How to create a business transition plan

Exiting a business can be a complex process — and one of the most important transitions of a business owner’s life. The decision to sell not only requires preparing emotionally but also ensuring the business is in optimal shape for sale, while developing a plan that aligns with post-exit goals.

Once the decision has been made, breaking down the steps to address before, during and after a sale can ensure a smoother and less stressful transition. Having a solid plan also helps position a business for a successful handover once the owner steps away from daily operations. Without one, the process can quickly become overwhelming due to the many moving parts. This is the case whether the owner is passing the reins to a family member or selling to another entrepreneur or investor. Here are key things to consider.

Owners who have run a business for a while may find their identity is inseparable from their business. As a result, planning to leave may bring fear of the unknown. Visualizing the future and writing down their long-term goals and personal priorities can be the first step toward navigating the journey ahead.

There’s a lot to potentially gain by thinking and planning ahead: Owners can stay prepared for unexpected events, such as a surprise offer to buy the business, the departure of a partner, or an unexpected health problem. It can also help with optimizing tax planning.

When crafting a business exit plan, it’s important to consider both business and personal financial goals. Here are some questions for owners to ponder.

Building a management team that can run the business without the owner’s leadership can make it more valuable and salable, so consider whether it is necessary to provide additional training to key team members or make critical hires. Adding an equity incentive program might encourage senior managers and other selected employees to stay on, helping them benefit from the potential value they helped create in the business.

The business may produce a significant cash flow for the owner and their family or cover expenses that they’ll need to pay for once the business is sold. For instance, if the business leases a car used for some personal driving, the owner may need to purchase another car. Owners may feel more confident about selling a business after working with an accountant and financial advisor to estimate how much money it might take to replace the income and perks they currently receive from the business. Owners should consult their legal and/or tax advisors before making any financial decisions.

If so, it’s important to do some thinking about estate planning issues well before the sale occurs for at least two reasons:

• Valuation: Gifting a business interest — to family, say — before the closing may result in an appraised value less than the value the owner receives from the sale. It could be beneficial to make the gift well before the closing to enable a gift-tax-efficient transfer.

• Discounts: For gift-tax purposes, the fair market value of a business interest is best determined by a qualified independent appraiser. Often that value will be lower than the same percentage of the company’s total value due to two common discounts — one for lack of control and the other for lack of marketability.

If so, it may be helpful to consider a philanthropic strategy to try to minimize capital gains tax before selling or maximize charitable income tax deductions after the transaction. It’s also important to consider how personal and family values will inspire charitable giving and civic leadership after the exit. The owner may want to set up a private family foundation with the help of legal and/or tax advisors.

The things that make a company appealing to buyers are usually the same things that make it a well-run company. Here are characteristics to focus on.

Strong financials

• A reliable revenue stream and cash flow, with contracts to support their continuation in the future
• Clear visibility into future financial performance, with data to show improvements in the business’s financial statements or key performance indicators, such as revenue over time
• A strong and well-documented history of profitability, with the potential to expand over time
• Comprehensive and verifiable financial statements that exclude any nonbusiness or personal expenditures

An appealing industry

• Strong industry fundamentals, or if the industry is distressed, evidence of opportunities to generate revenue and profits by solving its challenges
• A leading and defensible market position or one that is unique
• Growth potential (organic and/or through mergers and acquisition)

Well-documented assets

• Tangible assets (equipment, inventory, property in good shape) that could potentially be used as collateral for a loan
• Intangible assets (patents, brand, proprietary products, trade secrets, copyright protected), with documentation on the steps taken to protect them
• A desirable location (if the business requires a physical presence) that will be available for the foreseeable future, whether the company owns it or has a long-term lease

Strong relationships with key stakeholders

• A strong and competent management team
• A well-trained staff with little turnover
• A diversified and loyal customer base
• A deep and reliable supplier base

A successful exit should reflect the owner’s business, personal and financial goals. Reviewing various scenarios and priorities for the future will help shape an appropriate strategy.

Many business owners want to pass the baton to the next generation of their family when they retire. However, that doesn’t always happen. Family members may not have the experience, interest or aptitude to take this on. In those cases, selling to a third party may be best. Here are some things to consider.

• Transfer within the family: Many owners find it much more fulfilling to pass their legacy on to a family member who shares their passion and pride of ownership. If they do, they’ll need to consider which family member will run the business, what other family members will be included and the roles they will play and how their choice will affect family members who currently work in the business or own shares.

• Selling to a non-family member involved in the business: Some owners find that it is easiest to sell to a partner, shareholder or investor — or a manager or key employee — because they know the business well. In making this choice, it is important to consider the buyer’s ability to finance the purchase. While an existing investor may have the funds or multiple sources of financing to tap, an employee may need to obtain a loan, such as those backed by the Small Business Administration.

