Exit Planning

Examining Available Sale Options and Steps to Maximize the Financial Outcome (Part I of II)

Effective exit planning is essential for business owners to maximize financial outcomes when selling or transferring their business. This two-part comprehensive guide explores the strategic options available, the timing required for preparation, and key value drivers to enhance sale success.

Effective exit planning is essential for business owners to maximize financial outcomes when selling or transferring their business. This comprehensive guide explores the strategic options available, the timing required for preparation, and key value drivers to enhance sale success.

I have been involved in buying and selling businesses for about 25 years and have talked to countless business owners during that time. What has repeatedly struck me as surprising during those conversations is the fact that so many business owners who have spent most of their working life building their business into what is often their largest nest egg, spend so little time on proper exit planning. Many have little or no awareness of all strategic options available to them and the factors they should consider when evaluating these options. This often leads to disappointing results for the business owners. It is thus crucial for any trusted advisor to alert clients early to the fact that proper exit planning is a process that should start at least three to five years prior to an owner wanting to exit the business. The bigger the business is, the longer lead time needed. Three years is appropriate for a retail establishment or most businesses with profits below $500,000 per year. However, businesses with more than $500,000 in profit typically need at least five years to optimize results.

The strategic options of exit planning can be broken down into three—relatively obvious—categories. First, there is the option to simply close the business. Second, there is the option to transfer or sell the business to family members or employees, and third, there is the option to sell to an unrelated party.

Close the Business

Let’s take a closer look at the option to simply close the business. Unfortunately, many business owners are not aware of the fact that this is realistically the only option available to them; even when the business has provided them with a reliable six-figure annual income stream from many years.

Did you know that only 20%–30% of businesses with a valuation below $2 million that are put up for sale, do sell? The percentage for businesses with a valuation between $2 million and $50 million is slightly higher, 30%–50%, but that number still leaves most businesses unsold. A variety of factors contribute to these low numbers, a key one being that many business owners try to sell their business themselves but are not very good at it. Managing the sale of a business is complicated and requires specialized know-how. Unless someone has a lot of experience doing it, it is unlikely that they will be able to achieve the desired result. Another key reason is grounded in the valuation concept of personal goodwill. Many businesses are a job, and not a sellable asset, because the owner equals the business. Key questions that an adviser should ask a business owner include: “Does the business not have employees? Are referrals to the business actually to the owner? Are customers and referral sources used to speaking mostly, or only, with the owner?” If the answer to any of these questions is a “yes”, it is quite likely that the business cannot be sold because the personal goodwill of the owner is practically its only value. And as valuation experts know, the personal goodwill of the owner is not a business asset but stays with the owner.

Sell to Family or Employees

The second option available to a business owner is the sale or transfer to relatives or employees. Until a generation or two ago, passing a family business to the owner’s child or children was very common and many children felt obligated to “carry on the family tradition.” However, in today’s world, only about 30% of family-owned businesses successfully pass from the first to the second generation, and only about 12% of businesses make it to the third generation. There are a variety of reasons for this which are tied to profound changes in societal and family structures. Children often have very different interests and capabilities than their parents. In the past, they were expected to sacrifice their personal desires and plans for their lives to carry on a family legacy. In the 21st century, much more emphasis is put on self-fulfillment and the pursuit of individual life goals. Consequently, most children are not interested in taking over the business a previous generation has built. Particularly not if the alternative to that is becoming the beneficiary of a trust fund that was created from proceeds from the sale of the business. As part of the exit planning process, it is important to have honest conversations with both generations involved. For that, it can be very beneficial to talk to the second generation without the first generation being present as many “children” are reluctant to be completely honest when their parent is in the room. I also recommend soliciting input about the second generation’s capabilities from key employees, as it is often difficult for a parent to see their children’s strengths and weaknesses objectively. I have witnessed more than one situation in which a parent was so focused on keeping a business in the family that they turned a blind eye to their child’s abilities to continue the family legacy successfully. Trusted employees tend to be more objective and should thus be interviewed with the promise that what they say will not be reported back to the parent with their names attached. Instead, the parent should be supplied with a summary of employee feedback in which specific comments cannot be linked to individuals.

