Returning from a less-than-positive physical exam, Sebastian realizes he needs to start thinking about retiring in the next few years.

But how?

Although he has a daughter in the business, she's still inexperienced. His CFO would do a great job running the business, but he has insufficient resources to buy Sebastian out. And with the tight credit markets, competitors may not be able to afford a buyout; plus, Sebastian doesn't want them to know he's even considering retirement.

So here he is, with a business worth at least $25 million, and yet he's concerned he won't be able to exit his business for at least five years. He doesn't want to liquidate his business, but he certainly would like to liquefy some of his business equity.

This scenario plays out over and over in American business, and it will be an even bigger issue as baby boomer business owners flood the marketplace. Different from their affluent counterparts who have their wealth diversified and managed, the owner of a closely held business often has wealth concentrated in a nondiversified, low tax-basis asset. There is significant wealth on the company books, but the equity may be trapped in a C Corporation, unavailable to access without double taxation.

Further, because of tight credit markets the owner may not be able to leverage the business's equity through traditional loans. Compounding the challenge is that family members are often involved in the business, and there is no such thing as purely a "business decision" when it comes to how to exit the firm. Simply stated, retirement and wealth transfer planning for the private business owner involves far more moving parts than for the wealthy individual who is sitting on a diversified, managed portfolio.

But all is not lost; the business owner can convert business wealth into diversified retirement wealth. It's just a matter of timing and planning. A good start is for the owner and advisors to recognize some fundamental principles that affect business exit planning. These principles are paramount in helping the owner realize that what helped build the business is not necessarily the same as what will help the owner leave the business.

Principle 1. To convert business equity into retirement income, the owner needs to begin managing the business more like an asset than just as an enterprise.

Most business owners have spent a lifetime working in their business, but little time working on their business. Their success in the marketplace was derived from hard work, strategic thinking and strong execution. But if the business value is now intended to be personal capital for the owner, then that value must be managed as an investment asset.

Noted business appraisal expert Z. Christopher Mercer has suggested the owner consider allocating 1% of the business's value to the active management of the business as an asset. The idea is that a managed brokerage account typically has as asset management charge in the 100-to-150 basis-point range. If a business owner earmarks a comparable percentage of the business equity to asset management, the process has begun for converting business equity into retirement income. These earmarked funds might be used:

to obtain a business appraisal that indicates the likely sale value of the business interest;

to pay for independent advice concerning exit planning and business continuation, including plan design and document drafting;   

to pay for funding, typically in the form of insurance premiums, associated with contingencies such as death or disability.

Returning to the example of Sebastian and his concerns about exiting in a few years, he needs to look at his business not just as his passion, but also as the source of his retirement income and personal wealth. He should use some of the equity in the business to hire professionals who will help him value the business, create an exit and retirement plan, and do so in the most tax friendly manner possible.  

Principle 2. The business owner rarely knows the true potential sale price of the business. Although Sebastian likely knows the value of his business for both banking and tax purposes, he may not have a clue what the business can sell for. Consider this: He wants to have an ongoing retirement income of at least $1 million a year and he thinks his business has a "going concern" value in excess of $25 million. In theory, this plan should be easy to accomplish. The issue, however, is what the business is really worth when it is put up for sale.

If he has a low tax basis in the business, his net after taxes could be much lower. Further, issues such as thin management or bad economic times could force him to sell at a deep discount. A privately held business is a fragile asset. Getting an accurate valuation will not only help Sebastian determine if he can meet his retirement goal; it will also help him and his advisors create ways to secure and even increase the sale value of the business. Just as a home owner invests in new kitchen counters and bathroom fixtures to improve the resale value of the house, so can Sebastian target key business tactics that will help his business become a better buy on the market. From improving his management succession plan to expanding his customer base, a business owner like Sebastian can improve the company's likely sale value.

Principle 3. The owner of a privately held business will probably have to finance some or all of the cost of selling the business. In cases where a privately held business is worth approximately $10 million or more, it is common for the owner to contract an investment banker to either find a buyer or obtain refinancing. In essence, the investment banker, for a fee, will help secure a valuation, assess ways to improve the value, and either locate an outside buyer or find sources of financing. In many cases, the financing is available through both traditional banks and through mezzanine financing (debt financing junior and subordinated to traditional secured bank financing). Beyond banks, there are capital lenders such as hedge funds and private equity firms that are looking for creative places to put money to market.

