Exit Planning for Small and Mid-Sized Businesses

Matthew J. Lapointe, Esq., Business & Corporate Law; Health Care Law

Melanie Luten - Attorney

Melanie Luten, Esq.
Business & Corporate; Real Estate Law

Many business owners have only a vague idea of how they will exit from their current businesses. They have a general notion that when the time is right they will sell their business and retire or that their children will take over the business someday. Many business owners don’t realize that they need to plan their exit strategy well in advance.

A good exit plan requires a comprehensive approach, including estate planning, entity planning (that is, appropriate formation documents and restrictions on the transfer of ownership interests in the entity), tax planning, and insurance planning. Early planning is essential for a number of reasons.  A business may not have good vendor and customer agreements or good documentation and protection of intellectual property.  The business might not have enforceable non-competition agreements with key employees.  All of these agreements build value and a buyer will look elsewhere if they are not in place.  Early planning is essential not only to assure that you get the best value for your business, but also because planning and executing an exit from a business takes a remarkable amount of time. From initially deciding to explore exiting to finalizing the transition, the process can take from three to five years or more. Having a realistic timeline when you begin the process will help keep stress low and goals feasible.

Before we get started, let’s define some of the terminology used in this article.  The words “exit planning” or “exit strategy” refer to the business owner’s departure from the business and the process of converting his or her investment in the business into cash.  The words “succession planning” or a “succession plan” refers to the steps that a business owner puts in place to ensure the continuation of the business after he or she leaves.  Thus, a good succession plan is important to a successful exit strategy, especially if the business owner self-finances part of the new owner’s acquisition.

There are several ways for a business owner to exit his or her business: internal succession and sale, external succession by sale or merger, or liquidation and dissolution. This article will provide a brief overview of these options and will conclude with a list of issues to consider when planning your exit and a checklist of steps a business owner should take to start the exit planning process.

Internal Succession (Stock Sale or Asset Sale)

An internal succession is often a business owner’s first choice, particularly if the business is family-owned and operated. An “internal” succession refers to a transfer of ownership to a person or group of people who are already involved in the business – either family members or long-term employees.  This process allows the business to continue to provide employment to the people the owner knows and cares about. With an internal succession, however, the owner needs to view potential successors with a dispassionate eye and must examine carefully how such a transfer would work financially. Employees and second generation family members often lack the financial means to pay cash for the business and they may look to the business itself to finance the purchase. The owner should also be mindful of internal dynamics among business personnel, which can lead to disgruntled employees who feel excluded from the process. Before putting in place agreements for an internal succession, it is important for the business owner to “road test” the prospective successors by providing them with increased responsibilities and closely evaluating their performance. It is in no one’s interest for the business to fail after the transfer, especially if the business owner is being paid out over time.

The transfer of ownership can be accomplished through a stock sale or an asset sale, although a stock sale is more common with an internal succession.  When a family business is involved, the lawyer for the business will work closely with the owner’s estate planning attorney to minimize exposure to the estate tax.  When the successors are the children of the owner, the owner may decide to use a combination of gifting and sale of ownership interests to the next generation.  When the estate tax is not an issue (in 2017, an individual can transfer $5.49 million without incurring estate taxes, while a married couple can transfer $10.98 million), sometimes the transfer is accomplished through an asset sale.  There are complicated tax issues at work here, and it is important to review various scenarios with a tax lawyer or an experienced CPA.

Internal Succession (ESOP)

Another internal succession strategy is an Employee Stock Ownership Plan or ESOP (pronounced “ee-sop”).  An ESOP is a kind of employee benefit plan, similar in some ways to a profit-sharing plan.  In a common ESOP exit plan, a company sets up a trust fund.  The trust borrows money, which it uses to buy the shares of the existing owners.  The company then makes tax-deductible contributions to the ESOP trust to repay the loan.  The ESOP trust allocates the shares to individual employee accounts. Allocations are made either on the basis of relative pay or some other formula permitted by the applicable federal rules. As employees accumulate seniority with the company, they acquire an increasing right to the shares in their account, a process known as vesting. Employees must be 100% vested within three to six years, depending on whether vesting is all at once (cliff vesting) or gradual.  When employees leave the company, they receive their stock, which the company must buy back from them at its fair market value (unless there is a public market for the shares). Private companies must have an annual outside valuation to determine the price of their shares.

An ESOP is a very complex arrangement that can be costly to establish and manage.  It is important to seek the advice of qualified advisors early in the process to determine if it makes sense to pursue this strategy.  The legal, accounting a valuation expenses involved in setting up an ESOP are substantial — between $50,000 to $100,000 depending on the size of the business and complexity of the legal, tax, accounting and valuation issues.  While an ESOP is not appropriate for many businesses, it can be an excellent exit strategy for the right business.

