Exit Strategy: Succession Planning Is Not Just For Larger Businesses – Considerations For Small And Medium-Sized Privately Held Companies

You have worked hard over the years to establish and grow your business through the good and challenging times. Your vision and beliefs are what molded this organization and its culture. What are your plans if you suddenly or gradually can no longer actively involve yourself with your business? It may be hard to look ahead and address that question, but the organization’s future is a strong ongoing concern. If no succession plan is in place, then you could deal with your legacy fading away, being liquidated, or quickly sold to entrepreneurs who may not have your values. All this simply because you never had a business exit strategy in place? 

Reflecting On an Exit Strategy.  

Below are some ideas to consider when developing exit strategies: 

1) Do you have any close family member(s) or valued employee(s) who are capable of managing all aspects of business operations and whom you would trust with your company in the future? 

2) Do you have personal or family financial considerations that need addressing? 

3) Has your intention always been to build and cash out? 

4) Are there any close or complementary competitors who share your values? Are you willing to sell to them at some point? 

5) If you have an exit strategy in mind, do you want to sell out 100%, or do you want to have an equity or debt holder’s position in the company? 

6) Would you want to stay on for a few years as a paid advisor or employee of the company regardless of an equity or debt holder’s arrangement? 

7) An immediate consideration: Does your estate and legacy planning include the continuity or disposition of your business? 

All these questions above may be uncomfortable to consider, and we may eliminate some outright. However, you should still develop a succession plan.  

Modifiable Exit Planning Strategies. 

A good exit planning strategy is modifiable and adapts as situations in your life change or the business goals evolve. Yet, always remember you should have an end game in place while you continue to manage and grow your business. 

Communicating Exit Plans to Employees.  

When developing an exit plan, be careful only to share ideas and concepts with your closest trusted advisors. Consider outside professionals with whom you have a long relationship and who would not necessarily profit significantly through a change of ownership. You can also consider close family members since they are affected by your decision. Remember that people may develop ulterior motives if they stand to profit substantially from the change of ownership. Many family members can be adversely affected or harbor resentments if fair and equitable decisions are not made or communicated. 

Any accidental or intentional dissemination of these discussions to employees or into the industry will likely cause rumors to occur, damaging morale, the company’s public image, and even sales volume. As an example, let’s say a key customer hears you may be selling out at some point. They may consider moving their business with you to a competitor for the long-term security of their business plan. Or if you discuss with some key employees the business valuation and give them the impression that they may gain some equity in the enterprise and you later change your mind, you will undoubtedly have a trust and morale problem. 

Deciding the Business Methods of Succession and Controlling Partners. 

1) Close Family Member(s) or Valued Employee(s) 

If you already have a family member(s) working in, or interested in, joining the family business, they are often the first you’ll deliberate to take over the company eventually. Some key considerations follow: 

– Can the person or persons manage all aspects of the business? If not, what development training do they need to move up the skills ladder and allow for a smooth transition? 

– The tough question is, does the person have the capability to manage all aspects of the business? If a family member can handle most of the critical business functions, then do you have or can you hire a professional to give the organization strong management across the board (e.g., sales professionals, CFO or Controller, Ops Manager, etc.)? For these non-family members, there needs to be accountability, goals, and incentive pay to motivate them. After some time, consider a small ownership % also. 

If you want pivotal employees or all employees to take over the business, there are a few options to consider. 

– If no family members want to continue ownership in the future and you believe an ESOP (Employee Stock Ownership Plan) buyout with all the employees or a selective buyout by some key employees would be a good option. For the founder to liquidate their ownership, an ESOP can be phased in over time and be leveraged or non-leveraged1. Seek professional help on this before you communicate any of this to employees. 

2) Retain Family Control without Family Management 

– If you do not have family members interested in working in the industry but still want family ownership control, you’ll need an exit plan to promote or hire talented professionals to run the company for the potential investor looking to purchase the business. As mentioned above, one must implement the same incentive pay schemes. These concepts are a multi-year process. Setting up an ESOP trust may also be appropriate. 

– Remember that a strategic buyer cannot expect the business to run on autopilot. Consider establishing a board committee with regularly scheduled meetings to review results, strategy, investment opportunities, etc. Contemplate using outside professionals to participate on this board (e.g., accounting, legal, banking, industry knowledge, etc.) 

