The Succession Trap: Responses to all Q&A Topics.

Make your financials pristine

Eliminate personal expenses by paying yourself a quarterly distribution and handling those amounts out of your personal bank account. Make sure your classifications for revenue and expenses are consistent, and aligned with the way your industry records them.

Establish your culture

What are the values everybody is going to live out every day that make your group of employees attractive to a purchaser? What is the vision for the organization that could continue on even after you sell it? What is the business's why — why does it exist, and why is it pursuing that vision? Potential purchasers who resonate with that purpose will be the best buyers. What is the mission your team is striving to accomplish every single day that a purchaser would never consider removing from the warehouse wall or the back of every business card, because it makes your business different from all the other ones they could have bought?

Invest in your leadership team

The single biggest factor in being able to transfer your business is whether it will run without you. Make sure you have good leaders handling sales, product or service delivery, customer service, and finance. If you're currently acting as the general manager, you need to plan on having someone else in that seat at least three years before you want to go to market. This is the person who would allow you to step away from the business for a minimum of 90 days without any negative impact.

Execute a plan to grow

Businesses on a growth curve fetch much higher multiples than those that have been flat. A purchaser wants to invest in continued growth. If they have to invest in creating growth, they're going to subtract that investment from your purchase price so they have the money to get the company going in the right direction again.

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Yes — but be realistic about what you are going to learn. If you are the CEO, leaving the business for 90 days is nothing like leaving the business forever and appointing another person CEO. And succession is about another CEO being able to take your place.

Leaving for 90 days will help you identify things you shouldn't be doing as CEO. Those are called bottlenecks, and you just need to delegate them. But the real goal is to build up a leadership team that another CEO could step in and run without missing a beat.

Even better, we would like a leadership team with more than one potential CEO, so we can promote from within. However, if you have two potential CEOs on the leadership team, expect the one who didn't get the job to leave. That is their only option.

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Very — but only if the business already has a written strategic plan. That plan outlines:

• The cultural foundations of the company, in the form of values, vision, why, and mission
• The two- to three-year strategic focus
• The annual strategic and financial goals
• The current 90-day priorities of the leadership team
• The location of the monthly financial dashboard
• The location of the weekly operational scorecard

A separate succession plan is necessary during the two to three years leading up to the transition.

For internal or family succession

For an employee buyout, ESOP, or family transition, the current owner and everyone who is part of the succession plan should have an agreed-upon timeline for:

• Handing over specific responsibilities
• The future owner training curriculum
• Role and title changes
• Compensation changes
• Share transfer target dates
• Announcements to those inside and outside the company

For third-party exits

The timeline needs to be kept confidential between the owner and the outside advisor who is working with the team on the strategic plan and with the owner on the succession plan. That timeline needs to cover:

• Leadership team moves and org chart changes
• Necessary financial reporting and accounting method changes
• Triggers for engaging other outside accounting and legal advisors
• Disclosure to key leaders who will have to meet potential buyers
• Engagement with personal financial planners
• Infilling missing documentation of core systems and processes
• Cleaning up various anomalies and deficiencies in the balance sheet

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Every business is going to transition from the current generation of ownership eventually. Succession means that the transition is accompanied by an exchange of value. Without succession, the business just ceases to exist — and this is the option many small independent freelancers and sole proprietorships take. The business pays them well enough that they can accumulate savings and diversify those into other investments that will provide an income and a pool of assets to pull from, so they can afford the lifestyle they want. There's nothing wrong with this. This is a successful business.

The bigger question is whether self-interest was the reason the business never grew to provide opportunities for others after the founder decided they no longer needed to be involved. Even in the smallest case of a sole freelancer, I would argue it's a good thing to build something — a system, a process, a client base, a reputation, a brand — that another freelancer would be willing to purchase from you, so that they did not start at zero. At the end of their time, you would both be able to look at what they were able to accomplish and say that it wouldn't have been possible if you had not built a succession plan they were able to be a part of.

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There are three general buckets of valuations.

1. The benchmark valuation

The first is what you might call an informal benchmark valuation. We do these for all new clients in order to establish and benchmark the current value of the company. It involves looking at the last three to five years' worth of financials, restating them to pull out discretionary expenses, and arriving at a normalized earnings figure — the net income a buyer would expect the business to generate.

We then evaluate the risk of the business using over 50 criteria to assess culture, leadership, operations, sales and marketing, and financial health. Recent sales transactions in your industry are researched, and we determine the range of multiples your industry is trading in — say, four to seven times earnings. The risk assessment tells us where your particular business falls within that range. We apply the appropriate multiple and determine the value.

2. The formal valuation

A formal business valuation prepared by an accredited business valuation expert follows a similar process, but they do a much deeper dive into the projected cash flows for the next five years, taking into account your historic growth rate. My experience is that they do less to truly understand the inherent risks in the company. For example, they are unlikely to do in-depth leadership team interviews or assess the overall health of the team running operations. It is much more of a financial analysis and spreadsheet approach to assigning a value based on discounted future cash flows.