External Succession (Merger)

Sometimes, a business owner will look to merge his or her business with a complementary business with a proven management team to serve as the business owner’s successor. Such a situation can prove to be a great opportunity for the business owner planning his or her exit. In such a “cash-out merger,” the owner of the target firm is paid in cash for his or her stock.  Depending upon the size of the business, a business broker or an investment banker can be helpful in finding the right merger partner. Always consult with your attorney before entering into any arrangement with a business broker or investment banker and have your attorney review the contract before you sign it.

An external succession through merger takes time and requires a back-up plan if the right merger partner cannot be found. Here, especially, internal company dynamics can undermine the success of the plan and should be considered carefully. It is also important to consider whether the business cultures of the entities are compatible.

External Succession (Stock Sale or Asset Sale)

The sale of a business may be accomplished as a sale of the ownership of the business (stock sale) or the sale of the business assets (including the name, customer lists and other important attributes of an ongoing business). There are tax considerations and liability considerations that cause sellers to favor stock sales and buyers to favor asset purchases. For example, asset sales can be structured to allow buyers to acquire the business without pre-acquisition liabilities and to allocate part of the purchase price to certain assets, giving them a stepped up tax basis and enabling the buyer to take higher depreciation deductions. Allocation of the purchase price for tax purposes is an important part of the negotiation, because what benefits the buyer may harm the seller.  It is important to consult a good CPA early in the process.

When selling the business is the exit strategy, the succession plan will sometimes include the former owner staying on as an employee for a period of time, which many former owners find difficult. In addition, the buyer will almost always impose some kind of non-competition agreement, so business owners considering a sale need to be sure they are ready to retire or are willing to leave their industry – at least for a period of time.  A business broker or investment banker can help the business owner find a suitable buyer.  As noted above, it is important to consult your lawyer before signing any agreement with a broker or investment banker.

Closing the Business (Liquidation/Dissolution)

Many small business owners simply close their business when they are ready to retire. They sell off the assets, pay off the liabilities, collect the receivables and take the net proceeds.   The business can formally dissolve by filing articles of dissolution or it can be administratively dissolved if it fails to file its annual report with the Secretary of State’s office.  Liquidation is the least lucrative exit strategy because the seller gets no value for the goodwill built up in the business. However, it may be appropriate for those businesses that are typically valued based on accounts receivable at the time of sale.  Liquidation and dissolution may also be appropriate if the alternative is a stock sale or asset sale in which the buyer requires a significant indemnification obligation from the Seller.  In this context, “indemnification” means that the seller retains responsibility for liabilities associated with the business even after it is sold.

Business owners can and should evaluate the liquidation value of their assets (including accounts receivable) and compare that to the potential value achievable in the sale of an ongoing business (with the “goodwill” in the business name and reputation). If the values are close, or there is no ready market for your business, your best exit strategy may be liquidation.

Liquidation and dissolution are not risk-free, however. In particular, Florida law states that participating shareholders can be held personally liable for claims against the business if they receive “improper” distributions in liquidation. Improper distributions in liquidation are distributions made without adequate provision for existing and reasonably foreseeable debts, liabilities, and obligations of the company. Accordingly, careful planning is required even with the liquidation/dissolution option.

Issues to Consider When Planning Your Exit

What are your goals and what is your timeline? Business owners should begin identifying and prioritizing goals in connection with their exit strategy as early as possible. Important questions to consider include:   What are your anticipated financial needs upon leaving your business? What is the actual amount (after taxes and costs) that you expect to realize? Is that enough for you? Is it important to you that the business continues in existence? In what form should it continue? Do you want or are you open to continued involvement in the business? What do you want to see happen in connection with your employees, including family members? In connection with your customers? In connection with your community?

What is your business really worth? It is a good idea to get a realistic view of what ongoing businesses sell for in your industry sector so you can better evaluate your financial expectations.   If you understand what factors are important to achieve value in your industry you can work to improve the value your business ultimately will achieve. However, valuing closely-held businesses is difficult because the fair market value is not readily apparent.   Unlike publicly traded companies there is no active market for the ownership interests of privately-held businesses. A formal valuation by a business appraiser can be expensive and impractical for many small businesses, but business appraisers will often provide a less formal “calculation report” at a lower cost.

