Choosing the right business exit strategy may be one of the most difficult decisions you face as an entrepreneur. There is a lot riding on the outcome, and the perfect fit can seem elusive. It’s not uncommon for what looks like the most obvious exit path to turn into an unworkable quagmire, leaving you back at square one.
If you’ve struggled to figure out the best exit strategy for you and your business, you’re not alone. The statistics associated with successful business exits are about as dismal as the ones associated with startups: It is a complex task that is prone to failure. Regardless, it’s a choice all business owners have to make.
In this article, we’ll help you get your head in the game with a few things to keep in mind before you start considering your exit options. We’ll provide an overview of the most common exit strategies available to small business owners, along with some insights into what contributes to the success of each method, as well as some pitfalls to be aware of.
Who this article is for: This article is for small business owners who have built a successful lower middle market business (annual sales $2M to $25M) with transferable value and opportunities for future growth. It also assumes that the owner’s goal is a 100% exit from the business, both operationally and financially.
Business exits not covered in this article: Two business exit strategies not covered here are an initial public offering (IPO) and a wind down or liquidation. The first is not a realistic option for the vast majority of lower middle market businesses. The second is the exit of last resort for a failed business, or a small business that has no future without current ownership.
We’ve also left out discussing the nuances of family business succession planning: A partial exit strategy that allows one generation to step away from business operations yet remain financially invested as stockholders. Note: Succession planning and exit planning are not synonymous.
All Business Exits Happen In One of Two Ways
Every small business owner will leave their company in one of two ways: voluntarily or involuntarily. The former, of course, is preferable to the latter.
Losing control of anything important in your life is an awful experience. Reasons why owners get forced to exit their business include death, illness, divorce, partnership disputes, and personal or business insolvency.
If you’d prefer to avoid the topic of how to leave your business, keep the following statistic in mind: 100% of small business owners will exit their business. Unless you’re immortal, you will be leaving your business at some point. The only questions are when and how.
3 Things Influence Your Business Exit Strategy
Before we discuss the different types of exit strategies, it’s important to be clear on a few things that will determine which options are the best fit for you and your business.
#1: Your Personal Financial Situation
Do you need significant liquidity from the sale of your business in order to retire? Alternatively, are you in a solid financial position that allows you to choose an exit strategy with a lower business valuation, or even give the business away? If you care less about a big liquidity event and more about tax consequences, that could influence your decision as well.
#2: Who You Want the Next Owner To Be
Do you want the business to stay in the family? Do you want managers or employees to own the business? Do you want a strategic buyer to triple the current size of the business and get your product/service into as many hands as possible? Or, perhaps you don’t have a strong preference, as long as you feel the new owner is competent enough to continue to run the business. Each one of these scenarios will inform your approach to an exit.
#3: What Your Business Can Support
On some level it doesn’t really matter how much money you want or need from the sale of your business, or who you want the new owner to be.The only exit options available to you are the ones that your business will support.
Start by exploring the following question: What exit(s) will your small business support today? If you want something different, you’ll need to either …
- Do the work to make the business support your desired exit strategy, or
- Adjust your thinking and consider other exit options that your business will support
With all that said, we’ve separated the most common business exits into two categories: internal business transfers versus external.
Internal Business Exit Strategies
Internal business exit strategies are often seen as the most straightforward and logical way for the existing owner to leave the business. In reality, many internal transfers take longer to plan, longer to complete, and come with a lower valuation. There is a wide variety of options for complete or partial internal exit strategies. Here are the most common:
Gifting Business Stock or Assets
This exit strategy is typically employed by the wealthiest business owners. It is primarily a way to a) reward someone with ownership — be it family members, existing management, a charity, or anyone of your choosing — and/or b) pay as little in taxes as possible. Gifting is often the most tax-efficient business exit strategy, depending on your gift and estate tax exemptions.
Success Factors: This exit gives owners the satisfaction of hand-selecting new ownership. In most cases, the new owners are deeply familiar with the business and/or have a strong sense of gratitude for the windfall you’ve given them.
Pitfalls: From a practical standpoint, gifting is largely a legal and tax exercise. Hiring the wrong advisors can be costly (e.g., estate planning attorney, CPA, wealth manager). There is also the issue of the new owners having no “skin in the game,” as they will assume business ownership without taking any personal risk.
Selling Your Business To Family
This is one of the most popular business exit strategies available. One recent study of 150 high-net-worth business owners found that 88% planned to leave the business to a family member. (In reality, most studies show that a little over half of small business owners end up selling to an outside buyer.)
There are two schools of thought on how best to place the business in the hands of the next generation. Some believe that a tax-efficient exit, like gifting, offers a seamless transition while allowing the family to maintain financial and operational control. Others believe giving the business away fosters a sense of entitlement that leads to poor decision-making about the future direction — and ultimate survival — of the business.
