Running Your Company with the Exit Strategy in Mind

At the Giersch Group, we believe that a systematic approach to strategic planning lays the foundation for good decision making throughout the year. We encourage the review of the company’s strategic market position. Understanding your market position lays the foundation for the company strategy, which we look at this month. Through our prior resources, we have covered the process on how to build a strategic plan and how to avoid the propensity of risk avoidance.

This resource addresses the importance exit planning plays in the overall strategic plan. We also touch on the reasons why owners choose to sell their company rather than passing it on to family members and how to create value that can be identified and transferred at the point of such a sale.

Reasons Why Owners Sell their Company

Let’s review the key reasons why small business owners sell their company rather than transferring it to a family member:

1. Exhaustion. Running a company is far more work than a job. Not only are the hours typically longer, but an owner carries the risks and rewards of every decision that is made. For many small business owners, if scale is not reached within a reasonable period of time it can become utterly exhausting.
2. Lack of Scale. While some entrepreneurs are able to systematically grow the company, others are stuck for extended periods of time at the same size. Within some industries, a certain level of scale must be achieved in order for the returns to be attractive to the owner. For many reasons--be it lack of skill, lack of financial resources, or lack of marketing—the owner may be unable to take the company to the desired scale and choose to sell it instead.
3. Economic Pressure. Some owners choose to sell their company when they foresee or experience pressure from the economy. Without a strategic plan for dealing with the economic pressure, an owner can quickly become exhausted.
4. No Succession Plan. While some owners have trained a family member or employee to take over the business in the future, or implemented an ESOP (Employee Stock Ownership Plan), many small business owners are caught up in the day-to-day operations and have not made plans for the continuation of the business with other family members. Even if an owner wishes to transfer the business within the family, no family members may want the business or are able to undertake the ownership/operations of the business. 

Regardless of the reason for selling the company, every small business wants to maximize the value that they can receive from their hard work. Preparation is key to realizing the value that has been created. When an owner sells out of exhaustion and is not prepared, it is very difficult to realize the value that is created. 

Understanding Value Creation

There are three typical stages to the life of a small business: hobby, practice, and going concern. In the hobby stages a concept is brought to life and implemented, but does not provide sufficient income for the owner’s support. Indeed the owner may be indifferent as to income, enjoying the undertaking as such. As the company grows it moves into the practice stage where it produces sufficient revenue to provide the owner(s) reasonable compensation. However, the company remains dependent on the owner for survival due to a lack of systems, brand dependency, proprietary knowledge, or any number of reasons. Cathedral defines a business as a going concern when it has the ability to continue if something were to happen to the owners. 

After the business achieves going concern, value creation becomes one of the elements for the business builder to consider. Opportunities are now available for the creation of lasting value, often referred to as enterprise value. Enterprise value is the future cash flow to the buyer. Future cash flow must be identifiable and transferable.

In order for a buyer to purchase an enterprise, the value must be able to be seen and demonstrated. There are several key components of identifiable value including the customer base, the facility, and intellectual property. Although this list is not comprehensive, for a small business most components fall within one of these categories.

The customer base is the driver of revenue and key to demonstrating value is the ability to identify these drivers. For example an online store has many ways in which they can track and identify their customers, while a brick-and-mortar retail shop may not have a clear customer list. Many creative strategies such as rewards programs or birthday coupons are implemented in order to track this data. Products and services fit within this category. 

Market and competitive position is about identifying these distinct value drivers in both the customer base and the product and services. Our strategy planning needs to incorporate strengthening the revenue drivers. Prior resources give clear action items to be incorporated into the strategic plan.

The facility component is typically over-valued by owners since the spending for this is very easy to identify. The facility really encompasses the system of production whereby the goods or services are created. The costs of the facility are well documented and for most owners form the starting point for valuation – we want our investment back. Yet, we must remember that all valuation is based on future cash flows. Too often the investment was made some time back, so it is aged (think depreciation) and the business is being transferred because of the reasons noted above (think cash flow is not as good as we would like). Thus the value of the facility can be lower than the owner is thinking.

Intellectual property is the most under-identified and includes patents, trademarks, trade secrets, formulas, inventions, software, and any other proprietary knowledge or tools which allow the company to conduct business in such a way that monetary value is realized. Today there are tremendous amounts of IP in companies, even very small companies. Understanding the IP and its role allows us to strategically develop our IP and enhance our company’s performance with this IP. An example is the website and its use in marketing. Too often these are under developed and under documented. Our strategic plan should include this component in our value creation component. 

Being transferable is the ability for the business to be transferred via a transaction between a willing buyer and a willing seller. If the entire knowledge of operations of the business remains in the owner’s head, it is not transferable. Systems and documentation are vital to creating a going concern that is no longer owner-centric.

One way that professional practices create value is through a proper buy-sell agreement. Buy-sell agreements help to create a market for an interest in the business and the market than creates the liquidity for the interest. A good buy-sell agreement should include identification of a triggering event, the value calculation metrics, and the payment structure and timing. 

Pricing and the Sale Process

When a business has determined that it has identifiable and transferable value, a potential buyer is than located. In small transactions the seller typically has a clear idea of who should purchase their company. The Giersch Group advises many of our clients on transfers and every case has shown this to be correct.

There are four potential buyers for the typical small enterprise:

1. Sell to an insider, or bring someone inside and groom them for the sale.
2. Sell to a competitor.
3. Transfer to a family member.
4. Sell to a larger company. 

Regardless of what the seller believes the value of the enterprise to be, the price is dependent on what the buyer is willing to pay. In small transactions there is no merit to thinking that a bidding war will be created between multiple buyers. The seller needs to demonstrate the value to the buyer through a clear picture of the value drivers noted above and the synergies created upon this acquisition. The seller should have a realistic sense of the value, which often is helpful to communicate to the buyer upfront.

