Exit Planning--Structured Financial Partners: Building value for your company's tomorrow ℠

Exit Planning brings together uncoordinated planning

You can now download our new Exit Planning Edge e-Newsletter— Exit Planning brings together uncoordinated planning.

Here's an excerpt: "Most of us are guilty of planning in a vacuum.  We choose a wealth manager we like and take his or her advice.  We buy our life insurance from someone else we like.  We choose our CPA and attorneys the same way.  But they do not communicate and coordinate with each other all that often".

Structured Financial Partners is a consulting firm working with the owners of closely-held Middle Market companies to improve the profitability and value of their companies in the years immediately prior to their sale to third parties, key employees or family members.

The Wisdom of Selling Too Soon

I made my money by selling too soon.
--Bernard Baruch

In our Exit Planning consulting work, we always get our clients—typically the owners of middle market companies—to identify a "target exit date."

We call it a target date, but it has flexibility…. The owner may decide to work longer because he or she wants to… Or may have to because financial conditions have changed. He may want to sell earlier because an unexpected opportunity arises.

The exit planning process is about having the business ready for that sale event, to the extent possible, even before the "target exit date."

We utilize a process we call Reverse Due Diligence. We coordinate a process using a sample due diligence questionnaire that a buyer might use in a Merger and Acquisition (M&A) transaction. We take on certain tasks and we assign tasks to the client and to the clients other advisors—particularly their CPA and attorney. By preparing Due Diligence binders in advance, we can 1.) find problems that will cause roadblocks in the sale process and correct them before a buyer is performing "real" due diligence" and 2.) look professional and organized when the sellers M&A team comes in to decide whether or not to represent the company and 3.) shorten the time it takes for the M&A firm to take the company to market.

By having this process completed in advance of the target selling date also allows the company to capitalize on unexpected opportunities, such as an unsolicited offer from a Private Equity firm. By having all of the necessary work done in advance, the company will look prepared and professional and likely get better results.

So instead of waiting until the top of the next market cycle, the best time to prepare for sale is now…

Like in Football, the Time Clock Matters in Exit Planning

Now that we are nearing the end of football season, a lot is still up in the air, but certain things have been decided. Those teams that got off to lousy starts and lost too many games early have been mathematically eliminated from making the playoffs. When the announcers talked about "do or die" games for those teams, they didn't.

When you look at the teams that are leading their divisions, they are great at the "two-minute drill." When the clock runs down, they have a plan to move the ball toward the goal line. They spend a huge amount of their practice time on perfecting execution of what they will do when the game hangs in the balance.

Business isn't always like football, but sometimes, we see parallels in our exit planning practice. In a perfect world, clients would come to us in their early 60s or earlier when they assume they have two to five years left to work with full vigor. But in reality, most wait until later, they wait until the two-minute warning.

Fortunately, in the transitioning out of one's business, it's not about winning or losing a game, but in preparing for the exit event, time gives one options.

We have recently taken on two client companies where the owners are 88 years old. For each of them their age causes similar problems:

• They want more for their companies than they are worth in today's market environment
• They are set in their ways and don't want to do anything differently to improve profitability and value
• They don't have time to ride out the market cycle and wait for sales and profits to improve and multiples to (potentially) improve
• One has recently had a heart attack. The other is in good health and his younger (80 year old) brother runs the day-to-day operations and is in good health, but come on…

Many business owners want to work as long as they can. With Exit Planning, that can be worked into the plan. But one can't go into Sunday without a game plan. Even Brett Favre  gets knocked out of a game one day.

For most business owners, a prudent game plan dictates beginning this process earlier so they can reap the fruits of their labor from a easy chair before they are to beaten up to enjoy it.

Susan the Ostrich Whisperer—An Exit Planning Tale

 

Today's guest blogger is my partner, Susan Laine, MBA

Sometimes I wonder if the laws of evolution are all wrong. I read a recent news article verifying the conventional wisdom that humans are descended from apes, but I'm not so sure. Based on my interaction with business owners, I really think we might be descended from the ostrich.  As we get older our wisdom grows in so many ways, yet I look across the landscape and see acres of business owners with their heads buried in the sand.

We know people don't like to plan for death. They stay away from life insurance agents and estate planning attorneys in droves. BUT EXIT PLANNING IS NOT ABOUT DEATH. It is about monetizing a valuable—perhaps your most valuable—asset during your lifetime.

Consider this: At any given time, approximately 25% of all businesses in the US are for sale. Less than 50% of those will actually be sold. The difference between those that sell and those that don't is often packaging the business into something a buyer will pay top-dollar for.

But some owners would rather stick their heads in the sand and wait for Warren Buffet to come and buy them out. But last I checked, Warren Buffet wasn't buying ostriches.

When will be the right time to sell your business? How will you position your company so that it has the greatest chance of selling? Do you expect to just wake up one day and be able to sell your business?

A few can, but the great majority have to plan, and that planning usually takes 2 to 5 years before the sale in order to reap the greatest benefit.

