Graceful Exits: Six Steps for Successful Busiess Exit Plaig. Prepared by: Robi Love, Maagig Director, M&A Advisory, Busiess Advisory Services. Tim Morriso, Seior Busiess Appraiser, Busiess Advisory Services. Richard Watso, CFP, CHFC, CLU, Seior Director of Plaig, Busiess Advisory Services. I this white paper 1 Overview of the process 1 Idetify busiess exit plaig goals ad objectives 1 Aalyze the busiess 1 Determie a prelimiary rage of values for the busiess 2 Idetify optios for trasitioig the busiess 5 Review optios for fudig or fiacig the trasitio 5 Develop implemetatio strategy ad timelie
Graceful Exits: Six Steps for Successful Busiess Exit Plaig At some poit, every busiess ower faces a busiess trasitio. Sice the busiess ofte represets the sigle largest asset o may busiess owers persoal balace sheets, its value ca represet a lifetime of focus, eergy, ad work. This ca make the time spet plaig for a busiess trasitio a period of high stress ad emotio. For this reaso, may owers fid participatig i a comprehesive busiess exit-plaig process especially valuable. Busiess exit plaig helps busiess owers to clarify their busiess trasitio ad exit plaig goals, objectives, ad motivatios, icludig idetifyig whe ad how they ited to trasitio from the busiess. Overview of the process. The exit plaig process cosists of six sequetial steps. Each of these steps is discussed below. Six Step Exit Plaig Process i greater detail. This ofte etails learig more about a ower s persoal fiacial ad retiremet plaig goals ad eeds, the seior maagemet ad leadership team, rak ad file employees, ad other stakeholders, such as key customers ad suppliers, as well as reviewig trasitio-related goals for the busiess. Aalyze the busiess. Aalyzig the busiess ivolves both qualitative ad quatitative factors. Amog other cosideratios, idustry dyamics, compay performace ad positioig, ad market coditios ca greatly impact what a compay is worth ad, therefore, a ower s trasitio alteratives. As a result, the busiess exit plaig process ofte icorporates ecoomic ad idustry specific research, i additio to fiacial statemet aalysis ad idustry bechmarkig. The iclusio of this ecoomic ad idustry aalysis ca help idetify the compay s historical ad projected fiacial status prior to a aticipated trasitio. 6. 5. Develop Implemetatio Strategy Review Fudig Optios 1. Idetify Exit Plaig Goals 2. 3. Aalyze the Busiess Determie Busiess Value The compay s pla for maagemet successio should also be reviewed, sice maagemet successio, especially amog the compay s leadership team, ca be a critically importat factor i certai trasitios. Maagemet buyouts, sales to employee stock owership plas (or ESOPs), ad sales to private equity, for example, ca be very difficult trasitio paths without a strog maagemet team i place. Special arragemets to retai these key employees, such as employmet, o-compete, o-solicitatio, ad icetive arragemets, should also be cosidered. 4. Idetify Trasitio Optios Idetify busiess exit plaig goals ad objectives. As with ay comprehesive plaig process, the busiess exit plaig process begis by explorig a busiess ower s busiess exit plaig goals, persoal ad busiess objectives, ad the ideal trasitio timelie Determie a prelimiary rage of values for the busiess. Regardless of the method of trasitioig the busiess, a prelimiary estimate of what the compay is worth helps to cofirm that the aticipated rage of values is acceptable (i.e., ot too low) from a shareholder s perspective. This estimate is especially helpful early i the busiess exit plaig process, as shareholders assess, evaluate, ad compare the ecoomics of differet trasitio optios at the same time. Graceful Exits: Six Steps for Successful Busiess Exit Plaig 1
Whe providig a prelimiary rage of values for the busiess, a bled of three geeral busiess valuatio approaches is commoly suggested. Commo methodologies iclude the followig: Asset-based approach. The asset-based approach to busiess valuatio cotemplates the value of the compay s assets, et of liabilities. This approach is ofte cosidered of greater importace whe valuig a compay that has o earigs history or has oly bee margially profitable, or if its value ca be attributed to tagible assets. Market-based approach. The market-based approach to busiess valuatio compares the subject compay to similar busiesses that have bee sold or are publicly traded. This approach etails makig a direct compariso to completed trasactios of similar compaies 1 or to select publicly traded stocks. 