Exit Planning 101

Exit planning is the process of preparing your company and yourself for an eventual ownership transition. Successful exit planning achieves personal financial freedom, creates a legacy, and enables you to exit on your terms.

Ideally, owners should begin serious exit planning no less than five years before their desired exit. Getting your company ready for exit requires implementing several tactics over multiple years to increase value and minimize taxes. Waiting until the last minute means you will have fewer options and less flexibility, reducing your chance of a successful exit.

There are precisely four exit strategies available to all closely held business owners:

1. Sell to outside buyers, or the Outie approach. This exit path typically provides the maximum potential purchase price.
   
2. Sell to inside key employees. If your trusted employees can profitably run your business, have a desire for ownership, and the youth to outlast you, an Innie route can be a viable and rewarding strategy. While employees are unlikely to have the capital to rival an outside offer, this is an excellent way to preserve company culture, reward loyal employees, and fulfill legacy aspirations.
   
3. Pass to family. If you have children or other family members ready and willing to succeed you in the business, becoming a Passer is a natural choice. Rather than maximizing value for a sale, passers should look to minimize the tax burdens that can come with transferring a business to relatives.
4. Wind down and liquidate the company. While few business owners aspire to be a Squeezer at exit, for some, it is simply the most logical option. If the business is wholly reliant on you, isn’t attractive to outside buyers, and there are no internal employees or family members either interested or capable of assuming control of the business, then an orderly liquidation of assets for maximum profit should be the goal.

The most common financial goal for business owners looking to exit is to secure enough money from the sale of their business that continuing to work is a personal choice, not an economic necessity.

To ensure you meet this goal, we calculate your Exit Magic Number^TM, or the exact amount of capital you need to receive from the business between now and the exit to achieve personal financial freedom. This is typically not the same as what your business is worth, and in some cases, can be drastically different.

To derive your Exit Magic Number^TM, we first determine the nest egg size required to fund your desired lifestyle, accounting for taxes, inflation, and expenses currently subsidized by your business that you will need to pay for personally after exit (such as a company car, travel, meals, insurance, and memberships). Overlooking these factors can dramatically understate your true needs. We then subtract available capital and other income sources from this nest egg. This would be money you already have and income sources you expect to have outside the business (think retirement accounts, real estate, etc.).

Once your unique number has been identified, you’ll better understand your financial dependency on the business. Ideally, we can work together to reduce this number to zero through systematically moving money out of the business in a tax-efficient manner, maximizing your company’s sell price, and other tactics.

Determining a proper valuation for your company is both an art and a science. While there is no perfect formula, a business’s value is typically determined by analyzing adjusted EBITDA, or Earnings Before Interest, Taxes, Depreciation, and Amortization, over the past three to five years. The “adjusted” aspect of adjusted EBITDA involves adding back discretionary ownership expenses that may have artificially reduced reported earnings, like above-market compensation, inflated leases, or other items.

It’s often best to hire an outside accounting firm to review these numbers, as failing to accurately calculate your adjusted EBITDA can lead to delays during negotiations and may mean you’re unnecessarily leaving money on the table.

Buyers generally apply a multiple to adjusted EBITDA to arrive at a sale price range. This multiple varies by industry, and there are other factors to consider that can increase or decrease the value. NAVIX has several proprietary tools that can help determine your company’s value and help benchmark it against other similar businesses.

Remember that the business value (what you have) is distinct from your Exit Magic Number^TM (what you need).

To maximize your company’s value at exit, the focus must shift from building a profitable company to building a truly exitable company that minimizes risk for a potential buyer or successor. This centers around enhancing your company’s transferable value. Some of the key drivers of transferable value include:

• Reduced Owner Dependency: Your company must be able to thrive without you there.
  
• Strong Documentation: Key company documents like vendor contracts, legal agreements, and customer records should be up-to-date and well-organized.
  
• Clear Financials: Your financial reports should be accurate, well-maintained, and consistent with industry norms so potential buyers can easily assess.
• A Compelling Growth Plan: Buyers purchase companies based on future potential. A written strategic plan that clearly outlines a path to scalable growth creates confidence.

Most business owners exit only once. Buyers, on the other hand, often regularly execute deals, giving them an advantage at the negotiating table. This means preparation and careful planning are paramount, as there is little room for error.

Both internal and external conditions have a major impact on determining your ideal exit timing. In a perfect scenario, the economy would be strong, tax policy favorable, and your company would be owner-independent and poised for continued success, with a clear and achievable growth plan. While you don’t have control over all of these factors and cannot necessarily wait for best-case conditions, you must be mindful of the selling environment.

In our experience, it’s common that business owners state their exit timeline in a number of years that tends to keep rolling forward. They state a desire to exit “in 10 years,” but three years later, that number hasn’t changed. For this reason, we recommend viewing your planned exit timing as a defined age range that allows for some degree of flexibility (ex. “between ages 55-60”).

In today’s M&A market, unsolicited inquiries from private equity firms, strategic buyers, or brokers can be common. It’s important to understand that these are not formal offers and, if handled incorrectly, can lead to wasted time, revealing sensitive information, or creating rumors.