There are many ways to value a business. Typically business appraisers consider relative valuation (comparing your company to companies with similar operating characteristics) or a discounted cash flow analysis (based on the present value of the future stream of free cash flow). Often the valuation calculation is based on multiples or ratios considering important financial metrics like revenues, earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation, and amortization (EBITDA), and net income. It is helpful for owners to evaluate these metrics to try to “ballpark” the value of their entity, bearing in mind that a formal valuation may be necessary prior to sale.

How will you manage your ongoing business? It is a big mistake for a business owner contemplating his or her exit to lose focus on the current operations of the business or to prematurely release news of his or her exit planning. Both are likely to cause business deterioration.   If key employees feel insecure, they may leave. Customers concerned about a company’s long-term viability may withdraw their business or slow down bill payment. Vendors may change the terms of credit. All these issues can cause the value of the business to deteriorate.  Careful advance planning, such as securing restrictive covenants from key employees, vendor agreements that include multiple options exercisable by the seller and customer agreements that permit the transfer of the business can be very useful to have in place prior to seeking a potential buyer.

Business owners should develop information management strategies early in the succession planning process, identifying whether, when, and on what terms to let people know of the planning process. At some point, business owners may wish to provide employees with incentives to give them a vested interest in maintaining profitability and confidentiality, through phantom stock, performance-based bonuses or bonuses contingent upon the successful completion of a sale or merger. Information control is important. While employee confidentially agreements are helpful as a general deterrent, they are ultimately of limited assistance when a premature disclosure actually occurs. By that point, the damage may be difficult to address.

You weren’t considering selling, but you’ve been approached by a buyer, and the deal looks good. What should you do?  If you are being courted by a “consolidator” (a group, often backed by private equity, that purchases multiple companies in the same business or industry), keep in mind that these are skilled and experienced buyers.  You should assemble a team of advisors including a valuation expert, experienced lawyer and a CPA experienced in mergers and acquisitions.  Take care to protect your customer and employee information as long as possible and obtain a strong confidentiality agreement from the prospective buyer.  Do not sign anything, especially a letter of intent, before having it reviewed by your lawyer.

Conclusion

Getting an appreciation for possible successors and determining which method of succession is best for your company is critical to meeting exit strategy goals.  It is critical to have an experienced team to guide you through the process.  As odd as it may sound, succession planning should begin the moment one embarks on forming a business. However, very few entrepreneurs do that, even though proper planning and decision-making can help reduce ultimate tax liability, ensure achievement of maximal value for the business, and generally ease the transition out of ownership. A good succession plan is essential for a smooth and successful exit. Now is the time to start the planning process.

A Succession Planning Checklist                          

The sophistication and complexity of a business succession plan will depend upon the owners’ personal financial means and needs, the size and complexity of the business and the succession method (internal, external, merger, sale, or liquidation). Therefore, while not all of the items on the following checklist may apply to your particular situation, the checklist will provide you with a framework within which to think about your own succession plan.

  • Assemble a good team of advisors, including a business lawyer, estate planning lawyer, and CPA.
  • Current owners should review estate planning documents with their attorney. Consider whether a program of gifting stock to the next generation is advisable in light of the next generation’s involvement in the business and the value of the business.
  • When the time is right, communicate your wishes regarding the future of the business to the next generation, whether or not they are involved in the business.
  • Review the organizational documents of the business, including any Shareholders’ Agreement, Cross-Purchase Agreement or Stock Redemption Agreement to ensure that they comport with the succession plan.
  • Review vendor, customer and employment agreements.
  • Make sure that at least one other person in the business has authority to make necessary banking transactions in the event of the unavailability of the primary bank contact.
  • Consider the tax planning alternatives and methods of funding applicable taxes (estate taxes, income taxes, etc.).
  • Review Insurance Portfolio: disability insurance, life insurance (to provide working capital during transition or to fund purchase of deceased shareholder’s stock).
  • Review retirement plans: deferred compensation, 401(k), profit-sharing plans, annuities
  • Establish a policy for family members entering or working in the business. The policy should cover criteria for entry into the business (such as previous work experience or education requirements) and ongoing criteria which must be met to keep a job with the family business (such as satisfactory performance reviews). Different criteria may apply to employment by the family business vs. ownership of the family business.
  • Consider establishing a formal compensation system for higher-level employees (including family members). Such a system could include bonuses of cash or stock.
  • If considering an internal succession, establish a mentoring or training program for the middle managers to prepare them for ultimate management of the business.
  • Consider the ongoing role of existing owners as advisers or consultants during and after the transition (either paid or unpaid).

If you have questions about this article or would like to speak with corporate attorneys Matthew Lapointe and/or Melanie Luten about your business exit strategy, please call 941.748.0100 or email Matt at mlapointe@blalockwalters.com and Melanie at mluten@blalockwalters.com.