At some point, it will be time for a business owner to determine a company’s future without the owner’s involvement. There are eight common ways for business owners to leave their companies.
A business owner may…
- transfer the company to a family member,
- sell the business to one or more key employees,
- sell the business to one or more co-owners,
- sell to key employees using an Employee Stock Ownership Plan (ESOP),
- sell the business to an outside third party,
- engage in an Initial Public Offering (IPO),
- retain ownership but become a passive owner, or
Each of these options is presented in greater detail below. In order to determine the appropriate exit strategy for the business, the business owner should consider a number of factors including…
- the role the business owner would like to play in the company in the future,
- how much money the business owner will need when he or she leaves the business,
- the future potential of the company, and
- market conditions.
A business owner should start planning their exit strategy far in advance of their actual departure to better ensure a successful result since many aspects take years to prepare; a plan for a sale should begin at least 3-5 years in advance of the exit. To increase the value of the company before a sale, the business owner will want to work on increasing the company’s transparency, efficiency, and revenue while reducing the company’s risk of cost.
Sale to Friendly-Buyer
There are a number of overarching considerations that overly the sale of the business to a friendly-buyer such as a family member, key employee, or co-owner. In each of these sales, the business owner will usually finance the sale and then the buyer will pay the business owner off over time. The biggest advantage of a friendly-buyer sale is the business owner is able to sell the business to a known entity. The person is typically someone the business owner foresees as continuing to run the business as it had been run and keeping the company’s mission, culture, and community presence the same. Through a friendly-buyer sale, the owner can typically remain involved in the company if he or she wants to. Each of these sales, however, does have the disadvantage of a less objective sale. Consequently, the business owner may not receive full compensation for their interest in the company nor receive cash for the full purchase price at closing. With this, the business owner will retain exposure to financial risk and will likely need to remain involved in the company post-closing.
Option 1: Transfer the Company to a Family Member
Transferring a business to a family member may be the ideal exit strategy for many business owners. Many prefer this exit strategy because it allows them the ability to keep the business within the family and provide for the well-being of their family members. Additionally, the business owner’s tax liability may be limited by transferring the business interest during his or her lifetime as a gift. This strategy, however, may result in family conflict as some family members may simply not want to own the business, and if others do there may be issues of how to treat family members equally. Additionally, transferring the business to a family member may not provide the business owner with enough capital to leave the company and live comfortably. Therefore, the owner may want to sell the business outright to a family member. As long as the business is purchased for its fair market value there will be no gift or estate tax on the sale. This sale may take place at any time; however, if the business is sold before the business owner dies there may be capital gains tax. Careful planning can help the business owner evaluate whether a family transfer or sale will be in the company’s best interest. When making this determination the business owner will want to consider the family member’s age, desire to own the business, and skill set. The business owner will also want to consider the potential reaction of key non-family employees. If sibling rivalries are a potential issue, a carefully prepared plan should be created that describes ownership shares and decision making authority.
Option 2: Sell the Business to One or More Key Employees
Selling a business to one or more key employees is very similar to transferring the business to a family member. This exit strategy may be chosen by business owners because it may be seen as allowing the business owner to pay the employee back for their contribution to the company’s success or to provide the key employee a business opportunity that could lead to financial success like the business owner had. When a business is worth less than $2 million and there isn’t really a market to sell a business to a third party, selling the business to a key employee is a good alternative. Like a transfer to family members, however, key employees may not want or be able to assume the ownership role or have the capital to finance the transaction.
Option 3: Sell the Business to One or More Co-owners
Although selling a business to co-owners is similar to family transfer or sale to key-employee, this transaction may be governed by an ownership agreement. An ownership agreement may include certain restrictions on when and how the transfer may take place, who the business owner may transfer it to, and the transfer price. If there is an ownership agreement, the co-owners may have a right of first refusal to purchase the interest before it may be sold to an outside third party. In the sale to a co-owner, the co-owner is more than a known entity with the advantages discussed above, the co-owner is an individual that has already been involved in the ownership of the business. The business owner knows the buyer’s knowledge, skill set, and commitment to the company. A sale to a co-owner may be set up as a quick transaction or a gradual sale that takes place over several years. If there is a gradual transfer, the business owner may maintain a voting interest while obtaining an upside gain. With a co-owner sale, the business owner will know the buyer is committed to making the company successful.
Option 4: Sell to Key Employees Using an Employee Stock Ownership Plan (ESOP)
A qualified retirement plan that allows employees to be owners of the business, an ESOP is ideal for companies with high-value employees, low debt, and solid prospects. With an ESOP the business owner sells a trust to the employees. A company may either make tax-deductible deposits into the ESOP trust with the trust gradually purchasing the owner’s shares or the ESOP can borrow funds to buy all the shares through a bank loan to the company that is loaned to the ESOP. There are a number of advantages of an ESOP: this option will result in a very motivated workforce, allow the business owner to receive cash at closing, and flexibility regarding the speed of the sale and the owner’s involvement post-sale. An ESOP, however, may not provide the business owner as much cash as a sale, may tie the business owner’s assets up as collateral to secure the loan, and may not provide key employees enough benefit to stay with the company. Additionally, there are a lot of regulatory requirements to an ESOP and this option may be very expensive and complex to set up and maintain. In order for this option to work, the company must be making enough money that it is able to buy the owner out and there must be a plan for management continuity.
