When business owners start to think about exiting their companies, the number of possible exit routes can seem limitless, but in fact, there are only eight:

• Transfer the company to family member(s).
• Sell the business to one or more key employees.
• Sell to employees using an Employee Stock Ownership Plan (ESOP).
• Sell to one or more co-owners.
• Sell to an outside third party.
• Engage in an Initial Public Offering (IPO).
• Retain ownership but become a passive owner.
• Liquidate

Which of these exits do owners intend to use? A January 31, 2005, survey by PriceWaterhouseCoopers indicates that:

• About one-half anticipate a third-party sale.
• Nearly one-fifth anticipate a transfer to the next generation.
• Fourteen percent anticipate a management buyout.
• Seven percent expect to sell to an ESOP.
• Ten percent anticipate an IPO or other option.

This White Paper examines the advantages and disadvantages of each route and describes a process that enables owners to choose the best exit path for them.

Let’s begin with a fictional company case study.

Ben (55), Tom (45), and Larry (35) purchased Front Range Powder Coating from its former owner in 2004. They paid “book value” or about $1 million. Now, seven years later, they are at a crossroads: Ben, the oldest, is interested in reducing his role in the company and has approached Tom and Larry about purchasing his one-third interest.

But there’s a kicker. Ben is not interested in selling his interest on the same basis as he acquired it—book value. Instead, he wants one- third of the fair market value of the company.

Since the company has increased its book value to $2.5 million and its annual cash flow from $200,000 to more than $2 million, Tom and Larry face a major cash crisis. Should they proceed with the buyout?
As these owners discussed their objectives, it became clear to them, as it does to all owners, that business succession planning has little to do with the characteristics of the business and everything to do with each particular owner’s personal exit objectives.

• Ben wants to exit immediately for fair market value.
• Tom wants to continue to work for a number of years but isn’t too keen on dedicating the company’s entire cash flow to the purchase of Ben’s stock. Tom believes that it is a risky proposition to use cash flow to pay off Ben rather than to fuel future growth. Further, Tom figures that, at just about the time Ben is paid off, it will be his turn to retire (at, he hopes, an even greater value).
• Larry, the youngest, shares Tom’s cash flow concerns, but is sensitive to the desires of several non-owner managers—the next generation of ownership. Several key employees are quietly, but rather insistently, clamoring for ownership or similar ownership- based incentives.
• Larry wants to remain active in the company for the next 15 to 20 years as its principal owner and knows he can’t indefinitely defer meaningful incentives to the key employee group.

HOW TO CHOOSE AN EXIT ROUTE

How can the owners of Front Range Powder Coating choose an exit path when they have three very different opinions? When they finally met with their advisors to determine the best exit path for Ben, or perhaps all three of them, their first question was: How do we agree on an exit strategy that is fair to all of us? The answer their advisors gave them is one that applies to all owners.

Step 1: Start thinking about your exit before you are ready to exit. Owners who give themselves time to plan give themselves the greatest number of exit path options.

Step 2: Owners should each put in writing their objectives and the resources available to reach each objective. Objectives may include when they want to leave and how much money they will need. Resources include: business value, non-business income and business cash flow.

This exercise helps owners to evaluate how well each exit path matches their objectives and resources. It also facilitates frank discussions based on realistic possibilities (rather than conjecture or wishful thinking).

Step 3: Each owner sets his or her own objectives related to desired date of departure.

Step 4: Owners should retain a professional to  Provide for the well-being of the determine a company’s “fair market value” to owner’s family; place all owners on the same objective page. Valuation results often eliminate potential exit paths. For example, if the value of a company is high, but the owner is not willing to devote the time necessary to orchestrate a transfer to employees, a sale to a deep-pocketed third party is a better option for him.

Step 5: Owners must perform cash flow projections to determine if there is sufficient cash available to even consider an “insider” purchase; in this case, a purchase of Ben’s stock.

Step 6: Owners must evaluate the tax consequences of each exit path.

Keep in mind that while this analysis takes place, owners must continue to increase the value of their companies. Additionally, they will likely need to revise their existing buy-sell agreements to reflect the true value of their companies.

Let’s now examine each exit path available to business owners.

