In Part I, we pointed out that runners would never start a race without knowing where the finish line is. The same holds true for a new business owner. When you’re starting a business, you should give thought to how you’ll want to finish it. Exit strategies include: (1)) selling all or a portion of the enterprise, (2) passing the business to a family member, (3) selling to an Employee Stock Ownership Plan (ESOP), (4) taking the company public, and (5) liquidation. These five options were fully explained in the last segment of this article.Once you have an exit strategy in mind, you’ll be better prepared to make some addition decisions. These are: (1) selecting the source, type, and amount of capital you will need for your business, (2) deciding on the current form of organization or legal structure (sole proprietorship, partnership, or corporation) that will best serve your needs, and (3) considering the tax issues that will impact your business.Financing Your Business
Your choice of financing (source of capital) is important and will directly influence your choice of exit. When considering financing options, keep in mind not only the ease with which you can raise the funds you require to reach your goals, but also the costs of each type of financing in terms of both money and relationships. In the simplest sense, capital is available from four sources: (1) yourself, (2) friends and family, (3) financial institutions, and (4) the public at large. The monetary cost of each of these options is generally inversely proportional to its personal or “relationship” cost.
- Yourself (owner financing): The first question you should ask yourself is: “Do I really need additional financing to meet my goals, or do I just need to manage my cash flow effectively?”
- Friends and family: Friends and family can be the easiest, quickest, and least expensive form of financing. However the emotional or relationship cost can be very high. What if your business fails and you are unable to repay your friends and family? Receiving funds from a traditional lender or a venture capital firm will take far longer, but failure to repay them isn’t likely to affect your family gatherings.
- Financial institutions (debt capital): In the middle is the traditional bank or finance company. Like the venture capitalist (below), they want to see a completed business plan before loaning any money to you. However they don’t tend to focus on your exit. Instead they focus on their exit, which is repayment of the loan when it is due along with interest and other applicable fees. These lenders want to see that management will be able to generate sufficient income and manage cash flow in such a way as to ensure timely repayment. They typically require personal guarantees of the owners and often will require additional collateral, such as a lien on your house or other property, to further ensure repayment.
- Venture capitalists (equity capital): Venture Capitalists typically invest in opportunities in which they expect to earn a high compound rate of return and that will provide an exit (return of their capital along with a return, or profit, on that capital) within five to seven years. They require a complete business plan with a strong exit strategy. Exit in this case is usually via an Initial Public Offering (IPO) or acquisition by a larger (often public) company. In either case, such an exit typically results in a change of management and loss of control of the entity by the founders. While the Venture Capital option can be attractive, obviously it is not appropriate under many circumstances.
Dealing with Legal & Tax Issues
It’s always a good idea to seek the advice of an experienced corporate attorney and a business accounting professional. Since laws vary from state to state, it’s best to choose advisors familiar with the state in which you will operate and live. The determination of financing needs has a direct bearing on the form of legal structure you will want for your business. Thinking about your exit strategy will provide the basis for determining the form or organization that will best serve your needs as you pursue your goals. If you are a new business and the choice is not clear-cut, your attorney and tax advisor can help you make the best decision. Alternately, if you are a current business that is planning to expand through the use of debt or equity capital, you may be advised that you need to change to a legal structure that will enable you to protect your personal assets and to insure your ability to deal with your lender or investor.
1. A few of the legal issues which you and your advisors need to consider:
- Liability of owners, directors, and officers: Owners, directors, and officers may become liable for the actions and debts of the company in certain events. Reasonable protection from such liability can be achieved by a combination of effective use of elections and structuring alternatives and supplemented with Directors and Officers (D&O) insurance.
- Applicability of State and Federal securities laws: Rules regarding solicitation of investors are complex and require close compliance to avoid civil and criminal penalties.
- Rights of minority owners: Access to books and records and minimum disclosure requirements create obligations requiring strict compliance.
- Ease and cost of transfer of ownership: Depending on your time frame for exit, some legal structures are easier to deal with than others.
- Buy-Sell Agreements among partners or shareholders: Terms and conditions for buying out a partner/shareholder or their heirs should be spelled out clearly up front to avoid later disputes.2. Some of the tax issues to be considered:
- Treatment of capital gains upon the sale/transfer of the business: Tax events need to be planned far in advance. This includes available tax elections to minimize taxes incurred when all or a portion of your interest in a business is sold.
- Corporate and personal taxes: Proper structuring can strike an optimal balance between corporate and personal taxes and avoids double taxation.
- Title to any real property owned: Certain property may be best owned by partners/shareholders individually and leased to the business in order to achieve the lowest overall tax bill.
- Reasonable compensation limits: The IRS and state taxing authorities can set limits on the level of salaries to owner employees. Payments in excess of these limits become dividends that are taxable to the owner and not allowed to be deducted by the corporation.
- Retirement plans: A strong retirement plan can be a key tool for attracting high-quality employees as well as providing for the owners’ retirement. A wide variety of plans exist ranging from simple IRAs to complicated 401K plans. Each has advantages and limitations.
- Unrelated business income: If you’re planning to start a “not-for-profit” corporation, which is not subject to normal income taxes, you will need to follow specific guidelines restricting the types of revenue you can generate. Sales of products unrelated to your not-for-profit business purpose may subject the organization to taxation.
Just Makes Good Sense!
I think that by now you can see that thinking in terms of your future exit strategy will help you with your financing decisions and with your legal and tax considerations as you write your business plan. Obviously the less complex your business is, the fewer decisions you will have to make.
It doesn’t matter whether you’re writing a business plan for a new business or for an existing business that is moving in a new direction. Business planning is an ongoing process. As you continue to operate, your goals may change radically. The current and future goals and their impact on your exit strategy need to be continually reflected in your business plan.
With your vision established and sound financial, legal, and tax strategies decided upon, you can confidently build your business plan and …. start the race with the finish line in sight!
Linda Pinson runs an award-winning small-business publishing company called Out of Your Mind… And Into the Marketplace. She is also developer of the software, “Automate Your Business Plan 9.0,” and author of the book, “Anatomy of a Business Plan.” You’ll find her Web site at www.business-plan.com. John P. Neal is an expert in business exit strategizing. He is CEO of the Ace Group Inc. of Solana Beach, California.