grandexit

The Grand Exit: Understanding Business/Practice Transition Options

Paul R. Brown, Principal
BROWNSTONE Capital Advisors LLC

For several years we have helped dozens of private business owners develop and then execute their business succession/transition
plans. During the initial discovery process, we find many owners expressing a desire to capture more time, energy and resources in
order to pursue other interests. At the other end of the spectrum are those who simply want to cash-in and away entirely from any
involvement in business or practice.

We call this, “retirement.”

Regardless of the goal, most owners of a closely held (privately owned) middle-market business have more than one-half of their
personal wealth invested in their company. As they consider selling all or part of their business interests, they have eight basic options
to choose from as they create and implement a plan to leave their business on their terms.

1. Transfer Ownership to Family Members

According to studies between 50 percent and 70 percent of all business owners want to transfer their business to their children. In
reality, less than one-third actually do so, and of these less than one-half of the transfers actually succeed over time.

Still, this option should be explored if the owner desires to maintain the connection between the business and the family. In addition to
providing financial opportunities for family members, this strategy can also provide a way for the owner to stay active in the business
with his or her children. When the time comes to actually “sell” the business, owners usually have more flexibility when the buyers are
members of the family.

Before going down this road, owners should consider the challenges of using this option. I’m now working with a client whose
children would like to buy the business. Unfortunately, to do so they will have to rely on the “First Bank of Dad.” Although the owner
might be willing to accept payments, doing so will diminish his financial security. Furthermore, his two children who are not involved in
the business believe that an installment purchase of the owner’s largest (and riskiest) asset puts their inheritance at risk. All of this is
adding to the owner’s anxiety.

2. Sell to Other Shareholders

Not all owners have this option, but if the business has other shareholders (or partners) there should be a ready market for his or her
shares; particularly when there is an effective buy-sell agreement.

A well-prepared share transfer agreement outlines the steps taken to sell shares in a business. In most instances, the departing
owner (shareholder) is selling to someone who knows the business and its value and has already agreed – in principle at least – to
buy the shares if and when they are offered. The agreement can help owners with their planning (both financial and personal) since
they already know the price and terms they can expect to receive for their ownership interest when they are ready to leave.

Keep in mind that the security of having a ready buyer is frequently offset by a reduced price. By creating a limited market, i.e. other
shareholders, owners create a situation in which the value of the company is usually discounted. Furthermore, without some sort of
funding in place, the departing owner and his or her family may rely on an extended payout for their shares, resulting in additional
financial risk.

3. Sell to Management (“MBO” of “LBO”

A Management Buy-Out (MBO) or management-led Leveraged Buy-Out (LBO) happens when the owner sells all or part of the
business to all or part of the company’s management team. The management team uses the assets of the business to finance most
of the purchase and contributes additional equity – at times with outside investors – to make up the difference in price.

Since the management team is already in place, lenders and investors are more willing to provide the funding needed for the buy out.
If they partner with an equity investor, the new ownership team may be able to acquire additional capital to fund the company’s growth.

At times, the management team is not able to fund the entire transaction thereby requiring the owner to take a note to finance the gap.
For one of our clients in California, the risk was too high. After several discussions with his managers, he gave them 60 days to come
up with the additional funds needed to complete the purchase or he would pursue other options.

4. Sell to an Employee Stock Ownership Plan (ESOP)

An Employee Stock Ownership Plan (ESOP) is an effective way for owners to cash in a part of the business interest. In an ESOP,
borrowed funds are used to buy shares from the owner who then contributes those shares to a trust. Participating employee have an
account in the ESOP trust. When vested employees leave the company, the company must offer to buy the shares back from the
employee, usually at market value.

Since the shares are purchased with pre-tax dollars, owners typically “net” more from this strategy than they do from others. For
proponents of ESOPs, this is a compelling argument that should be considered.

However, this benefit may be offset by additional costs. An ESOP can be complicated and expensive to set up with development costs
ranging from a low of $25,000 to a high of over $100,000. Once in place, the annual costs of maintaining an ESOP should also be
reviewed. Even if it is an appealing option, if the company is an “S” Corporation, an ESOP may not be suitable. And finally, since an
ESOP works best if it is implemented over time, an owner desiring to exit quickly from his business should probably consider other
strategies.

