An exit strategy is the method by which a business will transfer ownership (all or only a portion of it) to a third party at some point in the future. This is often memorialized in a company’s Operating Agreement, Bylaws, or other formal and binding contracts, and is typically referred to as a buy-sell agreement or buyout provision. There is no question that, at some point, every small business owner is going to have to leave his or her business, in one form or fashion.
The following are among the most common “trigger events” that should be considered:
- Divorce. This can be between co-owners, or between one of the business owners or LLC members and his or her non-owning spouse;
- Deadlock or disagreement amongst the business owners or LLC members;
- A business owner of LLC member has a personal bankruptcy;
- Default on a loan secured by an ownership interest;
- Death, disability, or incapacity of an owner or LLC member; and
- An owner or LLC member simply wants to leave the business and move on.
Crafting an exit strategy
Regardless of where it is written, or what it is called, a business’ exit strategy should at least contain the following:
- Identification of what events will trigger the provision ( listed above)
- Identification of the ways in which a business owner/member can transfer his or her interest in the entity
- Details regarding how that interest will be valued.
What are the ways out?
As far as a small business is concerned, there are typically four ways that an owner or LLC member can move on:
- Sell to a Third Party: While this method typically results in the largest net gain for the selling individual, the downside is that it’s difficult to determine whether the third party buyer will share the business vision of the remaining owners/members.
- Sell to a Family Member: Unlike when selling to a third party, individuals tend to be comfortable selling to a family member, as there is an increased likelihood that he or she will run the business with some continuity and degree of care. Leaving a running business to a family member can also be a great gift! Conversely, however, one’s family members may not have any interest in participating in the business and, even if they do have the interest, they may not have the skills to run the business.
- Sell to an Employee(s): This option can be great for the selling owner if he or she utilizes an Employee Stock Ownership Plan (ESOP), which will provide him or her with some nice tax advantages. It is important to consider, however, how the employee(s) will pay to purchase your interest, as they may not have large amounts of funds laying around.
- Close or Liquidate the Business: This method seems to be used more by closely held businesses, with only one or two owners, and often ends up being the easiest way out. With that ease, however, comes the downside of the owner(s) not receiving a significant, if any, return, and the employees being out of a job.
How will the business be valued?
Finally, an exit strategy should detail how the business, or the various ownership or LLC membership interests in the business, will be valued for sale purposes. The question of valuation is a complex one, often resulting in heated disagreements and sometimes delaying, or even completely interrupting, the sale process. As such, the following is a very brief overview of various things you ought to consider.
Initially, all of the owners or members of a business can agree on a valuation amount each year, however it bears considering that when the triggering event occurs, the actual value of that interest will likely be different from the earlier agreed upon number. Alternatively, upon the occurrence of a triggering event, the value of the business, or a given interest in the business, may be determined by (1) a calculation using historic company data; (2) the company’s Board of Directors after consultation with various financial professionals; or (3) a professional appraisal, which would be guided by a market, asset, or income approach.
Regardless of which valuation approach is used, a business’ value will ultimately be determined by how much the market, or a specific buyer, is willing to pay for an interest in that business.
We’ve discussed all of this, so now what?
Now that you’ve spent a good deal of time contemplating and negotiating the above topics, it is imperative that the final exit strategy – whether it be in the form of a buy-sell agreement or otherwise – be included in your business’ governing documents. As the saying goes – if you fail to plan, then you’re just planning to fail!
If you’re just starting a new business, or have a strong business but no exit strategy, please give us a call to see how our experienced business lawyers can help you draft and execute a buy-sell agreement most favorable to your interests!
By: Attorney Jon Gelber