How To Mitigate Risk With An Effective Exit Strategy

Apr 12, 2017|Mergers and acquisitions
Rodriques Law

Every smart entrepreneur wants to know that they will be getting something out of a new business venture, whether it be money, or the pleasure of seeing the business continue in a family succession or a sale to employees. Whatever the reason for starting a new business, the entrepreneur and her investors want the business venture to be successful so that they may see a return on investment (ROI).

Every new business venture needs to have an exit strategy. One of the reasons that many startups fail is because they lack an exit strategy. An effective exit strategy allows business owners to have a planned termination (or continuation, such as, in a family succession) of a business venture in a way, and at a time, that will maximize returns or limit business losses. The anticipation of returns is why smart entrepreneurs are willing to take the risk.

Successful companies mitigate their risk with a carefully planned exit strategy. Risk mitigation is the process of taking steps to reduce exposure to adverse effects, such as, business failure.

Reasons that may call for execution of an exit strategy include:

  • the company has (or has not) reached a certain milestone, such as, profit margin;
  • lack of access to capital needed to continue operations;
  • partners cannot get along and decide to dissolve the partnership, or a founder simply decides to leave. In some instances when a founder leaves the company automatically dissolves.
  • the business needs new skills, a new approach or resources the entrepreneur is unable to provide.
  • loss of intellectual property, such as, patents, trademarks, service marks, trade names, copyrights, customer lists, trade secrets or other confidential information owned by the company;
  • interest rate trends;
  • company cannot scale further;
  • changes in tax law;
  • changes in the general economic climate;
  • entrepreneur has received a very lucrative offer from another party for the business.
  • legal reasons, such as estate planning, liability lawsuits or a divorce; or
  • the entrepreneur wants to retire, dies or becomes disabled and has no heir to continue the company.

The most popular exit strategies are Initial Public Offering (IPO), Mergers and Acquisitions, and Closing.

Closing

Closing the business may be the best option if your business venture is failing, isn't valuable enough for anyone to want to acquire it, or is the type of business that's unlikely to be valuable without you personally doing all the work (such as, most consulting services). You will sell off the company assets (such as, inventory, fixtures and intellectual property), lay off workers, pay creditors and employees and shut down the business.

However, if you plan to close as an exit strategy, you will make sure to exit at a time when you can raise enough cash from an asset sale to pay all the company’s debts and pay wages. Otherwise, you may have to make formal or informal arrangements to pay off your creditors, file for voluntary liquidation, and declare bankruptcy, and/or be subject of litigation brought by your employees for non-payment of wages. Although the entrepreneur does not, in general, have individual responsibility for the business contracts, debts, and engagements, New York Law imposes personal liability on LLC members and corporate shareholders with the ten largest ownership interests or shares in the company for the failure of the company to pay employee wages. 

Mergers and Acquisitions (M&A)

you can plan to sell the business to qualified buyers, pay creditors and pay back investors. You can transfer ownership of the business to an individual (such as, a third party, partner or key employee) or another business in a merger or acquisition, consolidation, acqui-hire or management buyout.

  • Merger - This is a way for one company to absorb another company. After the merger, your company becomes swallowed up by the acquiring company and ceases to exist. Typically, you and the acquiring company reach agreement on acquisition terms, such as, if you will need to maintain an active role in the surviving company after the merger, or will cash out and walk away from the business.

  • Consolidation – This is a way for two companies to combine to form a new company, usually with a new organizational structure and a new name.

  • Acqui-hire -  This is a way for a purchaser to acquire a company primarily for its talent, rather than a company’s product or service. Often, the talent (generally software engineers) is recruited by the acquiring company and the business acquired is terminated after the acquisition transaction. You should make sure your obligations to creditors and those employees who are not acquired will be satisfied and you’re getting the best deal you can get for your founders and investors.

  • Management buyout – This is a type of acquisition in which the company’s management team purchases a controlling stake in the company. A management buyout (MBO) is typically a favored exit strategy for a private business which owner wishes to retire, and has no family members to take over the company.

