What is the Best Way to Exit a Business

What is the Best Way to Exit a Business?

by Bill Mitchell Business Broker at Sunbelt Business Sales in San Francisco Bay Area

All business owners eventually face the question of what will they do with the business they have built.  There are a myriad of reasons for wanting to exit a business, such as retirement, relocation, poor health, divorce, burn-out, or the desire to pursue other business interests, but there are surprisingly few ways to actually do it.  This short write-up is not a comprehensive review of these options, but is a summary of what they are and some of their merits and issues. 

Four Primary Courses of Action  

That's not many options is it?  I have listed below these options in the order (highest to lowest) of the value you may expect to realize from each. 

  1. Put the business on the market and sell to an outside buyer. 
  2. Create an Employee Stock Ownership Plan (ESOP) and sell your business to it. 
  3. Sell it to insiders: your employees or family members. 
  4. Close down the business and liquidate the assets. 

 

Selling to an Outside Party

This is the method most likely to yield the best value and terms provided the business is one that is attractive to an outside party.  Many businesses are not attractive to buyers, especially those that are unprofitable or only marginally profitable or too dependent upon the talent and efforts of a single person.   However, a profitable business whose operations could readily be assumed by a new party is often a good candidate for sale to outside buyers.   

There are two basic types of buyers: financial and strategic buyers.  Most buyers are financial buyers.  They will value the business based on a financial analysis of its operations with little, if any, regard to how this business might impact other businesses.  A strategic buyer’s analysis, however, will not only focus on the target business but also on what enhancements that acquiring this business might garner for their existing business; or as some put it: will one plus one equal three?  A strategic buyer can be expected to be willing to pay premium above what a financial buyer would pay.  For most practical purposes, relatively few small businesses make good strategic acquisitions and most buyers will value businesses based on historical financial performance.    

There are two types of business sales: an asset sale or a stock sale.   An asset sale is a sale of all or some of the business' assets, possibly along with the assumption of selected liabilities.  A stock sale, on the other hand, is the sale of the legal entity, or specifically the company’s stock.  The business does not change, simply its ownership.  If the business being sold is not a corporation that sale will be structured as an asset sale as there is no stock to be sold.  The subject may arise in the sale of a corporation where sellers generally prefer stock sales while buyers usually want the transaction to be an asset sale.  There can often be quite a bit of negotiation about this, but most small and mid-sized business sale transactions are structured as asset sales.   

 

Buyers generally prefer asset purchases

  • They can buy just those assets that they want.  A list is created and Bill of Sale drawn up.  In sales of smaller businesses the buyer may only purchase the physical assets (inventory and equipment) and perhaps contracts in progress, assuming the customer agrees, while the seller keeps the cash and accounts receivables.   
  • They can avoid assuming the liabilities (known and unknown) of the business or at least pick and choose which liabilities they will assume. 
  • If there is potential litigation or other claims against the former owner, the buyer is much less likely to be drawn into them after an asset purchase, whereas in a stock purchase, the same legal entity is still in existence and may be subject to all such claims. 
  • They can allocate much of the purchase price to the assets which can be depreciated or amortized generating tax deductible expenses.  If an asset had been depreciated by the old owner, even to zero, a new owner can get a new depreciable life, reducing taxable income.  Whereas if the stock of the firm had been purchased, the depreciated book value of the asset would remain unchanged. 
  • Sales tax will most likely be due on many of the tangible assets purchased. 
  • Buyer and Seller must agree to how the purchase price will be allocated among the assets. The tax impact of this will mean that some portion of the sales price will be taxed to the seller as income and some as capital gains. 


Sellers generally prefer a stock sale

  • The sale of the corporate entity,( rather than a sale of its assets) taxed at capital gain rates, usually results in a smaller tax bill for the seller. 
  • An asset sale of a “C” corporation could result in the corporation paying capital gains tax on the sale of its assets and then the owners paying tax again after they receive the net proceeds from the corporation, a double taxation problem that the sale of “S” corporations or LLCs generally don’t cause. 
  • By transferring the entire business entity, the seller is generally free of any liabilities, known or unknown, pre-existing or subsequent, related to the corporation. 


Sellers should realize that if they press hard for a stock sale because of the favorable capital gains treatment, buyers, should they still wish to move forward with the transaction, will likely press for a lower price to compensate for the benefits they give up. 

Seller Financing

Most sales of small or mid-sized businesses, whether to outsiders or insiders, require at least some seller financing, commonly a down payment and a promissory note with regular monthly or quarterly payments.   An SBA-guaranteed loans often require the seller to “keep some skin in the game”, meaning they will want the seller to carry a partial note subordinated to the bank's note.  The seller’s benefits typically include a higher price and quicker sale and an income stream and tax deferral, as the payments are stretched over a few years. 

Employee Stock Ownership Plan (ESOP) 

Many business owners contemplating selling their business will be exposed to the idea of setting up an ESOP. ESOPs are a complex subject beyond the scope of this article but I will highlight a few key points.  An ESOP is an employee retirement plan, much like a profit sharing plan, that is authorized to invest in the employer's stock.  The main reason ESOPs appear attractive to a business owner is the tax deferral on sale proceeds received from the ESOP.  Once an ESOP owns 30% of the shares of a company the selling shareholders can invest in qualifying securities (many corporate securities qualify) and defer paying capital gains tax until they sell those securities.  If they die before selling those qualifying securities capital gains taxes might be avoided altogether or for years down the line depending on how long their spouse lives or how large their estate is.

