This column converts an excellent article by John P. Napolitano, chairman and CEO of U.S. Wealth Management, into a checklist that could be used to advise clients.
John’s column was about preparing clients for their exit from their business. I liked what he wrote and am presenting a summary here in checklist format with some comments. I copied a lot of what John wrote and did not use quotes, and refer you to his complete column. John also graciously permitted me to use his article as the basis for this checklist.
- He suggests that an eventual exit is with a sale, and I concur, but businesses can also be transferred in some manner to a successor or close down. Not much planning is necessary if you plan on working until you drop, but if not, then it makes sense to do some planning.
- If you will not be working until you drop, then there should be some “when” in mind. Napolitano suggests choosing a hypothetical jumping-off point so the planning can begin and that is good advice, but I think the planning should start even without that date in mind.
- Even with no desire to sell or end the business, planning can present a way the owner could exit on their own terms. Planning doesn’t provide a “must do” process. It is a plan, that’s all it is. If the plan makes sense, then there is comfort. If it doesn’t make sense, then the owner needs to relook at his or her business and perhaps their personal financial situation.
- A first step after the client confronts the possibility they might not work in the business forever is some number crunching to help the client figure out how much they need to remain financially independent for life as well as to fulfill any other financial objectives.
- You need a valuation of the business. While I perform valuations and think they are extremely important to guide a client, John makes an excellent suggestion of having a discussion with the client about the value and using a number for which the client has a sense of what they feel is the value. I find that many clients have an exaggerated perception of what their business is worth, and this discussion can be used to provide some grounding. It’s also a great way to get started. In this situation, it is the interchange of ideas that is important and not necessarily the actual number. For later use, the changes in that “number” can be discussed, making that the benchmark or jumping off point to measure growth and perhaps uncover hidden value drivers.
- Along with the estimate of value, a model should be drawn up indicating the net after tax proceeds from an exit, and the expected cash flow from that net. For these calculations, I use the highest numbers suggested by the client since that cash flow, no matter how it’s calculated, always falls significantly short of what the owner is taking out of the business at present. Occasionally this process is a real eye opener when the client compares the investment income from the net proceeds with what they are taking out of the business.
- The reduced cash flow suggests the exit is not a cash flow issue, but a lifestyle change. I find it helpful for clients to have a sense of what they might do after they no longer own and work in the business.
- A best practice of Napolitano’s would be to have the business in shape and ready to sell at all times, especially in the event of a premature death or the owner’s disability. That is absolutely right, but it’s also a better way to manage the business and makes it easier to control and plan for growth.
- Financial statements prepared using GAAP are a must, and the type of accountant’s report would depend on the size of the business. Even with a compilation, I suggest that having notes is important (notes are required with a review or audit). This causes a formalization of many issues that might be overlooked, especially with a single-owner business, and elevates the role of the accountant’s financial, tax, business and controls planning.
- As to a potential sale, almost every buyer is going to want some sort of GAAP financial statements, and having them prepared is a necessity for that. It also provides the client with a view of how potential buyers would look at the business and might even uncover some not so evident value drivers. Companies can continue to use the cash basis for filing their tax returns even though they have GAAP financial statements.
- I agree with John that audited financials are better for larger businesses. Audits are becoming more complicated, involved and compliance-oriented and are the gold standard for buyers and banks. A benefit for clients is the thoroughness of the audit process where a company’s processes and internal controls are also reviewed. Clients should also request a management letter from the auditor and then go over it with them point by point.
- John says that in addition to the financial statements, a quality of earnings report is frequently desired. I agree, but I think it is a must. This is a method where the earnings are normalized to what they would be under professional management and also where one-time nonrecurring items are eliminated from earnings. This is done to arrive at the “actual” annual earnings of the business without the expenses a single owner might run through the business while trying to “get away” with making some personal expenses tax deductible. An example might be health insurance premiums for grown children who are performing minimal services for the business, excess salaries paid to college-age children, or any above market rent the owners pay to themselves for the business’ use of the premises. Also normalized would be one-time nonrecurring expenses such as moving costs, and accelerated tax depreciation deductions in excess of GAAP. The normalized earnings are usually the starting point for a potential buyer but also can provide the owner with a sense of what they are really making from the business.
- Another important point is to have records and information that can be easily transferred digitally, or placed in a data room. This is useful when a buyer is performing due diligence but is a best practice today for all businesses. It can also enable employees to work from remote locations if that becomes necessary.
- John’s column also suggests engaging an M&A consultant. I think that is important and can also help clients crystallize their thoughts. However, a good start can be made with the business’ accountant, and if it looks like the deal will proceed beyond the preliminary preparatory stage, the M&A consultant can then be engaged.
- Overall planning is a best practice and should be done regardless of how the client feels or their ambivalence toward the idea of exiting. It helps sort things out, creates order and can set a larger table for the client. I’ve seen some of these so-called “exit” plans propel clients to greater heights and successful, aggressive growth actions.
The balance of John’s column covers succession planning with employees and family members. I believe these discussions should only take place after a succession plan or exit strategy is developed, or the client has a pretty good idea of how they would want to proceed. While John’s comments are all excellent, I would defer such discussions until a plan is formulated, no matter how vague the plan. This issue, in and of itself, is very complicated and involved with many alternatives and considerations.
So, there you have my comments and a checklist based on John Napolitano’s column. Keep this for your future use, and make sure you read John’s column.
Do not hesitate to contact me at firstname.lastname@example.org with your practice management questions or about engagements you might not be able to perform.
Edward Mendlowitz, CPA, is partner at WithumSmith+Brown, PC, CPAs. He is on the Accounting Today Top 100 Influential People list. He is the author of 24 books, including “How to Review Tax Returns,” co-written with Andrew D. Mendlowitz, and “Managing Your Tax Season, Third Edition.” He also writes a twice-a-week blog addressing issues that clients have at www.partners-network.com along with the Pay-Less-Tax Man blog for Bottom Line. He is an adjunct professor in the MBA program at Fairleigh Dickinson University teaching end user applications of financial statements. Art of Accounting is a continuing series where he shares autobiographical experiences with tips that he hopes can be adopted by his colleagues. He welcomes practice management questions and can be reached at (732) 743-4582 or email@example.com.