"The world of work —and the world in general—is changing. People are living longer, new technologies are emerging, and we’ve never been more globally connected. That means the skills we use now in the workplace are not necessarily the skills we’ll need in the future."
Historic low interest rates during the past several years have not only been a catalyst for economic growth, they've also created enormous demand by private equity firms seeking to invest in a wide range of small businesses. In turn, these investments have created a "once-in-a-generation" opportunity for thousands of small- and medium-sized businesses, raising their value and minting new millionaires across our nation.
Data from BizBuySell Insight Reports shows that a record number of small businesses were sold in the third quarter of 2017. A total of 2,589 transactions were reported nationwide, a 24 percent increase from this time last year. This puts the number of sales so far this year at 7,491, making it a record-breaking year for small-business transactions. Just as important, the median sales price is also up year-over-year, by about 15.7 percent.
According to Thompson Reuters, private equity funds raised more than $340 billion in 2016. And with a 12 percent increase in the number of private equity funds this year, 2017 expectations are similarly high. In recent years, I've worked with several business owners, whose companies were valued from $1 million to $100 million.
But with the Federal Reserve set to meet and raise interest rates on December 12–13 — and possibly throughout 2018 — the window to take advantage of the economics of these deals may be starting to close. Borrowing costs will rise, making it more difficult for private equity firms to profit from future acquisitions.
To take advantage of this window, the entrepreneurs that created these businesses need to determine soon if they want to cash out. As a financial advisor who works with many entrepreneurs, here are a few items to help business owners maximize their potential profit and tax benefits.
Determine the right business structure
The correct business structure can make a significant difference in the net proceeds from a sale. I've found that a surprising number of older small businesses are structured as "C" corporations, which means sale proceeds may be taxed twice, at the company level and again as shareholder dividends.
For sole owners of a service-based business, an S Corporation may be a better choice. As a so-called "pass-through" entity, it would escape any corporate level taxes. These businesses also generally have few depreciable assets, so most of the proceeds receive capital gains treatment to the owner. But beware, if your S Corporation owns real estate that you are not planning to sell because you want to keep the rental income, you will likely pay additional taxes.
For businesses with multiple owners or that require a large asset base, such as real estate, a Limited Liability Company — another type of pass-through entity often structured as a partnership — is a flexible and inexpensive option. However, if you have any significant charitable intentions for your sale proceeds, this structure can create unintended additional taxes. Most often, this is in the form of unrelated business income tax. This is a tax imposed on the charity that reduces the value of the business owner's gift. With planning, these additional taxes can be avoided, so early communication with a tax advisor is key.
Understand how a sale creates financial independence
The thought of losing control and a familiar source of income can be terrifying for many business owners. So it's critical to know how much money you need to net from a sale.
Take time to calculate your annual living expenses before the sale and be sure to include a buffer for larger one-off expenses like a new car or home renovations. After that, determine other income sources, such as pensions, rental income or even Social Security that you'll have after you sell your business. The sales proceeds will need to cover the difference between annual expenses and other cash flow sources.
I've found that many business owners are so busy running their companies that they don't realize they have significantly more assets than they need to be financially independent. "Knowing your number," can help ensure you take advantage of the right sale opportunity.
Make legacy planning part of the equation.
A surprising number of business owners I consult with don't have an adequate will and haven't even considered how their business should be incorporated into this planning. With proper planning, they could leave a much larger portion of their wealth to their children, or even grandchildren, and much less to the government.
The US Congress' tax reform plan may raise the estate tax exemption amount, or even eliminate this tax altogether. But keep in mind changes can occur every few years. Given this, legacy planning will continue to be an important consideration for business owners.
Donate some proceeds to charity
Many business owners contemplating a sale also want to kick start their philanthropic goals. Developing a plan for charitable giving can save millions in taxes and provide additional purpose to the next phase of their lives. But it's tricky; the way a sale is structured can save money for some owners, but not others.
I recently worked with one business owner to make certain his sale met these goals. By choosing to make a charitable gift from a portion of the business before selling it, the owner eliminated the taxes that would have been realized on the sale and received a full tax deduction for the gift. The result: the business owner's tax bill was reduced by over 70 cents for every dollar donated to a nonprofit.
Too often, individuals focus more on getting the buyer to pay the maximum price rather than maximizing how much of that price they actually get to keep. This distinction makes all the difference to a business owner transitioning to the next phase of their life.
While the current economic environment is favorable to achieving a premium sales price, time may be running out. Business owners considering a sale should review their objectives now and determine if a sale makes sense in the near future.
Baby boomers, the generation born immediately following World War II, are getting old. Many of them are small business owners and, over the next few years, are likely looking to wind things down, play a little golf, move to Florida, spend more time with the grandchildren…and exit their businesses. Some are calling it the “Silver Tsunami” – a massive shift in ownership of private companies. That could be very good for the boomers. But it may not be so good for their employees.
According to recent research done by Project Equity, a nonprofit group, there are about 2.34 million businesses owned by this generation that generates more than $5 billion in sales and employs 24.7 million people–about one-sixth of all U.S. workers. As the current owners look to exit, their options are few: sell (six out of 10 business owners plan to do this in the next decade), hand the company to their kids, or close it down. Unfortunately, many of them may be forced to go with the third option and close up shop. Why?
According to Project Equity, many small business owners do not have succession plans–and because of this they’re putting their employees at risk. As a small business owner I empathize–we tend not to think ahead. This leaves us with fewer choices when it comes time to retire. Without succession planning, many of these businesses “will just quietly close down and go away,” says Project Equity’s co-founder Alison Lingane.
Lingane says a third of business owners in this generation who want to sell are having a “hard time finding a buyer” and many are being bought out by out-of-area buyers that are consolidating ownership and wealth. The result: the jobs of all of their employees are at risk, regardless of their industry.
