INSIDER'S APPROACH TO BUILDING AND EXECUTING AN EXIT PLAN
By A. J. Matsuura, CEO, EFM Capital Partners
There are five key concepts owner operators need to understand and accept in order to build and execute an exit plan for their businesses:
Concept 1
"Treat your businesses as you would your other assets and constantly work on improving its value." You may find it difficult to treat your businesses as an asset, because you are so involved in your business on a daily basis. However, for the vast majority owner operators, their companies represent the largest, albeit illiquid part of their personal wealth.
Concept 2
"The very fact that you are so involved in your business means you have the ability to significantly influence the value of your business."
Concept 3
"No matter how much you love your business, sooner or later you will stop working in your business. When that happens, it can either be on your terms in a fashion of your choosing or it will be forced upon you." If you want to exit on your terms, and maximize the chances of achieving your goals or dreams, you must have a plan.
Concept 4
"Developing and executing an exit plan is a process over time not a point in time," and finally
Concept 5
"You will need experienced professionals to help develop and execute the plan, because your primary responsibility is running your business."
There are many books and articles covering exit planning or how to sell your business. However, what makes this five concept approach unique is that it is based on my 20 plus years of experience working on over 40 transactions involving principally owner operated businesses first as an investment banker assisting owner operators sell their companies, and than as a private equity investor making investments into owner operated businesses. These concepts use a buyer's, a seller's and a professional investor's perspective as they relate to the exit planning process. The purpose of this article is to provide owner operators with a comprehensive insider's approach to developing and executing a proactive exit plan.
The Overall Process
In almost every one of the 40 plus transactions I've been involved with, the owner operators viewed their exit as a point in time, rather than a process over time. The exit usually was a response to something that happened to the owner like illness, divorce or just plain fatigue. As a result of this event, the owner engaged a business broker or investment banker to market the company, and if things went well, the company was sold within six to twelve months. Pretty much everyone's attention was focused on executing the transaction. Using this one phase approach, the owners usually left money on the table and/or their objectives were not met, specifically because they did not take a comprehensive approach to either planning or executing their exit.
A comprehensive exit plan process should include three phases:
Exit Outcomes
Exit Preparation
Exit Execution
Most owners' experiences with exits revolve around the execution phase with little or no consideration to the outcome or preparation phases, because most business owners have no prior experience going through an exit of their business. Additionally, the business brokers or investment bankers who are driving the execution process are compensated using a contingency fee. They are motivated to close deals at the maximum price in the shortest amount of time. In contrast, developing and executing a comprehensive exit plan may take many months and sometimes several years. Each phase builds on the one before it enabling a business owner to maximize the potential of achieving his goals upon the execution of the exit.
Phase 1: Exit Outcomes
For publicly traded corporate sellers and private equity investors, defining the optimal exit outcome is almost always about maximizing the financial objectives or more simply the sale price. For private company owners, an exit is seldom only about meeting financial objectives. That's why it's important for private company owners to evaluate and prioritize their personal objectives in addition to their financial objectives.
As far as establishing and prioritizing your personal objectives, you must first accept Concept 3, "No matter how much you love your business you will someday need to leave it." Next, you must determine when and on what terms you will leave it. You will need to do some serious soul searching to answer these questions. You will also need to consider if and how you might want to factor other parties such as family members, management and employees involvement in the business into the outcome. The outcome you choose to pursue may have a material impact on these other parties.
On the financial side, the question is "How much will I end up with at the end of the day?" and "How do I want to I spend it?" For the vast majority of manufacturing, distribution and services companies, buyers today value a company based on a multiple applied to a company's earnings before interest, taxes, depreciation and amortization or EBITDA.
