Business Planning is an integral part of any entrepreneurial venture. It’s been said that no business plans to fail, they just fail to plan. One of the most over looked parts of any business plan is succession. What do you plan to do with the business when you no longer want to run it or even own it someday? Failing in the area of succession planning will inevitably lead to a failed business. So today let’s take a look at two of the most common ways entrepreneurs can negotiate the sale of their business and retain value in a business that they purchase.
A lot of clients who work for themselves don’t really own a business at all, they simply own their job. In a lot of cases, especially in regards to trades people and even small retail operations when you really get down to the day to day operations the number one asset of the business is the owners own entrepreneurial spirit. When an entrepreneur like that stops working all of the good will and client relationships they have built up go away. In that case the only value in the business is in equipment, inventory and referrals, and all of those things are depreciating assets.
In that case the most common way to sell your business is by getting fair market value for your equipment and then doing an honest assessment of the value of any client introductions that you might do for the new operator. The value of a client introduction is only as good as the first time that new operator does business with that client. If they don’t bring the same level of quality and customer service to the job as you did they will lose the client forever. Generally the value of a client introduction is one to two times the value of their average purchases after that they aren’t buying on the strength of the relationship they had with you, they’re buying on the strength of the relationship they have with the new operator.
For a “job-owning” type business by far the most common and fairest way to negotiate a sale is through the sale of assets. After the purchase is completed the new buyer may even choose to operate the business under a different name, that’s okay because the value of the business is less in the name than it is in the client relationships.
But if your business is a little bigger and a little less reliant on the personality and work ethic of the owner then you might want to sell it through a transfer of shares. Here valuing the assets of the business is done in much the same way but equipment is depreciated inside the corporation for tax reasons and the value of client relationships is much more heavily weighted in favor of the seller because the clients are more likely to stick around under new management.
Valuing a business of this nature is usually done using a multiple of revenue, say 2-3 times annual sales as it is assumed the equipment will eventually depreciate to zero and the customers will remain loyal through the transition because they were less tied to the individual owner than they were to the company itself. Businesses sold in this manner are also much less likely to go through a name change, at least in the short term because the goal is to make a smooth transition that the customers might not even notice.
Tax wise the seller of shares is better able to take advantage of capital gains exemptions and dividend tax credits as well. Although I’m not an accountant and am unqualified to give much in the way of tax advice this just makes sense on a broad level.
In both cases it’s a good idea for the buyer of a business to insist on a non-competition clause as part of the agreement. The last thing you want is to spend hundreds of thousands of dollars on a business with depreciating assets only to turn around and be faced with competition from an experienced operator sporting newer and better equipment that you helped finance by purchasing their old stuff. Not to mention their ability to cherry pick your best customers through old relationships and loyalties.
If you are thinking of selling a business or even starting one, start with the end in mind, like Stephen Covey says. It’s always a good idea to think about how you will go about selling it someday. For more information on The Meekonomics Project and how we work with business owners around issues of succession and estate planning write to email@example.com