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Plan B (and C) for Retiring Small-Business Owners

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar.

Planning in retirement can be a cumbersome task even in the most straightforward of circumstances, but throw in a small business transition and things can get complicated in a hurry.

Here with me to offer some tips about small-business transition in retirement is Jerry Mills. Jerry is the CEO and Founder of B2B CFO. He is also the author of a related book called "Avoiding the Danger Zone: Business Illusions."

He is here to talk a little bit about some of the things you need to keep in mind as you're transitioning your small-business in retirement.

Thanks for joining me, Jerry.

Jerry Mills: You bet.

Stipp: So, the first question for you. You've written a little bit about some of the broader trends that are happening in the United States, will be happening in the United States, over the next several years, involving retirees and small businesses. And there's a pretty interesting, and in some cases maybe jaw-dropping, numbers there. What's the picture look like for small-business owners in retirement in the next few years?

Mills: Well, the numbers are dramatic. We know that in the United States that there are about 78 million baby boomers that are going to retire in the next 12 to 15 years. Interestingly enough, they own about 12.5 million businesses. And because the younger generation doesn't want to take over those businesses, about 70%, or about 8.4 million, of those businesses are going to have something happen to them. They are going to transition to a third party, they are going to be liquidated, they are going to go to their employees in ESOPs--something is going to happen. Actually, I call it a tsunami. It's never happened in terms of volume in the history of mankind. So, it's going to actually be fascinating, and there's going to be some winners and some losers as we go through these numbers.

Stipp: So, I want to talk a little about what are some of the implications that you see here? Because it seems like there could be some negative implications, certainly, or at least this is a very important thing to have on your radar screen. Do you have any concerns about this massive shift and change in how we're going to see business transitions occurring?

Mills: Oh, I have significant concerns. One, I know for a fact that these 12.5 million baby boomers that own these businesses are not preparing properly for this. The other thing they are not considering is just the law of supply and demand. They are not considering because of this humongous, this enormous amount of businesses that are going to be sold that there may not be enough buyers for their business or they may not buy it for what they think that the company is worth. And that takes some planning and some discipline, and also some emotional dis-involvement, and I am not sure they are all doing that right now.

Stipp: So you think, for example, of the housing market, and the supply and demand situation. We see what that's done to prices right there. So a similar thing could be on the radar for these small businesses?

Mills: It's very similar. It's just the law of supply and demand. So much supply very little demand.

Stipp: So, I want to ... bring this back to the individual's perspective. So, let's say, I am nearing retirement, I do have a small business I've been running for many years. Maybe my children aren't interested in taking over the business. And I know that this economic situation could be coming up, where there might be a lot of businesses, and a lot of business owners, in the similar situation. What steps should I be thinking about, what concrete steps should I be tackling to try to make sure I am going to put myself to the best advantage in this environment?

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Mills: Well, there are several things you should be doing. The first thing is not putting all your eggs in one basket. My recommendation is that the business owner should have at least three plans for exits. They should consider possibly selling to a third party. They should consider perhaps creating an ESOP and selling it to their employees in certain situations. And/or they should consider liquidation and divestiture into other things over a period of time.

One of the worse things they could do is just assume, "Okay my company is just the greatest! Somebody is going to want to buy it!" and not do any planning for that event. What if somebody doesn't want to buy it? We need to have some backup plans for that alternative.

Stipp: So, have a plan B. So, it's not just the fact that you have these three alternatives, it's the fact that you should prepare the business for the possibility that any one of those three is going to be the better solution when it does come time to transition?

Mills: That's exactly right. One of the three will be the best solution, or combination of all of them: Maybe an ESOP, there may be a third-party buyer of a segment of a business, a vertical if you would, and some asset liquidation. But just to assume that someday down the road somebody is going to buy my business for X is somewhat hopeful and not realistic, because of the numbers.

Stipp: So, part of what your business does is you help businesses go through these transitions and prepare and make sure that they are going to be able to execute a transition like this successfully.

You have several client stories. Can you give me a case study of something that went especially well and what were the success factors behind that preparation for transition?

Mills: Yes, I helped a client sell several years ago. They needed to have some lending and some banking before they could be approached by investors. And it took us 16 months to find all their assets and all their liabilities. We were able to do that; it was very difficult. They had assets in one part of the country. They had some assets in Europe. They had assets that weren't on the books. They had liabilities that weren't on the books. And what that did was, it was deterring bankers from lending them money to help them grow their sales the way they needed to grow them, and it was deterring our ability to introduce them to investors.

So, it took about 16 months--the company was doing sales of about $6 million or $7 million. We helped it grow to close to $18 million and sold it for $20 million. So that was a good success story, but it took a lot of organization and a lot of planning and almost a year and a half of work to make it where it was sellable to a third party.

Stipp: So, in effect this was a good business, but it wasn't a business that was sellable in its current state just because of the fact that it wasn't organized in a way that was able to be sold.