To be clear, the value arrived at based on a multiple of EBITDA is the enterprise value of a company:
EBITDA x Multiple = Enterprise Value(EV)To arrive at the equity value, add excess cash on the balance sheet and subtract long term debt from the enterprise value as follows:
Equity Value (EQV) = EV + Excess Cash - Long Term Debt.Now to get to what goes into your pocket:
Money in your pocket = EQV - taxes +/- post-closing adjustments
There are many attributes of your company that will positively or negatively impact either or both the multiple used and the EBITDA used. The enterprise value equation speaks directly to the importance of these factors. For example, let's say your company is assigned a multiple of 5 by a buyer, then each additional dollar of EBITDA you are able to generate will be five dollars of additional enterprise value. Additionally, you may be able to positively influence the multiple itself, which in turn will also increase the enterprise value. Some of the key areas of influence are discussed below as the heart of the preparation phase.
The other aspect of the financial considerations is how you intend to spend the proceeds. The money you receive in a transaction can be spent in four ways: on yourself, on your family, on others (charities) and, of course taxes. Going back to Concept 5 "You will need experienced professionals to help develop and execute the plan," this is one of the first areas you should seek out professional help in the form of a competent wealth management advisor and an experienced estate tax professional.
The wealth management advisor can help you determine how much money you need to support the lifestyle you want, based on detailed modeling factors such as life expectancy, asset allocation, expected returns and inflation. If for example, you want a complete exit and don't want to work for the rest of your life, they can help you determine how much the after-tax proceeds of a transaction would need to be for that objective to be viable.
On the tax side, there are many tools such as living trusts and charitable remainder trusts that can be employed today to improve your post-transaction after-tax financial outcome. Don't wait until after the transaction to go to these people. They can still provide valuable help to you after the transaction, but they can be even more effective if you go to them beforehand.
You may be saying to yourself, "I'm not thinking of selling my company any time soon. This sounds like it will cost me a lot money. I can't afford it. I'll think about these things later." The reality is you can't afford to avoid addressing these matters now. What if something beyond your control happens to you tomorrow? What happens to your family? Having a comprehensive wealth management and estate plan in place will serve your family well regardless of whether you are planning to sell your business in the near future.
Up to this point, the outcome of an exit has been characterized as the sale of the company. In fact, there are a range of possible outcomes each addressing different aspects of your personal and financial objectives. Here are some common outcomes to illustrate this point:
- 100% sale to a corporate entity: A corporate buyer, especially a competitor, is likely to have its own management team that will take over operations of your business. They should be able to pay more, specifically because they can eliminate redundant overhead costs like executive management and administrative positions. All of these types of "add-backs" should be applied to your reported EBITDA resulting in a larger enterprise value. This outcome is best suited for owners seeking to maximize his financial objective of liquidity at the maximum value in order to meet his personal objectives outside of the business.
- Partial (minority or majority) sale to a private equity (PE) investor: PE investors seek to partner with existing owners of businesses providing them with guidance in building a professional management team and professionalizing business processes which will enable the owners to grow their businesses faster with improved profitability. This outcome is best suited for an owner seeking to balance his financial objective of achieving partial liquidity while also meeting his personal objective of taking the company to the next level.
- Sale to existing management team (MBO) in partnership with a PE investor: The PE investor must be convinced that the owner has successfully transferred all key operating controls and decision making to a professional management team. Next, the PE investors must be convinced to back the management team as their partners, rewarding them with sweat equity to grow and improve the business. This outcome is best suited for an owner seeking to balance his financial objective of achieving liquidity, while also meeting his personal objective of providing his management team with an opportunity to take over ownership of the business.
There are many nuances and variations to the outcomes. The purpose of outlining them in this form is to illustrate that different outcomes will address different aspects of a business owner's personal and financial objectives. The most important point is that having more choices is preferable to having fewer choices, so the more flexible your personal and financial objectives are, the more outcomes you will have to choose from. It is very important not exclude considering an outcome until it is presented to you.
Phase 2: Exit Preparation
Preparing your company for an exit goes directly back to Concept 1, "Treat your businesses as you would your other assets and constantly work on improving its value," and Concept 2 "The very fact that you are so involved in your business means you have the ability to significantly influence the value of your business." The best way to adopt these concepts is for you to evaluate your company the same way professional private equity investors and corporate acquirers would evaluate your business.
