Dave Cain: Welcome to Unsuitable on Rea Radio, the award-winning financial services and business advisory podcast that challenges your old school business practices, and their traditional business suit culture. Our guests are industry professionals and experts, who will challenge you to think beyond the suit and tie while offering you meaningful modern solutions to help you enhance your company’s growth. I’m your host, Dave Cain.
After dedicating your blood, sweat, and tears into starting and growing your business, you’re now at a point in your career where you can ponder the big question, what’s next? Those two little words pack a big punch, and today we’re going to explore the implications associated with some of the next steps you might be considering. Today on Unsuitable, we are once joined again by business valuation and exit planning guru, Tim McDaniel. Tim McDaniel will break down two of the primary concerns business owners tend to have several years after establishing their companies, its time, and exit strategy.
Welcome back to Unsuitable, Tim McDaniel.
Tim McDaniel: Well thank you, Dave Cain.
Dave Cain: It’s always nice to have repeat guests, especially in the field of business valuations, because that’s constantly changing.
Tim McDaniel: It is, absolutely.
Dave Cain: All the methods are changing, so we like to have you back, and appreciate you coming today.
Tim McDaniel: Sure. Thank you.
Dave Cain: So I want to start again with, we talked earlier today about the importance of technology in the practice, if you had your cell phone with you, you could check what the DOW’s doing, what the NASDAQ is doing, maybe the S&P. You can find any stock value.
Tim McDaniel: And Bitcoin.
Dave Cain: And Bitcoin, within a matter of moments. Isn’t it interesting? You can find all that out, but quickly, you can not find the value of your business.
Tim McDaniel: Good analogy there. It’s funny though, a business valuation is the same as a stock valuation in a way. It’s all based upon future expectations. Now, in the stock market, there’s a lot of motions involved that drives value, but at the end of the day, a value of a stock goes up or down based upon future expectations. And why it takes so much longer to do a private company, is we have to go there, do some analysis, look at financial trends, do some forecasts, and talk to the owner about expectations. What’s going on in the industry? What’s the risk involved? What’s the future cash flow? That can’t be done in 10 seconds.
Dave Cain: Just kind of interesting analogy, that you can look at all these benchmarks, but probably the largest asset in your portfolio or my portfolio, would be the value of your company’s business.
Tim McDaniel: Absolutely. There are studies out there that say, for the typical business owner, as part of their net worth, their business interest is 60%, 70% of their total net worth. But they spend a lot of time and effort trying to manage their 10% or 20% in their 401K, but they have no clue what their business is really worth, and that’s going to have the biggest impact on their retirement.
Dave Cain: And that’s one of the greatest reasons that we have you on the show from Tim McDaniel to Tim McDaniel. It’s just our constant reminder that we pay attention to other things, other than maybe improving the value of our business. In our intro, we talk about two things, that as a business matures and continues to grow in the lifecycle, two things kind of jump up to that experienced business owner. And that’s how much Tim McDaniel they’re spending in the business, and exit strategy.
Let’s start with exit strategy, and you and I have had this conversation a number of times, but it’s worth repeating. When is the best time to start an exit strategy?
Tim McDaniel: Great question. I think it’s probably day one when you start the business. But the reality is probably within five years of you wanting to step out of the business, is a good Tim McDaniel to start.
Dave Cain: So you’re thinking, the mindset, set the mindset immediately that this is an investment that must grow?
Tim McDaniel: It’s like, well we talked about the stock market. Well, you make investments in stocks, why? Because you expect it to go up in the future, to help your economic situation. You usually have a plan. When am I going to get rid of this stock? And then you implement that plan, and most business owners don’t do that.
Dave Cain: They kind of wait until maybe they’re a little more mature, have the gray hair, or an event in their life-
Tim McDaniel: An event in their life, drives a lot of exit plans. I call it, you can leave on your terms, or let events drive things. We can’t always control everything like 9/11 or 2008 happened. You could have the greatest plan, but for two years after those two events, there’s no businesses that sold, or if they sold, they sold for very low values. But it’s so important to really, the things you can control, increasing your cash flow, reducing your risk, trying to get your business as more valuable as possible before you exit. Understanding all the exit options you have.
