Planning for an exit strategy - The devil is in the details
By Connie Lannan
May 1, 2021
Just as there are so many considerations and details to manage when entering the equipment and event rental industry, there are just as many, if not more, when thinking about leaving the industry. All can impact the most important aspect: securing the rental owner’s wealth that has been built in the business over the years so that owner can have a comfortable living after years of work.
The most common ways to exit are to:
- Sell to a third party, be that an equity investor, another rental operator or other high-net-worth individual.
- Have the next generation take over the family rental operation.
- Sell the business to an employee or employees.
Impacting all of that can be what Gary Stansberry, president, The Stansberry Firm, Boerne, Texas, refers to as the “four Ds — death, dispute, disability or divorce.” Those can change the timing and trajectory of the exit strategy, but those aspects make it even more imperative that rental operators plan for how they want to exit the business and who they want to take over when they leave.
“The majority of our transactions are with rental business principals with whom we have had a relationship for many years — frequently 10, 20, 30 years, sometimes longer — and during the more recent 10 years have been working with them in ‘getting the bride ready for the altar’ long before they were ready to begin contemplating an exit,” says Ed Latek, president, Latek Capital Corp., Lake Forest, Ill.
Dan Crowley, founder and president, Peer Executive Groups, Coopersburg, Pa., agrees that one needs to plan an exit strategy.
“On the exit side, ideally we love it if someone comes to us two or three years before they are thinking of exiting and asks, ‘What should I do?’ That is the million-dollar question. There are books written about this topic. The idea is if you are going to sell to a third party, you want to get the maximum dollar for your business. How you run your business has a big impact on that,” he says.
Selling the business to a third party. If the owner decides to sell the business to a third party, it is imperative that they “put their best face forward,” Crowley says.
“You want to make sure that you shine up your business. Do you have job descriptions, an employee roster with salary history, an organizational chart, performance evaluations, etc.? When a buyer asks for certain things, they have a sense that this seller really has their stuff together. The idea is that you will have ‘prettied up’ your place regarding systems, people and facilities. You also want to make sure you have a good, well-maintained fleet. You won’t get paid for your junk,” he says.
In that same vein, Latek encourages owners who are thinking of selling to “maintain good, consistently prepared accounting records. Though everyone wants to minimize their tax liabilities, the financial records must properly reflect the income and expenses of the business. In addition, a strong middle management team, including an effective general manager, is of utmost importance. The buyer/investor is not looking for a business whereby he has to ‘turn the keys in the door every morning.’”
Sellers will need to go through the valuation process. Because the valuation examines all aspects of the business, it is important to have every element in the best condition possible to assure a maximization of values. (See the article “Setting a value for a business: It’s more than just profit and loss.”)
When selling to a third party, there are both micro and macro considerations, Stansberry says.
“The micro is how your business is performing — is it growing, does it have sufficient cash flow and is your fleet in good condition? The macro level looks at what is the sale environment out there. Oftentimes you have your business performing well, but the market, or the macro for a special event rental business, for instance, isn’t there now. I also have had it from the flip side where someone approached me to buy a business.
I look at the business’s results. This may not be the best time — if the business had a couple of down years. Maybe it is time for that rental operator to work at their results before talking with that acquirer,” he says.
Common obstacles, according to Stansberry, are “poor books and records. As an acquirer, the biggest tangible thing you are buying is those assets. You have to be able to show them the record of make, model, serial number, acquisition cost and date of your equipment. You have to be able to show them what they are buying.”
Another obstacle can be the legal structure of the business. “With smaller businesses — under $10 million — most acquirers want to structure the sale as an asset purchase. Structuring it legally as a purchase of assets is easy to do with an LLC or S-Corp. If you have a C-Corp., often the acquirer does not want to buy the stock but the assets of the C-Corp. The seller can be faced with double-taxation. The corporation is taxed, and then the seller is taxed a second time to get their money out of the C-Corp.
A lot of people don’t realize that it takes five years to convert from a C-Corp to an S-Corp. I also see some people who have a party and event rental and general tool/construction business and have them under the same C-Corp. The reality is that there are two buyers — and with one of those two sales, if not both, the seller can face the double-taxation issue. You need to understand what the tax ramifications of the sale may be to you personally,” Stansberry says.
If the owner has been the key figure in the business, there can be challenges, too, Stansberry adds. “You might have a $1 million business that is worth that with the assets and cash flow to support it, but the owner has made the business all about him — he has the customer contacts, he has been the day-to-day manager of the business and makes all the decisions. He hasn’t delegated to anyone. If that person is leaving the business and not willing to do a reasonable transition, you may have a business that is worth $1 million, but it is not marketable.”
And, as Latek referred to earlier, if that third party is an equity investor, “that investor does not want to run the business. They want a strong management team who can do that.”
John Haener, CPA, president, Vendo Rental Solutions, Rockford, Mich., agrees.
