The Re-emergence of Exit Planning

By: John A. Mascarich, Senior Investment Banker

According to a 2006 article published by Robert Avery of Cornell University, "the majority of Baby Boomer wealth is held in 12 million privately owned businesses, of which more than 70% are expected to change hands in the next 10 to 15 years." During the “Great Recession”, however, merger and acquisition (“M&A”) activity was severely curtailed, declining by 33% in 2009 from 2007’s activity level. Exit planning is one of the most important tasks for owners of closely-held, family-owned businesses. This is because, in many cases, the business represents the single largest asset of the individual’s estate and is the primary source of income for multiple family members. 

As 2011 unfolds, private equity funds are still perched upon enormous amounts of uninvested capital, despite the uptick in M&A activity. These surpluses of capital are the product of the recession’s drought in private equity deal activity, combined with record-breaking fund raising years. In the last two years, private equity fund raising exceeded investments by approximately $200 billion. Presently, private equity is seeking a home for more than $400 billion of capital. Assuming a modest 1:1 debt-to-equity ratio, this translates into more than $800 billion of potential M&A activity.

Private equity funds are typically structured with a limited lifetime of ten years, with portfolio investments typically occurring in the first three to five years. To avoid returning capital to their limited partners, fund managers are expected to be aggressively seeking transactions over the coming months. A significant amount of this capital should make its way into the middle market. Of the firms that have raised new funds in 2010, more than 75% are targeting the middle market.

Supply and demand conditions for facilitating business ownership transitions thus seem excellent. Yet many business owners find that as they near retirement, they have neither selected a successor, nor instituted a clear plan to address the transition process. In an ever-changing marketplace, it is difficult to determine what a business is truly worth to an outside buyer – the fair market value of the business – and what factors can significantly impair or enhance that value.
Business owners typically allow too little time to develop a sound business exit plan. As a result, key mistakes are made, such as:
  • Selling to the (only) competitor who approaches them
  • Not using experienced advisors (hoping to save transaction costs)
  • Setting expectations based on personal needs and without reference to the market
  • Failing to explore legitimate positioning strategies
Role of business valuation and “valuation engineering”
Sound business exit planning typically begins with a business valuation that becomes a scorecard or reference point. Most owners don’t have a clear and accurate view of the value of their business and of what creates that value. They may see business value in such things such as pride of ownership and providing employment opportunities for family members. However, these have little true economic worth to an outside owner, Alternately, they may fail to see the company’s significant value because they are focused on the “trees versus the forest” – i.e. daily problem solving.
The business valuation itself adds value through “valuation engineering”, which is a review and assessment the critical factors that drive business value. A business valuation uncovers these key factors, which may include:
  • Having scale beyond a significant dependence on the founder/owner
  • Proprietary products, services or processes
  • Strong management team
  • Defensible, differentiated market position
  • Stable, diverse customer base
  • Recurring revenue business model
  • Business growth opportunities
  • Strong operating margins
  • Manageable business risk
  • Quality business and accounting systems
  • Audited annual and timely internal monthly financial statements
The business valuation and valuation engineering thus serve to enhance business value by providing a roadmap to increase business value over the owner’s time horizon. Value enhancement strategies vary greatly depending on the type of business. They may include: 
  • Reviewing and revising the revenue and/or business models
  • Implementing product / market enhancement plans
  • Expanding and diversifying the customer base
  • Securing title to patents and intellectual property
  • Commissioning of financial and operational audits
  • Strengthening or upgrading of systems and procedures
  • Documenting or codifying contractual relationships (employees, vendors, customers, debt) 
Additionally, the firm’s corporate structure and governance mechanisms are assessed to consider whether the business is optimally positioned for the intended business exit. For instance, an asset sale from a taxable entity could result in having tax obligations at both the corporate and the individual levels. Conversion to a pass through entity may be advantageous, but the tax benefits vest over an extended period of time. The makeup of the board of directors and of any advisory board may also have an impact on the value perceived by a buyer. The business may benefit from a combination with or consolidation into another business prior to its sale. Alternatively, it may be desirable to spin-off one or more non-synergistic or non-performing divisions to increase profitability or allow greater management focus.
Operational improvements that increase profit margins are strongest when they are reflected in trailing (historical) earnings. More recently effected changes, or even planned changes, can also influence valuation, however, if the benefit of the changes can be quantified and demonstrated. Because of the multiplier effect built into earnings-based valuations, a $1mm earnings improvement may increase the valuation by, say, $5mm. Just as a homeowner has options for enhancing real estate value, such as upgrading an outdated kitchen, so a selling business owner often has unknown and untapped opportunities for increasing the value of the business. As in the real estate analogy, the stakes are highest at the time of exit, but the focus on marketability and valuation needs to begin well before there is an urgent need to sell.  
Exiting a business is more than selling
Exit planning is a process, not an event. It involves the development and execution of a series of systematic steps taken to maximize the owner’s “accumulated wealth" to be extracted from the business, via one or more of the numerous available strategies, including:
  • Selling the business to partners, strategic buyers, investors, competitors, or international buyers
  • Recapitalizing the business for partial liquidity
  • Merging the business to achieve enhance valuation and/or marketability
  • Transferring the business to family, management or employees
  • Gifting the business to meet personal and/or tax planning goals
  • Liquidating or partially liquidating the business
From the owner’s perspective, the optimal exit will be achieved through the implementation of a managed process which includes:
  • Establishing a business valuation reference point
  • Clarifying "life-after-business" goals
  • Working with a team of specialist advisors
  • Preparing a written plan
  • Identifying and evaluating the applicable alternative strategies (options)
  • Executing any necessary positioning or preliminary strategies
  • Executing the selected exit strategy. This typically includes investing sale proceeds so as to optimize the owner’s post sale financial position.
Selecting a Team
Exiting a business is a complex subject with many moving parts. No single advisor is an expert in all aspects, so the process should involve inputs from a team of experienced advisors, and should address the possible need to re-position the business before going to market. The team must include the necessary knowledge, skills and experience in M&A, corporate law, taxation and financial planning, wealth management. It may also include specialists in ESOPs, insurance, industry experts, personnel and business consultants.
The primary purpose of approaching a business exit in a systematic, goal-focused and planned way is to dramatically increase the likelihood that the outcome will be optimal to the stated goals. The employment of a team of professional and experienced advisors will add a cost of, say, 3% - 6% of the wealth transferred, but will potentially add considerably more value by focusing on the goals to be achieved, helping to implement the strategy, and monitoring and adjusting the strategy as required to achieve the goals.
For more information on Exit Planning, contact: John Mascarich, Senior Investment Banker.
© 2011. No part of this newsletter may be reproduced or distributed without the express written consent of J.J.B. Hilliard, W.L. Lyons, LLC. Although the information in this newsletter is believed to be reliable, we do not guarantee its accuracy, and such information may be condensed or incomplete. This newsletter is intended for information purposes only, and is not intended as financial, investment, legal or consulting advice.