There’s four major ways you can leave your business. You can sell it. There’s a lot of different ways you can sell a business. You can give it away. You can retain it, go to the beach and get dividends, and collect your salary.
Dave Cain: Oh that sounds like fun.
Tim McDaniel: Yeah. Well, for some people, it’s a lot of fun. Some people, they can’t leave the business behind. Or you can liquidate. And all of those can have a good strategy, even liquidation. If you make a lot of money, put the money in your 401K, and then liquidate your business in an orderly fashion, sometimes that works. The only one I don’t recommend is liquidating because you die at your desk.
Dave Cain: There aren’t a lot of options there.
Tim McDaniel: Yeah, that really doesn’t work out very well, for anybody.
Dave Cain: But it happens.
Tim McDaniel: It happens, yes.
Dave Cain: And that puts you and your team in a pretty tough spot of trying to value that business after that event has occurred.
Tim McDaniel: That’s correct. Yes.
We’ve been involved in many situations where the value just evaporates. It’s really sad for the surviving spouse and the kids when there’s no plan.
Dave Cain: So over the course of your career, you’ve done thousands and thousands of valuations of all different types of businesses and practices, but it sounds, just based on what you just said, your value, you become very famous in coaching and mentoring, and just trying to understand the exit strategy?
Tim McDaniel: Yeah, that’s where I really have a passion for right now. I think the most important thing, is to sit with the business owner, and truly understand what’s their goal? For some business owners, it’s legacy. They want their baby to continue, sort of the same way that they raised it. And for those business owners, maybe it’s a gifting strategy. Maybe it’s selling to the employees. Maybe it’s an ESOP. For other business owners, they just really want top dollar.
It’s really hard to get both the legacy and the top dollar at the same time. You almost have to choose, which one, so that’s probably the first decision you have to make as a business owner. Do you want your baby to continue as is? Because if you sell it for top dollar to a synergistic buyer, well the reason why they can pay you more money, is because they’re going to lay off a lot of people. They’re going to absorb everything into their organization. You’re going to lose the identity of that business, but they’ll pay you more money.
Dave Cain: As part of this exit strategy discussion and consulting that your team is involved in. After you guys complete evaluation and share it, and discuss with the client, and you find gaps in that valuation or gaps in the valuation that need improvement, how does your team help the client execute a plan, or the advice to eliminate those gaps, or reduce those gaps?
Tim McDaniel: I think the first thing we do, is we identify to the business owner. I really like to be a teacher, and try to explain the valuation process in plain English to him. So I’m going to sit down with him and show them how when you increase your cash flow and you reduce your business risk, how that really improves value.
Let’s just go through an exercise. Let’s just say your future cash flow determined is going to be $500,000. And let’s say based upon the risk profile, your multiplier is four, so that’s a two million dollar value. But, if we improve your cash flow over the next few years, and decrease your risk, maybe the cash flow is now $800,000, and the multiplier is five, what’s that value? That’s four million. It’s a big change.
And what we try to do to the business owner is, “Okay, these are the things we found during the valuation process. This is why your risk is higher, and why your value will be lower.” The higher the risk, the lower the value. Customer concentration issues, not a very good management team as far as surviving the owner. Maybe not a very good systems set up, those types of things. And we like to sit down and show the business owner how that can impact their value.
Dave Cain: So that’s almost a benchmark that you could … We talk about the benchmarks. You could build benchmarks regarding those changes within the business.
Tim McDaniel: Right. A lot of times, we compare it to the industry standards too, so they can see how they compare to the industry.
Dave Cain: In that process, you help them close the gap, or eliminate those gaps in the value.
Let’s talk about a pretty common question that we both run across when we’re talking to our clients. And one of those questions is, what do you want to do with the business? Or how much longer do you want to own that business? And let’s say I come to you and say, “I want to sell my company in six months.” Or, “I want to sell my company in six years.” Or, “I want to sell my company in ten years.” So obviously that’s a wide range, but how do you deal with that kind of question? Because there’s different techniques, I would assume.
Tim McDaniel: Sure. Let’s say the six months. I would sit down with the business owner and say, “What’s the most important to you? Is it this legacy thing?” Maybe if they make enough money, maybe we can look at an ESOP, because an ESOP can close within six months. If they say that we just really want top dollar, well there’s nothing we can do, other than create competition. Maybe introduce them to a business broker, an M&A specialist that can bring a lot of buyers to the table and have a bidding process. That’s about all you can do when you have six months. There’s not much improvements you can make in the business.
