Exit Planning Tools for Business Owners

entrepreneurs

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.

Is Google Making Us Stoopid?

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As an Exit Planner, most of my engagements involve assessing a management team. They may be the intended buyers of the company, or else they are key factors in the saleability of the business.

The biggest and most frequent complaint I hear about managers is that they don’t know how to THINK. Business owners lament the inability of employees to discern critical paths, assess alternatives, or analyze complex problems.

Examples of Thinking Shortfalls

A CPA is doing a final review of a client’s tax returns, as prepared by an associate. As with many business owners, the client has two related entities, one acting as the management company for the other.

The reviewing partner notices the income from management fees in one entity, but no corresponding expense deduction in the other. The associate explains that the client’s books didn’t show the offsetting expense, so he ignored it.

The owner of an IT services company receives an irate call from a client. His technician has just spent two billable hours on the client’s PC, and it still won’t print his documents.

When the employee is asked for an explanation, he points out that the client said he needed updates to his printer drivers, and that is exactly what he (the technician) did. At no point did he try to determine whether updating the drivers would solve the customer’s problem, or even what that problem was.

The customer made a request, and the technician complied. He didn’t perceive the customer’s lack of technical knowledge as a factor.

As the adage goes, “When someone asks you for a drill, what he really wants is a hole.” If you are in any business where the customer expects you to be more knowledgeable than him (and why would he hire you otherwise?) thinking is a core competency.

I Can Look Up the Answer

Numerous educators and managers have related to me the effect of the Internet. Students resist rote learning. Employees refuse to train in procedures. Their answer is ubiquitous; “Why do I have to know that? I can look it up whenever I need it.”

In some circles, gaining “knowledge” is a game of speed and skill. Participants in a conversation whip out their electronic lozenges upon any reference to a historical fact, person or thing name, geography question, et al, ad infinitum. (Don’t know Latin? No problem. Google it.)

What is eroding is the concept that an answer may not be the best answer, or even a good answer. It’s just an answer.

Life isn’t “Fill In the Blanks”

Getting an answer doesn’t mean you’ve solved a problem. What we are losing is the ability for critical thinking. For saying “Wait a minute. That is one approach, but might there be others? Is there a better answer?”

We used to have to work through that step by step in our brains. Now we are becoming conditioned to accepting the answer on a little screen as the final word.  It’s great for learning how to change a faucet, but maybe not so hot for solving a customer complaint.

Your management team is the most important factor in realizing value for your business.  If you are planning a fully controlled (time, method, and proceeds) internal transition, they are your buyers and the guarantors of any financing you may underwrite. If you are selling to an external buyer, he or she wants to see a business capable of running (and making good decisions) without you.

Either way, you need to teach them how to think.

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

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