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January 11th, 2010 |

Author: Gavin

The Optimal Exit Strategy – For Private Middle-Market Business Owners

The Challenge

This past year has been a difficult one for business owners seeking an exit. Is this the recession, or a reflection of a longer term reality? The answer, it seems, is that exiting business owners will need to engage a new reality for the foreseeable future. According to an article published by Robert Avery of Cornell University in February 2006, “the majority of boomer wealth is held in 12 million privately owned businesses, of which more than 70% are expected to change hands in the next 10 to 15 years.” Only a portion of these businesses will successfully cash out, because of a fundamental oversupply of sellers.

Key Mistakes Sellers Make

Business owners make a mistake when they allow too little time to complete a properly executed business exit strategy. Another mistake owners make is focusing on the price while disregarding the terms and structure of an exit transaction. Other key mistakes business owners make in exiting their companies are:

selling to the (only) competitor who approaches them
not using experienced advisors (hoping to save transaction costs)
setting expectations based on personal needs and without reference to the market
failing to explore legitimate positioning strategies

Buyers of middle market companies don’t buy jobs for themselves in the way that small business buyers do, they “invest” with the expectation of a return commensurate with the risk. Nothing enhances a buyer’s perception of value more than:

evidence of sustainable growth
a capable management team as the key to managing the risk

The Business owner who engages professional advisors, plans thoroughly, and negotiates to ensure that the wealth transfer mechanism chosen most closely delivers on his goals is the business owner who will have executed the optimal exit strategy.

Characteristics which Appeal to Buyers

If the fundamental laws of risk and reward prevail, only the least risky and most profitable businesses will change hands successfully. With buyers focusing on businesses which represent good investments capable of operating with little or no dependence on their owners, the following characteristics will be seen as desirable:

Businesses which have scaled beyond a total dependence on the owner
proprietary products, services or processes
strong, remaining management
defensible, differentiated market position
stable, diverse customer base
recurring revenue business model
business growth (opportunities)
strong operating margins
manageable business risk
quality business and accounting systems
audited annual and timely internal monthly financial statements

Defining the Exit

Exiting is more than Selling
Exit Planning is a process involving the development and execution of a series of systematic steps taken to allow both the owner and the “accumulated wealth” to be extracted from the business, via one or more of the numerous available strategies, including:

Selling the business to partners, strategic buyers, investors, competitors, international buyers, or the public
Recapitalizing the business for partial liquidity
Merging the business to achieve enhance valuation and/or marketability
Transferring the business to family, management or employees
Gifting the business to meet personal and/or tax planning goals
Liquidating or partially liquidating the business

Exiting is a process, not an event.

The Optimal Exit will be achieved through the implementation of a managed process which includes:

Establishing a business valuation reference point
Clarifying “Life-after-Business” goals
Working with a team of specialist advisors
Preparing a written plan ▪ Identifying and evaluating the applicable alternative strategies (options)
Executing any necessary positioning or preliminary strategies
Executing the selected exit strategy

Exiting is a complex subject with many moving parts. No single advisor is an expert in all aspects, so the process should involve inputs from a team of experienced advisors, and should address the possible need to re-position the business before going to market.

Setting Goals

Clarifying the Endgame
The Exit Strategy begins with the M&A Advisor providing a likely range of the pricing, terms and structure expected from a sale in the current market. The Financial Planner or Wealth Manager then develops a plan to invest the after-tax wealth extracted from the business to meet lifestyle and life-after-business goals. For the majority of business owners, this newly liquidated business wealth will constitute a meaningful portion of the total wealth driving the financial, tax and estate plans. The key, then, to beginning the exit planning process, is to clarify the endgame, taking into account the likely value of extracted business wealth.

Legacy Goals – what will have been your contribution?
Lifestyle and Life-after-Business Goals – what do you want from the next phase of your life?
Estate Planning Goals – how will you ensure that your estate passes to your heirs in the most tax efficient way?
Exit Strategy Goals – based on all of the above, what are the priorities to be met by your selected exit strategy as to risk, time, wealth and income?

Selecting a Team

Play the “A” Team
The M&A Advisor should assemble and coordinate a team, including existing advisors where applicable, that will ensure:

access to all appropriate options and opportunities
being fully informed as to the merits and demerits of proposed strategies
having expert counsel and representation

The team must include the necessary knowledge, skills and experience in Mergers & Acquisitions, Corporate Law, Taxation and Financial Planning/Wealth Management. It may also include specialists in ESOPs, insurance, personnel and business consulting disciplines.

Writing a Plan

Planning Precedes Execution
Business owners should not expect to exit successfully in the next 10 years without figuring out how best to exit and what preparatory steps should be taken…and should not assume they can wait until they are “ready”. While the critical execution phase will not be a problem for most take-charge entrepreneur business owners, the planning for an exit will be foreign to them as exiting has never been their purpose. Their purpose has been to create and build, and to consider the exit (if at all) a retreat. The M&A Advisor should coordinate a collaborative team effort to prepare a written Exit Plan incorporating a valuation of the business, a statement of goals and objectives, a review of alternative strategies (options), an analysis of the gap between the goals and the options, and strategies for closing the gap.

