Michael Carlin

Hi, this is Michael Carlin, President of Henry+Horne Wealth Management here in Scottsdale. This is episode two of the Manage the Funds Podcast. Today we are talking about transitioning small business. I’m excited today to be joined by Phil McCollum. Phil is a Partner at Henry+Horne and he specializes in helping business owners transition their firms, organizations or institutions to the next generation, sometimes to someone else.

Today is a critical discussion that I find is not discussed enough. We have so many small business owners as clients that have not had this type of discussion about the most important asset they own. We do a lot of talks about stocks, bonds and cash. We talk about residential real estate and buying a second home. We don’t spend a lot of time talking about the business asset. What are we going to do with it? How do we make is work for us beyond income? Phil will help us break down transitioning the business.

Just a few facts that you should know. According to the Small Business Administration, do you know that small business represents 99.7% of all business in the U.S.? Small business from 1995 to today created 64% of new jobs. It’s a fabric of the U.S. economy and it’s something that needs to be digested and understood. If you think about it, it’s hard to start a small business and they often fail. Two-thirds of all small business survive two years. Half of new businesses last five years and one-third make it 10 years.

Phil, we have this important asset to the economy, to people’s families and lives. It’s beyond an income. Let’s start at the very beginning. What do you need to know before you start contemplating selling your business?

Phil McCollum

It’s a great amount of information and facts that Michael shared to understand the importance small business is to the U.S. Selling your business isn’t as easy as walking in the doors of your office and saying, “I’m going to sell my business.” It takes several years of preparation, steps to follow and a thought process that you go through as an owner. There is an emotional investment in this idea or concept that you have created throughout the years. So, what you want to do is get your house in order.

What does that mean? One of the things that the buyer is going to look at is the financial statements and your financial information. You want to get those tax returns and financial statements in order. Many buyers like to see a financial statement that has the level of certification from an accounting firm. That could be compiled financial statements, reviewed financial statements or audited financial statements. Those are very important, because it provides some history of the company, trends of the company, along with tax returns, which should confirm the financials that are on the financial statement. A prospective buyer is going to ask for those from day one.

If you have internal financial, that doesn’t mean that the deal is not going to happen. It only means that you may have to do extra work to provide more information.

Michael Carlin

I view this from a buyer perspective. A buyer of this asset wants to know all aspects of the data is authentic. An accounting firm can help get you a sense of security. In addition, we know we must get a confidentiality non-solicitation agreement in place. That we know. Once you have these things in place, there are other things that you need to know to sell the business

Phil McCollum

Now you think, how long is this timeline going to take and what am I going to do afterwards? Do I want to be involved with the business as it goes on for a couple of years? You see this as well. The impact on the employees that remain with the company. This is where the emotional impact comes into play. The business owners have had employees for 20-30 years and the impact on those employees is very important. How do you want to see it play with employees? That’s a non-financial factor and motivating factor but it’s very important. Then you have the impact to your family. Those things come into play and are your personal goals.

Michael Carlin

This is all part of the process of understanding the end. Therefore, you do not want to wait till the end. It’s all a part of internal and external that you don’t decide till the end.

Phil McCollum

This is true. The planning upfront on selling and what to do after. What do I want this to look like? What is my legacy? Is it for the family or myself? It can be done if started early enough.

Michael Carlin

Clients come to see me, which I don’t think is right. They talk about their revenue and how it’s growing. Is revenue growth important? The most important thing that a buyer is looking at?

Phil McCollum

Most times not. Depends on the buyer. If It’s a strategic buyer then yes, it may be important. If it’s someone who is looking to operate the business and not looking to expand into different markets – this may be a key employer that’s looking to take over – they’re going to be looking at the profit, some of the expenses that have accrued. Are these normalized expenses? Are these expenses to accrue in the future? These profits are going to be important to them. Is it a profit margin that’s easy to move around from a depreciation standpoint or cash flow stand point? Is it ridged and you know what you’re going to get and maybe there’s not room to move things around to improve that net profit? So, yes it would be important to see the revenue.

Michael Carlin

Can we touch on strategic buyers? I know this is jumping ahead but you touched on this a little and I want to make sure we hit on that term.

