How Frictional Costs Can Affect Your Total Proceeds

Frictional cost is the total direct and indirect costs associated with the execution of a financial transaction. The frictional cost comprehensively takes into consideration all of the costs associated with a transaction.

According to the Exit Planning Institute, only 5% of owners who sell their business are happy with the proceeds. There are a number of factors that contribute to this dismal statistic, but most of them boil down to poor planning and unrealistic expectations.

To decrease this potential loss, creating and implementing an exit strategy is key. Additionally, creating this plan long before you consider selling is an important aspect of an exit strategy. Research shows that 70% of business owners do not have an exit strategy, leaving the future of their enterprise and potentially their own or their family’s financial future, unprotected.

The first step in a successful and satisfying exit from your business is to figure out your number. Meaning, how much money will you need to achieve your post-exit goals? Typically, we recommend determining your number 5-10 years in advance of your anticipated exit. This may seem like excess planning, but if you wait to determine your number until you are forced to sell, there is very little you can do to impact the valuation of your business.

During the exit strategy planning, knowing the difference between where you are now and what you will need for a sufficient exit will increase your chances of a happy ending. We call the difference the value of your business today you are today and the price that you need to get for your business when you sell, the Valuation Gap. Knowing you’re the Valuation Gap early, can help you set goals and plan to minimize the gap before you put your business on the market.

In determining the number to achieve your post-exit goals, you should consider your motivations for the exit. Here are a couple of steps that can assist you in establishing your number:

  • Consider the lifestyle you imagine post-exit and come up with a number that you will need on an annual basis to obtain that lifestyle. Are you planning on retiring after this transaction? If yes, your number may need to be higher.
  • Using a financial planner can assist you in a variety of areas. These can include managing your investable assets, provide guidance on achieving your financial goals, help you retain your key employees, protect you and your family with various insurance products and help you navigate the complexities of the financial instruments and markets.
  • If you have investments outside of your business, you are able to deduct those assets from the overall goal. It’s important to note that you should not count principal residence as an investable asset.
  • Don’t forget to include those frictional costs! These costs can include taxes on the sale of your business, the cost of an intermediary, legal review, bonuses for employees, and insurance tail.

To most, steps 1-3 are instinctive, but it is the frictional costs can blindside an unwary seller at the end of the sale transaction when there is no opportunity to correct. It is critical that you anticipate these costs and minimize errors from the start.

To identifying these frictional costs, we recommend you consult a professional business intermediary, CPA and financial planner. However, we have listed a few items below to get you started:

Taxes – Determining the tax burden on the potential sale of your business is difficult in the abstract because your taxes will, in part, depend on the business structure. It is critical that you consult with your CPA in advance of signing any letter of intent or offer.

Intermediary success fees or commissions – Intermediaries usually charge a percentage of the sale price of your company. For a small business, they will typically charge 10-15% on the first million dollars of value, with a declining percentage for each million dollars thereafter. Larger businesses, over $10 million in value can expect to pay an M&A professional 3% – 5% of the sales price. A good intermediary will earn their money by helping you to correctly value your business, finding and vetting prospective purchasers allowing you to continue running your company vs. focusing all of your energy on responding to inquiries, negotiating with the buyers and making sure that all of the necessary steps are taken to close the deal.

 Legal fees – These can average 2% – 4% of the deal.

Insurance fees – If you have E&O or other professional insurance, you will want to call your agent and find out how much tail insurance costs. Tail insurance covers you in the event that you are sued in the future for a claim that happened during the time frame that you were practicing.

EXAMPLE:

If you want to retire at 65 and the retirement lifestyle that you envision would cost you $100,000 per year, you will need 25-30 times that amount invested, or $3,000,000. If you have investments assets outside of your business, (not including your primary residence) you would deduct the value of those assets from the amount.

For the sake of the example, we will assume you have $700,000 which means that after the sale of your business you would need to net $2,300,000.

Many small business owners stop their calculations here. However, to end up with the $3,000,000 invested, you would actually need to sell your business for around $3,570,000, not $2,300,000.

Example of Frictional Costs assuming 20% Capital Gains

Sale Price –$ 3,570,000.00

Intermediary Fee Varied – $1M to $262,800.00

Legal – 2% = $71,400.00

Employee – 10% = $357,000.00

Total Frictional Cost Before Tax – $691,200.00

Subtotal – $2,878,800.00

Capital Gains Tax – 20% = $575,760.00

Net Sales Proceeds – $ 2,303,040.00

When you are contemplating your future, it’s important to properly plan and to plan way before you are considering exiting your business. Having an exit strategy does not mean that you have to sell your business immediately.

It means your business has great financial records, is positioned for, and has a plan for growth, is staffed appropriately so that you could leave your business for 30 days or more, and that you have confidence that the business would run smoothly in your absence, if not grow.

It means that you have plans in place for replacing employees if they leave and that you are not overly reliant on a single customer or supplier. Your cashflow is excellent and you have a well-positioned product or services that help you stand out from the crowd. This kind of business is not only ready to be sold when the time is right, but it is a pleasure to own.

If you take some time to figure out your number early you can take definitive steps to maximize the value of your business over time and when the market valuation and your personal valuation coincide, it may be the right time to consider an exit.

The Liberty Group of Nevada is well-aware of the laborious and often challenging process of selling a business and is equipped to assist owners in navigating through each step of the transaction.  We provide high-quality service and guidance through the entire process to make the selling of your business as simple, profitable, and painless as possible. If you have any questions or would like more information, please contact us today, www.thelibertygroupofnevada.com/contact-us/.







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