Consider Sebastian's business. He has three likely buyers for his business: his daughter, his CFO or an outside buyer. Unless Sebastian and his investment banker are successful in finding an outside buyer willing to pay cash, he may do better to finance some of his business and begin an orderly sale of the business internally. With a sale to his daughter or the CFO, it's clear he will have to take back some kind of note for his equity interest.

The financing of the business will help significantly reduce the value of the business, and make the sale more manageable for the buyer. For example, Sebastian might secure a $10 million long-term bank loan and another $5 million in mezzanine financing. Granted, borrowing increases leverage, but it also lowers the value of the business. At a value of less than $10 million, the purchase is more manageable for the inside buyer. Sebastian has in-pocket capital of several million dollars that he can now diversify, plus the promise of ongoing payments from the sale of his business.

A wealthy retiree whose assets are in a large pension account has less to grapple with than a business owner whose assets are not diversified and are tied up in day-to-day operations. As a business owner, Sebastian has many options; they are simply more complex.

Converting Equity To Income
The key for converting business equity into retirement income is to get good help and get it early. Creating a business plan tends to be more challenging than creating just a retirement plan alone, so advice and time are precious planning tools. Sebastian's case offers a glimpse into how an owner can deal with this vexing yet manageable challenge.

Prioritize. Working with his advisors, Sebastian must first prioritize his goals and needs. It is unlikely that he can tackle all of his business and personal issues in one master plan. Breaking the plan into bite-sized pieces makes success more likely. Key first steps include securing an investment banker, gauging the interest and financial status of his daughter and CFO, and assessing possible outside buyers. Once this market overview is completed, Sebastian can start planning his exit.   

Create an Exit Plan. The exit planning process involves more than just having an attorney draft a buy-sell agreement. Particularly with privately held businesses, there are many options above and beyond simply selling the business. Sebastian might consider various forms of capital transfer, essentially getting retirement cash now while planning to exit later. The concept of financing the business and then selling to his daughter or CFO is one such example. Here are two other examples of capital transfer techniques that might work for Sebastian:

He could sell part of his stock through an employee stock ownership plan. An ESOP can be a highly tax efficient way for Sebastian to access and diversify his ownership equity. He would sell a part of his business to his employees via the ESOP and reinvest the equity in a broader portfolio of retirement assets. So, for example, his company could borrow $10 million from a bank and use that amount to fund an ESOP for the benefit of the employees. The ESOP would in turn buy a comparable amount of his stock, and he could then reinvest that amount, potentially tax deferred, into a diversified stock portfolio.

He could use compensation as a means of accessing business equity. Because of Sebastian's age and salary, a qualified defined benefit plan might not only be an employee benefit; it could also generate an attractive retirement income for Sebastian. Add a nonqualified deferred compensation agreement to the package, and his retirement income will be size able. Especially if the business is to be sold internally, these combined plans can help ease the cash flow of buying out his interest.

The retirement packages would be a liability that lowers the value of the business, and the payments would be a way for the buyers to pay Sebastian on a tax-deductible basis. Sebastian would get approximately the same amount as if he sold his business directly, but using qualified and nonqualified retirement plans is more tax efficient for the buyer.

Execute. An exit plan without execution is like a mission statement without strategies. Timing and action are crucial with private businesses because of the realities of the marketplace. It takes time to identify buyers, arrange financing, draft documents and move when the market is favorable. Additionally, most tax strategies require several years of lead time in order to be effective. For example, to fully reap the tax benefits of converting from C to S Corp income tax status, an owner should allow as much as 10 years before sale. Similarly, with the referenced qualified and nonqualified retirement plans for Sebastian, the plans will need several years of contributions to build sufficient retirement capital.

The conversion of wealth into retirement capital is a challenge for any person of affluence. If the wealth is concentrated in a closely held business, the challenge is compounded, but not impossible. Recognizing the principles of private business ownership and then executing them can yield a source of tax-efficient and diversified retirement capital. It may take more time and more professional assistance, but business owners can enjoy the same financial security in retirement as their wealthy counterparts.

Steve Parrish, JD, CLU, ChFC, is National Advanced Solutions Consultant for the Principal Financial Group. With more than 30 years experience as a practicing attorney, financial planner and insurance industry executive, he frequently addresses the challenges of business owners and executives. For more information, visit www.principal.com.