By Andy Stockett

Your company has “hit the radar screen” of a larger competitor, a company seeking an avenue into your industry, or a Private Equity Group (PEG) looking for a platform acquisition that allows it to put to work money raised from investors.  Or maybe you have received a letter from a firm indicating that it has buyers for your company.  What do you do?

If you have put as much effort into planning your exit from your business as you have in planning your personal estate, then you are prepared for these inquiries and are in a position to respond to, and even take advantage of, the situation.  Of course an exit plan has to be fluid—specific factors will determine strategy and tactics—but with the large amount of cash on the balance sheet of corporate America and approximately $490 BILLION waiting to be invested by PEGs, business owners would be well advised to at least consider what a transaction would look like.  And this means determining in advance what it would take to ensure a favorable outcome for owners, management, and other stakeholders.

Business owners should first think about their goals and objectives.  Do they want to:

• Sell the business and exit the company completely?
• Sell the business and remain an employee of the larger entity with incentive options, bonus plans, etc.?
• Sell controlling interest to a Private Equity Group (PEG) but continue running the company?

At FourBridges Capital, we are routinely contacted by owners who are considering some type of financing or sale of their company.  In either case, we spend a considerable amount of time reviewing their options and understanding their financial and lifestyle objectives.  The nuances around these objectives influence the process we initiate and the types of buyers or investors that are targeted. 

Putting a company on the market requires a considerable amount of money, time, and emotional involvement.  In fact the “Business Reference Guide” reports that only 25% of closely-held businesses offered for sale ever actually close.  Each of the options in the bulleted points above are associated with factors that must be considered and addressed in order to ensure a transaction whose terms are acceptable to the owner.

Sell the business and exit the company completely.

In this scenario, the number of potential acquirers is limited primarily to corporate acquirers and the few private equity firms who are comfortable dealing with a management transition at closing.  A majority of PEGs maintain that they consider management depth and breadth above all when evaluating a company.  This is because they are focused on investing and do not have a base of operations applicable to a particular company.  Unless they already have an investment in a similar company in a similar industry, they will be reluctant to even entertain the notion of buying a company if the key executive is leaving. 

Corporate acquirers tend to be more comfortable than PEGs with management transition because they understand the business and will typically have a pool of human and technical resources to draw upon.  In many cases, they will fold the company into existing operations and look for synergies in a variety of areas.

Even so, if a buyer perceives that a company’s successful operation is largely dependent on a specific owner who intends to exit the business, that person’s exit will be considered a risk factor, and it will have a negative impact on the price that buyer is willing to pay.  For example, when a business is largely dependent on the owner’s technical or creative expertise, and this knowledge base departs with him, prospective buyers will be hard-pressed to believe the company will continue to perform as before.  Or if the owner’s personal relationships with customers are the key to company sales, buyers will be concerned that revenues will be at risk. 

Owners should consider investing in employees and organizational structures that can maintain the level of new product development, customer service, product quality, and sales and marketing expertise that has driven the company’s performance to date.  If owners do not make this investment, they can expect a lower valuation and/or an offer that reflects the buyer’s concern about future performance. 

In transactions in which owners walk away, they must be prepared emotionally for changes.  In many cases, the company will lose its corporate identity and, as stated earlier, be folded into the operations of a larger entity.   If the acquirer has similar operations, many functions, such as finance and accounting, purchasing, and human resources, will be consolidated into the home office, and layoffs will result from the acquisition.  At the same time, it makes sense that if the acquirer believes that the company has growth potential, it will make additional investment into the operations.  Existing employees may find that becoming a part of a larger organization provides them with more opportunities for advancement and the potential for increased access to more attractive benefit plans.

Sell the business and remain an employee of the larger entity, with incentive options, bonus plans, etc.

In this scenario, owners typically trade their company for cash at closing.  Depending on the value received, owners may have achieved permanent financial stability and be in a position to diversify assets.  They are no longer personally liable for any debt held by the company. 

