By Michael Torney, CFP, J.D., LL.M., CEPA
So, you’ve started thinking about exiting the business. It happens to every owner at some point. We spend so much time building the business and running the business. But at some point, we start to think about retirement, spending less time at work, or putting more time into another hobby or business idea. If you’ve found yourself reading this article, chances are you’re wondering how you turn this business into an income stream that will allow you to focus on what’s next.
There are generally four options available for owners looking to exit the business. We’ll cover each one here and some relative advantages and disadvantages of each. As with most things in life, the earlier you start to have discussions about these topics, the more you can plan.
The more you can plan, the more options you have. You can:
- exit the business on your timeline
- earn more money from the sale
- stay involved in certain areas of the business but delegate others that do not give you fulfillment
- find the right party for buying the business
Selling to Insiders
This is probably the most commonly used exit path. Often, executives within the company would happily buy the company from the owner if given an achievable road map. This can have a number of advantages. The owner can engineer a longer exit path compared to selling to a third party. There’s comfort in knowing that the key employees will stay at the firm because they are owners – this can help ensure the business’s legacy. Sometimes, this can be more profitable than other transfers because of the longer runway where an owner can still receive income as part of the buy-out, though their workload is much smaller. The fact that the path is longer also allows for a contingency sale plan in case something happens to the next generation of buyers along the way. Owners who choose a longer runway also have more time to learn what they would like their life to be in their next venture while still having one foot in the door of the business. Finally, the owner can negotiate better tax mechanics for the sale than are available for a 3rd-party sale.
The disadvantages to this approach are there can be more at risk financially than a 3rd party sale where more money is paid upfront. Since the buyers don’t have the liquidity day one, they either take out debt or pay from future earnings. Either scenario potentially puts more risk on the business operations that may need to be overcome. The longer buy out can also be problematic if a business owner needs to exit quickly. Last, if the buying group does not include at least one person who has an entrepreneurial mindset, it can be problematic.
Selling to Family
This is another very common approach for business owners. What better way to set your kids up for success than to help transfer a successful business to them? There are a few advantages to transferring to family. You can get solid financial security and design the transfer along a timeline that’s in your control and allows you to control the business decisions along the way. The transfer process typically takes longer than selling to a third party, which provides time to mentor the next generation on how to run the business well. The longer time horizon on the sale also allows owners to gradually transition into retirement. Finally, it allows the family legacy to deepen through continued management of the business.
But it also has some disadvantages. What if your kids are not a good fit to run the business? You might get a good sale price and bankrupt them in the process. Even if they are a good fit, they might not be ready on the same timeline as the owner. The longer time horizon for the sale means the owner can’t cash out right away. Transferring business within family often creates family discord, especially if one family member has more decision making authority.
Sell to a 3rd Party
This is the route most people think of when they imagine a sale. Compared to selling to insiders or family, there are a few advantages to selling to a third party. The biggest advantage is you get most of your cash up front! You can also potentially get additional compensation if the buyer has certain incentives they want your help in obtaining. The sale can be quicker than insider or family sales. The sale can usually be done in a more tax favorable way than selling to family or insiders also. Finally, you avoid the family dynamics problems that come with selling to family – you can just give everyone cash!
There are some disadvantages though. You may not get as much control over your company’s legacy. Often the acquiring company will make changes you would not agree with. Sometimes the purchase has an earn-out component – since you’re out of the business you risk not having those earn-outs paid. The fast paced sale can be bad for owners who are not ready to dive into retirement. The tax consequences of a sale to a third party without proper planning can be dramatic.
Sell to an ESOP
This is the sale that most owners are not familiar with. An ESOP is a type of qualified retirement plan. Yes, you can sell your business to a qualified retirement plan! Essentially this is an alternative way to sell the business to your employees. But it has a number of advantages over a traditional sale to insiders and advantages over a third-party sale.
You can do a partial sale, and get a liquidity infusion while still working in the business for a period of time. Then you can sell the remainder at a later date. An ESOP sale can also be flexible on the timing of the transaction, allowing you to ease into retirement and/or get key employees or family members mentored and ready to run the business. It has a number of tax benefits beyond the scope of this article but is covered in another blog post we’ve done. Depending on how it’s structured, the entire sale can be tax-free. The ESOP sale also allows for your values and culture to live on – after all, you are picking the people who are going to run the business after you’re gone. ESOPS also have attractive financial incentives for the key employees who will run the business.
There are a number of disadvantages too. First, ESOP sales are often complicated. There are generally a lot of different experts needed to do an ESOP sale correctly. ESOPS are expensive – they can still be very beneficial even after expenses, but they are expensive nonetheless. Depending on facts/circumstances, ESOPS may provide less capital than a third-party sale (though the opposite can be true with the addition of warrants and some other features of ESOPS). ESOPs often make you wait for your cash and force the future business revenues to fund it – if the business falls on hard times you may not experience your liquidity event. Even if the business can fund an ESOP sale, it may put a strain on cash flow because of the payment schedule.
Those are the four most common exit paths for business owners. If you have questions about how to best exit your business, reach out to a member of the team to schedule a consultation about your business at DuffTeam@monetagroup.com. We are happy to discuss how/if we can help you maximize the sale of your business.
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