All business owners eventually face the difficult dilemma of planning for the future of their companies when they can’t or don’t want to run them. When a business owner looks to future company ownership, there are a variety of options to consider. Many of them result in instant liquidity for the owner, while some require the owner to wait for a longer period of time. Regardless, each of the following options has pros and cons that an owner should carefully consider prior to exiting a business.

Sale To A Third Party

The most common practice for exiting a business is for a business owner to sell the company to a third party. Potential third-party buyers often fall into two broad categories: private equity (PE) investors and strategic investors. PE investors have very different investment philosophies than strategic investors. PE investors generally own many businesses and look for opportunities which don’t require them to take over the day-to-day operations of the business, often relying on the business owner and its management team to continue running the business.  As a result, PE investors often require sellers to keep some “skin in the game” by rolling over (maintaining significant ownership) a portion of their stock, which provides additional potential upside to the seller along with risk on such retained ownership. In contrast to PE investors, strategic investors (businesses that are in the same industry as the business owner) are more likely to have professionals that will take over the day-to-day operations of a business since they have experience operating in the business’s industry.  In addition, strategic investors generally will purchase all of the seller’s interest in the business, which gives a seller more liquidity but removes the seller’s ability to benefit from any future upside in the business.

Sale/Transition To Family Members

Many business owners feel a moral obligation to pass the company on to their relatives, which can help ensure the owner’s and the company’s legacy and provide multiple benefits for future generations. If executed properly, the sale or transfer of the company to family members may involve intricate estate planning techniques, depending on value of the business and complexity of the owner’s estate. The most popular transfer techniques include gifting of ownership interests and sale of interests. If the gift or sale is structured properly, the Internal Revenue Service allows discounts to the valuation of the equity allowing major tax savings to family members. This involves careful tax planning and should be accomplished in consultation with attorneys and accountants.

A business owner should consider the problems that often arise when a business is passed on to family members. Handing down a business past the first generation is very complicated and requires careful planning. For example, owners often want to designate one child the primary owner but want to treat all their children fairly, which often complicates planning. It is important for the family member owners to have a shareholders agreement that governs the management of the company and the control of the shares. Family members often have disputes over the company when a thorough shareholders agreement is not in place. Also, a business owner should consider which family members will be active in the business and which will not be involved and consider how to properly treat each of them. Mixing business and family often leads to difficulties, much of which can be avoided with proper planning.

An example of poor transition planning recently arose when a client transferred a family business to the client’s two children, with one child receiving 60% of the business (the “Majority Child”) and the other child receiving 40% (the “Minority Child”.  The client gave a larger percentage to the Majority Child since the Minority Child had married into wealth.  Since a shareholders agreement had never been put in place between the two children, disputes over the operation of the company eventually caused the Minority Child to sue the Majority Child over failure to make tax distributions, taking of an excessive salary and the eventual firing of the Minority Child as an employee of the company.  A thorough shareholders agreement put in place at the time of transfer could have prevented this dispute.

Sale/Transition To Employees

Employees of a company are often logical buyers of a business since they already have knowledge and experience with the company and loyalty to the long-time business owner. Often, the largest obstacle for the employees is the ability to find the capital necessary to fund the purchase.

One method for funding a purchase by employees is through an employee stock ownership plan (ESOP). In an ESOP, the company sets up a trust fund into which it will contribute shares of its stock or cash to buy existing shares from the owner. Alternatively, the ESOP can borrow money from a lender to buy the shares, with the company making annual contributions to help repay the loan. The company can use the proceeds of the loan to provide liquidity to the company’s owner.

One of the advantages of using an ESOP is that it provides a tax-advantageous method for generating liquidity and transitioning stock to employees since company contributions to the trust are generally tax-deductible. This method also rewards long-term employees by giving them the opportunity to become owners of the company. A primary disadvantage is that it increases the administrative burden on the company and creates legal complications, such as creating a fiduciary duty to the ESOP. In addition, the valuation of the company is usually not as high as with some of the other liquidity options because the liquidity is being created from continuing company cash flow and available current leverage.

Another method through which employees can obtain ownership of the company is a management buyout. In this scenario, management purchases the company from the owner, which they can accomplish with a combination of funding sources: using their own funds, teaming up with a third party that will provide the capital and borrowing from third-party lenders (capital markets currently are robust with liquidity). The advantage to sellers is that the business remains with familiar faces, cutting down on due diligence costs, major disruption to the business and uncertainty. In addition, management is often in the best position to understand the upside potential of an investment in the company.

Initial Public Offering

Depending on the size of the business and the health of the public markets, a business owner can also consider an initial public offering. Under this scenario, the business owner obtains liquidity by selling shares to the public. This option can provide liquidity to all the shareholders of the business and can raise the prestige of the company.  After going public, the business will have a valuable tool for attracting and retaining key employees—public company stock. In addition, the company will have a better ability to issue its own stock as part of any future acquisitions.

However, there are many drawbacks to going public. The process can be costly and take tremendous time and resources. For example, once the company becomes public, it will be subject to reporting requirements that take time and money to fulfill. In addition, the company’s financial information will no longer be confidential and the company will face pressure to meet the public’s expectations on performance.

Going public was a very popular exit option many years ago.  In today’s environment—with stricter oversight and reporting requirements—fewer business owners are considering this option.

Dividend Recap

Some business owners seek to realize some liquidity and take some “risk off the table,” but are not ready to consider a sale of their equity. A dividend recapitalization is a technique to accomplish this goal. This entails borrowing funds from a lender, secured by the company assets. The loan is then distributed to the company as a dividend to the owner. The company now has more leverage on its balance sheet, but the owner is able to realize liquidity as a result (which is often tax advantageous).  The capital markets are competitive, and often good companies can borrow attractive multiples of earnings at very low rates without any personal recourse to the owner.  However, this may not work if the company already has incurred significant debt or if its free cash flow will not allow it to meet its debt obligations. In addition, business owners may not like the idea of taking on debt to pay themselves, as leverage often scares business owners who are not used to operating with debt.  This technique is a quick and inexpensive way to retain ownership and capitalize on the value of the business.

A recent example of a dividend recap involved a private equity client that wanted to take some profits out of one of its portfolio companies. Since the private equity client had only owned the company for two years, it was not ready to sell the company. However, a rapid growth in earnings caused a lot of profit to be held in the company. Rather than sell, the private equity firm had the company take on additional debt, the proceeds of which were distributed to the private equity firm so it could realize some of its investment profits.

Decisions, Decisions

As there are many available techniques to monetize a business, owners should carefully consider their available exit options. Regardless of the option chosen, the process takes a long time and careful planning well in advance is recommended. With a good team of trusted advisors, a business owner can obtain information on the benefits and drawbacks of the many exit strategies available and plan and implement the decision that is best for the business and the family.

Mitchell S. Roth is managing partner and shareholder at the law firm Much Shelist. He has more than 20 years experience advising entrepreneurs, business owners, investors and C-suite executives at large public and privately held companies

Michael Shaw is chairman of the business and finance group and head of the private equity practice at Much Shelist.