3. The go-to-market valuation

When you go to market, the broker or sell-side advisor handling the sale will do a valuation to establish an asking price for the business. This is generally part of their fee, but it's common for them to charge a minimum fixed dollar amount in order to cover the cost of performing all of that upfront work before you go to market. Most brokers are going to use a process similar to the benchmark valuation above. Smaller transactions under $5 million are likely to follow some kind of rule of thumb based on a multiple of revenues or a multiple of seller's free cash flow.

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It depends on the size of the transaction. For sales under $1 million, a 10% broker's fee is common, and it comes out of your proceeds. In addition to that, you may need to spend many thousands of dollars on professional fees to clean up the books, review the contracts, and structure the tax side of the closing.

As the sales price increases, the commission paid to brokers and sell-side advisors diminishes. We recently completed an eight-figure sale of a client's business for a 4% success fee, with additional professional fees of roughly $150,000. Success fees of 5–8% are also common.

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Step 1 — Have them work somewhere else

If it's not too late, have them work somewhere else. It's important that they bring value to the company, and one of the best ways they can do that is to work for another business. They can bring back what was working there, and they will have first-hand experience of what didn't work so they don't repeat it. Working somewhere else also gives them a much greater appreciation for what you have built, and it lessens the likelihood of entitlement.

Step 2 — Excellence as an employee

Give them opportunities to demonstrate excellence as an employee. The bar is much higher for somebody with your last name. They have to be better than everybody else just to be considered equal to everybody else. They don't have to work in every position in the company, but it helps a tremendous amount if they have experience in the trenches — starting at the bottom, working in the field, building street cred with the people who make the work happen.

Step 3 — Competence as a leader

They should have several years of experience on the senior leadership team, handling significant responsibility, working shoulder to shoulder with other senior leaders. Over time, they should clearly develop into the best leader in the room, even if they don't have the most technical experience. It shouldn't be a surprise when they are appointed CEO.

Step 4 — One to two years of after-hours preparation

There is an extraordinary amount of information, tasks, responsibilities, and nuance required to run even the smallest business. To this point, they have been exposed to a fraction of it. They need to understand:

• How to read financials
• How managing risk through insurance works
• How to deal with the most difficult employee issues
• What the tax situation looks like
• How you think about the decisions you're only asked to make once every year or two
• And a couple of dozen other topics

This involves putting time on the calendar twice a month, usually in the evenings, for two to three hours, and working through a structured list of topics. We have developed a two-year Future Owners Curriculum designed specifically for this purpose.

Don't leave it to chance, and don't expect them to pick it up as on-the-job training after you hand over the business.

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You groom your future successor the same way you would develop any other leader. You encourage, exhort, and empower them. Notice the things they do well and encourage them in those directions. When they fall short, exhort them to do better and affirm that you believe they can. But once they've responded to encouragement and exhortation, you have to empower them and hand over large chunks of responsibility.

You have to do this knowing that they are going to fail. It is the only option for gaining the experience they need to run the company. Fail smartly, in ways that will tell them and the company what needs to be done next.

Sometimes the failure will be personal — becoming a leader who does things well is difficult work. Sometimes the failure will be corporate — good leaders take smart risks, and sometimes those risks turn into failures. As you develop your successor, distinguish between their personal failures as a developing leader and the failures that every leader experiences running a business.

Also see the comments above on working through a Future Owners Curriculum with your successor. On-the-job training in their current role will be insufficient to cover the large volume of knowledge and information they will eventually need to stand in your shoes.

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I wish this was a question that more business owners were asking — and more importantly, that they were prepared to hear an honest answer to.

Over the last 30-plus years, I have seen family relationships damaged because the second generation felt obligated to take over a family business that they did not want. As a business owner myself, with two amazing college-age sons and a phenomenal 11-year-old leader who consistently takes the world by storm, there's nothing that I would enjoy more than working alongside my kids every day. But I also got to experience working in my dad's business for four years, and being given the gift of understanding when I came to him and said, "I don't think this is what I want to do with my life."

Whatever disappointment my dad felt, he hid behind a very genuine smile, and he told me: "I would never want you to do something that you're not excited about."

If your kids do not want to own the business, or desire it but are not willing to become the leader necessary to run it, then it just removes one succession path from your options. Explore the others, and support your children in what they want to do and what they want to be passionate about.

As a side note, it is often the case that the child who is capable of running and growing the family business into something much bigger is also the child who is going to want to do their own thing. There is an ambition itch that has to be scratched. This is where encouraging and supporting your child to go and be a part of something else may lead to that itch being scratched sufficiently. Later, when they have great confidence, expanded capability, and — most important — appreciation for what you have built, they may come back into the business and take it to a whole new level.

It may not be "no." It may be "not yet."

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A buyout can mean a one-time sale of 100% of your shares to employees, or the sale of your remaining shares to existing or new partners.

Your approach is heavily contingent on one thing: whether the employees are going to pay you cash from their savings, borrow the money from somewhere else to pay you, or pay for the business over time while you hold a note receivable.

Cash purchase

If they are paying cash from their savings, you simply need to agree upon a value for the business. It's usually the case that employee buyouts are priced at a discount to what the business could be sold for to a third-party buyer.