The heart of the exit preparation phase is identifying and amplifying the positive attributes and eliminating or mitigating the negative attributes. In order to identify those attributes, you must undertake a deliberate and comprehensive "self due diligence" evaluation of the key business and operating attributes influencing your business.
The following are some of the key business attributes which you as the owner can influence:
- Absolute revenue and EBITDA size
- Organic industry growth potential
- Market share and composition
- Acquisition opportunities and successful execution of acquisition(s)
- Competitive advantages and disadvantages relative to industry competitors
- Customer, product line, geographic and/or vendor concentration
- Supply chain relationships (i.e. foreign or domestic sourcing)
The following are some of the key operating attributes which you can influence:
- Quality and depth of your management team
- Form of management compensation
- Family members in the business
- Personal, non-operating expenses run through the business
- Hidden asset value (i.e. real estate)
- Quality of financial control and reporting systems (i.e. monthly financial statements and audited annual financial statements)
- Quality of IT systems
- Planning and budgeting processes
- Legal structure (i.e. C-corp, S-corp, LLC)
- Business documentation (i.e. articles of incorporation, minute books, material contracts and agreements, patents, sale and use tax documentation)
- Outstanding, pending and settled lawsuits and/or history of lawsuits
- Environmental issues
- Tax issues either pending or settled
There are also factors you will have no control over, which can have a major impact on your company's market value. Most notable of those factors is:
- The business cycle
- Condition of the financial markets
While you can't control these factors you can prepare your business to weather a bad business cycle and/or financial markets. The actions you to take to make your company more valuable to a third party are the same actions that give it the best chance of surviving and even prospering in an economic down cycle. Additionally, even if your company can just tread water in the difficult conditions of today, its ability to do so will be considered a major plus to buyers if you plan to sell on the other side of this business cycle.
You're probably saying to yourself, "I just don't have the time to do this, I have a business to run." However, if you accept Concept 4 "Developing and executing an exit plan is a process over time not a point in time," and you also accept Concept 5 "You will need experienced, professional help with the plan, because your primary responsibility is running your business," the preparation phase becomes much less daunting. Remember, you are in control working at your pace, not at a time compressed deal pace. If corrective actions to a key negative attributes such as high customer concentration require a couple of years to complete, you can to address it in a timeframe of your choosing because you are in control of the process.
In terms of help, you may want to consider forming an advisory board or formal board of directors that can give you advice and act as a sounding board for you. Most importantly, having the right management team to assist and support you let's you focus on the attributes that may have the greatest impact on the value of your company. Having a strong management team is another important safeguard to protect your company's value for your family and employees should something unforeseen happen to you.
If you choose not to address these matters systematically over time, but wait to address them during the execution phase like most people, one or more of these following things is highly likely to happen:
- Most of the actions which you could have taken to materially improve a positive attribute or mitigate a negative attribute will not get done because you won't have the time
- All you will have time to do is identify what those positive and negative attributes are, explain them, and let the buyer determine their impact on valuation
- The universe of potential buyers is more limited because you did not address one or more of these matters properly or in some cases at all
- You will leave money on the table and/or preclude certain personal objectives from being achieved
- The buyer ends up capturing the value you leave on the table, because they are willing to do the things you did not have the time or desire to do
- The transaction will not go as smoothly, will take longer and be much more stressful than if you had addressed them earlier under your control
Most deals do get completed in spite of these issues, because unfortunately owners only begin to understand how they might have done things differently to improve value of their companies after the deal closes.
Phase 3: Exit Execution
By working diligently through the first two phases, you will put your company and yourself in the best position to move to the execution phase at a time of your choosing. It is imperative you get help from an experienced investment banker and deal attorney when you begin this phase.
Consider hiring an investment banker if your business has at least $10 million in revenue and/or $3 million in EBITDA. Their job is to manage the entire sale process from the very beginning to the successful completion of the transaction, so you can continue to run your business with a minimum of interruptions. If you have a smaller business, you might want to consider using a business broker. They specialize in working on sales of smaller businesses, however, their services are much more limited.
