Litigation + Valuation Perspectives

Demystifying Valuation, Economic Damages + Forensic Accounting

8 Essential Elements of an Exit Strategy for Business Owners: Part I

At some point in time, every business owner will need to transition their business to new owners, which could be a business partner or management buy out, a transfer to family members or an outright sale of the business on the open market.  Regardless of the expected exit strategy, every business and business-owner should probably have a transition plan. Otherwise, significant value can be lost in any ultimate transfer of the business. This article will discuss how to increase the value of your business when developing and implementing an exit strategy.

 

Understand the Value Proposition

What is a business really worth?  There are two ways to find out – have a business valuation performed (hypothetical) or actually sell the business (reality).  The reasons for an owner to have a business valuation performed include:  strategic planning, evaluation of offer to purchase, gifting of equity interests in the business to family members, division of assets in marital dissolution, disagreements among co-owners, or setting values for a buy-sell agreement between co-owners, among others. In performing a business valuation, the valuation analyst typically determines “fair market value” which is the cash equivalent amount at which the business would change hands between a hypothetical buyer and seller. Therefore, it represents a hypothetical value.  The cash that could be received from an actual transaction might be different.

 

When a business owner is contemplating a sale of his/her business, the owner should know the amount at which similar sized businesses have changed hands in their market.  Sellers also need to understand how businesses are being acquired in their market.  Most business sales are asset purchases where the buyer acquires the assets of the business, both tangible and intangible, versus a stock purchase where the owner sells common stock (or other equity interest) in the business entity.  A team of outside professionals including legal, tax, valuation, and business brokers can provide valuable assistance in these matters.

 

Understand Deal Structures and Consequences

Sellers should have a good understanding of typical deal structures and their income tax consequences.   When a transaction is structured as a sale of assets, the buyer receives a new income tax basis in assets for depreciation, amortization and disposition. The seller generally pays tax on the difference between the purchase price received and the tax basis of the assets sold. Some of this gain may be taxed at ordinary income tax rates.

 

If the assets of the business are owned by a regular corporation (i.e., a “C” corporation) this tax will be assessed at the corporation level. The shareholder will then pay tax on any distribution of sale proceeds from the company to the shareholder. If the deal is structured as a stock sale, the buyer receives no step-up in basis unless it liquidates (or is deemed to have liquidated) the target company. Of course, any income tax on built–in gains of the target company would be the responsibility of the buyer in this case. These issues are somewhat simplified if the business is structured as a pass-through entity (S-corporation, partnership, limited liability company, etc.).

 

If a transition is planned as a transfer from the owner to family members, gift and estate tax considerations become important. The transfer of minority interests in business enterprises to family members requires valuation of the interest transferred. This valuation should consider appropriate discounts for lack of control and lack of marketability of the minority interest. The value should be documented in a thorough appraisal report of the interest to be transferred by a qualified, credentialed appraiser. If a sale to employees is considered, the owner may wish to consider the benefits and cost of a sale to an Employee Stock Ownership Plan (ESOP).

 

In theory or reality, owners should understand how deal structures affect value and outcomes when considering an exit strategy.

 

Review the Business’s Legal & Ownership Structure

An owner should understand how the form of organization affects value and tax consequences.  Pass-through entity structures (such as partnerships, Sub-S corporations and LLCs) may present simpler tax issues compared to a regular corporation (C-Corp) since an owner need not be concerned with double taxation issues. A C-Corp pays income tax on corporate earnings and on the distribution of appreciated assets to shareholders. The individual shareholders of the C-Corp then pay income tax on any dividends received from the corporation. Therefore, there is a double tax, once at the corporation level and then again at the shareholder level. Unlike C-Corps, pass-through entities generally pay no income taxes. The individual owners pay tax on their proportionate share of the earnings of the business.

 

There may be significant tax advantages for an owner to convert from a C-Corp to an S-Corp. An S-Corp generally pays no income taxes. Rather, the shareholders pay tax on their proportionate share of S-Corp earnings, whether or not distributed. This structure avoids the double tax on corporation earnings, once at the corporation level and again on any distributions of corporate earnings to the shareholder. A conversion from a C-Corp to an S-Corp can also help a seller reduce income taxes on the sale of assets since an S-Corp pays no income tax. However, this benefit is only available if the assets are not sold within a certain period of years subsequent to the S Election.  The issue is that the full benefit of a conversion from a C-Corp to an S-Corp can take years, which could make the business less attractive to sell for tax reasons during the Sub-S conversation period. The conversion presents complex issues that are outside the scope of this article and should be addressed by a qualified tax professional.

 

A review of the business’s ownership structure should take place as part of the planning process.  Consideration of alternative forms of organization may present opportunities to position the business for a transition. In addition, all ownership interests should be properly identified and recorded in the business records.  It may also be appropriate to eliminate minority interest holders since there is always the possibility that a minority owner could attempt to block any sale transaction. It may also be possible to recapitalize the business with voting and non-voting interests.

 

Next week I will continue with four more of the 8 Essential Elements of an Exit Strategy for Business Owners.

Stephen E. Koons, CPA, ABV, CFF, ASA and Daniel R. Silburg, CPA, CVA