“One of the biggest challenges when selling is who will run the business post-acquisition. For smaller businesses you want to have a good team. If you have one, two or three locations, you want to have a strong branch manager and supportive team at each location. That will give people a comfort level to buy the business and pay the maximum value. These businesses are all about people. This is a service business. You have to have a management team that will allow the investors to grow the business post-acquisition. Whether small, medium or larger businesses, the management team and underlying staff are important. That industry experience is very important,” he says.
Overall, the financials of the business are so important to buyers, Haener says. “Rental business owners need to understand that the trending of financial performance leading up to and during the sale process of a business impacts the valuation of a business. Therefore, in working with sellers, we emphasize that it is very important for them to stay focused on running the business during the sale process. The sale process for a business is a major undertaking and having an adviser to drive the process while the seller and their team focus on running the business is key to maximizing value.”
Selling the business to your children or another family member. Most family-owned-and-operated rental businesses are transferred from generation to generation. Most have completed this transition successfully, with the business thriving and even growing with the next generation at the helm. However, this is not always the case. Because of what is at stake, a rental owner has to take off his or her parent’s hat and take a critical view as to whether the next generation or other family member can handle and succeed with this arrangement.
“Your rental business is your single-largest asset. You have to objectively think about your family members,” Stansberry says. “Are they really capable, qualified and motivated to take this over? I have seen situations where maybe you have a son or daughter who has been motivated at times and not so motivated at other times. You are turning over a very important percentage of your wealth to them. You have to make sure they will be the proper custodian of that wealth. And, in most all cases, if a business is worth $1 million, your son or daughter or other family member probably won’t be able to write you a check for $1 million, allowing you to just walk away.”
Even if your children or other family member can secure financing to help with part of it, “most likely you will be on the hook — and those family members will need to pay you back via a note, an employment contract or a combination of both. And that payback is contingent upon them being able to continue the operation and the cash flow that would be necessary to pay you back in addition to continuing to fund the operation,” Stansberry says.
“I have seen some nasty family situations that have come out from this. I have seen animosity develop between siblings, parent and child. My father had a saying, ‘You can’t push on a rope.’ If you will turn it over to a family member, they have to be able to look you in the eye and say, ‘I am 100 percent committed to this. I will be the guardian of your wealth, your assets and your lifetime of work that you deserve to have.’ If you don’t have that commitment or you are trying to force something (push that rope) onto someone who doesn’t want to pull on that rope, you are wasting your time,” he says.
The situation becomes more complicated if more than one child is involved.
“The fact is that in most families there are multiple children and many of them, if not all, end up in the business — making for a very challenging situation, particularly as they get older, married and have families of their own,” Latek says. “Each offspring has his or her own personality, drive, ambition, talents and passions, all as it should be. However, in a family business, they all end up in the same pot, making for a most virulent environment in the long run. Frequently, there may be one offspring who truly possesses all the tools — smarts, personality, drive, discipline, etc. — and willingness to forego many of life’s other pleasures in order to drive the business to become a much larger, more profitable organization. However, other siblings normally possess other desires, goals and ambitions, with each child being unique unto themselves. Yet each is forced to live a life that is someone else’s and not get to pursue his or her own goals. As a result, by the time members of the next generation reach the big 4-0, the family and the business start to become very dysfunctional. Yet the situation continues to deteriorate as each feels that the only way they will inherit their share of the ‘family farm’ is to work in it.”
“I have been involved in working with these family challenges for more than 50 years,” Latek says. “This dysfunctionalism is not unusual. In fact, for it not to occur would be uncommon — an exception. For such reasons, I tend to be anti-family business, not withstanding the fact that I came from a family business.”
“Over the past 25 years, we have helped many families resolve this very painful situation by bringing in an equity investor to partner up with the family member who truly is the ‘jockey on the horse’ by acquiring 60 percent to 80 percent of the business, thus providing the capital for the folks to have the liquidity long dreamed of and the other siblings to cash out their interest in the business, being free to go and pursue their passion,” Latek says.
As one starts thinking seriously about retiring, an objective outside resource can be helpful, Haener says.
“I think when people are looking to exit the business and one of the options is family members, you have to do a very honest risk assessment. I do think that the engagement of an adviser to talk about the true risk assessment and the potential for alternative paths to allow family members to be rewarded for their efforts are things that need to be explored for sure. We read about success stories. There are less fortunate stories that we don’t read about. It is about engaging an adviser to facilitate a risk assessment with that transition and the pros and cons to address those risks and the different structures,” he says.
When helping a child or children understand the magnitude of taking over the family business and discerning whether they have the right skill set to do it successfully, Crowley has everyone who takes part in an American Rental Association (ARA) Peer Advisory Group complete a legacy plan.
“Every member inside a Peer Advisory Group is expected to have a legacy plan. We urge them to stand up in front of the group and share their ‘Here’s when I want to work until, here is what I expect from the sale of my business, etc.’ All have to work on their business valuation first. The goal is to work with the end in mind on Day One, understanding the value of your company and what you can sell it for on Day One. Your whole life and career will be focused on making that number larger, but you have to start by understanding your financials and know what to expect if you sell the business,” he says. Click here for an example of a legacy plan worksheet.