Don't be an ostrich…

Exit Planning and the price of waiting

In my last post, I wrote about how often a business owner wakes up one morning wanting to sell his company and begins the process that day having done no planning! With a company in a hot niche in a hot M & A market he might get away with it and make and succeed with this approach, most owners would be well advised to prepare for their exit.

What do buyers want to see?

Financial data—this is presented in the company's financial statements. In smaller companies, the balance sheet and the income statement will typically be prepared by the CPA. In larger companies, they may be prepared by the CFO or the CPA. Three years prior to the sale of the company, a company with over 10 million in revenue should be doing audited financial statements. This is where an outside CPA firm will verify the truthfulness of the financial data presented. Companies smaller than that can get by with reviewed financial statements, where their own CPA firm can examine their books to verify the data presented. Buyers won't pay for what they don't believe. Sloppy financial statements will yield a discounted offer or no offer at all.

Your customer base—because this represents cash flow. The buyer must believe that the cash flow they are buying is sustainable and not volatile. This is why a customer base that is diversified between consumers (and product lines, if appropriate) is attractive. That is why, having say 70% of your business with a single customer is considered risky. But sometimes 70% isn't really 70%. We met with the owners of a company last week that had 70% of their business with a single defense contractor, but with three separate divisions that are totally unrelated. A good investment banker could help a buyer understand there is some diversification in the customer mix that isn't visible to the naked eye.

Your systems—your unique processes for bringing your product to market. Your methods of manufacturing product, controlling costs, driving sales all these contribute to what makes you attractive to a buyer.

Your management team—this is big part of what the buyer is paying for and without it will often cause a big discount to their offer. The acquirer is buying a going business. Without you what is there without a well trained functional team to run it?

No lingering liabilities—Is your retirement plan up to code? Are there employment lawsuits waiting to be filed? Are there problems with your leases that will be triggered upon change of ownership? You will want to find these things out before you are in the middle of a transaction.

So why engage in exit planning? Why not just sell your business today? By starting the exit planning process two to five years prior to your target exit date and working on holes in your company in the above areas, not only will you net more for your company when it's time to sell, but you will be more profitable in the intervening years. Your business will run more smoothly and you will enjoy it more.

What are you waiting for?

Exit planning when the heir apparent bails

I was visiting with the 62 year old owner of a building supply company last week when the subject exit planning arose. It had always been his plan to turn the company over to his son, but the son has other plans. "He wants to coach his kids little league teams and be home by five o'clock. With what the economy has done to the business, if he's going to be here, I need him to think like and entrepreneur, not a nine-to-fiver. I told him if he can find a nine-to-five job, he should probably take it,"  Tom said.

This is more common than you might think. Business owners often have an exit strategy in mind, but the players they are counting on have other plans. Consider these scenarios we have seen:

• An 80 year old father is finally ready to let go and sell the business to his 55 year old son who he has paid well, but to whom he has never ceded an ounce of control. The son turns around and tells dad, "Thanks, but I'm ready to retire myself…."
• A 68 year old business owner plans to sell his company to his key employee on the installment plan when he turns 70, but the key employee doesn't want to take any of the financial risk, that comes with ownership.
• A 70 year old father in setting up his estate plan, has a daughter who runs the business and a son who is not involved in the business and not enough cash to equalize their inheritance. He decides to leave the business to the daughter and the building the business resides in to the son, so he can be her landlord…

I can go on telling stories like this, but the point is simple. The moral to the story is the same whether it is your goal to keep the company in your family, to sell it to your co-owner or management team, or to sell it to third parties in an M & A transaction. To avoid being blindsided by roadblocks an owner must plan plan plan.  Planning must begin well in advance of your target exit date. This planning is best accomplished working with a team of trusted advisors, including a quarterback is experienced a systematic the exit planning process.

What is a TCLAT and should you even care?

My partner was at a meeting this morning where her reputation had preceded her. She was accosted by an attorney who by way of introduction said, "You're Susan Laine, you do Exit Planning. You must use TCLATs in your practice…" Susan just stood there and allowed him to continue. "What about 368…?" He continued. Susan knew, of course, that these were tools that might be used by a business owner in his or her planning. A Testamentary Charitable Lead Annuity Trust or TCLAT is a trust which may be created by a living trust or will which requires the trustee to make a stream of payments to a charity (for which it gets a tax deduction) and at the end of the trust period pays out to a family beneficiary. The "368" the attorney referred to is Section 368(a)(1)(A) of the Internal Revenue Code which allows for tax-free treatment of certain mergers and reorganizations.

All this is immaterial when put in context. Exit planning is not about the tools we use. It is not about the hottest new asset protection trust or captive insurance company. Exit planning is not about buy-sell agreements whether or not funded with life insurance. It is not about ESOPs. All these things are tools. Just like "368," TCLATs, 83(b) elections, SARs and Phantom Stock. Until we know the specs of the job TOOLS AND TOOL VENDORS are immaterial. Some professionals (accountants and attorneys) get enamored with a certain planning technique or product and push it as aggressively as any salesperson.

