Periodic insights from our Investment and Private Client Teams on a broad range of investment and advice-related topics
“The whole purpose of places like Starbucks is for people … to make six decisions just to buy one cup of coffee. Short, tall, light, dark, caf, decaf, low-fat, non-fat, etc. So people who don’t know what the hell they’re doing or who on earth they are can … get not just a cup of coffee but an absolutely defining sense of self.” (Joe Fox played by Tom Hanks in the motion-picture movie “You’ve Got Mail”.)
In contrast to that Starbucks customer, business owners do know what they are doing, but often find themselves stymied when it comes to making the myriad of decisions related to their exit strategy. They face the challenge of having a significant concentration of their wealth and income locked up in the business. And for many it is the business, not coffee, that provides them with a defining sense of self.
Sooner or later, business owners will face the difficult decision of how to turn those years of sweat equity into cash. The sale of a business is both an end and a beginning. It’s the culmination of many years of hard work and, in theory, should be a life-fulfilling event. In theory! The reality is, however, that exit strategy planning is something many business owners don’t do well. There is often a lack of understanding, attention and urgency when it comes to planning an exit. Too often, the end result is frustrating: did I sell to the right person? Did I get the right price? How do I analyze and think about what I should do with this newly-created financial windfall?
Time and again over the past twenty years, we’ve seen many clients face this challenge: transitioning from a business owner to an investor owning a diversified portfolio of assets. The real challenge for entrepreneurs is transitioning from “wealth creation” to “wealth preservation”. Our firm is made up of entrepreneurs, business owners and former senior executives of public companies. Our combined skill-sets in portfolio and investment management, corporate and investment banking, private equity and law provide us with a unique vantage point to work with our clients on strategic wealth management issues such as the monetization of their businesses. While our core business will always be professional investment management, having been there before, many of our clients look to us to provide value as strategic advisors that can help them plan, navigate and implement their exit and transition strategy. This includes listening
carefully to our clients’ future goals, objectives and, not least importantly, values in order to help them consider and analyze the options the appropriate exit strategy, as well as the options that they will have to re-deploy the proceeds of a monetization event as part of an overall strategic wealth management plan.
The solution is to think of the end right from the beginning, and to turn the challenge into a major opportunity.
For most entrepreneurs, selling their company is the biggest transaction of their lifetimes. But often inertia sets in; owners are too busy building their businesses to think much about leaving it. They spend their time, importantly, on product strategies, budget processes, financings and sales and marketing plans. Exit strategies, however, are the least understood part of being a business owner.
The solution is to think of the end right from the beginning, and to turn the challenge into a major opportunity. The single most important benefit to a thoughtful and well-planned monetization strategy is that it puts the business owner back where they are most comfortable – in control.
The purpose of this paper is to better understand the particular challenges and opportunities for the entrepreneur as they transition between life as an active entrepreneur (i.e., wealth creation) and what will be the next chapter (i.e., wealth preservation). By exposing a number of vulnerabilities inherent in being an entrepreneur, primarily related to business concentration risk and certain emotional biases, we can better appreciate the nature of the liquidity trap that often arises where there is a significant concentration of wealth and income in one asset. Finally, we will provide an objective framework to help you ask the right questions, assess the options available to effectively mitigate these risks and biases and implement a successful exit strategy.
ARE YOU VULNERABLE?
Fortunes are made by the concentration of risk; fortunes are maintained by diversification, good governance structures and a well-thought-out spending policy. You likely made your money through a single company or a series of companies. You probably knew the industry very well and ran a smart business. Whether or not you spent time thinking about it, you were taking very high company-specific risk. You also had industry risk and broad economic risk. If the company, the industry, or the economy had trouble, there is a good chance you had trouble too.
One of the most important reasons to plan for a liquidity event is wealth diversification. Many owners have a disproportionate amount of personal wealth tied up in their company. Financial vulnerability is determined by the extent to which income and wealth are derived from the same source. Findings suggest that business owners face unique financial vulnerability because of their reliance on the business as both a source of income and wealth. A loss of either can greatly undermine household financial security. If these two are tied together, the vulnerability is even more pronounced. Further, the stronger the relationship is between the two, the greater the risk.
