In the first two parts of this series discussing five keys to successful exit planning for your business, we’ve already discussed taking care of your people, and ensuring that you cement a positive legacy.
That brings us to the next big consideration to think about during exit planning: what exactly do you want for your business?
Buyouts can take a number of forms and you should be thinking about how each of these potential deal components might fit into your plans, or whether some of these are simply not in the cards. This is usually different depending upon what you plan for your next act. If you are going to exit company now, golf for six months and then go straight to founding company tomorrow, then what you might need to get for your company and when are likely two different things.
#3 – Determining Appropriate Deal Components
Here are some of the most common forms of compensation that you should be considering when planning your exit. For each component it is important to realize that during the planning phase you are only determining what you would be willing to accept.
The choice of what actually comprises the deal lies primarily with the buyer. But the more you have considered the various main components, what you might be willing to accept for each, and what mix of those components might look like, the better prepared you will be at the actual negotiation table.
Cash, as they say, is king. Always will be. It will most likely be one of if not the largest and maybe even the only component of your buyout.
But how much do you need versus how much do you want? Are you sure you know how much your company is worth right now? On top of that, you need to consider whether you might get a better tax treatment with compensation other than cash at closing.
Often, cashing out over time results in better tax treatment than getting one big check at the closing table. Let’s also look at a couple of ways that cash can be structured over time and why that might enable you to realize a higher total purchase price, even if it’s not all paid at once.
One of the most common ways to defer cash is known as an earn out. These are often leveraged when the buyer isn’t totally sold on the purchase price and would prefer to only pay out once they have proof of value. An earn-out could be 6, 12, 18 or 24 months. Sometimes even more.
The earn out could be in a single additional payment awarded once particular metrics or goals have been met. Or it could be a trickle-out where a certain portion of the purchase price is paid out over time provided that the company is performing satisfactorily. Or that the transition process is proceeding according to plan, etc.
Because earn outs tend to be tied to some kind of performance metric (hence the word “earn”), they do include a certain amount of risk. You may not get paid any of it if the company is not actually as valuable or as capable as you thought it was. But, if you are certain you have properly prepared your legacy and know that the proof of value will manifest itself, then an earn out can be a good choice.
That said, it usually isn’t one a seller offers up front – it’s one a buyer insists upon in order to feel more comfortable with the deal. The key is to be prepared for that ask. If you are confident in your legacy plans, then know what metrics make sense, negotiate them with your buyer and then collect as the proof rings in.
Depending upon your business and the size of your business, another way of getting cash other than cash at closing is by financing some of the purchase price. This is more common in smaller deals (<$7-8M), but could still be used even in a larger deal.
Why help finance a buyer? Because it defers cash at close and potentially lowers tax liability on a single large transaction. Additionally, it provides an income stream over a period of time. And, last but not least, it generally earns interest, which means you make even more money on the sale.
Another reason to provide financing is to get the deal closed. With financing, once the deal is closed the buyer has time to get the business going in their name and they can then work on getting bank financing to buy you out or to afford a balloon payment at the end of the financing term. You get paid over time, you get more than you would have if the deal was all cash, and you might also enable a buyer who is the right successor in other ways to get to closing.
The Power to Foreclose
One last thought on financing is the power to foreclose. If the buyer starts to struggle and starts missing payments to you, you might have the power, depending upon the financing deal you work out, to jump back in and retake control of the business.
Think of going to the cockpit in a plane and the pilot has fallen ill and you jump behind the controls and pull the plane out of a fatal nose dive. Then you find a new pilot and potentially make even more money.
Another way to defer cash but still get paid, potentially more than you might otherwise, is by consulting.
A consulting arrangement might be in lieu of you continuing to work full time as an executive through a transition period. Maybe the buyer likes your executive transition plan, but they are still wary of whether it will work or not. You want to hit the beach, but you also know that if you spend even a few hours on the phone with your old team from St. Maarten, that you can be sure that they will be successful.
Another version of consulting is the “on demand” model. This tends to be more of a cash over time model with a “bat phone” provision. You get paid over time to provide consultative assistance to ensure the performance of the business you just sold, but that assistance is on an “as-needed” basis.
- Someone forgot one of those highly specialized processes that you used to handle personally. They give you a call and all is well.
