Exit Planning: 4 Questions Every Small Business Owner Should Answer

As Ben Franklin (almost) said, “Nothing is certain for small business owners except exiting your business and taxes.”

While every business is different, we’re here to talk about the one inevitable stop on every business owner’s journey: the end. Very few things in business are guaranteed, but an exit is 100% inevitable – whether you’re ready or not.

Whether you sell your business to an external third party or to your children or to someone who currently works for you, how you leave your business is just as important as how you entered it. It impacts your retirement, your family, and your business itself. 

That’s why exit planning (a.k.a., succession planning or perpetuation planning, as we like to call it) is so important, even if you don’t expect to sell your business for several years. 

Today, I want to look at four core questions that we use to help business owners begin piecing together an exit plan.

1. What Are Your Personal Goals?

People always talk about keeping your business and personal life separate, and there’s wisdom in that. But the truth is that your business ultimately is personal. Everyone starts a business so they can provide a certain lifestyle for themselves/their family, and retire the way they want.

According to the Exit Planning Institute, 80-90% of the average small business owner’s wealth is tied up in their business. In addition, 78% expect the sale of their business to fund at least 60% of their retirement.

In other words, if you’re like most small business owners, your exit is the thing that makes your retirement possible.

That’s why we start with personal goals. In this area, we need to identify four core elements:

1. What is your current situation, financial and otherwise?
2. What do you need in order to accomplish your personal goals?
3. Can your exit of the business facilitate that?
4. If not – if there is a “wealth gap” between where you are now and where you want to be when you exit – how can we solve for that in a five-to-10-year runway? 

The longer the runway, the better. Five years is great. Ten is even better. Once your runway gets shorter than five years, you’re in greater danger of making tradeoffs that you’d rather not make, such as:

• Lessening the value of your business, 
• Negatively impacting the tax strategy of your exit, 
• Making it harder for new owners to take over, and 
• Making it harder for you to leave. 

To be clear: A five-year runway is not absolutely essential. But if you shorten your timeline, you may not have access to all of the strategies you want. After investing decades of your life into making your business work, a sufficient runway is core to getting what you want out of selling it.

If You Have a Partner, a Runway Is Even More Important

If you are the sole owner of a business, ensuring that the sale of your business matches your personal goals is fairly simple. But when you throw a partner into the mix, all bets are off. 

Consider the following:

Two partners are ready to sell their business. They find a buyer who offers them $10 million, giving each of them $5 million. Partner #1 has already built $3 million in personal wealth and his retirement goals require $5 million, giving him a surplus of $3 million. Partner #2 has saved nothing, loves Bentleys and caviar, and needs $15 million for his retirement goals, leaving him with a wealth gap of $10 million. 

Most business owners have no idea what their partner’s financial situation looks like. As a result, Partner 1 is ready to accept the offer and is shocked to find that Partner 2 won’t even consider it. 

While the situation may seem impossible, it is solvable – with enough runway. By building a personal financial plan for Partner 2 and taking steps to maximize the value of the business, the partners can be closer to the same page when it’s time to exit.

2. What Are Your Business Goals? 

To state this question another way: How much do you care what happens to your business after you leave? This one is much more straightforward than the other questions we will address here, but it is no less influential in the outcome of your exit.

Maybe you want to make sure that your clients are taken care of when you’re gone. Maybe continuing the legacy of your business is important to you. Maybe you want to make sure your employees keep their jobs.

How you answer this question will greatly inform who you sell to, how much you get out of your business, and what your exit looks like – which leads us to our next question…

3. Will Your Succession Plan Be External or Internal?

Who you sell to is the single greatest determining factor in what your small business exit plan runway will look like. 

There are two categories of buyers:

1. External buyers, such as private equity (PE) firms or another new external business owner, or you could merge with another business.
2. Internal buyers, such as your children, your partner, one of your key personnel, or another employee.

The type of buyer you choose has a huge impact on your exit strategy. 

External Exit Plan

With an external exit plan, the owner’s goal is primarily to maximize value. That doesn’t mean you don’t care what happens to your business or your people, it just means that your main priority is getting the most money out of it, so all of your planning should center around that.

