Exit Strategy

This may come as a shock to you—or you may become ecstatic as you think about it: Someday your business will be sold or transferred and you will no longer own or control it.

Will your business be ready to sell when you are? Without a plan in place for that ultimate transfer, you are just working a job and missing the opportunity to create wealth for you and your family.

Think about it. Would you be running your business differently if your exit plan were an IPO? Of course you would. Your business may not have the story or numbers to go public, but the principle is the same. You create substantially more wealth by planning your exit strategy than by letting that ultimate transfer sneak up on you.

The Exit Strategy Plan, which I cover in this issue, consists of determining your selling trigger and the most likely buyer category. It also includes setting a program to enhance your value to that buyer. The Exit Process, which I will cover in subsequent issues, is what you do once you decide to sell or someone or circumstance forces you to sell.

The Exit Strategy Plan

The sale of your company will be to a specific buying entity or it will be through an initial public offering (IPO).

Public companies have significantly higher valuations than private companies. This is primarily because of the liquidity of public stock. Call your stockbroker and it is sold! In selling a private company, call your intermediary and hope it sells within a year. Shannon Pratt, founder of Willamette Management Associates, one of the oldest and largest independent valuation consultants, states in his recent book, Cost of Capital, that discounts for lack of liquidity (marketability) are often in the range of 10 to 50%.

To be successful in the IPO world, a company has to have a story that captures the public investor’s eye.

Some mundane companies have successful IPOs without the story, but they have the financial performance (numbers) to support the valuations. The threshold for a successful IPO is a market capitalization of at least $250,000,000. Below that number the mutual funds and the market analysts are not interested. Below this capitalization, the stock doesn’t have the support to sustain the value in the market.

The up front costs to go public are significant—in the $400,000 to $700,000 range. And it takes significant management time for an extended period.

There are cheaper ways to go public such as merging with a shell company or one of the short-cut methods allowed by the Security and Exchange Commission. Using one of these methods for a small company lets you enjoy all the negatives of being public without the benefits.

Recommendation: If your company has the potential market capitalization of $250,000,000 and you have the stomach for the fishbowl of the public arena, go public. If not, plan a private sale.

Buyers for private companies

There are two types of buyers: financial and synergistic (sometimes called strategic).

Financial buyers are interested in return on investment (ROI). Synergistic buyers bring efficiencies resulting from the combining of the buyer and seller thus enhancing the return and making the combined entity more valuable than the sum of the individual values. (2+2=5).

Ideally you could expect to receive a higher price from a synergistic buyer. However the synergistic buyer will not offer a higher price unless forced to do so. Forcing means an auction environment where two or more synergistic buyers bid against one another.

Categories of buyers

Let’s consider the characteristics of various categories of buyers. Unless it’s an IPO or a involuntary transfer (see below) the ultimate sale of your business will be to one of these.

Not a day passes that I don’t get an inquiry from a private investment group. There are over a thousand of these groups operating in the country at the present time. These are groups of financial buyers who have raised capital from pension funds, banks, foundations and high net worth individuals with the purpose of investing in and owning middle market companies (usually $5 to $100 million in annual revenues).

While the specific acquisition criteria vary from PEG to PEG, any middle market company is of interest to most of these groups. Their purchase can take many different formats:

· Industry consolidation and roll-up (PEG backs management to buy other companies)

Individual buyers

These are high net worth individuals. Some are previous owners of businesses who are looking to get back into business.

Many are former corporate executives who have been downsized or ostracized from their big corporation and are out there looking to buy a business. My experience is that most of these people never buy a business. They spend a year or two looking, the money runs out or they get burned out on looking.

Going from a plush corporate job to running a small business is culture shock. As you well know, sometimes one has to sweep the floor or even get his/her own coffee.

One of my clients had an insightful remark about his metal bending business. He said, “If an individual buyer had enough money to afford my business, he or she wouldn’t want it.”

Also, there are lots of individual wantabes out there with no money who want you to finance the deal for them. Make sure you fully qualify potential suitors both technically and financially before spending time with them. I often tell these people, “You can buy a business with no money, but you can’t buy a business with no money if you have no money.” Many times they will put you off with “My uncle (or some other individual) is going to help with the financing.” If so, talk with the uncle who can make the investment decision.

Family members

About 30% of the country’s family businesses are passed on to the second generation and only 15% make it to the third generation says Nancy Drodow, project manager for the Family Business Program at Wharton School of Business. If you have a son, daughter or other family member that is capable of taking over the business, consider yourself very lucky (or very talented in training and motivating them to do so).

Of course, this is moot if you give the business to your daughter. If you choose this, remember gift taxes and plan to minimize them.

Theory of relativity in business: “What good is a business if it can’t take care of a few relatives?”

Competitors

Competitors may feign interest just to learn how to better compete with you. Tread carefully.

Competitors have the dilemma of deciding whether to pay you for your goodwill and equipment versus foregoing buying you and spending the money on marketing to convert your customers.

Having said that, a company in the same business in a different geographic market or with a complementary product line may be the ideal buyer in that they can bring significant synergy to the deal.

