Plan Your Exit Before Entering into a Business

A study conducted in 2007 by the Center for Women’s Business Research titled “Exiting Your Business: Serendipity or Strategy” and underwritten by Massachusetts Mutual Life Insurance found that the majority of small business owners do not have any well defined strategy for exiting their businesses. The study also found that 43% of the business owners interviewed had never conducted a formal valuation of their businesses and that at least 67% of the interviewees had no documented sales plan. The study further revealed that business owners who lacked exit plans failed to respond in time to changing markets and were the most likely to close down their operations.

Successful businesses both begin and end in profits and excitement for the owners. The owners may be compelled to discontinue a business for any number of reasons, most of which may not include financial failure of the business as a component. However, it is hard to retire from a business without having a clearly defined exit strategy and a proper valuation of the worth of the business made according to industry-defined standards. So, one needs to plan for an exit even while entering a business and run the business as if every day might bring a purchaser willing to buy it. In fact, a lot of successful businesspeople have made careers out of building up businesses and then selling them off at a profit. And even though you may not take that particular approach toward making money, following the patterns and attitudes of such entrepreneurs can make your own business safer and more secure.

As Marshall B. Paisner explains in his book Sustaining the Family Business: An Insider's Guide to Managing across Generations, “too many owners of family businesses fail to execute a plan. When it comes time for them to retire, the only sensible exit strategy is to go public or sell out. If your goal is to live a certain lifestyle, you must make arrangements early on” (Paisner, pg. 115). However, going public is not an easy option, and as Paisner points out, “The use of public money as an exit strategy is at best risky and at worst a disaster. . .if you choose this route and hit a string of bad years or make one poor management decision, the roof can fall in” (Paisner, pg. 157).

So, for most business owners, selling at a profit is usually a better option than trying to go public. However, to do that one has to plan from the very beginning of entering a business and run the business every day as if the business could have a potential purchaser at any moment. So, one has to learn to value one’s business according to market standards and run one’s affairs in such a way that transferring ownership of the business can be both smooth and lucrative.

To make this process and an exit plan feasible, one has to:

Create the business in such a way that the business and the owner become separate and distinct legal entities
Put into place a process for valuing the business at periodic intervals according to parameters that match IRS standards

The usual practice in the market is to follow one of four methods when attempting to determine the value of a business for sale or purchase. These are:

Owner’s Benefit: Here the annual discretionary cash flow expected from the business in a year is calculated on the assumption that most businesses prepare accounts with an aim towards minimizing income taxes. Even highly profitable small businesses have been known to operate with low net incomes shown in their account books.
“Rule of Thumb”: Here the worth of a business is calculated by multiplying the gross profits before interests and taxes by a number from 3 to 5 depending upon the circumstances. The lower the amount of tangible assets held by the business, the lower the multiplier.
Asset Valuation: This method includes accounting for things like fixed assets and equipment, fair market value, inventory, goodwill, etc. The value of an asset-driven business is usually calculated by adding an “owner’s benefit” to the asset valuation.
Industry Average: Here the business is valued by comparing it with similar kinds of businesses sold in the recent past.

All of this said, one does not need to rely on an approximate valuation if the accounts of the business are clear and periodic assessments are made according to IRS standards.

When considering the sale of a business, one also needs to be aware of proper timing; it is always good to sell a growing business when interest payments are low, assuming a firm decision to exit the business has been made.

Reference:

Marshall B. Paisner, Sustaining the Family Business: An Insider's Guide to Managing across Generations (Reading, MA: Perseus Books, 1999)

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Plan Your Exit Before Entering into a Business