TRANSFER TO FAMILY MEMBER(S)

Owners who consider transferring their businesses to family members usually do so for a host of non-financial reasons. These reasons include:

• Put the company in the hands of a known entity—specifically one’s own flesh and blood—who the owner believes will run the company as s/he did.
• Perpetuate the company’s mission or culture.
• Keep the company in the community; and
• Allow the owner to remain involved in the company.

The major disadvantage to a transfer to family members is the owner’s heightened exposure to financial risk. In almost all cases, family members are incapable of paying an owner the amount of cash s/he wants or needs for the company. As a result, owners remain tied to the company’s future financial performance. To mitigate this risk, most owners choose to stay active with the company to ensure its (and their own) financial success.

Since family-member buyers have limited financial resources, owners often receive little or no cash at closing. That’s a clear disadvantage to owners who must convert their largest, illiquid assets (their companies) into cash for retirement.

Realistically, all owners are not blessed with children able and willing to assume ownership of a company that is much larger and more complex than when its owner was the child’s age. Even children who have demonstrated success in managerial roles may not be equipped to assume the responsibility of ownership.

In summary, the disadvantages to an owner of a family transfer are:

• Without planning* there is little or no cash at closing available for the owner’s retirement.
• On-going financial risk to the owner.
• Requires owner involvement in company post-closing
• Children may be unable or unwilling to assumethe ownership role.
• Family issues complicate treating all children fairly or equally. *Planning—well in advance of one’s departure date—can minimize or eliminate many of these disadvantages.

SELL TO KEY EMPLOYEE(S)

In terms of advantages and disadvantages, the sale to key employees is remarkably similar to the transfer to family members. (Recall that Larry’s exit strategy involved a transfer to key employees.) So similar are the two paths that if you substitute “key employee” for “family member,” the advantage/disadvantage lists are the same.

The owner who considers a transfer to key employees hopes to achieve the same objectives as the owner transferring to a family member.

• Put the company in the hands of a known entity.
• Perpetuate the company’s mission or culture.
• Keep the company in the community.
• Allow the owner to remain involved in the company.
• Achieve financial security.

The perils of this exit route are the same as those present in the family transfer:

• Without planning there is little or no cash at closing available for the owner’s retirement.
• Owner experiences on- going financial risk.
• Requires owner involvement in company post-closing.
• Employees may be unable or unwilling to assume the ownership role.

Many of these disadvantages can be minimized if owners begin planning this type of transfer well in advance of their departure dates. For more information, please contact us for our White Paper, “Transferring Your Company to Key Employees.”

TRANSFER TO EMPLOYEES VIA EMPLOYEE STOCK OWNERSHIP PLAN (ESOP)

ESOPs are qualified retirement plans (typically profit sharing plans), in which all employees participate, that must invest primarily in the stock of the sponsoring employer.

Transfers to key employees and to ESOPs appeal to owners who wish to transfer their companies to known entities, perpetuate their companies’ mission or culture and keep their companies in their communities.

The owner who uses an ESOP to transfer to employees may enjoy three benefits that the owner in a standard transfer to key employees may not:

• Beneficial tax treatment. Using an ESOP, an owner may be able to defer or avoid tax on the sale of the stock to the ESOP. Even more importantly, the company can pay for the owner’s stock with pre-tax dollars.
• More cash sooner. The owner may be able to leave the closing table with all of the cash necessary for a financially secure retirement due to more favorable tax treatment, and the greater possibility of at least some outside financing.
• Motivated work force. Perhaps because all employees participate indirectly in the benefit of ownership as ESOP participants, performance may improve. Studies, including one by Douglas Kruse and Joseph Blasi of Rutgers University, indicate that this can be the case.

Of course, not all aspects of the ESOP exit route benefit the owner. Disadvantages include:

• Owners must take into account the cost and complexity of setting up and maintaining an ESOP.
• At closing, owners may receive more cash than they would in other key employee transfers, but perhaps not as much as they would have had they sold to a strategic buyer.
• In securing the ESOP loan, the owner’s assets may be tied to the company as collateral.
• In many cases, key employees may not benefit as significantly as the owner might have anticipated nor as much as the employees may demand to stay on and run the company after the owner leaves.

Of course, good planning, well in advance of the owner’s exit—may substantially minimize or eliminate these disadvantages. Please see our White Paper “ESOP Opportunities” for ESOP planning tips.

