When It’s Time to Consider an Exit Strategy For Your Business

This article originally appeared on The Financially Independent Millennial and was republished with permission.

Many people say a business plan is a key element for any start-up business. But in many cases, not just an operating plan, but a business exit strategy needs to be considered upfront. An exit objective and strategy may affect the business plan. And it may affect the best operational model for running a business. It’s never too early in the lifecycle of a business to begin thinking about an exit strategy for your business.

An exit strategy is especially important at start-up in these situations:

When the growth cycle of your business may require a large infusion of capital at a future point and you don’t want to put money at risk.

Going to market with revolutionary products takes a tremendous amount of capital. The same applies to building many other types of businesses like software companies or service companies. Businesses with slow cash flow also demand high levels of capital. Often, it makes sense to build these businesses to a certain level and sell them rather than lower profits through borrowing or diluting ownership by seeking investors needed to secure capital.

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When you plan or hope to get out of the business at a certain age or after some number of years

If you’re running a small business and hope to retire 3 years from now, it might make sense to sell now.  Many purchases will want you to stay to transition for some number of years. If an employee buyout is a plan, you might need to collect installment payments over several years before transitioning the business. Few employees have the cash needed upfront to buy you out.

Downturns in the market can greatly affect your business. Your plan needs to realize you might be financially better off selling your business now and staying two years than gambling on market conditions two years from now.

When there may be tax implications of not exiting the business at the right time

Some individuals who are planning to immediately sell their business may be regretting that they didn’t do it last year. Tax law changes currently being discussed could end up costing entrepreneurs a lot of money. Income thresholds might cause some business gains to be taxed as ordinary income instead of as capital gains.

An installment sale might provide more favorable tax treatment in a divestiture. An installment sale is a sale of property where you’ll receive at least one payment after the tax year in which the sale occurs.  If you need the money from the sale of your business in 2025, you might want to sell in 2022. Then, save money on taxes through a 3-year installment sale. This requires advance tax planning.

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When multiple parties are involved in operating a business that is not liquid there needs to be an agreed exit plan or point

If your business partner gets divorced, you may need to be prepared to buy out 25% of your business. Do you have the cash to do that, or are you about to begin a court-ordered fire-sale of your business?  Will the court order a sale of your business if your partner dies? Have an exit plan and rules dictating what happens in these circumstances.

At what other points might an exit strategy really matter

When you have achieved your financial objective with the business

You need to be prepared for this day and positioned to capitalize on it when it arrives.

When further investments in growth will not yield a desired level of return 

Sometimes, a business reaches a point where investing additional time and money is a business that will yield only modest returns. At this point, the business owner has a financial incentive not to further invest in operations. This is generally a good time to sell.

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When earnings from a sale of the business and future investments exceed what you might get through continued operations

If your business is yielding a 4% return on capital and someone offers you the right valuation, you might actually make more by divesting and investing than by continued operation.

When you have achieved your long-term financial goals with the business

If your goal was to retire when your business was worth some number, and you’re there, it’s too late to start thinking about getting out. The process of preparing to sell needs to start sooner. Securing multiple bidders requires time and preparation and is a key to receiving maximum value for your business.

When you desire to extract accumulated value from the business 

There’s always a risk of loss of underlying value through continued operations. A declining economy, loss of a major client, new competitors, loss of key personnel can lower the value of your business. In many cases, selling is the only way for an owner to access the value they have accumulated in their business.

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When the business is worth more to someone else than it is to you  

Sometimes, a buyer comes along that can get tremendous value from your business because it’ll provide economies of scale. This might be because they can lower SG&A expenses as a percentage of sales. Or, it might be because of an opportunity to eliminate redundancies. And there might be an opportunity to drive additional sales through an expanded distribution channel. Regardless of the reason, when this happens, selling usually results in significantly more earnings that could be achieved through organic growth.

Unquestionably, owners who don’t have an exit strategy can lose business value. And they can have a less favorable outcome if they’re forced to exit because of illness, death, disability, disputes, family circumstance, etc. Such an exit may be financially less desirable and almost certainly will lead to a less favorable situation for employees and minority shareholders.

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Few business owners divest at a point of maximum value. Owners are most often focused on selling, growing revenue, building profits, adding new products or services. Few are thinking about a plan to get out. To successfully exit, a business owner must focus on building “Salable Value.” The salable value may be affected by things other than revenue itself like long-term contracts, margin, trademarks, copyrights, the strength of the management team, competitive advantages, and other factors. So, entrepreneurs need to think about building up these elements, not just building revenue.

Building salable value, thinking in advance about exit timing, and having an exit strategy is important from the very beginning if an entrepreneur wishes to receive maximum value for their efforts.

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