also: don’t let them undervalue themselves.
by anthony glomski
based on my years of experience helping successful entrepreneurs, as well as my research and interviews with experts in the area of successful business exits, i have identified key financial challenges that entrepreneurs who are about to cash out must address.
more on liquidity: when clients cash out: four smart financial moves
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the idea is to ensure that you can help them make a smooth and successful transition from where they are today to where they want to be post-exit.
1. minimizing taxes on the transaction. i don’t have to remind you about the importance of determining the likely tax exposure that a liquidity event will trigger for your client. you’ll also want them to avoid any unpleasant tax surprises and mitigate that tax bill as much as possible.
proactive, rather than reactive, tax planning can significantly reduce an exiting entrepreneur’s tax bill. consider that without a plan, your client could pay more than 50 percent of their earnings in high tax states such as california. if you take a few basic steps, you can reduce that tax burden to around 37 percent. and if you make all the right moves in advance of the transaction, the tax bill can fall below 30 percent. many entrepreneurs miss the “qssb” rule that could potentially eliminate 100 percent of the taxes paid. advanced planning can result in millions of dollars in taxes saved.
despite the significant impact that tax planning can have on an entrepreneur’s net worth, too many entrepreneurs and their advisors fail to plan around taxes effectively or don’t plan effectively enough. this should be at the top of your mind as your client moves toward liquidity. there are more than 77,000 pages in the u.s. tax code, and the rules and regulations pertaining to liquidity events are among the most complex on the books. most owners don’t have the time or the patience to get deep into the weeds about the nuances of the code, nor will they be impressed by how much you know about the code. they just want to know that they have to do to get the best possible tax outcome pre- and post-exit. that’s where you can really shine.
you will also want to introduce your client to a law firm that works with entrepreneurs who are approaching liquidity events, as well as other specialists such as derivative and valuation experts. with expert strategies, you’ll find smarter ways to maximize your client’s wealth and ensure ideal outcomes for your owner clients and their families. for example, if they have stock options, they can take steps to “get the clock ticking” on those options as early as possible. that way, gains from the sale can be treated as long-term capital gains instead of as short-term gains, thus potentially cutting the owner’s tax bill in half.
with the right guidance, they can also take advantage of charitable trusts, qualified opportunity zone funds and post-transaction positioning so your client’s assets can grow tax-free. make sure you’re up to speed on these techniques.
2. maximizing wealth by not “leaving money on the table.” to get where they are today, an owner had to make many smart decisions along the way. their expertise about their business and entire industry may be unmatched by anyone else. however, a liquidity event is a different beast entirely. there are numerous ways that they can unwillingly leave money on the table.
say, for example, that your client is selling his or her company to a private equity firm. their job – their life – is to be great at their business. but the job of the mbas sitting across the table from you and your client is to acquire companies at an attractive price. most likely they simply know the world of acquisitions better than you do. your client’s business might be selling software or construction materials; their business is buying businesses.
this imbalance can leave you and your client feeling uncertain, or even fearful that you are not getting a deal that maximizes the entrepreneur’s value creation. at best, without proper planning, you’ll leave some money on the table. in extreme cases, transactions can fall apart entirely because the deal terms include risks that the business owners and their advisors don’t fully appreciate.
during my research, i interviewed many entrepreneurs who had successful exits from their businesses. one of the questions i always asked was, “what is your biggest regret?” surprisingly (or not), some say exiting their business was their biggest regret. others say their biggest mistake was agreeing to a cap on the earn-out. by underestimating their own value, they ended up leaving a lot of money on the table.
i’ve discussed failure with entrepreneurs. in one case, a private equity firm came in with an attractive offer for the founder’s company. one of the terms was that the private equity firm would infuse capital in the short term, ramp up the company’s staff and incur additional overhead to lay the groundwork for expansion. however, neither the founder nor the private equity firm anticipated the dramatic shift in the economy that occurred at the time – the global financial crisis era of 2008-09. the severe recession caused the deal to fall apart and the business ultimately folded, largely because of the ill-timed expansion plans.
3. preserving wealth by avoiding excessive single-stock risk. if your client’s business is being acquired by a publicly traded company, the deal may be done entirely by using the acquiring company’s stock. that means post-deal, the lion’s share of your client’s wealth will be composed of just one stock – the acquiring company’s – and your client will be incurring tremendous single-company risk from his or her lack of diversification.
the fact is, companies can – and do – blow up unexpectedly. (remember fannie mae and freddie mac, government-sponsored entities that lost over 90 percent of their value?) when your client keeps the majority of their money in the shares of just one company, they risk losing enormous wealth in short order. having lived through the dotcom bust in san francisco, i unfortunately witnessed several instances. take for example these dotcom darlings that crashed back to earth:
one of the saddest examples of single-company risk occurred when media mogul ted turner lost $8 billion that he had concentrated in the stock of aol time warner. while he was still a billionaire, the aol time warner implosion had a devastating effect on turner, his family and many of the philanthropic causes his family supported.
that said, addressing single-stock risk or single-company risk can be challenging. for one, your client is on the inside of their industry, which gives them justifiable confidence about its major players and direction. this can be especially true if their company is acquired by an industry competitor. this can lead to a false sense of security and knowledge about the future of the company and its stock. they may think they know the industry backward and forward, and would be able to sense if something were about to go wrong. this knowledge might have been useful when the company was still private. however, once a firm becomes part of a publicly traded operation, your client and those he or she confides in can no longer use insider information to their benefit. even if they do have knowledge of impending negative news, they might not be able to share it, much less do anything about it. it’s at times like these that entrepreneurs can be tempted to gamble with their financial health and it’s your job to prevent them from going down that road.
even very financially astute entrepreneurs can fall into the trap of being overly concentrated in a single stock. for years, they’ve had the bulk of their wealth tied up in just one place – their company. so after going through an exit or liquidity event, it seems logical that most of their wealth would remain concentrated in just a single stock (i.e., their company). that’s especially true if the stock of the acquiring firm is red-hot. your client doesn’t want to miss out on the gains if they sell or even trim back their holdings.
there is also a social-emotional issue at work here, as some entrepreneurs worry that they might appear to be disloyal (or that they are “going against the team”) by selling some of the shares they hold of the acquiring company’s stock.
it’s no surprise that you want them to diversify, but holding a large basket of stocks is not the answer. major stock market corrections punish even the best of companies. instead, we recommend that exiting entrepreneurs hold a broadly diversified portfolio of assets that includes not just different types of stocks and sectors, but other asset classes including fixed income, real estate, private equity, limited partnerships and investments in companies that they own and have some control over.
the bottom line: smart entrepreneurs preserve their wealth and let the gamblers gamble with theirs.