Exit Planning Basics
What You Need To Know Before You Start
www.genequityco.com
Exit Planning Basics
Generational Equity - Experienced M&A Advisors www.genequityco.com 877-213-1792
The term exit planning has evolved over the years to include a wide variety of topics, many of which, although important, are not directly related to the eventual exit from your company. Unfortunately, because the process of exit planning has become so convoluted and confusing to the typical business owner, most do not have an exit plan in place. According to a recent study conducted by Atlanta-based White Horse Advisors and Vistage International, 96 percent of baby boomer business owners agreed that having an exit strategy was important but 87 percent did not have a written plan. Generational Equity encounters the same dichotomy in our M&A conferences. Most attendees realize that it is vital to develop a plan, but very few actually have one in writing. The excuse given most frequently is time business owners are simply too busy to take the time to adequately plan for their exit. This is most unfortunate if you dont plan for your exit, eventually circumstances will force you to sell, meaning youll be selling when you have no other choice and not when you desire to sell. In other words, its a less-than-optimal scenario. In this whitepaper, which is our fourth in a series designed to help business owners navigate the entire M&A process, we will simplify the process for you and examine what we consider to be the two most vital pieces of any exit plan. Of course the challenge with exit planning is that each business owners financial needs, age, and circumstances are unique. We cant hope to cover every possible scenario in this whitepaper. What we will cover are the two critical elements that you need to know so you can effectively plan your exit: 1. What your company is worth 2. How much capital you will need for the next stage in your life These two go hand in hand. Keep that in mind as you continue reading. There are more facets than this, but if you can nail these two issues in your planning, you will be way ahead of the game.
Step One: Knowing Your Companys Economic Value
There is an old saying that goes something like this: If you dont know where you are going, any road will take you there. The same can be said for approaching the exit of your company with no idea what it is worth. If you dont know its value, how will you know which offer to take? Also, if you have no idea what it
Exit Planning Basics
Generational Equity - Experienced M&A Advisors www.genequityco.com 877-213-1792
is worth, how can you possibly know how to plan your financial future? Sadly, we encounter too many business owners that leap into the market without taking care of this first step. And the key component of this first phase is accurately recasting your financials.
The Foundation Of The Valuation
Because of the critical nature of this step, deciding to have a third party do an evaluation of your firm is well worth the investment. Of course you can do this on your own if you are well versed in the practice of recasting. If you have not heard of this term, or if you are not sure what it entails, I would highly recommend that you hire a professional firm to do this for you. Recasting is the accepted accounting principle of removing or adjusting items on your financial statements that are unrelated to the ongoing business. Many of you have worked hard over the years with your accountants to under-report your earnings for tax purposes. This is perfectly legal and acceptable. But it understates the true value of your company. Keep one key principle in mind: Professional buyers are buying your future, not your past. But the only way to accurately highlight your future profitability is by recasting your historical financials and then project out three years to five years using the new recast baseline as your starting point. Items removed or adjusted via recasting can be superfluous, excessive, or discretionary expenses, and nonrecurring revenues and expenses. Other specific recastable items could include: Owner-related direct expenses Owner-related indirect expenses Excess costs of family on the payroll Non-recurring bad debts Discontinued or nonrelated product lines/businesses Nonessential real estate/facilities Discretionary professional fees Extraordinary expenses Nonrecurring expenses and/or income
The recasting process can be quite time-consuming and tedious. The person providing the service will ask you countless questions and will dig deeply into your historical financials to find as many legitimate recastable items as possible.
Exit Planning Basics
Generational Equity - Experienced M&A Advisors www.genequityco.com 877-213-1792
They will also examine which accounting methods are standard and acceptable for your industry and may make adjustments as necessary. Again, buyers are buying your future and will base their offers on what they see in your financials. So if they are not recast accurately, your base year could understate your profitability, impacting what buyers will pay for your company. For example, lets assume a buyer is looking at two similar companies in the trucking industry. Both are generating the same level of revenue, and Company A is showing $500,000 in EBITDA (earnings before interest, taxes, depreciation, and amortization) on its latest fiscal year income statement. However, Company B, again doing the same level of revenue, was wise enough to have its financials recast and it is showing EBITDA of $750,000. Which of these companies do you think will receive a better offer? Assuming that there are no extraneous issues affecting Company B, it will most likely generate better offers than Company A. This example illustrates how vital recasting is in protecting you from offers that are too low.