The following is an outline of the sale process and the role of the investment banker in that process:
Step 1: Preparing to Go to Market (Month 1)
- Establish preliminary valuation expectation range
- Review all key financial and operating information on the company
- Assist management prepare adjusted historic financial statements and forecasted financial statements
- Establish sale process and timetable
- Work with company attorney to finalize confidentiality agreement
- Prepare confidential information memorandum (CIM) which will commonly include the following sections:
- Executive summary
- Company history and background
- Products and brand
- Distribution channels
- Sales and marketing
- Facilities and operations (including any environmental issues)
- Management and employees
- Financial performance (historic and forecasted)
- Industry and competition
- Organic growth and acquisition opportunities
- Various appendices for items such as: audited financial statements, organization chart, and product brochures
- Prepare potential buyers list for approval by management, if appropriate, rank based on specific criteria
- Assist management prepare management presentation
- Prepare data room
- Prepare blind one page summary to use in making preliminary contact with potential buyer
Step 2: Going to Market (Month 2 - Month 3)
- Contact potential buyers, assess preliminary interest and if appropriate distribute summary
- Follow-up contact with buyers to assess interest in receiving CIM, qualify buyers and have buyers execute confidentiality agreement
- Work with management and company attorney to negotiate any changes to confidentiality agreement
- Distribute CIM with bid instruction letter
- Work with management to respond to buyer questions
- Remind buyers of preliminary bid deadline
- Analyze bids, if necessary, clarify offers with potential buyers
- Present comparison to management and assist in making decision on cuts for management meetings
Step 3: Picking a potential buyer (Month 3 - Month 4)
- Schedule and facilitate management presentations and plant tours
- Supervise access to due diligence information
- Distribute final bidding instructions and deadline
- Work with management to respond to buyer questions
- Remind buyers of deadline for final bid in the form of a letter of intent (LOI)
- Analyze LOIs, if necessary, clarify LOI terms with potential buyers
- Present comparison to management and assist in making decision on cuts for final negotiations
Step 4: Negotiate and close transaction (Month 5 - Month 6)
- Conduct final LOI negotiations
- Pick primary and back up offers
- Facilitate buyer final due diligence activities: accounting due diligence, environmental reviews, management background checks, insurance due diligence, legal due diligence
- Work with attorneys drafting purchase agreement and related schedules and documents
- Negotiate terms of purchase agreement and related documents
- Close transaction
Properly managing this process is time intensive, and it's definitely not something you should think of undertaking yourself. It's basically a controlled auction aimed at generating the highest purchase price by going out to the broadest universe of potential buyers. At the end of the process, you should feel very confident that the outcomes presented to you are the result of an open market process.
In addition to an investment banker, you will also need to hire an experienced deal attorney. Do not assume your current corporate attorney, if you have one, has the requisite experience. An experienced deal lawyer working in your corner will make the transaction run more smoothly, and more importantly, will ensure you have the key legal provisions negotiated properly on your behalf. There are certain basic terms and conditions in the legal agreements of a sale transaction that are customary and those that are not. There are also certain legal issues which are typically highly negotiated and those that are not. A lawyer inexperienced in working on deals may not know what is customary and what is not, and may materially slow down the process and in some cases kill the process. Most importantly, a really good deal attorney will know the difference between a legal issue which they should be advising you on, and a business issue which you or your banker should be working on.
Once you've hired your banker and attorney, it is critically important that you actively manage your team of professionals, and not have them manage you. Don't be intimidated because they know more about the deal world than you do. That is why you are hiring them. Make sure you are comfortable with what they are doing for you and why they are doing it.
For your banker and deal attorney in particular, make sure you interview at least two or three different providers for each service even if they are being recommended by someone you know. Ask them for references and check those references out. You will be working very closely with your banker and deal attorney under highly stressful conditions, so you also have to feel comfortable with them personally as well as professionally. Also investment banking and business brokers' fees are negotiable, which is another reason for you to have more than one proposal.
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There are no guarantees that you will achieve the optimal outcome if you develop and execute a comprehensive exit plan, but doing so will put you in the best position to increase the likelihood of making it happen.
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