Building a Succession Plan

John M. O 'Brien John M. O'Brien is the managing director of The BVC Group, a professional services firm providing independent business valuation opinions to clients, based in Amherst, N.H. John's work has been reviewed by the SEC and Big 4 public accounting firms, and he has successfully worked with companies all the way through the IPO process. For additional information visit www.thebvcgroup.com. The key for any succession planning is understanding the value of the enterprise. Sooner or later at any construction firm, the time for leadership to be passed from one helm to another will come. Every construction business needs an exit strategywhether it is to be sold or passed down to the next generation. In an ideal world, the optimal time to initiate exit planning is during the business startup phase; it is vital for construction business owners to understand their time horizon to an exit event and the strategies they can execute to maximize their value during such a transaction. However, many construction firms do not have the luxury, for whatever reason, of having a succession plan built into the initial strategic plan. Still, the operative word in succession planning is planning. If there was no well-thought-out and comprehensive plan developed at the business's origin, there is no time like the present. But even before the idea of succession, the first issue to be addressed is the company's survival. In construction firms where the ownership is concentrated or controlled by one individual, this has the potential to impede a company's long-term survival if the death of the owner occurs. To avoid this possibility, many companies purchase life insurance for this individual, to insure that the firm will be able to purchase the owner's equity from the estate in the event of his or her untimely death. Companies that don't purchase life insurance for this type of situation often find themselves taking on huge amounts of debt or selling the company to satisfy the estate tax liability.

So the question is: How much life insurance is enough? A business will never really know unless it has been appraised by a qualified business valuator. Most business owners think they know the value of their business. However, how the business owner views value can be very different from how the IRS looks at it when considering the value of the estate to be taxed.

Understanding value
The key for any succession planning, not just in the construction industry, is understanding the value of the enterprise. In the case of succession planning, this is a process that usually takes a number of years while everything falls into place and the ownership structure is transferred in an optimal fashion. Whether the succession is to the next generation of family members or the next generation of management (given that, in many cases, construction businesses are family-owned or at least very closely held), it is vitally important to understand the construction of the capital structure of the company. Whether the firm needs a full valuation or a calculation of value is dependent on what stage of succession planning the firm is in. To support a transaction, a full valuation is necessary; in the exit-planning process with no transactions to support, a calculation of the value will suffice. A firm's owner can also use a calculation of value when reviewing estate planning (unless the planning results in a gift or some other type of transaction; then, a full valuation is necessary). Regardless of the type of transaction, an independent and comprehensive valuation is vital to the process. Although it may seem reasonable to assume that a business should sell for a certain amount based on the sum received by an industry colleague's sale, keep in mind that no two businesses are exactly alike. The value drivers of a business are key elements to a valuation bottom line. As an example, a business may have recently made enhancements through supplementary equipment, secured bids, or perhaps additional staffthese are just a few of many significant changes that could result in increased cash flow and profits over the next several years. The rule of thumb is a three-to-five-year window to plan for exiting or to position for sale, and evidence of sustainable cash flow is critical. Sustainable growth is defined by steady increases year to year. Regardless of where the business is in its exit-planning stage, remember that high

margin and constant cash flow are what will attract a potential buyer. Prospective buyers are less concerned about sales than they are about margins and sustainable cash flow. And for the construction business owner, there are a lot of variables to those all-important marginsthe weather, the cost of energy, the price of materials, etc. Protect margins by pricing accordingly, keeping in mind that erosion of margin is the erosion of value. Also be aware that knowledgeable buyers recognize that a 40 percent spike in revenue may not necessarily be the best indicator of long-term value. A business owner can strip mine the firm for a couple of years to grow the margins, but that does not set the table for future growth. A savvy buyer will also recognize this and make an offer accordingly. The quality of financial statements cannot be overemphasized during the valuation process. Working with the highest standard of financial statementsthose that include cash flow, historic earnings, and trends that have been established over the yearwill ensure an acquirer the greatest comfort level and, perhaps more importantly, will increase the likelihood of receiving the maximum amount possible for the business upon the owner's exit. Audited financial statements those that have been prepared by the company and audited and certified by a CPAwill provide the highest level of assurance to a potential acquirer. Through proper analysis and realistic interpretation, the amount an owner can expect to receive at the time of sale can be determined based on the business's financial history. As such, a reasonable projection of future cash flow can be established.

