Succession planning basics: What is your business worth to others?

The fabrication industry is, at heart, a family industry. This is hardly a profound statement. The vast majority of businesses in the U.S. could be described as family businesses, and those businesses are approaching a crisis in ownership transition.

According to the Family Business Institute, approximately 40 percent of family businesses expect the leadership of their companies to change hands within the next five years. Over half expect a leadership change within 10 years, and more than four out of five businesses are still controlled by their founders.

With baby boomers retiring at an ever-increasing rate, the situation is simply unsustainable, and everyone knows it. Yet few are doing anything about it. Only about 20 percent of owners we work with have a succession plan in place, and that statistic hasn’t changed since I started in the corporate consulting field 28 years ago.

Reporters love to write about it, speakers love to talk about it, and industry panels love to debate it. You can’t open a trade magazine or attend a conference where succession planning is not a topic. So why aren’t business owners doing it? The reason is not as complicated as you may think. Many business owners have made succession planning an event and a standalone topic unrelated to the business’s long-term corporate plan. Also, many owners have created jobs for themselves, wrapped in a business structure, so succession planning becomes less about growing and perpetuating a business and more about preserving a career.

Transition planning involves long-term and short-term strategies that will allow you to perpetuate the business at a price and time of your choosing while protecting you in the interim against an unforeseen event, such as death, disability, or some other incapacity. That sounds easy enough, but why aren’t more owners putting these strategies in place?

We believe there are two key reasons. First, succession planning means having to deal with emotions and tough decisions. It’s human nature to procrastinate or avoid it altogether. Second, by nature business owners have no problem calling the shots or taking calculated risks, but they do not spend time talking to experts and educating themselves about their options.

How do we begin to solve a problem that is not going away, is probably worsening, and is detrimental to preserving the vision and legacy many business owners have worked a lifetime to create? We begin by realizing that transition planning is not a subject unto itself but rather part of a short- and long-term corporate planning strategy. And like any other strategy, we first need to examine the options.

Broadly speaking, there are two potential transition strategies that companies will employ: internal or external. Business leaders choose the internal transition when business ownership shifts to existing management and/or within a family, typically from one generation to the next. We group family and existing management together because, though the ownership may differ, the strategies and pitfalls tend to be similar. Business leaders choose an external transition when they shift ownership to an outside party.

Each of these avenues has its pros and cons. Internal transitions tend to deliver slightly less value to an owner and generally require a longer timeline to fulfill as the current owner usually offers some sort of financing or earn-out. Continued involvement by the prior owner usually is expected by both sides, and owners like to see their values and culture carried over to the next generation.

External transitions open up the possibility of receiving a higher value as strategic buyers or competitors may become involved, but they bring with them the risk of culture shock, employee disruption, and potential morale problems. Either option can be successful; each just requires adequate planning. And planning is really the heart of any successful transition.

How Do You Plan for a Successful Transition?

The key to a successful transition starts with asking yourself, Is my business transferable? A transferable business is one that can be owned and run by someone else without necessitating your constant involvement. Your efforts should not be imperative to the company’s operation.

That said, when should you build this transferability into your business? It’s never too early, and it’s often too late. The sooner you begin to improve your company’s transferability, the better your chance to perpetuate that business into the future. Because leaving a business, or even preparing to leave a business, is often an emotional decision, many wait to make it. Unfortunately, if you wait to begin building transferability, you will encounter several problems.

First, you will lose the luxury of time. Napoleon Bonaparte once said that quantity has a quality all its own, and this is doubly true for time. Its importance cannot be overstated. Ideally, good decisions are made when business owners have time, money, and ability. By procrastinating, you will have the same amount of work to do without adequate time.

Second, if you wait to build transferability, you could forfeit years spent reducing your personal financial risk from the performance of the business. The reduction of this risk creates the true financial freedom that many business owners dream about but never achieve.

Third, by waiting, you may be deprived of a more pleasing ownership experience, because the heart of increasing transferability is making an owner replaceable while improving and growing the business. The first tasks transferred are generally those owners find tedious or unpleasant. Delaying preparation robs an owner of all these things.