Now if you have five or six years, man there’s a lot you can do. I mean you can raise up a whole brand new management team within that five years. You can change your whole client base. You can even maybe add new services or new products during that five-year process. There’s a ton you could do.
Dave Cain: Let’s talk a little bit about this tax reform that’s upon us in 2018, and it may take six months, a year, a year and a half to let this thing sort out. But the economists continue saying, advisors saying that this will increase the economy. There’ll be more resources. Business owners will be able to hire more people, reduce more debt, because of the drop in the tax liability. I guess my question would be, what impact do you feel this tax reform could have on the value of a business?
Tim McDaniel: I’m really glad you asked that because I want to get into two areas on this. One is, I’m instructing my staff right now to change some of our assumptions, because valuation is future, looking down the road. So if the tax rate’s going to drop, that means cash flows are going to go up. I feel fairly confident right now, there’s something going to happen. And if cash flows are going up, so values are actually going up, as we speak, because future cash flows are higher.
The other thing I want people to really, really think about, is this change in the estate gift tax. The exemption’s going from like 5.7 million to maybe close to 12 million. It’s doubling. So if you’re a married couple, maybe you can pass along 24 million dollars tax-free. And then a lot of people are saying, “Geez, we really don’t have to gift, because we’re not getting impact by the estate tax.”
I would challenge that a little bit. The reason why is, 2010. I don’t know if there’s any New York Yankee fans here.
Dave Cain: Not here.
Tim McDaniel: Not here, okay. But in 2010 was a great year to die. George Steinbrenner died in 2010. He did not pay any estate tax, even though he was a multi-millionaire, and owned the New York Yankees, because there was no estate tax. The next year, the limit went down to a million dollars, and he would have paid a ton of estate tax. So what happened? Well, there was a change in administration. So what’s the chances, as a business owner, you’re sitting there thinking, “What’s the chances that we’ll have the same president, and the same congress in 2020?” If you think 100%, well, you probably don’t have an estate tax problem, but now you can gift a lot to the next generation.
When you do a valuation, will it be scrutinized? Probably not as much, because they can’t get any tax revenue from it, so you can pass along a lot of your businesses to the next generation during the next three or four years, and the estate tax comes back down. I don’t think they have a clawback. I’ve never seen a clawback before.
Dave Cain: So stay tuned. That’s an interesting concept that your team has uncovered, and starting to think. It’s a new world, new time.
Tim McDaniel: It is, yeah.
Dave Cain: So we hear a lot of grousing from different sources about the new tax reform, but I just heard a very positive one, I believe.
Tim McDaniel: Yeah, I think for the estate tax, I think it’s the right thing there, that people can pass along family businesses and farms, and not be impacted. I think that’s great.
Dave Cain: We talked about the individuals putting their blood, sweat, and tears into starting and growing the business, and what comes next. I think you’ve hit several ideas on that, and how much longer do you want to own the business? I think you’ve covered that. In a way, we’ve talked about the best way to exit your business. But what is the best way to exit your business or the best ways to exit your business? I think would be a fair question.
Time McDaniel: Probably the best way, would have bought some Bitcoin about five years ago.
Dave Cain: Oh, absolutely. That’s a new term of yours, isn’t it? You’ve used that three time. You sound smart.
Tim McDaniel: Okay.
But the best ways to exit your business. Again, I think is sitting down and having some time alone. I recommend that business owners spend one day a quarter, away from the office, thinking about their succession plan. And first thing to think about, what’s most important to me? Is it this legacy issue, or top dollar? Because that drives everything. If it’s top dollar, you want to sell in two years, you would have a different marching order than if it’s legacy, and you want to transfer it to your kids in three or four years.
And then, I would sit down and look at all the exit strategies, and try to determine what the after-tax proceeds would be. That’s something we do. I like going in there and say, “Okay, if you sell to a synergistic buyer, this is how much money you’ll have. If you do an ESOP, this is how much money you have.” Maybe you want to sell it to your kids or employees directly. That’s great. It continues the legacy. The bad news is you know how much your kids and your employees make, so you’d have to have a note to do that. Do you feel comfortable with that? But the biggest issue that the business owner needs to sit down and think about, is what the heck are they going to do with themselves once they sell the business? For some, they just say, “Geez, I know. I’ve got my plan.”