The ownership of the business introduces its own idiosyncratic risk. This risk extends to both wealth and income flows. Business owners not willing to accept any risk, ironically, tend to have higher allocations to their business. Research is consistent on this point and confirms the notion that entrepreneurs do not see the business as risky and have more faith in their own business than investing in others. In addition to defining oneself through your business, other emotional biases at play include over-confidence in both the business and sustainability of the industry within which it operates, and an entrenched view of the value of their business that often does not ebb and flow with the realities of the general economy, credit and capital markets. These biases and the lack of an objective framework to recalibrate expectations may also create a real financial risk. In addition, entrepreneurs must bear in mind that their business as a “wealth preservation” vehicle, in the absence of obvious internal successors, either management or family, runs the distinct risk of becoming a diminishing asset.
START PLANNING YOUR EXIT NOW
The most important aspect of a business exit strategy is advanced planning. A recent survey by PricewaterhouseCoopers revealed that only 25% of business owners had done any formal planning for selling or transitioning their business. Among those business owners with a strategy surveyed the principal options were to:
On the flipside, a study of 300 U.S. business owners found that 75% felt their sale did not accomplish their personal and financial objectives. Advanced preparation allows you to sell the business on your own terms with set financial objectives in mind. According to the Financial Post, out of one hundred business owners that recently sold, the majority claimed they made crucial mistakes and wished to do it over. Furthermore, a survey by Thomson Reuters in May 2009 concluded that 58% of North American business owners did not know their company’s true value.
Advanced planning gives the opportunity for valuable tax planning opportunities to maximize the cash (or other securities) you receive from the monetization event. It gives you ample time to enhance the value of the business if a preliminary valuation does not offer the financial objectives you had hoped to achieve, and it allows you to position and present your business in the best possible light to interested parties. Most importantly, strategically planning your exit gives you control over the structure, timing and outcome of the liquidity event.
A BLUEPRINT FOR SUCCESS
In the book “Every Family’s Business”, Tom Deans invites readers to listen in on a conversation between two people who meet on a plane. Both have recently sold their family businesses. Through their discussion it becomes obvious that one of them was much more successful than the other at running their business, timing its sale and cashing in on its full value. The two discover why that was the case and this culminates in the book’s revelation of the twelve questions that must be answered each year in the business to protect family wealth (see Appendix I for Deans’ twelve questions). Underpinning the twelve questions is a fundamental precondition to running successful family businesses: dynamic family involvement in business requires a candid discussion of performance, compensation and control issues.
Deans’ twelve questions, while an excellent framework for running a successful family business, have wider application to all business owners. Whether or not management and shareholders are related, preparing a blueprint by honestly reviewing and answering these twelve questions and updating it annually serves as an excellent, objective framework for developing a sound exit strategy.
A Word on Valuation
If an owner decides to monetize all or part of their business, then they are faced with an equally tough question: How much is my business worth? As stated earlier, the entrepreneur typically has an emotional bias that may create a deeply entrenched view on value. Preparing an exit strategy may lead to the recognition of a “valuation gap”. In our experience, expectations need to be recalibrated based on a fact-finding mission to effectively determine the appropriate valuation range for the business in the context of the market at the time.
Two important valuation principles need to be addressed: firstly, an owner must determine the appropriate and meaningful valuation metrics to use for valuing their business in their industry. For example, different businesses and industries might use a multiple of EBITDA, price to book, price to revenue, etc. Secondly, owners need to inform themselves, as much as possible, about comparable transactions which, similar to looking at comparable residential real estate trades when selling a home, can provide direction on valuation.
It is equally important for owners to engage an accredited business valuator with proven experience in selling and acquiring private businesses in their sector. A standard business valuation addresses areas such as financial reviews, facilities and equipment, information technology, management track record, market conditions, as well as intangibles such as intellectual property.
Many owners are disappointed when faced with the fact that valuations do not reflect the time and personal commitment to the building of a business. Early planning identifies the actual value and gives owners the opportunity to take steps to increase it. These might include:
1. Maintained revenue trends over time;
2. Entry into/potential for new markets;
3. Increased market share;
4. New management hires; and
5. New products in development.
Ultimately, the more unique, dominant and innovative the company, the more dynamic the sector, the more proven the management team, the more opportunities for growth, and the more the purchaser wants “you” and no one else, will be the key characteristics that determine the price. Value is in the eye of the purchaser. A smart business owner knows that and those planning an exit strategy will consider that there is no more important a challenge for their business than to ensure that they maximize the value.
Once you have developed your blueprint for an exit strategy, what next? It is important to select a good set of advisors who:
• Have experience in selling private businesses in your sector;
• Have experience in acquiring private businesses;
• Understand all the taxation consequences;
• Have research capabilities;
• Are able to communicate and negotiate effectively; and
• Are able to provide well-considered and objective advice.
