In his groundbreaking book The 7 Habits of Highly Effective People, Dr. Steven R. Covey encourages readers to “begin with the end in mind.” If you’re the owner of a closely held business, you’d do well to keep this advice in mind as you think about exiting your business.
Unfortunately, many owners give little thought to their exit plan. Or if they do think about it, they wait until it’s too late to execute a plan that helps them realize their post-business objectives—whether this is retirement or starting a new business venture.
Think About Your “Business End”
Ideally, you should start thinking about your exit plan as soon as you start your business. In other words, you should begin your business with the end—or your eventual exit—in mind.
One effective but often overlooked tool that can be part of your exit planning strategy is the use of nonqualified retirement plans. These include deferred compensation, executive bonus, cross-tested, cash balance, and split-dollar life insurance plans.
Nonqualified plans fall outside of ERISA guidelines, so they are exempt from the nondiscrimination and top-heavy testing rules that qualified plans like 401(k)s must follow. Businesses use these to maximize benefits for owners, key executives, and other highly compensated employees.
Employee Retention … and Acquisition Funding
Incorporating nonqualified plans into your exit strategy can accomplish two key objectives:
1. It can help retain key employees for the long term. This is critical in boosting the value of the business over time—because buyers will pay more for a company with long-term, experienced managers and executives than they will for one without them.
For this reason, nonqualified plans are sometimes referred to as “golden handcuffs.” They are structured in such a way that key employees are incented financially to remain with the business until (and preferably after) it is sold.
2. It can help fund the business acquisition if you eventually sell your business to key employees via a management buyout (MBO). Funding is often the biggest challenge that keeps otherwise qualified managers and executives from being able to acquire the company they work for and keep the owner’s legacy alive.
For example, suppose you want to sell your business to a group of executives for $5 million. A nonqualified plan could provide 30 percent of the price (or $1.65 million) that can be used as a down payment for the purchase, with the remainder financed by the bank or yourself.
A wide variety of funding mechanisms can be used to fund a nonqualified plan, including permanent life insurance. Importantly, the plan doesn’t have to be funded until the payments are due to the executives, which provides you with additional financial flexibility.
Don’t Forget Qualified Plans
In addition to incorporating nonqualified plans into your exit strategy, you should also take maximum advantage of qualified retirement plans like a 401(k) or a Simplified Employee Pension plan (SEP). This way, you won’t be totally dependent on the sale of your business to meet your retirement income needs in case you can’t sell your business for some reason when you want to.
In 2018, you can contribute up to $18,500 to a 401(k) if you’re under the age of 50 or $24,500 if you’re 50 years of age or over. The contribution limit for SEPs is much higher: This year, you can contribute up to $55,000 or 25 percent of your compensation (whichever is less) to a SEP.
Start Planning Now
If you haven’t yet planned for your business exit, now is the time to get started. As you do, think about the role that both qualified and nonqualified plans can play in helping you realize your exit planning goals.