Exit Strategies for Small Business - Englander, Leggett & Chicoine, PC

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3. Exit Strategies for Small Business. Probably the easiest way for the retiring owner to leave the business is an outri
Exit Strategies for Small Business

By: Debra Leggett, Esquire Englander, Leggett & Chicoine P.C. www.elcpc.com

© 2012 Englander, Leggett & Chicoine P.C.

Exit Strategies for Small Business

Introduction When we start our businesses, we think about how to form it, finance it, run it, and grow a client/customer base. What we don’t always think about is what will happen to our successful business once we are ready to retire. This paper highlights various ways that small business owners may extract the value that they’ve built into their business as they transition into retirement.

Note: This article is based on my experience as an attorney and my opinion only. It is not intended to be an in- depth legal or financial analysis of the exit strategies discussed. It is also not intended for medium to large businesses; therefore, I have not included discussion of other exit strategies that may be available to these businesses, such as becoming a publicly traded company. This article does not constitute legal advice.

© 2012 Englander, Leggett & Chicoine P.C.

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Exit Strategies for Small Business

Arm’s Length Sale Case History: Selling to an Unassociated Company An interntionally recognized Internet-based service provider with approximately 30 employees was bought by a large publicly traded company. The buyer felt that the seller’s expertise would enhance the business and valued the selling business accordingly. All (100%) of the corporation’s stock was bought at close with 10% of the purchase price held in escrow until end of the year audited financials were completed, with a mechanism to adjust the purchase price, if necessary. The majority owner was retained as a consultant for public engagements and to write publications for a period of time following the closing to ensure continuity of the business and client retention.

© 2012 Englander, Leggett & Chicoine P.C.

Probably the easiest way for the retiring owner to leave the business is an outright sale of ownership interest (i.e. stock) or company assets to someone you don’t yet know. This kind of “arm’s length” transaction between a willing seller and a willing buyer is the way you will most likely be paid fair market value for your business–especially if there are multiple possible buyers–and to put more value into your retirement relatively quickly. Whether you’ll be able to find a willing arm’s length buyer depends on a number of factors. This type of sale is most likely to occur if: • The business is easily transitioned to new owners • without any disruption in your business’ profitability. • The business offers a systematized, consistent • product or service. • The business is not dependent on the owner’s • participation in it to succeed. • You are either the sole owner of the business or a • majority owner who can bring other lesser owners • to the sale in order for the buyer to purchase the • entire business. This type of transaction may involve a business broker who looks for potential buyers–just as a real estate broker assists people selling real estate. Brokers can play various roles depending on your needs. They can access your business and help get it in order for a sale or they can simply introduce potential buyers to your business. This can also be helpful in setting a reasonable price. The costs of the broker’s services depends on the scope of the work performed and whether the broker is seeking a fee for services and/or a percentage of the sale price. Since a broker’s compensation is often tied to a percentage of the sale price, they are incentivized to get the best price. Once a potential buyer is found, there is typically a confidentiality and non-use agreement put in place so that a buyer investigating your business for acquisition doesn’t use any of your proprietary information without

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Exit Strategies for Small Business

Arm’s Length Sale having completed a transaction. Following the initial review of your business, the parties (seller and buyer) will negotiate an outline of the deal. If the lawyers haven’t been previously consulted, this is when they need to be brought in. This step involves the drafting of a term sheet detailing the terms of the sale. There are a variety of ways to structure a sale and many details and nuances that may change during the transaction process as it unfolds. Some of the bigger decisions that will be made are: • Will the buyer purchase your ownership interest or the assets of the business? • Will payment be made in full at close or purchased over time?¹ • Will some of the purchase price be held in escrow and, if yes: how much, for • how long, and for what contingencies? The purpose of escrow is to provide the buyer security in case the business doesn’t turn out to be all that the seller says that it is or certain classes of liabilities arise after closing (i.e. tax liabilities as a result of an audit). If the purchase price is paid in two or more installments, the later installments can be adjusted (often only down) if the financial statements for the business don’t meet expectations. Once the term sheet is entered, the buyer, seller, and their respective attorneys and accountants go to work on the transaction details. This is the due diligence phase of the transaction where an in-depth analysis of the business is undertaken. How much of the various due diligence tasks are done by hired outside professionals or inside personnel will vary depending on the sellers’ and buyers’ inside expertise and resources. Due diligence includes: For accountants: • Review of financial statements, including tax returns • Tax analysis of how the sale and the business are structured For attorneys: • Review of contractual relationships (clients, suppliers, landlords, etc.) • Review of business status (business records, statutory filings, etc.)

¹ Any time there is a sale phased over time from seller to buyer, which may occur in all of the approaches discussed in this article, often the seller will be concerned about how the business will run and who will be making decisions for the business during the transition period. Many specific concerns may be addressed in governance documents (the incorporating documents and other owner agreements, such as stockholders voting agreements) defining how the management team will be appointed, who they will be, and perhaps, providing guidance on how key decisions should be made. Not all circumstances can be perfectly anticipated in these documents but agreements can provide direction. © 2012 Englander, Leggett & Chicoine P.C.

