By Mike Mess, CFO, CEPA
As a business owner, you’ve likely spent decades building your company from the ground up. With so much hard work and dedication, it can be difficult to plan for a scenario in which you are no longer the one in charge. But this day will one day come for even the most dedicated business owners, and it’s crucial that it’s planned well in advance. The more time spent understanding your options, the more likely you will be able to make a decision that aligns with both your ideal retirement and the long-term success of your company (or make strategic changes if you are not on track to retire the way you’d prefer).
The first step in the exit planning process is to consider the person or entity to whom you would like to sell or transition your company. Many business owners are surprised to find out that there are numerous transition options available, including both internal and external strategies. It’s not as simple as closing your eyes and picking at random, though; each option should be carefully weighed against your business’s unique strengths. In this guide, we’ll explore the top 5 exit planning strategies so you can prepare well to make the best decision for you and your business.
An internal transfer typically involves selling the business to members of your management team, the employees of the business, or one or several of your family members. Let’s review the pros and cons of the top three internal transfer strategies.
Management Buyout (MBO)
A management buyout (MBO) occurs when members of the existing management team buy the assets and operations of a company. In general, MBOs are easy to set up and execute (as long as proper financing is in place), and they are one of the best options for maintaining confidentiality. This type of transfer is also more likely to have a high degree of success since the incoming owners already have in-depth knowledge about the company’s day-to-day operations.
Keep in mind that the current management team may find it difficult to finance the buyout, since they may not have enough personal wealth to purchase the company outright. You can utilize internal financing, through a seller’s note, or you can seek financing from a bank or private equity firm. In some cases, the management team may be able to pool their resources to purchase the business from the existing owner.
Aside from financing considerations, selling your business to the management team may come with other disadvantages. For instance, there is a transition that needs to occur from being a manager to owning a business, and your current team may struggle with this shift in mindset.
Additionally, conflicts of interest could arise since the current management team is incentivized to reduce the price of the business in the lead-up to the sale. They may deliberately sabotage the value of the company in order to get a bargain deal. The current owner must be cognizant of this potential pitfall so as to avoid an undervalued sale price.
Employee Buyout (ESOP)
Employee Stock Ownership Plans (ESOPs) can be an excellent option for business owners who have a strong sense of loyalty to their employees and want to provide them with a stable future going forward. An ESOP also has exceptional tax benefits for the ongoing business enterprise as well as for the owner who is selling. In many cases, an ESOP can provide the best overall economic value to a business owner due to the valuation methodology and tax benefits.
Although the name would imply that the employees are buying out the business owner, that is not actually the case. An ESOP functions as a retirement plan first, so the employer contributes pre-tax funds to each employee’s account, which is then used to purchase company stock according to a vesting schedule.
A business sale to an ESOP occurs when the ESOP trust uses future, pre-tax profits to purchase the remaining shares of the business. The purchase can be gradual, or the trust can borrow a lump sum from a bank, or utilize a seller’s note to buy all of the shares at once. With an ESOP, the selling owner can remain at the company in whatever capacity the parties agree upon.
ESOP sales provide major tax advantages to both the buyer and seller, and they have a high degree of leadership continuity. And since ESOPs are highly regulated, an ESOP buyout is required to purchase the business at full fair market value. This can be a great advantage for the owner, who knows exactly what he or she will receive from the sale. But it also means that the business cannot be sold for more than fair market value. Additionally, ESOPs involve ongoing maintenance and regulatory requirements to maintain ERISA compliance.
Sell to Your Children
Selling the business to your children is another internal transfer strategy. More than likely, they will not have the personal resources to purchase the business in full, so financing will be a major consideration for this strategy.
Most banks will not extend a business loan to individuals without a strong commercial credit history, in which case you will have to provide your own financing in the form of a seller’s note. As with many of the other strategies discussed above, there should be ample trust between buyer and seller for this option to work out in the favor of both parties. In selling to your children, there is likely a strong sense of trust and loyalty already present, but there may be a lack of experience and/or conflicts of interest with other employees. It’s not uncommon for non-family employees to feel overlooked, or slighted if your children jump into the ownership role without truly paying their dues.
