What’s my business worth? What is my exit strategy? What am I going to do about capital gains? These are three of the most important questions a business owner will ever ask himself. Before I get into addressing each of these questions, I would like to give you some food for thought.

It is amazing that a start-up business is one of the only investments people make where they do not think about the exit at the onset. No one establishes an exit strategy when they should: before they open the doors of the business.

When we invest in real estate, mutual funds, or stock, that is all we are thinking about — hoping the investment will gain in value so we can sell. When we invest in a home, or even in an automobile, we analyze market conditions, patterns, and resell or trade-in values, once again thinking about our exit.

Individuals starting a new business do not think “exit” or “sale.” They are so focused on operations, planning for an effective and profitable harvest is just not part of the scenario. The small percentage of entrepreneurs who do establish an exit strategy as part of their business plan are the ones that take their company public or cash out on their terms, thus achieving an effective harvest.

By establishing an exit strategy, you are more likely to manage the value of your company, and much more likely to create a company that someone would want, thereby allowing you to one day harvest what you have planted.

Statistics

To give you some idea as to the importance of establishing your exit strategy early on (preferably in the infancy stage), let’s take a look at some of the alarming statistics related to start-ups and businesses that are for sale.

First, I would like to congratulate you on not becoming a statistic, because the statistics related to business survival are not good:

More than one million businesses are started in the U.S. each year. That is 2,700 businesses per day. Forty percent of those businesses will fail in their first year. What that means is about 400,000 will fail before completing year one. Of the businesses that do survive the first year, 50 percent will fail by year five.

Only 200,000 of the one million businesses started make it to their fifth birthday. And more than 80 percent of the businesses that do survive the five-year mark, will fail before they reach their 10th anniversary. That is less than a 4 percent survival rate. And if you were fortunate enough not to have become a casualty, now you have to contend with the statistics related to trying to sell your company:

  • Over 1.47 million companies were offered for sale in the year 2001. Only 242,000 were actually sold. That is only a 16 percent success rate.

  • Of those that were sold, 87 percent received less than fair market value and 42 percent sold for less than the value of their assets.

    Now you ask yourself, what happened to the other 1,228,000 businesses that were for sale? Obviously, many are still for sale; some are kept in the family by handing them down to the children; and some end up closing their doors.

    These statistics, when analyzed separately, are disturbing. But when you look at these statistics combined together and look for a relationship or pattern, it becomes much worse. It just does not seem to make sense that out of over one million businesses which start every year, over 95 percent fail within 10 years.

    Approximately 1.5 million viable businesses go on the market for sale each year, 84 percent of which fail in their efforts to be sold. A high majority of the businesses that are sold sell for much less than fair market value and, in many cases, below asset value.

    I believe that the failure rate of start-ups and the inability to sell a company are directly linked. Most ventures cannot truly be defined as businesses or companies, because most owners do not establish operating and exit strategies at the onset. The majority are more likely to be defined as a “job for the business owner.”

    If the entity you have started is nothing more than a job for you, it is less likely to survive as a business and almost impossible to sell as a viable entity. You have to start focusing on your operating and exit strategies so that you manage your company with the end in mind. Once you have established this strategy, all business decisions and operational foci should reflect that exit plan.

    The Multimillion Dollar Question

    So, what is your exit strategy? Before you answer this question, you need to know what your various options are. I believe there are seven basic options. In no particular order, you can either:

  • Sell your business to a financial buyer (individual).

  • Sell to a strategic buyer (company).

  • Sell to a key employee(s).

  • Sell to all the employees through an ESOP (Employee Stock Ownership Plan).

  • Take your company public.

  • Manage for life (keeping it in the family).

  • Plan for controlled liquidation (bleed cash flow at a predetermined point).

    At this juncture, I think it is critically important to define each one of your options, as well as identify some of the key elements and barriers of each option. What I am referring to when I use the word “barriers” is anything that creates an obstacle to a possible transaction, acquisition, or implementation of a successful plan.

