Options for Transitioning a Business: Exit Planning

Time to Read: 6 Minutes

Regardless of where they are in the business lifecycle, owners of a successful business should be considering their options for a future transition or sale.  Being proactive in this process will ensure that all options are available to an owner when they decide the time is right.

Should I Transition the Business? – Start With Your Goals

Before reviewing the various transfer strategies and options, an owner should define their goals, both for the future of the business and for life after transition.

Business owners who have built the enterprise over decades often feel a strong allegiance to the employees and will want the business to continue.  And they may be willing to stick around during transition to ensure that occurs.  Other owners may be ready to leverage that success to move to the next chapter in life.

Owners whose legacy concerns for the business are the driver of the decision to sell should decide what level of continued involvement is acceptable and what amount of business risk they are willing to retain.

For an owner ready to move on, they need to consider how to monetize the value she has built.  What payout structure is acceptable to meet the cashflow and investment needs of her family?  In addition, what wealth planning is appropriate to secure their family’s future?

Stratos Private Wealth can be very helpful in working through these considerations.  As a firm, we work with our clients to help them map out their wealth plan to (i) understand the short-term cash flow and tax implications of these transitions, and (ii) develop investment and planning strategies to protect and grow their wealth for themselves and their families, often for generations.

What is this Business Worth? – Market Value Considerations

Regardless of the path the business owner is on, it will be necessary to develop a valuation range for the business.  This will be a critical component of any transfer strategy.

Every business valuation approach begins with an analysis of what the business owns and what revenue it generates.

What the business owns is a relatively simple evaluation of the capital assets, real estate, inventory, etc., offset by any liabilities.  This value would set a floor to any appraisal because it essentially defines what the owner would get if she sold the business for parts.

Of course, a business is often (but not always) worth far more than the sum of its parts.  There is value associated with things like an on-going customer base and a reputation for effectiveness and quality of work done by the business.  This is typically referred to as “goodwill,” and it can be difficult to value.

But examining the cash-flow can serve as a proxy.  By analyzing the revenue stream, the goodwill is naturally folded into the appraisal process by looking at the historical ability of the business to leverage its customer base and reputation to drive results and to grow earnings over time.

For most successful businesses, this revenue approach will have the greatest impact on value.  In fact, many appraisals at their core are simply a result of multiplying business revenue by a certain number referred to as a “multiple.”  That multiple could be as little as 3 or as high as 12 to 15 depending on the state of the industry and the overall market.

The valuation can be affected by the reliability of revenue and the likelihood of growth over time.  For instance, if a majority of the business comes from a single customer, this undiversified revenue stream could be considered less valuable.  Similarly, if earnings expansion began to plateau years ago, this may indicate a saturated market and limited growth potential going forward.  On the other hand, steadily increasing earnings over time could indicate that tremendous growth is available with some investment in business operations.

Finally, there is an analysis of comparable business sales in the recent past.  This is an evidence-based analysis of the value.  But it can be hyper-focused on industry trends and other factors unrelated to the business itself, such as interest rates and market volatility.

How Do I Transfer or Sell the Business? – Transition Options

With goals and a valuation range in mind, the owner can begin an informed analysis of business transfer options.

While there are several complexities and some possible overlap, all business transfer strategies fall within one of three categories: (1) Selling the business to some or all the employees, (2) transferring the business to the next generation or other family members, or (3) selling the business to an unrelated 3^rd party buyer.  And each has a significant impact on the company’s operations going forward.

Transfers to employees and/or family are typically collaborative with all parties working together to find an effective strategy that benefits everyone.  Sales to 3^rd party buyers, on the other hand, can involve significant amounts of due diligence and negotiating time.

Sale to Management and/or Employees

Owners who are more concerned with the ongoing health of the business rather than receiving an immediate, top-dollar purchase price often consider a management or employee sale.

These exit strategies rarely provide a full cash payout because the “buyers” do not have the liquidity to make the purchase.  They usually involve financing from a commercial bank and can be structured over years.

For a sale to certain key employees or the management team, the cash received up front is made up of whatever the individuals can provide along with a substantial loan taken out by the company itself.  Going forward, much of the profit the owner previously took out as a distribution is now devoted to paying off the bank loan.

The remaining purchase price is received in the form of a promissory note and perhaps a warrant agreement.  This note is usually secondary to the bank loan and paid off over a longer time horizon.

The owner does not really get to “walk away” in this structure.  Even if she chooses not to be involved in operations, the former owner is financially tied to the ongoing success of the company.  In fact, she might be a guarantor on that bank loan.

A company sale to all the employees, rather than to just management or key individuals, is done through an Employee Stock Ownership Plan, more commonly referred to by its acronym ESOP.  An ESOP is more administratively complex than the management buyout described above, but it is a surprisingly similar overall structure.

