The step by step guide to succession planning
They say there are only two things certain in life: death and taxes. For business owners, we can add a third – that one day you will no longer be part of your business. The terms under which you retire, sell or transition your share to a new partner ultimately depends on the succession plan you put in place now.
A succession plan is a blueprint for your eventual exit from the business, but it also helps you realise the value you’ve created. Like many professional service consultants, engineers, architects and consulting surveyors are often too busy running the day to day business activities to think about that possibility in the future – and some don’t realise just how much value their knowledge has created.
“A significant number of participants within the built environment are private firms, and their chief asset is their intellectual capital. This is true for all participants regardless of size, with a significant number of firms most likely representing some saleable value,” explains Danny Chung, National Head of the Built Environment with Macquarie Business Banking.
“At some point, the owner will need to cash out of the business, or transfer some equity to junior staff as part of their retention model. This process can take time, so it's important to start planning well in advance.”
The current market for acquisition
Whether you are planning to transfer ownership internally or sell to an external buyer, your business valuation will be tied up in future earning capacity – so current and future economic challenges need to be considered.
“The appetite for acquisition depends on a firm’s capabilities and disciplines, and its geographic location,” explains Chung. “For example, NSW is in the middle of a significant spend in infrastructure right now. But Queensland has some challenges and the Western Australian market is declining as investment in resources infrastructure eases.”
The barriers to entry for consultancy firms are minimal capital outlay but strong for relationships and networks. So if a firm wants to establish a position in a new geographic market to access larger projects it may find it simpler to acquire a business or existing teams that are already on the ground and have established relationships.
“For example, you may be servicing a client in NSW that is now building in Queensland. Sending a few people from your NSW office may not be practical Instead, you may poach a small team and fund their first few months,” explains Chung.
There are risks to this strategy, so the purchaser may want to lock those staff in for a set period of time and determine the impact of these new staff on the culture of the existing business.
What's next in Australia's construction markets?
Victoria’s strong residential construction cycle is now into its sixth year, and NSW has recently shot up. However, apartment construction is dominant and CBD oversupply is anticipated – which means not all approved projects will proceed. Interest rates and immigration will dictate the next property cycle.
As we transition from the mining boom, road and highways will take over from oil and mining infrastructure. In the quarter to March 2016, roads and highways contributed 43 per cent towards the value of work commencements – up 133 per cent on the previous year (source: Owners Advisory).
7 steps to realising more value in your business
An exit strategy can take many forms. It may be partial or full for the outgoing partner – you may choose to stay on in a different capacity or stage the transition, for example. It may involve simply appointing a replacement director. Or it may be part of your talent management strategy, giving high performers the opportunity to share in the business success and increase their sense of ownership in the firm’s future.
All these strategies need to start with the end goal in mind, according to Chung. He outlines the seven key stages.
1. The end result
“Think about your goals, and when you want to achieve them by,” advises Chung. These are often quite personal (such as funding your retirement, scaling back on hours or starting a new venture), but they also need to take taxation, legal and financial considerations into account.
This is also about the legacy you want to create through your business. How would you like to it run without you? “Be cognisant of these things, write them down and talk it through with your advisors.”
2. Identify your successor
Your successor may be an internal appointment, or they could be an external party. If looking at an external party, you need to make sure they are the right cultural fit for your business.
- Do they share your vision for the business?
- Can they bring something else to the firm – new clients, a new approach to management systems, innovative service models?
- Will they align with your businesses behaviours and values? If not, they may cause disruption or discomfort for staff and clients.
Being seen as a successor can be a powerful motivator for your most talented staff. It’s important to note that talented staff aren’t always the staff who are the most significant revenue generators. While this is often the case, just because they’re your biggest fee earner, they may not be the right person to take the helm. Look for leadership qualities such as their ability to motivate and coach others, take new ideas or opinions on board, and commitment and resilience when times are tough.
