Many business owners have only a vague idea of how they will exit from their current business. 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 – business succession doesn’t happen overnight or like a bolt out of the blue.
Creation of a good succession 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 not only because it saves money and aggravation, 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 takes multiple years. Three to five years is a very short time line to execute an exit plan. Five to eight years is more reasonable, and will likely yield better results. Eight to ten years is best. Having a realistic timeline when you begin the process will help keep stress low and goals feasible.
There are several ways for a business owner to exit his or her business: internal succession, outside succession, sell the business, or simply close the business and dissolve. This article will provide a brief overview of these options and will conclude with a checklist of steps to take and issues to consider when planning for the succession of your business.
An internal succession is often a business owner’s first choice, particularly if the business is family-owned and operated. Internal succession allows the business to continue and provides employment to the people the owner knows and cares about. However, with an internal succession 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.
External Succession (Merger or Acquisition)
Sometimes, a business owner will look to acquire or merge with a smaller, complementary business run by someone with proven entrepreneurial skills to serve as his “replacement.” Such a situation can prove to be a great opportunity for the business owner planning his or her exit. Depending upon the size of the business, a business broker or an investment banker can be helpful in finding the right merger or acquisition target. An external succession through merger or acquisition takes time and requires a back-up plan if the right target company 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.
Sale of the Business (Stock Sale, Asset Sale or Merger)
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.
Selling the business sometimes requires that the former owner stay on as an employee for a period of time, which many former owners find difficult. The buyer usually requires a non-competition agreement, so business owners considering this option need to be sure they are ready to retire or are willing to leave their industry – at least for a period of time.
Closing the Business (Liquidation/Dissolution)
Many 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 annual corporate reports with the Secretary of State’s office.
Liquidation and dissolution carry their own set of potential pitfalls for business owners. In particular, Florida law states that participating shareholders can be held personally liable for claims against the corporation 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. Improper distributions also include distributions made without giving preferred shares their required preferred treatment. 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.
Many businesses do not get sold, but are closed. 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 your 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. Understanding the sale of business option can help you operate your business with an eye to maximizing cash generated by liquidation.
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.
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.
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, 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.
- 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 financial reality of the family and the qualified family-owned business (QFOB) deduction.
- 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.
- 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).
Getting an appreciation for possible successors and determining which method of succession is best for your company is critical to meeting exit strategy goals. 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.