Six "Myths" That May Just Kill Your Business

It is painfully common for owners of successful, closely held companies to be so busy “running” their companies, that they ignore the six biggest mistakes that can actually become the demise of their enterprise. We will shortly consider and summarize these six mistakes ... business killers if you will, but first consider these startling statistics: only three out of 10 businesses survive to the second generation, and only one in 10 to the third. 

Over time, it’s easy for successful family business to evolve without written agreements between partners, especially relatives. Frequently, this loose structure leads to unjustified expectations, misassumptions and misunderstandings between partners and family members as to who is to run the business in the future.  The result?  Broken businesses and, just as bad, broken relationships that can last lifetimes.

As professionals dealing with closely held businesses, we have first-hand seen these tragedies impact many successful, respected business leaders.  This article outlines the six myths and real-life case studies where a business and retirement could have been salvaged simply by reaching out, in advance of a life event, to their accountant, financial planner and/or estate planning lawyer to develop a game plan.  After working a lifetime to establish a business, the time needed to plan, in advance, for a successful retirement, business transition and/or contingency plan in the event of a death or disability is a small price to pay.

Myth #1 – “I know what my business is worth” –Most business owners rarely know with any precision what their business is worth and do not have the enterprise appraised with any regularity.  This not only includes having an effective buy/sell agreement with appropriate values in place, but using life insurance as a funding vehicle to adequately protect heirs, partners and frankly, the health of the company and as such, all employees.  Of course, the myth is that the ballpark valuation they have in mind could be easily agreed upon someday by partners and potential buyers.

Five members of a management team we know threw their savings together and borrowed money from the bank to buy out the owner of a manufacturing operation.  The buy-sell agreement they signed placed an initial value on the business, fixing it in stone until such time as the valuation was updated.  When the economy tanked, as did the real estate and stock markets, the company’s sales suffered.  As a result, it was unable to reduce bank principal, and the union pension plan became grossly underfunded.  As the company struggled, the owner group was so busy keeping it afloat that they never updated the valuation. Tragically, one shareholder suffered a heart attack and became disabled.  Under the buy-sell agreement, the other four owners were forced to buy him out at a price much higher than the actual value of the vulnerable firm.

Solution: This could have been avoided with appropriate planning involving three steps – (1) a periodic, cost-effective re-valuation of the business, to reflect market conditions, (2) an exploration of buy-sell funding through a variety of financing options (3) possibly securing enough life insurance to cover a buy-out of the deceased parties heirs and having an extra amount of coverage to benefit the business, call a key-person portion. 

Myth #2 - I’m too busy running the company – In this instance, a business owner we know gave company stock to his two sons which equaled the amount of federal gift tax exclusion allowed by law.  The business continued to do well.  When the father died, a valuation was made on the remaining stock in the estate.  To the sons’ shock, the combined gifted stock and the retained stock generated significant federal estate tax, far more than they could afford.  Because the estate was comprised of predominantly the stock, no liquidity was available to pay the tax.  The sons had to borrow significant funds (backed by company stock) to pay the estate tax, at a steep cost and a long future of indebtedness.  This busted the myth that passing the business from one generation to the next may be difficult for some businesses, but not for ours’.

Solution: Many business owners think the reduction in the federal tax code means they can avoid planning.  Depending on the administration in control at the time, the reduction in federal estate taxes may be short-lived anyways. A proper succession plan during the father’s lifetime could have identified his intentions for ownership, transition and leadership. Life insurance, again a potential assistant in this example, could be the effective means to “render to Caesar what is due to Caesar”, instead of searching for bank loans and additional partners at the worst-possible time...shortly after the death of the business patriarch or matriarch as the case might be.

Myth #3 - "That’ll never happen to me" – Because it’s 400 percent more likely that a business owner will become disabled than to die, it’s critical for firms to have a formal, written succession plan, including a replacement stream of income.  Yet the myth is…I will not become disabled, because I am in control.

Two business partners we know once ran a very successful staffing firm. They personally purchased a building together, which the firm rented from them. In the aftermath of an elective surgery, one of the owners became addicted to pain pills. Over the next two years, his problems compounded when his wife left him, the business revenue sank and his partner defected and launched a competitor under another legal entity, effectively killing the original firm.  Mentally unstable, financially broke and physically disabled, the remaining owner was forced to move in with his mother, having no other means for income for support. 