Sale to Outside Company or Individual
An exit strategy that involves selling to an outside party brings the advantage of outside capital to the business. If a business owner wants to bring a company to the next level when he or she exits without contributing any more of his or her own money, a sale to an outside third party would be a good exit strategy.
Option 5: Sell to an Outside Third Party
If a business owner’s main objective behind the exit strategy is obtaining capital, selling the business to an outside third party may be ideal. This form of sale will usually involve the sale of the business to a larger public company. By selling to an outside third party a business owner will likely get the highest purchase price, more cash at closing, and no additional investment or risk; however, it is important to note that smaller companies may need to accept a promissory note as opposed to a cash closing. This option provides the business owner with the ability to negotiate and show the potential third party buyer the company’s worth. To the right buyer, the value that the business owner may sell may far exceed the value based on income. Such buyer will be someone who will expand the company into a new market or wants to add a new product to their current company. Like the previous exit strategies discussed, there are disadvantages to selling the business to a third party. Selling to a third party typically does not line up with the business owner’s company objectives, as the company’s culture or mission may be lost and there may be a risk to employees’ jobs and career opportunities. Through this exit strategy, the business owner will be able to completely walk away from the business.
Option 6: Engage in Initial Public Offering (IPO)
Many business owners may see an IPO as the ultimate exit strategy, as an IPO can provide the business improved financial position, long-term capital, prestige, and public awareness. However, selling a company on the public market is very rare, complex, and may simply not be a viable option if the business does not have a high stock market valuation. A business owner may only start thinking about going public if the company’s debt capacity is exceeded by the funding required to meet the business’s growth. Selling a portion of the company in the public markets is a very expensive process, as very detailed reports of basically all aspects of the business will need to be created. These reports will include information on financials, staffing, marketing, operating, and management. Analysts and investors will look at these reports and the company’s quarterly performance to determine how much stock will be worth to investors. Instead of running the business, the business owner will need to prepare to spend a lot of time selling the company. As a public company, the business must comply with a number of regulations, such as the Sarbanes-Oxley requirements, which will require extensive record keeping. If a business decides to go the IPO route, the business owner can expect to lose control of the business without being able to exit the company, or cash out on any shares, until a predetermined future date.
Less Company Involvement
Option 7: Retain Ownership but Become a Passive Owner
A business owner who wants to be less active in a business but still be in control may choose to become a passive owner in the business. This option may appeal to business owners who want to make sure the business is set up for success without his or her involvement before committing to a more definite exit strategy. This option may also provide a good transition as the business owner prepares for another exit strategy, such as sale to family member or third party. By becoming a passive owner, a business owner can minimize the risk of income loss while maintaining the company’s mission and culture. However, with this option, the business owner does not actually leave the company, receives very little extra cash when leaving active employment status, and maintains all risks associated with business ownership. In order for this option to work, the business must be structured in such a way that the business owner may take on the passive ownership role without affecting the business’s profitability. The business must have very thorough documentation of all operation systems, compensation that retains key employees, and the business owner must have the ability to stay out of the business and not meddle in day-to-day operations and decisions.
Close the Business
Option 8: Liquidate
With liquidation, the business owner will close the company. Therefore, this option is typically only appropriate when an immediate exit is desired and there is no alternative exit strategy available. There are no negotiations involved in this process and no need to worry about the transfer of control of the business. Liquidation, however, provides minimal proceeds to the business owner, offers less cash than any other exit route discussed, and results in the most significant tax consequences. The business owner will often be required to allocate the most proportion of their proceeds to taxes than in any of the other exit strategy options. Additionally, liquidation will have a devastating effect on employees and customers. In the end, liquidation destroys everything the business has built up, including client lists, reputation, and relationships, and provides no opportunity to recover this value in any way; however, this exit strategy provides the business owner cash and a speedy end.
It is unlikely that there will be a perfect exit option, as there are advantages and disadvantages to each exit strategy. A good exit route can still ensue if the business owner carefully weighs his or her needs and what he or she wants for the business. As a result of the widespread impact that the business owner’s decision may have on the company and its employees, the business owner should start thinking about this process well in advance of an anticipated exit. Whether it is setting the company up to for a successful sale, making sure all processes are clearly documented for the business owner to take a back seat presence in the company, or preparing the required financial statements to go public, there are things that can be done well in advance of the business owner’s departure to ensure a successful transition.