Alternative Exits for Business Owners - BusinessWeek

Alternative Exits for Business Owners - BusinessWeek

By Monica Mehta
Small Business

If you're looking to sell your company, it's time to get creative. While the small business mergers and acquisitions market is finally inching forward and deals are getting done, they better reflect seller motivation than attractive valuations. Bank involvement in acquisition financing deals also remains low. As long as buyers are forced to pony up bigger equity checks, sellers frustrated by anemic valuations are unlikely to see pricing snap back. Offers remain far from desirable.

Still, if you're looking longingly at an exit, fear not. Unconventional deal structuring can maximize a company's long-term value and do wonders to bridge the gap between a buyer's limitations and a seller's expectations. If there's just no way to get there via a traditional sale, there are alternative exit strategies that may yield better results.

1. Strike a deal with a third-party buyer.

Sellers who can look past a low valuation and embrace strategies that offer added, deferred payments can bump up a deal's overall payout over time. "Business owners that are flexible with terms and open to seller financing can still create a feeding frenzy among buyers," says Domenic Rinaldi, president and managing partner of Sunbelt Chicago, a leading business broker. He's seeing more creative deals than he did a few years ago and notes that sellers willing to assume greater risk regarding terms are netting premiums.

There are a variety of ways to sweeten a sale down the road. A low up-front price can be offset by a long-term consulting contract that pays the seller an outsized salary for minimal post-sale involvement. Sellers that own the real estate related to their business can also make up for a low purchase price by excluding the real estate from the deal and negotiating a long-term lease with the new buyer at favorable rates. Negotiated earnouts—bonus payments based on company performance—can also give a bounce down the road.

Deferred payments can also lower overall tax liability by spreading payments over an extended period, potentially during a period of years where your income will be in a lower bracket. If you are able to direct the downstream income to a separate business entity (for example, a consulting company or a real estate business), you may be able to write off certain expenses as well. A tax professional can help you think through related considerations.

Another way to bump up your company's value is to introduce healthy competition to the sale process. Start by making sure that your business is priced right. A realistic valuation is critical to generating interest. Today sellers can expect no more than two-times to three-times earnings for their business, excluding the value of hard assets such as real estate. If you can get enough potential buyers involved, the leverage swings back in your direction and you can negotiate the best terms.

Seller involvement in deal financing is also a prerequisite. A business owner unwilling to provide seller financing is generally not serious about making a sale. It is not unusual for purchasers to expect 30 percent to 50 percent participation from a seller. (For more about seller financing, see "Sellers Increasingly Play Banker.")

2. Sell to your employees.

If you can't make the numbers work with an external buyer, selling to your employees through an employee stock option plan, or ESOP, can be a good Plan B.

Here's how it works: A business directs up to 25 percent of its annual payroll before taxes into an ESOP trust. This pretax money can be used to buy a variety of investments, including shares of the founder's company stock.

The money held in the ESOP trust is managed exclusively by the company's board of directors, not employees, allowing the principals to maintain control of these funds until the owner is ready to retire.

An ESOP can buy any number of shares, from a minority position to a controlling interest. If the ESOP acquires more than 30 percent of the outstanding shares of a company, a seller can avoid capital gains on those shares indefinitely, giving this method of sale a huge leg up. Like an external buyer, an ESOP trust can also seek a bank loan, using the business's assets as collateral, to cover a portion of the purchase price.

An ESOP doesn't make sense in all cases. Only corporations—C or S corps—are eligible to form an ESOP. The business must be profitable, generating at least $100,000 in pretax income, and must have at least 15 employees. An owner selling shares to an ESOP must use a fair market value that can be supported by an appraisal.

A plan and trust will cost approximately $50,000 to set up and roughly $10,000 to $15,000 each year to maintain in legal, accounting, and appraisal fees. Ideally, ESOP experts advise that you set up a plan 10 years before you seek liquidity. In reality, business owners rarely plan that far in advance. A transaction can be structured in a matter of months.

With an ESOP sale, you will be ceding control to your workers. A transition plan is critical to make sure they are prepared to carry on once you leave the business. ESOP advisors such as the Menke Group specialize in these vehicles and can be a good source of information if you choose to explore this path.

3. Don't sell just yet.

When all else fails, your best option may be not to sell at all. Think about how you can rework your business to run without you and still let you collect a portion of its annual profits. If you can forgo a large up-front payout, you may make more money this way than by selling for a mere two-times to three-times earnings.

In order to step back from the day-to-day activity, you will need to promote existing employees or hire management to run the business without you. Finding such talent isn't easy, but a business that doesn't rely on its founders to survive is in a better position to sell. Bringing in management will also require you to be involved for a longer transition, but no more than would be entailed by a sale in which the seller's purchase price is tied up in back-end payments.

The profit your business generates after paying for additional employees may start to feel just like the staggered payments you would receive from a highly negotiated third-party sale. You might find that you net more over time this way. And if the economy improves in three to four years, you will be in great shape to sell for a premium, having already properly structured your exit.

Monica Mehta is managing principal of New York-based investment firm Seventh Capital.