Another issue that can prevent the successful transfer of a business to the next generation is tied to the age difference between the business owner and her/his children. If the business owner had children relatively young (in their 20s), they are often not ready to step aside by the time their children reach their 30s and are ready to take over. I have seen multiple examples in which adult children were initially in the business, with the interest to take it over, but left and pursued other careers because the owner was not willing to let go and step aside. Business owners need to understand that the willingness and ability to let go and step aside is crucial for the successful transition of a business to the next generation. No 40-year-old wants to hear a regular lecture from their parent about how to best run the business. Instead, they want to spread their wings and do it in their own way; even if that means making some mistakes. 

However, just as big an issue can be created by a business owner having children late in life (above 40). By the time the first generation reaches retirement age in their 60s, the second generation does not have enough professional experience to run a business. It is important to keep in mind that banks and many customers and employees might be uncomfortable with someone in their 20s being in charge of an established business. 

Another issue arises in situations where the business is the only meaningful asset that can be passed on to the next generation but there is more than one child. How do you determine which child gets the business if more than one expresses an interest? And even if only one expresses interest, how do you compensate the other child, or children, in your will for the fact that they did not get a share of the only meaningful asset? Many family bonds within the second generation have broken apart over these issues. Business owners should thus ask themselves what is most important to them: “Business stays in the family?”, “What is best for the business and employees?”, “Preservation of wealth?”, “Avoidance of family conflict?” It is also important to discuss this with the business owner’s spouse who is sure to have an opinion on these priorities. A spouse who is not actively involved in the business tends to care far less about the business staying in the family but typically prioritizes avoidance of family conflict and wealth preservation for children and grandchildren. An advisor should never underestimate how powerful such a voice behind the scenes can be. I have observed several situations in which a business owner initially went ahead with his exit plans, only to completely change course once the spouse got involved. Thus, the spouse should be involved in the exit planning from an early stage. 

Once it has been determined whether a business should be transferred to the next generation or employees, several other issues need to be examined. These include the key question of whether the first generation needs to be paid for their equity to be able to have a comfortable retirement. If they need to get paid, it needs to be examined if the family member (or employees) who will take over the company are credit-worthy enough to get an acquisition loan. Many business owners are unaware of the fact that acquisition loans are not simply given out based on the strength of the business that is being acquired. A bank will evaluate the professional background of the person taking out the loan and their ability to provide collateral, in addition to analyzing the acquisition subject. And while SBA loans might be available to some with just 10% of the acquisition value being provided in cash by the buyer, traditional bank loans typically require a cash down payment of 20%–25%. Therefore, to acquire a business valued at $1.5 million, the buyer needs between $150,000 to $375,000 in cash. Given that acquisition loans typically have an interest rate several percent above mortgage rates and a term that averages seven years, paying back such a loan can put a very significant strain on company finances. It is important to keep in mind that banks’ loan covenants almost always require a minimum ratio of 1.25x between total loan obligations (interest + principal) and EBITDA. So, if annual loan obligations are at $200,000, the EBITDA has to be at least $250,000. This typically leaves very little room for error, or a drop in financials due to the unforeseen loss of a key client, an economic downturn, etc. Business owners should keep in mind that the frequency of U.S. economic downturns since World War II has averaged about once every 6.5 years. Thus, experiencing an economic downturn during a seven-year loan term is highly likely.

Seller financing can be an alternative to bank financing, but the seller needs to think through a few items before deciding whether seller financing is a good option. Many of these are connected to the questions of “What happens to the equity if there is a default on the seller’s note?” and “Is all the equity transferred at one point in time or is this a slow transfer over time?”

If the equity reverts to the seller upon a default, does this mean the seller has to “unretire” and is the seller willing to live with that possibility? Can the seller still comfortably retire if they did not receive payment on some, or much, of the seller’s note? Does the seller live in a state where owning even a small amount of equity in a business makes one personably liable if the company gets sued?

ESOP

Another option, other than bank financing or a seller’s note, to transfer a business is the creation of an Employee Stock Option Plan (ESOP). There are several pros and cons associated with an ESOP and it is important to analyze them all because what might not be an issue under one business and exit scenario, might be one under another.

ESOP Pros

1. Succession Planning/Ownership Transition

ESOPs provide a way for owners to gradually exit and sell the business to employees, especially in closely held or family businesses. They avoid external buyers and keep ownership internal.

