When you are creating a business plan, you need to describe your exit strategy. This is your long-term plan for how you will ultimately sell your business and, hopefully, make a lot of money in the end. For many business owners thinking about selling their business is the last thing on their mind. Unfortunately, failure to come up with an exit strategy in the very beginning of your business could result in your being unable to raise business funding. Not planning your exit strategy can also result in your paying much higher taxes on the sale. Unfortunately for many businesses, a failure to plan an exit strategy results in failing to sell the business when it’s at peak value. All too often when these business owners do decide to sell, there are no offers on the table to buy them.
One of the main reasons why it is so important to have an exit strategy is that it’s necessary for raising outside business funding. An Angel investor or venture capital firms will always want to know up-front when they will be able to cash out of the business and move on to the next deal. Most investors have a particular investment time horizon. On average, it is about four to five years. These investors will walk away from any deals that don’t have a well-thought-out plan on how everyone is going to walk away with their investment and profit from a deal after a certain time frame
One important element of your exit strategy is your selection of your business entity. Choosing the wrong business entity in the beginning can have major tax consequences when it comes time to sell your business. For example, if your business is a C-Corp and you sell your business’ assets using an asset purchase agreement, you will be subject to double taxation. In addition, many of the assets being sold will be taxed as ordinary income rather than as a capital gain. Currently top federal income tax bracket for ordinary income is 39.6%. In contrast, the top federal bracket for long-term capital gains is 23.8%. An asset sale can also trigger state sales tax. Fortunately, double taxation, having to pay taxes using the higher ordinary income tax rate and having to pay sales tax can be avoided if you have a good exit strategy. For example, if your C-Corp is converted to an S-Corp ten years prior to the sale, you can avoid double taxation onan asset sale. You can learn more about how C-Corporations can avoid double taxation on a business sale in the article How a C-Corp Can Avoid Double Taxation When Selling a Business. In another article titled, Tax Planning to Reduce Taxes When Buying a Business, you can learn more about how to structure your business sale so that you minimize your taxes.
For some businesses, their exit strategy is to find another business that wants to buy them and cash out. As a result, their ultimate goal is to make themselves attractive to acquisition candidates. Acquisition is by far the most popular exit strategy. Oftentimes, it yields the most profit to the sellers because the acquirer will value the business much higher than what would be justified based on income.
Choosing the right business entity can greatly simplify and speed up another business acquiring your business. In most cases, having your business structured as a C-Corp will make you a more attractive acquisition target. This is because there are no limitations as to who or what entity can purchase stock in a C-Corp. In contrast, S-Corporations can only sell stock to natural persons. In addition, shareholders of an S-Corp must be US citizens or legal US residents.
If your exit strategy is a public stock offering (IPO), you need to set up your business as a C-corporation. This is because investors will want tangible evidence of their partial ownership in your business in the form of corporate stock certificates. This is not possible with an LLC. S-Corporations are also a poor candidate for IPOs because they can only have one hundred stockholders.
It is important to keep in mind that in most cases an IPO is not a desirable exit strategy for most businesses. This is because they don’t have the scale to justify the underwriting fees. For this reason, and many others, only 222 firms held initial public offerings in the U.S. in 2013. In contrast, over 7,000 small businesses were sold in the US during the same time period.
In summary, it is important to think through and spell out your exit strategy when you are creating your business plan. Having a good exit strategy can make the difference between whether you can successfully sell your business in the end. It can also greatly increase your profit and minimize your tax liability on the sale. One of the most important elements of a good exit strategy is choosing the right business entity. Once you’ve determined what business entity is best suited for your business, I would recommend using LegalZoom.com to help you with the process of setting it up.
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DISCLAIMER: This site and any information contained herein are intended for informational purposes only and should not be construed as legal advice. Seek competent counsel for advice on any legal matter.
Written by: Mark J. Krupp, Confounder of NewBusinessCreator.com