Phil McCollum

Strategic buyers, we see plenty of those amongst the venture capitalist group. We see a lot of that in the health care industry in the last few years where they want to get into a new market or in a new subclass of health care. So, they are looking at the revenue of the firm. They figure they can add that to their top line and that improves their overall multiple and makes them more attractive to investors. So, they are not concerned about the profit because their overhead cost is absorbed by their own accounting operation or administrative office.

Michael Carlin

A few notes I want to throw in. We’ve had so many clients going through to transition their business. Clients when going through the process, they forget to run the business and get so caught up in ending the business and excited about the future, that they fail to keep their eye on the ball. Make sure that when you are going through the being part of the process, do not take your eye off the ball. One final point that I know you wanted to make? If you’re thinking about the end, the things that you want to do before selling. What can you do to increase the value of your business?

Phil McCollum

This is where we look at what industry are you in, what are the current ratios, profit loss ratios or current passive ratios, different factors that are in that line of business to say, “You know we are below average in this area. What do we need to firm this up?” If you can start on that process before you go to market with a broker or a potential buyer you’re going to firm some things up internally. Maybe your wages to the owner are too high. Maybe the rent for the building is too high. You need to do some strategic items to get them in place and that improvement to the bottom line can pay off tremendously on the sale price that you receive.

Michael Carlin

We see that if you own the building that your business is in, it can be an opportunity or a challenge. We are going to switch to our second topic understanding the business asset. What we want to do is unpack what your organization looks like and how to put together all the pieces of the puzzle. Phil, when you’re thinking about your business from a buyer’s perspective, what are some of the things that a potential seller needs to be thinking about?

Phil McCollum

When the owner starts the process looking at what they’re going to get out of this business, they need to get their team together. You can’t do this in a vacuum. Get your CPA together with your attorneys and financial advisors. You may have a broker or investment banker that needs to be involved. They all need to understand what’s out in the market place and this is what the buyers are looking for here is what the overall sale price could look like, but most of all, what is this going to look like after taxes?

I remember a few years ago, I had a client that had a number in mind of what they wanted to get financially after tax. We told them we would present this to the buyer. Once presented, the buyer said no they were not going to get that. That ended the meeting. It was good because we got it out of the way in the beginning. It helped the client set a better expectation to a more reasonable number. Then it leads into how do you structure this for tax? Maybe this was a C Corp and now needs to be an S Corp. Then as an S Corp you can take the time to eliminate some taxes.

Michael Carlin

How do you eliminate taxes going from a C Corp to an S Corp within a short period of time?

Phil McCollum

With C Corps, you have the double tax. C Corps will pay the tax and, if they want to get the cash out or income to their investors, they need to issue a dividend which is the second level of tax. Conversion to an S Corp after a period of five years, you have eliminated that double taxation because it’s passing through to the owners. If you take cash out as an S Corp, likely you will be okay. There isn’t a second level of tax. That’s one way to be more efficient with tax. It’s five years to get the S Corp to work. It used to be 10 but now it’s five. So, if you’re thinking of selling your business and changing from C to S, you need to think ahead and plan.

Michael Carlin

One of the things that strikes me about businesses is statistically, 82% of small businesses fail because of cash flow problems. When do you start to think about a business valuation?

Phil McCollum

Once you get your house in order financially, let’s say you have your compiled financial statements and tax returns all caught up, consistent, and know your what you’re overall game is, then you would want someone to come in to look at what the value of the company is using an objective third party. So long as you provide them with the right information, they can come up with a range of value for your business. It doesn’t mean that it’s the number that you’re going to get, but it gives you an indication of what you’re worth. It can also help you to see where you can increase the value of the business.

I’ve worked with client who do not want to know the value of their business because they think the value is lower than they think. We explain that they need to know the value. How do they know if they are getting low balled when you get an offer? It gets them to think that the do need to get a valuation.

Michael Carlin

We also see these clients who see a major transaction in their business and in the market place and think, I’ll get the same thing for me or the same valuation. It will help to get a third-party view of your business and wrap your head around it. Do you want to comment on that?

