Thinking about an exit? Here's the plan

Thinking about an exit? Here's the plan

Nerre: Welcome back to Building More Than Business. I'm Nerre Shuriah, a certified business exit consultant and certified M&A advisor, and I head up our wealth and business planning capabilities. I'm joined today by my co-host, Ann Lucchesi. She's a certified financial planner and a certified equity professional, and she's a senior director here at First Citizens Wealth. Today, we continue our quest to connect business and personal planning, and we're going to tackle a question that every business owner has to answer to eventually. What happens when it's time to step away from your business?

Ann: Yeah, Nerre, this is a conversation I think you and I have with clients over and over again, and it just seems like it's so often the one that they put off having. You know, they're so focused on growing the business that they put off their personal financial planning for what's next until it's either too late or it just feels way too rushed.

Nerre: What's behind the reluctance to really get down into this conversation? And how do their emotions, identity and uncertainty get in the way of good decision-making? I think that something we always like to do is to show what good looks like. What is a good transition? And how do you get there?

Owners are busy. They have 70-hour work weeks. Some types of businesses require the business to be open 7 days a week, so they truly don't have a lot of bandwidth left to think—not of the present—but of what's going to happen in the future.

Secondly, succession can feel distant. If things are going well, if they're busy from day-to-day now, it feels like it's not really an issue. They can deal with it later. But until it suddenly isn't, right? Your future can change on a dime. Something can happen—divorce, illness, an unsolicited offer. Or sometimes we meet people who say, "You know what? I just woke up and I realized I'm done. I don't want to be owner anymore. I kind of want out of this." And so all of that factor into reasons why business owners may delay, but it's important that they start thinking about it now.

Ann: Yeah, it's really interesting in the innovation economy that they are just as apt to put off the planning even though they're kind of rushing towards that exit, right? To the point you made. They're also quite optimistic they're going to have the big outcome. They're aiming for that IPO. But along the path they're failing to plan around things like what the dilution looks like, what and when can they get some liquidity or even what life might look like in a post-exit.

Nerre: I think we're both saying the same thing. Traditional and innovation founders do tend to avoid planning, and maybe that's out of overconfidence or fear, but that's not necessarily a good thing, and we see that when things are not going well and then you start to make emotional decisions based on that negative situation that may not provide good or that may result in poor implications down the road. We see that when there's a down market and clients start to get upset and make financial or investment decisions based on a short-term situation.

Ann: Yeah, I mean letting go of that identity, right, or reimagining life after an exit, it's so emotionally charged. It's really complex. Along these lines, Nerre, if the emotional side plays such a big role, what are the actual steps that founders can take, whether that's emotionally or financially, to prepare for a more successful exit?

Nerre: There's no one path to a successful exit, but I would say for most folks what really works is to get ahead of it. We suggest successful exit planning—start 3 to 5 years before the actual transaction. I mean, one of the worst things that we frequently get is a client who makes a big deposit, you know, they've sold their business, they're making a big deposit into their accounts—$10 million, $20 million, sometimes upwards of $50 million. They didn't bring us into acting as their advisor during that transaction, but afterwards, they'll ask us for tax advice. And that's so hard to have that conversation because at that point, the window has almost closed. Our ability to implement any strategies to lower that capital gains tax has really been impacted and limited. So starting early really helps.

It's also about something that we talked about on this podcast last time—separating out your business and personal finances, clarifying and aligning your business and personal goals. If you go through that process, you can have clearer vision for what you want to happen and protect your wealth going forward.

So I'll give you a couple of examples of what I'm talking about. We had a client who listened to us, worked with us on doing their planning, took maybe about a year or so to get everything in place prior to, you know, working on the transaction that transitioned their business to their oldest son, and we were just about done with everything.

We were at one of our last meetings after we planned out their retirement for the future, and the wife of the husband-wife team told us that she was just diagnosed with Parkinson's. So that's a terrible situation, but I would have to say that given that we all worked so hard to put a plan for their retirement in place, they actually walked out of there in a better situation than if they had done nothing because now they had a plan to deal with everything, and she could focus on what's best for her health without having to do both of those things at the same time.

Ann: Yeah, those are some difficult stories, but I do think they illustrate why planning can be helpful during difficult times. Even in innovation where I'm working with much younger founders and they're making fast exits, but they're putting off that personal planning, it can put them in difficult situations. You know, that exit is expected, but it isn't always the exit that they were imagining, right? It can look a little bit different. They might get locked into an earn-out. They might be working underneath a new management team with misaligned goals. And of course, the one I see almost all the time, they could have a really big tax surprise because they didn't plan for it.

