No. 7: Revisiting Lesson Nos. 9 & 32 – How Shareholder Value Works For You

One of the keys to understanding and appreciating the power of succession planning lies in the concept of “shareholder value”, or “member value” for those with an LLC. As you may recall from reading my new book, Building With the End in Mind, we apply corporate attributes making the explanation process clearer and simpler. If there is any material difference between the corporate terms (shares, shareholders, directors, etc.) and the LLC terms (units, members, managers), I will point it out. This approach means I only have to explain things once and you don’t have to sort through multiple explanations for your preferred entity structure.  

Let’s start with basics. Sole proprietorships with one owner and no entity structure do not have shareholder value. Shareholder value is a lynchpin in the building of an equity-centric organization that supports the ownership and investment in a business. This concept involves separating your business’s cash flow stream into its basic components such general overhead, wages, profits, and equity value, creating balance and helping to guide the owners and investors. But there is more to it than that – much more. These different cash flow streams, after overhead is paid, offer lower tax rates and the ability to implement strategic tax planning as part of the succession process – providing owners with some important choices and benefits. The basic formula from a G1’s point of view is this: 

Wages + Profit Distributions + Equity Income + interest income + Stock Appreciation

Why does it matter? One of the underlying tenets of a succession plan is that G1, or the founding owners, sell their equity incrementally. This means that, while the founding owner(s) doesn’t receive a single, large, lump sum check up front (as in the case of selling the entire business), he/she does enjoy the benefits of a long term, tax efficient cash flow stream while often remaining in control of the business. In addition, as G1 sells his/her equity, it is expected that they will also gradually reduce their hours worked in that business. Think about it – that is a powerful and lucrative combination of benefits over time, but it requires patience to be sure. And while patience might be a virtue, there has to be a real, ascertainable benefit to most founders to wait and see.  The sum total of the tax efficient cash flow stream over 10, 15, even 20 years has to surpass that of the lump sum from an exit plan, or a single, complete sale to an outside buyer. In a strong, growing business, it will – or the succession plan may never happen.

Accordingly, one of the most challenging questions a G1 who is considering both a succession plan and an exit plan is this: “What is the specific value of my business through each route? Just tell me.” Starting with the easy answer, an exit plan that is sold to an outside buyer (or perhaps a key employee) is the price exchanged between buyer and seller; the appraiser and the buyer’s bank, if involved, will also have an opinion. The point is, there is an ascertainable, stated value that can be expressed and supported before the transaction occurs. It is a formal, business appraisal and the report can be developed and handed to the owner to consider.

The value of the cash flow to G1 through a succession plan, however, is much harder to calculate because growth and profitability over time (usually at least ten years), along with wages and perhaps interest rates in the future, even competition, health issues of the owner(s), will alter the final answer, likely significantly. Regardless, this is why, throughout the book, I counsel you to do the math. A ten-year, conservative pro forma spreadsheet provides the answer, but it is not nearly as black and white as a business appraisal. In this financial analysis, the answer lies in viewing the results through the lens of shareholder value. Literally, G1’s benefits are tracked annually over the course of the plan, even as equity is gradually sold, as the business continues to grow and evolve, and those benefits are derived from the formula expressed above. Add it all up, year by year, for the duration of the Plan, and that is the answer to the succession planning value. Compare that to the appraisal value of an exit plan and you’ll have an interesting decision to make.

In my experience, the answer to the valuation question between a succession plan and an exit plan (certainly taking into account the present value of money), isn’t all that close, depending, of course on future growth and profitability. But adding in the tax efficiencies (see Lesson No. 38 in the black book) and the joys of mentoring a younger team and seeing them succeed, and gradually having few responsibilities and hours to work, and choosing your own retirement date, also adds a lot of value to the equation in my opinion. As I mentioned in my book, nine of out ten of the professional service providers we talk to in the financial services space choose the succession planning route after gaining an understanding of the process and doing the math.

So, what’s in this for G2/G3? Shareholder value works hand-in-hand with the three-basket cash flow system (see Lesson No. 7). From a next generation perspective, the shareholder value concept is this:

Wages  +  Profit Distributions  –  Debt Service  +  Stock Appreciation

This formula expresses not only the incoming cash flow and tax efficiencies to a next gen investor/buyer, it addresses the question, “Where does the money come from to service the buy-in debt?” It comes from the isolated profit distributions of a growing business, often at reduced tax rates. Effectively, harkening back to the industrial gearing on this website and the book covers, next gen owners harness the cash flow machinery of the very business they’re investing in to service the debt. These are essential attributes to the process because buyers who pay for equity on an after-tax basis, out of their future profit distributions, need time, growth and cash flow efficiency to succeed. Of course, the G2s will bear more and more responsibility for the growth and cash flow efficiency as the Plan matures, as they should. Shareholder value works for each generation.

Thanks for reading,

David Sr.