Although very important for entrepreneurs and business owners, we would all be served well by having a well defined exit strategy. Similarly to your investment portfolio, an exit strategy needs to be recalibrated over time to make sure it serves you and not the other way around.
Every business goes through a life cycle. It may be a sudden chapter 11, the sale to a relative, wanting to buy something else, or a market opportunity to sell. It is a good idea to consider how your business (and skill) will be valuated, before you get to that bridge and need to cross it.
Business owners and entrepreneurs often risk placing an unrealistic value on the “good will” component of their organization. What are realistic market valuations of businesses? A couple of years ago, our professional network asked that question to Richard Ward, of the middle market investment banking firm Everingham & Kerr, Inc. and got an education. Here’s what we found out.
Where the value is
A normal growth per year hovers around 3-4%. And owners of mid-sized companies often have no idea of the value of their business. Many of the companies E&K works with started probably as businesses with a turnover of $200k or $300k and are now making $2.5MM a year.
Most founders are pretty poor at selling and marketing their businesses — they are the specialists: engineers, scientists, and operational people. For example, a business that earns $2-3MM per year may have the growth potential opportunity/value to $10MM but the owner takes home $750k and does not care. There is tremendous opportunity for a marketing specialist to help you build more equity in your business, yet, as Mr. Ward stated, most business owners are quite happy with status quo.
Another example is the value of a company’s customer base. E&K may talk to an owner that will be able to sell the customer portfolio for $2.7MM, stay on to help with transition for a hefty salary and, on top of that, lease the building he owns to the new owners of the business.
What is an Exit Strategy?
Having an exit strategy is about increasing the value of a business, not about the things you’ve always done and been successful at. What are the things you can do to make a business stronger?
Every situation is different. Take for example a company’s culture. It may seem a soft issue. Yet, it is a huge determining factor in buying and selling a company. The deal goes through if the buyer and seller like each other — and that includes the employees. In most cases the owner stays on for a transitional period of time to run the business.
This is true even of larger companies. I’ve been in 4 corporate acquisitions to date (on the acquired side), and the companies that in my view realized the most value out of the deal have been those who set a specific transition process for knowledge and people. Never underestimate the value of people. A bunch of files, even when well kept, will never give you the same value as the experience and relationships of the people who got the company to where it was palatable to buy.
A case study
Comparing two companies that on the surface look similar:
- Company A — Company L
- Current $4.0 — $4.0 [revenues in millions]
- 2001 $4.7 — $3.6 [revenues in millions]
- Loans ($1.7)– (750k) [liabilities]
- Capital 0 — (1.0) [expenditures needed*]
- Owner 1/2/3-yrs — 3/cash [terms of sale in millions]
* purchase price = what you pay and what you have to spend
In the past, banks would lend against cash flow. Today you leverage against assets (equipment, for example). Plus there needs to be a personal guarantee (collateral). Many companies to not have many assets (consultancies, for example) so you put more up or the seller takes on more risk. For a good company you’d put down 20%, finance 60% and the owner holds the remaining 20% back, usually for three years.
Everingham & Kerr deals with mid-sized companies, but 80% of the deals that are done in today’s market are worth less than $1MM.
What are the Steps?
- A buyer LOI (letter of intent)
- Due diligence (up to 90 days)
- Purchase agreement (lawyers, bankers and accountants get involved — the accountants for the buyer are easy to work with; the ones for the seller don’t want to lose the account)
Situations happen at any time during the process. For example, someone may die in a car accident. Investment banks work in different ways, so make sure you ask yours. Everigham & Kerr takes a $15k retainer that gets applied against the success fee at the end.
There is a moral problem inherent with dealing with people’s largest assets — their business. Mr. Ward is President of the PA Business Brokers Association and is working with State Senator Stuart Greenleaf to regulate business brokers. There have been many scams wrought in by unscrupulous companies that give seminars for $20-25k, give you a nice looking binder and then nothing comes of it.
There is an opportunity to write legislation that will protect businesses in their most vulnerable times: when they are thinking of selling. The International Business Brokers Association requires a license to do business.
How do you go about it?
Figure out what your future is and develop a transition plan. It’s not about revenue, it’s about value. Review your exit strategy with a professional. Look at fixed costs vs. revenue stream, for example and where your opportunity to increase the margin is.
The planning stage should be 2-5 years out. The market price is the amount of risk the buyer has to take on. For the seller it’s the future — when is enough, enough?
Time is an enemy when closing the deal so make sure that your communications are frequent and well articulated. And remember: “Goodwill” should be just for old clothes.