2 Icome-based approach. The icome-based approach to busiess valuatio attempts to covert the compay s aticipated ecoomic beefits ito a preset sigle amout. The icome approach is ofte applied by the use of a discouted future beefits method ad/or a capitalizatio of beefits method. These methods estimate the value of a compay based o its expected beefits stream. Geerally, this ca be accomplished by the capitalizatio of a beefits stream over oe period 3 or discoutig future beefits 4 forecasted for a period of years. Because these valuatio approaches do ot ecessarily assume specific trasitio paths, reviewig what the busiess may be worth to differet types of buyers ca also be very isightful from a busiess exit plaig perspective. For example, a ESOP trasactio may ivolve a lower valuatio tha, say, a sale to a strategic buyer, who may be willig to pay a premium for the perceived syergies of the acquisitio, which the busiess exit plaig process should also attempt to aticipate. Idetify optios for trasitioig the busiess. Most owers face a predictable set of strategic alteratives for the trasitio of their busiess. These alteratives ca differ i material ways, depedig o a ower s objectives, the compay s positioig withi the idustry, ad market coditios. I additio to multigeeratioal family busiess trasfers, the busiess exit plaig process typically icludes a review of several trasitio optios at the same time: Maitaiig the status quo. Sellig to maagemet (maagemet buyout). Sellig to a employee stock owership pla (ESOP). Sellig to a fiacial buyer. Sellig to a strategic buyer. Goig public through a iitial public offerig (IPO). Each optio has distict advatages ad cosideratios. The most appropriate type of busiess trasitio may deped o a ower s ear- ad log-term trasitio plaig objectives, the compay s curret performace, ad prevailig market coditios, amog other factors. Table 1 o the ext page summarizes the most commo trasitio alteratives cosidered by most owers, alog with a discussio of the practical issues that ca surface durig the busiess exit plaig process for that alterative. Each of the busiess trasitio alteratives are discussed i greater detail below. Maitaiig the status quo. A decisio to maitai the status quo represets the default alterative for busiess owers. Shareholders retai 100 percet owership of the compay, maitaiig full cotrol. Doig othig itroduces o icremetal risk ad owers cotiue to beefit as the compay grows ad prospers. The compay fiaces expasio through iterally-geerated cash flow ad additioal bak borrowigs i the ormal course of busiess. Owers cotiue to ejoy the beefits (ad risks) of the veture. Status quo offers limited liquidity ad wealth diversificatio, relegatig wealth preservatio ad creatio to ogoig busiess executio risk. Without iput from a strategic or fiacial parter, the ower cotiues to go it aloe, potetially riskig wealth by bettig o favorable future operatig results. Importatly, maitaiig the status quo may ot address the liquidity eeds of distict owers who develop uique iterests ad objectives over time. Should additioal bak borrowigs prove ecessary to fud growth, a busiess owers persoal liability may icrease as a result of the persoal guaratees required by may leders. Sellig to maagemet (maagemet buyout). I order to capitalize o the experiece ad loyalty of the existig maagemet team, sellig to key maagers sometimes referred to as a maagemet buyout (or MBO) may be a primary objective of may 2 Graceful Exits: Six Steps for Successful Busiess Exit Plaig
Table 1: Exit Plaig Strategic Alteratives Drivers Alteratives Ratioale Practical Issues Status Quo Cotiue growth ad build scale Ehace competitive positio Maitai owership/cotrol value creatio No icremetal risk itroduced Difficult to fud icreased growth Lack of wealth diversificatio Postpoes liquidity/future value ucertai Busiess executio risk Does ot address eeds of juior parters Shareholder Objectives Maagemet Buyout Capitalizes o experiece of existig maagemet team Provides key maagers with the potetial for a sigificat fiacial retur Key maagers are able to preserve their preset job ad icome stream Maagemet ca utilize leverage to fiace the purchase Maagemet team may ot have skills to effectively maage the busiess Ower retais busiess executio risk to the extet he/she fiaces the trasactio Liquidity available to ower depeds o the fiacial positio of maagemet Leverage may impair fiacial flexibility Possible loss of cotrol Idustry Dyamics & Compay Positioig ESOP Compay fiacial positio ca support a ESOP trasactio Opportuity to beefit all employees Equity owership motivates employees ad icreases commitmet level to the compay Tax beefits deductible cotributios, sectio 1042 tax deferral Liquidity evet for sellig shareholder(s) Limited votig rights to pla participats Feasibility study eeded Ower s desire to beefit all employees Admiistrative costs associated with a ESOP C-corporatio vs. S-corporatio tax issues Qualified pla subject to ERISA rules Repurchase obligatio with respect to departig employees Sellig shareholder typically retais busiess executio risk Leverage may impair fiacial flexibility Majority/Partial Sale to Fiacial Parter Provides sigificat liquidity while preservig some upside Provides additioal fiacial/strategic resources Desired liquidity ca be varied Helps to equalize juior parters ad fouders Addresses key shareholder goals Valuatio discout to outright