I always dread admitting that I should have paid more attention in economics class in college. Of course, it didn’t help that it was a 7:30 AM class (on Friday’s no less). It is amazing how much in the world equates down to the simple concept of supply and demand. Business owners of all sorts are realizing that today as they go to transition their businesses. I am not just talking about baby boomers either. This impacts them the most, but the reality is it affects anyone looking to sell a business.
In 2017, Christopher Nicholas from ACG Boston’s DealSource Select said “On the supply side, we have about 60 percent of the 15 million privately held businesses in the U.S. are owned by business owners born before 1964.” As we sit here in 2019, assuming most of these individuals were at least 18 when they started their business, that would mean the majority of these business owners are over 73 years old.
However, if we assume that all of these businesses change hands in the next 10 years, that is 9,000,000 businesses that will transition. Let’s assume that some percentage of these businesses transition to children or shut their doors. Assuming that maybe half of these businesses, that leaves 900,000 businesses that will need to find buyers each year. That doesn’t take into account other owners that are not 73 years old that will attempt to sell their business. That means there will easily be over 1,000,000 businesses that will sell per year for the next several years.
So many issues, where to start?
While there are so many issues with this, there are two larger ones that I would like to start with.
First, let’s assume that for a business to be sellable, it has to be making some sort of income (this is not always true). Most of these small businesses are valued simply off of either their assets or as a multiple of earnings. It’s not too far of a stretch to say that of all these businesses for sale, the floor sales price will be close to $100,000. That would mean in the best-case scenario, a buyer would need to have $20,000 on hand for a down payment on the business (they most likely would need more).
The first problem is most American’s don’t have this much. In 2018, the average American savings account was $16,420. The median net worth for a 35-year-old was $11,100. The median net worth for someone between 35-44 is $59,800. My point is, the market of people that can afford to purchase a business is not large. While almost two-thirds of people dream of opening up their own business, 84% lack the finances to open a business. The point is, the market of business buyers is rather small.
The second issue is that according to Dealogic, between 2007 and 2016, there were only right around 10,000 transactions annually. To remind you if you have forgotten from above, there will be about 1,000,000 businesses looking to transition each year going forward. Say half of those are transitioned through passing down to a younger generation or they just close, that still leaves 500,000 businesses looking to be sold.
These two issues should be sobering for any small business owner. In case you forget the supply-demand graph from economics, it does not paint a kind picture for the price when supply gets to be inflated.
Small Business Owners Need to Look for Options
There is a solution many small business owners don’t consider. One that literally stares them in the face each day. That option is to sell their business to their employees.
First, there is no one size fits all when it comes to transitioning a business to employees. The transaction does not need to be structured as an ESOP (a four-letter word!). When an owner sells to employees that does not mean ALL employees nor does he need to transition all control. There are many ways to transition to employee ownership and one size does not fit all.
An employee stock ownership plan (ESOP) is cost prohibitive to many small businesses. Legal fees can approach $100,000 on such transactions. There are plenty of alternatives which allow employees to purchase a company in a variety of ways. In fact, most deals for small companies involve no formal pension plan or in some cases, the business does not qualify for traditional financing.
In most of these cases, the owner will issue and carry a note receivable that will pay them out of the business over time. With the Small Business Administration having recently expanded its definition of eligible ownership to include cooperatives, more lenders are now expected to enter the market.
These transactions often start with a small group of employees, sometimes as small as 1. Most companies that convert to this process are not fully employee-owned on day 1. In fact, it is a good planning point for an owner to begin having these discussions with their advisors years before they are looking to transition out of the business. Governance of companies is flexible as the company transitions ownership. Most owners retain control for a long period of time to ensure that the company is still properly managed.
The key to this process is planning. An owner that wishes to sell their company in 6 months has a lot fewer options than the owner looking to sell in 5 years (this doesn’t even begin to go into all of the tax considerations that must be contemplated). While selling a business can be a tricky, and sometimes painful conversation to have, it is a prudent one. In order for this process to be successful, the business needs to build a culture of ownership and financial literacy. That might take time and like everything else, requires planning.
If you would like to discuss your goals and how Krieger Analytics can help your business grow to achieve them, contact us now. What are you waiting for? Phone calls are always free!