The Business Owners’ Special Series (B.O.S.S.) No. 31
By Rich Gunn, CEPA, CPA and Craig Hamm, CPA
An effective exit strategy includes identifying the right type of buyer early in the exit planning process. Before you can identify the right type of buyer, however, you first have to identify your exit goals and objectives. Next, you identify which type of buyer will align with those exit planning goals and objectives. In other words, your choice of buyer should be in sync with your exit goals, and your goals should be supported by your exit strategy. Once you understand the types of buyers in the marketplace, you can then determine which type of buyer supports your exit strategy.
Keeping the business in the family gives rise to many exit planning challenges and opportunities. Founders may expect a payout at exit or a post-exit income stream, whereas children may be expecting to inherit the business with no cash outlay required. Heirs can purchase the entire enterprise. Alternatively, heirs may purchase a partial interest in the business, with the rest of the interest in the business being gifted or inherited. The exiting founder can receive a post-exit income stream in the form of an installment sale of equity, or compensation for continued service as an officer or board member. These are some of the many possibilities that should be explored early in the exit planning process.
Some pros of keeping the business within the family:
- The founder’s legacy goals are more likely to be adhered to. Heirs are more likely to continue the company culture, keep up its commitment to the community, maintain the current location, preserve local jobs, protect the current employees, and maintain commitments to the current customer base.
- Family continuity of ownership preserves the appearance of commitment to quality of product and services in the eyes of loyal, long-term customers.
- Heirs are “insiders” so there is far less time commitment in the transition process, and far fewer legal expenses, when compared to a third-party sale.
- Founders may retain a post-exit income stream.
Some potential cons include:
- Founders may not receive a full payment up front, as they would with a sale to a third party.
- There is no cash infusion in the business as there would be with an exit plan that includes selling a portion of the business to professional investors (thereby using investors’ funds to fund growth strategies, followed by the ultimate sale of the business).
- Continued family wealth is dependent on the next generation’s success. Statistically speaking, the failure rate of second- and third-generation of owners is huge. Less than 15% of family business succeed beyond the third generation.
- Key management who are not family may feel resentment if they believe they are more qualified to run the business than the heirs who are now in charge. This may result in turnover of key staff, and a loss of historic business knowledge and talent.
- Animosity may develop between heirs and founders if the founders cannot “let go” and allow for heirs to manage with business with autonomy.
- Not all heirs who inherit ownership of the business will actually work in the business. Conflict may develop in the area of entitlement to the business profits among the heirs who work in the business and the heirs who do not.
- Business owners (and some professional advisors) confuse estate planning with business transition planning. The estate plan is just one component of the business transition plan
- It takes a very disciplined owner with a thorough exit plan to sufficiently develop and train the heirs to successfully run the business independently.
- Anticipating and effectively addressing conflicts among management and among family members is extremely important. This must take place early in the exit planning process.
2. Employees or Management (Buyout):
Similar to transitioning the business to heirs, in an employee or management buyout the founder’s legacy goals of the owners are more likely to remain intact than with third-party sales. The founder may finance the sale with a note payable to the founder, typically repaid in the form of business profits over several years. If the founder wants cash up front, the employees can involve a lender or investor.
Pros of selling to this type of buyer:
- Employee or management buyouts typically preserve continuity of company culture and commitment to the community, maintain the current location, preserve local jobs, protect the current employees, and maintain commitment to the current customer base.
- Diversifying risk: Selling a business for cash is effectively converting the investment in one single business (a high-risk investment) into a diverse portfolio of investments that can be professionally managed.
- Employee ownership preserves the appearance of commitment to quality of product and services in the eyes of loyal, long-term customers.
- Employees are “insiders” so there is far less time commitment in the transition process, and far fewer legal expenses, when compared to a third-party sale
- Employees often do not have sufficient cash to buy the business.
- Seller financing provides no cash up front to founder, leaving the founder vulnerable to risk of payment if the business fails. Bank financing is possible but not always available.
- Pricing: Employees may buy the business for fair market value, as provided by an independent business valuation professional. However, this price may be less than the price provided by third-party buyers who are competing to buy the business.
- It takes a very disciplined owner, with a thorough exit plan, to sufficiently develop and train the key employees to run the business successfully and independent of the founder.
- Employees often desire the rewards of ownership without understanding the risks of ownership. Employees should understand, as owners, they may be required to personally guarantee leases, lines of credit, and bank loans. They may need to make additional investments in the business to keep the doors open during economic downturns, pursue opportunities to expand, and fund other financial challenges that may occur in the natural business lifecycle.
- Structure: Would this be a sale to all employees or only key managers? Would it require outside financing? Would this be straight sale of the business, or would it involve other vehicles, such as an employee stock ownership plan (ESOP) or employee cooperative? Have you considered the pros, cons, costs, legal requirements, tax issues, and other unique issues involved with these alternative structures? Each one of these options has its own unique challenges and opportunities.
Current co-owners are also insiders, which often makes for smooth ownership transitions. If a buy-sell agreement is in place that defines a formula for a buyout price, there is little to negotiate in the sale process.
- Continuity of company culture, commitment to the community, maintains the current location, preserves local jobs, protects the current employees, and maintains commitment to the current customer base.
- Co-owner sales preserve the appearance of commitment to quality of products and services in the eyes of loyal, long-term customers.
- Co-owners are “insiders” so there is far less time commitment in the transition process, and far fewer legal expenses, when compared to a third-party sale
- Lack of competitive bidding means the exiting owner may not achieve the highest possible sale price.