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Exit Strategies for Small Business

Arm’s Length Sale Based on the agreed upon term sheet and any variances that may arise during due diligence, the transaction documents will be negotiated and drafted including: • Financial terms of sale • Representations and warranties • Holdback/escrow • Employee matters • Non-competition and non-solicitation provisions • Indemnification • Other terms and conditions Depending on whether the seller is going to stay with the business following the transaction, there may also be: • Employment agreements • Changes to the governance documents (Charter, Bylaws, Operating • Agreement, etc., as applicable) Based on tax and legal advice there may even be a complete restructuring of the business (i.e. reorganizing the business under the laws of a corporate friendly state like Delaware) or other changes. All of these efforts can cost the parties tens to hundreds of thousands of dollars. Generally, a higher valued business equates to higher transactional costs.

© 2012 Englander, Leggett & Chicoine P.C.

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Exit Strategies for Small Business

Arm’s Length Light Case History: Selling to Similar Business The owner of a copy center wanted to sell his business to the experienced owner of other copy centers. The seller and buyer retained lawyers to draft agreements, including representations and warranties and an escrow; however, they performed their own due diligence and financial analysis and

Many small businesses can’t (or don’t want to) engage in the process of a true arm’s length sale, with its typically high transactional costs (see above). It may be that the costs don’t balance out against getting the best value for your business, or the business is not well-suited to attracting an interested arm’s length buyer. In such a case, a target buyer may be someone you know or who is in your line of business. This sale will be very similar to an arm’s length sale, but because the buyer knows you and/or your business, you may decide on price through discussion only, instead of through an independent financial analysis of the business. The buyer may be willing to forgo some of the extensive representations and warranties, due diligence, the hold back of escrow, etc., that are typical in an arm’s length transaction because s/he is familiar with your business or has experience running the same type of business and knows what to expect. This “arm’s length light” transaction provides the benefit of savings on transaction costs (reduced accountant and attorney fees, etc.) but may not get you your highest and best value for your business.

limited the terms of the agreement only to those they believed were important to the nature of business being sold.

© 2012 Englander, Leggett & Chicoine P.C.

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Exit Strategies for Small Business

Multiple Co-Owners Case History: Selling to the Business Multiple co-owners of a real estate company/developer agree that upon the retirement, death or disability of an owner, the business will purchase that owner’s interest. In the event a co-owner moves or changes his/her line of business, the business has the option -- but not the obligation -- to purchase that owner’s interest. In each case, there are pre-agreed terms of sale and an agreed upon method to value the

For businesses with multiple significant co-owners (two or more approximately equal owners) who also work at approximately equal levels within the business (act as partners regardless of the form of entity) there may be a desire or need to keep the business interests within the existing ownership structure. In this case, the sale can be to the business entity or to the co-owners and can be done a number of ways. Such sales: • Can occur upon retirement, death or disability; • Can occur automatically or at the option of the • business entity or retiring owner (or his/her estate); • May be paid for by insurance, profits, or separate • financing. The important message here is that there are many choices in structuring how you and your co-owners may want to handle the retirement of one of the owners. Retirement, disability, death, or decisions to move or change career paths are also events that can be handled differently. ² The terms of sale for purposes of retirement do not have to be the same as for a voluntary job change. While included here as options for retiring owners, in a multiple-owner business, these matters should be thought about, discussed, and agreed upon at the time the co-owners decide to go into business together--not at the time the business is confronted with the event.

interest as of the date of the event.

² Many of the strategies discussed in this article may also benefit an owner’s estate in less pleasant scenarios than retirement; however, such scenarios should be specifically thought through and planned for before they happen.

© 2012 Englander, Leggett & Chicoine P.C.

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Exit Strategies for Small Business

The Next Generation Family Case History: Passing a Business to the Next Generation A father is the majority owner of a small advisory firm employing himself, his non-owner son and a young minority owner. For years, year-end stock bonuses are issued to the two younger employees and a cash bonus is issued to the father. Over time, the father’s interest in the business is diluted and the younger employees’ interests increase. The father’s interest is held in trust for the benefit of first his wife and then his children. It is anticipated that at the time of father’s retirement he will own a minority interest and at the time of his death the business and/or other owners will be able to leverage the business to buy the father’s minority share from his estate. This plan will be reviewed every 3-5 years and adjusted, if necessary, to continue to meet the father’s goals.

If you’re lucky enough to have children who want to work in your business and are interested in carrying it on, then transitioning the business (or your interest in it) to those children may be a good option for you. You will need to work with your advisors (accountant, business attorney, estate planner) to determine how and when to transfer your interest (i.e. through gifts in whole or in parts during your lifetime, in trust, or in your will). This is a very different type of approach to an exit strategy than the others discussed in this article. It is not a sale of the business per se but a transfer of your interests in the business to your children and is likely best done through an estate planning vehicle. However, in addition to consulting an estate planner, the business’ attorney should be consulted to work with you and your estate planner to consider how proposed changes in the ownership of the business may impact your desires and goals for running the business now and in the future.

