Leaving a Business: Which Exit Plan is the Best Option for You?

Posted on September 15, 2015 by Oozle Media

Four common strategies for leaving a business are transferring ownership to family members, setting up an Employee Stock Ownership Plan (ESOP), selling to a third party, and liquidating the business, though other structures and variations exist as well. There is no single right answer. The best option depends on your financial goals, how involved you want to stay, and how the business is positioned to be sold. Lightheart, Sanders and Associates works with business owners in Mississippi and South Carolina to think through these options and build a plan around the outcome you actually want.

What questions should you ask before choosing an exit plan?

Deciding on the right exit strategy is an important process, and it requires a careful assessment of what you want from the sale and who can best give it to you. A few important questions to ask yourself:

• What can you expect to happen when you leave?
• What are your financial goals? How much will you make, or hope to make?
• How long will the exit process be?
• Do you want to continue to be involved in your business?

What is the family legacy option?

Transferring your business to your children can provide financial well-being for younger family members who are unable to earn comparable income from outside employment.

Setting a sale price is not simply a matter of choosing whatever amount you need to live on. If you sell or transfer the business to a family member for less than its fair market value, the difference may be treated as a gift and can create tax and basis consequences, so the price and financing terms should be reviewed with your tax advisor.

You will need to determine if anyone in your family is the right person for running your business, and whether it is something they actually want to do. Some investors or current employees will not always support who you choose, and this can be a stressful process depending on your family dynamic. Financial security may be diminished rather than enhanced, and the existence of the business is at risk if it is transferred to a family member who cannot or will not run it properly.

This option can also increase family friction, discord, and feelings of unequal treatment among siblings. Parents often feel the need to treat all of their children equally, but in reality this is difficult to achieve, and in most cases one child will probably run or own the business at the perceived expense of others.

Whichever direction you decide to take, it is necessary to develop a contingency plan to convey your business to another type of buyer.

What is an Employee Stock Ownership Plan (ESOP)?

If your children have no interest or are unable to take over your business, an Employee Stock Ownership Plan (ESOP) is another option to ensure the continued success of your business.

ESOPs are qualified retirement plans subject to the regulatory requirements of the Employee Retirement Income Security Act of 1974 (ERISA). An ESOP is designed to invest primarily in qualifying employer stock, though it can hold some other assets as well.

An ESOP is set up as a trust 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, subject to certain limitations. Shares are then distributed to employees, typically based on compensation levels, and grow on a tax-deferred basis until distribution, at which point they are generally taxable to the employee, subject to the usual rollover rules for qualified retirement plans.

Selling to an ESOP does not automatically avoid capital gains tax. A shareholder who sells qualified stock in a closely held C corporation to an ESOP may be able to elect to defer the gain under Section 1042 of the Internal Revenue Code, but that election has specific requirements: the ESOP must own at least 30 percent of the company’s stock after the sale, the stock must generally have been held for at least three years, and the seller must reinvest the proceeds in qualifying replacement property within a set window. This is a complex, irrevocable election that should be worked through with a tax advisor before the sale, not assumed.

If your company is a stable, well-established one with steady, consistent earnings, an ESOP might be worth exploring as part of your exit plan.

What does a sale to a third party involve?

In a retirement situation, a sale to a third party too often becomes a bargain sale, and the only alternative to liquidation. But if the business is well prepared for sale, this option can be your best way to cash out.

One important tradeoff to weigh is how much of the price you receive at closing versus later. Receiving more cash upfront gives you immediate liquidity and reduces your exposure to the buyer’s future performance and intentions. Structures like seller financing, earnouts, installment sales, or rollover equity can also be part of a legitimate deal, but they generally mean part of your proceeds depends on what happens after you leave.

If you do not receive the bulk of the purchase price in cash at closing, you are placing a substantial amount of the money you were counting on in the unpredictable hands of the buyer’s future performance. Whether that tradeoff makes sense for you depends on your own risk tolerance, the buyer, and the deal structure, so it is worth working through with your advisors before you negotiate terms.

When should liquidation be your exit plan?

Liquidation is often considered a last resort. It can be one of the quickest and simplest strategies for exiting a business, and it commonly produces a lower return than selling the business as a going concern, since it is limited to the value of the assets rather than the business’s ongoing income-producing potential. If there is no one to buy your business, you shut it down: the owners sell off assets, collect outstanding accounts receivable, pay off bills, and keep what is left, if anything.

Liquidation is generally considered as an exit plan when a business lacks sufficient income-producing capacity apart from the owner’s direct efforts and apart from the value of the assets themselves. For example, if a business produces relatively little income compared with the value of its underlying assets, such as $75,000 a year in income against $1 million in assets, a buyer may be unwilling to pay significantly more than the value of those assets.

A business is often harder to sell for an attractive value when its revenue and customer relationships depend heavily on the owner personally rather than on the brand, systems, contracts, or workforce. Building value that does not depend on you directly, sometimes called reducing owner dependence, can make a real difference in whether liquidation ends up being your only option. Smart owners plan ahead so they do not have to rely on liquidation as a last-ditch method to fund their retirement.

The sooner you start planning your exit, the easier it will be.

Next step: If you need assistance figuring out which exit strategy is best for you and your business, contact us and our team will walk through the options with you.

Frequently asked questions

What are common ways to exit a business?

Four common strategies are transferring ownership to family members, setting up an Employee Stock Ownership Plan (ESOP), selling to a third party, and liquidation, though other structures and variations exist as well.

What is an ESOP?

An Employee Stock Ownership Plan is a qualified retirement plan, governed by ERISA, set up as a trust designed to invest primarily in the sponsoring company’s stock on behalf of employees. Some owners who sell to an ESOP may qualify to defer capital gains tax under Section 1042 of the Internal Revenue Code, but that election has specific requirements and should be reviewed with a tax advisor.

Why is liquidation often considered a last resort?

Liquidation is limited to the value of a business’s assets rather than its ongoing income-producing potential, so it commonly produces a lower return than selling the business as a going concern. It is most often used when a business has little income-producing capacity apart from the owner’s direct efforts.

Is it better to get all the sale price in cash at closing?

Getting more of the price at closing reduces your exposure to the buyer’s future performance, but it is a tradeoff rather than a rule. Seller financing, earnouts, and other structures can be part of a legitimate sale depending on your goals and risk tolerance.

Comments are closed.