Kathleen M. Stotish, Esq. focuses her legal practice on business transactions and commercial litigation. Ms. Stotish gets great satisfaction out of assisting small business owners with the often complicated process of establishing and maintaining their business entities. She has drafted, negotiated, and reviewed a wide variety of partnership and joint venture agreements, management and operating agreements, asset purchase agreements, and many other contracts. Ms. Stotish’s articles can be found on LinkedIn and on the firm website of the Law Offices of Jonathan Gelber, PLLC.
Our firm’s recent article, Avoid These 5 Common Legal Missteps That Many Small Business Owners Make provided a general overview of each of the listed mistakes, as well as some advice for how to avoid, or overcome, them. Some of those mistakes, however, including number 2 on the list – not discussing and executing a buy-sell agreement or exit strategy – deserve more in-depth treatment and discussion.
Buy-Sell Agreement? Exit Strategy? What Are We Really Talking About?
While the phrase “buy-sell agreement” is used in the article referenced above, the reality is that a buy-sell agreement is just one provision that a business’ exit strategy may be comprised of. An exit strategy, then, 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 contract, and is typically referred to as a buy-sell agreement or buyout provision. Regardless of where it is written, or what it is called, a business’ exit strategy should at least contain the following: (1) identification of what events will trigger the provision; (2) identification of the ways in which a business owner/member can transfer his or her interest in the entity; and (3) details regarding how that interest will be valued.
Does My Small Business REALLY Need an Exit Strategy?
According to a 2014 nationwide survey conducted by Securian, more than 60% of businesses do not have an exit strategy in place. Roughly 15% of business owners reported that they were working on developing a plan, and only 24% said that a formal exit strategy was already in place.
If so few businesses actually have an exit strategy in place, it must not be all that important, right? Wrong! Particularly in the case of small businesses, partnerships, and sole proprietorships, as the business itself is often the owner(s) largest asset, it would be foolhardy to tempt fate by failing to plan for the future of your biggest asset. Without a plan, you very well may find yourself in a difficult and emotional situation – as discussed below – where it will be difficult, if not near impossible, to sufficiently decide upon and execute a plan to either continue or leave your business.
Components of an Exit Strategy
Now that it is clear that all businesses need an exit strategy in place, we will explore some of the different things to consider and include in your strategy.
What Triggers The 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 reasons for this, and are “triggering events” that ought to be included in one’s exist strategy:
- Divorce. This can be between co-owners, or between one of the business owners/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;
- An owner or member simply wants to leave the business and move on.
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:
1. Sell to a Third Party
According to the Securian survey cited above, 33% of business owners plan to sell to a third party, whether that be an individual entrepreneur, a competitor, a private equity group, etc. 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.
2. Sell to a Family Member
Roughly 20% of owners indicate that they will sell their interests 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.
3. Sell to an Employee(s)
As with selling to a family member, about 20% of business owners plan to sell their interest to one or more employees. 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.
4. Close or Liquidate the Business
Finally, about 25% of business owners indicate that they plan to simply close or liquidate the business when it is time for them to leave. 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.
Assuming that you do not use the agreed valuation process, 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!