Leaving A Business: Which Exit Plan Is Best?

“Nothing lasts forever,” as the age-old saying goes. Eventually, ownership and key employees will leave your business, voluntarily or involuntarily, and no longer play a role in the business they worked so hard to create. Integrating an exit strategy into your business plan is crucial in order to achieve long-term goals — things like having sufficient levels of funds to meet retirement needs. For this reason, selecting your business successor and identifying the method of transfer to the successor are the key objectives of an effective exit strategy plan.

The importance of identifying and integrating your exit plan into your business plan as soon as possible cannot be overstated.

The Importance of Securing Flexibility for Your Future

Catastrophic events can easily occur that will impose unneeded pressures and influence the decision-making process at a less than ideal time. In the world of business the most successful decision makers are those who have the flexibility of options on their side. Waiting until the last minute to formulate some sort of exit plan will work to the business owner’s disadvantage.

Why? Simply put, the number of options diminish over time. It is not a matter of whether you will sell or otherwise dispose of your interest in this business. Those things are a certainty, and the sooner you plan for it the more freedom you will have.

According to a study by Bank of America, as noted in MyOwnBusiness.org, three out of four companies claim to have a succession plan, but less than 40% of those companies implement their plans. For family businesses, the numbers are worse: only 15% of family businesses survive to the second generation. Even less than that survive to the third.

Most, if not all, business transactions have some sort of tax consequences associated with them. Exiting a business is no exception. Timely and careful exit strategy planning will allow you to maintain valuable flexibility when trying to decide on the most advantageous approach on how to avoid, or minimize, the negative tax consequences.    

All of it boils down to a simple question: who is in the driver’s seat when it’s time to leave your business? The ultimate goal of effective exit planning is to maximize the chance that you will leave your business on your terms and under the conditions you want.

Of course, selecting the right exit strategy team (attorney, CPA, etc.) with the proper expertise and experience will go a long way toward securing real flexibility. You should always be the one in the driver’s seat when it’s time to leave your business. However, ensuring that happens requires diligent forethought and a thorough understanding of the possibilities.

Consider the following four ways to leave your business:

1. Transfer Ownership to Family Members,

2. Employee Stock Option Plan (ESOP),

3. Sale to a Third Party, and

4. Liquidation.  

1. Transfer Ownership to Your Children

Transferring a business to your children is the dream of many business owners when contemplating his or her exit strategy. Such a transfer can provide a level of financial wherewithal your children they might not otherwise have.

However, be wary of the following risks:

• This option increases the risk of family discord.

• Financial security may be diminished, rather than enhanced.

• The very existence of the business is at risk if it’s transferred to a family member who can’t or won’t run it properly.

In those cases where a transfer to your children is not realistic for whatever reason, alternative options will have to be considered and formulated.

2. Employee Stock Option Plans (ESOP)

Another alternative is the Employee Stock Ownership Plan (ESOP) — a helpful way, using the participation of your employees, to maintain control over your exit. As the IRS notes on their site, an employee stock ownership plan (ESOP):

• is an IRC section 401(a) qualified defined contribution plan that is a stock bonus plan or a stock bonus/money purchase plan

• must be designed to invest primarily in qualifying employer securities as defined by IRC section 4975(e)(8) and meet certain requirements of the Code and regulations

• has features over which the IRS and Department of Labor share jurisdiction

• are trusts into which either cash to buy company stock or newly issued stock is placed. Contributions the company makes to the trust are generally tax deductible, and because transactions are considered stock sales, the owner can avoid paying capital gains. 

Some of the advantages of ESOPs include the following:

• The Company can buy out the current owners.

• Employees can share in any stock appreciation.

• An owner gets to keep control until he is ready to retire.

• The company uses the ESOP as a motivating tool.

3. Sale to a Third Party

When you structure the transaction as sale to a third party, the primary benefit is simple: the transaction can be structured in such a fashion that all, or most, of the sales proceeds come to you immediately upon closing in the form of cash.

If the bulk of the purchase price is not paid in cash then the risk complexion of the transaction will be much higher for the seller. For example, crucial funds that he or she would be counting on for retirement would be left in the uncertain control of the buyer. The best way to mitigate this risk is to structure the transaction in a fashion where the seller’s control of his or her funds is immediate and not pending until other variables out of the seller’s control are resolved.  

4. Liquidation

Another option is to liquidate the company. The liquidation process entails the sell-off of the company’s assets and the payoff of outstanding accounts payable and other liabilities. After collecting on all the assets and the payoff of all outstanding liabilities whatever remains goes to the owner.

Watch out for a liquidation scenario whereby the buyer refuses to recognize a market value for the seller’s historical efforts, apart from the value of “hard” net assets. In this case the buyer would likely only pay for the value of the hard net assets, leaving little, or nothing, to fund retirement.

Service businesses are somewhat more troublesome to the selling owner who is trying to “net out” enough cash from the sale to fund his or her retirement. Service businesses are generally viewed as having little value once the owner leaves the business. Thus, the liquidation of a service business tends to produce the least favorable return.