sale Sigificat ivolvemet from ivestors i compay post-trasactio Possible loss of cotrol Modest leverage icreases fiacial risk Market Coditios Strategic Sale Complete liquidity evet; potetial spike valuatio Opportuity to combie with a larger, well-capitalized player May icrease access to cliets ad accelerate growth Reduces busiess executio risk Market valuatio Loss of cotrol Maagemet roles post-closig Trasactio executio risk IPO Headlie trasactio Partial liquidity Stock value established o a daily basis Access to log-term capital Public awareess of compay Lack of operatig cofidetiality Loss of maagemet cotrol Pressure for short-term performace Ogoig costs of beig public, icludig Sarbaes-Oxley compliace costs Potetial udervaluatio busiess owers; i other istaces, it ca be a importat back-up trasitio optio, particularly if idustry ad market coditios or the compay s positioig for a exteral sale prove to be a challege. Determiig whether a sale to key maagers is feasible requires careful cosideratio of a umber of factors. The ower must idetify potetial successors withi the maagemet team ad assess whether they have the fiacial ability ad commitmet to buy out the ower, which ca be especially difficult. Uless the buyout group ca secure fiacig for the buyout (usually from a leder or a equity sposor, such as a private equity group), may maagemet buyouts ivolve some level of seller fiacig, meaig that the departig ower must carry back a istallmet ote to help the buyout group fiace the sale trasactio. Sice these paymets are idirectly based o the cotiued success of the busiess, the ower s remaiig paymets may be at risk should the busiess or maagemet team experiece a reversal durig the seller fiacig period. Graceful Exits: Six Steps for Successful Busiess Exit Plaig 3
Sellig to a ESOP. A ESOP is a special type of qualified retiremet pla established for the beefit of employees. ESOPs are permitted to ivest i employer stock ad may eve borrow moey to buyout a shareholder, makig it a especially attractive trasitio optio i some situatios. For example, busiess owers with C corporatios who have held their stock for three years ca use the proceeds from their stock sale to purchase a qualified replacemet property ad defer their capital gais whe this trasactio is completed withi 12 moths of the stock sale, uder Sec. 1042 of the Iteral Reveue Code (IRC). Owers of S corporatios ca also use ESOPs as a trasitio optio or for shareholder liquidity, but do ot reap the same capital gai deferral beefits. While ESOPs offer may special tax beefits, icludig potetial capital gai deferral for C corporatios, they also ivolve icreased complexity (i.e., IRS, ERISA, ad Departmet of Labor regulatios specific to ESOPs), which ca icrease the iitial ad ogoig admiistrative costs of the trasactio. I practice, ESOPs also face maagemet successio, fiacig, ad risk issues similar to maagemet buyouts. Uless the ESOP ca secure fiacig for the buyout (usually as a back-to-back loa from the compay, leveragig the compay s credit facility), the sale trasactio may require some level of seller fiacig, though the tax beefits ca also help to accelerate the repaymet term. Sellig to a fiacial buyer. Shareholders seekig partial liquidity ofte look to a partial sale to a fiacial buyer or private equity sposor. Fiacial buyers ad private equity fuds acquire miority ad majority equity positios i operatig compaies, build the busiesses by cotributig strategic ad operatioal experiece, ad the achieve liquidity i a future secod sale, geerally two to six years later. This relatively log timelie ofte fits the eeds of a ower balacig the wish for ear-term liquidity with the desire for participatio i the future upside of the busiess. Sellig shareholder groups with diverget iterests, such as fouders, secod geeratio owers, ad outside executives, ca mix ad match their trasactio liquidity ad equity rollover participatio based o their persoal situatio ad objectives. Maagemet stays i place with a focus o growig the busiess, frequetly through acquisitios ad other ew strategic iitiatives. Similar to other o-strategic alteratives, fiacial sposor-led liquidity evets geerally rely o the use of leverage to fiace a sigificat portio of the purchase price while offerig few strategic syergies. Credit availability, required ivestor returs, ad the lack of strategic syergies may limit the purchase price fiacial buyers ca pay. Havig ew istitutioal parters, such as a private equity ivestor ad seior or mezzaie leders, ca create ew fiacial reportig ad operatioal requiremets at the board level dow to day-to-day operatig decisios. Additioally, ew trasactio-related debt creates default risk for postclosig shareholders ad debt service may become a stressful, upleasat experiece for maagemet teams ot accustomed to operatig with leverage. Sellig to a strategic buyer. Etrepreeurs ad busiess owers focused o achievig maximum value ad full liquidity typically seek strategic sales. A strategic sale ca represet the shortest timelie to liquidity ad departure from the busiess post-closig. Facig a buy-vs.