2. Tax Benefits

Contributions to the ESOP (used to buy stock) are tax-deductible. Sellers in C-corporations can defer capital gains taxes if proceeds are reinvested in qualified securities (Section 1042 rollover). ESOP-owned S-corporations are tax-exempt on profits proportional to the ESOP’s ownership percentage.

3. Employee Motivation and Retention

Employees become beneficial owners, which can lead to increased engagement, loyalty, and productivity. Retains talent through vesting schedules.

4. Improved Company Performance

Studies have shown ESOP companies often outperform non-ESOP peers due to employee alignment with company goals.

ESOP Cons

1. Complexity and Cost

ESOPs are expensive to set up and maintain (legal, administrative, valuation fees). For example, an annual valuation of the company stock is required.

2. Repurchase Obligation

The company must buy back shares from employees when they leave or retire, which can strain cash flow (especially if many employees retire at once).

3. Dilution of Control

Founders and original owners may lose control over time as ownership shifts to employees.

4. Regulatory Oversight

Subject to Employee Retirement Income Security Act (ERISA) rules and Department of Labor scrutiny, requiring careful compliance and fiduciary management.

5. Risk

ESOP accounts are often heavily concentrated in one company’s stock, exposing employees to risk if the company performs poorly.

It is important to keep in mind that ESOPs are strictly regulated by ERISA and IRS qualification rules and thus do not allow for preferential treatment of specific employees, or employee groups like c-level management. Employers cannot handpick only certain employees to participate. Instead, ESOPs must meet strict non-discrimination and coverage rules. Under the law, ESOP fiduciaries must act solely in the interest of plan participants (not the seller) and can be held personally liable for breach of duties. ESOPs are a frequent source of litigation.

While there are tax benefits to selling a business to an ESOP, these must be weighed against the administrative costs and the fact that equity must be transferred to the ESOP at fair market value, which is typically a significantly lower amount than the strategic value for which the equity could be sold to a strategic acquirer.

Business owners can also opt for a gradual transfer of ownership in a traditional, non-ESOP, setting. Transferring less than 50% of equity to a relative or trust makes the shares subject to a discount for lack of control (DLOC), which can be significant, and thus be an estate planning tax savings tool. However, selling less than 50% of the equity to employees (whether under an ESOP or not) and third parties under the application of a DLOC, reduces proceeds to the seller. So, what is beneficial under one scenario can be a significant drawback under another.

A gradual transfer can be a tool to give adult children the time necessary to acquire skills to run the business independently while making them benefit from their efforts. However, once the majority (>50%) of the equity has been transferred, the seller will lose control, unless the transferred shares are non-voting. The pros and cons of creating different classes of shares should thus be evaluated before any share transfers happen. 

Sell to Unrelated Party

The third option to exit a business is to sell the equity to an unrelated third party. If the exit strategy of the owner prioritizes the maximization of financial value, this is typically the preferred option, particularly if the buyer ends up being a strategic acquirer. Strategic buyers tend to have deeper pockets and can pay more, due to benefits of synergy. The sale to an unrelated third party often also reduces the chance of family feuds over who gets to take over the business. In addition, it presents less financial risk to the seller, as typically 70%–80% of the company value is paid at closing. However, this option also comes with several disadvantages. It poses a larger cultural risk and risk to job security for current employees, particularly if the acquisition is an “add-on” to the buyer. Strategic buyers will often centralize functions like HR, Accounting, IT etc., and layoffs are thus not uncommon. The time and cost involved in selling to a third party can be significant. It typically takes 6–12 months to sell a business in a well-managed manner, and the seller will often be required to stay on for an additional 6–36 months post-acquisition. This is thus not a quick exit route. Many business owners wait too long until they initiate the sale of their company. By the time they do, they are often tired of running it and want to exit as soon as possible. However, that is not a way to maximize value. It is best to sell at a time when one is very comfortable with staying involved for a few more years. As far as cost is concerned, a seller of a company with a value of up to $3 million should expect associated costs to be up to 10% (the smaller the business, the closer to 10%, as certain expenses are pretty much fixed). These costs include those of legal and tax advice, and the services of a business intermediary. For businesses with a value between $3 million and $50 million, those same services typically add up to about 4%–5% of the sale value.