Solution: If the two partners had a formal succession plan with provisions for disability, as well as disability insurance as a funding mechanism, they above scenario could have been averted.  Disability overhead expense coverage could have helped to offset office expenditures, while disability buy-out insurance could have provided a lump sum for the healthy partner to buy out the disabled one, if it was later determined that he would not return.

Myth #4 - "There’s plenty of time for that" – Many business owners do not know when they want to retire or how much income they will need in retirement. They do buy into the myth however, that I should keep investing back into my business, since that will afford me the greatest return. There’s no need to diversify into an investment portfolio, since I can get around to that later.  For many, the business is their net worth, their sole source of future revenue, and selling it will be their ticket to a prosperous retirement.

The sole owner of a towing company we know consistently re-invested profits in new trucks and other equipment to expand services.  At the time he retired, he tried to find a buyer, but none stepped forward.  Unable to sell his client list or business goodwill, he was forced to gut a substantial part of the firm by selling off equipment, at prices less than he had bargained for. 

Solution: This owner should have considered replacement income sources and more comprehensive retirement planning, including retirement plan accounts as well as after-tax investing. In our experience, failure to plan for succession and retirement, regardless of the excuse, especially in a family-owned firm, is a primary reason why businesses fail after the founder leaves or dies. 

Myth #5 - "My business is my retirement" – Similar to Myth #4, it’s important for business owners to diversify wealth assets so they are not so dependent on the value of the company.  These should be directed into other, unrelated qualified investment vehicles, which might include investments with guaranteed returns, selling/leasing back the company’s building, or gifting shares in installments to future owners. To further diversify, it’s good to partner with a lender from which owners can borrow working capital, to for example, finance their inventory, to enable then to draw more funds out of and away from the business and to diversify future income sources.

After a divorce and then losing his job in his early 50s, one of our clients recruited a partner to co-start a niche technology business. Eight years later, the startup became profitable.  However, the owner depends entirely on the income from the business, since his savings and retirement accounts were wiped out in a divorce settlement, so he could retain his full 50 percent stake in the business. At age 62, he believes his enterprise is worth $2 million and buys into the myth that it will be salable at a two-times revenue multiple and allow him to retire before turning 70. However, upon a closer look, deep-pocketed competitors could easily enter his niche, drive down the business value in the future, and jeopardize his retirement. Furthermore, his partner, also in his early 60s, is content to ride out the next eight years or so, since he is already financially stable through a sizable inheritance.  

Solution: Our client needs to diligently create pools of wealth outside of the business, via a diversified investment portfolio that is separate from the business. He may also need to consider a loan to buy-out his unmotivated partner now, if the partner is unwilling to grow the business and strengthen the business.   

Myth #6 - "You can’t beat Uncle Sam" – Even the most successful business owners have to pay the tax man.  While their CPAs can advise them on their obligations and changes in the tax law, as retirement approaches, it’s critical to identify potential sources of retirement income that can be secured through tax-free or tax-advantaged methods.  Often this can involve creation of a pass-through entity, or finding ways to qualify for capital gains rates rather than ordinary income rates. 

One owner we know worked his entire life to build a successful equipment distribution and engineering firm.  He embraced the myth that he can sell his business and even after taxes, retire comfortably. However, because he and his advisors had not planned properly, when the offer came to sell the business to a larger competitor, not only did he pay a 40 percent tax at the corporate level, but another 18 percent tax individually to extract the proceeds from the firm.  To his great dismay, more than half of the gross proceeds went to pay taxes.  This caused him to downgrade his retirement lifestyle plans.

Solution: IRS rules on exemptions, regulations, fees and taxes seem to change endlessly.  But with the changing tax environment come legitimate opportunities to reduce taxes, if owners know where to look.  With early planning, strategies and investments, one can become better prepared for the future.

Summary: Our firms provide clients and friends with a unique, 90-minute educational presentation known as “businessKillers®,” designed by industry experts and like-minded business owners.  Contact us today to discuss whether viewing this makes sense for you and your company’s future.