Exit Planning Tools for Business Owners

Exit Options

Exiting a Small Business Part 1

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Owners who are exiting a small business are often stymied by the range of choices in exit planning. Most literature on the topic discusses seven or eight avenues to exit.

A sale to a third party can be to an entrepreneur, private equity (including family offices,)  or a strategic acquirer. Internal sales can be to family, or employees via  a Leveraged Buy-Out (LBO- often called a Management Buy-Out or MBO.) There is also a sale to an Employee Stock Ownership Plan (ESOP) or the oldest method in the book, closing down the company.

While the jargon is appealing to those advisors who want to sound smart, most of it doesn’t apply to the 90% of owners who have fewer than 20 employees. For those owners, about half of those options aren’t realistic. Here’s why (or why not.)

Exits That Don’t Apply to Small Business

Strategic acquirers, as the term suggests, seek a strategic addition to their business. Very few small companies have exclusive rights to a product or territory. Even fewer have proprietary intellectual property (patents or software.) In fact, if you have less than 20 employees the odds are you do about the same thing as several competitors in your own geographic area. No strategic value there.

Private Equity Groups and Family Offices have a fiduciary responsibility to their investor/owners. The level of due diligence needed to protect their interests makes a small transaction hard to support. They traditionally look for companies with more than $1,000,000 of cash flow after owner compensation, and many will only consider two or three times that amount. That’s too rarefied a level for most businesses with a dozen employees.

ESOPs are a great transfer vehicle, but until they loosen the regulatory environment (some laws are being proposed) they usually cost several hundreds of thousands of dollars to complete, and another $50,000 or more for annual compliance thereafter. Too rich for most small businesses.

When I say “small business,” I mean one with five or more employees. Smaller than that usually describes one person with some helpers. That’s more like a job, and closing is often the only avenue to exit.

Exits That Do Apply to Small Business

So, when exiting a small business with between five and twenty employees, you have three choices left. Sell to another individual, to your employees, or your family. If you don’t have family in the business, your choices become even simpler. You can flip a coin, but even for small business owners exiting is usually a major financial event. It’s still worth putting some time and energy into planning.

Over the next few weeks, I’ll discuss the three avenues for exiting a small business. Stay tuned.

Invest 15 Minutes and take our FREE Exit Readiness Assessment. We do not request any confidential information.

John F. Dini develops transition and succession strategies that allow business owners to exit their companies on their own schedule, with the proceeds they seek and complete control over the process. He takes a coaching approach to client engagements, focusing on helping owners of companies with $1M to $250M in revenue achieve both their desired lifestyles and legacies

Using Waterfalls in Exit Planning

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One of the most useful concepts in business planning is that of “waterfalls.” The analogy is apt, if perhaps less than perfect. Think of any outcome anticipated in a contract that is based on an “if…then” situation. It can likely be served by structuring waterfalls.

I originally started using the term in buy/sell agreements. When a shareholder chooses to leave (or is forced out,) the options for purchasing his available stock are waterfalls. The first option may be for all the the shareholders to buy the stock in proportion to their existing ownership. If not all the shareholders wish to purchase, the “waterfall” or back-up option is for any subgroup of shareholders to buy the stock.

The next waterfall is for a single shareholder to purchase all the surrendered shares. The final waterfall, if everyone declines the opportunity, is for the company to buy the shares as treasury stock. Each option level is defined in priority order and has its own time frame for exercise.

Waterfall Distributions

Recently I saw a business structure where the profits were distributed through waterfalls. (This is pretty much an advantage of using an LLC.) The investor partners received 100% of the profits until they reached a defined return on their investment. (This was a cumulative right, similar to cumulative preferred stock.) Once the target ROI was reached each year, there was a split of the profits between the investors and the managers, with the investors share being considered a return of their original capital. Finally, when all the capital had been repaid, there was another shift where the managers took the lion’s share of profits. The investors received some additional profit participation on a permanent, ongoing basis.

How can this work in exit planning? Often a seller has a target number in mind for retirement funding to be generated by his or her company. That number can be come from operating income, or from the proceeds of a sale.

Waterfalls in Leveraged Buyouts

When the buyers are employees, they likely purchase some or all of their shares in installments. The pricing is at a fixed valuation, or may use a formula that rises and falls with the profitability of the company.