Phil McCollum

Every deal is a different deal. Every buyer has a different motivation. Every seller has a different motivation. So, you can’t look at an industry multiple and say that it applies to me, because it’s not.

Michael Carlin

One of the things you highlight is pulling your real estate out prior to selling the business. What does that look like? We see that a lot of these dental offices, these big office parks owned by the organization and they’re paying themselves rent. Talk a little bit about why you would do it and when would you do it.

Phil McCollum

In many cases real estate is going to be a source of income for seller of the business. This may be in a location that’s been there for five or 10 years and have a long-term lease and they want the buyer to take on the lease. Also, the seller looks at that as a source of income/retirement income. It could be a significant amount that’s usually a part of the deal. We would want to look at ways to get that out of the entity. Say it’s in a Corp or an LLC; you want to be careful because you want to look at the tax ramifications for it. Look at that because it may be an asset you really want to keep. It may be a business you want to keep moving forward.

Michael Carlin

Would you see that they would end up selling and separating the business and selling the building before they sell? Do you think that they would often try to maintain the real estate through the sale? Do you see one thing more common that the other?

Phil McCollum

I would say the common transaction we deal with is the owner keeps the real estate and hangs on for another three to five years. Then they can open the lease term for negotiations. By then, the buyer has an idea if this is the right location, what their expansion plans have been. So, typically we see the owner hold on to it for a few years after the transaction closes.

Michael Carlin

I like that from a planning prospective. As the advisor on the other end of the transaction, when you’re dealing with someone that is selling a business and they’re suddenly losing income, having that building to provide a source of income is key and critical. I like it when an owner can maintain that real estate income as they ease into the next stage of their financial life.

Phil McCollum

Their real estate may be their second most valuable asset that they own, and they might want to keep it in the family for years and look at gifting it. It’s definitely something that we see owners hang on to for a few years.

Michael Carlin

One last note that I would like to make before we get off this topic about understanding your asset, the organization asset – is to try to avoid the situation where any one client is worth more than 10% or is more than 10% of your business. You want to maximize your organization value and too much dependence on any one client can end up being a negative in the eyes of a potential buyer.

Phil McCollum

We have seen that in the past and, when you have a customer that has such a large portion of your revenue base and that customer is very successful, they may be swooped up and now you do not have a connection with that client any more. The purchaser is in another part of the country and they want to use their own person. You want to have a broad customer base, so you can weather those situations. Having one client could be traumatic and troubling. It could also decrease your value because you were relying on one customer.

Michael Carlin

One thing I pulled from the Small Business Association’s website is what an acquiring company is looking for and they had their top six items:

Right product or niche
Company with the right funding
Clean balance sheet
Clean operating industry
Experienced management – they want to buy the expertise in the company
History of enhancement shareholder value – you want a track record of performance

Phil McCollum

We love seeing a company or companies that have increasing sales, increasing bottom line with a trajectory of heading upwards. It shows the buyer that there’s value and nimbleness in the company because they are changing over time if they’re able to increase the sales and bottom line of the company as the market changes. It provides more support and value to the potential buyer.

Michael Carlin

Structure of the deal, let’s talk about this. A lot of clients think they are going to get a check or cash up front and then I’m done. But that’s not how it always happens.

Phil McCollum

You’re correct, that’s not how it always happens. For tax reasons, you may not want that money up front. If you sell it on an installment note, you can defer that gain over a period of years. There may be assets that you have to pay a higher tax rate. The other part we will see is a seller wants to be involved in the business moving forward, do they want some of their shares they’re getting or cash they’re getting. Actually maybe units in the new company, so they roll over the investment and defer the tax on that piece of it, so they have some say. So, in the new company and a small investment piece – we see that too, especially in partnerships.

Michael Carlin

Let’s talk about the installment note.

Phil McCollum

Let’s say a business owner agrees to sell his business for $10 million and that payment isn’t made in one year. It could be over a two or three year period up to five years. What this shows is the seller is still involved with the business. They say, we will keep you on but will pay you out over five years, but we need your help to keep this thing going. You can get your money down the road. That’s very common. Also, we see key executives or owners who will have W-2s or some guaranty payment for a few years and may drop over a couple of years as they become less involved. It’s there to help the transition of the business, especially if it’s been around for 30 or 35 years.

