This is the first installment of many on the topic of business owner exit planning. What is business owner exit planning? Business owner exit planning in its most basic form recognizes business owners will not operate a business forever and in many ways runs parallel to what you may recognize as estate planning. Stated differently, what do you as the owner and operator of a business want to happen when you are no longer able—or want to—continue running it? Similar to estate planning, there are many proactive things you can be doing right now to save you time, money, and headache for your eventual exit.
There are areas in which business owners can and probably should be thinking about their eventual exit. Therefore, we begin at the earliest stage of the business life cycle—inception.
We often think of businesses beginning as an idea. The idea may come from some anecdotal experience and a thought of doing “it” better than everyone else. It may come from a hobby turned passion. It may come from having some unique insight into an industry or simply finding an opportunity to turn arbitrage into profit. Whatever the idea, entrepreneurs should consider their potential exit before they even begin. Here is why:
You could pay more in taxes
A properly structured exit plan can result in material tax savings when it comes time to sell or transfer the business to key employees or family. The federal tax code creates unique incentives for certain types of businesses. For instance, new business owners might benefit from provisions that permit business owners to exclude up to $100 million dollars of taxable gain when they sell. Similarly, employee stock ownership plans (ESOPs) can defer an unlimited amount of taxable gain on sale, and provide a tax leveraged method for transitioning ownership, in the right circumstances. New business owners may or may not qualify for such planning simply based upon how your business entity is classified for federal tax purposes.
On the other hand, certain types of businesses are ineligible for this preferential tax treatment and not all potential buyers may be willing to acquire your business in a way that qualifies. In such cases, improper structuring could result in two separate levels of income tax. The first level of tax occurring when the business owner sells its assets, and the second level occurring when the business liquidates. Having an exit plan from inception lets professionals who are experienced in business transitions provide new businesses with an efficient tax structure, designed to minimize taxes over the life of the business.
You may create obstacles to the desired exit path
Starting a business is an arduous task involving many different specialists, which may be completely unrelated to your new company’s mission. You may find yourself overwhelmed in the startup phase, giving little thought to an eventual exit. However, failing to address an exit during the startup phase may create obstacles to your desired exit path. For instance, you may find yourself tempted to incentivize early employees with equity in the company. What happens if your governing documents require unanimous consent from the equity holders approving a desired equity sale down the road? You may be stuck trying to convince minority owners to agree to a desired exit, causing unnecessary headache, delay, and exit-related expenses.
You can manage the business toward a chosen exit goal (rather than annual profits)
A startup may find it tempting to focus their attention on short-term metrics such as generating free cash flow or earnings before interest, taxes, depreciation, and amortization (EBITDA). However, one possible exit plan may involve selling everything to private equity or a much larger competitor. If potential buyers value acquisition targets (i.e., your business) using a sales multiple or some other measure and you exclusively rely on annual EBITDA, you might not be maximizing the benefit you receive upon exit.
You can train, hire, and incentivize those who will run the company after your exit
In the current business environment, finding and retaining talent is a challenge for any business. On top of this, there are additional considerations for business owners wanting to hire one or more employees to eventually take over running and owning the business. You may want to incentivize new employees with a mix of cash and equity compensation. Letting your service providers know a transition to one or more employees is your desired exit, gives them helpful information for structuring your new business.
You may disagree with your business partners
Many businesses begin in some form of a honeymoon phase. Everyone is content and has high hopes of the success that lies ahead. If your business plans involve more than one person holding the reins, then it makes sense to think about exit planning before you begin. Not every owner will share the same view on exit planning. Therefore, it is important to put in place mechanisms that can prevent a premature or even unwanted exit. These mechanisms may include, among others, voting agreements, tie-breaker rules, mediation or arbitration provisions, buy-sell rights, and insurance requirements. Failing to consider these mechanisms may result in an untimely exit or even the end of an otherwise successful business.
Key employees may leave
A successful business needs to attract and retain talent. What happens when a key employee leaves for greener pastures? Planning to minimize employee turnover from the beginning can help maximize business valuations upon exit. Businesses should consider the benefits of maintaining employee handbooks, employment agreements, work for hire clauses, noncompete clauses, incentive compensation arrangements, etc. Ideally, when a key employee leaves there should be a minimal impact on business operations.
You may be asking yourself, how is this relevant to exit planning? The answer is any potential buyer of your business is going to look under the hood and kick the tires in due diligence. Having solid employee-related agreements in place from day one helps minimize potential issues that may arise in the due diligence phase and helps maximize the value business owners receive upon an exit. To the extent you are the only person who can run the business, the business value to a third party may be lower.
Your heirs may not want to take over the business
Some new businesses may plan to hand over the reins to their children when the time comes for retirement. While this is a workable exit plan for many businesses, it isn’t for everyone. If you know that you’ll be transferring the business to your children, then it’s best to plan for this outcome from the beginning. It may be possible to gift interests in the business over time and minimize the tax impacts. It may also be possible to retain control and voting rights in the business, while transferring economic interests to one or more children. If a business owner fails to plan for this exit from the beginning, they risk letting the business die on the vine when their children take over the business and find themselves unprepared or lacking the skills necessary to run a business. It is important to start the transition early and plan for contingencies when a child says “thanks but no thanks.”
It is easier to do things right the first time. Most owners only get one chance to exit their business in the manner they choose.
While even the best laid plans are always subject to change, it is much better to have a plan versus failing to plan. In my experience, it is much more costly to “fix” an issue after it occurs rather than planning and doing it right the first time. Businesses should work with experienced and qualified advisors to get things done right the first time. Failing to properly document ownership and other business-related transactions can be costly to clean up later. Worst case for your exit plan? The failure to do it right the first time causes a potential buyer to walk away or a transition in ownership to fail.
Be prepared to think about your exit before you even begin. Confused about where to begin? Below are five questions to help get you started. Still have questions or ready to take next steps? Please contact us for more information.
1. How will your role with the business change over time?
2. What issues could arise that would prevent you from finding success?
3. What is your plan for your ownership interest in the business?
4. Who will lead the business after you?
5. What can you do to retain suppliers, employees, and customers once you exit?
This article is provided for informational purposes only—it does not constitute legal advice and does not create an attorney-client relationship between the firm and the reader. Readers should consult legal counsel before taking action relating to the subject matter of this article.