-build decisio, may strategic acquirers tur to acquisitios to quickly build market share ad gai access to ew markets, proprietary products, ad complemetary brads. Opportuities for syergies, i the form of icremetal reveue opportuities ad/or expese reductios, ca ehace the post-closig value realized by the strategic buyers, allowig them to pay a higher purchase price relative to other buyer types who do ot reap such beefits. For strategic buyers, the curret market may provide opportuities to grow through target acquisitios, especially for those with strog cash-rich balace sheets ad available borrowig capacity. While the beefits of full value ad immediate liquidity ca meet key shareholder objectives, sellig shareholders must come to terms with certai trade-offs iheret i a sale to a strategic etity. While the owership chage elimiates the risk to curret owers from ufavorable iteral or exteral developmets i the future, sellig shareholders reliquish cotrol of the busiess, face itegratio-related chages, ad give up participatio i the future upside of the busiess. Durig the sale process itself, the busiess ca be exposed to a variety of risks, icludig competitive exposure, breaches of cofidetiality, ad maagemet distractio. 4 Graceful Exits: Six Steps for Successful Busiess Exit Plaig
Goig public through a IPO. Fially, if owers are willig to liquidate their holdigs over a log period of time ad feel that a IPO might provide a premium price for the compay stock, the, i select istaces, they may cosider goig through a IPO as a trasitio optio. However, the substatial oe-time costs of a IPO, eve if usuccessful, plus the aual cost of compliace as a public compay, which ca be $1 millio or more per year eve for smaller compaies, must be cosidered. Eve if a compay is large eough to cosider a IPO, ad the compay s idustry ad track record make it a cadidate, a IPO will usually ot provide owers with a sigificat amout of immediate liquidity. This is due to the fact that ivestors wat to see a IPO where most or all of the proceeds remai i the compay for busiess expasio, acquisitios, etc. While the sale of a small amout of idividually held stock i a IPO is geerally acceptable, the larger percetages usually see i other sale trasactios (30 to 100 percet) are ucommo i a IPO. It is also ot uusual for the stock to be subject to a lockup provisio, which prevets owers from sellig their stock i the public markets for a specified period of time (i.e., oe or two years). Review optios for fudig or fiacig the trasitio. Sources ad uses of available fuds ofte determie or limit a ower s busiess trasitio ad exit plaig optios. Most trasitios ivolve some form of fiacig or fudig from a debt or equity sposor, such as a commercial bak, mezzaie capital, private equity, etc. Otherwise, by default, seller-fiacig ca play a large role i a trasitio. It is also ofte ecessary to determie how various fiacig or fudig arragemet may affect busiess operatios, especially if the busiess is cotemplatig ew debt as part of the trasitio strategy. Develop implemetatio strategy ad timelie. Fially, implemetig a busiess exit pla requires a team of professioals. I additio to a CPA ad attorey, a busiess ower may ofte eed a experieced ivestmet baker, busiess appraiser, ad/or other specialists to help implemet the strategy. This requires commuicatio ad early idetificatio of the ecessary steps, as well as estimatig a timeframe for completio ad amig resposible parties for specific aspects of the busiess exit plaig process. While busiess trasitios ca be complex, followig a disciplied process ca help owers to cofidetly pla ad execute a successful busiess trasitio ad maximize outcomes for all stakeholders. To lear more about busiess exit plaig, please cosult with a Wells Fargo relatioship maager today. Ed otes. 1 Guidelie Compay Trasactios Method. 2 Guidelie Public Compay Method. 3 The capitalized beefits method is appropriate whe the compay is stable, ad the historical results of operatios are cosidered a good idicator of future results. 4 The discouted future beefits method is appropriate to use whe the compay s future operatios are expected to be substatially differet from curret operatios ad the future operatios ca be forecasted with some accuracy. I additio to such fudig cosideratios, busiess owers also may wat to cosider the icome tax cosequeces of their chose trasitio pla at this step i the busiess exit plaig process. Will the trasitio be structured as a taxable or tax-free stock sale, asset sale, or merger? What tax electios will be made (i.e., will a Sec. 338 electio be made) by the seller ad buyer, ad how will tax plaig for the ower be icorporated ito the deal s structure ad sale process? Graceful Exits: Six Steps for Successful Busiess Exit Plaig 5
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