By Drea Schmidt
It is an open secret that many business owners, no matter how organized, regularly neglect an important task—developing their exit strategy.
The right transition plan depends on the nature of the business and the business owner’s goals, both business and personal, such as cash-flow needs in retirement. Common succession planning examples include:
- Transitioning to the next generation for family business
- Selling to employees, including through an employee stock ownership plan (ESOP)
- Selling ownership interests back to the company or a co-owner
- Selling to an outside party
In every case, COVID-19 has complicated a process that remains critical for survival of the business and preservation of the wealth it has built for its owners. One of the largest complicating factors is valuation. The pandemic has added a host of new considerations when valuing a privately held business.
The most common methodology used for valuing private companies, particularly in third-party sales, is the market approach, which relies on historical profitability, typically EBITDA, to value a business. This creates an issue when the pandemic has altered EBITDA. Owners should determine whether the effects are temporary or permanent in analyzing COVID-19’s effect on a company’s EBITDA and determining how such effects should apply to its valuation.
Existing shareholder and other agreements governing succession planning often value a business at the end of a logical period, such as the end of the last fiscal year. This timing may be inappropriate given the significant disruptions caused by COVID-19; current valuations will need to be more carefully reviewed and creatively analyzed to reach an equitable estimation for all parties.
The pandemic has created numerous other complicating considerations, such as PPP loans/forgiveness, new employer obligations to employees, and the applicability of “force majeure” clauses based on past closures or potential future closures. Each circumstance could impact valuation and transition planning.
These factors—and others associated with our uncertain economic climate—will become part of the due diligence process and negotiated in contracts for the transition of the business. The added uncertainty may give both buyers and sellers pause in the short term.
While COVID-19 brings plenty of challenges for transitioning business owners, there are some potential benefits, which could make the decision to pause a transition a costly misstep. An owner may want to specifically pursue transition during the pandemic for a few reasons:
- Lower business valuations can mean a lower tax bill if gifting is part of a transition strategy. Currently, an individual can gift a business valued at up to $11.7 million free from federal tax; that amount will be cut in half in just five years under current law. Accelerating a planned transition to take advantage of both pandemic-related lower valuations and current federal tax laws could be just the window of opportunity needed to hand off operations.
- Lower interest rates during the pandemic have made more credit available to a larger pool of potential buyers, possibly increasing buyer interest. Depending on the business, some buyers may have relatively few reservations in the current climate because they can see the business’ post-pandemic potential and are getting an interest-rate bargain.
During a pandemic or not, business succession is a long-term process filled with challenges—even unexpected opportunities—but careful planning and periodic review is crucial because life is full of surprises.
Drea Schmidt is partner in the firm's Business Department, Her practice emphasizes securities, corporate governance, corporate finance, mergers and acquisitions, and general corporate matters.
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