Reconciling Goals and Options

Once one has established an indication of the Expected Wealth Transfer (the after-tax proceeds from the business exit) on the one hand, and an estimate of the Targeted Wealth Transfer (the wealth transfer required to provide the personal life-after-business goals) on the other, the business owner and the exit team must now reconcile the two before selecting and implementing an exit strategy. Whether or not the expected and targeted wealth transfer values are the same, the owner should review all exit options, and should also evaluate a number of Positioning Strategies for execution prior to implementing an Exit Strategy. Reconciliation or Closing the Gap is an iterative process of evaluating combinations of positioning and business exit strategies that will yield a release of wealth (the Expected Wealth Transfer) compatible, as to quality, time, value and certainty, with achieving the specified goals and the associated Targeted Wealth Transfer. Closing the gap may also involve modification of the Targeted Wealth Transfer. Again, notice that there are two key points of inflection for matching the exit with the personal goals:

The ability to vary the value, timing and certainty associated with extracting the business wealth
The ability to vary the timing, risk tolerance, estate wealth, living standards and other variables inherent in the personal goals

A key issue business owners face in considering Positioning Strategies is the very central question of the risk – reward paradigm. Positioning strategies cannot be executed entirely without risk, but manageable risk strategies may deserve consideration if they serve to better ensure that the business wealth will be delivered in the context, amount, time and certainty needed to meet the identified personal goals.

Positioning Strategies

Corporate Value Enhancement
The team should look at the corporate structure and governance mechanisms to consider whether the business is optimally positioned for the intended business exit. For instance, an asset sale from a C Corp could result in tax obligations at both the corporate and the individual levels. Conversion to an S Corp may be advantageous, but the tax benefits vest over an extended period of time. The make-up of the Board and any Advisory Board may also have an impact on the value perceived by a buyer. Management strength is considered below. From the standpoints of scale, product or market diversity, management strength or any number of others, the business may benefit from a combination with or consolidation into another business prior to its sale. Alternatively, it may be desirable to spin-off one or more non-synergistic or non-performing divisions to increase profitability or allow greater management focus.

Business Value Enhancement
Business value enhancement strategies generally influence valuation because of their perceived impact on risk, growth or profit margins. At the top of many buyers’ lists is the need to see a strong, experienced and motivated management in place. For financial buyers, this often includes the need to be assured that management has skin in the game, typically an equity interest. Improvements in profit margins are strongest when they are reflected in trailing (historical) earnings. More recently effected changes, or even planned changes, can also influence valuation, however, if the benefit of the changes can be quantified and demonstrated. Because of the multiplier effect built into earnings-based valuations, a $1mm earnings improvement may increase the valuation by, say, $5mm. It doesn’t seem entirely logical that an exiting business owner would have unexplored opportunities available for making improvements to the business. It’s a little like living with an outdated kitchen and upgrading just before selling the house. As in the real estate analogy, the stakes are higher at the time of exit, and the focus on marketability and valuation greater, so these opportunities often do exist. Other business value enhancement strategies include:

Reviewing and revising the revenue and/or business models
Implementing product / market enhancement plans
Expanding and diversifying the customer base
Securing title to patents and intellectual property
Commissioning of financial and operational audits
Strengthening or upgrading of systems and procedures
Documenting or codifying contractual relationships (employees, vendors, customers, debt)

Business Marketability Enhancement
If growth opportunity, managed risk and strong margins are the foundation for building value enhancement strategies, then clarity, transparency and certainty are the engines which drive marketability. Business performance is clearly reported and accounted for, activities and status are transparent to the buyer, and all information portrays a level of certainty about the future. Experienced buyers know that completing acquisitions is a time-consuming and expensive exercise. Buyers will perceive greater clarity, transparency and certainty, and therefore be more motivated to engage, when the seller has:

Audited financial statements
A business plan with a clearly defined growth path
An in-place sector-experienced management
Current market metrics and analysis

Multi-Step Liquidation Strategies
Reference is made above to the risk-reward paradigm. This fundamental reality plays out in ways too numerous to mention, including strategies elected by business owners to both take cash off the table to reduce risk/exposure as in a re-cap, and assume reasonable risks for an enhanced valuation as in an earn-out structure. Consider:

The lowest price is an all cash price (not often available in today’s market)
Waiting before selling is risky
Participating in an industry consolidation or roll-up increases the risks and uncertainty of an exit, but potentially enhances marketability and yields a greater valuation

A classic two-stage exit is accomplished by means of a re-capitalization in which an investor / partner / buyer acquires part of the business with an expectation to either buy the rest of the business or to market the business in cooperation with the remaining owner at a later time and at a greater valuation. The owner takes some chips off the table, but retains a stake, and usually continues to participate in management. Merging the business into one or more other businesses before exiting can lead to increased marketability and even an improved valuation sometimes referred to as multiple bump. Consider a $20mm revenue business with earnings of $3mm which commands a valuation of $15mm (or a 5 multiple). Combining that business into a $100mm business with earnings of $15mm and which commands a valuation of $90mm (a multiple of 6), now values the original company’s participation at $18mm, and the consolidation strategy has yielded a $3mm valuation gain.

