Mark: Welcome to Unsuitable on Rea Radio, the unique financial services and business advisory show that challenges your old school business practices and the traditional business and culture. You'll hear from industry professionals who think beyond the suit and tie to offer meaningful and modern solutions to help you enhance your company’s growth. I'm your host Mark Van Benschoten. For Episode Two, How to Ruin Thanksgiving Dinner, I'm joined by Tim McDaniel. Tim helps owners prepare to exit their business, and hopefully get maximum value for it when they do.
Tim how are you today?
Tim: I'm doing really well, Mark, thank you.
Mark: You talked about maximum value. That can mean a lot of things to a lot of different people. You and I are in a fantasy football league, and I think I've beaten you the last couple two or three years.
Tim: First lie.
Mark: We talked maximum value. That could mean different things to different people. Fantasy football, who would you say was maximum value in fantasy football?
Tim: Oh boy, I think it's harder these days for fantasy football. It used to be really easy. You'd draft that stud running back, and they would give you all those points. You'd draft Tom Brady, Payton Manning, now they're getting old, so it's hard. You have to really do some homework this year. In the past, I thought I was really smart at fantasy football, but I realized my competition just wasn't that good.
Mark: Talking about me?
Tim: Yeah, you're part of that.
Mark: I understand. You talk about people getting old, and unfortunately that happens to all of us. Does that enter your thinking, "I got this in place. Here is what I did last year for my fantasy football, for my research. I'll do that again." Does that transcend into buy-sell agreements?
Tim: Buy-sell agreements are more of an afterthought. Let me explain what a buy-sell agreement is. A buy-sell agreement is basically like a business will. If something bad happens, you die, you get divorced, you get disabled, or it could be something good, you want to retire, it spells out what happens to the company stock. It's a very important document to have if you have more than one owner.
Mark: Do you need them if there's family members involved?
Tim: Absolutely. It's just sort of funny.
Mark: You're emphasis seems like there's even more reason to have them with family members.
Tim: Yeah, you know, usually what happens with buy-sell agreement, you start this company, and you all get together. Somebody says you need to do a buy-sell agreement. You say, "Well why? We all love each other, and we're going to love each other for fifteen, twenty years." You throw together this two dollar buy-sell agreement. Whether it's family members or not ... I've been involved in a lot of disasters ten, fifteen years down the road.
Mark: Anything you can share in those disasters?
Tim: One of my favorite story is, I call it "How to Ruin Thanksgiving Dinner." You had four brothers who own a home building company. This is back in 2005, I think. Home building companies were doing really, really well, just taking off. I think it was around 2006, the industry started to really falter. I think one brother saw that and said, "You know what? Things are going to be really, really bad for the next four, five years." He could tell.
Their buy-sell agreement said he would get one-fourth, even one-fourth of the stock. He'd get one quarter of the value of the company. The way the company was valued was based upon the last two years of earnings, times a multiple. He just sat there and thought about it and says, "You know what? Things are going to be really, really bad, and this is what I'm going to do." He got probably sixty, seventy percent of the value of the company, and subsequently the company's gone bankrupt.
Mark: That's too bad to hear. When I hear you talk about relationships, but how are the relationships with those brothers? Do you know anything about that?
Tim: I just hope there's no knives at Thanksgiving dinner. I think that they used the plastic knives there, and stuff like that, right now. I honestly do not know, but I cannot think that ... If I was a brother, and I ran a company, and it went bankrupt, my one brother got all the money, I wouldn't be happy.
Mark: Sure. Some things come to mind there. When you start the business, it sounds like you should have a buy-sell agreement.
Tim: Right.
Mark: It doesn't sound like the value ... I mean you might agree to a valuation method, but it maybe needs to be a little more realistic. How do you accomplish that?
Tim: I think it's very, very difficult to have a little formula on a complex business. Valuation and what I preach, it's all a prophecy of the future. What's your future cash flow going to be? How can you create a legal document that predicts that? That's what I see most buy-sell agreement trying to do. I get very, very frustrated when one of my fellow partners calls me up, or a client, and says, "Tim, we're writing a buy-sell agreement. Can you please give us a simple formula?" My answer is always, "No."
