Next Article: Closing Up Shop
Exiting Your Business
Many startups begin with the expectation of capitalizing on the firm’s value through a later exit event. An exit event is any method by which the entrepreneur divests herself of her ownership interest in the firm. This section discusses various methods for the entrepreneur to the startup venture.
Overview of the Decision to Close Down Your Business
You may determine that you no longer can or want to run the business. In that case, you may decide that shutting down the business is more advantageous than attempting to sell the on-going operations to someone else. In this case, you will need to follow several steps to undo all of the activity you undertook in setting up the business.
Checklist for Closing Down
Organizational Decision to Dissolve – Depending on whether you are operating as a sole proprietor, partnership, or other business entity, you will need to follow the requisite formality in reaching a decision to dissolve the business. In a sole proprietorship, the owner can unilaterally decide to dissolve the entity. In a partnership, any partner may be able to cause dissolution and trigger a winding up of the business by any number of activities. In an LLC or Corporation, however, the decision to close the business generally entails the decision of the members or shareholders to dissolve. Any such decision must be documented in accordance with the default entity rules or the governing documents for the business.
Wind Down Business Affairs – Winding down the business affairs entails the procedural steps for stopping operations, notifying all interested third parties, settling the affairs of the business, and extracting any remaining business value for the business owners. Below are the major steps that one must undertake in shutting down any business.
- Halt Operations – This means stopping the process of selling your product or performing your service. Generally, this will requires extensive notification of all interested parties. For large employers, this may entail legal notification requirements, such as under the WARN Act or similar state law.
- Notify Interested Parties – The list of interested parties goes much further than just your employees. You will need to notify any Debtors, Creditors (particularly lien holders), Suppliers, Customers, and Employees. Often state law will require a business to publish notice of dissolution in a newspaper of general circulation for a specific amount of time.
- Cancel Contracts (service/supply/purchase contracts, leases, etc.) – Individuals affected by the cessation of operations need to know that business is permanently halted. You may need to extend contractual performance and payments out until the date of dissolution.
- Inventory All Assets and Liabilities – The creditors and owners of the business will want to preserve all of the residual value of the business to be dispersed to claimants in order of their priority. Determining the net value available for distribution is the first task.
- Sell Inventory – In a heavy inventory business, there may be substantial value in unsold inventory and materials.
- Liquidate Assets – Once operations have ceased, you can now sell of the operational equipment. It can be difficult to find a purchaser for reasonable value. This process will often require the satisfaction or release of liens by creditors.
- Collect from or Settle with Debtors – Much of the residual value of the business may be in the form of debts owed by creditors of the business. You will want to collect any unpaid debts or settle unpaid, contested debts for a stated amount.
- Pay or Settle Business Debts – The residual value of the business is distributed in order of priority of the claimant. Secured debtors are paid first, unsecured debtors are paid next, and finally, owners of the business receive any remaining value.
- Distribution to Equity Holders – Distribute any remaining assets to owners (equity holders). This may require valuation of remaining assets by a professional.
- Cancel Accounts – Early in the dissolution process, you will cancel any lines of credit, credit cards, etc., that are not necessary for winding up the business. Some accounts may not be able to be closed until assets are sold or other funds collected. Closing bank accounts should be last, as you will need a place to store the funds collected from the liquidation of assets, collection of debts, etc.
Dissolve State Entity – This requires sending in a notice of dissolution to the State Secretary of State’s Office.
Notify Local Government (Permits and Licenses) – You may need to give your country or city government notice of your dissolution. This will include canceling any local permits, business licenses, or D/B/A filings. There may be other notification requirements specific to your locality.
Settle all Tax Accounts: Settling tax accounts may be the most procedurally daunting part of winding down a business. You must account for capital accounts, distributions, employment taxes, etc. See http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Closing-a-Business-Checklist for a description of the various final tax filing requirements. I recommend searching your state’s Department of Revenue website for information on closing state tax accounts.
