BUSINESS OWNER EXIT PLANNING
When business owners start to think about exiting their companies, the number of possible Exit Paths can seem limitless. There are only eight:
- Transfer the company to a family member(s)
- Sell the business to one or more key employees
- Sell to employees using an employee stock ownership plan (ESOP)
- Sell to one or more co-owners
- Sell to an outside third party
- Engage in an initial public offering (IPO)
- Retain ownership but become a passive owner
Which of these Exit Paths do owners intend to use?
- 59% of owners anticipate a third-party sale
- 30% anticipate a transfer to the next generation
- 31% anticipate a management buyout
- 6% expect to sell to an ESOP
This scenario examines the advantages and disadvantages of each Exit Path and describes a process that enables owners to choose the best Exit Path for them. Let’s begin with a fictional-company case study.
Ben (55), Tom (45), and Larry (35) purchased Front Range Powder Coating from its former owner. They paid book value of about $1 million. Now, seven years later, they are at a crossroads: Ben is interested in reducing his role in the company and has approached Tom and Larry about Purchasing his one-third interest. However, there’s a kicker. Ben is not interested in selling his
interest on the same basis as he acquired it (book value.) Instead, he wants one-third of the company’s fair market value. Since the company had increased its book value to $2.5 million and its annual cash flow from $200,000 to more than $2 million, Tom and Larry faced a major cash crisis and wondered whether they should proceed with the buyout.
As these owners discussed their Objectives, it became clear to them, as it does to all owners, that business-succession planning had little to do with the characteristics of the business and everything to do with each owner’s personal Exit Objectives.
- Ben wants to exit immediately for fair market value.
- Tom wants to continue to work for a number of years but isn’t too keen on dedicating the company’s entire cash flow to the purchase of Ben’s stock. Tom believes that it is a risky proposition to use cash flow to pay off Ben rather than to fuel future growth. Further, Tom figures that, at just about the time Ben is paid off, it will be his turn to retire (at an even greater value, he hopes).
- Larry, the youngest, shares Tom’s cash flow concerns but is sensitive to the desires of several non-owner managers—the next generation of ownership. Several key employees are quietly but insistently clamoring for ownership or similar ownership-based incentives. Larry wants to remain active in the company as its principal owner for the next 15 to 20 years and knows he can’t indefinitely defer meaningful incentives to the key-employee group.
How to Choose an Exit Path
How can the owners of Front Range Powder Coating choose an Exit Path when they each have very different Exit Objectives? When they finally met with their advisors to determine the best Exit Path for Ben, their first question was “How do we agree on an exit strategy that is fair to all of us?”
The answer their advisors gave them is one that applies to all owners and is comprised of six key steps:
Step 1: Start thinking about your exit before you are ready to exit.
Owners who give themselves time to plan give themselves the greatest number of Exit Path options.
Step 2: Owners should each put their Objectives and the resources available to reach each Objective in writing.
Objectives may include when they want to leave and how much money they will need. Resources include business value, non-business income, and business cash flow. This exercise helps owners evaluate how well each Exit Path matches their Objectives and resources. It also facilitates frank
discussions based on realistic possibilities (rather than conjecture or wishful thinking.)
Step 3: Each owner sets his or her own Objectives related to the desired date of departure, amount of cash desired upon departure, and desired successor.
Step 4: Owners should retain a professional to determine a company’s fair market value in order to place all owners on the same Objective page.
Valuation results often eliminate potential Exit Paths. For example, if the value of a company
is high but the owner is not willing to devote the time necessary to orchestrate a transfer to
employees, a sale to a deep-pocketed third party is a better option for that owner.
Step 5: Owners must perform cash flow projections to determine whether there is sufficient cash available to even consider an insider purchase (in this case, a purchase of Ben’s stock).
Step 6: Owners must evaluate the tax consequences of each Exit Path.
Keep in mind that while this analysis takes place, owners must continue to increase the value of their companies. Additionally, they will likely need to revise their existing buy-sell agreements to reflect the true value of their companies.