Beyond that, the price not only needs to be connected to the value but must also be financeable. Particularly in the current lending environment, the buyer needs to have sufficient cash or access to capital. Bank lending is limited to fixed assets, accounts receivable and inventory. The rest of the price will often be a note and/or an earn-out over time based on agreed upon revenue targets. This leads to sellers effectively financing the transaction.

Valuation Techniques

There are three predominant ways value is measured in transactions including net asset value, a percentage of revenue, and discounted cash flow. Net asset value typically leads to the lowest value, since intellectual property is not included. For example, a medical practice valued by this method might factor in real estate and equipment and deduct debt to reach the value. However, this does not factor in the patient list or other items that might hold value to the buyer.

Most professional firms utilize the percentage of revenue valuation methodology. The bandwidth of value can be wide at 50 to 200 percent. In this method accurate financials are key to demonstrating the profit margins and how these margins will be maximized by the buyer.

The discounted cash flow method is a more complicated level of thinking which does not typically work for transactions under $5 million. Only if the buyer is a large company might this method be considered for a small business. In this method a multiple of free cash flow or net income is evaluated against the potential payback period. A payback period of 3 times, or three years, is a long time for a small business to project consistent net income in the future. The risks inherent in small businesses make long term projections a risky basis for determining value.

Value Transfer Stumbling Blocks There are some common stumbling blocks to the transfer of value which should be avoided:

• Poor tax structure: The wrong tax structure can cost a lot more than anticipated at sale time. Being structured as a C corporation will cost you 30 percent of the amount over the net asset value in a sale. Another common problem is if the business is utilized as a tax shelter. This inhibits the buyer from really seeing how profitable the company actually may be.
• Poor financial statements or lack of records: While a potential buyer might be able to watch a retail shop or car wash for traffic, they should be purchasing based on financial records that are provided during due diligence. Inaccurate tax returns or missing records increase the risk to the buyer, often causing a dramatic decrease in the price they are willing to pay.
• Complicated structures: If there are too many family members, partners, or a complicated trust in the ownership, it creates unnecessary complexity to closing the transaction. Cathedral has seen such structures make the company nontransferable.
• Minority interest without Buy/Sell agreement: Without an agreement in place a minority interest is not transferable and therefore has little or no value. • Inability to Identify Buyer: A small business owner needs to be able to identify potential buyers and know who they would like to sell their business to.
• Poor asset structure: Mixing real estate or other owner assets in the business entity can impair the sale of the business. 

Case Studies

In our experience, we have found that most small business owners are not aware what their business is worth, or how to value it. In order to establish a realistic sale price, it is vital for the owner to be clear on what value is and how it is realized.

Let’s suppose Companies A, B, and C are all owned by people who simply no longer desire to continue as the owner/operators. As demonstrated in the chart below, Companies A and B had annual revenues of $100,000 with a 40% gross margin, while Company C had annual revenues of $300,000. Although Companies A and C had a long history and Company B was relatively young, all owners were tired of running their businesses.

After Company A and Company B identified potential buyers to acquire their company, the sales price dramatically different in each situation. Why was the value of the companies in the sale process so dramatically different?

Company A and C both encountered the value stumbling blocks outlined above. A lack of preparation in demonstrating synergies to the buyer as well as an inability to produce the necessary financial documents and records led to the low price for Company A. In the case of Company C, there were interested buyers in the business, but combining it with the real estate caused the structure to be undesirable to those buyers. Exhaustion led to a quick liquidation with no value received for the customer base or intellectual property.

Company B, however, identified two potential buyers. With good records and a package that clearly demonstrated the synergies and gross profit value to the buyer, the desired price was obtained. A willingness to allow seller financing through an earn-out further enabled the buyer to be able to complete the transaction.

Preparation Begins Now If a company is to realize the value that it has or will build, it is important to begin considering the exit strategy from the creation of the initial business plan. The annual strategic plan is the perfect time to implement solid business disciplines and best practices for your industry, while being sure to build the value drivers. A potential strategy for exit should be identified and written down as part of the annual strategy plan. Ideally, the exit strategy is being considered at least three years prior to the sale to allow maximization of value realization.

When the time comes to exit, create a package which clearly shows the business and each value component to the potential buyer. Regardless of the size of the business or the knowledge of the buyer with the industry, do not presume that the buyer knows your business. Use the presentation as an opportunity to demonstrate the full value that you are seeking in the price.

Actions

1. Update the strategic plan giving consideration for clarifying value drivers.
2. Add an exit plan section to the strategic plan, including:
   1. Identify a potential buyer for your enterprise.
   2. Undertake a quick value analysis to understand what the business could be worth today and at the end of the strategic plan.
   3. Consider what preparation is needed for your company to realize full value. 

Articles for Further Reading

1. “Persuasive Projections.” This article discusses the necessary elements of financial projections particularly focusing on what loan officers and investors are looking for. http://www.inc.com/magazine/20000401/18118.html.
2. Robbins, Stever. “Exit Strategies for Your Business.” This article highlights four potential exit strategies: Just Take it, Liquidation, Sale, or Acquisition. http://www.entrepreneur.com/management/operations/article78512.html. 3. The SBA.gov website provides additional resources for planning your exit from the business. http://www.sba.gov/smallbusinessplanner/exit/planyourexit/index.html. 4. “Gain Control by planning the exit from your small business.” Listen to this discussion featuring David Gage as they discuss why to establish an exit strategy now. http://smallbusiness.forbes.com/small-business-interviews/david-gage-8416 

For more information, please visit the Giersch Group at http://www.gierschgroup.com/ or contact us at prosper@gierschgroup.com