Welcome to The Charleston Entrepreneur Podcast where you go behind the scenes with financial planner and business exit planner, Brett Fellows to hear stories of how leading Charleston entrepreneurs navigate the inevitable challenges that arise on the path to financial freedom, and get insights from real business owners about how to break through to the next level in your business. And now here’s your host, Brett Fellows.
Welcome everyone to The Charleston Entrepreneur Podcast. In the beginning of these podcasts, I often will mention that it’s my radical idea that personal finance should be personal. Ultimately, the human element in each of us is what makes up personal finance. You and I are business owners doing the best we can to make the right decisions about our personal lives with the information that we have. So in this podcast, it’s my goal to give you everything I have to make you successful. I want you to live your most fulfilled life. And I know you can do it.
So as a business owner, here’s one thing, one personal thing I know about each and every one of you. If you haven’t already, at some point in time, you are going to leave your business. And for most of us, that event is going to be something that funds our future, or let’s say, commonly, for retirement. And for many, that’s an overwhelming thought, because the number of possible ways you can leave your business, or what’s known as exit paths can seem limitless.
In reality, however, there are only seven options.
If it’s a family business, you could transfer your company to family members. A second option is you could sell your business to one or more key employees. If you want to sell to your key employees, and they can’t afford it right now, you could maybe use what’s known as an employee stock ownership program, or ESOP. If you’re in business with other owners, you could sell to them. You could sell to an outside third party. You could retain your ownership but become a passive owner. And lastly, you could simply close up shop and liquidate your business.
So in today’s episode, I want to dive a little bit deeper into the advantages and disadvantages of each of those exit paths, and then give you a process you could use to choose the best exit path for yourself one day.
So what do most small business owners use? In my experience, 60% of small business owners anticipate a transfer to the next generation of family members or key employees, while less than 40% of business owners look to sell to a third party.
So how do we choose who we sell to and what is the best exit path?
How do we agree on an exit strategy that is fair for everyone? The answer to that question is, there are five steps we first have to work through. And this will apply to all types of ownership entities and exit paths.
Step one, start thinking about your exit path before you are ready to exit. Like most things in life, time is your greatest asset. And the owners who give themselves time to plan give themselves the greatest number of exit path options.
Step two, as an owner, put your objectives and the resources available to reach those objectives in writing. What I mean by that is: when do you want to leave? Put that in writing. How much money will you need? Put that in writing. What resources do you have that could achieve those objectives, like the business’s value, any non-business income, and business cash flow? Put those in writing too.
If you do no other step than just this, it really will help you evaluate how well choosing the right exit path matches your objectives and resources. And the reality is it will also facilitate the frank discussions about whether that is even realistic. It helps get rid of any conjecture or wishful thinking that will be there.
Step three, retain a professional to determine your company’s fair market value. What this does more than anything is that it helps eliminate potential exit paths. Let’s say the value of your company is high, but you as owner are not willing to devote the time necessary to orchestrate a transfer to your key employees. Well, then selling to a third party is a better option for you.
Now business valuations get expensive so depending on the size of your company, there are different levels of valuation you can have done. So, know that and get some feedback on that before you engage with anyone.
Step four, get serious about performing cash flow projections of your company to see if there even is enough cash to consider an insider purchase.
Step five, evaluate the tax consequences of each exit path. And I hope this goes without saying, but this is huge. This will be a taxable event and the tax implications vary. You have to plan for this.
Okay, now that we’ve gone through these first five steps, there are many similar, non-financial reasons that are advantageous for those of you who are considering:
Transferring your business to an insider, whether that be family members, key employees or co-owners
First off, you’re putting the company in the hands of a known entity, and sometimes maybe even your own flesh and blood, who you probably believe will operate the company just like you did; your company’s mission and culture will continue to live on; the company can remain active in the community. This exit path also lets you remain involved in the company. And gradual incremental sales staged over several years can offer you the possibility of upside gain, while at the same time maintaining your voting interest until you finally cashed out.
Now, the biggest disadvantage of selling to an insider, a family member or key employee: it’s a financial risk to you. What I mean by that is in almost all cases, family members or key employees are incapable of paying you the amount of cash you want, or need, for the company. So as a result, you remain tied to the company’s future financial performance.
So to mitigate this, you frankly have to stay active in the company to ensure your own financial success. Well, what’s the point in that if the objective is to stop working? And since family member or key employee buyers usually have limited resources, you’re most likely to receive little or no cash at closing. Now, this is a huge disadvantage. The goal is to convert your largest illiquid asset—your business—into cash for this event.
And lastly, what I see happen a lot: realistically, not all owners have children or key employees who are willing and able to assume ownership. Even if these people have demonstrated success in managerial roles underneath you, they may not necessarily be equipped to assume the responsibility of ownership.