A great example of that was a founder that we'd been working with, and we'd been talking to them probably for over a year on and off as things came up, but just never, again, back to your point, they didn't engage with us the way we wanted them to engage. And calls up super excited—has a letter of intent in hand.

So he's going to be acquired, loves the offer, wants to take it, and he's like "Okay, now I'm ready to plan. Like what do I do for taxes, and what do I do for the wealth transfer side?" And I have to say, I just shook my head and said, "You know, we really needed to do this 6 months ago so that we could really make some decisions around exercising stock options or where you are on your QSBS planning or, gee, you want to transfer a lot of wealth that's well beyond the estate limit, it would've been easier to do when the valuation was lower because underneath the IRS rules, once you have that LOI in hand that you would accept, in their view, the company is now worth that amount of money. And so it takes away a lot of the planning we could have done for them. Tough situation, and as you've pointed out, news that we don't like to deliver.

Nerre: Ann, I can't imagine what that conversation must have been like to tell your client "You've missed out on saving in taxes that you didn't necessarily need to pay." And you mentioned the QSBS. Just to clarify for our listeners who aren't familiar with it, it's the qualified small business stock extension. And it has quite a bit of rules, but it can be extremely favorable. And so, when we say, "Hey, they didn't engage with us." It's not a selling point per se, it's just an acknowledgement that taxes and the business world is complex. No one person can know it all.

And I'll tell you, a lot of the times when we see a business owner upset about the final outcome from their exit from their business, it's not necessarily the proceeds that they're upset about—it's the process that they went through, the negotiating, sometimes negotiating those provisions at the end to determine how much of your payout is taxable. Or what does your walk-away look like? Is it a clean break? Or, as you mentioned, are they staying on for some time, maybe in a consultant role?

Nerre: So let's move on a little bit and talk about exactly what that process is and break it into some manageable stages and timelines. I've said before that we would really love for business owners to come in 3 to 5 years ahead of that transition and talk to us about planning. And I get it, if you don't know when that transition's going to occur, you may be like, "Well, I don't know it's 5 years out." So guess what? Come in anyway. And we'll talk about a number of things that we're doing in that stage. For instance, early on at the 5-year mark, if it's 5 years or more until you think you'll transition from your business, some of the things that we're doing are working on determining what your retirement number is.

So retirement number is the amount that you need once you retire to fund your retirement—remember, we're projecting out to past your life expectancy—to live in the quality of life that you want to live, to do the things that you want to do in retirement, whether that's travel, buy an RV, you know, get a second home. All of that costs money, and you need to know what you need to fund that.

So once you get that number, then you can back into knowing how much does this business need to be worth post-tax to fund all those dreams that I have? And those two things are hugely important. If you get an unsolicited bid from an outside competitor or buyer, you don't know if that number will work for you until you know your retirement number.

Then a little closer in 2 to 3 years we're working on your estate plan. How do you want to distribute your assets? Or how can we connect what you're planning for with your personal assets and how they'll be distributed along with your business? And if it's worth enough money, given how high your estate tax exemption is, some people still exceed it. And lastly, during that year or so in the end of our stage planning, we're looking at what's the best transition pathway. Are you transferring it to the next generation of your family, internally to managers or employees, or outside to a third party or IPO?

Each one of those different transferee pathways have a plethora of different strategies that work. And sometimes choosing the right one is a process of elimination. We use tools like informal valuations, risk assessments, readiness reviews—all of these to help an owner understand where they are and how they have prepared compared to everyone else in their industry. And a lot of the times we're taking that time to build value in the business or de-risk the business. When buyers see that, they're willing to pay more for the company.

Ann: Yeah, for certain, Nerre. I think even in the innovation economy, you know, what we find with clients is we want them, to your point, start early. You can't go wrong on being too early because then we can at least tell you pivotal points where we will need to step up and engage in a deeper planning discussion. But they need to get started pretty early with both estate and tax planning strategies. And there's some things that they can do along the way to piece it out. To your point, if you do it all at once, it feels so overwhelming that people then just put it off and don't do anything. And we really want them to continue to take steps forward. You know, what we'd see with a young founder might be their first thing is, gee, they need to figure out how to take some liquidity off the table to go buy their first house. Well, that requires planning. What's the best piece of their equity to use for that? Who's going to be purchasing it? What are the tax ramifications?