SALE TO CO-OWNERS

Once again, the owner (like Ben) who examines a sale to a co-owner or co-owners finds the list of advantages and disadvantages nearly identical to those on the lists for a transfer to family member or key employees.

The advantages to a sale to co-owners are:

• Buyers whose commitment, skills and knowledge are known to departing owner.
• Perpetuates the company’s mission or culture.
• With planning* the owner can remain involved in the company.
• Gradual, incremental sales staged over several years offer an owner the possibility of upside gain while maintaining his or her voting interest until finally cashed out.

The disadvantages of the sale to a co-owner are:

• Owner is not generally cashed out at closing.
• Owner experiences on-going financial risk.
• Owner involvement may need to continue post-closing.
• Owner typically receives less than full fair market value. (That prospect holds little appeal to Ben!)

A number of planning concepts that take time to implement (usually three to ten years) may well allow Ben to reap his full share of the fair market value of the company and do so with less risk. For example, this buyout can be designed so that Ben sells no voting stock until he receives the entire purchase price.*As is always the case, smart planning undertaken well in advance of the transfer can minimize the effect of these disadvantages.

SALE TO A THIRD PARTY

This exit route usually offers owners the best chance at receiving the maximum purchase price for their companies. In addition, owners of larger companies who sell to third parties are best positioned to receive the maximum amount of cash at closing.

Owners who top their list of objectives with, “Leave for Tahiti the day after closing,” initially choose this exit strategy. This route also appeals to owners who want to propel the business to the company next level—on someone else’s dime.

Our list of advantages looks like this:

• Achieves maximum purchase price.
• Usually maximizes cash at closing.
• Allows owner to control date of departure.
• Facilitates future growth without owner investment or risk.

This is undoubtedly an impressive list of attributes, but before you grab the phone to call your favorite investment banker, let’s review the drawbacks of this exit route.

The first difficulty is that this exit route does not match the stated intentions of most business owners. If you look back at the survey results quoted at the beginning of this Paper, just over half of business owners wish to transfer their companies to an “insider” (family member, key employee or co-owner).

Second, sellers to third parties may not receive all cash, or even substantially all cash. Much depends on the size and intrinsic strength of the company, and on the state of the Merger and Acquisition marketplace.

On a personal level, owners who choose this exit route must be prepared to walk away from their companies, but often not before working for the “new boss” for one to three years. All owners who sell to third parties wrestle (with varying degrees of success) with the issue of losing a meaningful part of their lives.

Also lost in a sale to a third party is the company’s corporate culture or mission. As a company merges with a competitor or is assumed into a larger entity, its culture and its role inevitably change.

Last on the list of disadvantages is the owner’s perception that a sale to a third party means that employees’ jobs are at risk and that their career opportunities are, at best, limited and, at worst, jeopardized.

This perception appears on the list of disadvantages because it is so widely held by owners of privately held companies. Extrapolating from the mergers and acquisitions that they see among public companies (that in fact, often do lead to massive layoffs) they assume that the effect on their employees of a merger or acquisition of their company will be the same.

In our experience, however, few employees lose their jobs. Employees may, and often do, choose to leave a new employer for reasons that have nothing to do with limited or diminished career opportunities. In fact, because larger (and often public) companies do the acquiring, employee career opportunities frequently improve. Compensation and benefit packages rise to the level of the larger organization. When competitors make an acquisition, they put high value on the workforce of the acquired company.

The disadvantages of a sale to a third party are:

• Inconsistent with original exit goal of approximately 50% of owners (see study cited on page 1).
• Loss of owner identity.
• Loss of corporate culture and mission.
• Receipt of a perhaps significant part of the purchase price subject to post- closing performance of the company.
• Potentially detrimental to employees.

Note that owners of smaller companies are less likely to close all-cash transactions and will likely have to accept promissory notes and a loss of control.

For more information on sales to third parties, please contact us.

IPO

The exit route marked “IPO” or Initial Public Offering occurs very rarely, but attracts the attention of business owners amenable to a sale to a third party for two reasons. First, the valuation of the ownership interest is usually higher than in any other form of transfer— including the sale to a third party. Second, an IPO brings with it an infusion of cash (from a pocket other than the owner’s!), which propels the company to a new level. Not surprisingly, the advantages of the IPO: 

• High valuation on ownership interest; and
• Cash infusion for the businessare extremely attractive to the owner weighing various exit routes.

