Exit Planning Strategy: Who Needs It?
Harold: An exit strategy is planning for a transition of ownership. It is a way or means of either entrepreneurs or investors to basically reap the benefits of what they created.
Dawn: It's also known as a cash-out. When an entrepreneur realizes that their business is going to grow, they may start to think about how and when to cash out.
Harold: In the case of the entrepreneurs and a family-owned entity, it is a means of transitioning the ownership to the next family members, company management, or the employees.
Mark: You not only want an exit strategy if you're planning on selling your company. As an entrepreneur with a growth business and a family, you are wise to have one, just like is it wise to have need life insurance, to protect your family.
Harold: Wanting or needing an exit strategy varies as much as the reasons for starting a business. Everybody creates a company for different reasons. Some people do not want to work for anybody else. Some people want to try and change the world. Some people are doing it for family reasons. It depends upon the organization itself whether you must have a "defined" exit strategy or plan.
Mark: The majority of entrepreneurs are not planning to exit any time soon. And almost all entrepreneurs are risk takers. So, it's hard for them to imagine planning for a future without them in it. But if the entrepreneur passes away and leaves a very successful business, there could be significant estate taxes to pay, which could force a fire sale or liquidation of the business in order to pay the taxes.. The business you have spent a lifetime building could quickly turn from a great asset into a liability for the family. Estate planning and exit planning go hand in hand
Dawn: That is a good point because in this case your exit strategy is basically succession planning. And your exit does not necessarily mean a cash out at that point and time if you are transitioning from family member to another family member.
Harold: You know I think that when it comes to exit strategies or exit plans, fundamentally no matter the size of business, if you have partners or you have family or investors, you should have at least a buy/sell agreement in place at a very minimum to cover in case of death or disability. Divorce can also impact a family-owned business.
Mark: I've worked with entrepreneurs who distributed ownership of their company at an early stage to the members of their family when the valuation was below the gift tax threshold. I've also had a business founder create and moved his business into an estate trust to protect family ownership against divorce and other negative events. It was expensive, but a year later, it protected the business from the attorney of a new "ex" family member.
Dawn: The one thing that you do want to ensure is the continuity of the company. And the size of the company certainly has an impact on planning an exit strategy, because if it's a small or mid-sized mom and pop type company, they are the ones that are going to have decide to plan for an exit. As the company becomes bigger you have an impact on a lot of people. If you haven't figured out how you are going to replace the people at the top, or put some type of a buy sell agreement in place, it can come to ruination in a heartbeat. But, if you are of the size that you have a board of directors, it is going to be the board that probably raises the issue of an exit strategy and helps to put a plan in place.
When You Should Start Planning Your Exit Strategy
Dawn: If you are a family owned business, it is important to start sooner rather than later to prepare everybody so that you can exit when the time comes. As Mark said, very few entrepreneurs have an exit strategy because they do not think about it unless they have someone with a strategic or financial perspective on their management team.
Harold: Then when it comes time to exit, retire, or transition the company, there are critical elements they have not put into place. They have not thought about whether they want to continue in the business. They have not thought about what their needs may be financially.
Dawn: So the answer to when should an organization start thinking about an exit strategy is the sooner the better. In the case where an entrepreneur does not have an exit strategy, they very often have unrealistic goals for what they think they are going to be able sell their company for. They frequently find that if they had thought about an exit strategy early on they would have done things differently along the way to maximize the value of the company.
Mark: Of course if you're planning to exit it's a no-brainer – you need to start now.
Putting Together Your Exit Strategy Planning Team
Dawn: And planning depends on the working team that you put together. There is a certain amount of internal expertise and company or institutional knowledge in the entrepreneurs behind a company and its management team. Even so, organizations typically need outside resources to be brought in to form an effective working group to formulate an exit strategy.
Mark: Your working team should have your CFO/finance person, your business attorney, and your estate planning attorney. And you should make it a point to talk with several M&A people. Most will be happy to sit down with you and discuss ideas at no charge They typically want to get involved with the business owner two or three years before the business is sold.
Harold: You may also have investment bankers come into play and some of them specialize in boutiques, and companies at different stages of growth, and you have business brokers who can assist as well as M&A attorneys.
Dawn: I agree with Mark that you should have an expert to help you with the tax implications of what is going to happen when you exit -- especially if you are an individual owner. You need to understand what will pass on to you in the way of income and what the tax treatment of that might be because how you structure it really makes a difference as to how it impacts your taxes.