If they decide to remain with the company, their compensation package will be modified to be in line with that of an employee.  It may still be very attractive but typically not at the levels experienced before the buyout.  If the company was represented by an experienced advisor, the advisor would have argued that any historical compensation or owner perks that were above market for the position, should be an addback to the adjusted EBITDA on which the acquirer should base an offer. 

Consider a situation where a company with $10,000,000 in revenues generated $1,500,000 in EBITDA.  If companies in this industry are valued at 5 times EBITDA, the company would be valued at $ 7,500,000.   However, if the owner/CEO received $500,000 in compensation which is $300,000 higher than “market” for a non-owner CEO, the excess should be added back to EBITDA.  In this case the $300,000 excess is added to the base EBITDA of $1,500,000 for what is called an “adjusted EBITDA” of $1,800,000.  The prospective buyer will be asked to pay 5 times the higher number or $9,000,000.  If the buyer agrees to a purchase price based on this Adjusted EBITDA and the CEO stays as an employee post-transaction he will logically receive the market pay of $200,000 going forward.

A key consideration should be whether an individual can transition from owner to employee.  As opposed to the private equity structure described later, he may no longer have a board seat and cannot make unilateral decisions relating to company strategy, capital expenditures, or personnel.  The converse is that he no longer has the emotional burden of making those decisions.  If he genuinely enjoyed the business and the day-to-day operations, being relieved of other responsibilities can be an advantage.   The degree to which this transaction structure is attractive for an individual is dependent on his personal goals and psychological makeup.

Sell controlling interest to a Private Equity Group (PEG) but continue running the company and take it to a new level.

This structure has become increasingly available to owners over the last five to ten years.  PEGs manage and invest pools of capital typically received from endowments, pension funds, and high net worth individuals or family offices.  As in the previous example, the target company is valued on a multiple of EBITDA.  Almost always structured as a sale of assets versus a stock sale, the company assets and certain liabilities go into a new company, or NEWCO.  However in this case, the PEG and the existing owners agree that a portion of the proceeds received at closing will be reinvested or rolled into the NEWCO.  Post-transaction, the PEG would own controlling interest of 70-80% with the current owners, who are also members of management, owning the balance.

In the example below, a company is valued at a multiple of five times its EBITDA of $ 2.0 million to give an enterprise value of $10 million.  After the owner pays off $ 4.5 million in debt, the equity before fees and taxes is $5.5 million.

If the owner then takes $ 1.0 million of his net proceeds and reinvests into what is now his old company (which has become NEWCO) alongside the PEG’s investment of $3.6 million, he will own 21.7% of the company’s equity.  By selling control, the owner will have received $ 5.5 million before taxes and fees, will own approximately 22% of the recapitalized company, will remain CEO, and will still run day-to-day operations.

Many owner/entrepreneurs are interested in this type of transaction because it can provide:

1)  substantial liquidity that allows them to diversify their assets

2)  a means of being released from personal guaranties relating to any company debt

3)  access to additional capital for growth

4)  additional strategic and financial expertise from PEG relationships and/or resources

5)  a “second bite at the apple” relating to their reinvestment if the company is sold later at an

      attractive valuation

In this structure, the PEG is evaluating a number of company factors, but is heavily focused on the quality of the existing management team.  The PEG makes its investment assuming management has the vision and skills to take the company to the next level so that it can be sold or recapitalized at a higher value.  The typical holding period for a PEG is five to seven years.  By having management/owners reinvest some of their proceeds and become co-investors with the PEG in NEWCO, both groups have an incentive to see that the company performs to expectations.  The popularized image of Wall Street-types buying companies and firing all of the employees is a myth. 

 As in the previous example, the compensation package is usually normalized for market conditions.  If the previous owner is now CEO of NEWCO, he will be on the board, but the position of chair may be held by a partner at the PEG or by an independent outsider.  This selection would be made with input and a formal action from the other board members who are designees of the shareholders, but given the PEG’s controlling interest, it would have the ultimate say.