In its simplest form, a business owner, with sufficient time for planning might set up an ESOP, fund it regularly with tax-deductible cash contributions, and then use that cash to buy the owner's shares over a period of years.  Likely the ESOP would start with an initial purchase of at least 30% of the shares to take advantage of the tax deferral provisions.  Often, the business owner may not want to take years to sell the shares and may utilize a leveraged ESOP wherein a bank loan is used to fund the purchase of the owner's shares.   The ESOP and loan payments are structured such that the principal payments on the loan are effectively tax deductible.  

Any business owner contemplating selling their shares to an ESOP should seek expert advice.  However, they should also be aware that some proponents of ESOPs are almost religious in their fervor for them.  While there are tax advantages, the price paid for the shares must be set by an independent appraiser who will value them based on a financial analysis.  There will be no strategic premium.  If a bank loan is used to fund the share purchase the seller will often have to personally guarantee that loan until it is repaid making it risky to simply cease involvement in the business’s management.  The debt on the company’s books can act to actually reduce the business’s value until it is paid off.  Finally, a key consideration is who will manage the firm once the owner steps aside?  Are they capable of managing on their own or will you need to remain actively involved until the ESOP loan is paid off several years down the road? 

There are many aspects to ESOPs that can be examined in a longer discussion, particularly as regards to operating a business owned, or substantially owned, by an ESOP, and the benefits to employees, that require careful consideration and detailed legal, accounting, financial planning and tax advice.  There are some very successful ESOP-owned companies.  Nevertheless, many business owners may find that an outright sale of a business will garner more value with less risk.  Often business owners turn to ESOPs when they can’t find a buyer.   With an ESOP they essentially create a buyer.

Selling to Employees or Family

This is a time honored method of transferring ownership.  When selling to employees or family members typically great care is taken in selecting just which individuals should be brought into ownership.  A program is then developed, often with the help of attorneys or consultants who specialize in such internal transfers of ownership, for the principal shareholders to slowly sell their shares to their employees over time.  The methods by which the employees finance these purchases vary.  They include bank loans to the employee(s), bonuses of cash or shares from the employer/owner, dividends received by the shareholder/ employee.  Some firms that set up key man life insurance may use the cash value of the insurance policies to buy the shares from the principals.  Some may make the mistake of saying that the company will just buy them out on a promissory note, which they then structure, impacting the firm's financial statements and causing great problems with their banker when they next report financial statements. 

There are definite risks with employee buyouts.  There may be good that reasons the employees are employees and not owners.  They may simply not have what it takes to be an owner and be in charge.  Or the entrepreneur may find that while he places a substantial value on his equity in the business, a value that is backed up with formal appraisals, the staff doesn't value the equity so much and resent the cash burdens that buying him out place on them.  Perhaps they just want a job, their salaries, and maybe their bonuses.  Perhaps they feel that after years of service that the firm should be effectively given to them.  Similarly family members may not have the capability, financial capacity or interest to pay the market value for and effectively operate the business. Many companies have gone into successful successions of ownership, but it is important to plan it carefully with professional advice, if the owner is to increase the likelihood of receiving a fair value for his or her equity.  

Liquidation

This option will probably realize the least value for the business owner, though it may be the only one available if the business is really just a one-person operation, is financially distressed, or is simply not attractive to a buyer.  Depending on the business, this option can actually be fairly expensive because it may be difficult to reduce your expenses as fast as you wind down your revenue generating activities. You may incur lease termination costs, selling expenses on the disposal of assets, and even a period of operating losses until you are finally able to close the doors.  There will be no value received for the “goodwill” of an ongoing business, so this option is hardly recommended for anyone who actually has a viable business that might be of interest to someone else.  You must carefully plan such a close-down process in order to net as much cash as you can. 

Selling Your Business

The sale of a business is a complex subject, and there are entire books devoted to each of the options discussed here in these few paragraphs.  Operating a business and selling a business call upon quite different suites of skill, training and experience.  For best results a team is required that can integrate the legal, financial and marketing elements.  Typically a certified business broker can get a higher price for a business and get it in a shorter period of time, as the owner concentrates on running the business well, and developing his or her exit strategy while maintaining the all-important confidentiality throughout the process. 

The Sunbelt Network is world’s largest and oldest business brokerage network with over 250 offices around the globe, and over 40,000 small and mid-sized business sale transactions completed.  The San Francisco territory, headquartered in Alameda, is staffed with experienced, highly trained agents, most of whom have run their own businesses.   The credentials held by the local staff include that of CPA, Attorney, Financial Analyst, broker and Certified Business Intermediary.    

Selling your business may well be one of the most important decisions you make in your lifetime.  Understand your motivations, consider the options, assemble a seasoned team, and pursue your goal.  

For more information visit http://www.sunbeltbayarea.com or call Kris Moe at 707-529-6458

Bill Mitchell can reached through his website, http://califbusinessbroker.com/