As a business owner, you’ve probably heard of EBITDA before. It stands for Earnings Before Interest, Taxes, Depreciation, and Amortization, and it is the primary building block for business valuation. As a result, it’s your best tool when it comes to maximizing the value of your business.

When you’re running a business, any money you spend on operating expenses can lower your EBITDA. That’s all well and good. As they say, “You’ve got to spend money to make money.”

But once you hit your exit runway, you want to start minimizing those expenses as much as possible. Valuation professionals look at revenue over the last three to five years, so you want to keep your EBITDA as high as possible during your last few years before you exit.

Internal Exit Plan

With an internal exit plan, the primary focus is typically on the legacy of the business. 

While external transitions have their challenges, internal transitions are notoriously complicated due to the fact that the sale of the business has to accomplish two goals: 

1. Maximize the value of the business
2. Keep the purchase price affordable for the buyers.

It’s a delicate balance, considering that those two goals work against each other most of the time. As you may have guessed, a longer runway can be very helpful with an internal plan.

External successions typically involve higher EBITDA multipliers and buyers with deep pockets, so they almost always generate more dollars.

Internal buyers tend to have more limited resources. In addition, the money they use to buy your company is coming from your company, which creates a unique loop of taxation: When the dollar comes into the company there are tax consequences, then that dollar is paid to the employee and has income tax applied, then that same dollar is used to purchase shares from the exiting owner who pays capital gains tax, and so on. In the end, the dollar that came in is a fraction of itself as it funds an internal purchase.

That being said, an internal succession plan gives you the ability to extend the purchase of shares longer than you typically would with an external plan. You may choose to build your small business succession plan into an employee’s benefits plan by offering stock options that allow your successor to buy you out over several years.

Internal succession plans are much more complex, and I plan to go into them in greater detail in my next article.

External vs. Internal: Pros & Cons

There are countless factors you could take into account when deciding on an external or internal plan, so I’ll wrap up with a quick pros and cons list. Of course, none of these are guaranteed, but they are often the case in my experience:

External

Pros:

• Quicker exit
• Higher dollars
• Break through ceiling to next level (if purchased by a bigger buyer), giving greater national/global reach
• Increased access to technologies

Cons: 

• Often buyer is not local
• You’re like everyone else
• Your employees and clients now work with some new company they don’t know

Internal 

Pros: 

• Remain true to your core beliefs as a company
• Remain locally held
• Keep it in the family (if selling to family)
• Smoother transition for your people, culture, clients 
• Your brand carries on (in most cases)

Cons: 

• More challenging
• Lower dollars 
• Longer timeline
• More emotionally difficult

4. Are You Prepared for What Will Happen If Your Exit Plan Doesn’t Go Exactly as Planned?

We’ve talked a lot about building a runway, but not everyone’s runway is the same – and some people don’t get any runway at all.

Unplanned exits can dramatically reduce your options when it comes to maximizing the value of your business or having a say in the future of your business. Maybe you or your partner passes away or becomes disabled, or maybe you find yourself in life circumstances that make it impossible for you to continue running your business.

Unplanned exits are the reason operating agreements exist. In the case of death, disability, or divorce, everything will happen as it appears in your contracts. In many cases, the surviving partner has to buy out the deceased/departing partner’s value and give the money to his/her estate.

Life insurance is a great tool to protect you against what can be a huge unplanned expense in such a situation. The biggest issue I see here is business owners who take out life insurance on their partners once and then never look at it again. Then, when the partner passes away ten years later and the company’s value has gone from 5x to 10x, the old life insurance doesn’t cover the loss. 

The biggest gap we see here is disability insurance. The lion’s share of agreements should address what will happen if one owner becomes disabled, but most don’t protect against this risk because they don’t realize the impact it would have. 

What would happen if your partner suddenly lost their eyesight or had a stroke and could no longer perform their duties? Your legal agreements should identify disability as a triggering event for an exit. That may seem harsh to say, but disability insurance will ensure that your partner receives compensation for their shares. If you don’t have disability insurance, then you’re on the hook for buying your partner out, which could be disastrous depending on your situation.

What’s your exit plan? 

Your exit is inevitable, but how you exit is up to you. By addressing these four questions now, you can help set your business – and your family – up for success when it comes time to sell. 

If you need help, we’re here when you need us.