Mills: That's right. It's almost like having a home that needed to be painted and landscaped, and cleaned up. The plumbing needed to be fixed. It was a very good business, but an outsider, someone who is objective, someone who is going to actually write the check, couldn't see the value of the company because the owner couldn't present it in objective numbers, and show detail. Because buyers are very skeptical. They do due diligence and ... so it took quite a bit of work, but it was done. It just took quite a bit of work to do that.

Stipp: On the flipside there are also several pitfalls that business owners can fall into. You have a case study of a narrowly averted disaster. What is something that you should keep in mind and what was that pitfall and how was it avoided?

Mills: Well, that pitfall, this company was enthralled with a company that was 750 times bigger than it. They were enthralled because this company wanted to take over all of their assets and in exchange wanted to give them less than 10% of the mothership of the acquiring company.

When they hired me, they were so emotionally tied, they just wanted to do it. I was a referral from an attorney, and they were just placating the attorney. I asked them very kindly if I could see the financial statement of this large company that had this incredible reputation, and upon looking at it, I determined very quickly that the acquiring company was not going to be in business very long even though it had been in business for about 20 to 25 years.

So, I just asked them a simple question: "Well, if you go back to 1913 and someone tried to get you to invest 8% into the Titanic, what would you get?" And the owner thought for a minute, and said "Well it would get me 8% of a ship that's on the bottom of the ocean." I said, "Well, this is what's going to happen to you."

Because of my advice--which they didn't like, they were not happy with my advice--they decided not to exchange their assets, which were seven figures, in exchange for stock. Six months later, they called me and told me that the company that was going to acquire them filed Chapter 11 and went out of business.

Stipp: So, I think this raises an interesting point. So, both the success story and also the story that could have been a disaster that was actually…

Mills: ... The near-Titanic...

Stipp: It has to do with, I think in some respects, the mind-set of the business owner. And they sort of have a feeling for what the business is worth or they think, "somebody wants to have a stake in my business, and so it's really worth something."

But I think part of the key in what I am hearing from you is being able to step away from that and look at your business objectively and also look at what the business transaction is objectively to ensure you don't fall into a pitfall, and also on the flipside to make sure that you get what your business is actually worth.

Mills: That's exactly right. As business owners, we are very emotionally tied to our business. We are not objective. This is our baby. This is what we do.

Our emotional well being is tied up into it. We typically think that it's worth more than it is. Sometimes, though, I have seen business owners want to sell for less than it's worth.

So whatever it is, we are emotionally tied. In the situation of the Titanic story, this business owner, who is an incredibly wonderful man, actually was just tired. He needed to go on a vacation and to not be emotionally involved, because his attorney and then myself as a professional were saying, "you're going to have a piece of paper that's worth nothing."

Now, that company has grown from $1 million to almost $10 million in sales over the last few years, and he's really glad he didn't do that. But it was very difficult for him, because we get emotionally tied. And it's also difficult to tell an owner, don't be emotionally tied. But we have to do that. Sometimes we have to just go to Hawaii, go on a vacation for two weeks, and try to calm down and listen to objective advisors.

Stipp: Get that perspective. I think it's the same with investors as well. There is a certain irrationality that can take hold when you think a certain asset is worth what you paid for it, for example, and being able to step away from that can sometimes help you make the better decision.

The last thing I wanted to ask you relates to the rest of small-business owners' wealth and how they should maybe think about that separate from their business.

So, I'm sure in the case of a lot of small-business owners, most of their wealth is tied up in this small business or perhaps a large, very large chunk of their wealth.

Do you have any thoughts about how investors should think about diversifying elsewhere outside of the business, and the implications for that in their retirement plan?

Mills: Yes. For most small-business owners, 80% to 90% of their wealth is tied up in the business. That's not wise. What we need to do is we need to start diversifying. If there is excess cash [in the business], there are ways if you use good tax advisors to perhaps take some of that out tax free or at a reduced tax basis, and to purchase other things, perhaps equity, perhaps bonds, and so forth.

And there's a significant risk--because we've seen this, for example, in the home market--maybe someone thought they had $0.5 million or $1 million of equity in their home--overnight it's gone. And that could happen to small-business owners.

So, part of the plan is on a worst-case scenario saying, "Okay--what if somebody doesn't buy my business?" Okay, well let's start taking some out. Maybe we put some in retirement and defined contribution, defined benefit plan. Maybe into some land, maybe in stocks, bonds whatever over a long period of time.

And then if the worst happens--nobody wants the business--guess what. On this side we have a lot of assets and hopefully most of them are liquid. So there needs to be a plan to liquidate. When I say liquidate, it doesn't mean sell the business, but to be lean, and I teach business owners, the only purpose of the business is to help you get personal wealth--that's it. If we're not doing that, something is going wrong. Otherwise they ought to just go get a job and enjoy life.

Stipp: Jerry, thanks so much for the tips on helping retirees or near-retirees transition their small business. Some very important context and tips for them. Thanks for joining me today.

Mills: Thank you.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.