  • The preparation for the M&A part of your exit strategy involves making sure that the company is saleable at the time, and you have assembled a team (of experienced advisors) that has the skills and experience to successfully execute the exit. The team must have the necessary knowledge, skills and experience in M&A, Corporate Law, Taxation, Financial Planning and Wealth Management.

    Of course, exit timing is critical. Missing the optimum time to exit means that you may be settling for an exit valuation significantly below market, or not exiting at all. 

    To prepare the business for a sale means that you will ensure that the decisions you make will maximize the value of the company, and make it more attractive to the next owner. If you have something a buyer wants and can't find elsewhere, such as a unique product or distribution channel, they may be willing to pay a premium price. In preparation, you will do anything that increases transparency, efficiency, revenue or profitability, or decreases risk or costs. These include:

    • Build (or hire) a solid management team.
    • Form an advisory board consisting of smart people, who you can trust, who understand your business, and who will ask tough questions and help you find solutions.
    • Bring in outside consultants.
    • Set up and document business processes and systems. This includes an employee manual, an automated accounting system, a CRM system, a marketing and sales process, etc.
    • Clean up the balance sheet and the company’s books, including, proper documentation of financial statements, expenses, invoices, backorders, payroll deductions, benefits and cash management.
    • Maintain the company’s own business bank account, separate from its owners. There can be no commingling of the company’s money and assets with the personal funds and assets of its owners.
    • Drop poorly performing products or services.
    • Terminate insider deals, such as property the company is renting from you or family members.
    • Trim excessive fringe benefits.
    • Make sure the company has paid its taxes.
    • Conduct a financial audit: obtain audited financial statements for at least the last two years.
    • Periodically conduct business (or operations) audits that covers marketing, sales, information technology, customers, partners, internal operations, management structure, compensation, etc. These help spot business issues early so that you can fix them.
    • Protect and enforce intellectual property rights, including, registrations for copyrights, trademarks, and applications for patents.
    • Reduce liabilities. For example, unusually high liabilities (such as a higher than normal level of litigation) is a red flag to potential investors and buyers.
    • Perform recapitalization. This is where the company swaps its debt for equity to improve liquidity. This makes the corporation’s shares or LLC interests less risky, since the company has fewer debt obligations to satisfy out of income. Without the requirements of debt, the company can return more of its profits and cash to the equity investors upon exit.
    • Identify the big players and potential competition within your industry to know if they’re able to present an untapped opportunity to a potential buyer.
    • Conduct a company valuation.
    • Make sure the company has adequate insurance coverage for all major risks.
    • Review all employee, partner, and vendor contracts and policies to make sure the company is in compliance with all applicable city, state and federal laws, and minimize chances of frivolous lawsuits or other legal actions.
    • Talk to your attorney and HR Director and have appropriate stay agreements drawn up and signed by key employees. A “stay agreement” specifies the terms and conditions under which an employee may leave.
    • Start networking with business buyers, other business owners, business brokers, and others.

IPO

Typically, a company chooses to go public when: (a) the company has achieved significant milestones, typically, in the form of sustainable profitability or solid revenue growth; (b) the company needs to raise a huge amount of additional growth capital via the public markets; (c) existing investors, founders, and employees are seeking liquidity: the ability to sell shares on the stock market (where the stock is easily traded).

To prepare for an IPO, the entrepreneur obtains the assistance of an external IPO team consisting of an underwriting firm, lawyers, certified public accountants (CPAs) and Securities and Exchange Commission (SEC) experts. The IPO team helps determine what type of security to issue, the best offering price, draft documents for the SEC, prepare Significant legal & disclosure documents, including, tax, financial or accounting information - to be provided to prospective shareholders - and files its prospectus with the SEC via a S-1 filing. 

A company that is planning to go public usually starts to plan 12-18 months in advance. To go public, a company needs to be formed as a C corporation and have a valuation in the hundreds of millions. 

An IPO is an expensive and lengthy process that involves considerable risk, and the company will need to be ready for the scrutiny and exposure that comes with being a publicly traded company.