Maintain Records – Business dissolutions are frequently challenged by regulatory and taxing authorities. Business owners should maintain records for seven years.
Deciding to Sell
Selling a business is commonly the objective of startup ventures. Many factors go into the decision of when and whether to sell a business.
Valuing the Business
Numerous methods exist for valuing a business. The method relied upon generally corresponds with the type of business, the stage of the lifecycle, and the type of investor. We advise consulting a professional who has experience valuing your type of business. We discuss valuation methods further in our Startup Finance Resources. Here is a brief list of categories for valuing a business:
- Asset-based Methods
- Market-based Methods
- Cash-flow Methods
Sometimes buyers approach the business to initiate discussion for sale. Other times the business owner actively searches for buyers. Finding potential buyers is often difficult and many business owners business brokers who have experience in handling the sale of businesses. The sale of larger businesses may require additional help from either a commercial bank, CPAs, and attorneys. Depending on the type of business, potential buyers expressing interest in the business is a common occurrence. Startup ventures attract a great deal of attention from potential investors and acquirers. Startups often receive interest from dozens on interested, potential buyers before arriving at a deal. Meanwhile, lifestyle businesses are rarely approached by potential buyers unless he or she is serious.
Negotiating a Deal
Deal negotiations, like other parts of the buying/selling process, vary depending upon the type of business. The sale of a startup generally begins with an inquiry from a potential buyer. During this phase, a potential buyer is made privy to the information necessary to do a cursory evaluation and value the business. After some preliminary discussions, the parties often engage in term sheet negotiation. This process lays out the major provisions of the purchase. The parties then enter into a stage of due diligence. Here the buyer employs professionals to verify the structural, operational, financial, and legal stability of the business. Once any issues associated with due diligence are negotiated, the deal is memorialized in a purchase agreement. The terms of the purchase agreement are fairly standard. One important aspect of the deal that may vary between deals is the method for financing the sale.
Financing the Sale
Financing of a business sale comes in a variety of forms. In the case of smaller businesses being acquired by a larger business, the larger business may be able to pay cash for the purchase. In the purchase and merger of smaller businesses, there is generally either seller financing, bank financing, or some combination of these financings involved. Other financing deals include the use of cash, debt, and equity of the acquiring company. Acquisitions of larger companies generally consist of detailed and complex financing arrangements involving multiple types of debt. The issue of buying and selling a business is discussed further in the Startup Financing Resources.
Overview of Private Equity
Private equity is a broad term that refers to various classes of equity financing arrangements (such as venture capital investment). More specifically, however, private equity refers to the class of equity financing. Private equity refers to investments in mid-to-large companies by private equity firms. These firms often purchase a controlling or all of the interest in a company. The private equity firm holds the purchased company for an intended period of time (3 -7 years) and capitalize on the company’s growth at the end of the term by selling the company. Private equity is a form of intermediate owner that comes after the early growth stage of the business. Private equity firms generally use a common practice known as leveraged financing to purchase the company.
How Private Equity Works
Private equity firms form an investment fund and seek funds from any variety of investors. Investors generally commit funds for a period of 7-10 years. The fund managers select companies in which to invest the funds with the intention of selling the companies and recouping the investment and profit within 3-10 years of the investment. The investment is generally a purchase of all or a controlling share of the company’s equity. In some cases, private equity firms and private investors or other private equity firms will join together to purchase larger companies.
Generally, there is insufficient investment cash in the private equity firm to complete the purchase. The PE firm has to employ various forms of debt financing to complete the purchase. The debt providers are banks or other private lenders. This is because loaning the entire amount may be too risky for a single lender. This structuring of debt gives rises to different classes of debt with different level of priority of repayment (e.g., senior debt, mezzanine debt, bridge debt, etc.). A lender that has a lower priority for repayment bears a higher risk of loss. As such, the lower the level of priority, the higher the interest rate charged by the lender. The PE firm posts the shares of the acquired company as security for loans to purchase the acquired firm.