It’s simple enough to develop waterfalls. Once the owner has received a target amount of operating income each year, the employee/buyers get a higher portion of any overage to apply to their stock purchases. Once the stock is paid for, the owner has an upside of more than the original planned price for the business.

Structured correctly, waterfalls can be highly motivational (and lucrative) for all parties in a transition. As profitability rises, the buyers get paid-up equity more quickly. The seller has the ability to receive more than the originally anticipated price. Everyone shares in the rewards of their work.

Video on Preparing for Your Exit Plan

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I contributed this video interview about preparing for your exit plan to SuccessionMatching.com for their recent Summit.

It is about preparing what you need before starting your exit planning process. Succession Matching has made it available for free for another week. (requires creating a user name and password)

 

I hope that you enjoy it.

Invest 15 Minutes and take our FREE Exit Readiness Assessment. We do not request any confidential information.

John F. Dini develops transition and succession strategies that allow business owners to exit their companies on their own schedule, with the proceeds they seek and complete control over the process. He takes a coaching approach to client engagements, focusing on helping owners of companies with $1M to $250M in revenue achieve both their desired lifestyles and legacies

Exit Planning Choices Podcast

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I had a nice conversation, on exit planning choices, in 2019 with Pat Ennis of Ennis Legacy Partners and Walter H. Deyhle of Gelman, Rosenberg and Freeman,CPAs, both in Maryland. Learn about your choices when preparing to create and implement your exit plan. Exit planning is about choices, get to know the choices that you have. Thanks for the invitation, Pat!

You can listen (25 minutes) here. I hope that you enjoy.

Invest 15 Minutes and take our FREE Exit Readiness Assessment. We do not request any confidential information.

John F. Dini develops transition and succession strategies that allow business owners to exit their companies on their own schedule, with the proceeds they seek and complete control over the process. He takes a coaching approach to client engagements, focusing on helping owners of companies with $1M to $250M in revenue achieve both their desired lifestyles and legacies

Time Frames for Exit Planning

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Time frames are one of the most critical, challenging and frightening factors in planning your exit. At the same time, they are one of the most flexible factors in your plan. How can something be this important and still be fungible?

When we interview an owner, one of our first questions is about time frames. Note that they are plural. The first is when you want to step away from daily management of the business. The second is when you want to leave entirely.

Those questions  also lead off our exit preparedness Assessment, the ExitMap®, and impact the scoring on many of the other responses. When it comes to actually implementing a plan, however, their importance is often the opposite of what you might expect.

Owners frequently are most concerned about the second question. Setting a date for leaving the business is scary. That is when their lives will change substantially. That is why good exit planners focus so much on the owner’s personal vision of life after the company.

The First Time Frame

It’s the other question about time frames that is more important. Stepping away from daily operations is hard. Letting other people make decisions is hard. Seeing people get excited about initiatives that aren’t yours is hard.

In my book Hunting in a Farmer’s World I discuss “taking off the Superman cape,” or the challenge of letting your employees go to someone else for answers. Once you get beyond that, running the business can be a lot more enjoyable.

So part of an owner’s fear regarding time frames is the fear of the unknown, the void that looms if you don’t have a post-exit plan. The other part is a fear of leaving the business just as it becomes a lot more fun.

In fact, I’ve seen a number of owners who, once relieved of the daily burden of being the answer man or woman, want to postpone their final exit date. That’s not surprising. You didn’t become a business owner because you thought you would hate it. In fact, owner burnout isn’t usually caused by the creative or innovative parts of an owner’s role. It’s caused by the tasks and workload of running things day in and day out.

Leave  on Your Own Terms

That is why we design many exit plans with a kind of escape clause. Once the owner has transitioned his or her duties, most of the requirement for the second time frame have been met. At that point, the remaining criteria may be the accumulation of retirement funds, or accomplishment of a non-financial life goal (such as training for a new role.)

The final time frame is only met when the owner is ready. In an internal transition to family or employees that may involve selling a last bit of controlling equity.

Even if you are planning a third party sale, having your employee team spun up for an easy transition to a new owner will add considerable value to your company.

The goal in exit planning isn’t to set a departure date in concrete. It is to understand the time frame required to put you in a position to exit. The last move is up to you.