5. Sell to a Third Party

Let’s be honest: most companies are not ready to be sold. Before choosing this option owners should take a long, honest
assessment of their business or practice to determine whether or not it can be sold at the price needed (or expected). In the finicky
world of business acquisitions, there plenty of buyers willing to pay a premium … for business that is well run; well capitalized; well
positioned in the market; and well prepared to grow. By using this definition we have eliminated the majority of middle-market
companies.

In fact, one of my colleagues spent the better part of a year looking at manufacturing companies. After visiting more than sixty
companies, his investment group ended up making an offer on two. “Everything else,” he said, “was a waste of time.”
Third party buyers typically come from two different buying groups. Strategic buyers have a relationship with or an interest in the
business. These include competitors, customers or suppliers in familiar with the industry. Investment buyers, as the name indicates,
are interested in purchasing the business as a part of a larger investment strategy. Investment buyers include private equity groups,
hedge funds or institutional investors.

For many owners, a third party buyout can be an ideal exit option. Third-party sales usually result in higher value (resulting in more
money to the owner) and faster payouts (resulting in more money received in cash at closing). In some instances, owners may find
several prospective buyers. As a result, he or she can satisfy needs relating to the softer issues (time and involvement) as well as the
financial ones (price and payment).

There may also be some drawbacks. After selling his business to a strategic buyer, a friend of mine was asked to stay on as both an
officer and manager of the larger company. He quickly realized that while he enjoyed owning and growing the business, he did not
enjoy being an employee of it.

6. Refinance or Recapitalize the Business

If an owner wants to stay involved with the company while reducing his personal risk or diversifying his holdings, he or she may
recapitalize the business. The owner may be able to refinance the company, essentially bringing a lender in to act as a partner. Or, in
some instances, the owner may be willing to sell an interest in the company – either minority or majority – to an equity investor while
keeping a percentage of ownership.

Owners using this strategy may be able to maintain an equity interest in the company while participating in its future growth. In the
best-case scenario, he or she has been able to take money out of the business, diversify risk and remain active in the management of
the company.

Before using this option, owners need to make certain they are ready to have partners. Equity investors want a return on their
investment and may be less sympathetic to the owner’s long-term succession goals.

7. Go Public

For many, the ultimate exit strategy is to conduct an Initial Public Offering (IPO). Yet for the vast majority of owners, this option is
unrealistic. And despite its appeal, it comes with a number of potential weaknesses.

When a company goes public, owners give up a considerable amount of control and privacy. By definition, a public company is no
longer private and must make regular disclosures to the SEC and whatever exchange the company is listed on. Restrictions may also
be placed on shareholders whereby they are not permitted to cash out for several months following the IPO. And, since the inception of
Sarbanes-Oxley, the administrative costs may be too much for the company.

8. Liquidate the Business

If there is no one available to buy the business, the best strategy may to simply shut it down.

When a company is liquidated the owners sell the assets, collect outstanding accounts receivables, pay the bills and keep what’s left.
Some surveys indicate that this option is used by more than 70% of all businesses.

This strategy makes sense when a business cannot produce enough income (apart from the owner’s direct efforts) to support the
investment required to maintain the company’s assets. For example, if a business can only produce $75,000 in profits each year on
assets that are worth $1 million, it makes sense to sell the assets at liquidation value. In this case the value of the assets is higher
than the value of the cash flow.

While this method is fairly simple and fast, liquidation usually results in the lowest possible value for a business since it only includes
the fair market value of the salable assets and does not include any consideration for client or customer lists, employee knowledge or
company reputation.

Conclusion

Choosing the right option can make the difference between an effective and positive exit, or one that is disappointing. Which one
should you choose? The best exit strategy involves a careful assessment of the business, the owner’s personal and business goals,
and the objectives of each of the other stakeholders. After that, owners should be able to find a solution that fits their unique needs.

HOME