Once the price is determined, you need to set a timeline. There's going to be a lot they need to know about ownership that wasn't previously covered in their key employee role. Is that knowledge transfer going to happen before the sale, or a combination of before and after? If they want you to stick around in any capacity after the sale, you need to agree on fair compensation for your services. You can become an employee and get paid a salary or an hourly wage for that time, or you can become an independent contractor consulting to the new owners.

But since they are paying cash, ultimately all the risk rests with them. This is another reason these deals trade at a significant discount to what they would fetch if you marketed the business to outside buyers.

Third-party financing

If the employees are going to borrow money, it's important that the loan be structured so that profits from the business can make the payments. This may require you to reduce the sales price or find alternative financing over a longer term. The same consideration needs to be given to the timeline and any post-sale consulting work you do, although third-party financing will usually drive a fairly short timeline once loan applications are submitted.

Seller financing

This is obviously the riskiest type of buyout. However, it's also the most common, for one reason: the business's value is significantly diminished from where it should be. If the business cannot fetch a market price from a third party, and the existing employees cannot obtain financing sufficient to service the debt out of profits, it's probably because the culture, leadership, operations, sales and marketing, and financial health are not in great shape.

Often, seller financing is the only exit path available to a business owner who has not prepared the business for succession. The buyers in this scenario are essentially purchasing their job, with the hope of turning the business into something that can be transferred later — so you should expect a significantly reduced sales price.

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The value of something is what people pay for it. Giving equity to employees, while generous, does not accomplish anything meaningful when it comes to succession. The exact opposite happens: they fail to understand the true value of the company, value transfers without added responsibility, and no one comes away understanding any more about what it means to be an owner.

What you can do is reward top performers with equity — but the reward has to come after the accomplishment of a defined objective. Not as appreciation for work they were already getting paid a fair salary to do, and especially not out of fear that if we don't give them equity they will leave.

Phantom stock, a better performance comp package, a better title: these are all preferable to gifting equity.

Equity is a signal that succession has happened, not an on-ramp to succession.

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Private equity gets a bad rap, and much of it is deserved. But in our experience, there are two types of private equity.

My estimate is that 80% of the offers you will get from private equity are purely financial. You will be talking to a deal maker, not the CEO who is going to be responsible for running your company after you step out. If we are representing a client in a sale and the PE CEO does not get involved in discussions before we are presented with a letter of intent, we typically do not move forward.

It's also the case that if you want the highest sales price, the buyer is going to want you to stick around for a while — and the CEO of that company is going to be your new boss. The right kind of PE firm is going to put you in touch with that person almost from the beginning. You will be able to tell by the questions the CEO asks whether they are truly interested in what you have built and the people who have helped you build it.

Make no mistake: that private equity CEO has one job the investors hired him to do, and that is to grow your company and every other company they buy. But the 20% you want to take offers from understand that this is much more than a financial transaction. There are people who run the business, and they are going to want to know a lot about those people. That is a good sign that you are working with a good firm.

For more on this, listen to Episode 191 of the Grow With Purpose podcast: Not All PE Is the Devil.

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Much like real estate, the majority of the profit you make is when you buy the business, not when you sell it. Buy-side due diligence is a completely different discipline than sell-side preparation.

In a majority of transactions, the broker is working for the seller. This means you must verify every single fact presented in the marketing document. That just gets you to the starting line of being able to make an offer. Once the offer is documented in a letter of intent, you will need to perform due diligence — discovering all the facts about the business, good and bad, that were not presented in the marketing document. It is heavily financial, but it also involves many direct conversations with the key employees and leaders who will be running the business after you purchase it.

For any transaction over $1 million, you should be prepared to invest a minimum of several tens of thousands of dollars to make sure the sales price is justified and the economics are real. If you are not prepared to invest that kind of money in due diligence — and potentially walk away from two deals until you find a third that makes sense — you should look at buying businesses in the $500,000-and-under range.

Too many buyers get $50,000 into professional fees and decide they have to go through with the purchase, otherwise that money was wasted. The result is usually a lot of debt for a business that is underperforming.

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This is a very difficult question. It is a little like asking, "Should I buy a vehicle?" A Honda Civic, an F-150, a Ferrari, and a semi are all vehicles, but they're built for completely different jobs, require different skills, have different economics, and create very different ownership experiences.

A franchise is a legally protected term that puts certain obligations on the seller of franchise rights. It covers things they must disclose to potential buyers and things they are prohibited from saying to buyers. All of that legal and regulatory red tape results in a document called a Franchise Disclosure Document, required by the Federal Trade Commission.

My first piece of advice to anyone considering the purchase of franchise rights is to hire an expert with specific franchise experience in the industry you are exploring — restaurants, home services, retail. My second piece of advice is to talk to every existing franchisee in that system that you possibly can. My experience is that more than half the time, those off-the-record conversations with other franchisees dissuade the buyer from moving forward.

Remember, there are five elements of a business that create intrinsic value for the owner:

• Culture
• Leadership
• Operations
• Sales & marketing
• Financial health

Franchisors focus almost exclusively on selling you systematized operations. Everything else will be up to you.

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