Imagine you're building a custom house. As you sit down with your architect, you ask the architect what kind of nail gun the general contractor's carpenter is going to use while framing the house. That is what this attorney looked like to Susan. Like the architect, with each client, we develop a plan—a blueprint. And for each client we assemble a team of professionals who will work together to execute the clients wishes. Each team has a CPA and one or more attorneys, and other team members will be added as the project dictates. But NO ONE comes to the table with a preconceived notion of what tools will be used.

Exit Planning and ESOP who is a candidate?

When we are talking with other professional advisors and business owners about which of our Exit Planning prospects might be good candidates for ESOPs we start with a basic checklist:

• Company has available debt capacity
• Company is profitable and can handle the ESOP debt from a cash-flow standpoint
• Company and shareholders are at or near top income tax brackets
• Company has five year track record of profitability
• Company has a payroll of at least $1 million excluding selling shareholder(s)
• Company revenue is at least $7 to 10 million dollars
• Selling shareholder is interested in a an ownership strategy to recruit, reward and retain productive employees
• Company has a strong management team in place
• ESOP will purchase at least $3 million of stock from existing shareholders

To summarize these checklist items, a good ESOP candidate is a strong, well managed company. Because the company will be taking on new debt, they can't be over leveraged and must be able to service the new debt created by the ESOP. Because the ESOP is most often used as part of an exit plan, there must be strong management in place to keep the company running. And lastly the company must be profitable so that the cost of installing and administering the plan won't make the owner sick.

An ESOP is a huge undertaking and should not be entered into without a great deal of forethought. It is important to recognize that ESOP vendors have a product to sell and may not be as objective as one might like in making their recommendations. For this reason, a business owner and his or her trusted advisors should engage in planning to evaluate all the options at the owner's disposal prior to making a decision as to how to exit the business.

 

ESOP as an Exit Planning Strategy

Our clients are owners of companies in a certain niche in the business landscape. They typically generate between $5 million and $100 million a year in revenue. We refer to this as "small middle market." When we talk to these business owners about "exit planning," we typically focus on a sale of their company to third parties in some form of an M & A transaction OR the transition of the company to insiders. Insiders are family members, existing co-owner(s) or a key employee of the entire management team.

These types of transactions are available for all businesses, large and small to consider.

There is a third type of transaction that that isn't appropriate for most business owners we talk to, BUT when it is appropriate, it can be an incredibly powerful tool. That is the sale of the company to an ESOP.

ESOP stands for Employee Stock Ownership Plan. It is a qualified retirement plan covered under ERISA. Unlike other ERISA retirement plans, which are forbidden from investing in employer securities, an ESOP must invest primnarily in the stock of the employer.

So, in essence, with an ESOP, the shareholder(s) create the entity that will purchase his or her stock. We'll get into the mechanics of that later.

Owners selling to an ESOP can achieve many of these objectives:

• Diversifcation of personal wealth without incurring tax liability or giving up control of the company.
• Transfering management to the next generation.
• Passing ownership to key management, who may not have the funds available to acquire the shares outright.
• Funds to buy out a co-shareholder.
• A method to raise capital at a reduced cost to expand the business.
• Create an employee ownership culture to increase profitability and aid in employee recruiting and retention.
• Create a 100% employee owned company that is also 100% exempt from federal (and most state) taxation. (S-Corp ESOP)
• Spin off a line of business without selling to an industry competitor.

While bank lending for ESOPs in these economic is tight just like other lending and ESOP promoters only talk about the benefits of ESOPs, let me take a moment and talk about some of the downsides.

• They are expensive to install and administer. Depending on the size of your company, the first year cost could be $75,000-100,000 or more. Annual administration requires that the company has a formal valuation EVERY YEAR. Expect annual administration (including the appraisal) will run approximately $30,000.
• The ESOP is a separate entity with its own board and cannot be run as a puppet for the benefit of an owner. All the formalities must be observed.

Next we'll explore ESOP in more detail

What makes a business valuable?

I was sitting at lunch today with an M & A guy we'll call John, whose firm does transactions between $5 million and $75 million. We were talking about how differently we view our worlds. He wants a business owner who is ready to sell now, whose business is generating solid, sustainable well-documented, growing profits. The business has a management team that is running the business without much help from the owner and will stay on when the new owner buys. Not all of John's clients look exactly like this, but since he only gets paid to close a deal, he insists that they look pretty close.

Our clients, on the other hand, are different. One difference is they are not selling today, but 2 to 10 years from now. This gives them time to improve so if they are going to sell on the M & A market, they can meet John's criteria and John will be successful getting top dollar selling the company. Another difference is our clients may or may not be M & A prospects at all. Our clients may want to keep a business in the family or hand the business off to a co-owner or sell to the management team or to a key employee.

But in any case, the owner needs to demonstrate how valuable the business is if he or she wants to get paid for that value. John and I talked about financial statements. Even in his sales of $30 million of more, it's rare that the seller has audited financials--so the buyer can't be fully confident in what he's getting. Some of this can be offset by the lengthy due diligence process. This is why, we in the Exit Planning process, for many of our clients start suggesting audited financials as we get closer to the transaction date…Spending time and effort pre-sale can increase the price…especially in a down market like now.