Customers

Many times your business will be of interest to customers who are looking to vertically integrate. The issue the customer has is will the other customers of the business remain after the transaction since they now see their supplier as a competitor.

Suppliers

Suppliers have the same issues as customers in that customers visualize them as competitors after the close.

The vertical integration strategy is out of vogue with the current trend to outsourcing.

Employees

Frequently a partner employee will buy out another partner. It’s rare that a pure employee has the funds and/or the collateral to buy the business. I have seen successful management buyouts with the help of PEGs.

When you sell to an employee with a low down payment, you still own the business because have to worry about payments and worry about getting the business back.

ESOP (Employee Stock Ownership Plan) will allow the employees to buy the business. This is a program where the owner sells stock to a trust that has the employees as beneficiaries. The trust is funded by contributions by the company based on a percentage of the payroll. The payroll has to be large enough in relation to the value of the business to make sense.

ESOPs work in cases where there is competent successor management in place or where the owner is willing to stay around and run the business until management can be in place. The qualifications to establish an ESOP are highly technical, so make sure you have a ESOP consultant to lead you though the process of establishing and managing the trust.

Venture capital and angel investors

Involuntary transfer

Part of the exit planning process is thinking about potential involuntary scenarios in your business and taking steps to reduce to potential of those scenarios happening. Early planning will substantially reduce the likelihood of an involuntary sale.

Owner health

The objective of every business owner should be to create a business with second tier management capable of running of the business without the participation of the owner. A business with this characteristic is of maximum value to any buyer because the buyer’s risk of transfer is substantially reduced. And a business with this characteristic can survive serious owner health events.

It goes without saying that you should have a trained replacement for your job. Every job in the organization should have a replacement trained and cross-trained. All of the systems and procedures of the organization should be documented.

One of the great benefits of ISO 2000 certification is documentation of systems and procedures such that replacement training becomes easier thus reducing the risk of sudden owner health or other personnel changes jeopardizing the viability of the business.

Bankruptcy

Bankruptcies happen when a business has a cash crunch or a threat of a cash crunch. Some of the situations I’ve seen leading to bankruptcy include: loss of major lawsuit, under capitalization, bet-the-business decision that doesn’t work out, embezzlement, product obsolescence, key employee becoming competitor, severe economic downturn in industry, bankruptcy of customer. I have seen companies forced into bankruptcy because they grew too fast and ran out of cash. You probably know of many other situations.

Some of these situations are beyond the control of the owner. The advice I give is to assess the risks in your business and take steps to reduce them. Make a list and evaluate the likelihood and severity of each risk item. There is no such thing as a risk-free business, but assessing the risks and planning to handle them can substantially reduce likelihood of bankruptcy.

Bankruptcy is an expensive, debilitating experience. It bleeds the business owner, sometimes even more than the event that caused the bankruptcy in the first place. Bankruptcies should be avoided at all costs except in those rare occasions where the motivation is a strategic negotiating ploy.

If you are threatened with bankruptcy, first think of working with a Credit Managers’ Association. Many areas have these associations that act in a non-judicial way to help you through your period of trouble. The credit managers realize that surviving a bankruptcy is difficult at best and their members will likely receive more return from their claims outside of bankruptcy than inside it.

Government Intervention

As the dramatic picture of the Government taking Elian Gonzales at gunpoint shows, the Government can do anything it wants to—it has the guns and power to ruin your business. You need to manage any situation relative to the government’s regulations and taxation and issues on politicians’ current politically incorrect list.

Natural catastrophe

Are you subject to earthquakes, floods? Could the business survive a fire? Are your records secured? My advice is to have a disaster plan.

Making time for disaster recovery planning is never easy. There is no good time‑just don’t wait until after the disaster happens.

Deciding to sell

What will the triggering event be prompting your decision to sell? Will it be when the value of the business exceeds the financial goals you have for retirement?

Will it be when you reach 65 or some other pre-determined age? Will it be when all the kids leave home or get out of college? Is it dependent upon some event in your industry?

Will it be when you need to invest another $1 million to remain competitive and you don’t want the risk? Could it be burnout? Could it be some passion you have to be a missionary in Azerbaijan? Or do you just want to SCUBA dive in Belize for the rest of your days?

Some business owners never plan to retire; that is OK. Just make sure there is a succession plan in place because we all are mortal.

Think about these scenarios and others and determine the most likely event, then pick the most likely buyer category and plan your strategy to enhance the value to that buyer.

And remember the typical length of time to sell a business is nine to twelve months.

What to do

Next meet with your staff and create the company’s strategic plan, consistent with your exit plan. You don’t have to share your exit plan with your staff; you just have to guide the strategic planning process so it is consistent with your exit plan.

Tip of the Month

Many sellers initial reaction to an offer is, “I’m not going to sell to someone who uses the money generated by the business to buy my business.”

That attitude won’t work. Where is the money to buy the business coming from if it isn’t from the business? Said another way, “The business must pay for itself and provide a reasonable return on the money invested.”

Next Month

I had planned to talk about the Exit Process next month. However, I think I’d better spend some time talking about the strategic planning process, so the topic next month is “Strategic Planning.”

_____________________________________

Policies

Feel free to forward this newsletter to anyone you think will benefit.