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Leaving on a good note: It's never too early to start planning an exit strategy

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Peter Laughlin has been a lawyer for more than 30 years, “but in the last five years or so, I've been asked more often to help pick up the pieces in business succession strategies that didn't work out,” he said.

Perhaps the bulge of baby boomers who are aging out and want to pass on their ventures is driving the activity. But whatever the reason, Laughlin — a partner with the law firm McElroy, Deutsch, Mulvaney & Carpenter LLP, whose practice focus includes corporate and commercial law — said he’s seen a variety of situations.

In one instance, the law firm was approached by a family that ran into operational issues. “The elderly owner-founder basically ran a high-tech services and products company and unfortunately suffered from a sudden onslaught of Alzheimer’s disease,” he related. “There were likely some early warning signs, but sometimes family members just don’t recognize them. In this case, he became unable to run the business but no one had ever seriously discussed succession issues. Further, none of his adult children were involved in the day-to-day operations of the family business.”

Ultimately, the business was sold, “but in the meantime the company’s profits had eroded since no one was at the helm, and the sale didn’t fetch the price it should have,” said Laughlin. “This points up a serious issue: Business owners should engage in succession planning early on, even as soon as the company is first formed.”

That’s especially true if the company has multiple owners. “It’s not just a matter of operating control,” Laughlin counseled. “You should also address buy-sell and other issues. What happens if one of the partners becomes ill or disabled and has to exit suddenly?”

Family-owned companies have their own issues, he added. “I’ve seen situations where the founder-owner of a successful company planned to pass the business on to his heirs through a will or trust. But what if you have multiple adult children from multiple marriages, or some of your adult children are involved in the business while others aren’t active in it? Depending on who the trustees of the estate are (like an ex-spouse with children from a previous marriage), their actions may not align with your wishes.”

Even a sole proprietor should consider exit issues during the formation phase. “Your specific plans about growing and ultimately selling the business will affect a lot of things, including the form of the initial business structure,” Laughlin said. “So your exit plans should be part of the initial conversation.”

Can an ESOP work for you?

“At Lakeland Bank, we’re seeing more requests for ESOP (employee stock ownership plan) loans,” according to John F. Rath III, the financial institution’s executive vice president and chief lending officer. “They can work out for some companies as a way for the owner to monetize his interest and transfer a stake in the business to employees. But the plans can be complicated and may incur significant administrative costs.”

In the U.S., there are nearly 7,000 ESOPs covering more than 14 million people, according to the nonprofit National Center for Employee Ownership. But Achim Neumann, president of the M&A and business broker firm A Neumann & Associates LLC, is no fan of them.

To create an ESOP, money is often borrowed to buy the company’s existing shares from the owner at a fair market value, he said. But the thing is, “the bank will most likely seek a loan guarantee from the current owner, leaving the departing owner with considerable loan exposure.”

Plus, the current — and presumably successful — business owner no longer has control of the company, although he or she is still responsible for the loan that bought the company, according to Neumann. “Not a desirable position to be in,” he said. “Owners of privately held midsized business are generally better advised to sell their business on the open market. This will not only allow obtaining the best price, it will also free the owner from substantial financial exposure subsequent to exiting his company.”

One tip: “Start grooming a successor while you’re alive and well and active,” he added. “This way you can see what the fit is and if it’s working out well.”

Laughlin is currently involved in exit strategies for two successful companies — a marketing business and a technical services company — both of which happen to be family-owned. In each case, the adult children are not interested in taking over, he added.

“The marketing company owner is comfortable with an outright sale,” according to Laughlin. “The owner of the tech services company is looking at a management buyout as a way to monetize his own hard work while also rewarding key employees.”

If management can find a lender who can structure the right deal, they may be able to buy the company for cash. “But more often, it’s a staged buyout,” said Laughlin. “In that case, the management group may pay a part of the selling price up front and get a controlling stake in the business. Then they’ll make partial payments each year for a certain number of periods.” The owner’s children may also be taken care of by inheriting a minority stake in the company.

One reason that early succession planning is critical for a business is there’s so much to do, according to Tiffany Wagner Donio, a partner with the Archer law firm who focuses on corporate and tax law.

“It’s never too soon to start,” she said. “You never know what can happen tomorrow and it can be difficult if a family is suddenly left holding a business and no one knows how to run it effectively.”

Planning for the next generation of ownership is only part of an exit strategy. Another issue, a big one, is determining an asking price for the business. “Some research helps a lot,” according to Laughlin.

“Different industries often have their own metrics,” he counseled. “A common one is a multiple of EBITDA (earnings before interest, taxes, depreciation and amortization — a kind of modified cash flow). Some industries use a multiple of sales, while the pricing of many financial services businesses are based on assets under management.”

Some accountants have valuation expertise — in fact, the American Institute of Certified Public Accountants has a business valuation credential called an ABV (Accredited in Business Valuation). “The ABV credential helps you drive your career forward, highlighting your expertise in areas such as fair value reporting, mergers and acquisitions, succession planning, shareholder dispute resolution, marital dissolutions and bankruptcy,” according to the AICPA. “The ABV credential also gives you added credibility with clients and within your organization.”

A number of independent companies also specialize in business valuation, although “if your firm is a large one, you may need an investment banker with expertise in your industry,” said Laughlin. He also had some advice about structuring a buy or sell contract.

“On the buyer side, we may suggest an asset purchase, since this way you can buy the machinery and equipment and other assets that you really need,” he said. “Also, you can generally pick and choose the liabilities you’re comfortable assuming. When we represent sellers, though, a stock sale may be tax-efficient for them.”

Donio noted that the ability to minimize tax effects could impact the purchase price that the buyer or seller is willing to accept. “One of the reasons it’s important to have a good advisor is to reduce the likelihood of any surprises.”

Another way to cushion against unexpected issues involves taking out insurance on representations and warranties, noted Laughlin. “It may make the seller’s hunt for a buyer a bit easier. In part that’s because it can bring some peace of mind to the buyer, since they may be able to collect from an insurance company if it turns out that there were shortfalls in representations or warranties,” like customer contracts and other issues.

In some ways, the process of selling or otherwise transferring ownership of a business is similar to launching a new company. In both cases, it’s critical to have a good foundation and a deep understanding what makes the enterprise tick.

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