The PE firm later makes money by exiting the venture at a far higher valuation. PE firms either sell the company to other PE firms that believe the acquired company has additional growth potential, sells the firm to a larger company that gains some strategic advantage by purchasing the firm, or take the firm public through an initial public offering.
What is a Public Offering
A public offering is the sale of a company’s shares to the public. Most businesses have shares that are owned by individuals. These shares are not openly sold in a public market or exchange; rather, the business ownership is “closely held”. The public offering makes the shares available for purchase by the public without general restriction. In some cases, the shares will be sold on a public exchange. In other situations, the shares are sold in private deals known as “over-the-counter” transactions.
Why Go Public?
Going public is a method of acquiring additional funds for the operations and growth of the company. It is a primary method by which current owners exit the firm. The existing shareholders are able to sell their shares to future shareholders. In many cases, the existing business owners will sell only a percentage of their ownership interest.
The Process of Going Public
Going public, often referred to as an Initial Public Offering (IPO), requires the registration of a company’s stock with the Securities and Exchange Commission (SEC). The law governing the IPO is the Securities and Exchange Act of 1933. The SEC requires extensive disclosures to the public of information about the company and the offering. Failure to closely adhere to the regulations prescribed by the SEC can lead to both civil and criminal liability. The intricacy of the IPO process generally necessitates the use of professional service providers. For example, most IPOS involve commercial banks that manage the sale of the shares to the public, law firms who negotiate and memorialize the deal, and business consultants who plan the operational aspect of the offering. These banks serve as intermediaries between the company and the purchasers of shares. If the shares may meet the requirements to be traded on a public exchange. The exchanges have their own requirements for the companies selling their shares. A public company must meet continued disclosure requirements to the public and its investors. The continued disclosure requirements are governed by the Securities and Exchange Act of 1934.
Bankruptcy is a common method for business owners to exit a business venture. Technically, a business is bankruptcy when its liabilities exceed its assets. Most notably, however, when a business fails to produce sufficient profits to continue operations, the result may be the need to shut down the business or to restructure the business’s liabilities (debts).
Shutting down a profitable business is far easier than shutting down a business that has outstanding debts that it cannot pay. In such a case the debtors of the business often argue over who gets paid how much. The bankruptcy process is an orderly way of administering the assets (or cash) of the business to those who have the highest claim of right or priority.
Reorganizing the liabilities of the business is often fraught with disputes with creditors. Again, the bankruptcy process provides an orderly manner of distributing the available assets to those with the highest priority. Reorganization, unlike liquidation, allows the business to continue operations. After the reorganization, the business is treated similarly to a new business entity.
Types of Business Bankruptcy
There generally two types of bankruptcy Chapter 7 (liquidation) and Chapter 11 (reorganization) under the US Bankruptcy Code. All bankruptcy proceedings are federal in nature. As such, bankruptcy law and procedure is relatively uniform across all states (with limited exception for state exemptions).
Chapter 7 Bankruptcy – This is a liquidation of all of the assets of the business. It is an organized procedure whereby all the assets of the business are collected and sold. The value of the assets is distributed to the creditors in the order of their priority. Secured creditors must be either paid in full, or the collateral securing the loan is turned over to the creditor. Unsecured creditors are next in priority. Owners of the business will only receive value from the liquidation once all creditors are paid.
Chapter 11 Bankruptcy – This is a reorganization of the business’s liabilities. It requires the business to put for a plan for using all available profits from operations to pay toward its debts. Secured debts must be paid in full. Unsecured debts receive a payment toward the existing debt for a stated period of time. These payments are almost always less than the actual debt. Once the business makes payments on the debts for a stated period of time, any remaining debt is extinguished. The business is free to continue operations free of the pre-existing debts. The difficulty associated with a Chapter 11 bankruptcy is the ability to work out a payment plan with secured creditors and not have to surrender key business assets.