Exit Options - Preparation PhaseDeveloping an exit strategy is an essential part of running any business and the best option in any given situation may differ depending on an owner’s visions for his or her own future. In addition to maximizing price, a business owner may be interested in achieving other factors as well - preserving the legacy of the business, continued growth for existing management, and/or continued influence over business decisions after the sale. An optimal exit strategy for any business will balance the often competing interests of the seller. In general, exit options can be broken down into three general categories as follows:
Internal TransferInternal transfer options generally allow the business to be transferred into hands of those who are more familiar with the existing operations, such as current management, employees, or family members. Because of this, there is a lower likelihood of a change in management and a lower likelihood that new management will take the company in a drastically different direction after the transfer. A common downside of an internal transfer, however, is pricing. In exchange for the benefits listed above, owners often must sacrifice optimal pricing and/or an immediate cash payout.
Once a business owner has decided that internal transfer is an exit strategy that he or she would like to pursue, the business owner has a number of options to choose from. He or she may choose to transfer to a family member, shareholders, management, or employees.
Family MemberTransfer to family members has a number of rewards. An obvious advantage is that the business stays in the family. This means that if a business owner has had time to properly groom the intended successor, the value and culture of the business can remain relatively unchanged upon transfer. Successors who take over a family business likely value the business beyond just the earning that the business can generate. A family successor who has spent sufficient time in the company prior to the transfer - whether as an employee or as management-in-training - can also give employees and management a sense of familiarity and thus, comfort. If it’s done right, this type of transfer minimizes the anxiety and unrest among employees that often come with a transfer of ownership.
There are, however, large risks involved in an internal transfer to a family member. First, this type of transfer can be the most emotionally charged. Jealousies and family rivalries are often magnified when such a large asset is at stake. If trouble arises at the management level, a business and its employees may be adversely affected in their performance and profits as well.
Another disadvantage of an internal transfer to a family member involves valuation. Oftentimes the objective of obtaining the highest value is sacrificed for the advantages listed above. Additionally, depending on the arrangement involved, a business owner selling to a family member sometimes may see little or no cash at all upon transfer.
Other Existing ShareholdersTransferring to already existing shareholders is another type of internal transfer. It shares similar benefits to an internal transfer to family members - the successor is familiar with the business, the successor can have ample time prior to the transfer to serve in employee and/or management-in-training roles, and is more likely to value the business’s culture and values than an outside buyer might.
A shareholder transfer has some advantages over a family member transfer as it may decrease the likelihood of family rivalries surfacing to affect the business. Additionally, a shareholder transfer can oftentimes be easily facilitated through a shareholder agreement.
Similar downsides remain, however, with a shareholder transfer. For example, a shareholder transfer will likely not maximize the sale purchase price. Additionally, because shareholder rights in the transfer will be embodied in a shareholder agreement, the owner must take care that the transfer is well-planned in order to avoid potential disputes down the line. Similar to an internal transfer to a family member, a shareholder transfer may fail to provide all cash at the closing.
ManagementAn internal transfer to the management team is another option. This type of transfer, call a management buyout (MBO) is designed to maximize efficiency, as the management team is often the one most familiar with the business. As a result, transition can be seamless. Additionally, where maintaining confidentiality is very important to the seller, an internal transfer to the management team can minimizes risks of information leaks.
Similar to other internal transfer options, however, an MBO may often fail to obtain the best price and fail to provide cash upon closing. Additionally, owners transferring the company to management likely will likely not see full proceeds on closing. Vendor financing may be required to effectuate a management buyout but bank financing is accessible for strong management team that can deliver a seamless transition post closing.
Employees (ESOP)An Employee Stock Option Plan (ESOP) is another well-established internal transfer option. An ESOP sets up a stock equity plan for employees to gain ownership over the business. ESOPs differs from MBO in the fact that an ESOP is open to a larger pool of employees and the exit for the owner is not as immediate. Essentially, an ESOP allows the original business owner to make a gradual exit over time while at the same time maximizing employee productivity and company profitability. Because employees know they will eventually have an ownership stake in the business, employees will be incentivized to work hard to maximize their own profits. An ESOP may also have positive tax consequences for the business and its shareholders.
Like other internal transfer options, an ESOP will not maximize the sale price of the business. Also with an ESOP, a seller will often have to wait years to get cash out from the sale and, depending on how the ESOP is structured, may only see profits from the sale if the business continues to do well.
External TransferExternal transfers are transfers to outside buyers - third parties or the general public. External transfers tend to be less personal and the seller will end up with less (or no) control than in an internal transfer, but have the potential to maximize the sale price of a business. A business owner who decides on an external transfer as an exit option should take ample time to position the company to be favorable to potential buyers, whether third-parties or the public.
Third-party SaleA third-party sale is the sale of the company to strategic buyer, private equity group or individual investor. Third-party acquirers take into account the synergies of a potential acquisition and, as a result, these prospective buyers may be willing to pay a premium for the business. Additionally, sellers in a third-party sale are more likely to receive more cash at the closing.
There are, however, some downsides to a third-party sale. First, the structure of a third-party sale is usually more complicated than an internal transfer. Because the buyer is a third-party and the transaction is arms-length, the buyer would be especially interested in negotiating terms to minimize their risk of investment. This is sometimes accomplished through a vendor financing or earn-out, both of which are ways a buyer may seek to ensure a smooth transition post acquisition.
Buyers will also require representations and warranties from a seller related to the information that the buyer is relying on when evaluating the company purchase. Buyers also require ancillary agreements such as non-competition and management agreement where certain key executives stay for a set number of years after the acquisition to ensure customer retention. Additionally, a sale to a third-party is often a longer process with, sometimes, tougher negotiations. A drawn-out process may open the business up to information leaks and confidentiality issues.
Public Offering (IPO)Public offerings, or IPOs, are the most publicized type of exit options for business. In an initial public offering (IPO), a business sells shares of the company on the public market. An ideal IPO candidate would need consistent high revenues, earnings and growth. In particular, because investors often look at industry benchmarks to determine a company’s financial strength, the business should have a strong record of performing well within their industry.
Additionally, a business preparing for an IPO must be careful to comply with rigorous governmental regulations, including Sarbanes-Oxley regulations. This often means a need to reassess corporate governance, business structure as well as financial reporting.
Most mid-market business are not ideal candidates for an IPO and it is the least likely exit option.