Ever wonder what all of the blood, sweat and tears that you pour into your decorated-apparel company will translate into when you decide to retire or get out of the business? What will be your legacy? A mistake many business owners make is to concentrate too heavily on the day-to-day operations and ignore developing an exit strategy on the assumption that a son and/or daughter will want to “accept the torch and carry on.”
If exit planning remains unfinished or undecided, there are a host of potential problems that can arise with the transition from parent to children—including infighting among siblings as to how ownership and future roles are determined and finding out too late that the children lack the vision, leadership, competence and/or desire to run the business successfully. Heck, even Willy Wonka had the forethought to choose the heir apparent to his chocolate empire. He employed great care through a selection process that singled out only the most dedicated Wonka devotee—a little boy who also happened to be his most loyal customer. At the end of the story, he rides off into the sunset a happier entrepreneur.
For those of you who like to plan ahead—and for those who don’t but should—there are five basic exit alternatives to consider and “the owner’s children” is not necessarily the right answer to the succession-strategy question. You see, it’s not enough to grow a business worth a fortune if you don’t make sure there’s a plan to get the money back out. Let’s consider each option and then you can decide which is best for your particular situation. Fair enough? Here we go. . . .
Five paths to the exit
Small-business owners can choose from five fundamental alternatives for exiting the business—in case the kids are not interested or deemed incapable. Some of these clearly do not allow for the owner’s legacy to be realized, but they certainly do allow for the recapturing of the monetary worth of the enterprise. Each comes with definite pros and cons which will be revealed herein.
The five basic strategies—in no particular order—are:
- Bleed the company dry to liquidation
- Sell to a friendly buyer
- Bring in outside management
- Recapitalize to a private equity group, and
- Initiate a public offering (IPO).
Perhaps the best approach to selecting the most appropriate exit strategy is to rank the five alternatives from most desirable to least. No matter which exit option the owner decides to pursue, the best advice one can offer is to plan for that exit well in advance—three years minimum is the accepted rule of thumb. The best-case scenario should be determined by considering the owner’s goals, the size of the business, its legal entity and market position and the seller’s tax and estate implications. In every case, the smart business owner will seek the advice of a good tax professional, attorney, business valuation firm and a board of business advisors to help make these critical decisions. Skimping here could cost the owner(s) dearly.
Let it bleed
Let’s assume for a moment you are the owner and sole shareholder of the business. One interesting exit strategy is to simply bleed the company dry on a daily basis, then call it quits, close the doors and walk away. Sounds funny for someone who’s founded a business and worked hard to grow it to plan to liquidate it someday, but it happens all the time. By bleeding it dry, I don’t mean to run it with the financial statements dripping in red ink.
This strategy consists of raising such large equity in the company that you end up paying yourself a huge salary and/or rewarding yourself with a gigantic bonus regardless of the actual company performance in its waning days. Understand, though, that once you eventually liquidate, any proceeds from the company assets must be used to repay creditors.
When you transfer money from the company coffers to your wallet, it is no longer available to the business. If your business must invest in order to survive and grow marginally, taking out too much money can hurt you down the road if you come across an interested and generous buyer, or pick up other shareholders or quiet investors along the way. Imagine your business partners’ surprise when their shares of and loans to the company are repaid at rock-bottom returns over a long period of time because the owner was pulling out big bucks.
The way you pull out money may have negative tax implications, too. Your high salary will be taxed as ordinary income in comparison with the sale of your shares in the company to another party paying you money in the form of capital gains.
If this option still sounds appealing to you—and it may not because your legacy as a successful business person will be very short lived once the shop closes—minimize your reliance on outside investors, structure the company to allow you to draw out cash at will, and accept the fact that the most the business will ever be worth is the market value of your assets—not the value of your customer list or market share, not the value of your reputation in the community, and not the value of your business relationships in the industry.
Sell . . . sell . . . sell
If your company is well managed, profitable and an attractive size, it can appeal to any number of potential buyers—including your children. The advantages of selling to friendly buyers include the fact that they know you and you know them. There’s less due diligence required on the part of the buyer(s). Further, the new owners will most likely preserve what’s important to you about the business and retain most of its employees.
Friendly buyers include your children and extended family members, existing management—who often look, sound and act just like family—a strategic buyer, and an Employee Stock Ownership Plan (ESOP). In each case, except possibly the sale to a strategic buyer, the owner will probably not maximize the value of the business. However, the incremental dip in selling value is offset by leaving behind a proud legacy. Company size matters to the strategic buyer. So, for many small businesses, a sale to a strategic buyer may not be an option.