The succession plan

Now that survival has been addressed, it is time to consider the implications of succession planning. Obviously the goal is to have the business continue to grow and prosper for the next generation, whether that be family members or not. Another key component to any succession plan is to make sure the company can incentivize and retain the key players of the next generation. If a business owner wants the next generation to act and perform as owners, then they really need to be owners. This can be accomplished through a stock option plan where individuals are rewarded for their performance with options to purchase shares or interests in the business.

Again, the business owner might think he/she knows the value of the equity securities, but it is a good bet his/her view and the IRS's view will be very different. There is a regulation in the tax code known as IRC 409A that governs the issue of deferred compensation. Stock option grants fall under the guidance of IRC 409A. Basically, it requires that the stock options be issued at fair market value (FMV). If a business owner decides he or she is going to engage a qualified business valuation professional to help determine the FMV, then the IRS may review the report to make sure the valuator uses acceptable methodologies. If the business owner decides to determine FMV on his or her own, he or she better have significant support for the conclusion; otherwise, the IRS's business valuation professionals will be determining the value. This hardly ever works out for the betterment of the company. While many business owners recognize the importance of a team of professionals to help guide them through the exit-planning process, too often the valuation portion is left in-house. But in the absence of an independent business valuation, the true value of a practice can be woefully underestimated. Suffice it to say, if a business owner undervalues the equity interest, there are significant penalties and interest to be paid by the company as well as the stock option holder. The cost of a 409A valuation will seem very small compared with any penalties and interest the IRS might levy.

For sale
If the goal of the exit plan is to sell the business outright to the next generation, this can be accomplished by way of a multistep process in which the buyers pay for the business over time or buy it in steps. It is not uncommon for business owners to play the role of the bank and selffinance all or part of the deal. However, it is important to recognize that what the business owner wants so he or she can retire may not be a price the business can support. If the business cannot support it, then the succession planning is doomed to fail, as the loan will likely default and the business owner or the bank will be in chargeagain, not the goal of a successful succession plan. The answer is not to avoid incentive plans like stock option plans and stock awards. They are very important tools in insuring that the succession to the next group of owners is successful. Most often, a succession plan that uses incentive strategies over gifting offers better outcomes. This type of approach helps people believe in themselves and gives them a strong sense of commitment to the company for the long haul. If the owner cares enough about the business and

the people who will be running it in the future, it makes sense to do it the right way. To do otherwise would be jeopardizing the long-term future of the business.

Help along the way

In any succession planning endeavor, it is imperative to assemble a team of trusted advisors to assist in the process. In addition to a business valuator, the company should seek the guidance of its CPA, lawyer, and exit-planning advisor. Each of these professionals brings specific expertise, with all playing respective essential roles to the exit strategy. A strong team working for the same goal can only increase the chances of success. Selecting a business valuator for inclusion on your exit-planning team is not a one size fits all proposition. Make sure the individual has a business valuation credential, and ask if business valuation is the focus of their practice or just one of many service offerings. It is essential that you work with an accredited valuation specialist to ensure the proper level of skill set. Establish who will perform the valuation work and from what location. Some valuation practices offshore their work to foreign countries; ideally you should be able to at least speak to (or better yet meet) the person conducting the valuation. And under the category of you get what you pay for, it may not be to the firm's long-term advantage to retain a low-cost valuation provider. This business is likely one of the owner's largest assets, so it is imperative that the firm's leadership conduct research and choose all members of the exit-planning team wiselythe work they assist the owner with today will ultimately be the basis for the owner's financial future. No matter the field, knowing the true value of an operation is essential. A larger company may make an offer that seems reasonable, or perhaps more than expected, but the owner could still be leaving money on the table. A business is like a living organism that continually changes and evolves over time. It is essential that a company's business strategies do the same, while planning realistically for the future. Ensuring that the right exit plan is in place, with an accurate valuation to support it, is critical toward ensuring the longevity of the business.