Transaction Structuring Strategies
Every step along the complex path of executing an exit strategy demands access to advice from professionals who have been there and who know the opportunities and the pitfalls. Even though the structuring of the exit transaction comes toward the end of the process, structuring is included here as a positioning strategy because it impacts the value of the Expected Wealth Transfer. Key structuring considerations include:

Considerations of risk and reward
Tax considerations
What incomes and expenses are included (i.e. belong to the transacted business)?
What assets and liabilities are ex/included
What pre-transaction liquidation, settlement/exclusion opportunities exist?
What relationships between buyer and seller arise? (employment, advisory, landlord, supplier, partners, etc.)
Documenting or codifying contractual relationships (employees, vendors, customers, debt)

The majority of middle-market businesses bought and sold derive their valuation, at least in part, from cash flow or earnings. The very key question then arises: “What assets and liabilities are essential to and an integral part of the ongoing enterprise, thereby supporting the established earnings flow?”

Exit Strategies

The business owner should have his M&A Advisor prepare an analysis of the fit and applicability of each of the exit strategy options to the stated goal and objectives. Not all options will fit every business or every set of goals. Individual strategies might include:

Sale to Partner, Competitor, Strategic Buyer, Financial Buyer, International Buyer, the Public
Re-Cap
Merge
Transfer to Family, Management, Employees
Gift
Liquidate

Benefits of a Planned Exit

The primary purpose of approaching a business exit in a systematic, goal-focused and planned way is to dramatically increase the likelihood that the outcome will be optimal to the stated goals. The employment of a team of professional and experienced advisors will add a cost of, say, 3% – 6% of the wealth transferred, but will potentially add considerably more value by:

mitigating against a failure of the mission
dramatically expediting the mission
intermediating the process to eliminate the risks associated with direct negotiations between principals
increasing the negotiated value of the mission
reducing the income tax burden
helping to reconcile the Expected Wealth Transfer to the Targeted

Wealth Transfer

…not to mention providing the knowledge and human resources to navigate a complex and time-consuming labyrinth of decision making and task execution.

About the Author

Peter Heydenrych has more than 30 years experience in corporate finance and investment banking, including international banking and M&A. He draws on a depth of experience and brings important insights to bear on the issues faced by clients.

Peter’s entrepreneurial experience, as the owner of both service and manufacturing companies, provides added perspective and an enhanced ability to execute successful transactions, serving clients through a thorough understanding of both the process and the anatomy of M&A transactions. Most importantly, Peter’s acknowledged capabilities make him a highly skilled negotiator who is analytical and tenacious, yet objective and fair.

Peter began his career with the Big Four Public Accounting firm of Arthur Young, initially in Cape Town, South Africa and later in London, U.K. He managed audits in diverse sectors including manufacturing, shipping, publishing and retail. Expanding the range of his financial skills, Peter was appointed by its Board to the corporate office staff of the Controller of Barclays Bank in London (then the 6th largest banking group in the world), where he advised the bank on its capital investment and infrastructure strategies.

Returning to his native South Africa, Peter served as the senior operating executive of a retail chain of 110 department stores, before moving to California in 1980. International experience was the foundation-stone for Peter’s critical leadership contribution, as the Chief Financial Officer and member of the Board of Directors, to the rapid growth of a $200 million ocean freight transport and logistics company with operations on 5 continents.

Peter began his work in M&A when, as a Partner and the Managing Director of one of the largest U.S. interior architecture and design firms, he represented the company in a highly strategic sale to a Fortune 100 company. He transferred to the acquiring company, and implemented a national roll-up of interior architecture & design and furniture distribution companies.

Peter joined Corporate Finance Associates in 1991, and was a member of the management team which completed a buyout of the firm in 1996. He has participated in numerous M&A and corporate finance transactions, representing parties wishing to sell, buy or capitalize middle market businesses. Building on corporate affiliations and M&A experience, Peter has served the needs of middle-market companies in the technology, health, business services, transport, telecommunications, manufacturing, financial services and construction industries.

He is a Chartered Accountant of South Africa and holds a Masters Degree in Business Administration from the University of Cape Town, South Africa.

Peter holds FINRA Series 7, 79, 24, 28 and 63 licenses. Securites offered through Corporate Finance Securities. Inc.

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