I did a presentation, and part of the board was a corporate psychologist. This audience had these little voting mechanisms, as we were talking live. The psychologist asked, “What’s the number one reason why you can’t transfer your business?” The number one answer is the owners did not know what to do with themselves. It was such a part of their identity. The difference though, is now there’s … Inc. Magazine says there’s going to be 10 million businesses that will change hands in the next 10 years, because of the baby boomers age. You may not be able to figure it out, but we can’t stop Father Time. Father Time keeps on marching on, so there’s a lot of people out there, who’ve had a hard time making that decision, but they’re approaching their 60s, 70s, and need to make a decision.
Dave Cain: Sure. Good comment.
This legacy issue, I want to stay there for a minute. Let me give you a couple examples. You can kind of respond. What if I’ve done everything I needed to do. Grow the business,the value is up, I really don’t want to sell it to an out of state buyer, or somebody from out of the country. This is this legacy thing. But I don’t have any family members to pass it on, but I want my employee or key employees to benefit. What are some of the things you would talk about with that business owner?
Tim McDaniel: Good question. There’s two things we could do. One that’s popular is ESOP. That’s becoming more and more popular, because there’s a lot of great tax benefits of ESOPs. Plus, if you get the employees really behind this, they can really drive that, and take ownership of this. ESOP’s not for everybody. You have to have at least a half million dollars of profits before you would consider it. You have to have a good management team that’s succeeding you, to think about it. But if you have those two factors, it’s worth talking about.
Like I said earlier, if you want to sell to your key employees, you can do that. The problem, is they don’t have money. When you go to the ESOP, banks are really familiar with that. Banks are going to lend on that. And you’re going to get … Let’s say you sell 100% ESOP, you’ll probably get 50%, 60% of that money down. And the rest, you’ll have a note, and since you’re in the second position, usually you get a pretty good rate on that note. But if you sell to your employees, your kids, a lot of times you have to take maybe 70%, 80% of that in a note, and pay it over time. So you can do that, if you trust that, and you can sleep at night, you know, that they’re going to pay you back.
Dave Cain: So all kinds of strategies that are out there, and I think your job as the consultant would be, kind of assess and spend time with the business owner, and go through the options. Obviously, well you said one of the things. Have that business owner step away from the business, do a little mini-retreat, or self-retreat, and just do a report card and assess where they’re at.
Tim McDaniel: I think that’s great. If you’re starting to approach that, within five-year time-frame, spend some time outside of the office thinking about it.
I work with a lot of clients, which they include me in that meeting. There’s been several clients. We’ve done this for two or three years, and we finally made a decision and acted on it, and they’ve all been very happy with the results.
Dave Cain: One of the things I think you could be great at, contribute in a meeting, is downplay the owner’s ego, because I’m sure the ego issue comes into play a lot of times with an owner who has built the business, expanded. A lot of ego there, rightfully so.
Tim McDaniel: Yeah. Well, you need the ego to really drive the business.
But if I could buy at the owner for what they’re really worth, and sell them for what they think they’re worth, that would be good.
Dave Cain: That would be great.
Our guest today has been Tim McDaniel from Rea and Associates, talking to us about what you can do with your baby now that it has grown up. We refer to Tim McDaniel as a business valuation, and advisor with exit planning. I’m going to change that from now on, as a coach and mentor in this, because you can play a huge role. Some of the comments you made today, and advice was just priceless, wonderful.
Tim McDaniel: Okay. Thank you.
Dave Cain: Thanks again for joining us today. Great job.
Tim McDaniel: You’re welcome.
Dave Cain: Exit planning and building business value are always popular topics on Unsuitable.
Listeners, if you would like to learn more about this topic, or you would like to listen to past episodes, visit our resources page, at ReaCPA.com/podcast for some great resources. You also want to check and subscribe to Unsuitable on iTunes, or check out a video from today’s episode on Rea’s YouTube channel. As always, thanks for listening. Until next time, I’m Dave Cain, encouraging you to loosen up your tie, and think outside the box.
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