• Sale to a third party: There are two primary types of third-party buyers: financial and strategic. Financial buyers generally are investors, such as private equity firms, focused on the financial return they can achieve by purchasing a company — either in terms of expected future earnings growth or the return from a future sale (perhaps to a strategic buyer) or initial public offering (IPO).

Strategic buyers tend to be companies focused on seeking acquisitions as part of their own long-term growth strategy — maybe to eliminate competition, strengthen their own operations, expand into new regions or achieve other synergies.

Every buyer is different, so it’s important to conduct due diligence on any potential buyer. If the seller will be maintaining some ownership of the company, or staying on in the future, they will need to work with the buyer in the future. And even if they won’t be, they may be happier knowing the business is in the hands of an owner who cares about their current employees, their community and the future of the business. The right advisors can help sellers weigh the many considerations involved in choosing the best buyer.

A sale can take one of several forms that will determine some important consequences, like income tax treatment of payments the owner receives and liability exposure.

• Sale of stock for cash or note: This is the simplest transaction. The owner and any other shareholders simply sell their stock for cash or a promissory note from the buyer.

Potential liability: This generally results in the same business continuing with new owners/shareholders, and the new owners of the business bearing the burden of liabilities going forward.

• Sale of stock for stock of the buyer: The owner exchanges their stock in their current company for stock in the buyer and becomes a shareholder in the buyer’s company.

Potential liability: The seller remains an owner of the continuing/acquiring company and as such will bear a share of the burden of liabilities with the other owners.

• Sale of company’s assets for cash or note
  The seller remains a shareholder in the company and now it owns cash or a promissory note. The next step might be to distribute the cash or note and dissolve the company.

Potential liability: In general, if the owner sells the assets for cash or a promissory note, the company remains an entity owned by the seller. The company’s exposure to any of its liabilities continues, even if related to past events that become known in the future.

• Sale of company’s assets for stock of the buyer
  The owner remains a shareholder in the company and now owns stock in the acquiring company. The next step might be to distribute the stock and dissolve the company, in which case the owner would become a shareholder in the acquiring company.

Potential liability: In general, if the owner sells the assets for stock, the company remains an entity owned by the seller. As such, the company continues to be responsible for any liabilities it incurs, even if related to past events that become known in the future.

• Initial public offering (IPO)
  The owner remains a shareholder in the company, and it becomes a publicly traded firm, and the seller’s ownership percentage will become smaller.

Potential liability: The owner continues as a shareholder in the same company, though now it will be publicly traded. As such, the seller will bear the burden of a share of liabilities with the other owners.

The type of transaction executed will have a significant impact on the owner’s financial future. An accountant, attorney and mergers & acquisitions advisor, if the owner has one, can help in understanding which structures are best suited for the business and the owner’s goals.

The structure of the sale affects how the business is taxed, which is an area in which the interests of the seller and buyer may be at odds.

Competing tax rules can offer advantages to a seller and disadvantages to a buyer, and vice versa. Buyers and sellers might sometimes be motivated by tax considerations. For sellers, there may be opportunities for the buyout to be characterized as a long-term capital gain, which could have some tax advantages. For buyers, there might be tax considerations around whether their payment can be characterized as deductible or can be depreciated.

Placing the sale proceeds in short-term, liquid vehicles can give sellers time to create a “multibucket” approach to reinvesting them for future use. When meeting with a financial advisor, sellers may want to discuss how much money they want to keep in a bank account or short-term fixed-income investments to cover near-term spending needs, what they would like to put into a long-term investment portfolio, how much to allocate to aspirational projects such as a future business investment and how much they would like to set aside for charitable donations or philanthropy.  

Once owners sell a business, they will usually remain involved for several months or more to ensure a smooth transition. If the deal includes an earn-out—a portion of the payment for the business tied to performance—it will be especially important to make sure the new owner understands what to do to ensure the business continues to succeed and to make introductions to important customers, vendors and other key stakeholders to ensure those relationships continue. 

As sellers transition out of owning a business, it will also be important to take stock of their personal goals at regular intervals; new possibilities may open once they no longer have to manage the responsibilities of business ownership. Maybe, for instance, travel is more appealing now that the work of preparing the business for sale has been completed and the owner’s schedule is very flexible. Communicating with financial advisors about any changes can help owners keep their financial plans up-to-date and make adjustments when necessary.

Positioning a business for an exit requires careful planning, often starting years in advance. A strategic approach can help strengthen its value and create a smooth transition for everyone involved.

Having a well-designed plan can help ensure that owners exit on their own terms. Reaching out to business and personal finance advisors early can contribute the peace of mind that comes with knowing what one’s next steps will be.