Much of the conventional wisdom suggests you should start serious planning no earlier than five years before you are ready to exit. This misperception is so common; we call it the Five Years’ Fallacy. This approach gets owners in more trouble than perhaps any other mistake.
There are four major flaws with this approach:
1. Selecting the ideal business entity is an important consideration, especially in the event of a sale, because the type of business entity may greatly impact taxes.
For example, owners of C corporations in some cases may reduce taxes upon a sale by converting to S corporation status prior to sale. However, the tax benefits can be lost if the company is subsequently sold within a ten-year holding period after conversion. In another example, the reverse may be true—owners of S corporations seeking to implement an ESOP as an exit strategy may secure tax-free proceeds from the sale if they convert to a regular C corporation. Matching up your exit plan with the appropriate business entity may require years to implement.
- Owners seeking to pass a business down to the next family generation often desire to make tax-free gifts of business interests to the successor generation. Congress limits the value of gifts that can be made without triggering gift or estate taxes, including annual gift limits. As a result, passing down a large family business can take many years to accomplish. Too little time inhibits the effectiveness of gifts and other family-business transfer strategies.
- If you intend to sell to a third-party buyer, your business’s intellectual property may be an important factor in driving value at US law sets timelines required to register, file, and protect your intellectual property. If you wait until five years or less to develop an intellectual property strategy, likely you will have forfeited many of the rights and opportunities available to grow value.
- Owners seeking to sell their business to one or more employees need to hire, train, and groom a key employee or entire team prepared to run your business after your departure. Developing successor leadership may take many years.
- Many exit tactics benefit from the “miracle of compound growth” on invested assets. For example, funding an income tax deductible retirement plan creates potential future income outside the business. If you have only a few years to implement this tactic, your results likely will be greatly diminished.
2. Waiting until the last five years to prepare for exit, reduces your control over many factors that influence the business’s sale price.
Road market conditions, interest rates, capital markets, your industry’s health, and other external forces influence the availability of cash, the cost of capital, and the demand for businesses in your industry or market. Many economists note that these cycles can take as long as seven to ten years to complete. If you are restricted to exiting within a specific time frame such as five years, you may choose a time when your business’s price is lower due to external conditions. Your investment advisor probably has been telling you, “Don’t try to time the market,” when investing in publicly traded stocks, bonds, and mutual funds. But when it comes to selling your business, you must try to time the market. Leaving only a few years’ preparation to sell, may limit the ability to achieve the most favorable external climate.
3. Limiting your exit planning preparations to the last five years is you simply cannot predict the future.
A prospective buyer with a large checkbook may walk through your front door tomorrow. Your industry may go through an unexpected consolidation (often called a “rollup”) which heats up your potential market price, but only for a window of time. You may become seriously disabled and unable to work. You may die. Who guarantees how much time you have? Life happens.
4. The fourth and final reason why you cannot wait to start serious exit planning is that if you have not clearly defined where you want to end up, then you do not know if the decisions you are making today will get you there.
In Stephen Covey’s best-selling book, The 7 Habits of Highly Effective People, the second habit is to “Begin with the End in Mind.” His lesson applies here. To paraphrase Mr. Covey, the successful owner must be able to visualize the desired outcome and concentrate on activities which help achieve success in the end.
Align your business growth plan with your business exit plan. Every day you are making decisions that in some small or big way will impact your success at exit. Making today’s important business decisions without considering the ultimate impact on your exit, causes great difficulties down the road.