There is a variety of ways in which a business owner can monetize all or a portion of their business. In addition, some of the monetization strategies may be combined. While an in-depth examination of each strategy is beyond the scope of this paper, we will touch on the following monetization events:
1. Public equity investment or strategic sale;
2. Leveraged recapitalization;
3. Private equity investment or buy-out; or
4. Succession passing to family or management.
Public Equity Investment or Strategic Sale
A buyout by way of an initial public offering (IPO) into the public capital markets may be a viable option to gain liquidity. The decision of whether or not to sell to the public sector largely depends upon business cycles and the overall economy. Larger payouts are available during market highs. During economic downturns, however, this market may simply be closed.
The size of the company is a deciding factor since initial public offerings are realistically for larger and more mature companies. Underwriters tend to favour companies of at least $150 million market capitalization before making their shares available to the public. Furthermore, there are a number of other friction costs associated with a public buy-out. IPO candidates must adhere to stringent accounting and reporting regulations which often results in a significant pre-IPO corporate reorganization including an overhaul of financial systems, all of which is time-consuming and expensive. The benefit of taking a company public is that the owner can retain control or significant equity ownership in the public entity.
A strategic sale, whether to a public company or a private company, is also an option. The benefit of this is gaining an immediate payoff of 100% of the company’s current value. However, this is not ideal for those looking to maintain majority control. Strategic sales force owners to give up larger shares of control so this would depend upon the owner’s willingness to step away from the company. Furthermore, public companies tend to align executive pay with performance, but most executives are awarded stock options on top of substantial salaries, leaving downside risk and loss if the company fails in new hands.
Leveraged recapitalization is a strategy where a company takes on significant additional debt with the purpose of paying a large dividend to the shareholders. The result is a far more financially leveraged company – usually in excess of the “optimal” debt capacity. The simplest measure of value added comes from the tax shield gained when a firm, which has debt capacity resulting from free cash flows in excess of ongoing needs, increases its leverage. The calculation of the present value of the tax shield is obtained by multiplying the amount of debt by the tax rate of the firm. Other results of the leverage include the disciplinary effects of having to meet debt service payments, as well as the possible negative effects of the costs of financial distress. One of the main benefits of a leveraged recapitalization is that the owner has not diluted his shareholdings and, consequently, is still able to benefit from the future financial success of the company. This “second bite of the apple”, in addition to the cash taken out of the business through a recapitalization, can potentially result in greater value than an outright sale.
Not all companies, however, are cut-out for leveraged recapitalizations; so careful consideration should be taken before adding significant debt to the balance sheet. Companies that historically do not demonstrate stable and high free cash flow, defensible market position, or realizable future growth are not strong candidates. Businesses that tend to fail post recapitalization are those who manage solely for short-term cash flow to pay down debt.
Private Equity Investment or Buy-out
Owners who need liquidity yet want to stay in control of and continue to build their businesses should consider a private equity investment. In essence, this alternative entails the sale of a portion of the company to a private equity firm. There is no need to give up control. In fact, many private equity firms insist that owners stay in place.
The private equity is extremely flexible. Owners can sell as much of their holdings as they want, depending on how much equity they want to divest. In addition, the private equity partner will help the management team continue to grow the company, so a future liquidity event will, hopefully, net a larger payoff.
Importantly, the benefits of a private equity investment go well beyond a cash infusion. Entrepreneurs gain a strategic business partner who can offer objective advice and high-level guidance to accelerate growth, enhance management practices, and prepare the company for a final liquidity event down the road. Partners from the private equity firm will participate on the company’s board of directors and will offer connections to other prospective members with deep board experience. They will help fill key management positions with proven executives who have moved similar companies to market leadership. They will also help develop the fiscal discipline and public company reporting systems that are critical to engaging potential buyers and underwriters.
Thanks to the high number of small and mid-market businesses in Canada, there are many private equity firms looking to purchase parts of small and mid-size businesses with much success. In fact, in 2008, Canadian buyout firms outperformed US competitors with 10-year returns reaching 16% vs. 7% in the US, and 5-year returns reaching 19% vs. 14% in the US. According to a Thomson Reuters report in 2008, the private equity market managed $84.7 billion capital, $41.5 billion captured through private equity buyout. This was an increase of 17% from 2007 despite the global financial crisis. Canada’s largest institutional investors remained bullish on private equity (up 17% from 2007) despite the recession. 2008 buyouts occurred in a variety of fields for small and mid- market firms including energy, manufacturing, professional services, healthcare, IT, media, and wholesale trade. With over 190 private equity fund managers and private equity funds continuing to rise, private equity is a viable option for business owners looking to unlock value in their company while still keeping control. Private equity buyouts occurred in a range of sectors in Canada in 2008 with high degrees of success making it an excellent choice for Canadian business owners.