If a rental operator has taken an objective assessment and the child/children or another family member has been determined the best candidate(s) to take over the business, there are a variety of ways to structure that transfer.
Here are just a few:
“You can sell to your kids. So many in the industry already have. Consider the value of the company when the child becomes the manager. Any increase in value is, at least in part, due to the child’s decision-making. In essence, you are giving them equity credit in the business. Speak with those who have been there first on how they handled the transition. Most prevalent is this idea of taking W-2 pay and rent payments while the child is running the business. The owner may have to provide personal guarantees as the company continues to borrow from banks, but you can move the equity shares into the kids’ hands,” Crowley says.
Crowley has helped create “incentive plans — allowing children or employees to have stock options in the business, which then can be executed later for conversion into stock. It allows the child to get locked in at the current value of the business. There is nothing worse than when a child is working in the business and taking over the management and the value keeps increasing and they haven’t structured a deal to buy out their parents yet. That is why it is important to get to an agreement on the sale right away, get the valuation of the business done. Then you can set up a structure to buy out over time, pay the parents in consulting dollars or W-2 employment dollars. When you transition the risk from the parent to the child, you will have to tell the government that you have sold the business. The valuation of the business could be $2 million, and the child will pay an additional $2 million in consulting and management fees. It depends how you structure it.”
Stansberry notes that if “the business is worth $1 million if sold on the open market, theoretically, that is the price you should get from your family member. I have seen situations where instead of selling for $1 million, the parents will sell to the child for $800,000. That is fine, but thinking of this as your single largest asset, I recommend that the business be transferred at fair market value. There also are questions from an IRS standpoint. You have to justify, if you are selling it to a family member, that it is a fair market value transaction. If you are giving it to your son for $800,000 instead of the $1 million it is worth, the son is being unjustly enriched by $200,000. The IRS looks at that as taxable. You have to be careful whoever you sell it to — internally or externally — that it is legally supposed to be at its fair market value.”
Another structure that is worth considering is a “sinking fund for the owner,” Crowley says.
“It allows you to create a fund that will be on the balance sheet that is loaded with money. That money is equal to the value of the company. When the owner leaves, he will sell the business to the kids, but the money is already funded. He is actually becoming the bank. When you do this, you buy a large insurance policy on the owner/the parent. It has a large premium that is best financed with a bank note. If you want to have a $2 million sinking fund — to have a $2 million whole-indexed life insurance policy — it might cost a total of $600,000 to get that $2 million pension-like payout from cash values,” he says.
“The $600,000 might be $60,000 a year for 10 years. At the end of 10 years, you have this sinking fund policy. It has the owner’s life insurance on it. If he passes, there is a death benefit. If he doesn’t pass, there is cash. The reason why this is doable is that you can get the bank to collateralize the life insurance and they will pay the premium. You pay this bank note, maybe a 20-year bank note. You might be paying $15,000 a year to pay the premium. What happens is the cash value is increasing significantly in the policy. After a few years, you pay off the bank note with the cash in the policy. If the sinking fund is not enough to buy out the parent by the child, the bank can use that as collateral and will give you additional debt. It is a way to do a bigger deal with your kids who don’t have any money,” Crowley says, adding “there are many ways to structure a transfer.”
Selling the business to employees. This option is not done very often because “many times with employee purchasers, the employee does not have significant cash to invest upfront and bank financing can be challenging to obtain. As a result, more seller financing is often required to get this type of transaction done. Sellers need to clearly understand the risks associated with seller financing,” Haener says.
Even so, it has and does happen. “A structure that might be viable in this scenario is an ‘incentive plan’ that is part of a supplemental executive retirement plan (SERP) as succession involving an insurance policy on the key employees, where cash is built up for employee ‘pensions’ but instead is ‘traded’ by the employees to the owner for equity,” Crowley says.
Another option is an employee stock ownership plan (ESOP). “The owner exits with money, the bank gives him that money and the bank takes ownership of the business, but the employees are owning and running it. They are paying back the bank. The employees have shares in the company, but they can’t exercise those shares for a period of such as five years. It is a way to sell your business to your employees; however, your business has to be a certain size. If you are a smaller company, that probably isn’t the best option,” Crowley says.
“There are a few ESOP companies that have been successful,” Haener says. “There are some situations where a strong employee, a No. 2, has been successful transitioning into ownership and purchasing the business over time. There clearly are risks associated with that.”
Resources can help navigate the process. No matter how a rental operator decides to exit the industry, each path has different pros and cons. To help one assess the right path for their particular situation, one needs a team of experts, from lawyers, accountants and financial advisers to brokers and investment bankers.
A rental operator who has spent a lifetime building wealth in the business doesn’t want to take a step that will jeopardize that wealth. That is why all interviewed for this article recommend talking with consultants who specialize in this area of the industry to properly value a rental operator’s business, provide feedback and help the owner understand all the ramifications of any choice so the owner can maximize the value at the time of the sale.
“Don’t act emotionally,” Crowley advises. “Use third-party advisers to help you. You are an emotional wreck going through this anyway. This industry has great business advisers. It would be foolish not to work with one of them. You won’t go wrong.”