“Start grooming them to think like a business owner, and begin transitioning some client relationships across,” suggests Chung. It’s also important to educate them about the responsibilities and obligations that come with ownership – this is not a decision to take lightly.
“For professional service industries, the most common valuation methodology is a multiple of Future Maintainable Earnings (FME),” explains Chung. “By using this process we are working towards obtaining an estimation of what we reasonably expect revenues will be over the longer term, and determine a reasonable level of EBITD (earnings before interest, tax and depreciation) as part of this process.”
A multiple is then applied to determine the business valuation– this multiple will depend on a number of variable (qualitative) factors such as how the diversity and consistency of income, profit margins and client base, to name a few.
So it’s important to build sustainable value in your business before you get ready to walk out the door.
“If you’re the sole ‘rainmaker’ and you want to exit, the business will have limited value to an external buyer,” says Chung. “Most valuation models are based on multiples of future maintainable earnings so you need to get all staff billing, not just you.” There needs to be goodwill at a firm level, rather than a personal level.
To mitigate the risk of an unexpected tax bill, that early conversation with your accountant will be vital. They can make sure you have the right structures in place personally.
5. Get sale ready
You can expect a lot of questions during the due diligence process, so be prepared to be completely transparent with financial reporting. At this stage, it’s also important to consult a legal adviser to get a new shareholders or partnership agreement, and advice on the most appropriate structures. “You need robust documentation to deal with different scenarios,” advises Chung. “That includes insurance to protect the other shareholders in case one becomes ill.”
6. Your future role
Selling your business, or even selling down your shares, doesn't always mean an immediate exit. You may want to transition out and still receive equity dividends or salary based on business performance, in exchange for consultancy services.
“You may still want to add value after you retire,” acknowledges Chung. “Be honest with staff about your plans – do you want to work part-time as a consultant or with a specific client?”
7. Invest the proceeds
You’ve worked hard to realise this value on your business – so get financial advice to make the most of your outcome. As well as talking with your accountant to check any personal tax implications of the sale, discuss your personal financial goals with your wealth adviser to ensure you protect your capital for your future.
Funding in new partners
Chung says ‘vendor financing’ – where the business itself is the vendor – is a traditionally popular method for bringing in younger partners. This can be an imperfect solution as there is no appropriate reward for the vendor and there are various potential tax implications to consider.
For example, an engineering firm has four principals with equal shareholdings and they want to introduce two new shareholders with 10% equity each. However, the two younger staff members have limited personal assets outside their family home, so the principals discuss alternative funding models with their Macquarie Business Banking Relationship Manager.
To purchase their 10% equity, Macquarie Bank could potentially leverage the cash flow of the business to fund in the new shareholders.
“The borrowers take on the debt in any entity advised by them or their accountant, and repay it at an agreed rate, but it’s secured by business and personal guarantees rather than their homes.” Typically in these instances, agreed repayments may be structured to ensure that free cash flow is used to reduce the debt. This process can be structured so that free cash flow can be used to pay of any non-deductable debt in the first instance.
The ingredients of a business valuation
As you can see, there is a quantitative (EBITD) and qualitative (multiple) element to your business valuation – and you can impact both through your business growth strategy.
“EBITD comes down to managing revenue and expenses,” explains Chung. “But the multiple applied depends on a number of factors, including the nature of your revenue (and who brings it in), your customers, the quality of earnings, evidence of sales, competitors and barriers to entry, and your staff.”
Macroeconomic factors in your market also play a part and, interestingly, so does whether you’re selling the business or share internally or externally.
“The business is essentially worth the same, but we typically see a ‘discount’ for an internal buyer compared with what the market is prepared to pay,” explains Chung. This is because vendors may be choosing to sell at a discount to staff who have been instrumental in the business journey, or have more flexibility in how the manage the process.
Ultimately, that decision comes back to your succession plan. What are your goals, and when do you want to achieve them? Then, once your business is sale ready, you can put your plan into action.