Exit Planning Tools for Business Owners

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Selling to Employees: Exit Planning for Small Business Part 4

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Selling to employees is one method of transition that is growing rapidly in popularity. Usually the  driving motivation is a desire to help the people who got you this far enjoy some of the benefits of ownership, but there is a substantial list of other benefits.

  1. Pricing is agreed at the start, not in adversarial negotiations.
  2. Valuation is flexible. The business can be sold for more or less than its Fair Market Value, as long as both sides agree and cash flow supports it.
  3. The legacy of the business lives on in the community.
  4. Where there are substantial challenges to an outside buyer, such as industries whpiere work goes to the lowest bidder, employees are more confident that they can succeed in the system.
  5. Financing is built into the transition plan.

(By the way, if you are just picking up this series now, prior topics included strategies that aren’t suited to small business, selling to a third party, and selling to family.)

“But they have no money!”

That’s the most frequent objection when we suggest an employee sale, but it is easily remedied by time. In fact, time and risk are corollaries. The more time you have, the less risk you’ll take. Faster is riskier.

At one end of the spectrum we’ll say you want to exit the business in the next thirty to sixty days. That’s probably enough time to draw up a purchase agreement and transfer ownership. The payment for the business would be entirely in an installment note from your workers. Rapid exit, but maximum probability that you will never see the entire purchase price.

On the other hand, what if you have five to ten years for selling to employees?  You could sell stock for a note, and let employees pay for their shares with bonuses based on increasing profitability. They are motivated to grow the company, while you continue to receive all the profits you were due anyway.

As they increase their ownership, they can qualify for lender financing to purchase your equity. Done well, and with enough time, you can realize the full value of the business and increase your short-term income along the way. Time gives you lower risk, and the potential for higher reward.

Are they qualified?

That is another question entirely and one that depends largely on you. If you’ve hired the right people and trained them well, selling to employees is a breeze. If you are the center of everything that happens in your business, it could be a problem.

Remember, the more you work in your business the less it is worth. To see how dependent your business is on you, take the quiz at www.ownercentricity.com.

What if they are willing and able, but not ready? Or perhaps you have a few key managers, but they lack some critical skill sets? Again, time gives you the flexibility to deal with those issues.

You may not have anyone who could ever run the business. Again, with suffcient time, you can “hire your buyer.” I’ve seen businesses where an owner used the promise of ownership to recruit someone whom he’d never attract otherwise.

Selling to employees is the ultimate exit plan in your level of control over the process, determining how much you want from the transaction, and choosing your date of departure. If you haven’t considered it in your list of options, you might want to think again.

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Family Succession: Exiting a Small Business Part 3

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It’s time to discuss family succession. In Part One of this series we looked at exit strategies that aren’t really available to small businesses, and in Part Two we discussed selling to a third party. Now let’s talk about the issues when transferring to a family member or members.

Which Kids?

When passing the business to family, often the primary issue is inheritance. Small business owners frequently have 50%, 60% or as much as 80% of their personal net worth in their company. There is a temptation to treat the business like any other personal asset, and divide it among all the children.
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“After all,” (the logic goes,) “We built this for our family’s security. It isn’t fair that only the kids who work in the business should benefit.”Sometimes the non-active children have succeeded in lucrative careers, like medicine or law. That may make an asymmetrical legacy easier.

Other times the children outside the business have not been successful at all. They are the ones who most need support, and in fact may be on the payroll already (although not “active” in any meaningful sense.) Parents’ expect the same unconditional love they have for them from their siblings, but it just doesn’t work that way.

Splitting it “Fairly”

When the company is too valuable an asset to balance inheritance with other assets, we recommend passing some to the active children before your death. That can be via sale, bonus or gifting, but it recognizes the active children’s contribution to the business.

Upon death, you can divide the balance of the equity evenly, but with a contract that says the non-active children must immediately sell their shares to the active ones at Fair Market Value. This accomplishes several things:

  1. The value of the business at the parents’ death  is divided “evenly.”
  2. The non-active kids get the step-up in basis, and should have no tax on the sale.
  3. The active kids retain 100% of the benefits from their efforts going forward.

Its especially important to get spouse signatures on these agreements. Valuations and agreements between family are fine, but an outsider (especially an ex-spouse) may not be as amenable.

