Exit Planning for Second-Generation Business Owners
According to a 2021 study by PwC, only one-third of family-owned businesses have a detailed exit plan in place. While one may have an informal plan somewhere in the back of their mind, it’s often not documented, much less reviewed by qualified exit planning advisors or communicated to all the parties involved.
An informal plan isn’t good enough to meet their current and future lifestyle goals and obtain maximum value for their business. Even though all business owners must eventually leave their businesses one way or another, they overlook the importance of planning well in advance.
Exit planning can be a daunting task for those intending to pass the business to the next generation and beyond. By focusing on the “4 Ps,” you have a higher chance of success. The 4 Ps are:
- Philosophy: Each business operates with an ideology that defines the company’s purpose. Understanding the purpose and philosophy is essential for any company to operate beyond the current generation.
- Planning: A long-term vision is crucial for success, especially if you intend to build a multi-generational family legacy. But that’s not all: planning for the future also clarifies the business owner’s financial planning, retirement goals, estate planning, etc.
- People: One of the most critical assets for any family-owned business is its people. Understanding and defining ownership rights and responsibilities enables you to develop a leadership protocol for the new business owner(s).
- Processes: All businesses need guidelines that help navigate future challenges. Strategies and business policies clarify a few critical aspects of the company, like employment, compensation, leave, etc.
With all four Ps working in tandem, it’s easier to address financial, tax, and legal matters when it’s time to leave the business.
So, let’s learn more about the whole process of exit planning:
What is Exit Planning?
An exit plan is a structured, comprehensive roadmap to leave your business. The exit strategy guides you on how to exit your business, what you need to accomplish to exit, and the steps to get there. Your exit strategy also addresses potential financial, legal, and tax-related issues as well as your personal financial goals.
The exit planning process is best led by an exit planning advisor and should ideally start four to five years before the actual exit date. Exit planning considers the impact of the transition on the owner’s personal life by evaluating how to maximize and harvest the business’s economic value and pass over that value when the owner is ready.
An exit plan should accomplish the following:
- Give the flexibility to exit the business in the owner’s desired timeframe
- Establish and fulfill personal financial goals
- Reduce tax liability as much as possible
- Exit the business on the owner’s terms
- Build the company’s value and get maximum value for the business
- Ensure the business is transferred into capable hands, be it a family member, key employees, or an external third party.
Why Do I Need an Exit Plan?
Even though business owners across industries will unanimously agree that their businesses are their most valuable assets, most owners still fail to plan their exits at the right time and reap the business’ value.
According to a survey by Exit Planning Institute, 76 percent of business owners will transition in the next ten years, and 48 percent in the next five years. However, the survey also highlights few bitter truths:
- Of the 20 percent of business that sells, 50 percent do so with significant concessions from the seller.
- Only 30 percent of businesses transition successfully to the second generation, only 12 percent to the third, and 3 percent to generations beyond.
- This lack of success is mainly due to improper exit planning. Business owners either wait too long to start the exit planning process or grossly underestimate the volume of work required to prepare for business exit.
The same survey also revealed the following findings,
- Two-thirds of business owners do not know all of their exit options.
- Seventy-eight (78) percent have no formal internal or external transition team; 83 percent have no written transition plan; 49 percent have done no planning at all.
- Ninety-three (93) percent have no formal retirement plan or a clear idea of the following “chapter.”
- Forty (40) percent have no contingency plan in the event of death, disability, divorce, or forced exit.
- Over half (56%) of business owners believe they have a good idea of their businesses’ worth; only 18 percent have a formal valuation.
A structured exit plan can certainly help change the outcome for you since the primary focus of exit planning is to build value today and understand how a potential buyer sees your business. An exit plan will also ensure that the company is capable of running independently without your constant intervention. The result? The firm is safeguarded against risk, there are more repeat clients, and processes are structured.
Exit planning helps you plan for what comes next for you after you transition and for your employees after you leave. Exit planning also promotes value accretion in the business and minimizes risks to prevent adverse changes in value before the exit.
How Does a 2nd Generation Business Owner Like Me Typically Exit?
Once you have established your goals, the next step is to choose the exit strategy that suits you best. Your exit options are:
- Succession planning: internal transition to a group of key employees (MBO). The company’s management team acquires the business. The acquisition is usually funded by pooling their funds, private equity, and seller financing.
- Internal transition to an ESOP or other shared ownership structure. In the absence of a qualified management team, an employee stock ownership plan (ESOP) ensures business continuity. A trust fund is set up, and, over some time, company stocks are allocated to employees. The shares are distributed based on the total tenure of an employee with the business. Senior employees are more invested in the company.
- External sale to a more prominent firm (M&A). In this scenario, the business is either acquired by a larger business entity, or two companies merge to become a single business entity. The deal can be structured in several ways: horizontal merger, vertical merger, congeneric merger, market-extension merger, product-extension merger, and conglomeration.
What Are the Key Steps to Exit Planning for a 2nd Generation Business Owner?
Identify when and how you want to exit (internally or externally).
Exit planning begins by answering the who, what, when, where, why, and how questions about the business and personal goals. Begin by addressing the following questions:
- What are your personal and business goals, and what do you want out of the company when you depart?
- If you are planning an MBO, choose who you want to take over management and plan and define the process to prepare them for their new roles.
- Who will be the new owner of the company? Do you plan on assuming an advisory role? Focus on developing a management team to demonstrate that the business is self-sufficient, more attractive to potential investors.
- Do you wish to stay involved in business operations as a member of the advisory board or exit it completely?
- When and how will the transfer take place?
- What is the source of buyer’s funding?
- What are the tax implications associated with the plan?
- How will you communicate the plan to those affected by it (family members, key employees, trusted advisers)?
Once you have understood the exit options (internal and external) available to you, it’s necessary to assess the pros and cons of each. Choose the exit option that fulfills both your personal and business goals.
Establish the baseline value of the business. The primary focus of an exit plan is to ensure the best value for your business. The plan focuses on all the action items that will optimize the company’s value until it’s time for you to leave. This begins by first establishing the business’ baseline value which is derived by evaluating three parameters: the current market position of the company, how it performs against competitors, and the current business value. The baseline value helps you understand what’s needed to increase the business value.
Execute the transition. Once your family-owned business has reached its business value target and has identified the prospective buyer, the next step is to transfer ownership. The actual price negotiation, due diligence, and initial sale contract are drawn up during this phase. Finally, after the deal closes, the management teams (depending on the chosen exit option) integrate the two businesses.
Sometimes the best management successor is one of your key employees, as opposed to a family member.