Determining the transferability of your business shines a spotlight on the strengths and weaknesses of your people and processes, allowing a business owner to enhance value with minimal disruption to staff, customers, or vendors.

Personal Value

There are many definitions of value for a private business, but two are relevant here: what your business is worth to you, and what it’s worth to someone else.

The value of a business to you, or personal value, conveys with it rights and privileges and may not be the same for every owner. A business may represent a life’s work. Frequently owners are so devoted to their business that they cannot imagine life without it.

I have known business owners who never left their businesses until the moment they died. I’ve seen others who have missed not only phenomenal opportunities to transition their businesses because they could not let go, but industry-changing strategic opportunities as well.

For some owners, the business represents position and prestige. Many mid-sized firms—and this includes many custom metal fabricators—are the bedrock of towns and cities across the country. Owners of those businesses are intertwined with those communities, and it’s easy for them to get caught up in their positions in their companies, their communities, and their industries. This makes it difficult to step down.

Owning the business also represents a lifestyle. Particularly with some smaller businesses, but even in businesses of significant size and value, the owners’ incomes and benefits may provide a larger lifestyle than they would be able to afford by living solely off of investment income. This can be a real trap. Before a successful transition can occur, this problem must be resolved by an increase in the value of the business, by a reduction in lifestyle, or both.

Small business owners usually are critical to the ongoing success of the business, either because of their special knowledge or expertise, customer or supplier relationships, unique operational or sales abilities, or other attributes. In such situations, the business is worth more to a particular key owner than it is to any other investor, because the key owner has a unique ability to increase value that others simply may not have. These sorts of “key-person” risks must be significantly reduced or eliminated.

The personal value of your business may make it priceless to you. However, if your business is not transferable, the company may be closer to “valueless” than priceless.

Transferrable Value

A company with transferrable value has characteristics that other investors find attractive—and are willing to pay for. Transferrable value generally stems from the following question: Have you institutionalized the cash flow generation process at your firm? Put another way, is the business capable of operating, growing, and generating positive cash flows without the skills, abilities, or oversight of the owner?

We often use the acronym GROW to provide a shorthand description of the qualities of a transferable business:

• G – Growth. Is your firm growing? Does it have a growth culture? How is that growth being demonstrated? By revenues, cash flows, customer growth, or something else? Demonstrating that your business is growing and has a process for continuing to do so is key.

• R – Risks. Many times, business owners forget that there are really three ways to increase value. They can increase revenue, decrease expenses, or improve their risk profile. The vast majority of them spend time on the first two and almost no time on the last. For instance, a fabricator could enjoy growing revenue and shrinking expenses, as the company employs process improvements and better serves its key customers. But if those few key customers all come from one area of the economy—and, even worse, make up the majority of the fabricator’s revenue—the business could be viewed as a high-risk investment. Firms that understand their risk characteristics and strive to make themselves less risky are inherently more valuable than their competitors.

• O – Organization. This includes the people and culture that have allowed the company to succeed and carry on into the future. A company that lacks the ability to find, retain, and motivate employees over the long term is doomed. One that can consistently do so is constantly building value for its owners, regardless of who they are.

• W – Wealth generation. Is the firm consistently generating positive cash flow for the owner? Cash flow can be measured many ways, but we traditionally use earnings before interest, taxes, depreciation, and amortization (EBITDA), and then make an adjustment for the owner’s salary and other benefits. Firms that consistently understand their cash-flow-generating ability and work to increase it are those that build wealth for their owners.

Building Transferrable Value

Every business has value for its owner, but does it have transferable value? Do you understand the difference? Business owners spend a lifetime building personal value. Now is the time to understand your transferable value and strive to increase it. Doing so will enable you to have the financial freedom shared by few of your peers.

Paul Lally is a partner at Wipfli LLP, 10000 Innovation Dr., Suite 250, Milwaukee, WI 53226 , 414-431-9300, www.wipfli.com. Lally leads the company’s business transition group, which specializes in transition and succession planning for business owners.