Exit Considerations for Owners of Small and Medium-Sized Businesses

Business owners contemplating the transition of their life’s work are entering a complex process with many different business exit options, each with their own unique paths. Many business owners face the challenge of transitioning their enterprise from being heavily reliant on their personal involvement to demonstrating its independent operational and financial viability. Preparation for a business exit typically includes rigorous and thorough financial documentation, often including an audit, quality of earnings analyses, valuations and more.

A careful analysis of what is important to you as the business owner is an important step in ensuring you choose the right exit opportunity. For business owners, this journey is not just about achieving a financial milestone but also about ensuring the legacy of their life’s work, making the business exit an endeavor that balances emotional considerations with strategic business and financial objectives.

Preparing for a business exit can differ depending on the size or stage of the business and the extent of owner involvement. Focus on ensuring the self-sufficiency of your company for a more seamless changeover, transitioning the source of profits from you as the business owner to the company and its staff, processes and practices. Extracting yourself as a critical cash generator of the business and transitioning that to the company can take time, and planning should begin far before a planned exit.

Assess Your Situation

To speed up the transition and improve the marketability of your company, you want to review and assess the questions listed below. The goal is to develop strategies that shift cash flow generation from you (i.e., personal goodwill like your skills, reputation and effort) to the company (enterprise or company goodwill).

• Why do customers come to your business? Is it a specific person or a narrow group of peoples’ ability, skill, reputation, name and contacts that drive business? Or is it the business’ reputation, name/brand, intellectual property (patents, copyrights) or location?
• Who owns most of the key client and vendor relationships? Are they concentrated in one person?
• When business comes in, who is needed to service the work (a key person or concentrated group of key employees, or is it driven by processes anyone can perform if appropriately trained)?

The goal is to shift the answers from you, the owner, to the company. If most of the company’s value lies in a single person, the company will have less value (risk that key people leave or the know-how and skills aren’t transitioned). Conversely, suppose a well-seasoned management team, a strong business reputation and clear corporate processes and practices in place. In that case, more value resides in the company, which is more attractive to a prospective buyer.

Also consider customer risk. A business reliant on a single or small number of customers can be perceived as higher risk by a potential buyer. This factor can be a risk for both small and larger businesses.

Next Steps — Preparing for an Exit

Assuming a relatively low contribution of personal goodwill to the performance of the business, preparing for an exit may require additional steps to maximize the potential exit price and speed up the exit process. Aside from organizing documents (e.g., leases, insurance, tax records, etc.) for easy access and review by a potential buyer, reliable financial statements are critical.

Company Information

Financial Statements

A prospective buyer will want to spend their time assessing the business’ systems, operations, risks and opportunities instead of assessing the quality of the underlying data.

• Statements reviewed by an independent third party (CPA) are viewed favorably by potential buyers. Due to the independent nature of an audit, audited financial statements are perceived as credible and of higher reliability. Even a review, compilation or other third‑party touch can enhance credibility.
• It should be noted an audit is not a precursor for a successful M&A (mergers and acquisitions) outcome, and many successful M&A transactions involve companies that were not historically audited. Whether the seller’s company is audited or not, many sellers opt for a sell-side Quality of Earnings (QofE) analysis. A sell-side QofE plays a fundamental role in improving the efficiency and success rate of today’s M&A transactions. Unlike traditional audits, which focus on compliance and financial reporting at a point in time, a QofE provides a comprehensive analysis of a business’s performance and the sustainability of its earnings. It focuses on metrics such as EBITDA, gross margin, sales, customer trends, as well as many other financial metrics, to offer insights into the financial performance of the business.
• Sellers, in today’s M&A environment, generally choose to have a QofE performed to increase credibility and confidence in the seller’s financial statements. Additionally, a sell-side QofE proactively identifies and addresses risks and opportunities for future buyers, thereby reducing the likelihood of surprises that could derail a sale process. A sell-side QofE will identify and recast financial statements, remove non-recurring and one-time expenses, helping interested parties understand the true economic performance of the business. Further, changes expected in go-forward cost assumptions, pro-forma and other analyses are clearly articulated and defended. Ultimately, a well-executed sell-side QoE can aid in maximizing transaction value and improving the likelihood of a successful M&A outcome.

Prospective Financial Information

• If you already prepare forecasts or budgets for your business, assess how well the company was able to perform versus forecast (e.g. always exceeded, always fell short or a mix of both).
• If you don’t prepare any budgets or forecasts, you might consider crafting a forecast for your business. As part of the negotiation process, you will want to have an estimate of your company’s value, and a forecast will be a cornerstone for developing this. An appraisal of the business by an independent third party can also assist in assessing the opportunities and risks of the business from an outside perspective. Risk areas can then be addressed or better understood.

What’s Important to You?

Determining your exit goals now will guide you in achieving those goals in the future. Below are key considerations to help determine what type of exit aligns with your values and exit goals. We suggest ranking the relative importance of each of these considerations alongside assessing what tools, people, resources or processes are necessary to facilitate these values and goals.