Employees Bonus Stock ³ Whether or not you have children who may become owners of your business, you may have a group of employees or a few key employees 4 who are interested in taking over your business. In this situation, assuming the employees are not in a position to buy your interest as in an “arm’s length light” transaction discussed above, you can adopt a plan over a period of years to grant them stock as part of their compensation package. During these years, you may grant less cash compensation to them (extracting that value for yourself) and, by granting these employees stock, increase their ownership position over time relative to yours. There is, of course, a tipping point here when the employees will become the majority owners of “your” business and you will be a minority

³ This strategy is distinct from Employee Stock Option Plans (ESOPs), which are heavily regulated by federal law and can be cost prohibitive to small businesses to set up and maintain. Also, in order for ESOPs to have value to the employee there must be a mechanism for the employee to monetize their interest once they become owners. There must be a readily available market for the interest, such as stock in a publicly traded company or an obligation on the part of the business to buy the employee’s interest at some predefined point. 4

These few key employees could be co-owners that have an existing small interest in the business.

© 2012 Englander, Leggett & Chicoine P.C.

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Exit Strategies for Small Business

The Next Generation owner. You can still retain some amount of control through the adoption of governance strategies; but typically, the day-to-day decision making will transition to others in the business. In anticipation of your becoming a minority owner and fully retired, you can combine this approach with an agreement that upon your retirement either the business or the then majority owners of the business will buy your remaining interest. There are innumerable ways to value that interest and the method of that valuation should be agreed upon in advance. Cooperatives Some businesses with a reasonably large number of long-term employees have transitioned ownership to the employees as a whole. An employee cooperative provides an ownership interest to at least a majority of all employees. In the typical cooperative, financial ownership is separated from share ownership. The corporation is governed equally by the employee owners and profits (after retained earnings) are allocated/distributed based on the relative contribution of labor that an employee puts into the business. This is not a particularly common exit strategy for most businesses as its requires the right retiring owner (one who is willing to be paid out of profits of the corporation over a long period of time), the right employees (who are interested in long- term employment and willing to work with their co-employees to run the business), and is a business of the type that would run well with this type of structure (farms, credit unions, natural food stores).

© 2012 Englander, Leggett & Chicoine P.C.

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Exit Strategies for Small Business

Special Considerations for Professionals Case History: Selling a Legal Practice An attorney brought his son-in-law into the practice a number of years before retiring. When he was ready to retire, he sold the practice to his attorney son-in-law at a price based upon the business financials. No representations or warranties, escrow, or the like were used. Outside attorneys were engaged to draft the transactional documents and memorialize the agreement.

© 2012 Englander, Leggett & Chicoine P.C.

For those businesses that practice one of the licensed professions, additional considerations come into play when looking for your buyer. Many of these types of businesses can only be owned by similarly licensed professionals (such as doctors, lawyers, and accountants). Also, these businesses are typically successful due to client loyalty to the individual service provider. There are two approaches you can take to retirement. One is to extract as much value as possible from your business during your practicing years and have no expectation to “sell” your practice later in life. If the right buyer comes along who is willing to pay you something for your practice, even though they may not retain any of your clients, then there’s some unanticipated money you can add to your retirement. Another approach is to plan to transition your practice over a period of years to another professional. Working closely with another professional who intends to buy your practice allows your clients to come to trust that professional as they have trusted you and increases the likelihood that the buyer will retain the clients. This approach has a great many challenges, including how long the transition will take, how to value the business, and what happens if your clients don’t like the would-be new owner (or worse, they like the would-be new owner so much that you lose your clients before you’re ready to retire).

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Conclusion Once you’ve decided that you would like to retire in a five to ten year time period, it is time to meet with your advisors to see which option, or combination of options, might work best for your circumstances. Be prepared to engage in a long process of exploring multiple options until you find the one that works for you. This article provides a variety of ways a retiring owner may be able to transition his/her business and they are not all necessarily mutually exclusive of each other. Some mix of approaches might be best for you. In addition to finding the right buyer, there are a number of financial and legal considerations that are involved in each of the strategies discussed in brief in this article. These exit strategies may take years to accomplish from decision to conclusion.

© 2012 Englander, Leggett & Chicoine P.C.

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Exit Strategies for Small Business

About the Author

Debra Leggett is a partner at Englander, Leggett & Chicoine, P.C., a Boston law firm with particular expertise in business relations, employment law, real estate transactions and land use, appellate litigation, health care and human services, and records management. Attorney Leggett’s practice is focused on business law, corporate representation, intellectual property and health care. She has provided legal counseling and representation to a wide range of corporations and entities, from large for-profit and not-for-profit entities, to small start-up business and charitable organizations. For more information, please visit www.elcpc.com.

© 2012 Englander, Leggett & Chicoine P.C.

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