 Selling controlling interest to a PEG should be considered if the owner is comfortable transitioning to the role of an employee and minority co-investor.  The benefits of having additional personal liquidity, asset diversification, reduced financial risk, and the potential upside from a reinvestment in NEWCO must be weighed against the loss of autonomy and the need to become acquainted with and work alongside new partners who ultimately control the business. 

OTHER FACTORS TO CONSIDER

In addition to determining personal objectives and the type of transaction that is appropriate, other factors should be evaluated in advance.

Company-specific issues

Owners considering a transaction in the next two to five years should be objectively evaluating their business now, so that they can address any factors that could either keep a deal from closing or impact how much a buyer would be willing to pay.  Proper planning is essential; when issues arise during the transaction process, the owner usually finds himself at a substantial disadvantage.  In a recent ACG newsletter, CPA firm Grant Thornton discussed the importance of having sound financial reporting and control systems, writing: “Nothing is worse for private equity firms than finding a company they really like and then discovering its financial reporting systems and controls are grossly inadequate.”

Depending on the magnitude of an issue that surfaces during a deal, the process may be put on hold causing potential buyers to question whether there are other things about the company that may put them at risk.  If the deal involves a third party, such as the licensor of technology used in a manufacturing process or a party to a key contract that needs to be assigned to the buyer, the owner may have to provide an incentive (typically cash) to resolve things.  Obviously if this third party suspects that a transaction is imminent, the compensation demanded can be much higher than it would have been had the issues been addressed during the normal course of business.

Owners should take a hard, objective look at their companies in order to assess what hotspots are out there.  As well, owners who are thinking of selling and retiring based on the proceeds should determine whether their expectations of value are in line with the realities of the marketplace.  Otherwise the actual value received may fall well short of what was anticipated. 

Timing

It is very rare that we hear a client say, “I think I sold too soon.”  When things are going really well, it can be difficult to think about selling, but it makes sense that a successful company would generate more value.  If business is good, owners who are already thinking about a transaction in a certain timeframe, say two to five years, would be well advised to

go to market as early as possible within that timeframe.  This strategy helps minimize the chances of being caught in a business cycle downdraft in year four, for example.  We have seen in the recent Great Recession that such a downdraft can result in a depressed or non-existent M&A market for several additional years. 

Process

Whether an owner decides to engage a limited number of buyers or conduct a broad auction, a logical disciplined process should be utilized.  In the same way that businesses engage attorneys to handle legal work, and accountants for tax and audit, once-in-a-lifetime transactions should also be handled by professionals.  By engaging a FINRA-licensed investment banking firm with a demonstrated track record, an owner can increase the chances that a transaction is brought to completion, that a broad variety of potential buyers has been contacted, and that the ultimate terms are a true reflection of the market value of the business.  Credible investment bankers utilize an efficient process designed to minimize the strain on the owner/management team.  They understand the nuances of an M&A deal and are used to speaking the language of corporate acquirers or private equity groups when communicating the essence and value of their client company.

CONCLUSION

In a year of tornadoes and floods, it was the people with bottled water, non-perishable food, and flashlights with working batteries—those who were prepared—who came out ahead.  The same is true in business: forethought yields tangible gains in stormy (and in calm) financial times.  Owners who consider in advance what the sale of their business will look like will be in a position of strength when the time comes.  Owners first need to consider what they want from the sale—a life of leisure for themselves, a limited day-to-day involvement in the business, or a financial piece of the business they built.  Then to ensure that they move from knowing what they want to getting what they want, business owners need the guidance of a FINRA-licensed investment banking firm to take them through the process of preparing for and completing this life-changing transaction.

© FourBridges Capital Advisors 2011

FourBridges Capital Advisors is a middle market investment bank providing sell-side, buy-side, capital raising, restructuring, and strategic advisory services primarily to closely-held and family-owned businesses. FourBridges is based in Chattanooga, Tennessee and serves clients across the Southeast, including Atlanta, Nashville, Birmingham, Memphis, Knoxville, and Huntsville.

FourBridges Capital Advisors is a member of FINRA & SIPC