When you decide it’s time to move on from your business, you need to choose your exit avenue carefully. It’s a busy intersection. Whether it’s passing the business on to a family member, turning control over to your employees or evaluating your merger and divestiture options, you have a lot of options to consider, and not all roads lead to the destination you want.
Achieving both your personal goals and your objectives for the company after your exit requires a careful weighing of the facts and circumstances of your environment. Start by considering what you want to do after you transfer control of your business. Examine your other sources of income, such as the rate of return you expect on current investments and the expenses, cost or quality of life expenditures that may come up. This will give you an idea of what you need to get from your business’s sale or transfer. Next, determine what you want for your business. How important is it that you maintain control? Do you want to keep it within the family? Do you want to preserve its name and mission? Non-financial considerations play a significant role in choosing which exit method to pursue.
With clear personal and business objectives in mind, next look at some of the most common exit options. Weigh the benefits and disadvantages of each, and you’ll start to see the signs for which path to take.
Employee Stock Ownership Plan
If your business is a corporation, consider an Employee Stock Ownership Plan (ESOP). ESOPs are tax-qualified, defined contribution plans that invest primarily in the stock of the company. ESOPs create a market for private business owners to sell some or all of their interests in the company, while deferring taxes and diversifying their investment portfolios.
Companies establish ESOPs on behalf of employees, and the ESOP borrows money to buy the owner’s stock. The lending bank typically holds the purchased shares as collateral and generally requires payment guarantees from the company, the selling shareholders and/or the remaining shareholders. The loan is paid back by the company making tax-deductible contributions to the ESOP. As the contributions repay the loan, shares are released to employees, typically pro rata in relation to their compensation. In this manner, owners transfer some or all of their stock to their employees at fair market value, as determined by an independent appraiser. Business owners looking to retain control of the company may find ESOPs appealing because they can maintain a controlling interest for as long as they want, or they can become trustees of the ESOP and maintain control of the voting rights of the shares held in the ESOP. The company also must agree to repurchase employees’ vested shares upon separation from service at the current appraised fair market value.
Creating and managing an ESOP, however, is complex. Because an ESOP is a qualified plan, it is subject to both federal tax and Employee Retirement Income Security Act of 1974 (ERISA) statutes, regulations and rules. This includes the prohibited transactions rules, which are intended to ensure that no transactions take place between the ESOP and the company that might directly or indirectly benefit an owner, fiduciary or related party. Another requirement is that company must have the stock valued annually by a qualified appraiser knowledgeable about the ESOP appraisal rules.
Choosing to establish an ESOP as an exit strategy is a complex decision and should be discussed with your advisors, but it potentially affords tremendous benefits for closely held business owners.
Deciding to whom you can afford to sell the business is a critical step in your exit method evaluation process. Transferring your business to a family member tends to produce lower sale values than what you would find by going to an outside party. To determine if this is an acceptable trade off, you need to consider both your goals for the company and for your personal finances.
Intra-family business sales often use discounted cash flow valuations to determine the price. If your company’s discounted cash flow valuation is in line with your target exit value, you can then look at the different options for transferring control. Common methods of transfer include creating a family limited partnership, grantor-retained annuity trusts or self-cancelling installment notes. Consider each option’s effect on your estate planning and determine the best option for you and for the person or persons receiving control of the business.
If your intra-family sales price isn’t high enough or doesn’t produce the necessary liquidity, you may have to pursue another exit method.
Companies that sell to strategic buyers tend to get sale values on the higher end of the spectrum. Rather than using discounted cash flow valuations, strategic buyers tend to use more complex valuation formulas. The sale price, for example, may reflect multiples of your company’s normalized EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). You can help lock in a favorable EBITDA multiple if you can demonstrate a strong earnings history and a bright outlook for increased earnings.
To determine what a reasonable value for a sale to a strategic buyer should be, test a commonly used valuation formula against a comprehensive valuation of your business. Keep in mind, certain agreements within the transaction may also play a role in your sales price, such as your willingness to accept stock, an installment note or variable payout based on your company’s performance.
No matter which exit method you decide to pursue, planning for your exit should begin long before you want to transfer control of the company. For example, if you want to leave the company to someone you know, you have to consider the training you will need to bring that person up to speed with the way the company operates. If you decide to use an ESOP, you should consider the optimal time to establish the ESOP in your business life cycle to make sure you are getting the maximum value for your investments in the company.
For additional assistance or questions about your exit methods, please contact your local CBIZ MHM professional.
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