If you’re on the fence about whether to give or sell your business to the next generation, we highly recommend reading Every Family’s Business: 12 Common Sense Questions to Protect Your Wealth, by Dr. Tom Deans.
Success Factors: Selling the business to family works well when the next generation has the skill, desire, and stomach for entrepreneurship. It also helps to have an existing owner — often the founder — who is truly willing to step back and let the business flourish under new leadership. Clear communication of goals and expectations is also critical, as many family members assume they know how the others think and feel about business-related issues.
Pitfalls: While this is one of the most popular exit strategies for business owners, it also comes with the highest failure rate: Close to 70% of family business transfers from the founder to the next generation fail. Only about 3% of family businesses survive transfer to a third generation. Thus the saying: Shirtsleeves to shirtsleeves in three generations.
There are a number of reasons for the high failure rate of family business transfers. Chief among them are conflict within the family itself, and mismanagement by family members who lack the skills and qualifications to lead and own a company. Lastly, it can often be a disincentive to talented employees, who recognize that their opportunities for promotion are limited and seek employment elsewhere.
Selling Your Equity To Partners
The most common scenario involving this exit strategy is when one partner decides they are ready to retire from the business. With proper planning in place, this should be a straightforward issue of executing steps that have already been spelled out and agreed upon by all stakeholders in a carefully crafted Buy-Sell Agreement.
Success Factors: There should be little disruption to the business when you sell to your partners. When one partner is older than the others, chances are that everyone at the organization has known this day would come and take it in stride. The clarity with which the Buy-Sell Agreement has been written, along with keeping it current, will go a long way towards determining how smoothly this process goes.
Pitfalls: If the exiting partner is the driving force behind the company’s success, the wheels could start to fall off soon after their departure. It also kicks the can down the road in that the remaining partners will still need to figure out how and when to exit the business when they are ready. For this reason, some owners decide to sell the business when one partner is ready to leave. Lastly, a poorly written and outdated Buy-Sell Agreement can turn a straightforward process into a prolonged, contentious, or even legal battle.
Note: If you don’t already have a Buy-Sell Agreement in place with your partners (whether you’re related to them or not), get the best attorney you can afford to draw one up for you immediately. Make sure it includes a third-party business valuation, and update the valuation either annually or semi-annually.
Selling To Your Management Team
Commonly referred to as a management buyout, this is another popular business exit strategy that seems simple on the surface, but comes with some hidden landmines. For this reason, you may want to hire an advisor who specializes in helping facilitate a management buyout. Similar to family business transfers, both sides can be prone to making assumptions, and emotional issues can play an outsized role.
One of the upsides of a management buyout is that they can be easier to finance, as the buyer has already proven that they can successfully run the business. There is also little disruption to the business if the management team has been in place for years, as employees, customers and suppliers are all accustomed to working with this team. If the managers are properly motivated, this can be a win-win business exit strategy.
Success Factors: In the best case scenario you are leaving your business in the hands of owners you have selected, groomed, and trust with the future of your company. It can also feel good to reward managers who have been with the company for a long time and helped grow it to what it is today. While you may have to receive your entire payout over several years, and accept a lower valuation, a transaction can be relatively straightforward to finance and complete.
Pitfalls: Like selling to family members, this exit can fail when the owner assumes the management team has a burning desire to make the leap from employees to entrepreneurs. Press them hard on the issue to ensure they want this outcome as much as you do. Depending on the managers’ upfront investment and financing abilities, this exit strategy may require a large seller note, or the use of business profits to help fund all or a portion of the purchase price.
Selling Your Business To Employees
There are two primary ways to facilitate an employee buyout. The most common method is to install an Employee Stock Ownership Plan (ESOP). The other is selling to an employee cooperative. While both of these exit strategies leave the business in the hands of employees for the foreseeable future, a business that is 100% owned by an ESOP has the added benefit of paying no federal corporate taxes.
In a nutshell, an ESOP uses a trust to hold the company stock in employee retirement accounts. An employee cooperative is the most democratic corporate structure available, and requires all employees to be on board with owning the company (even more so than an ESOP).
While many business owners want to give their employees the ultimate reward by selling them the company, there are a variety of ways to reward employees when you sell. Bonuses can come from both the seller and buyer at the time of sale and afterwards. However, if you want your employees to own your business outright, an ESOP or employee cooperative are two good options.
Success Factors: Selling your business to employees works well when you’ve built the company to support this type of transition. A flat organizational structure with as much financial transparency as possible — like open-book management — set the stage for this exit to succeed. The size of the business can also make or break this strategy.
Pitfalls: In order to install an ESOP your business will need to go through a feasibility study. Simply put, not every business can do an ESOP — this is why you need to build your business with an ESOP in mind. ESOPs are regulated by federal IRC and ERISA law, require specialized expertise to manage, and have ongoing administrative costs. Employee cooperatives also require using advisors, like lawyers and accountants, who understand how to work with this lesser-known business entity structure. It can take years for owners to get their final payout from these exit strategies. These businesses can also be difficult to sell at a later date.