Unfortunately, the IPO is not without significant disadvantages. The primary one is that despite the high valuation placed on and paid for an owner’s interest, the IPO is not a liquidity event for the owner.

An owner’s interest is exchanged, at closing, for interest (shares of stock) in the acquiring entity. The owner is typically prohibited from cashing out these shares until a prescribed future date. Also prescribed is the rate at which the owner can sell his new shares. And last, but certainly not least, when the former owner does sell his shares, the price per share varies (often significantly) from the price at closing.

Not only is the closing a non-event from a liquidity standpoint, it is also a non-event from a departure standpoint. In most IPOs, the owner is required to stay on with the acquiring company. Staying on is difficult because the former owner is no longer in control. She may still be the CEO, but she is accountable to shareholders,

Finally, an IPO creates a public company. As such, it is subject to reporting requirements and must uphold fiduciary responsibilities not required in privately held companies. Many business owners chafe under these additional requirements.

To summarize, the disadvantages of an IPO are:

• No liquidity at closing.
• No exit at closing.
• Loss of control; and
• Additional reporting and fiduciary requirements.

ASSUME PASSIVE OWNERSHIP

Another exit route that an owner can choose is to keep the business while assuming the role of a passive investor. This route attracts owners who wish to:

• Maintain control.
• Become gradually (or rapidly) less active in the company.
• Preserve company culture and mission.
• Minimize risk (or owners perceive risk to be low); and
• Maintain or even increase their cash flow with less risk of income loss.

The first four advantages listed above are the same as those listed in other exit routes. The last, however, deserves comment.

In some cases, especially in businesses with a value of less than $5 million, owners feel they are at less risk keeping their businesses than selling them when a third party buyer makes a major part of the purchase price subject to a promissory note or some type of “earn-out.”

The disadvantages to this exit route are fairly obvious. The owner:

• Never permanently leaves the business.
• Receives little or no cash when he leaves active employment.
• Is delayed on her journey to a significant post-business life; and
• Continues to experience risk associated with ownership.

LIQUIDATION

There is only one situation in which this exit route is appropriate: the owner wants to (or must—usually for health reasons) leave the company immediately and has no alternative exit strategies in place. Liquidation offers then, the two benefits most important to the owner in that position: speed and cash.Not surprisingly, the disadvantages to this exit route are numerous. First, liquidation yields less cash than any other exit route primarily because no buyer pays for non-existent goodwill.

Second, owners who liquidate often must allocate a greater proportion of their proceeds to taxes than do owners in any other type of sale or transfer.

Finally, owners considering liquidation must anticipate a devastating effect on employees and, to a lesser extent, on customers.

Given these disadvantages:

• Minimal proceeds.
• Significant tax consequences, and
• Affect on employees/customers.

Few owners pursue liquidation unless they have no alternative or unless they operate in an industry that is clearly in decline. In that case, however, if owners engage in significant tax planning years in advance of their exit dates, they can accomplish significant income-tax savings.

CHOOSING YOUR PATH

Which exit route is best for you? Which one meets your Exit Objectives? Which path is best for Ben, Tom and Larry in our case study?

Comparing the advantages and disadvantages of each path is a good way to start making that determination. Make this comparison through the lens of your objectives is the basis for your Exit Planning process: your exit objectives and your company’s value.

Owners need to establish their objectives (financial and personal) before they can identify the best buyers for their businesses. Once established, objectives (the timing of your exit, the amount of cash you need, and the type of future owner you prefer) become standards by which you can evaluate the various exit routes.

In determining company value, you learn important information about what you can expect to receive in a third party sale or through an IPO, for example. An accurate valuation will also tell you how much, in a sale to key employees, co-owners or family members, you will leave on the table. For all owners, valuation indicates the distance they must travel to reach financial security. How they reach this and other exit objectives depends on the exit path they choose.

In creating the best road map for your exit, use your objectives and the value of your business to carefully weigh the benefits and

detriments of each path. Armed with this analysis and at least advisor skilled in exit planning, you can map out the most appropriate exit path for you.