The organization is working to raise awareness of the issue. It is urging local governments to measure the impact on their tax base by using business license data to track how many businesses are more than 15, 20 or 25 years old so that local business and political leaders can get involved.
The most impactful solution is encouraging business owners to think ahead and consider transferring ownership of their companies to their employees. “Since today most family-owned businesses don’t have somebody in the next generation who wants to take over, employee ownership is one of the best ways to keep thriving businesses locally rooted into the next generation,” said Mark Quinn, District Director, U.S. Small Business Administration.
"Before there were special purpose acquisition companies and before there were capital pool companies – both of which represent ways for private companies to go public — there were search funds.
They were a structure, developed at Stanford University, more than four decades back, that allowed entrepreneurs — supported by backers who provided just enough capital — to seek out potential targets. Once the target was identified, the entrepreneurs, this time with considerably more financial help from the backers, would acquire the target and run it for the next few decades — most likely as a private company.
Over the years, but more so in the past few years, search funds came north: some were successful and found targets in fields ranging from manufacturing and supplying portable electrical products to IP video security and surveillance to providing pre-ordered meals for busy urbanites.
High Park Capital Partners was another search fund. Formed a few years back by Josh LeBrun and Adrian Bartha — who met while working in the private markets group at OPT Trust — it found a target in eCompliance Management Solutions — at the time, an e-learning company based in western Canada.
eCompliance partners with industry and governments to help companies become compliant with environmental health and safety (EHS) matters and thereby reduce their administrative burden. The company is now based in Toronto.
Through a series of changes, the most recent of which was unveiling the EHS industry’s first cloud analytics and reporting platform, eCompliance is radically different today than it was when High Park made its acquisition. How different? Apart from retaining the name and three former employees (total staff is about 35) everything is new.
After making the acquisition in early 2013, Bartha and LeBrun, in time, made a fundamental switch in the company’s strategy: growth would become the key objective because of the large business opportunity they had discovered. To achieve that goal, and after testing in the Canadian market, it decided to enter the U.S. market about 18 months back.
“Most of our new business is from U.S. companies,” said Bartha noting that sales to U.S. customers now account for about half of its revenue. “When we started, it was a case of solving problems in the local market,” he said, adding Canada “is a great launching pad to prove that something works internationally.”
But expanding to the U.S. and developing new products, takes capital and time. To get the capital to implement such a plan, eCompliance sold the legacy business and used the proceeds “to incubate “software as a service product,” said Bartha. The switch was both “necessary” and part of the “vision.”
The company hasn’t established an office in the U.S. arguing that “it’s optimal to fly down when we need to. But long-term setting up a physical presence there is probably a likely outcome.”
But like any small business, eCompliance faced a series of challenges. “There was definitely a learning curve,” said Bartha. For instance, the company’s main product is now a start-up — and not the ongoing revenue stream afforded by the product that attracted High Park to eCompliance in the first place.
Questions ranging from what product is being built for what customers and for what reasons all had to be answered. “That takes a feedback loop and that takes time. And we had to survive in the interim,” said Bartha. “We got through it and now have 300 customers. But it’s very scalable.”
So what’s next? While organic growth will still be the prime goal (revenues are the high single digit millions), acquisitions can’t be ruled out."
IN 2007 Lucas Braun and Ryan Robinson emerged from the Stanford Graduate School of Business with such a sense of “professional invincibility” that they decided not to return to their old jobs in a consultancy and a hedge fund, respectively. Instead the two Americans took a leap of faith—in themselves.
They were 32 and had no experience of running businesses, but they persuaded a group of investors to finance them for 21 months as they searched for a business to acquire. They discovered OnRamp, a Texas-based private company, and assumed the roles of chief executive and chairman. Following spin-offs and acquisitions, the company now provides cloud computing for industries with sensitive data. Over the past seven years, they say, revenues have grown by 30-35% a year.
The two executives are products of a niche of the private-equity industry known as search funds—such a small niche, in fact, that few in the business have heard of it. But Stanford, which helped pioneer the industry in the 1980s, tracks it, and says that it has grown sharply in the past two years. In 2015 more than 40 new funds were established, twice as many as in 2009. Over the same period the number of acquisitions made by these funds tripled, to more than 15 a year.
The typical search-fund principals are MBA graduates from an elite American university, who raise $400,000 or so of “walking around money” from investors, who purchase a stake in the fund for about $40,000 a share. The fund searches for a high-growth, high-margin target, valued at $5m-20m. The fledgling businessmen then hold a second round of acquisition financing, as well as raising debt. Their tenure as bosses lasts until they sell out.
Returns are surprisingly good. The average is 8.4 times the money invested and an internal rate of about 37%. They do much better than the average of the rest of the private-equity industry, analysts say. By the time of the exit the principals can hold a 30% equity stake, provided they have met their targets. That is not a bad deal for a no-money-down entrepreneur.
Some firms are injecting scale into the business. Boston-based Pacific Lake Partners, for instance, is dedicated to investing in search funds, and gives firm guidance regarding the industries and regions it prefers. Timothy Bovard, an industry expert, founded an incubator called Search Fund Accelerator in 2015 that provides capital and mentoring to aspiring search-fund entrepreneurs, in exchange for equity. Increasingly, the business is cherry-picking best practices from other bits of private equity. But the funds never invest in a portfolio of firms. Instead, the years knocking on doors can lead to a visceral sense of commitment to the targeted business.
For several decades, America and Canada were the sole home of search funds. But lately European MBA courses have included search-fund case studies that have whetted the appetite of some intrepid would-be entrepreneurs. There are plenty of reasons for caution, though. About a quarter of searches come to nothing, and about a third of the acquisitions end in failure. But that is still better odds than starting a business from scratch.