In this case, consider having your children work for the business for several years before transitioning the business over to them. Maybe they can start from the bottom and work their way up the ladder as other non-family members have done. The more experience they have in your company, the better.
You can also utilize a partial-sale strategy to allow you to transition slowly out of the business as your successors learn the ropes. You can continue to offer guidance and perspective as you gradually relinquish control.
External transfers involve selling your business to an independent third party, such as a competitor, a client or customer, or an interested investor. See two different options for external sales below.
Sell to a Private Equity Firm
A private equity firm invests capital in companies which they feel have the potential to make large returns for the firm’s shareholders. A private equity sale will typically involve selling a majority stake in your business (upwards of 80%) to a private equity firm. Generally, the exiting owner will be required to stay on for a period of three to five years as the private equity firm works to increase the value of the business. Once this period is up, most private equity firms will resell the business at a profit and provide hefty returns for shareholders.
This type of sale isn’t right for every owner, but it can be suitable for mid-size to larger businesses (usually businesses with a minimum of $1 million in annual profitability) and with huge growth potential. Owners who sell to a private equity firm stand to benefit from a second payday when the firm resells the business, but must be willing to work for someone else for a few years before fully exiting.
Sell to a Strategic Buyer
Also known as a merger or acquisition, a strategic buyer sale occurs when the business is acquired by or merges with another company that has similar goals, strategies, and processes. With this strategy, the buyer may be an existing competitor or another type of business wishing to expand their offerings into your specific niche or industry.
A merger or acquisition by a competitor can sometimes offer business owners a clean break if they don’t wish to stay on after the sale or merger of the businesses. This strategy also allows greater flexibility for the owner to negotiate the sale price, potentially resulting in a higher payout.
However, this type of transition typically means that a business owner who is selling their business has little to no say in the future of the business or even whether it continues to exist after the sale. Many employees of the sold business may lose their jobs as the buyer seeks to maximize returns on the investment made.
Do You Have an Exit Plan for Your Business?
If you are a successful business owner without an exit plan in place, it may be time to start thinking about your options. There are many different paths available, and they won’t all make sense for your particular needs. At Veracity Capital, we can help you make the best choice for both your retirement and the long-term success of your business. Don’t wait to start planning—call us at (949) 345-1954 or email us at email@example.com to get started today. We look forward to hearing from you soon!
As a Founding Partner of Veracity Capital, Mike Mess set out on this endeavor to create a profoundly personal boutique for his clients with deep institutional execution. Mike serves as Chief Financial Officer and Wealth Advisor. As CFO, Mike is responsible for the company’s financial function and helping guide the direction of the firm. As Wealth Advisor, he helps his clients achieve their personal and professional goals through the lens of wealth management and financial planning.
For more than 15 years, Mike has developed exceptional wealth management skills for business owners. He believes this process of best managing the family wealth starts long before any transaction event. Clients engage Mike to help maximize the value of their business early, best capture that value through the transition of the business, and then manage the wealth created following the transaction. As a business owner himself, he is acutely aware of these stages where he adds value before and after every transaction.
Prior to founding Veracity Capital, Mike invested over a decade of his time with AYCO, a Goldman Sachs Company. During this time, he built out a division responsible for meeting the needs of its institutional and private clients, which included C-level executives and entrepreneurs.
Mike earned his Bachelor of Science from California State University, Northridge, and his MBA (Hons.) from Chapman University. He also holds the CEPA (Certified Exit Planning Advisor) designation. Mike is a member of GoBundance, the high-level mastermind group for successful entrepreneurs. He is also active with Vistage Worldwide, a global CEO peer group.
Advisory services offered through Veracity Capital, LLC, a registered investment advisor. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial advisor and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.