That additional administrative complexity comes with a big advantage.  In the right circumstances, the owner can receive the sales proceeds tax-free.  Further, if it is ultimately owned 100% by the ESOP, the company itself will not have to pay any income taxes.  That provides a lot of extra revenue to pay back loans and pay off promissory notes.

Transfer to Family

Owners who have involved their children or other family members in the business frequently consider transitioning the business to the next generation.  This transition can be through a gift, a sale, or some combination of both.

Making a gift of the business requires planning that is very different from a sales transaction.  Rather than worrying about capital gains and income taxes, the owner must address the estate tax implications of such a transfer.

The most effective tax strategies for transitioning to children or family can significantly reduce or even eliminate the gift and estate tax implications.  Like management or employee buyouts, they typically occur over years.

The non-tax decision points for family transfers focus on timing and control.  Equity in the business is often bifurcated from control.  This allows the owner to transition ownership in the form of non-voting shares or units over time without giving up the voting interest until she is ready to do so.

There are also significant decisions to be made about how the family members receive the business interests.  The business could be transferred to them outright, or it could be placed into a trust for a family member’s benefit.

Outright is the easiest.  But it also subjects the business to that family member’s creditors, and could allow it to become marital property, which is subject to divorce and will be includable in an estate and subject to tax upon death.

Transferring business interests into a trust on the other hand, will protect the business interests from those concerns.  It can also create a nice structure for transitioning ownership to future family members over time without any gift or estate tax concerns.

Third-Party Sale

Selling to an unrelated party is the most common plan for owners who hope to monetize the success of their business and to move on either immediately or over some predetermined timeframe.  There could be multiple suitable buyers and various possible sale structures.  The complexities arise in trying to work through these various options.

Finding a Buyer

The prospective buyers almost always fit into one of two categories: financial or strategic.

A financial buyer can be a private equity group, hedge fund or other team looking to make a financial investment in the company.  These buyers are looking for significant returns on their investment, usually by increasing profit.  This can be accomplished by scaling the business, growing revenue and/or reducing expenses.  Therefore, significant changes to operations are almost certain.

A strategic buyer believes that acquiring the business will improve their operations through integration or that their presence in the industry will allow their enterprise to scale in some way.  Depending on their goals, strategic buyers may be less disruptive to the ongoing “factory floor” operations.  But management structures, financial reporting and decision-making protocols are frequently upended.

Finding the right buyer can be difficult.  An owner may be aware of a few competitors or those groups who have reached out to inquire about buying the business.  But an investment banker or business broker can ensure that the opportunity is marketed appropriately, and they can identify a larger population of interested parties.

Creating the Diligence Package

Once the most appropriate two or three suitors are identified, the next phase is providing the necessary information for the prospective buyers to go through their due diligence.  This can be a difficult process if, as is so often the case with closely-held businesses, the accounting procedures, invoice management and expense reporting were developed organically as the organization grew.  Those will now need to be recast in more standardized way.  In many cases, owners may have been running significant expenses through the company and it will be necessary to explain those to ensure they are added-back when examining company profits.

Maybe the most impactful operational step a business owner can take in the years leading up to a sale is to update their accounting process to align with industry standards.

Operational Concerns

There are operational concerns during this process too.  It is important to keep the business operating and successful.  That may require keeping the sale process confidential.  But providing the necessary information will likely require help from a few key employees.  It will be important to think through who in the organization will need to be made aware.

Sale Structure and Taxes

Finally, the owner and the buyer will need to agree on the sale structure itself.  There are both tax and operational implications to any option.

From a tax perspective, the buyer may want to purchase the assets of the company which will allow for greater depreciation going forward.  The seller, on the other hand, may get a better tax result by selling the company itself (i.e., ownership shares rather than the underlying assets).  If the two parties can agree, they may qualify for tax elections that would provide the best of both worlds.  In any case, these tax implications must be carefully thought through.

Operationally, the owner must consider how involved she is willing to remain.  The buyer may offer an earn-out to the current owner for staying on board for maybe 18 months to ensure that clients aren’t lost, employees remain, etc.  But there are usually hurdles that must be met, and some of them may be out of her control.  If the seller does not want to be tied to the success or failure of the business going forward, increasing the percentage of the price paid in cash up front is critical.

Putting it all Together

The options for the sale or transfer of a business can seem broad and overwhelmingly complex.  But defining and understanding the fundamental goals of the owner can provide a clarity of purpose which will eliminate much of the confusion by highlighting and informing the few, truly important decisions to be made.

At Stratos Private Wealth, we specialize in helping business owners transform their companies and savings into the fuel for living the life they want. Want to learn how we can help?  Checkout Director of Wealth Management’s upcoming webinar on Planning for a Business Exit Event or book a call below to chat: