer to 70 percent of the time. Q: What about other risks with deals? A: I saw a deal last year, the two sides were going back and forth in legal battles. There was a fixed earnout, and the husband and wife had both been working in the business, and both had to be employed as sales reps for the next five years. The cash came in a couple of pieces, 50 percent was cash up front, and 50 percent was in stock of the company acquiring them, as long as the two stayed on as sales reps. Four months in, the husband was fired. Now you’re in court, fighting that. The piece that’s potentially dangerous, the 50 percent in stock, you don’t know if the market value will be there in three, four or five years. A seller would never want that structure, but it may be presented to them, and it ultimately may be negotiated. Again, generally speaking, what you want is to get enough up front, without risk, to maintain your lifestyle. There’s always some kind of back end, something that ties to the transition. Sometimes it’s six months, sometimes longer, but it will always be something tying the owner to the business through the transition. If it’s too much for the seller to be able to hold, they give up control, and that’s too dangerous for them to do.
Q: So what kinds of mistakes have they made up front that put them in that box?
A: It depends on the business. There are times when the business is biz, times when the business is not necessarily marketable, because of high volatility. Right now, we’re working with an owner, everything he does is custom building of products for the assembly line. They have a good engineering team, but everything they do is custom. So you don’t have repeatable revenue in an ongoing basis. The bigger problem is that the engineering team is getting older and ready to retire, and you’re not able to replace them yet. Instead of selling, now you’re trying to bring in younger talent, so you have that ongoing concern.
Q: So a deal looks like it’s going to go through, both sides feel good about it: Is cash the first consideration for the seller?
A: If anybody can sell, they ought to take cash. They are not always going to get 100 percent cash, so they need, from a risk standpoint, however much they need so their lifestyle won’t have to change.
Q: How often, then, do sellers have to adjust expectations to meet the realities of what their companies are worth?
A: Again, it depends on the size of deal; the average seller is in $3-$4-$5 million range, and at that level, probably 90 percent of the time, there’s going to have to be some adjustment to their lifestyle.
Q: How often do owners have to confront that reality?
A: I would say over two-thirds are caught off guard, once they realize the terms and the tax effects.
Q: So what do they need to do earlier to avoid that situation?
A: The way to avoid that is, No. 1, understanding what you need to maintain your lifestyle. No. 2, understand what you can do to improve the financials of the business to make it more marketable. No. 3, spend the time to do it. You’ve got to make yourself irrelevant to the business. If you’re not irrelevant to the business, you have to hire. Repeatable cash flow will drive value. Sometimes it takes a lot of time and effort, it takes a management team, it takes having processes around key performers. It takes a lot to make it happen.
Q: When confronted with a deal structure that won’t let them make a clean break, are owners psychologically ready to accept the need to keep working?
A: No. We saw that in 2008. But in 2008, people were somewhat more reticent: ‘Hey, I can punch the clock for 3-4-5 more years.’ Now, with the effects of the pandemic, people are well down the road thinking of selling. We’ve started seeing deals uptick the past couple of years, because they were delayed four or five years ago and now they don’t want to punch that clock for four or five more years. I suspect a lot more sellers than buyers will be here real soon.