Planning for Their Exit: Advising Business Owners on an Exit in a Heightened Interest Rate Environment

May 31, 2024 10:00:00 AM


Planning for Their Exit-Blog

By Donald P. DiCarlo Jr. and Matthew T. Lee

Much has been written recently about rising interest rates and the impact it can have on various wealth and tax planning strategies. For the closely held business owner who is interested in selling their business—which is often their most valuable and prized asset—it is important for advisors to understand how interest rates might affect the exit plan.

This article examines four primary strategies a business owner might use when selling their business, namely, selling to a third party, to insiders, to employees, or to family members; how the current rate environment might impact each strategy; and the planning opportunities that advisors and their business-owning clients might consider in planning for a business owner’s exit.

Interest Rates and Closely Held Businesses Generally 

In response to the highest inflation in 40 years, the Federal Reserve began raising interest rates in March 2022 and continued to do so until late 2023 before pausing further rate hikes and indicating an openness to lowering rates again over time. Closely held business owners, like others, have felt the impact of rising rates in various aspects of their lives, but perhaps most significantly in their businesses. 

The nature of the business and the industry itself generally determine the extent to which any particular business owner is affected by interest rates. Some industries are especially susceptible to rate movements, including those that rely heavily on loans for acquisition, expansion, and operation, as well as companies in every industry that are particularly rate sensitive by virtue of their leveraged capital structures.

Companies that are rate sensitive may be particularly impacted by these increases in their cost of capital, cash flow, and profits, among other things. For those contemplating an exit, rising interest rates could in turn translate to lower valuations in the marketplace, as the rising rates could exert downward pressure on multiples and thus the price a buyer is willing to pay for an acquisition. Despite this, there may be silver-lining planning opportunities regardless of whether a business owner is considering a sale to a third party, insiders, employees, or family members.

Sale to a Third Party

Business owners who decide to sell to an outside third party generally want to maximize profit and therefore are most likely to consider selling when a buyer is willing to pay maximum value. Third-party buyers might be considered strategic buyers (e.g., a competitor) or financial buyers (e.g., a private equity fund). Strategic buyers in particular may be willing to pay a premium where they can create synergies that substantially increase their bottom line.  

Generally, sales to strategic buyers are less likely to be affected by increased interest rates than sales to financial buyers. While strategic buyers may utilize leverage in a transaction, as long as the cost savings created by the merger are greater than the higher interest expense, it may still be a worthwhile acquisition. Financial buyers, on the other hand, typically finance a large portion of the acquisition cost, so a sale to a financial buyer is more likely to be affected by higher interest rates.  

Creativity in the terms of the deal could counterbalance a softer market and price reductions for business owners selling to a third party. While a financial buyer may offer less cash up front, they may be willing to structure the deal to include other features that could be beneficial to the owner, especially over the long term. This could include receipt of rollover equity, which could provide tax and other planning opportunities.   

Rollover equity, often a feature of deals with private equity firms, is the amount a business owner-seller reinvests from the sale into the acquiring company or a newly created venture. Depending on structuring, this can be beneficial to the seller not only from an income tax standpoint, as they may be able to defer capital gains on the portion of the sale the rollover represents, but also in estate tax planning. Under current law, each person has an exemption from the gift and estate tax, which they can use during their lifetime by making tax-free gifts. In 2024, this exemption stands at a historic high of $13.61 million per person, or $27.22 million for a married couple. A business owner who wants to take advantage of this exemption before it is set to be reduced in 2026 could use some or all of their rollover equity for gifting purposes. By doing so, they could remove that asset from their taxable estate, and importantly, also remove any growth and appreciation in the value of the rollover equity, which might be multiples of its value when the transaction closes. This can be a powerful and effective estate tax planning strategy.

For this type of planning, business owners might consider using trusts rather than direct gifts to individuals. Certain types of trusts, including spousal lifetime access trusts (SLATs) and dynasty trusts, can provide an array of tax and other benefits, especially when established in favorable jurisdictions like Delaware. Trusts are discussed further below in the context of intrafamily transactions.    

Sale to Insiders 

In lieu of selling to a third party, business owners might be inclined to sell to insiders, including management or key employees of their business. Sales to insiders are often appealing because they can allow for business continuity and promote employee engagement. Importantly, they also eliminate the need to find an external buyer in what could be a more challenging marketplace.  

Despite these benefits, elevated interest rates may create financing challenges when selling to insiders.  Key employees frequently lack sufficient liquidity to pay full price for the business, which means they would need to borrow funds, and they are often highly sensitive to the cost of capital. While the business may have more capacity to borrow as part of a stock redemption, it may not be able to raise capital to purchase the entirety of the owner’s interest.  

With limited external financing options, an owner who wants to sell to insiders could consider structuring their sale as either fully or partially seller financed. Generally, a seller-financed transaction is one in which the business owner takes back a note from the buyer in exchange for the interest they are selling. This could be for all or part of the acquisition cost. While the note would be interest bearing, its rate and terms may be better than the buyer could find in the commercial market. For buyers, this means an alternative, and perhaps more favorable, financing option that could allow the seller to secure a higher sale price than they might otherwise receive in an up-front, all-cash sale to insiders.    

A seller-financed transaction may also have income tax benefits. For tax purposes, the seller may be able to treat part or all of the transaction as an installment sale, in which case they would recognize taxable gain over time rather than in the year of the transaction. This would effectively allow the seller to defer their income tax liability into future years.  

Receipt of sale proceeds on an installment basis could also be beneficial as a financial planning tool for a retiring business owner. Although this might mean forgoing an opportunity to invest more of the sale proceeds up front, installment payments could serve as an annuity to support their lifestyle going forward, providing a steady stream of income into their retirement.  

Sale to Family Members 

Owners of multigenerational businesses often consider a sale to family members for business or legacy purposes or perhaps due to emotional attachment to their business. Regardless of their reason, an intrafamily sale can present opportunities but also challenges.

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