Many business owners believe that, when it comes time to exit their business, they have just one option: to sell their companies. Few understand that selling a business is a complex, time consuming undertaking with many pitfalls. Many sales attempts result in deep discounting by the buyer or, as is the case nearly 80% of the time, they never come to fruition at all.
When considering an exit from your business, the most important consideration is how to get the most value for your company. In this blog, I take a look at the pros and cons of several options for doing just that: selling, structuring an ESOP, aggressively growing, maintaining controlled or “life-style” growth, and profitably running down your business.
Option 1: Pursuing the Sale of Your Business
An outright exit by means of a sale can seems the most attractive option for you to cash out and pursue other opportunities – particularly if your company’s financials are in good order and past performance is positive. But buyers will be looking for evidence of what the business is going to be worth next year or in five years’ time. They are buying future – not past — growth.
So, your company can appear very successful on paper, but a deep dive — the kind that happens during due diligence — can reveal many red flags. For example, there may be uncertainty over the business’ ability to successfully scale. Or the book of business and work backlog may be weaker than expected.
An often-neglected point is that you must find a buyer who understands your industry and business to appreciate the assets and value you provide. Putting your business out on the open market could invite buyers who will attempt to discount the company simply because they don’t understand its market or potential.
Option 2: Employee Stock Ownership Plan (ESOP)
ESOPs are trusts that acquire/hold/sell the company’s stock for the benefit of participants in the ESOP, the employees. Typically, the company borrows money from lenders, investors, and/or selling shareholders, and then loans the ESOP trust funds to acquire shares. As the ESOP loan is paid down, shares are allocated to employee accounts annually, generally in proportion to the employee’s annual compensation. Employees then receive cash in exchange for their shares upon retirement, termination, disability, or death.
An ESOP has a number of advantages, if successful. It can provide you with significant potential tax benefits (section 1042 rollover) – this provides an avenue for deferral of capital gains taxes until ultimate liquidation of the rollover investment assets. In a leveraged ESOP, both principal and interest payments are tax deductible to the Company. Also, an ESOP transaction has a greater degree of certainty of closing than a third-party sale.
Additionally, members of your management team can retain their positions, providing greater certainty and a smoother transition post sale. A transition to employee ownership helps provide continuity of company culture as the interests of owners (employees) and management are more closely aligned.
Finally, since an ESOP structure can provide employees with potentially significant retirement benefits, it can enhance the Company’s ability to attract and retain employees.
However, an ESOP is not a simple solution. Success depends on a variety of criteria, for example it requires:
- A track record of profitability
- A moderate to significant debt capacity
- A strong earnings/cash flow
- Demonstrated steady and controlled growth over time – consistent and predicable financial results
- A strong executive team that would stay in control after the active shareholders were no longer engaged
- An enterprise value that is sufficient to support the transaction
There are also potentially some drawbacks. An ESOP will typically not generate a strategic premium that would be available via an auction-based sale (ESOP limited to FMV of shares).
An ESOP is not a cost-free option and sufficient cash must be generated from the business to support ESOP administrative fees and debt service, as well as the buyback of vested shares from employees who terminate employment. Such cash flow needs should not compete with the cash flow needed to build and grow the company. The ESOP only provides benefits if the underlying shares have value to the participants – good management and operation of the business is essential. Finally, failure of an ESOP company can result in employees losing their jobs as well as any value in their ESOP accounts.
Option 3: Hold and aggressively grow via a combination of organic growth and acquisition
As I wrote in a previous blog, ideally you want to be thinking about an exit from your business at least two to three years before your desired departure date. The strategy of aggressively growing your company through both organic and inorganic methods requires about three to five years of planning and implementation. This may require such dramatic steps as:
- An investment in more experienced personnel, e.g., a strong CFO who has previous M&A and market related experience;
- A boost in business development, marketing and sales functions to help build a more robust and full pipeline of business over time;
- Substantial new debt for technology or infrastructure upgrades; or
- A necessary expansion of capabilities to enter a new market.
The advantage is that, if successful, this option would allow your company to grow and increase value over time, but it does require cost control and spending discipline. And, you may have to accept a substantial shift in your company’s culture and management.
Option 4: Hold and pursue controlled, targeted growth (a “life-style” business)
While similar to Option 3 in many respects, this option involves targeted growth within your company’s core capabilities. Less intense than Option 3, it nevertheless sets the stage for a potential sale of the business downstream. Of course, it may still require a review of the Company’s management, with specific emphasis on the role of the CFO and the mechanisms for cost controlling and spending discipline in order to provide a steady dependable income stream.
Option 5: A Slow Rundown
To some, this is a controversial option, but it is a perfectly legitimate one. This may be well- suited to you if you are doubtful of the ability of the business to operate in free and open competition. Essentially, this involves continuing to operate while not seeking new contracts, reducing the backlog of business, planning for an eventual sale of assets and taking the maximum owner’s draw out of the business until close.
The upside of this option is that it will allow you to exit while providing an income and reduced responsibility. It avoids the commitment required of a growth or controlled growth strategy as well as all the difficulties of a sale or ESOP. The downside is that this process needs to be managed carefully. Customers and any creditors may get spooked if they learn of your plans too far in advance, as might employees. An uncontrolled exodus of staff from your business could bring it crashing down sooner than anticipated or desired.
If you are looking to exit your business, take the time to plan and consider your options. Selling is not your only option and may not even be the most suitable for you, your employees or your business. Whichever option you choose to pursue, just be sure to give yourself enough time to prepare and plan well. Rarely is one given a second chance to exit on one’s own terms.
Tom Springer is a founding partner in Springer Lawson & Associates, a consultancy of former C-level executives who help mid-market companies maximize enterprise value in advance of, during, and following major business transactions or disruptions.
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