    Financial Buyer

    The first option is to sell to a financial buyer. A financial buyer is someone just like you or me who would buy the business, then operate the business on his own. Some of the key elements or barriers to a financial buyer are:

  • Limited capital; this usually requires you to carry some terms, most likely terms equivalent to the intangible or goodwill portion of the company’s value, if not more.

  • A financial buyer usually does not want to pay fair market and will try to negotiate you down closer to asset base. This barrier obviously ties back to the limited capital. They can’t afford to pay fair market value and the bank will not finance goodwill unless the buyer has other collateral.

  • The transitional desires will most likely be shorter compared to some of the other options. They may just want you around long enough to make introductions — train them on the basics — and help them collect outstanding accounts receivable, usually no more than 60 to 90 days.

  • Confidentiality can be an issue, if the potential buyer resides in or has ties to your market. Employees and customers get very nervous if they know the business is for sale.

    Strategic Buyer

    The next option is to sell to a strategic buyer. This is a company wanting to expand into your industry or market.

    It could also be a competitor wanting to dominate the market, or a public company looking to grow through acquisition. Some of the elements or barriers to a strategic buyer are:

  • A strong capital position — only requiring you to carry limited terms — may be just enough to provide them with the assurance that you will help in the efforts toward an effective transition and future.

  • Strategic buyers are more willing to pay fair market value. They are also more likely to know and understand what fair market value is.

  • The transitional desires of a strategic buyer will most likely be longer compared to some of the other options. They may want you to stay on in a key operating position for two to five years.

  • Another element is confidentiality — what I call “external confidentiality.” During the due diligence process, confidentiality is more of a concern with strategic buyers because they are in the industry or market, or have a desire to be in the market. The last thing you want is for your potential buyer to use sensitive information to the detriment of your company.

    Key Employee/Employees

    The next option is to sell to a key employee or key employees. Employees are similar to financial buyers because:

  • They typically have limited capital. You will usually need to carry some terms, although the banks are usually more comfortable loaning to a key employee than to financial buyers.

  • Employees usually do not want to pay fair market value; they feel they should get a better price because they have worked building this business. Besides, you did not have to go to the expense of finding a buyer.

  • The transitional desires will also be shorter in comparison to some of the other options. They are already intimately familiar with the business.

    The most sensitive element when dealing with an employee is going to be confidentiality (internal confidentiality). It would certainly have a negative effect if all the employees knew you were considering selling, especially negotiating with a fellow employee. You can never predict how an employee is going to react to the idea that the company is for sale.

    ESOP Plan

    The next option is to sell to all of the employees through the use of an ESOP. An ESOP can be a very effective method of exit if all the aspects related to a successful ESOP are present. Some of the elements or barriers to an ESOP are:

  • It requires a strong, self-sustaining management structure.

  • It also requires a core group of vested, level, key employees.

    The transitional period will vary based upon the structure and type of ESOP, as well as the financial condition and position of the company.

    With an ESOP, you are more likely to get fair market value for the business and possibly a premium, due to the fact that an ESOP is usually based upon a value determined by a formal business valuation with limited negotiating, possibly none. There are many tax benefits to the seller. An ESOP sale is one of the best legal ways to avoid capital gains. Confidentiality is also important with an ESOP, but in a different way. Also referred to as internal confidentiality, you need to keep the proposed ESOP confidential from the general employee population until you are sure that is what you want to do and that it is feasible.

    Take The Company Public

    You can go public with your company in different ways, but in any form it requires tremendous commitment, both physically and financially. Some of the elements or barriers to taking your company public are:

  • Solid operating systems and a strong management structure; the requirement of SEC (Securities Exchange Commission) approval of every aspect of your business and the offering.

  • There are many operational constraints when you are a publicly traded company. In other words, you will be more regulated, controlled, and exposed.

    You are more likely to get a premium price, often well above fair market. Going public provides many options for capital funding for expansion and growth. Going public is referred to as the ultimate exit strategy because it provides the business owner with a paced and controlled exit.

    Manage For Life

    The next option is to manage for life. This option might be for you if you are the type of person who is defined by the fact that you own this company, you cannot imagine ever retiring, or you dream of keeping the business in the family.