Okay. To recap, the disadvantages to an owner pursuing an insider transfer are: without planning, there is little or no cash at closing available to you, the owner. You, the owner, face ongoing financial risk. And as the owner, you must remain involved in the company post-closing as children or key employees may be unable or unwilling to assume the ownership role. The final one if it is transferred to a family member: family issue—and we all have them—really will complicate treating all children fairly or equally.
Now let’s take a look at selling to a third party.
This exit path usually offers owners the best chance to receive the maximum purchase price for their company. Also, those who sell to third parties are in the best position to receive the maximum amount of cash at closing. So for those of you who want to run for the hills as soon as you sell, you want to choose this exit path. This route also appeals to owners who want to maybe propel the business to the next level but do it on someone else’s own dime.
So to recap the advantages of selling to a third party: one, it achieves maximum purchase price. Two, it usually maximizes cash at closing. Three, it allows you as owner to control your date of departure. And four, it facilitates future company growth without owner investment risk.
I know these all sound great, but let’s now obviously look at the drawbacks of selling to a third party. The first issue is this exit path does not match what the majority of business owners want to do. Remember earlier, I mentioned over 60% consider transferring their companies to an insider, like a family member or key employee, not to a third party. Second, if you sell to third parties, you may not receive all cash, or even a substantial amount of cash. So much in getting cash depends on the size and intrinsic strength of your company and the state of the mergers and acquisitions marketplace at that time.
On a personal level, owners who choose this exit path have to be prepared to walk away from their companies, but often not before working for the new owner for maybe one to three years. All owners who sell to third parties wrestle with the issue of losing a meaningful part of their lives. Also lost in a sale to the third party is the company’s culture or mission. When your company merges with a competitor or is assumed into a larger entity, its culture and role inevitably change.
Last on the list of disadvantages is the owner’s perception that a sale to a third party means the employees jobs are at risk, and that their career opportunities are limited, at best. Now, this may not be something you originally think of. But this perception appears on the list of disadvantages because it’s so widely held by owners of privately held companies—and that’s what we have here mostly in Charleston.
In truth, in our experience, few employees will lose their jobs after a third-party sale. Now employees may and often choose to leave a new employer. But those are more likely for reasons that have nothing to do with limited or diminished career opportunities. What also happens, especially when companies are bought by larger companies in the same industry, employee career opportunities frequently actually improve. Compensation and benefit packages rise to the level of that larger organization. When a competitor buys your business, they are literally putting a high value on keeping your workforce. It’s in their best interest.
So to recap, the disadvantages of a sale to a third party are as follows: it’s inconsistent with the original goal of most owners, loss of owner identity, loss of corporate culture and mission, a significant part of the purchase price depends on the company’s post-closing performance, and potentially detrimental to employees. And a final note on selling to third parties. I want to go back to cash at closing. Owners of smaller companies like here in Charleston are less likely to have an all-cash closing. You’re likely to get or have to accept promissory notes on the future of the business as payment. And at the same time, you will have a loss of control. So this is big and since most of Charleston is small business owners, I thought it important to go back and mention.
Wrapping up, there is one more way a small business owner often exits from their business: liquidation.
Now from a planning perspective, there is only one situation in which this exit path is appropriate: when you, the owner, want to or must (usually for health reasons) leave the company immediately and have no other alternative exit strategy in place. A liquidation will offer two benefits most important to an owner in that position: speed and some cash.
Not surprisingly, there are a ton of disadvantages to this exit path. First and foremost, liquidation yields less cash than any other exit path. And that’s because there are no buyers. No buyer is going to pay for non-existent goodwill. Second, owners who liquidate often are forced to allocate a greater portion of their proceeds to taxes. And finally, owners considering a liquidation must anticipate the effect on employees and to a lesser extent, the effect on customers. So given the disadvantages of little proceeds, significant tax consequences, and the negative effects on employees and customers, not many owners pursue liquidation unless they have no alternative.
So which exit path is best for you?
Which one meets your exit objectives? Comparing the advantages and disadvantages of each exit path is a good way to start making that determination. Making this comparison through the lens of your objectives is really the basis for your exit planning process.
As owners we need to establish our objectives, both financial and personal, before we can identify the best buyers for our business. And if you remember nothing else from this podcast today, remember this. First, establish your objectives. Meaning, the timing of your exit, the amount of cash you need, and the type of future owner you’d prefer to sell to. And second, determine your company’s value. In creating the best roadmap for your exit, your objectives and the value of your business will carefully weigh the benefits and detriments of each exit path.
Thanks for tuning in today everybody. As always, visit our website, oakcapitaladvisor.com, for more information or click on the free retirement assessment to get started on your retirement planning journey. And check out the show notes for more resources that can help you succeed. Until next time, have a great day.
This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal financial or other professional services.