BY PATRICK CUNNINGHAM, FEDERATED MUTUAL INSURANCE COMPANY®
Patrick spoke to rave reviews at the 2024 IEC Business Summit. We asked him to turn his presentation into an article for the benefit of Insights readers.
Small and medium sized businesses, especially FAMILY businesses, are the backbone of the American economy. The succession statistics below paint a clear picture that the odds are stacked against the multi-generation business. We also know that selling a business doesn’t always go according to plan.
Business Succession Facts
According to SCORE, The Family Business – Successes and Obstacles, in January 2023, family businesses account for:
- 64% of the U.S. GDP
- 60% of all U.S. employment
- 78% of all new U.S. jobs
The Targeted Strategies Group, Succession Planning Equals Survival for Family-Owned Businesses, published March 2021, states about the next generation:
- 30% survive the transition to the 2nd generation ownership
- 12% survive the transition from 2nd to 3rd generation
- 3% survive the transition to the 4th generation
Finally, Seiler Tucker’s Why 8 out of 10 Businesses Don’t Sell, published September 2020 says:
- 80% of businesses listed for sale, don’t sell
Who Will Take Over Your Business?
One of the first questions that needs to be considered when thinking about your business succession plan is who is going to take over your business. For some business owners, it might be a child who has been working in the business and is ready and willing to step in at any time. Others may have a key employee with years of service who has expressed an interest in taking over.
In any case, finding the right person is an important decision. It can mean the difference between financial security and financial hardship for you, your family, and your employees if your successor is not able to keep the business operating successfully.
The Need for an Exit Strategy
Once you have identified who you would like to take over your business, the next step is to figure out the details — the when and the how of your transition plan. There are basically two ways ownership of a business can be transferred: By sale or by a gift/inheritance. The best option for your business — whether it’s a sale, a gift, or a combination of the two — will depend on a variety of considerations and your individual circumstances.
Entrepreneurs dream of being independent, building something of value, passing on something to loved ones, and being able to reap the rewards. Considering the sacrifices made, business owners deserve a first-rate exit package when they say it’s time to leave the business.
What would be your first-rate exit package? Will your exit package be what you deserve? If you’re like most business owners, however, you’ve spent more time planning a single vacation than your exit strategy.
The first step in a first-rate exit strategy is know the value of your business and set a price. To do so, business owners need to watch the cash flow and regularly monitor the profit and loss statements. Survival of a business depends on this, but owners seldom watch the balance sheet. Assets minus liabilities equals the owner’s equity.
But owner’s equity may not be a fair price. Should you sell at a depreciated “book value” or at a “fair market value”? The IRS says the fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. See Figure 1.
Owners tend to underestimate value which is why it is important to partner with a company specializing in this arena. At Federated, our Federated Value Estimator℠ service is an informal appraisal that acts as a starting point for discussions. It’s a way to obtain thought-provoking information and a foundation for getting full price.
Three common methods to estimate value are:
Adjusted book value: The book value of any business is simply the total assets less than the total liabilities. The term “book value” is synonymous with “net worth” and “owner’s equity.” For this method to reflect an accurate value of the business, each asset should be adjusted to its current market value (what would be received if the asset was sold). This is accomplished by adding a portion of the depreciation back into the asset value as shown in the financials. This method is best used when the assets, rather than future earnings, more accurately reflect the value of the business.
Book value plus goodwill: This method allows for an adjustment to the stated book value for intangible assets, like customer relationships, “know-how,” and location. These assets are collectively known as “goodwill.” Average earnings are first adjusted for salary discrepancies, such as higher or lower salaries paid to the owners. A fair return on book value is then subtracted from the result to find the adjusted earnings for goodwill. A good will multiplier is applied next to find the total value of goodwill, which is then added to the adjusted book value.
Straight capitalized earnings: The straight capitalized earnings approach considers the historical earnings and the earning potential of the business. A value is determined by identifying the amount of capital that would need to be invested at an expected fair rate of return in order to generate income equal to the company’s average historical income. This method is best used when the earnings, rather than the assets, are a better reflection of the value of the business.
You’ve invested so much of yourself into building your business. Federated encourages you to commit the time and energy to planning effectively for the day when you want to step away.
Patrick Cunningham is national account executive in the Association Risk Management Services (ARMS) department of Federated Insurance. He is responsible for managing Federated’s relationships with national association and buying group partners. Federated provides this article as general information only. It should not be considered an offer of insurance or legal advice. Qualified counsel should be sought with questions specific to your unique circumstances and applicable laws.