Mark: In three seconds, what would you say, how would you do that? What would you recommend for a buy-sell agreement?
Tim: What I recommend for a buy-sell agreement is we prepare a valuation-
Mark: Call you.
Tim: Yeah. I think in a perfect world, what you would do is get a valuation perform. You sit down, explain it to the shareholders, and they agree to a value for the next year or two. If something happens, this is what's going to happen to the value. We can update that every year or two. I'm going to throw you another horror story, because the other big buy-sell thing that I see-
Mark: Horror story?
Tim: Horror story. Excuse me. My mom always says that I should enunciate more when I was a kid. I guess there's a reason why.
In a lot of buy-sell agreements, there's a silly provision that says, "All right, if one person leaves, they get a valuation, and the company gets a valuation. If they can't agree then there's a third valuator."
Mark: Sounds only good for the business valuation key point.
Tim: It's good for attorneys, too.
Mark: Can't forget them.
Tim: There's a debt practice up in Northern Ohio. We get called in. We were the second valuator, and we valued the interest at sixty, seventy thousand dollars. Her valuation person valued it at a hundred thousand dollars. They had two attorneys involved, and they got the third valuator. We spent seventy, eighty thousand dollars valuing a sixty, seventy thousand dollar interest. It turns out that this lady then declared bankruptcy when it was all said and done. She knew what she was doing. She was just really pissed off.
Mark: That's a technical term.
Tim: The best thing you can do, even though it's a little bit more costly up front, it's either pay me now, or pay me later on buy-sells.
Mark: Sure, interesting. You mentioned cash flows. We just heard before in the previous podcast about Dave Kane talking about cash flows. Interesting how those things are tied together there.
Tim: If you think about a valuation, what are you buying when you buy a business? You're buying a future cash flows stream. The second question you have when you buy a business, I'm going to guess what the cash flow stream is going to be, and then how risky is that cash flow? How certain is that money going to be put in my pocket? That's why it's impossible to put that theory into a simple legal document based upon a formula.
Mark: My limited experience with buy-sells is, this is what we agreed to, and if we live that agreement out, then I can put my head down on my pillow at night and not feel guilty. I guess that's true, but still might not be fair to all at the end of the day.
Tim: It depends on how it's written. On buy-sell, there's the valuation part of it, but there's also how to fund it. That's another issue. If somebody decides if they want to leave, or if they die, or those types of things, how do you pay for it? Typically, in a buy-sell agreement, it's paid over time, or it's funded by life insurance. That's another important part of it to help you sleep better.
Mark: Okay, any other aspects of a buy-sell agreement that we need to worry about? Who can be shareholders? How do we get out? Things like that.
Tim: A lot of people write buy-sell agreements to prevent stock getting into somebody else's hands they don't want. Probably the classic one is the ex-wife. If somebody gets divorced, they don't want fifty percent of that shareholder's interest to go to the spouse. That's one of the big provisions in a buy-sell agreement. Most buy-sell agreements prevent somebody from selling their stock to somebody else.
Mark: Restricting them, okay.
Tim: Restricting that, or at least gives the other shareholders of the company the first choice to buy it.
Mark: Are buy-sell agreements only for big companies?
Tim: Oh no. Anybody that has more than one shareholder.
Mark: More than one shareholder.
Tim: Yes.
Mark: Would you have one for a husband and wife owned business?
Tim: I don't think that's necessary. I guess depends on the relationship.
Mark: Sure, could be. Maybe they were in business before, and then they got married. Maybe that would be a situation where that could be.
Tim: Yeah.
Mark: Interesting. Kind of sounds like your valuation, you buy-sell agreement, excuse me, should be a living document. It shouldn't be, "Here we have it. We signed that fifteen years ago," but something you talk about on some periodic basis?
