Through our succession planning work with clients, we frequently have discussions about the ways to exit a business and the pros and cons of each. For privately held companies, there are generally eight ways to exit.
Before I launch into the eight options, I want to highlight some recent survey data. In 2013, the Exit Planning Institute conducted a study along with a national university and a nationally recognized CPA firm to ascertain where privately held business were with respect to many aspects of succession planning. Here are some of those statistics that are relevant to our topic:
- Only 34.6% of the respondents were familiar with their transition or exit options – leaving 65.4% either not familiar or not sure.
- When it comes to how closely held businesses are planning on transitioning their business, 21.3% plan on a family transition, 29.4% plan on selling to a third party and 30.9% are not sure. That leaves another 18.4% that are looking at other ways to exit, which we will get to below.
There are two general categories of private ownership transition: inside transitions and outside transitions. Below is a summary of the options in each category as well as their pros and cons:
Inside Transitions
1. Intergenerational transfer – An intergenerational transfer is transfer of business stock directly to heirs. About 50% of business owners desire this option. In reality, about 30% actually do so.
Pros:
- There is business legacy preservation.
- The transaction can easily be planned.
- The transaction costs are lower.
- Sellers have more control over the outcome.
- There is less disruption to the business.
- Typically, the buyer and seller are highly motivated.
Cons:
- Family dynamics can have an adverse effect.
- The buyers are typically illiquid and lack funds for the purchase.
- Resulting sales price is typically lower.
- There is flight risk with key employees that are not family members.
- Tradition may out-strip good business strategy.
- While this is the path of least resistance, it may not be the path to growth or success.
2. Management buyout – With this method, the owners sell all or part of the business to the company’s management team. The management team uses the assets of the business to finance a significant portion of the purchase price.
Pros:
- Continuity of the business and employees. There is preservation of key human capital and knowledge.
- The buyers are typically highly motivated and have pent-up desire to own the business.
- The transaction can easily be planned.
- This method can be combined with private equity to access capital and resources for growth.
Cons:
- There can be significant distractions to the business with so many of the key people working on and contemplating the transaction.
- There is a threat of flight of the key management team. They have the ability to coerce the owner into the transaction.
- The buyers are typically illiquid.
- The transaction price is typically lower and the terms can be unattractive to the seller.
- The transaction typically relies heavily on seller financing.
- The buyers/key managers are not always good entrepreneurs.
3. Sell to existing partners – The success of a sale to existing partners is closely linked to the existence and quality of a buy-sell agreement. This option is not available to a single-owner business.
Pros:
- There is less disruption to the business.
- The transaction can easily be planned and controlled. As long as the owners have a buy-sell agreement in place, the funding can be taken care of more easily.
- Transaction costs are lower.
- The buyers are already well-informed about the business.
Cons:
- Resulting sale price is typically lower and realization of the proceeds from the sale is often slower.
- There may be competency gaps within key management. This is assuming the seller is exiting and has competencies that the other owners don’t have.
- The buy-sell agreement may restrict selling options.
4. Sell to employees – This is typically referred to as an ESOP transaction. An ESOP is an Employee Stock Ownership Plan and it is a trust set up for and on behalf of the employees. The company typically uses borrowed funds to acquire the stock from the owners and then contributes the stock to trust on behalf of the employees. The employees then earn the stock over a period of years and it is held in a trust for them similar to a retirement plan.
Pros:
- The business stays in the “extended family.”
- Shares of the company are purchased and paid for with pre-tax dollars.
- The gain on the sale of the company may be tax deferred.
- An ESOP is an employee benefit.
- ESOP studies suggest that employees think and act like owners and as a result the companies typically perform better than their peers.
Cons:
- It is complicated and expensive to establish and maintain an ESOP.
- It may not work for S-corporations.
- It requires securities registration exemption.
- The company is compelled to buy-back shares from departing employees.
- It is generally suitable only for a gradual exit over a longer time horizon.
Outside Transitions
5. Sell to a third party – A third party sell is a transaction to a strategic buyer, financial buyer, or private equity group through a negotiated sale, controlled auction, or unsolicited offer.
Pros:
- Typically the seller will receive the highest sales price of all the options available.
- Terms are typically more favorable to the seller such as more cash up-front, stability in the deal, and the seller can walk away faster.
- Can be refreshing to the business with new energy and growth.
- It is a cost-effective way to exit.
- It will break deadlocks at the management level with family members.
Cons:
- The process can be long and difficult to close – often 9 to 12 months.
- There can be distraction and loss of focus in the business.
- The sellers typically have privacy concerns.
- Can be emotional for the seller.
- While it can be the most cost effective when you weigh the sales price and terms to other transactions, it is also the highest cost and requires a significant amount of outside professionals to close the transaction.
6. Recapitalization – This transaction is finding a new way to fund the company’s balance sheet. It is the process of bringing in a lender or equity investor to act as a partners in the business. The owners can sell a minority or majority position in the company.
Pros:
- Allows a partial exit for the owner now and the ability to “take a second bite out of the apple” in the future that may be bigger than the first bite.
- Reduces the owner’s risk, allowing them to “take chips off the table.”
- Provides growth capital for the business.
- It works well with other exit options.
Cons:
- Continuing accountability to the new financial partners. It is not a clean break from the business for the owners.
- The owners lose control by having an outside “money partner.”
- There is typically a culture shift in that the company is now more accountable to a third party.
- Execution of the transaction can be slow.
- The costs to complete the transaction can be high relative to the benefit.
7. IPO – An IPO is an initial public offering and that is where a company becomes publicly traded on a stock exchange. We are going to skip this because it typically not relevant or even remotely cost effective for closely held private companies.
8. Orderly liquidation– This is the transaction that you hope you never have to go through and the results are typically not what the owners of a privately held business ever expected. This is the process of shutting down the business through a simple and quick process. It typically only makes sense if the asset values exceed the ability of the business to produce the income required to support an investment.
Pros:
- This is a good option when the value of the assets exceeds the value of the going concern.
- This is an efficient way to exit and may be less expensive than some of the other options.
Cons:
- There is uncertainty and no guarantee in the proceeds.
- The sellers receive no value for the goodwill that the company has built over time.
- There can be a negative emotional stigma for all parties involved in the process.
- There can be damage to the employee’s lives from losing their jobs.
- There can be very negative tax consequences, especially if the entity is a C-corporation.
As you can see, there are many different ways to exit a business and significant considerations in each of the options. If you would like to discuss any of these options and how they might impact your situation, please let me know.