Here are the main criteria for qualifying private equity firms: They should be at least 10 years old. Then you’ll know they are stable and have experience in both bull and bear markets. Make sure there is little or no turnover at the partner level and that they have proven experience in your industry. Ask for specific case stories and listen for a willingness to be candid and forthright about the details. A good private equity firm will also be very clear about its role and your role after an investment is completed.
Succession Passing to Family or Management
Another liquidity option for business owners is to pass the reins through a management buyout or family succession. A management buy-out (MBO) occurs when current management acquires all or part of the company. Most MBOs are funded through private equity investors who choose to invest in shares or offer management an interest-generating loan depending upon their risk preference. Most private equity firms will also require management to invest their personal equity in order to ensure that management has “skin in the game” and is motivated towards future success. With MBOs it is important for the owner to govern all principle-agent issues throughout the transaction. Impending MBOs could cause adverse management behaviour to subtly manipulate downward the company’s value through production lags, accelerating losses, launching questionable products, and publishing surprise earning losses. Passing the business onto a second generation family owner is another viable choice to gain liquid capital, but several important considerations should be made beforehand:
• Are they committed to the success of the business?
• Can they exercise good judgment to further the business?
• Can they lead and motivate the business’ employees to perform?
• Does your family member know the future goals of the firm? (Only 11% of family businesses have written rules to govern family members joining the team.)
These considerations can be achieved through mentoring the successor before you leave and eliminating any existing family conflict. Departing owners can even set up a strong set of advisors familiar with the business and industry to help a successor during the early transitional stages.
Without planning, there will be no transition between life as the business owner and what will be the next chapter. A financial windfall can create many emotions: excitement, anxiety, uncertainty, joy and fear. Business owners need to consider the impact of the new wealth, re-consider their life course, and define what they truly value. Understanding concentration risk and the emotional biases of the entrepreneur, and asking the right questions as outlined in this paper can help the entrepreneur be more thoughtful and strategic in creating a successful transition from wealth creation to wealth preservation.
Once you monetize your business, you have the opportunity to diversify away the vast majority of all of these types of risk, even economic risk. You can invest in a full range of assets that do well at different times in the economic cycle and that all do well over long periods of time. This includes the ability to continue to invest in the business and industry you know so intimately. As a follow-up to this discussion, a future paper will address the psychology of a windfall – transitioning from business owner to financial portfolio owner.
We have a lot of experience working with clients on this transition. By all means, do not hesitate to pick our brains!
This document is provided for information purposes only and should not be considered a recommendation to purchase, sell or hold any security.
APPENDIX I: THE TWELVE QUESTIONS
1. What does our [family] business look like in five years?
2. Are you interested in selling your stock? If yes, to whom?
3. Are you interested in buying stock and acquiring control?
4. Do you understand and agree that in the interest of maximizing shareholder value this business can be sold to a third party at any time? Yes or No.
5. I agree that within the next 60 days I will put in place a special compensation formula for my child [or key management] in the event that the business is sold in the next five years. Yes or No.
6. As a fundamental principle I understand that from time to time we will receive unsolicited offers from third parties to acquire the business. These offers will be considered and accepted at the discretion of the controlling shareholder and supported by the child [or key management]. Yes or No.
7. In preparation for the annual update of this blueprint I will arrange for an updated valuation of the business and will calculate whether there is an appropriate amount of insurance in place. I will furnish evidence that this has been done and that estate taxes will not impair the ability of this corporation to function after my death. Yes or No.
8. List at least three items in each of the following four categories that could affect the health of the business over the next five years: strengths, weaknesses, opportunities and threats.
9. To secure our future prosperity together we should either: A. Continue to run our business and invest more of our money in our company. Yes or No; or B. Proactively pursue the sale of our company. Yes or No.
10. Within 60 days of completing this blueprint we will complete a salary and bonus compensation review for my child [senior management]. Yes or No.
11. I agree to conduct an annual performance review of my child [senior management]. This review will measure performance against mutually agreed on and achievable goals and objectives. New goals and objectives will be set for the coming year. Yes or No.
12. Within 60 days of completing this blueprint I will present up-to-date job descriptions to all family members [management] working in the business that clearly describes their duties and responsibilities. I will include an up-to-date organizational chart. Family members [management] will adhere to the company’s policies and procedures. Yes or No.