Be Prepared To Answer Questions
But recasting is just one part of the evaluation process. In a sense, a good evaluation of your company is very similar to the due diligence that buyers will eventually conduct on your company. Although due diligence will involve much more intense scrutiny of your company, any reputable, experienced firm will ask you a series of questions that will delve deeply into your business. The goal in this evaluation process is to expose not only your companys strengths but also any perceived weaknesses that could affect buyers and their future offers. For example, some of the following questions could be asked of you during the evaluation: Do you have any patents? Does your company have an established brand in your market? Who are your long-term customers? Do you have contracts with them? How many suppliers of your raw materials do you have? Who are your key employees? Why are they key? What is your employee turnover ratio? Union vs. nonunion employee base? If union, when does the current contract expire? Do you have a backlog of orders?
This is just a short list of questions you may be asked by any experienced firm evaluating your
Exit Planning Basics
Generational Equity - Experienced M&A Advisors www.genequityco.com 877-213-1792
company. Business owners often become frustrated with this process because it requires quite a bit of your time and can be laborious. However, if you work closely with your advisors during the evaluation, you will be surprised what you will learn about your company. You will also be surprised at how you can improve your operations and enhance your value to buyers by implementing some very simple steps along the way.
How To Determine Value
As I mentioned earlier, it is possible to produce an evaluation of your firm on your own. If you have an accountant that is experienced with recasting (many are not) and if you have the time to objectively document your answers to these hard questions, you could produce your own evaluation document. However, once the evaluation is complete, the question now becomes how do you determine the value of your company? This is where it becomes critical to have the services of an experienced M&A advisory firm. You may be aware of standard multiples for your industry, and sometimes these can be quite accurate. But again, professional buyers are buying the future. This means that they will project your recast earnings into the future and then will discount them back into todays dollars using a discount rate that matches their internal rate of return for comparable investments like yours (the discount rate is based on a variety of factors including risk, stability of the investment, believability of the projected revenue growth, etc.). This is where it really gets complicated. Essentially the higher the risk associated with investing in your company relative to other investment opportunities, the higher the discount rate will be. Savvy buyers who look at hundreds of investment opportunities will also factor in their own return on investment (ROI) expectations. Again, relative to the risk associated with your investment opportunity, each buyers own ROI requirements will also impact the discount rate applied to your future earnings. Ultimately, a number of methods need to be reviewed to accurately value your company. In addition to discounted cash flow analysis, other methods that can be used are industry comparables, rule of thumb multiples, asset-based valuations, preceding transactions, etc. Each method has its strengths and can be used alone or in conjunction with other methods depending on your business. Time and space does not allow us to delve deeply into all of the valuation methods used, which could be a whitepaper of its own. If you would like to learn more, we encourage you to attend one
Exit Planning Basics
Generational Equity - Experienced M&A Advisors www.genequityco.com 877-213-1792
of Generational Equitys conferences about how and when to exit your business with the most profit. The conference digs much deeper into this topic and others related to the M&A process. If you are interested in learning more, click here.
The Bottom Line of Valuations
The valuation of your company sets the benchmark for where you will expect offers. If it is not done accurately, you could be undervaluing your company, placing your expectations too low. Conversely, you could also over-value your firm and end up with expectations that are way too high. These are things that you can avoid if you obtain the services of an experienced M&A advisory firm at the outset of this process. Be sure to contact firms that will not only value your firm but will also stand behind their valuation and represent you in the market, which is key. Lots of firms will value your company, but if they are unable to represent you in the market, how legitimate is that valuation? However, knowing your companys value is only one side of this equation. The other side is equally important.
Step Two: Knowing Your Income Requirements Post-Sale
Assuming a reputable M&A advisory firm valued your business, you now have a number. This value, commonly called an economic value is what your valuation firm believes your company could reasonably obtain from a willing and informed investor. However, that number is meaningless if you have not met with your trusted financial advisors and resolved two important issues: When do you want to move on to the next phase of your life? How much capital will you need for that phase?