One of the documents that is important to get in the process is the “letter of intent.” This could be a one page letter or a four page letter. It lays out the key terms of the deal. What’s the price, timeline, each party’s timeline to complete the transaction? One thing that you do not want to have in these transactions is open ends. If you don’t have closure things could go on and on and nothing gets done and the business won’t get sold. You want to get your attorneys and CPAs involved because there will be some tax impact in that letter of intent and legal wording that you will want your attorney to look at so you don’t pin yourself into something you don’t understand.

Michael Carlin

Do you want to talk about using an investment banker or broker? How do you figure out which one to use, or if you need one period?

Phil McCollum

If it’s a rather large business, like $10 million or more, you want to get an investment banker involved early on. They are the people who will be selling your business. If it’s less, and you have your valuation together, a broker will work well. Especially if you have a local business in the Valley and do not have plans to expand and you want to keep it local.

Michael Carlin

In both cases shouldn’t a business owner be prepared to have someone go through the financials and extract everything out of your business? I find that business owners are surprised at how challenging that process is. They want it to be smooth and easy. They don’t want to spend a lot of time providing information because it’s time consuming.

Phil McCollum

That’s where you have your management team or your trusted team keeping it confidential. That’s where we set up data rooms. You have one buyer come in and you have all the information for them. If the buyer is not interested, you have that information ready for the next buyer to look at. It makes you look like you’re organized and prepared. Remember that the investment banks and brokers have the same thing in mind. They want to sell the business for you. There’s a little bit of self-interest in there. That’s why you want to get input from your CPA or attorney.

Michael Carlin

We need to talk about deal types and tax knowledge.

Phil McCollum

If you get all your cash up front, you’re going to have the highest tax up front that you’re going to pay but you have your cash. At times you will see what we call a stock transaction, where the buyer will receive part cash and part stock. Depending on how that stock piece of the transaction is handled, you may have to pay taxes on the receipt of stock, which is not the greatest because now you’re getting an asset that you write for taxes. Many times, we see that stock ends up being an interest in the buyer – the rollover interest that you’re selling.

Let’s say you sold 80% of your business and 20% of it you’re going to roll over to the new entity. That’s the part that’s differed, so you don’t have to pay tax on that piece. The long-term employment contract – we’ve seen them up to five years. It seems like a long time, but it goes fast. We see this a lot in medical practices. Other times the seller wants to get out.

Michael Carlin

Don’t you see when we have an employment contract, we have a business owner who has never worked before; sometimes they don’t last long at the new company?

Phil McCollum

You do see that. It’s very stressful and hard on them. Sometimes they ask for a buyout because they can’t do it anymore. That’s where you have a five year deal. It’s the time that the previous owner is involved, and it drops each year. The first year, they may get $100,000, the second they may get $60,000. That’s to reflect that less time you’re involved with the company.

Michael Carlin

The final point we want to go over. We want to make sure you spend the time figuring out how this transition will help you accomplish your financial objective. You need to have a post-sell plan in place before you go through this process. One of my clients wanted to sell his franchises. He was all excited and thought he could get millions of dollars and retire. We went through what he spends, what are his total assets and where they are now. What his real estate picture looks like. In the end, what we found out – the amount of what he thinks he could sell for was about 70% of what he needed to retire. This allowed us to have a discussion to say rather than sell it, maybe you can do a reduced work schedule and have the business work for you financially for the long-term. Create this understanding now.

Phil McCollum

Once you start the process of looking at what the value of your business is from day one when you’re going to sell this, when you get close to the end, you should start meeting with your financial advisor to see what it’s going to look like the day after the sale. If you don’t have a framework of what that might look like, you’re going to be wondering what to do later.

Michael Carlin

In conclusion, go in early; start planning now because this is a long-term process.

Phil McCollum

It’s a process that evolves. If you plan on selling in five years, in a few years from now your goals may change, the economy may change, so you may have to modify the process along the way. It helps you save time. Remember, how do you want to leave your legacy?

Michael Carlin

This concludes our second episode. Stay tuned for our third podcast.