    You would think that is pretty self-explanatory. “Why should I think about exit strategy if I plan to die in the business?” Well, if you want to own the company and not have the company own you, you need to plan for the future, develop operating systems and controls, and structure the company so that one day you can successfully hand it down to your children, family members, or key employees.

    All too often, the business cannot survive the decisions that the second generation makes. It is important that you create a self-sustaining enterprise through effective operational systems and controls. With those operating norms already established, the business will take on a life of its own.

    Planned Liquidation

    The next option is to have a controlled and planned liquidation. This option is not as self-explanatory as you might think. To accomplish a successful harvest through a controlled and planned liquidation, you still need to have a plan and strategy.

    Part of a successful liquidation is determining the optimum profitable operating level of the company within its market and industry. Your objective should be to exceed this level during the life of the company so that when the time comes for your exit, you can purposely stop growth and/or expansion, scale the company back to this level of profit efficiency, streamline the operation, and bleed its cash flow.

    This process takes time, patience, and planning. It can be an emotional roller coaster to exit through liquidation. If this is your strategy, make sure you liquidate on your terms.

    That summarizes your exit options. Can you see the importance of establishing your exit strategy and then operating the company with that end in mind? The point is, if you intend to operate your company as an entrepreneur, your business plan — written or not — has to address the question: “What is my exit strategy?”

    What’s My Business Worth?

    To ensure that you have an effective exit strategy, it is imperative that you fully understand what affects the value of your company and how value is determined.

    The first step is to understand the difference between a valuation versus an appraisal. An appraisal, by pure definition, determines the value of something tangible or physical; something you can actually see, feel, touch, or stand on (i.e., property). A valuation analyzes the tangible and the intangible, the physical and the nonphysical. An appraisal often supports a valuation.

    You may have an appraisal performed on property or equipment that the company owns, then use the appraisal to justify the value being placed on the equipment or property in the business valuation.

    An appraisal does not typically consider income. It is used to establish the fair market (or liquidation value, in some cases) or tangible assets.

    A business valuation is designed to establish the fair market value of an ongoing concern. In addition to analyzing the fair market value of the operational assets, business valuations analyze internal and external factors related to the business in question, its industry, and the economy at the time of the valuation.

    A formal business valuation analyzes internal factors such as intellectual property, proprietary rights, management structure, operational strengths and weaknesses, projections, forecasts, historical performance, and customer base, just to name few. External factors focus on the economy, the industry, the market, the competition, the location, and any governmental regulations or licensing requirements. The internal and external factors combined ultimately determine the intangible or goodwill portion of the business’s value.

    Adjustments

    One of the most important things to understand about the valuation process is adjustments.

  • Adjustments to assets: recasting the value of the assets to reflect their fair market value instead of their depreciated value.

  • Adjustments to income: often referred to as “add backs.” The idea is to pull out any and all discretionary expenses such as owner perks, nonrecurring expenses, expenses related to the funding of growth, and unexpected losses. On the other hand, if the property is owned by the business owner but will not be included in the transaction, you must deduct fair market rent from the earnings of the company. These items are adjusted (added/subtracted) to the reported income of the company to determine its true profitability.

  • Adjustments to the owner’s compensation: Part of the process is to adjust the owner’s salary (up or down) to reflect what is deemed fair and reasonable.

    Before you can start applying the company’s financial numbers to valuation formulas, you must make these adjustments to reflect reality, so as to get a true picture of the profitability and asset base of the company.

    Once the value of the operational assets has been determined, the income has been adjusted, and the internal/external factors have been considered, it is now time to decide which “standard of value” will be used. This is determined by the purpose of the valuation.

    There are five basic standards of value:

    1. Fair market value — Used to determine the value of a company to the market. The definition of fair market value helps identify how difficult it can be to get it, and why it is so important to plan your exit strategy.

    Fair market value is the price a business can expect to bring if it were effectively exposed for sale on the open market, for a reasonable amount of time, assuming an informed seller and an informed buyer, neither of whom is acting under undue pressure or compulsion. Several factors have to simultaneously come together for you to get fair market value.

