Business owners go through lots of stages as they develop and grow their businesses. Survival, or not, is the first stage.
Every month that ends with most bills being paid is cause for celebration. It’s tiring and stressful, for sure, but the ego rewards of playing the game and surviving are enormous. Maybe the enterprise is teetering between life and death, but just making it one more month generates enough energy to plow into the next month and do it again.
And then, one day, the owner realizes that surviving from month to month is no longer a question mark. Sure, profits are low and cash is tight, but the doors are open and paychecks are going out on Friday. The first stage has ended and the business is entering the second phase, what I call the “What the hell, look’s like I’m going to make it after all,” phase.
Once survival is no longer an issue growth becomes the goddess we worship. We need to expand, get bigger, be more visible, increase sales and make some major bucks. Hire a secretary and buy a Mercedes. Who wants to stay small; bigger is better. And, bigger may very well be better, but growth is not always a profitable phase of a businesses life. The commitment to grow bigger means more capital is needed and more expenses incurred and, frequently, discounting prices in pursuit of getting big. If this phase continues ad infinitum, the business is likely to crash under its own weight as no one can sustain meteoric growth indefinitely. A targeted annual growth rate of 15% is about all a business can sustain over the long term.
But, most businesses reach a comfortable size and level off. At this point increasing the financial rewards of ownership become more of a priority than getting bigger and bigger. Having more time off for personal pursuits and nurturing grandkids takes on increasing importance during this phase. This is likely the most profitable phase of a businesses life and provides the owner a good opportunity to enjoy life and feather his nest for retirement.
Somewhere down the road, the owner is going to be nudged into addressing what’s going to happen to the business when he retires, dies or becomes incapacitated or incarcerated. Handing the business off to family members, particularly children, is a very popular and, usually, a terrible idea.
Most second-generation businesses fail within the first few years after the transition from entrepreneur to family members. Why? Without really knowing, I have long suspected that the children make decisions based on what they think daddy would have done rather than basing their choices on what actually needs to be done. Just a theory, but, for whatever reason, they usually fail pretty quickly.
A better idea, most of the time anyway, is to sell the business to an unrelated party. Since this process takes five years or more, the owner needs to get started early rather than later. Having a definite plan replete with goals, strategies and timetables is invaluable. Those last five years can pass in a flash.
What’s the business worth? Now, there’s a sensitive question if ever there was one. Small businesses (sales less than $10 million) usually sell for somewhere around five to seven times annual earnings. But wait, you’re thinking, my business is worth much more than that! You’ve got to add back the hunting expenses, the business trips to Mexico and the Winnebago payments. And, after all, the new owner won’t need to pay himself the six-figure salary that I draw and a Ford will be sufficient for him. The Mercedes is going with me!
Ah, it’s payday someday and the owner has just discovered the folly of living out of the business. If he makes a list of expenses that were non-business and purely personal he’s set up for trouble with the IRS. And, he’s documenting his sins. If he doesn’t, the value of the business is greatly diminished. The tax he’s saved by deception is discounting the value of his business.
About five years before selling, it’s wise to take a hard look at any “discretionary” expenses the business may be paying and consider paying them personally. Each dollar of expense reduces the value of the business by $5 to $7 since the valuation is likely to be based on a multiple of earnings. In addition to honesty for honesty’s sake, each dollar saved is likely to increase the capital gain by a factor of five to seven.
What about selling to an employee? A much better choice than giving the business to junior; however, employees may have a hard time raising the money to buy. Being open to seller financing for at least a portion of the price makes an employee buy-out more doable. Just be careful about who you choose since a poorly run business sheds value like a dog shedding its winter hair.
Planning, planning and more planning
All entrepreneurs like to believe that they’ve created a business that will continue on after they’re gone. In fact, many will not. Sometimes the value of a business is so linked to the personality or personal skill of the owner that there is just no value to it without the owner. In these situations, there’s no choice but to shut it down, collect the receivables and pay the bills. Many times people have tried to sell businesses that are unsaleable and failed miserably. They would have been better off to just liquidate and retire.
Starting and operating a business is a wonderful career. It can be both financially and ego rewarding. Getting going is tough, sustaining the business over time is a challenge and, equally important, making a planned and graceful exit is the right way to conclude the reign. Planning, planning and more planning can make it all work out.
Thought for the Moment
The chief danger in life is that you may take too many precautions. — psychiatrist Alfred Adler (1870-1937)
Joe D. Jones, CPA (retired), is publisher of the Mississippi Business Journal. Contact him at firstname.lastname@example.org.