Aligning your goals and objectives with an exit option and creating a well-rounded transition plan.
While some business owners have given considerable thought to the transition of their business and have a fully developed succession plan in place, many others have not given it much consideration. Business owners who have developed a well-thought-out transition plan have positioned themselves and their families for a better outcome whenever that event occurs.
There are a limited number of options available to any private owner wanting to exit his or her business and each situation is unique, so those options can be limited even further by the specific circumstances of the situation.
Aside from taking a company public through an initial public offering, there are two basic approaches to exiting a business:
“In my experience, no two shareholder situations are the same and understanding the true goals of the parties involved can help determine the best option for the shareholder,” says Paul Morgan, Managing Director, RBC Mid-Market Mergers and Acquisitions. “If keeping the business in the extended family is the most important goal, the business will in all likelihood be transferred to a related party; however, if maximizing proceeds on sale is most important, shareholders will typically look to sell to a third party.”
Keeping a business in the family and transferring it from one generation to the next can be very appealing to a business owner and his or her family. This option is usually selected by an owner who wants to see the business continue in a similar fashion. If done well — and seamlessly — one of the benefits of this approach is a reduced risk that there will be negative consequences from customers, suppliers or employees.
However, exiting a business can be very complicated and difficult at the best of times, and adding family dynamics to the situation can create considerable strain and stress that may have long-term adverse consequences on the family.
Choosing the right successor will generally have a significant impact on the future success of the business and, potentially, the family’s overall wealth. It is not always necessary to consider all family members when selecting a new leader. If the business is large and complex, it will need an experienced person to effectively manage the business to its potential. A person with that skill set may not exist in the family and, unfortunately, it is sometimes hard for a family to draw that conclusion on its own.
“I have found that outside assistance is often warranted in these situations,” says Morgan. “Business facilitators can be engaged to evaluate the capabilities of the family members and ultimately make recommendations to the family as to successor suitability. It helps to take some of the emotion out of the decision for a family, but it is never easy.”
In general, transfers to the next generation are fairly common and can be a viable option for a business owner if there is a capable and qualified successor within the family ranks.
A management buyout (MBO) is another attractive option for an owner wanting to exit his or her business. Selling to an MBO team can have many positive aspects.
The MBO team and the seller typically are very familiar with one another and recognize the win-win nature of the transaction. This may lead to fewer “hard positions” being taken and ultimately to an increased likelihood of a timely closing of the purchase and sale.
A top management team will also have fundamental insights into the business that will make the due diligence process (including accounting, business and legal) almost non-existent as compared to the same process with a third-party buyer. In addition, if the management team has a strong track record of operating the business, debt financing a portion of the purchase price should also be comparatively easier. The transition risk is also minimized, as the MBO team is already known to customers, suppliers and employees, and may limit the disruption to the business when ownership transfers.
In all leveraged buyouts, determining the amount and source of the equity component of the purchase price is vital and MBOs are no different. Internal buyers (whether a family member or a management team) will typically have access to limited amounts of cash or equity to use. Therefore, in most small- to mid-sized companies that are considering an MBO, the vendor typically has to co-operate to a great extent with the management team, offering a favourable purchase price and providing a vendor note on favourable terms, to enable the deal to close in a timely manner.
In the case of mid- to large-sized companies, management teams will typically partner with a financial partner that can provide a significant portion of the equity component of the purchase price. While this can be appealing to a management team, it does have its drawbacks. If they can contribute only a small portion of the total equity required, they will receive only a small portion of the ownership. Some management teams may or may not be willing to risk personal assets, have limited control and report into a new organization for a small ownership position. Everyone’s goals and risk tolerances are different. Understanding the nuances of MBOs will enable a business owner to determine if this is a viable option in his or her situation.
Selling to an existing business partner provides the benefit of working with a known party and may lead to quick and uneventful closing as compared to dealing with a third party. Unfortunately, any discord between partners can create a long, drawn-out process. Common issues may typically arise around valuation and payment terms. A well-devised and up-to-date shareholders’ agreement will lay out the rules and basic steps to follow when transitioning any ownership interest and can help smooth out the process.
Depending on the circumstances, financing these transactions may be relatively straightforward. There are a number of factors that impact a financial institution’s willingness to finance the buyer (assuming a reasonable, profitable business). These include: the buying partner’s track record of operating the business; a reasonable valuation; the existence of non-compete/non-solicitation clauses; and the absence of any foreseeable adverse effects on the business or its relationships from the loss of the partner exiting. In the right situation, by leveraging the cash flow of the business, the buying partner can generate a significant return on his or her investment.