3) & 4) Has your intention always been to build and cash out & potential buyers? 

– The common term for this is “Flip the Business.” It is appropriate if you are using the business as an investment stepping stone to move into other types of industries or investments, and you want the cash vs. having an income stream from the startup business. Your goal, in this case, is to either get a specific net after-tax dollar amount to finance future ventures or maximize the sales price of your current company for financial freedom. 

– Other considerations would be whether it is the right time to sell the company economically. Ask can the company be sold to a competitor, sold to private equity, sold to a local company, or an individual venture capitalist, or solicit entrepreneurs that may want to enter your regional market. 

– Other considerations are the welfare of existing management and employees. If you sell to a local competitor, there is a likelihood that they will consolidate your company, and some or all of your former employees will become redundant. 

– Will your company be a good fit with any potential buyers under consideration (e.g., reputation, quality, investment in your local community, etc.)? 

– Are you concerned about legacies (e.g., company name, product line branding, etc.)? 

– As best that can be legally structured, settle any outstanding claims on your business and ensure the new owner assumes all current and future liabilities (e.g., EPD issues, product liabilities, future claims, etc.). 

– It will take time to find a potential buyer, and due diligence is required when the prospective buyer or their proxies come into your business to examine your data room (all pertinent financial and business-related records). Thus it is best to put in place confidentiality agreements with them. Even with these agreements, rumors about why these people visit will circulate. Communicate to your customers, suppliers, and employees to manage harmful gossip. Consider offering retention bonuses to key employees as exit options. Here is also an opportunity to provide an ESOP if acceptable to you. 

5) Retaining an Equity or Debt Holder’s Position in your Company? 

– An equity position can be achieved through an ESOP as explained above or a majority (>50%) or minority shareholder (<=50%). This section addresses ownership by a limited number of people and not an ESOP. 

– A majority interest would lead to a silent financial partner or an active management position. Either could work, but it is really up to what you want at that point in time. 

– A minority interest would mean you do not have a day-to-day say in the firm. However, you will be sharing in the company’s profits and losses. As a minority interest, you may also be an investor. You may invest money to cover cash needs if the business needs a positive cash flow to cover expenses, invest in capital, or for a corporate expansion. 

– You would have a limited say in how the company operates. First and foremost, it would be through your industry knowledge and influence over the other shareholders. However, you can be outvoted in the decisions if the majority of the owners do not agree with you. 

– A clear and concise legal agreement will need to be in place, agreed to, and signed by all new owners. 

– Holding a promissory note with your former company would be a way for you to finance liquidating the business. It could be either non-convertible or convertible into equity. With the former, you should have a lien on the organization, and with the latter, you can convert the debt into equity. In either case, this would occur if the new owners cannot meet the obligations to repay the debt. The new owners could be family members, former employees, outside investors, or a combination. Depending on how much cash the owners can pay upfront, you can partially liquidate your investment and be paid the rest of the business’s value sometime in the future. This contract relies highly on how well the new owners can manage and grow profitably. You also will not have a say in how they operate and invest in the firm. The worst case with a convertible note is that you may have to step back in to help manage the business if the new venture begins to fail. Timing on doing this will be crucial. In any case, you must put a comprehensive legal agreement in place to protect your interests. 

6) Paid Advisor Position with No Equity or Debt Ownership 

– Many times, a new owner may want you to stay with the firm for a fixed period to safeguard sales and profitability during the post-acquisition transition period. Extending the owners’ stay is often requested when you have unique relationships with key customers and suppliers that may be new to the buyers. This process gives the buyer time to integrate your operations into theirs and develop those relationships. Private venture capitalists may want you to stay on for an extended period until they find a qualified replacement to manage the ongoing corporate or commercial activities. The private equity owners may be new to your industry. Other private equity owners may already have businesses in your industry, and a shorter transition period can occur since they are likely to roll up their common ventures. 

7) An Immediate Consideration: Estate Planning that Includes Your Business 

Recognizing Estate Planning Within Your Exit Strategy.  

Cogent Analytics works with you on soft skill issues and provides tools to develop a sound and successful exit plan. Yet, we do not offer estate planning for small to medium-sized businesses. We can make recommendations for legal advice in this area, but this type of professional needs to have experience with both state and federal corporate laws and estate planning. We recommend that you obtain reliable local advice. 