Leading up to the sale, there are several steps a business can take to maximize the sale value. An experienced exit planning expert should be hired about three to five years prior to the anticipated sale. Such an expert will conduct an in-depth evaluation of the strengths and weaknesses of the business and provide a ballpark valuation. They will then recommend concrete initiatives, not only to maximize the sale price but to also make the eventual sale process run more smoothly. It is not uncommon that a business does not sell despite receiving one or multiple offers and if that happens, it is typically because the seller and their business were ill-prepared. An experienced business intermediary will typically create significantly more in additional sale value than their invoice, so it will pay for themselves. There are additional issues, like the fact that the sale process is very time-consuming and almost impossible to handle without outside help while running the business. Also, many sale terms initially seem strange or unfair to inexperienced sellers who often jeopardize deals without appropriate advice. And I cannot stress enough that involving an experienced transactional attorney to limit legal exposure is worth every penny. To maximize value, a business needs to be professionally packaged, and an experienced sale advisor will know exactly how to do that. 

I repeatedly get calls from business owners who have been approached by someone interested in buying them. And because it seems so much easier to simply pursue that lead, or because of privacy concerns, they do not want to put the company on the open market. However, as any experienced sale advisor will tell you, this is almost never a good idea. Typically, the wider the company is marketed, the higher a sale price is achieved. No prudent businessperson will pay more than they absolutely need to to acquire a business; and when they know they have no competition from other buyers, they will rarely offer the maximum price they are willing to pay. Strategic value is set by the market and until a company has offers from several buyers, it is basically impossible to say what its maximum strategic value is. I had a client once that had an offer from an interested party with which they have had a longstanding, close business relationship. That first offer was for $27 million. When I told the buyers that I was going to put the company on the open market because $27 million was simply not good enough, they almost immediately increased the offer to $36 million (33% increase). However, this only worked because I showed them that I had already prepared a confidential information memorandum (document used in an M&A process to describe the company in detail) and a list of possible strategic buyers. In another case, prior to hiring me, a client had accepted an offer for $2.8 million from a buyer that had directly approached them. When that deal fell apart, they hired me. I put them on the open market and six months later, I sold them for $3.7 million (32% increase). The desire to focus on just one buyer early on in the sale process is often connected to a seller “falling in love” with a buyer. It might be because it is a company they have long admired from afar or maybe they simply like the people involved because they are saying just the right things. It is important to keep in mind that an experienced buyer will say what the seller wants to hear in order to get what the buyer wants. A lot of buyers, particularly those of the individual investor type, also overestimate their financial abilities to close a transaction. It is thus extremely important to verify their financial abilities early in the process. An experienced advisor will be able to do that. Sometimes a seller has a close relationship with a c-level executive at a possible strategic buyer and that executive is genuinely interested in an acquisition. However, most mid-to-large companies have an investment committee that needs to approve acquisitions. It happens regularly that an investment committee overrules the c-level executive. Thus, it is important to find out early who the real acquisition decision makers on the buyer’s side are. As a rule of thumb, low and mid-level executives hardly ever have any real decision power when it comes to acquisitions. So, such an executive expressing an interest or even submitting an informal offer, is often worthless.

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Anja Bernier, CBA, CVA, Managing Director of Efficient Evolutions, is an experienced company sale and acquisition adviser. She has experience as an expert witness in Federal Court on business operations and business appraisal related matters. Previously, she has served as Assistant Editor of “Business Appraisal Practice”, the official magazine of the Institute of Business Appraisers (IBA). In addition, she was the President of the National Association of Certified Valuators and Analysts (NACVA) Massachusetts Chapter from 2020–2024. NACVA is one of the largest business appraisal organizations in the world.

Ms. Bernier founded the company in 2005 after spending more than a decade working in marketing, strategic new business development, corporate strategy, and M&A for some of the world’s best known companies, such as Kraft Foods and Dannon (Danone). While reporting directly to the CEO of a privately owned, multi billion dollar European company, she had the sole responsibility for establishing a U.S. subsidiary which involved intensive M&A work.

Ms. Bernier may be contacted at (781) 806-0880 or by e-mail to abernier@efficientevolutions.com.