- The exiting owner may have unique skills, talents, or technical knowledge. If remaining owners do not possess such skill, they may have to recruit an expensive, high-level employee to replace the exiting owner. Such a high-level candidate may insist on immediately becoming an owner, complicating the transition process.
- Co-owners may lack the funds to buy the exiting partner’s ownership. In that case, the sale price may be paid from future business profits, meaning that the sales proceeds are contingent on the continued success of the business. If the exiting partner was the rainmaker for the business, the risk may be significant.
Every third-party buyer will go through a discovery process to determine if they want to buy your business, and then a further discovery process to determine how much they are willing to pay to acquire it. This is a normal process (often summarized under the buzzword “due diligence”) that cannot be avoided by a seller.
- The buyer understands your industry. That means the time you spend with the buyer on the due diligence process can be less than with other third-party buyers.
- If your brand is stronger than your competitor’s brand, that can have a positive impact on the price they are willing to pay.
- If they have a recent history of acquisitions in your industry, there is a higher likelihood of completing a sale than with a buyer who is looking at your business as their first acquisition.
- If the buyer has a positive reputation in the industry, employee retention and customer retention is more likely to stabilize after the sale than if they are new to your industry or have a weak reputation.
- A buyer will learn a lot about your business in the due diligence process. If the sale does not come to fruition, your competitor now has far more information about your business than you would like them to have.
- If the buyer has a stronger brand or superior product, they may only be interested in eliminating a competitor, and therefore they may offer a price that is far less than current potential value.
- There is no guarantee that they will keep the current employees, retain all your customers, or continue all ancillary products or services, and there could be a drastic change in company culture.
- If the competitive buyer is not local, there is also the possibility of the business being relocated to a lower-cost location and your employees being terminated.
5. Strategic Buyers
This typically involves the sale of your business to a company that does not currently sell the exact same product, but can bundle your product into their product, or otherwise sell your product to their current customers. In most cases the buyer is a much larger player in the industry and can achieve dramatic improvement in sales fairly quickly. For example: if you are selling one million units per year, they may easily increase sales to one hundred million units of your product per year, with little effort.
- The seller is more likely to receive a higher price from a strategic buyer because of the buyer’s upside from the increased sales multiplier upon acquisition of your company.
- An industry giant is more likely to pay cash without the need for third-party financing.
- An industry giant may offer a tax-deferred acquisition, if owning shares in the buyer is of interest to you.
- If the buyer is active in acquisitions, due diligence can move quicker than with a smaller buyer that does fewer acquisitions.
- The buyer may make significant changes that affect your legacy goals, your employees, and current customers.
- A change in business culture is highly likely.
- The buyer may relocate your business to another state or country.
- The buyer may terminate your brand name or discontinue products or services that are not important to their product strategy.
- The buyer may even terminate your entire business operations once they have acquired the rights to your products or intellectual property.
6. Private Equity
Private equity firms are actively seeking profitable businesses to acquire. They often target businesses of a certain size or a specific industry. There is a rapidly increasing number of private equity firms in the marketplace. Key facts you will want to know are how many acquisitions they have already made in your industry and how satisfied those sellers are with the sale results. Note that PE buyers often want sellers to remain as an employee post-sale.
- Immediate cash sale: Private equity firms raise money from investors for the sole purpose of buying businesses, so cash up front is available.
- Flexibility: There may be an opportunity to receive ownership in the acquiring company. This allows you to take some cash now, while retaining some ownership in the acquiring company, if that is desirable to you.
- Continued employment: If you were planning on selling and immediately retiring to a Caribbean beach, you may have to reconsider your plans. The deal may require you to continue to work in the business for several years, or until the subsequent sale.
- Loss of autonomy: If you continue to be employed post-sale, you are no longer calling the shots. That can be a difficult adjustment for many business owners.
- Private equity deals are rarely simple. Legal fees and other professional fees with be high.
7. Family Office
While this is not a new development, it is a growing opportunity for business owners to consider in their exit strategy. Families with extensive wealth are moving some of their assets away from traditional wealth managers, and instead using it to buy businesses, not necessarily to buy and resell, but to keep as a portfolio of business investments.
- Immediate cash up front.
- Family offices can be included in a bidding process and offer a competitive price.
- If you no longer want the risk and stress of ownership, but are not ready to retire, family office investors may be interested in retaining you as chief executive.
- If their portfolio has other businesses in your industry, an early retirement may be an option if continuing to work is not on your agenda.
- If they have no experience in your industry, they may require your continued employment while that Caribbean beach is calling your name.
- While offering a competitive price, they may not pay as high a price as a strategic buyer.
- If you are in a regulated industry, and the buyer has no experience in this industry, they may be unprepared for the complexity associated with the regulatory environment, and the deal may fall apart after you’ve invested considerable time and effort trying to close a sale.
The Bottom Line
Exiting your business should be the most satisfying event of your life as a business owner, a crowning achievement on top of a lifetime of hard work. This is what exit planning from an early stage can do for you. The first step is to articulate your post-exit goals and objectives. Commit them to writing. Develop a written exit plan with specific action steps that will accomplish these objectives. Your planning process will determine the type of buyer that aligns with your exit goals. Remember that early planning leads to more successful outcomes.
Discover More Exit Planning and Value Acceleration Insights
This article is No. 31 in the Business Ownership Special Series (B.O.S.S.), an ongoing cycle of informational guides from BPM designed for business owners who are proactively seeking guidance from experts on how to implement value acceleration in their business, delivered each month straight to your inbox. For more insights, download our e-book, “Value-Focused Business Planning,” and check out the rest of our B.O.S.S. articles.