External Business Exit Strategies
While an internal sale may be a great option in some situations, it’s definitely not for everyone. In fact, it is often the case that there are no internal buyers for your company. There can, however, be a universe of potential buyers from outside of your small business.
Upsides to selling your business to an outside buyer include a faster transition, a shorter payback period, and a higher valuation — including what is often perceived as the holy grail of exits: A strategic acquisition.
Following are the most common external business exit strategies:
Selling Your Business To Private Equity
The mere mention of the term “private equity” can prompt a strong reaction from small business owners. While there are plenty of stories about sales to private equity gone awry, this can be an excellent — and lucrative — way to exit your small business.
There are several types of private equity groups (PEGs). The key is finding one that’s a good fit for your personal exit goals as well as the future of your business. We recommend that you think of a PEG as a partner — as you are typically tied to the business financially and operationally for some period of time after a transaction. This is done through an equity rollover in which you retain a non-controlling interest in the new business until the PEG eventually sells (known as the “second bite of the apple”).
Success Factors: Selling your business to a PEG can be a great way for your business to achieve exponential growth. Look for a PEG that has operational expertise in your industry. Ideally, this exit comes with a second liquidity event when the PEG exits that eclipses your original sale.
Pitfalls: This exit strategy depends on the right fit perhaps more than any other. Things go sideways when the financial and business goals of the PEG are misaligned with the business and/or seller. You’re also dealing with professional business buyers. You’ll need experienced advisors to guide you through due diligence and contract negotiations.
Selling Your Business To Another Entrepreneur(s)
This is the most common buyer for small businesses with less than $10M in annual revenue. These buyers are often corporate refugees with significant savings who are looking to own their own business. They understand that buying an existing business is a much faster and less risky path to entrepreneurship than starting a business from scratch.
Oftentimes, these buyers are serial entrepreneurs themselves. Either way, they are the buyer of choice for a small business that generates enough cash flow to support this type of sale but is too small to garner interest from most PEGs and strategic acquirers.
Success Factors: This exit is also about finding the right buyer. A good business broker can make a market for the sale of your business, and attract the most serious and qualified buyers for you to choose from. This exit strategy can bring an unexpected variety of potential buyers to the table, so keep an open mind: The new buyer for your business may be someone you’ve never thought of.
Pitfalls: This type of buyer needs to be thoroughly vetted by an experienced business broker before engaging in any discussions. There are lots of so-called tire kickers who will waste your precious time and energy. In addition to needing the requisite skills to run your business, this buyer needs to prove that they are more than qualified to obtain adequate business financing. While you may like this buyer, a bank may not.
Selling your business to a strategic acquirer is often seen as the holy grail of business exits. If there is true synergistic value to be had after a company purchases your business, there is no telling what a larger company is willing to pay.
Under the right conditions, this business exit strategy comes with the highest valuation by far. While a financial buyer (like the PEG and entrepreneurial buyers mentioned above) may be willing to pay a 4-5 multiple for your business, a strategic acquirer may put a multiple on your business of 10 or higher.
A strategic acquirer in the lower middle market is usually another private company. While it’s exciting to think about your business being acquired by a larger company, most public companies only consider a target with substantial profits and upwards of $200M in annual sales.
Success Factors: This exit can check all the boxes when done right: High valuation, a quick exit, and enormous future growth potential for your product/service and employees. It helps if the corporate culture of the buyer’s business is compatible with yours. Being acquired by a well-known player in your industry is the cherry on the sundae of small business ownership.
Pitfalls: Problems with this exit tend to crop up post-sale during the integration process, often caused by poor planning, or trying to merge two corporate cultures that don’t mesh. There are also bad actors in this category who may claim that they plan to keep the business intact, but end up winding it down after they own the assets they really wanted (e.g., customer lists, employees, intellectual property, facilities and equipment, etc.).
Understand Your Exit Options, Be Realistic, and Plan Early
Business exits are tricky business. No matter what strategy you choose, there is always a chance it will not turn out as you’d hoped. There’s risk involved when you start a business, and risk involved when it comes time to exit. You’ll have the best chance of success if you understand the options that are realistically available to you and your business, then choose the best fit. When it comes to business exits, shoving a square peg into a round hole — no matter how badly you want it to fit — just doesn’t work.
- Plan early! Any exit strategy takes time to execute. Waiting often results in limited choices, missed opportunities, and a small (or nonexistent) payout for years of hard work.
- Understand what kind of exit your business can support today. If it doesn’t align with your goals and wishes for the future, then either get to work or adjust your expectations.
- Hire good advisors to help you with every phase of the business exit process. They will more than pay for their fees by making your exit a reality, and helping you avoid costly mistakes.
- If an internal transfer is your preferred exit strategy, selling to an outside buyer should always be your backup plan. Build a sellable business: It gives you choices.
- Take control of your business exit strategy, or fate will do it for you.