For many the answer to the first question is simple ASAP! You may be approaching (or past) retirement age, fed up with the risk of operating a privately held business, and/or tired of the daily grind. If you are in that group right now, you need to speed up your exit planning. Clearly you are at a point where you may actually be hindering the growth of your company and impacting its economic value. For others though, ASAP is not the right timing. You may be younger and have more interest in staying with the company for a limited time to aid in a transition or even longer, as part of an earnout. In fact, some of you reading this may not want to exit the company right now at all. For you,
Exit Planning Basics
Generational Equity - Experienced M&A Advisors www.genequityco.com 877-213-1792
retaining an equity interest for a larger liquidity event in the future is your goal. Family issues will also impact your exit timing. We strongly suggest that you discuss this with your spouse and family. Quite frankly, clients whose businesses we have sold often call and lament that they are getting cabin fever and miss work. This underscores the importance of meeting with those who know you best to get their opinions about the timing of your exit. You might be surprised by the input you get. Having answered the first question regarding when, you then need to take your companys evaluation to your financial planner and have him analyze your financial situation. If you are like most business owners with which we work, nearly all your net worth is tied up in two assets: your home and your business. Because of this, knowing the value of your company is vital to the timing of your exit. If your current lifestyle and age would require net, after-tax proceeds of, lets say, $1 million and the value of your company is less than that, then obviously now is not a good time to sell. In a case like this, you would need to work with your evaluation firm in order to enhance your value by growing the revenue and profits by some degree over time. That is what is relatively unique about Generational Equity. Each of our clients is entitled to two free updates of value during a five-year window. This allows our clients who decide to hold and grow their companies to come back twice over this time frame to see what impact growth is having on the companys value. In fact, we even provide them with value-enhancing strategies to guide them. Conversely if your age and income needs would require $1 million after tax and your company is valued at $2 million, then now may be a good time to move up your exit timing. Keep in mind, too, that there are all sorts of deal structures that can also be negotiated that will help you retain more cash at close. Your dealmakers will work with your financial advisors and tax professionals to craft the deal that optimizes your post-close position. But the overall point is this: If you dont meet with your financial planners and discuss your income needs, knowing the value of your company in todays market doesnt help you that much. You may think that the value of your company is too low. However, if your future income needs are below the value threshold, why would you entertain the notion of continuing to have most of your net worth tied up in one illiquid asset?
Exit Planning Basics
Generational Equity - Experienced M&A Advisors www.genequityco.com 877-213-1792
Quite often we have clients who have a magic number in mind when they start the valuation process. This number is usually an amount that is not necessarily based on financial or retirement planning. Because of this, it is amazing how many clients call us after we have delivered a value that they feel is low saying, Well I met with my financial planner and he suggested that I might not need $10 million to retire on after all. For this reason, we encourage all of our clients to conduct financial and retirement planning concurrently with the evaluation being conducted. By doing so, when you finally learn the economic value of your company, you will be in a much better position and be able to develop a logical exit plan. The decision to sell ones business is very complex. Pure logic rarely motivates any of our decisions. This is especially true when we start to talk about when to exit our businesses. Even though it is an emotional decision, you need to approach it in a systematic, methodical way. We hope that this whitepaper has removed some of the complexities of this topic and has helped you realize that you need to do two things at a minimum before you can even start to develop your exit plan: Know your companys value and know when you can afford to exit. If you take care of these two critical steps, chances are good you will develop an exit plan that will allow you to leave your company when you want to exit, not when circumstances force you to leave. 2011 Generational Equity, LLC All Rights Reserved
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Exit Planning Basics
Generational Equity - Experienced M&A Advisors www.genequityco.com 877-213-1792
About Generational Equity
Generational Equity and its professionals work with middle-market business owners who are contemplating selling a business or seeking merger and acquisition opportunities. We assist owners in all areas of stock or asset sales, mergers, or divestitures. Our highly experienced merger and acquisition specialists provide insight and strategies on questions such as: When is it the right time to sell? Should all or part of the business be sold? Is the company buyer ready or should the focus be on building value for a future deal? We have been successfully selling privately held middle-market companies for years, developing proven systems that have enabled us to value and sell more companies in the middle market than anyone else over the past few years. Dont take our word for it; look at the Thomson Reuters deal-making reports. Our seasoned M&A professionals can help business owners anticipate challenges and understand what needs to be done at every juncture of a transaction. For each owner, we can prepare a customized marketing strategy that presents your business to the most appropriate potential buyers while maintaining strict client confidentiality. We also have access to thousands of buyers who are actively seeking to acquire middle-market companies. For more information about Generational Equity, visit www.genequityco.com.
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