These are really important things to sit and have a discussion about. Maybe they haven't done their basic estate plan. We like that to get completed before you're going to delve into the advanced wealth transfer strategy. So step at a time. You know, we want to work with them. And earlier is better. Young founders, they think, "Oh, I don't need to do any of this." But the reality is all of a sudden the wealth event is on them before they're prepared. And so, one step at a time, piece it out, a little bit modular, maybe not as deep as some of the traditional ones that you work with, Nerre.

Nerre: And so, if you're not exiting for a time, which is typical for younger founders, and you don't know when it'll happen, it's good to build out a road map. For instance, we mentioned that QSBS, which is so important to owners in the innovation economy where they could really qualify for that big exemption. It's important to know when you might grow your business too big to no longer qualify. And there's some other things you could do. You could be gifting business interests to loved ones. You can retain control, gift at a lower value than the sale price, so now you're saving on transfer taxes like estate or gift taxes. When the actual sale or transition happens, you're also spreading the capital gain. But remember that QSBS has a huge exemption up to $10 million per person. If you are making gifts of business interest to your loved ones, they each get their own $10 million amount to work up towards.

So on the sale of a business you could be saving multiples of tens of millions of dollars. Also, keep in mind that gifting often takes time. Usually, people don't gift outright. They set up a vehicle like a trust that will offer additional protection, such as asset protection, or maybe you choose a state with favorable laws like no state income tax. To do that you often have to set up the vehicle, maybe fund it, and then wait a period of time before actually making a gift of interest in that vehicle, whether it's a trust or some other entity. The reason why is we want to make sure that the IRS does not compress both of those steps into one transaction and ignore the gift.

So sometimes you may be waiting upwards of 6 months between setting the entity and then actually making gifts. And also, I mentioned those provisions for flexibility, asset protection, takes time to figure out what do you want to put in there. So you also have to allot time to draft the actual document to your liking. So, Ann, let's say someone hasn't done a lot of planning and they're at the finish line for whatever reason, what do you tell them?

Ann: Well, I mean obviously in this case, Nerre, it's always a better late than never, right? We obviously can do a lot of planning with them. And what I find in innovation is because these are oftentimes repeat entrepreneurs, I remind them that even if they've lost an opportunity to do some of the tax planning that they could have done that they're still pretty young in their career. There's a lot of opportunity downstream to plan. And let's just take what they have and let's make sure we're doing all those things you talked about—how are we going to help them fulfill their goals and now plan for what's next in life. So one step at a time.

It's interesting, though, how important and impactful—and you talked a lot about the qualified small business stock exemption—in my world, it plays a really heavy role. And it reminds me of an example where I was sitting down with a founder in New York one day and we're talking about various things that he should know, things that we talk to founders about frequently. And one of them was understanding what the qualified small business stock exemption is.

And as I get into that and I'm talking about, "Hey, you know, on your first $10 million, you might be able to save $2.3 million" and just, kind of, these high-level things. He says, "Wait, wait, wait. I need to understand," he says. "I have three LOIs on the table." One of them was to buy IP. One of it was an asset purchase. And the third one was going to be a publicly traded company that was going to exchange stock for his shares.

And as we talked through the tax ramification of each of those, it turns out he made a different choice, and he chose to go with the publicly traded company because of the impact that QSBS was going to have on his final outcome. There's just no such thing as not having that conversation early enough so that you can begin to have those plans. And it's so important to engage with the advisor. I mean, he ended up pocketing an extra million just because of the choice he made.

Nerre: That's such a great example to show that, while we really want people to start 3 to 5 years in advance, we can meet the client wherever they are and provide some guidance—and more guidance, provided it's before the sale.

Ann: No matter what kind of business you run, there is one universal truth. The earlier you plan, the more choices you have. When your plan is aligned well with your personal goals, the smoother the transition to your next chapter will be.

Nerre: Your exit isn't just about walking away and there are a lot of things, feelings that could be obstacles to you achieving it. But we want to recharacterize it as—you're not leaving something, but you're really walking towards your next chapter. And if it's something you've planned and prepared for, it can be rewarding and even more exciting than the last.

Nerre: Thanks for listening. Be sure to subscribe on Apple Podcast, Spotify or YouTube Music. And if you liked what you heard, share it with someone who might find it valuable too.

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