If you still need to do this, estate planning is a critical area that needs addressing even before you have the time to develop and put in place good exit strategies. One thing to keep in mind is that the estate planning may need to be modified after you have a clear exit plan. As described in this paper, business succession planning takes time and is best thought through carefully with good advisors. 

An existing exit strategy is critical because you cannot predict when you may be incapacitated or die due to an accident or illness. Therefore, it is helpful to have some basic estate planning in place as soon as possible to protect your business and wealth. 

4 Estate Planning Options in a Business Exit.  

Assuming you do not have a trust in place that addresses the continuity of your company2: 

1. Sole Proprietorship: the company becomes part of the estate.
2. Partnerships: an unincorporated partnership dissolves at the time of the death of a partner. The net value of your share of the partnership goes into your estate.
3. Limited Liability Corporation (LLC): Business may continue, but the LLC must state what happens to the deceased’s share of the firm. The estate can take over the deceased’s share or dissolve the LLC, and the net value of the appropriate amount for the departed goes into the estate.
4. S and C Corporations: The deceased owner’s firm shares become part of the estate. The business continues as an entity unless the new owners agree to sell or liquidate according to the articles of incorporation.

Various Ways to Manage the Tax Effects When a Business Owner Passes3: 

If your organization’s legal structure is in the 1, 2, or 3 listed above, your share of the business will go to your estate. “The current estate tax exemption ($12.06 million in 2022) is so high that most estates do not pay any estate tax. However, a small business could put an estate over the limit. Also, the estate tax exemption scheduled for 2026 is to be cut in half, and states will have their own estate taxes, which means that tax planning in the now is crucial. Put your company assets into a trust or a separate business entity like a limited liability company to lower your estate tax burden. 

– Trust. A trust is useful to reduce estate taxes and ensure the continued running of your legacy if you die or become incapacitated. Because a trust passes outside of probate, you can transfer the assets within immediately to a delegated person chosen to run the company without waiting for the entire estate to go through probate. In addition, if you become incapacitated, the trustee can continue to run your organization without court involvement. 

– Buy-Sell Agreement. Buy-sell arrangements can be beneficial if you own your business with others. Buy-sell agreements are used if one of the owners dies, leaves the company, or becomes incapacitated. It specifies who can buy an owner’s share of the firm, under what conditions, and for what price. 

– Life Insurance. When you own a company, life insurance takes on new importance. A life insurance policy can ensure that your family continues to receive an income in the event of your death. It can also provide funds to keep the business running and be used to fund a buy-sell agreement.” 

Additional Exit, Succession, and Estate Planning Considerations4: 

– Operating Agreement: with multiple owners, you should address specific day-to-day management questions that will arise. For example, Who takes over temporarily? How are long-term decisions made? Will the surviving business owners buy out the deceased owner’s estate? 

– “Buy-sell agreement: A buy-sell agreement is a predetermined sale triggered by the death of an owner or some other event. This type of agreement allows one partner to sell their ownership to another without the other party’s consent at the time of sale. The agreement contains a price at signing, which could be a fixed price based on fair market value or some other valuation method.” 

– Sale during life: an agreement that allows a smooth transition of business ownership before a major event occurs, like the death of the founder or an owner. 

– “Private annuity or self-canceling installment note: Private annuities and self-canceling installment notes are special ways to sell a business, typically used within a family. With an annuity, you sell your company in exchange for the annuity.” 

– “Grantor retained annuity trust: A grantor retained annuity trust (GRAT) is a special type of trust that takes title to your business interest. You retain the rights to your share of the firm’s income for the rest of your life. Upon your death, your beneficiary receives the interest held by the trust, which helps to bypass the probate process.” 

Summarizing the Exit Planning Strategies.  

As a small business owner or a medium-sized owner, you should now understand that succession planning is more than just hiring and developing people to take over your leadership role in your company. That is only a small part of what should be your considerations. Extensive exit options are also available for your estate planning related to your organization. 

You need to address the inevitable situation when you cannot participate in managing your company either partially or entirely. It would be best to have successful exit plans that allow for a smooth transition, so the business’s value and legacy do not have a negative impact. Considering your family and significant others in exit planning is also helpful. In addition, you need to hire good professional help and get sound advice from trusted individuals, possibly those who have already gone down this road. Listen to their successes as well as any regrets. Hasty or delayed decisions and implementation may not ensure the legacy you have worked hard to create over the years.