    2. Fair value — Used in the breakup of partnerships, ESOPs, estate tax, and divorce; the objective is to establish the fair value to all the parties involved in the transaction because they are internal. (Even the IRS is classified as internal, but of course you already knew that.)

    3. Investment value — Used by investors to determine what the investment is worth to them, taking into consideration what they (the investors) bring to the table, what factors affect value based upon their strategy, and whether or not they get the owner for three to five years as part of the deal.

    4. Liquidation value — Generally self-explanatory, but it’s not as straightforward as you might think. All too often, people forget to include the costs of liquidating when determining the net value of liquidation.

    5. Intrinsic value — Probably the hardest part of an appraiser’s job is determining the value of something based upon a “perceived future outcome” (copyrights, patents, trademark).

    Once you have established which standard of value will be used, a proper valuation will then analyze the value of the company from several different approaches. There are four basic approaches to value:

    1. Asset approach — Book value, adjusted book value, liquidation value; these are accounting measures, not a good representation of fair market value.

    2. Income approach — A multiple of earnings or a capitalization rate; if you have heard someone say, “So-and-so got six times earning for his company,” they are referring to an income approach to value.

    3. Market approach — “Like companies” that have sold in the past two to five years;

    4. Hybrid approach — A multiple of any of the preceding three methods; the IRS formula, for example, is a hybrid called “excess earnings.” The IRS believes that you have to determine the value of the tangible (asset approach) and the intangible (income approach) separately, then add them together to determine fair market value.

    As you can see, many factors go into determining the value of an ongoing, viable company. An in-depth, impartial analysis of all the factors is necessary to determine an accurate opinion of value. All too often, business owners receive far less than fair market value because they did not know how to get a proper business valuation prepared — and they did not develop an effective exit strategy.

    What About Capital Gains?

    Many factors determine your level of capital gains liability. A starting point is whether the transaction is to be structured as a stock or asset sale. Most business sales are structured as asset sales because of important buyer tax benefits.

    Many questions need to be answered while you are structuring asset sales. What are you selling?

    Usually it’s some tangible assets, goodwill, booked business, covenant not to compete, and consulting by the seller. What are the tax implications of these allocations? Each transaction requires careful structuring for both the buyer and seller.

    Contrary to popular opinion, your accountant (in most cases) is not the expert to consult with on capital gains liability and avoidance issues. This is due to the fact that your accountant is trained to calculate the tax that you owe. S/he is not typically trained in structuring the company or the transaction to avoid capital gains tax.

    All business owners should seek the counsel of a certified financial planner, an estate attorney, and/or a tax consultant who specializes in the areas of tax, corporate structure, financial, and estate planning.

    Their specialty is structuring your company (in preparation for a future transaction), or structuring “The Deal” to help you avoid paying unnecessary capital gains tax.

    Several creative and legal methods can be used to reduce (and in some cases eliminate) your capital gains liability. Many of these methods must be established prior to the sale, and in most cases, before entering into negotiations. A formal third-party business valuation is recommended to help in the process and to defend the plan, if necessary.

    Closing Suggestions

    I would like to close with a few suggestions.

  • There are two books I highly recommend that you read: The E-Myth Revisited by Michael Gerber, and What is Your Exit Strategy? by Peter Engel. Both are excellent and will provide you with insight and guidance.

  • Step back from your business. You need to look at it from a different view — so you can see what the business does, the process by which it accomplishes its objectives, who is responsible for what throughout the process, and how the company is paid for the products and services it provides.

    You might be surprised at what you see.

  • Engage the services of a business valuation expert. S/he will help you pinpoint your company’s strengths and weaknesses, while establishing a plan to help sustain, manage, and increase the company’s value.

  • Finally, determine what your exit strategy is. After you determine your plan, start operating the company with the harvest in mind.

    Brown is chief operations officer, RSI & Associates Inc., Galveston, Texas. For more information, call 800-230-9086 or visit www.value-solutions.com.

    Publication date: 01/27/2003