A business owner can also approach third-party buyers (or engage an intermediary to do so on his or her behalf), such as strategic buyers or private equity groups (PEGs), to determine their interest in purchasing the business.
“If the business owner is attempting to get the highest and best offer for his or her business, engaging a professional to run the divestiture process will usually result in the best deal,” suggests Morgan.
Selling to a strategic buyer typically represents a very good option for most business owners. Strategic buyers are often in the same or a similar business to the company being sold. As such, they understand the markets served and the risks, and they have the potential to extract various synergies. Due to their competitive position in the marketplace, strategic buyers are usually in the best position to pay a premium for the company. The drawback with opting for a strategic buyer is the requirement to disclose confidential information to the potential buyer, who may in some cases also be a competitor.
Financial buyers, or PEGs, are looking for businesses with quality management teams, a strong earnings history, good margins/projected financial results, a sustainable competitive position in the industry and attractive long-term prospects. Often these buyers require the existing management team to stay on after the purchase, as they generally don’t have a management team of their own to put in place. Generally, PEGs have a very professional approach to the acquisition and can be a good option if the business meets many of the characteristics outlined earlier.
In general, selling to third-party buyers is considered to be a good option for an owner who wants to exit his or her business and maximize deal terms.
There are a number of items business owners should consider when preparing their organization for a sale. The most common factors to review and analyze are: shareholder/tax planning opportunities, the management team, the company’s management information systems, the customer base, the timing of the sale and cash flow.
A proactive approach to integrated family wealth and tax planning can produce a number of benefits for the shareholder and the family. Working with experienced, qualified professionals to set up a sound wealth and tax plan will help to eliminate risk in the transition process and ultimately lead to more after-tax proceeds following the sale. Additionally, engaging your qualified advisors early will give you the ability to think about your options thoroughly.
Existing business owners should evaluate the depth and breadth of their current management team and consider making changes that would improve the business and its potential saleability. In addition, businesses that rely on one key shareholder or manager can create significant issues for a buyer, and the potential for problems will increase if that key person leaves.
Well-managed companies usually have well-developed management information systems. The “it’s all in my head” approach to management information is never the best answer when you are transitioning. Investing in, and developing, good management information systems will pay dividends, as it gives the management team the tools to effectively manage and improve the business, which often translates into higher value. In addition, the due diligence process can be onerous, and having an ability to produce good information is a benefit to both the buyer and the seller.
When it comes to exiting a business, the statement “all situations are different” is very applicable. While there are a number of options, understanding your goals and objectives can often guide your exit strategy. If it is important to see the business continue into the future in a similar fashion, the internal buyer is a likely choice. However, if the objective is to maximize deal terms, the preferred choice may be a sale to a third party.
“Customer concentration is one of the most common problems in businesses that we see,” says Morgan. “If no action is taken to lessen the importance of that one major customer, this may limit the value and have an unfavourable impact on how the sale proceeds are paid.”
A potential buyer is ideally looking for a growing and diversified customer base. A business that is heavily reliant on one customer presents a substantial risk due to the potential that the business’ value will decline if that customer leaves. To the extent possible, expanding the number and quality of your customers will have a positive impact on the value of the business.
Running a good business with a good management team provides the shareholder with a greater ability to determine the timing of the sale. The best time is generally when the business is performing well, the economy is doing well and the potential for the industry is positive. Sometimes things do not work out as planned and poor operating results occur. Timing of the sale in this situation is tricky and usually delayed until a year of good results post-turnaround have occurred or some other strong evidence exists that the business is now performing well.
“Companies that attract a higher multiple when sold generally have a high-quality cash flow (consistent, recurring, high margin and growing) and are in an industry that has favourable growth prospects,” says Morgan.
Cash flow tends to determine value and the better the quality of the cash flow and its growth potential, the greater the value. One of the best ways to improve it is to put yourself in the buyer’s position and critically review the risks attached to the cash flow in the business. Issues may be related to customer, supplier or key employee reliance or declining markets for certain aspects of the business. Anything that creates a sense of risk or uncertainty in the buyer’s mind will have an adverse effect on value so a careful review and improvement of the factors that impact value will have a positive overall effect on the transitioning of the business.
Note: Given the complexities involved in business succession and that each business owner’s circumstances and goals are different, it is crucial to consult with qualified advisors and tax and legal professionals to ensure your situation is properly addressed and that planning is carried out to best suit your needs and goals.
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