- Some process is not working and people can’t figure out why the numbers are dropping, they give you a call and you remind them about the time that…
Either way, putting together a consulting agreement is another way to speed an exit, defer cash and tax, and provide a buyer with assurances that you will help them be successful, all in one.
Similar to consulting, another way to transition is with a board of directors position.
BuyerCo is buying Yourco out, but they want to be sure that everything goes right. You don’t want to stay on as a full time executive and you have a transition plan ready to go, but you also want to protect and assure your legacy. Taking a position on the board of directors of BuyerCo is one way to do that.
Depending upon the buyer, a board position may or may not be paid. Even if most director positions at BuyerCo are unpaid, a company is still able to ratify a paid board position as an exception, especially when doing so provides additional assurances around the success of a new acquisition.
Serving on the Board for Additional Equity
Alternately, a board position might be a way to get paid out with additional equity in BuyerCo over time. Once again, you are providing a longer term benefit to the buyer and generally not at the same operational cadence you had as a full time owner or CEO of Yourco. You are also getting paid on a deferred basis, which might make the deal easier for the buyer to close faster, and may again result in more favorable tax treatment for you. In fact, depending upon how the contracts are worded, you may not pay any tax on those shares until you sell them and earn a capital gain.
One last word on board positions: they are strategic, not tactical. The board of directors advises and provides approvals for the actions of the CEO. They do not and indeed are not supposed to actively manage the company. You can still spend most of your time on the beach with just an occasional flight back to the concrete jungle for a board meeting. Or, with Zoom calls these days, it might be from your villa at the shore.
One of the other key types of non-cash compensation (as I’ve hinted in the board positions discussion) is equity. Especially with larger deals, more often than not a buyout is structured with a portion of the deal in cash and the remainder in BuyerCo stock.
Sometimes, depending upon the relative stability and market position of your company, a deal might be more equity than cash. Occasionally, a deal is all equity and no cash, although, especially with an exit, that is not usually that great of a deal for the seller.
Knowing How Much is the Key
What you need to think about as you work toward your exit is what percentage of your buyout price you are willing to accept as equity. This may not be a set amount or percentage, either, because it also depends on the strength of buyer’s equity. Every deal is different and has to be evaluated based on the facts at hand.
Is stock in a major public company even better than cash? Might be. It’s marketable, it might pay dividends, it could appreciate over time, and it may even be leverage-able without actually selling it (i.e., you use the shares as collateral for a loan).
What about shares from a special purpose acquisition company, or SPAC? This might be a little more speculative, but that depends on how certain you are of your legacy and whether the SPAC is only buying your company or several companies.
Equity in a Privately Held Company
What if your company is being merged into a company that is privately held and that company is offering you stock in their company to replace the stock you own in your own company?
That is an even different equation to consider that involves your confidence in your legacy, your opinion of the buyer company’s strength and leadership, and what the prospects are to make those shares marketable.
If you take equity in a private company and it never goes public and doesn’t have a liquidity event that pays out your shares for years, you might suddenly have to worry whether you can still afford the villa by the sea and all of those Mai Tais on the sand.
You’ve probably noticed that the word “tax” has been used throughout this section. That’s because it is probably one of the biggest considerations you need to make when you determine the components of your deal. If you don’t already have a strong tax advisor, when you start exit planning you absolutely need a great one.
Be thinking about the usual questions that you need to ask a tax advisor.
- How can I reduce my tax burden?
- How can I defer the tax over time rather than paying it all at once?
- What are the best ways to reduce the tax percentage charged for each type of compensation that I might get?
Also – you likely need ongoing access to your tax advisor throughout the exit process. Talk to one when you are coming up with your exit strategy and be ready with some of the different scenarios or structures that you think your deal might take. As you are finding potential buyers and offers begin to come in, make sure that same tax advisor is looking through the terms sheets and helping you understand what you are going to have to pay and when and what deal terms are in your favor and which are not from a tax perspective.
Up Next …
In Part Four of this five part series we’ll look at the next key to a successful business exit, choosing the right timing and planning out the timeline for the exit itself.
Ready to Exit? Work with Us.
If you think you are ready to start discussing exit planning for your business, contact Navvee for assistance. Our services range from a simple review and advice on your plans to putting together a full strategy, to assisting with the legal work involved for the deal, to, with direct support from our partners at True North Mergers & Acquisitions, acting as your M&A Advisor and directly assisting with finding appropriate buyers and getting you the best deal for your legacy.