If you’re interested in exploring the inquiry, avoid sharing proprietary details or naming a price. We recommend stating that your company is not for sale, but you are monitoring the market. Ask for their “search profile,” which will highlight the types of companies they are looking to acquire and help determine if there is a potential fit.

As conversations become more serious, be sure to request a Non-Disclosure Agreement (NDA) and retain experts, such as an M&A attorney, to review any documents before signing and make sure any statements you are sharing are reviewed and accurate.

Business owners often struggle with exit planning due to a lack of experience and the ongoing demands of their company. The most common challenges we see include:

• Financial dependency due to a substantial majority of net worth tied up in the business and its assets.
  
• Underestimating the net amount needed to achieve their desired post-exit lifestyle.
  
• Balancing disagreements with co-owners regarding exit timing, desired price, or other goals.
  
• Remaining too essential to the company’s day-to-day operations and not having a leadership team ready to step up.
  
• Continually putting off planning to tend to business matters perceived to be more urgent.
  
• Simply handling the emotional toll that can come with the slow, somewhat unpredictable process of removing themselves from a business they’ve invested so much into over the years.
  

Our proprietary research and experience suggest that about 70% of business owners share ownership with one or more other individuals. When this is the case, it’s inevitable that co-owners will have different, sometimes incompatible, exit goals due to circumstances such as age and financial needs.

One of the most valuable services we provide for our clients is the implementation of incentive plans to take care of key employees before and after exit.

There are a number of different structures available with these plans, sometimes called “golden handcuffs,” that can be customized to the specific business and its needs. A typical structure has a top employee earning a payout distributed in installments beginning at a defined point, like an exit, and continuing for a defined period after. If an employee quits, the unpaid dollars are forfeited.

Incentive plans are often beneficial for both the seller and buyer. The seller gets a chance to show gratitude to loyal colleagues and celebrate with them at exit, while the buyer knows that the business’s most important employees have a strong incentive to stay on after the ownership transition.

Selling to key employees is a great way to extend the legacy of your business. However, it can be a difficult exit strategy to pursue, primarily because they often lack the necessary cash and collateral to fund a purchase. For this reason, it’s essential to achieve agreement on how the purchase price will be determined and financed.

Any owner pursuing an inside sale will need to understand and properly manage their risk if seller financing or deferred payments are involved as part of the purchase. Likewise, employees will also need to be prepared for the risks that can come with ownership and have a genuine desire to own and take responsibility for the business.

Transferring your business to the next generation can be incredibly rewarding, but it also presents unique challenges that must be well planned for in advance.

Unlike selling to an outside buyer, passing a business to family typically does not yield the maximum value. It’s important to make sure your financial needs will be met. Tactics like setting up retirement plans or implementing leasebacks can help you build personal wealth outside the business on a tax-advantaged basis. Effective planning with your tax and legal advisors can also lessen the burden of gift and estate taxes.

Success as a passer often depends on developing and documenting a clear succession plan and governance to formalize roles, especially when multiple family members are involved. It can be difficult to treat all heirs fairly without splitting the company in an untenable manner, particularly since they often have very different degrees of desire and ability to run and grow the business. Addressing a clear plan with written job descriptions and established compensation plans can help overcome this.

While virtually all owners have a financial goal at exit, creating a lasting legacy through their business is often of equal, if not greater, significance to them. NAVIX uses a framework called The Three Laws of Legacy to help owners define, prepare for, and achieve their legacy aspirations before exit. These three laws are:

1. Leave it in Good Hands: Ensuring new owners are both competent and committed to continuing to run the business successfully while upholding the company’s core values and culture.
   
2. Set it Up for Sustained Success: Preparing your business to thrive without you by leaving a credible growth plan, adequate resources to support future initiatives, and minimizing barriers so that nothing is left a mystery when you leave.
3. Go with Gratitude: Properly thanking and rewarding the key people who helped you build the company and motivating them to stay through the ownership transition, often through the implementation of incentive compensation plans.

A fulfilling life after exiting requires not just financial freedom, but a clear personal identity and purpose. Many owners face regret if they fail to adequately plan for how they will spend their time post-exit. Some key steps we recommend to ease this transition include:

• Ensure Your Financial Freedom is Secured: This doesn’t mean that you don’t work, but rather that work is a choice rather than a necessity. One common blind spot for business owners in this area is accounting for lifestyle costs that were previously subsidized by the business (company cars, medical insurance, travel expenses) that can add as much as 25-50% to the income required after exit.
  
• Define Your Ideal Calendar: Explore how you want to spend your time and talent well before exit. Picture what you’d like your days, weeks, and months to look like, especially in terms of activities and commitments.
• Investigate and Experiment: Start exploring hobbies and passion projects well before exit to “test-drive” what life may look like after exit and verify they provide meaningful engagement. This could be pursuing interests completely unrelated to your company or utilizing your business skills and talents for outside causes such as teaching, volunteering, or consulting.