Harold: Absolutely. That is probably one of the most important outside experts to bring into your planning process is to make sure you have a good tax advisor.
Mark: As CFO, you need to make sure that the company's contracts are in good shape, and ensure that the company's financial reporting is in compliance with GAAP well in advance of the actual exit.
Harold: I look at the CFO as being the objective person with regards to finances of the plan. They have got to be involved actively with the due diligence because they are primarily the ones that are gathering all the information. They make sure the i's are dotted and the t's crossed, but they also have got to be an advocate for the seller.
Dawn: It is very important for the CFO to be at the table to make certain that the presented financial statements are accurate. However, the CFO is also helping the owner to sell the business. What they want to do is present the potential for the growth of the business so you do not necessarily just look at the history, you look at the buildup of what is going on. So, for instance a lot of companies sell based on a multiple of EBITDA and you might be looking at an upward trend of EBITDA so what you try to do is to sell the company on the projection curve of the EBITDA, as opposed to the historical EBITDA. So, there are some situations where the CFO somewhat becomes that marketing person as well.
Timing Your Exit
Harold: Planning and timing are critical to executing a successful exit strategy.
Dawn: Yes, you want to time it so that the industry is at its peak. Depending on your ability to execute your exit strategy quickly, you may have to move it forward or hold off to take advantage of circumstances. Companies that weren't able to execute their plans before the start of the recession in 2007 had to wait several years for markets to recover. And you do not want to do a forced exit because somebody dies, is divorced or disabled. You need to have buyout agreements in place or something that protects you against that.
Mark: Ideally, you want to be three to five years ahead of your exit to execute your plan. However, you can accelerate the process by pulling your working team together and identifying and targeting the biggest issues for your company that would cause a potential buyer to discount the purchase price.
Harold: This can be impacted by the politics and financial goals of the entrepreneur and other stakeholders. It all depends upon what the individual or individuals really want to achieve in the end goal. If it is an entrepreneur, he may want to sell out to the management team or sell out to his employees. If it is a private equity company, they probably want a strategic investor, a strategic buyer who is going to pay a higher multiple. I've worked through situations where ownership is comprised of a private equity company, founding entrepreneurs, and the management team. So everyone has different ideas on what the exit strategy and pay-off should be. Usually everyone comes to the realization that with a successful exit everybody could walk away with a lot of money, so the exit plan comes together.
Mark: In order to sell the business for the highest price, the entrepreneur needs to have formed a strong management team because the real value in a company is its ability to execute its business plan, which is a direct result of the management team. This is not an overnight process. This almost always requires several years, as team members need to be recruited and integrated into the company. If the entrepreneur is the largest part of the management team, then he or she will likely be required to stay in the company as an employee after they cash-out in order to get a decent price. The easiest test, for an entrepreneur, of whether the management team they've assembled is up to the task is to take a long vacation (a month) and see that the company has continued to run smoothly in their absence. If so, then they've built real value.
Final Thoughts on Planning an Exit Strategy
Dawn: It can be important to a company's founder to reward the management team as well as the employees who helped them become a success. This is frequently the opportunity for the employees to cash out depending upon how the transaction has been structured and how long that owner may have been developing that exit strategy. If they've planned ahead, they have incentivized their management team with some type of ownership in the company and with the carrot of knowing that with the exit transaction they will cash out.
Mark: If you have multiple family members on the payroll not providing a lot of value or you're on the fringes of tax law with by such things as charging personal expenses to the business, then it will be wise for you to become much more conservative at least three years out from your planned exit so you get full credit in the sales price for the profits the business is actually producing.
Dawn: If you are involving a private equity group or a business broker, they will run their own evaluation models. I strongly recommend that you get your own evaluation. In this case, I would make sure you are working with an evaluation expert that can look at your business and give you an independent analysis of the value.
Harold: Because if you are working with a private equity group they have their own interests at heart.
Mark: Planning doesn't need to be complicated, or cost tens of thousands of dollars. You may find that it's simply a matter of your strategic decisions changing a bit. It's a matter of mindset, similar to preparing sell a house. If you're looking to sell your house in six months you pay attention to what buyers want when making improvements to the house; if you're not planning to sell for ten years, you make your choice of improvements based on what you want.