Exit strategies for private businesses
Privately held businesses typically make up a large portion of an owner’s overall wealth. The idiosyncratic risk resulting from such a concentrated position tends to be very high, and the position is generally illiquid. At the same time, non-investment psychological issues are often significant. The owner or founder may derive a large part of his sense of self-worth and income from the concentrated position.
On this page, we discuss exit strategies for private businesses. The exit strategies for business owners include a phase sale over time, monetization, sale, or an adjustment to the business structure that will provide the owner with cash.
Exit strategies for business owners
When performing exit strategy analysis, the following elements are typically considered:
- The value of the company
- The applicable tax rates
- Availability and terms of credit
- The buying power of potential purchasers
- Currency values if the transaction involves foreign currencies.
The strategies to consider when exiting a business partnership are:
- strategic buyers: strategic buyers generally take a buy and hold perspective and offer the highest price to the seller. Strategic buyers are also hardest to find.
- A financial buyer or financial sponsor: these are often private equity funds planning to restructure the company, add value, and then resell the business. Financial buyers tend to offer a lower price than strategic buyers.
- Recapitalization is often used for established but less mature companies. In a leveraged recapitalization, the owner may retain 10-30% of the equity and sell 70-90% of his shares back to the company. The owner then continues to manage the company with a significant financial stake. A private equity company could arrange the financing of the operation. In exchange, the private equity firm receives equity in the target company. This approach could be part of a phased exit strategy. Taxes are owed on the cash the owner receives, but additional taxes are deferred until the remaining stock is sold.
- A sale to other management or key employees: the owner sells his position to existing employees. There are several drawbacks to this approach. The buyers may lack the financial resources, the deal will typically be at a discounted price, a promissory note may be used to finance a significant part of the deal which may be contingent on future performance. The last approach is called a management buyout obligation (MBO) where existing managers buy the business in exchange for an obligation to pay for the business in the future. Finally, negotiation may fail and damage the employer/employee relationship. Thus, this approach is generally not very attractive.
- Divestiture, sale, or disposition of non-core business assets: selling non-core parts of the company may generate proceeds that can be used to pay a large dividend or to repurchase stock from the owner.
- A sale or gift to family members: an estate tax freeze or limited partnership valuation discounts can be used. The disadvantage is that these approaches will generally not generate a lot of immediate cash flow for the owner.
- A personal line of credit secured by company shares. The owner can borrow money from the company and pledge the company stock as collateral. If the company does not have the financial resources to make the loan, the company could borrow to obtain the cash for the loan. One advantage of this approach is that the interest paid by the company can be a tax-deductible business expense.
- An initial public offering (IPO): the owner sells a portion of his shares to the public and transforms the remaining shares into liquid public shares.
- An employee stock ownership plan (ESOP): the owner sells stock to the ESOP, which in turn sells the shares to the company employees. In a leveraged ESOP, the company borrows the money to finance the stock purchase. In the US, the owner’s sale of shares may not trigger a capital gains tax.
We discussed a number of methods that can be used by private business owners to exit a company.