The Importance of Converting Equity to Capital

Guy Baker By
Guy Baker

MBA, MSFS

 

  1. Introduction
  2. The Beginning
  3. Why have a business entity
  4. To Pass Through or not
  5. Closed Entities and Pass through entities
  6. The benefits of owning a closed entity
  7. The Three Circles of Wealth – The Common Denominator
  8. The Three Big Questions
  9. I. Creating and Retaining Value
  10. II. Keeping Superkeepers
  11. III. Exit Strategies
  12. Additional strategies to build and retain wealth
  13. Conclusion

 

III. EXIT STRATEGIES

Ok! So you are nearing retirement and you are thinking it is time to begin the transition process. What are you going to do? Let’s review your basic options. Obviously, you could hold on to the business as long as possible and then just have your family liquidate the business, and sell off all the assets. This might be very profitable and a great option. But in most cases this just means you hold a fire sale and sell these valuable, income-producing assets at a substantial discount. This can be very painful and tedious. It is a well known truism (maybe a myth?) you will always get more for your business selling it as a going concern than you will selling it piece meal.

Your next option is to sell to an internal buyer. We have discussed the problems this poses. But basically, just as a review, inside buyers rarely have any money and are unable to provide capital or collateral without your help. So you have to be flexible and willing to work with the buyer. But I will tell you an intriguing little secret. If done properly, you can sell 50% of your business for 100% of the FMV today and then still be positioned to participate in any upside. Yes, you read correctly. If your company is worth $2,000,000, you can sell it for $2,000,000 today and still receive 50% of the increased income and value in future years.

How?

We use this strategy a lot. Go ahead and arrange for the internal buyer to purchase your business, recognizing they are going to give you back your own money. Here is the trick. If you are willing to convert capital gains to ordinary income, you can accomplish some amazing results. And they are all legal under the tax code. You read right.

Now who would ever willingly and knowingly convert capital gains to ordinary income? No one would, unless there was a distinct advantage. Yet, this results in some incredible results for you and your family. More important, it eliminates 40-50% of the taxes. So instead of paying 107%, the tax will be under 40%. The best part is, the superkeeper can now afford to buy your business, and if structured correctly, it will never cost them anything out of pocket to do it.

The third scenario is what might be termed the “Holy Grail” of business succession. It is the one event every business owner is hoping for – sale to an external buyer. But let me point out something to you that may have escaped your radar. Many of the business owners today are baby boomers or may be even leading edgers. If you look at the impact baby boomers have had on every demographic milestone throughout their life, it has been pretty awesome. When they had babies, the diaper and baby furniture business became an industry. This then carried over to housing and recreation. And now as they head towards retirement, the world shudders to think what this will mean for long term care. But one thing we know, it will mean if boomers own a business, they may have a hard time finding a buyer. Why?

Think about this. If all the baby boomers were to decide to sell their business at the same time, how many buyers would be needed to purchase these businesses? Where would they come from? This is called supply and demand. When there is unlimited supply, what happens to prices? They decline to help move the products. But if there is limited supply, what happens? The price jumps through the roof. In other words, the more businesses for sale, the higher the chance the price will decline. More important there will be fewer buyers scrambling to find a good deal. So every buyer will become a precious and dear commodity. It will be a buyer’s market.

What does this mean to you? If you think your company should sell for $3,000,000 in a hot market, what is it worth with no buyers available? The economic law of supply and demand suggests the price will likely decline. If it declines, you may find it harder and harder to pull the trigger to make the deal. So this will limit your options and you may find yourself running this business a lot longer than you meant to or you may just decide to liquidate it.

Another Issue To Consider

There is another problem that is not always foreseen. Assume you are making $250,000 a year, a relatively steady income, and one that suits your life style and personal ambitions. Someone comes to you and asks, “Have you ever thought about selling your business?” This gets you to thinking. “So what price would I want?” Well at 10%, I need about $2,500,000 you figure. But with inflation and taxes, maybe I really need closer to $3,000,000. This is often how the reasoning goes. But then you sit down with your accountant. He runs the figures and you find out you will pay close to $750,000 in capital gains taxes – which nets you only $2,250,000. Then your investment advisor tells you that 10% is a very aggressive figure. You should really think more in the range of 4% if you want to preserve your capital and protect your income against inflation. So now your sale, if you actually could get your price of $3,000,000, is only going to give you $92,000 a year. This is a far cry from the $250,000 you have been getting.

So, you begin thinking to yourself, this is not right. “I worked my entire life to build up this business so I could sell it and live a relaxed, comfortable retirement. If I want to maintain my lifestyle, I am going to have to stay active in this business for a lot longer than I ever planned. I am tired and ready to do something else.” We have found that almost every business owner will face this issue, if they haven’t already. Is there a solution?

If you are 70 years old and already lived through much of this nightmare, there may not be a traditional solution. We think there is, but it is not a size 10 shoe. You require a customized fitting and it will require some creative thinking to get there.

If you are 50 years old, the time to start Red Zone planning is right now. I know, you are not ready to sell. You have just hit your stride and you want to ride this wild pony until it drops. You want to milk a lot more profit out of the company and that is good. There is nothing wrong with a good, profitable wild ride. But we have found that now is the BEST time to lock in your succession plan – right now! Remember, you WILL be bought out with your own money. So why not start moving some of your money out of the business now, while time is on your side? Start your exit strategy right now. If you plan properly, you can get much more value out of your business than you ever thought possible.

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