Company Value

• Determine how much value you need from the sale of your company for your own future cash flow needs.

Liquidity

• Liquidity at the time of sale or over time will determine whether a third-party sale, such as private equity or strategic purchaser, will fit better. If liquidity overtime is an option, other exit types may be appealing.

Tax Strategies

• Consider exit planning that is grounded in estate planning to tax efficiently transfer wealth to later generations via gifts, trusts and other opportunities.
• Defer paying tax today on the sale of a portion of your business by negotiating tax-deferred rollover into your exit so you convert or retain a portion of your current ownership into the ownership of the post-transaction business on a current tax-free basis.
• Utilize advisors to assist in negotiating a transaction to ensure you are making tax-efficient decisions. For example, stock sales are generally more tax efficient for a seller, but a buyer has a strong preference to buy assets.
• Consider the structure of your current business well in advance of an exit to ensure tax efficiency when the business is sold. One such opportunity may be restructuring the business to take advantage of significant taxable gain exclusion via Qualified Small Business Stock treatment.
• A sale to the employees of your company via an Employee Stock Ownership Plan (ESOP) may potentially unlock tax efficiencies for both the seller and the company.

Company Legacy

• Maintaining relationships with clients and a reputation for the quality of products and/or services are vital for a company.
• Retaining employees and preserving company culture with options for increasing employee benefits.

Corporate Governance

• Assessing whether involvement in corporate governance or maintaining a position within the company is a desire.

Types of Business Exits

There are many types of business exits which may be tailored to the needs of the seller through minority or majority sales, external versus internal sales or some combination of business exit types. Below is a basic summary of the key business exit types:

• Strategic buyer: A sale to a competitor or other strategic buyer may allow for an expedited exit as often strategic purchasers understand the industry in which your company operates better than other types of buyers. Strategic purchasers’ goals in acquiring companies in their industry are based on strategic plans for geographic expansion, economies of scale, related ancillary goods and services or other strategic synergies.
• Private equity: Private equity firms represent a financial purchaser coming to the transaction often with capital infusions and growth plans. Private equity may purchase 100% of a company, but often private equity transactions come with negotiated terms requiring the former owner to remain with the company through an agreed-upon time or milestone and maintain a financial stake in the company’s future. Private equity may negotiate a minority stake in a company, but private equity typically prefers a controlling ownership stake.
• Employee Stock Ownership Plan: An ESOP is a flexible way to exit your business through a sale to a trust that purchases the company stock on behalf of the company’s employees. The ESOP is a retirement plan that allows for investment in a privately held business and offers specific tax advantages for the company and selling shareholders. Such a transaction can be utilized to incentivize employees, create tax efficiencies for the company and possibly create tax deferral for the sellers.
• Management buyout: If there is a trusted member of management or management team with access to capital, a sale to this person or group of management may allow for the purchase of a portion of the company or of the company in full.
• Family gift: If there is a family member who has the skills or experience with the business to operate and manage the company, this may be a way to ensure continuity of the business as well as transfer the business in a tax-advantaged way. However, there are limitations on liquidity to the seller in this approach and often a gift transfer is combined with another form of business exit.
• Individual: An individual, or small group of individuals, seeking to become business owners may be interested in succeeding you as the owner should the price point and experience of the buyer(s) align with your business.

Wrap-up

Preparation for a sale (e.g., transitioning personal goodwill to company goodwill, getting your records in order, increasing the perceived quality of company information, etc.) is important, but also understanding what you want out of the process is critical to determining when to sell and to whom to sell. Different types of buyers will result in different outcomes (e.g., maximizing sales proceeds vs. maintaining culture and work environment, etc.). To recap, here are some key considerations:

• Honestly assess current conditions and management resources: Is the value mainly in the owner or the company? Is the company growing or just maintaining? Is your management team working well together? Is there work that needs to be done to improve the stability and long-term viability of the company?
• Minimize key person/customer risk, improve operations: If the company is heavily reliant on one person or customer, that is a risk factor that decreases overall value. You can maximize value if responsibilities and revenues are distributed. You may want to bring in an operations consultant or work on strategies to diversify your company to reduce risk.
• Get your financial house in order: Data reliability to a prospective buyer is critical. Make sure you have organized, reliable financials, support for potential adjustments and proper controls in place.
• Understanding your needs as a seller: What are the critical elements of a sale to you — maximizing proceeds, keeping company culture, exiting immediately or are you willing to stay during a transition process, etc.
• Find the right buyer: There are many different exit options, including a sale to a competitor or private equity, a sale to an ESOP or a sale to management, which have varying advantages and disadvantages to explore.

We’re here to help — with resources, referrals and knowledge in tax, valuation, financial reporting, ESOPs and more — we are eager to share what we’ve learned through our experience advising business owners to help you navigate toward a successful business exit. Contact us today to learn more.

Authored by Jennifer Krieger, Arlene Ashcraft, Aaron Bosch and Dan Brumwell

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