Tim: Absolutely. I remember I had to testify in a divorce case a few years ago. I was reviewing the buy-sell agreement. This husband's interest is worth maybe two million dollars. The buy-sell agreement was written twenty years earlier, and said that if the husband was to leave or to die, he would get fifty thousand dollars. It was never updated.
It's one of those things, how often do you update your personal will? You don't. You don't think that something like that's going to happen. It's a breathing document. You need to look at it ... I wouldn't say yearly, but boy if your buy-sell's ten, fifteen years old, you need to update it. It's not terribly expensive, too.
Mark: Sure. I would envision that the partners of the common shareholders sit down and just review, "Are we comfortable with this provision? That provision?" Doesn't need to be tense. Doesn't need to be confrontational.
Tim: Absolutely not. I'm working with one family right now. We meet quarterly to do their succession planning. We're working on their buy-sell right now. One brother wants to gift it to his kids, to start the third generation going. They were all surprised to learn he wasn't allowed to do that, based upon their buy-sell. That brought up some very interesting conversations that some of the brothers do not want these kids to own the stock. It's been good, because we've had some really honest conversations that ... I think there's been a lot of things stuffed among the brothers. Now we're getting the issues out on the table. We're able to deal with them.
Mark: In probably a less stressful situation than if something unfortunate was to happen.
Tim: I'm really glad you brought that up. That's more brilliant than your fantasy football.
Mark: I can go home now.
Tim: Because what happens is, usually when trigger events happens in a buy-sell, it's usually a bad thing: death, divorce, disability, somebody's fired. The only positive thing out of a buy-sell, usually is retirement, and that's well planned out. Do you want to deal with a grieving spouse with a bad buy-sell agreement?
Mark: I don't.
Tim: No.
Mark: Send those clients to you.
Tim: I'll send them back. Boomerang clients.
Mark: Anything else that you think we should talk about on buy-sell agreement today?
Tim: Again, think of it, it's like your personal will. It's your business will. It's not terribly expensive to have a lawyer draw it up. We have a special evaluation service that we do for buy-sell agreements. We don't have to give you that eighty page report that costs a ton of money. We do more of a summary report that could be updated. The initial evaluation's the certain fee. The updates are a lot cheaper, and it's a lot better than the alternative.
Mark: Sounds like some sort of insurance-type policy. I view it like this expensive money, and then it pays dividends down the road.
Tim: When you're writing your buy-sell, as a client, you get your attorney involved, your CPA involved, a valuation expert, and also a financial advisor insurance agent.
Mark: Okay, great. Before we wrap up, we have some other questions we ask all of our guests. The first thing is, what piece of advice do you give clients over and over again?
Tim: Since my practice is totally focused on valuation, succession planning, I give all my business owners this advice. You always have to know what the true value of your company is. It's fifty, sixty, seventy percent of your net worth, typically. Don't guess at that value. You're much better off trying to grow that value than trying to grow your ten or twenty percent of your network that's in your 401k.
Mark: Sure, that's a great point. All right, next question. What makes you get out of bed every morning, besides the dog?
Tim: We have no pets. I have two kids in college. That probably gets me out of bed.
Mark: A little motivation there.
Tim: A little motivation.
Mark: I hear you there. I have two kids in college, also. Here's a fun question that we have. If you could have one super power, what would it be?
Tim: Let's see here. There's not a super power that can grow hair, is there?
Mark: Mr. Play dough in the barber shop.
Tim: I would love to be able to be a time traveler, and be able to go back in time. I think that would be a wonderful-
Mark: It would be exciting, wouldn't it?
Tim: Would it? I think you could change a lot of events, and change some of the decisions you made and those types of things. That would be fun.
Mark: Tim, I appreciate you taking the time today.
Tim: Sure.
Mark: Good luck in fantasy football this year. Hopefully you come in second. Thank you for tuning in to Unsuitable, Episode two, How to Ruin the Thanksgiving Dinner.
Tim: I just have one advice for you. Johnny Manziel is number one.
Mark: Number one?
Tim: Number one!
Mark: That ties it back into getting our maximum value.
Tim: That's right.
Mark: Thank you, Tim. Have a great day.
Tim: Yep.
