Exit options: passing to family, management buy-out, and selling to a third party

Every business situation is unique, which means there is no cookie-cutter way to exit your business. You need to consider both the future of the business, and your own future as you move into retirement or onto new challenges.

One of the most important considerations is retaining legal and financial advisors who have the experience and wisdom not only to present the company to the market, but to lead it to a successful sale. Your legal advisor is particularly valuable in protecting your interests within the intricate language usually found on the purchase and sale agreement.

The three most common options when it comes to succession are to pass the business to a family member, transfer ownership through a management buy-out or employee buy-in, or to sell the business to a third party.

Passing to Family

Many businesses successfully stay in the same family, sometimes through several generations. Succession planning should begin very early – as soon as members of the next generation start to express interest in entering the business. This will provide an opportunity to talk about how the business was started, the current projects, and the challenges of the business and the industry. This open dialogue and the sharing of information can help family members make informed decisions as to whether they want to enter the family business.

A smooth succession will not happen unless there is a willing, competent, and well-prepared successor. This requires ensuring the current owner is comfortable with the skills, knowledge, management style, work ethic, and commitment of the potential successor to effectively transition ownership. It is equally important the next generation be comfortable with the succession plan and the expectations with respect to their role in it.

The most successful transitions are where the owner involves their spouse and children early in the planning process. The entire family needs time to identify and discuss their perspectives and concerns and how they will operate in conjunction with the family business and with each other.

Pros

• reduces third-party involvement
• gives your children or others the chance to inherit an already well-established business
• family members who have spent many years working for the family business already possess valuable experience
• gives you the potential to maintain involvement and influence in the business

Cons

• it can be difficult to identify and train the right successor
• potential for conflicts and family tensions
• career limitations for the heirs
• the successor is often regarded as the son/daughter or grandson/granddaughter of the first owner

Management Buyout (MBO) or Employee Ownership Trusts (EOT)

A management buyout (MBO) is an increasingly popular exit strategy for owners of small businesses. This option is essentially the purchase of a company by part or all its existing management. A management buyout is a way of achieving your goals for continuity of operation.

Building a successful MBO takes time: A common impediment to completing a management buy-out is financing. As a result, many management buyouts take place over a longer period than a sale to an outside party. Typically, the financing comes from a mix of personal funds, external lenders, and the seller. It could include stock option plans, a financed purchase, or a buy-out over time. An owner’s exit is quite often a gradual transition over a period of three to five years.

Laying the foundation for a management buy-out: As with all succession options, communication is vitally important when planning an MBO. You will need to understand each stakeholder’s objectives to ensure they are truly interested in obtaining an ownership stake.

You, the manager/management team, and potential lenders should consider the following important factors for a successful MBO:

• Strong, ambitious, credible management team.
• Consistent profitability of company.
• A well-thought-out business plan.
• Sufficient financial participation by ownership and management to assure lenders of their continued commitment to the business.

Communicating with employees: At what point should employees learn that the management team is taking over ownership? When a business changes hands, it can cause some instability. Employees may make decisions to stay or leave based on the people they work with. Communication at the appropriate time is important to ensure that everyone is aware of the change of ownership, and so they feel they are part of the decision about their future with the company. Openness reduces the fear and the loss of morale that could occur when a business is sold.

Structuring the MBO process: The process of structuring an MBO can take between four to six months, with your exit taking three to five years. In addition to having the financing tentatively arranged, you (seller) and the management team (buyer) need to know what your primary negotiating points will be before negotiations begin.

Employee Ownership Trust (EOT): EOT’s are a way for you to sell all or part of your business to your employees. Employee shares are held in trust and governed by a trustee, and the company continues to be managed traditionally. A recent survey by CFIB suggests significant interest among Canadian business owners in employee ownership.

The federal Government proposed a new EOT under the Income Tax Act (Canada) to encourage employee ownership of businesses, a significant step forward in Canada’s journey towards greater employee ownership. In the 2022 budget, the government committed to reestablishing an Employee Ownership Trust (scroll down for information).

Pros

• limited due diligence usually necessary
• buyouts and employee deals can be done in as little as three months in contrast to a full-blown sale process
• rewards management for their long-term support for the business
• protects legacy and business independence

Cons

• this kind of transaction is particularly complex to structure
• management often has limited access to capital, and this could affect the price and the terms
• vendor take back is likely (seller loans part of purchase price to buyers)
• failed purchase attempt can affect business morale and performance

Selling the business to a third party

Sometimes, the best strategy for all involved is to sell the business outright to a third party. This may happen when potential successors witness the time, effort, and commitment a small business owner needs to succeed and decide they are not prepared to make a similar sacrifice.

Preparing for the sale: It has been said that the time to think about selling a business begins in the start-up stage; most of the characteristics that will make a business attractive to a potential purchaser take time to develop. Selling a business is not like selling other assets, such as a house or a car. It requires considerable time to get a business ready for sale.

Once the decision to sell has been made, the next question is when to sell. It’s best if this decision comes from a well-structured planning process and not from an unexpected event, such as failing health. At the very least, you should plan to spend a year or two strengthening the business. This is an area where professional advisors can provide significant assistance in analyzing the business and identifying ways to enhance its value.

You also need to integrate the sale process with your personal income tax and estate planning to ensure the transaction is tax efficient. A well-structured sale could generate significant personal income tax savings. On the other hand, a poorly planned transaction could result in adverse tax consequences that could significantly reduce your future income.

Marketing the business: A major step in readying a company for the market is preparing a descriptive memorandum. This is a compilation of materials that will be distributed to interested buyers. The key to preparing this type of memorandum is to focus on its intended purpose: marketing the business. The memorandum needs to accurately describe the company, its history, products, markets, personnel, facilities, and financial performance in a way that highlights its strengths and potential. When prospective buyers review the memorandum, they should clearly understand the company’s unique investment merits, or growth potential.

Negotiating the deal: A negotiator can significantly enhance the seller’s position by acting as a buffer to protect the amicable relationship between the buyer and seller. This is particularly critical if the owner will remain for a transition period. A negotiator can say, “I am not sure that my client will accept this, but what if we were to…” and protect against the acceptance of a term or condition that, on closer inspection, would not be in the seller’s best interests. By including a third party, an additional step is added before any responses can be made on particular issues so that the seller has time to reflect. A negotiator can help reduce the element of emotion that is one of the leading causes of broken deals in transactions involving owner managed and family companies.

Closing the transaction: A letter of intent (LOI) will be drafted by the buyer and seller’s advisors, but once it has been signed, it’s still important to stay focused on running the company. The transaction is far from being closed and any glitches in the company’s performance at this time can have a major impact on the ultimate terms of the deal. The reality is that it takes more than agreement on basic terms and conditions to close a deal.

Pros

• these types of sales are often the ones chosen by owners who are looking to leave the company fairly soon
• third party sales are the ones that are most likely to close successfully after a negotiation process
• the proceeds from the sale will likely be taxed as long-term capital gains and thus at a more favorable tax rate

Cons

• selling your company to a third party could bring about drastic changes in the company’s culture
• outside buyers often have greater expertise along with stronger legal and accounting firepower
• third-party sales can create severe tax consequences for the unprepared owner