I have a comment that I use with parents who are deciding how to divide ownership among children. “In the long run, you want everyone to still have a nice Thanksgiving together.”

Securing Family Succession

This is the other big issue. The parent wants family ownership to be their legacy, but their child or children aren’t qualified to run it. There is capable management, but none of them have the same last name.

Remember, we are talking about small business in this series. Families named Cargill, Ford or Walton need not be too concerned  about non-family management.

But for a small company, you can’t put children in a position where the resignation of a key employee could sink the whole enterprise. That makes the children subject to blackmail. Key operating skills have to be retained with incentives.

You don’t need to make key employees into partners, but they should have a vested interest in growth and profitability. This can be as simple as bonuses for company performance, but long-term retention usually requires non-qualifed deferred compensation (NQDC) plans.

These are tied to the long-term growth and profitability of the business. “Non-qualified” simply means it isn’t an ERISA-qualified benefit (like an IRA or 401K) because it is discriminatory in nature.

There are a number of forms for NQDC, mostly involving virtual equity. Phantom stock, stiock options, stock appreciation rights and warrants are all avenues for such compensation. They allow an employee to amass an increasing nest egg over time, based on tenure and appreciation in the value of the business.

Da Plan! Da Plan!

Whether you are deciding how to apportion the business for your estate, securing continuation of a management team, or just minimizing taxes on the transfer, planning is the key. Determining your goals for family succession and working through your options well in advance (5 years or more before your planned retirement,) is the secret for the successful transfer of a family business.

Without planning, you are putting Thanksgiving at risk.

New! The affordable exit planning system for small business. 9 modules, 9 online tools and completion in 90 days. Take a look at ExitMap® Express!

Exiting a Small Business #2 – Selling to a Third Party

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“In our last episode,” (I’ve always wanted to say that) we discussed the exit paths that are not usually available when exiting a small business. Those are ESOP, Private Equity, and Strategic Acquisition. Now let’s talk about what you can do.

The Realities of Selling to a Third Party

Multiple surveys over the last decade all show the same result. About 85% of small business (5 to 20 employees) owners say that their exit plan is to sell to a third party.

Let’s do the math. There are currently over 3,000,000 small business owners over 55 years old in the USA. We can assume that by the time the youngest is 75, virtually all will have exited their businesses. That means an average of 150,000 businesses a year will transfer or close.

According to the International Business Brokers Association (IBBA), their intermediaries execute about 40,000 transactions a year. It should be a bull market for intermediaries (although not for sellers.) Let’s assign them 50,000 transactions annually.

That leaves 100,000 small businesses a year who will have to find methods of transfer other than through a business broker.

Broker Alternatives

Business Brokers can be cynical about their clients. They commonly complain that the best businesses sell through their accountants, bankers, attorneys, or word of mouth. Their listings consist mostly of the “Dismal Ds,” (Death, Disease, Disaster, Divorce, Declining sales, Dissention among partners, Disinterest, etc.) While this is an exaggeration, it’s true that the better shape your business is in, the more likely it is to sell easily.

If you’ve prepared your business well, understand your potential buyer, and are personally ready to move on, your best bet for selling is probably your business network.

Being Ready

Brokers sell about 20% of the businesses they list. Again, that number has been consistent for decades. According to the Pepperdine Private Capital Markets Report, the number one reason for an intermediary’s failure to sell a business is “unreasonable expectations of value” by the seller.

Again, that may be self-serving, but brokers are paid for success. None would sneer at a higher valuation if he or she could get it. A realistic expectation of value is the first and most important step in a successful sale.

Some brokers will take a listing at any price. They believe that eventually, the market reaction will drive their clients to a reality check. The problem with that approach is that the first buyers, and possibly the most qualified, are driven off by an unreasonable price at the outset. They don’t come back later.

If you plan on selling to a third party, you will be best served by being prepared before you talk to a broker. There are a lot more areas to cover, and this series of articles is just a high-level view of your options. For a more complete approach, you may want to check out my book 11 Things You Absolutely Need to Know about Selling Your Business. The EBook is free for Kindle Unlimited subscribers.

Next up, selling to family members.

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.

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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.