If you are a business owner who is looking to sell or retire, conditions couldn’t get much tougher. Valuations are down from the halcyon days of the mid 2000’s, interest rates continue at secular lows and the economy is sputtering. Call it the succession planning equivalent of the Perfect Storm.
So what is a business owner to do? One option is to let it ride until things improve, and maybe see an uptick in the value of the business. After all, you figure the dividends you’ll pull out while you wait will equal what you could sell for today, plus you will still own the business!
So one year morphs into the next and you still run the show. But your plans for retirement remain on hold.
Over the years I have encountered many business owners who delay succession planning using this logic. They may have had an opportunity to sell, or considered passing the business on to the children only to let it ride because these are tough decisions and things never quite added up. Sometimes this seat of the pants approach works out just fine. But sometimes not.
For large companies with management depth, financial resources and revenue diversity the rewards of staying the course far outweigh the risks. But for small and medium size companies where the loss of the owner/founder or a key customer can be devastating, letting things ride until ‘next year’ without adequate contingencies is a big gamble.
So how to explain this seeming complacency? I think that over time entrepreneurs develop a high risk tolerance. They live and breathe risk everyday, for years on end. They see opportunity. They weigh the risks and then they jump in with both feet. This is what makes the economy hum. Risk is in their blood. But that doesn’t mean they are immune.
But here is the thing. Risk of any type is by nature invisible, nebulous and random. It is everywhere but apparently nowhere. It is constantly changing, and it ought to have our attention at all times. It can be friend and foe. It greases the wheels of commerce but too much can cause a spin out. While you can’t really see risk, you know it is lurking just out of sight, somewhere in the reeds. And like startling a sleeping dog, it can rear its dark side and bite you unexpectedly.
But how does one know the point at which their exposure to risk crosses the line and enters the ‘no fly’ zone? I haven’t developed an algorithm for it – but I am sure one exists – a handy dandy equation that correlates the owner’s age, health, and state of mind with the type of business, earnings history, the proportion of wealth tied up by the business, the state of the economy and so on…and spits out some benchmark measure of riskiness. Just plug in the numbers and wait for the answer:
‘Hello Mr. Zilch. Your ERFI (Entrepreneurs Risk Factor Index) is 93. WHOA!’
Arguably, companies could benefit from something like an ERFI. A less fictional, and hopefully more reliable, solution would be to work with independent advisers who would bring the proper checks and balances to nix any creeping complacency that might expose a company to risks it ought to avoid.
But let’s consider the curious case of Mr. Zilch, a sixty something business owner who decided to replace his aging equipment with the latest state of the art. While having new machines was going to improve efficiencies, and the financing seemed affordable, doing the deal took his business from debt free to owing a bundle. Then September 2008 arrived and business dropped like a tire iron off a flat bed. Mr. Z was compelled to pursue the sale of his business at an inopportune time and find that most of the equity proceeds he hoped to realize for retirement were offset by the debt he had taken on to finance the purchase of new equipment. In banking lingo he mismatched assets and liabilities.
Had he taken pause to calculate his ERFI, he may not have purchased the new equipment. Instead he relied on the same gut instinct that had always worked for him, and made the fateful decision to borrow. The takeaway here is that the risk one assumes at age 30 or 40 may not be appropriate at age 50 or 60. This is known as life cycle risk, and there are well known strategies for mitigating it such as grooming successors, accumulating assets outside the business, buying life insurance, and making yourself obsolete so the business can carry on in your absence. In other words, if the decision is to ‘wait it out another year’ be sure to have a solid Plan B in place. That way if the dog gets startled by the falling tire iron you may hear the bark, but you won’t feel the bite.
In the next article we will consider tools for quantifying risk, how risk gets factored into determining the value of a business, and how this impacts succession decisions. We will consider the case of Rachel Riskmore, a business owner who is mulling over the merits of a possible sale of her business.