I think it’s a good idea to fully explore the eventual sale to an ESOP and, for that reason, let’s spend some time to understand the concept. ESOPs can be cumbersome since they are technically tax-qualified retirement plans and they are governed by a thick stack of regulations. Just to set one up can run upwards of $40,000 on consulting, accounting, legal advice and independent stock valuation—which is required. What’s more, the ESOP probably has to borrow money to buy your shares and will rely on future profits to pay off the loan. So, if your company is less than $1 million in annual revenues, unprofitable, or just scraping by, it is not (yet) a candidate for sale to an ESOP. Here’s another realization an owner must come to when an ESOP is considered: Are you willing to treat employees like owners?
Still, the tax provisions of an ESOP can be a source of tremendous benefits to a retiring owner as well as the privilege of remaining connected to the business in the role of being semi-retired or as an admired advisor. If the ESOP, in turn, sells the company to a third party, although the transaction can be very complex, it could make dozens of loyal employees millionaires overnight. I’ve seen that exact thing happen first hand—although, unfortunately, I was not with the company long enough to become one of the nouveaux riche.
The rest of the best options
Bringing in outside management is not as easy as it sounds. To be successful in this alternative you and your business must be able to find, attract and hire the right management, have a plan to retain them and have a system for easily and objectively monitoring the results. The retiring owner should have the capacity to relinquish day-to-day control and the equity of the company will be diluted as shares and stock options are issued to the outside management in order to incent their performance and lock them in place for the long haul.
There are plenty of examples of this alternative—albeit, a viable option—going awry when ownership abdicates its oversight responsibilities and then, under stress, tries to intervene to right the ship. It’s not always successful. Still, professional management with talent, experience and street smarts about the industry and marketplace can grow the company and add to its value.
Recapitalizing a company allows the owner to take money out through a partial sale—typically to a private equity group—while retaining a future interest in the company. Size is a determining factor as to the feasibility of this option for smaller businesses. Full recapitalization is called the acquisition—selling the company outright to the highest bidder. This option means you can sell the business and leave your spoiled rotten kids the money, but at least you spare the business from second-generation ruin.
The private equity sector is broadly defined as investing in a company through a negotiation process. This is good thing—the sky’s the limit on your perceived value. Investments made by private equity groups (PEGs) typically involve a transformational, value-added, active management strategy. Examples of PEGs include venture capitalists, buy-outs, and special situations such as bailing out distressed companies that still have potential. Some PEGs will take a minority interest in your company, but most will wish to have substantial control. Recapitalizations are attractive to PEGs because of a lucrative credit market and intense competition for good businesses.
The pros about recapitalizations include the seller receiving current cash while still retaining partial interest that can grow in value, survival of the company and retention of most of the employees, and motivated PEG managers in place generating value through improvements in systems, operations and profitability.
Saving the sexiest one for last
The Initial Public Offering (IPO) means your company has hit the big time. This option is by far the sexiest, flashiest and most exciting because of the media response. Too bad the potential for IPO success makes the lottery look promising by comparison. There are millions of companies in the world and only a little over 7,000 public ones. And, many public companies weren’t even founded by entrepreneurs—they are spin-offs of large existing companies.
If you are serious about imagining your business could someday go public, prepare yourself for the ride of your life. What’s actually involved in an IPO is mind boggling. You start by spending gobs of money trying to convince investors your stock should be worth as much as possible. Unlike a sale to a single buyer or buying group, you are romancing hundreds of Wall Street analysts. If your courtship fails, you will have blown millions. If you succeed, you end up married to the analysts who have no interest in what you do, your customers, or your employees—they only care about the price and direction of your stock. If you call that “the good life,” more power to you.
I won’t bother to tell you about the six percent investment bankers take off the top for underwriting fees and the things the company must do to conform to Sarbanes-Oxley laws and how “market corrections” can tank your wealth despite having a healthy business and . . . oops, I just did tell you those things? Suffice it to say, IPOs are a pain in the backside, but are an exit strategy option nonetheless.
To sum things up, no matter what ranking you give these alternatives, do comprehensive research about each of them early and re-evaluate your strategy often. Surround yourself with financial and legal professionals who specialize in succession planning and business transactions. Keep excellent—not just good—financial records and books that are easy-to-interpret and that a qualified CPA recommends. And, finally, develop a well-considered strategic exit plan and pull the trigger on it at the most appropriate time. Good luck!