For ambitious entrepreneurs, the creation of a business that solves real problems and galvanizes team members as well as stakeholders around a compelling mission, represents a pinnacle of achievement. However, an equally exciting stop on the founder’s journey can be – for some – a successful exit.
The concept of an ‘exit’ often conjures images of selling to private equity firms or strategic buyers, or the glamour of an Initial Public Offering (IPO). But what if your vision involves a different path – such as remaining with the company post-sale, transitioning ownership to employees, or navigating industries where earn-outs aren’t standard? A well-orchestrated plan can open doors to various tailored exit strategies.
The intricacies of exit planning
Preparing for an exit requires meticulous planning, akin to the rigor of building the business itself. Successful founders can be blindsided by unexpected, lucrative offers. Amidst the rush to present appealing financial metrics, the broader implications – for yourself, your employees, and investors – can be overlooked. Ahead of any potential exit, you will need to get your financial house in order. The structure of your company (e.g., C corp, S corp, or LLC) can also be an important consideration. For example, if your company is structured as a C corp, gains on the sale may be exempt from federal tax if it qualifies for qualified small business stock treatment.
— Brian Gaister, Co-Founder, Pennington Partners & Co., SaaS Ventures & PTM Partners share
Founders, owners, and general partners should take a proactive and thoughtful approach to minimizing income tax and future estate tax liabilities by planning before a sale.
Here are five options that could serve as a useful starting point for founders who want to start thinking about a potential exit.
1. An IPO
An IPO is often the target goal for many founders, but it is not often the outcome. While one of the more widely understood and preferred exit options, fewer than 1% of seed-funded startups will go on to become publicly listed.
For context, going public is the process of listing and selling shares through a public stock exchange or over the counter (OTC) market like the New York Stock Exchange (NYSE) or Nasdaq for subsequent trading or quotation on the OTC bulletin board (OTCBB). In the IPO process, a private company makes the transition to becoming a publicly held corporation. In the United States, a public company is subject to Securities and Exchange Commission (SEC) regulations, registration of securities, and significant reporting requirements. Still, an IPO can be an ideal outcome financially and can support the next leg of growth for the company. There are several key planning considerations if this is an exit option you wish to pursue.
At least 18-24 months prior to the anticipated IPO date, start the planning process so you can get all the pieces in place exactly when needed. You will need a strong team of advisers (attorneys, accounting firm, investment banker) and a management team with at least a few members who have been through an IPO already. Prospective investors base a large part of their decision to invest on the quality of management. Ideally, your company should start acting like a public company at least 12 months before you plan to go public. That means closing the books every month and producing quarterly and annual audited financial statements on a timely basis. These are just a few of the key considerations.
2. Sale to a strategic buyer
Another option is selling to a larger company that can either take your business to the next level or integrate your products and services into their existing offerings.
One thing to consider here is that if you want to stay involved in the business after giving up the final decision-making responsibilities, you may be able to use an earnout. An earnout is where a small portion of equity is sold (and proceeds distributed) each year if revenue or profit targets are met.
Please note that this is typical in some industries (such as professional services) and can be required if the new owner wants to ensure some continuity in the transition. On the other hand, some strategic buyers may have management in place to assume responsibility for the acquired business, which means you will be expected to take your sales proceeds and move on from the business.
It is critical to know what is common in your industry and what is expected if this is the exit option that you decide is best to pursue.
3. Sale to employees through an ESOP
An employee stock ownership plan (ESOP) is a way of granting company stock to employees and is often based on their tenure of employment. It is one of the most powerful ways to align the interests of employees with those of the company – increasing productivity and market cap.
It is also a way to reward employees and give them the chance to lead the business once a founder decides to exit. With an ESOP, business owners will sell some or all their shares to an ESOP trust. This trust owns the shares on behalf of the employees, providing beneficial ownership of the company to all qualified employees.
As the business grows, so does the value of the shares that are allocated to employees. This creates a direct connection between the success of the business and the financial benefits to employees.
4. Partial or majority sale to a private equity investor
The private equity (PE) industry has grown substantially over the past several years and now exceeds USD11.7 trillion in assets worldwide. These firms employ sophisticated financial professionals whose sole focus is buying businesses, making them more profitable, generating a return for their investors, and then exiting (often within a three-to-five-year time frame).
Private equity investors often pursue investments in companies that can generate cash consistently. They prefer to use their network to grow the business and either combine it with others in their portfolio or sell it to an even larger firm or competitor. If you consider a sale to a PE firm, two common deal structures are a majority recapitalization or a full buyout. A majority recapitalization lets you sell most of the business while retaining a minority interest and staying on with an equity stake in the company.
If you are interested in staying on for a little longer to get a “second bite of the apple” from selling your minority stake in a few years, the PE firm can help you achieve this. To determine if your goals align with the PE firm, consider if you want to sell your entire company or remain with the business for a few more years and only sell a portion of it. If you only want to sell a portion, you should think about what level of management you would be comfortable with.
5. Debt-financed recapitalization
Lastly, while this is not an exit in the traditional sense, some owners may want to simply change their current ownership arrangement. Recapitalizing their business with debt can potentially lower the cost of capital while allowing owners to retain some control in the process. This may set them up better for a future exit down the road.
The amount of money borrowed depends on many factors, such as the company’s cash flow and balance sheet and its ability to pay future financial obligations. There are, however, some disadvantages with this approach as well.
For one, debt providers require some sort of personal guarantee from the business owners, who will need to objectively evaluate whether they can take this additional risk with their business. The debt providers will also require additional corporate reporting requirements. Further debt that is taken out on the business could increase the burden on its cash flow, which may make it more difficult to secure additional financing of any kind in the future.
Tailoring your exit to your vision
Overall, there are several options that you can and should explore as you consider an exit. But like anything, the right planning is crucial. Knowing which option is best for you requires careful consideration of your personal preferences as a founder, the state of your business, what is common in your industry, and the macroeconomic picture at the moment.
Each exit strategy harbors unique opportunities and challenges. The right choice hinges on personal aspirations, business maturity, industry norms, and the broader economic landscape. Thoughtful preparation enhances the likelihood of a successful exit and also ensures alignment with your long-term entrepreneurial vision.
