We often jokingly tell our clients that succession planning is as easy as 1, 2, 3. First, know your worth.
Second, find a buyer. Third, structure the deal. Of course, the joke is that not one of these steps is truly easy, but we find that breaking down the process helps owners move things forward. With the pandemic winding down, interest rates rising, and legislators continually tinkering with the tax landscape, what can small business owners expect from these steps today?
The first step towards a viable transaction is understanding what your business is worth. Many businesses that successfully weathered the pandemic may incorrectly assume survival equals health.
Valuation processes generally use historical data to predict future cashflows, so an analysis completed post-pandemic may use some of the business’s worst years as a baseline for projecting future profitability. Likewise, forward-looking valuation processes necessarily exclude past windfalls related to Economic Injury Disaster Loans, Paycheck Protection Program, Employee Retention Credits, and the like when projecting future cash flows. This mathematical double-whammy may result in lower valuations than pre-pandemic for many businesses.
The second step in succession planning is the often-difficult search for a buyer that’s willing to pay what you’re asking. Unless your potential buyers are all flush with cash, you may find rising interest rates impact your exit prospects. With more of each payment on the buyer’s business purchase loan going to interest and less of it going to principal due to higher interest rates, the buyer’s purchasing power is reduced. In a rising interest environment, prospective buyers may therefore be scarcer, proceed more cautiously, and negotiate more vigorously than just a few short years ago when borrowing was comparatively affordable.
The third step on the path to closing a deal is structuring for tax efficiency. Understanding stock versus asset sale dynamics, seeking favorable allocation of sale proceeds between asset classes, and considering seller financing are all still solid strategies today, just as they were before the pandemic.
However, recent legislation in the State of Iowa repealed the capital gains deduction and thereby made exits more expensive for exiting owners. The clock is also ticking on many federal tax provisions in place since 2017 and set to expire in 2025.
With time the rarest commodity in the world, it’s good advice for exiting owners to start the three steps of succession planning as soon as possible. Ask your accountant if they can help with business valuation, have early chats with business brokers, and give your tax advisor a heads up. Each of these professionals likely has good advice on how to increase your value, find a buyer, and get the right structure.
Doug Reiling, CPA, is director of Centennial Tax & Accounting, Davenport. He can be reached at dreiling@centennialtax.com.
