Exit Planning Tools for Business Owners

Building Value

Is Your Business in the “Neutral Zone?”

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As Baby Boomers business owners approach retirement (the youngest of them turned 50 this year) they face a unique challenge. The market for small businesses is increasingly a buyer’s smorgasbord A shrinking middle-aged population, corporate competition for talent and less interest in the long hours associated with many traditional small businesses combine to make selling many Boomer enterprises a more difficult proposition.

The best-of-class companies on both the smaller and larger end of the spectrum will still stand out as appealing propositions to buyers. On the main street side (companies selling for less than $3 million or so) there are still plenty of aspiring entrepreneurs who seek a lucrative opportunity.

The mid-market (companies with over $1 million of pre-tax income) has more money chasing fewer target prospects. Current estimates calculate over $1.6 trillion (about the GDP of Japan) allocated by Private Equity Groups and corporate M&A departments for purchasing those businesses.

stuck in betweenWhat about the companies in the middle? As in the Star Trek “Neutral Zone,” the place where neither the Federation nor the Romulans travel, these businesses have a special challenge when their owners seek to transition, and especially when they want to exit with the value of what they’ve built.

A generic history of these Neutral Zone companies applies to thousands of them. A Boomer entrepreneur bootstrapped a business thirty years ago. Badly undercapitalized, he or she struggled for years to make a decent living. As time passed, a four decade long expanding economy, driven by the influx of workers and consumers from the same generation, helped to grow the business until it provided a comfortable living.

Now in their 50s or 60s, those owners have achieved their life goals. Their labors have resulted in an enterprise that employs between 15 and 50 people, and puts between 300,000 and a million dollars to the bottom line above and beyond their own salaries. Compared to 95% of Americans, they are “rich.”

But they are too big to sell easily in the small business (main street) markets, and too small to attract mid-market buyers. They are in the Neutral Zone.

In main street sales (as I’ve explained here before) solid companies sell for an upper limit of around three times the pre-tax profit combined with the owner’s salary and benefits. As that pricing exceeds $3 million, and certainly above $4 million, it becomes difficult to find an individual entrepreneur who can leverage that purchase price.

In the mid-market, where the cost of a transaction limits targets to those with $1 million and more in EBITDA, many Neutral Zone owners would have to grow the business by 30% to 70% just to make the entry level numbers.

A Boomer entrepreneur who is in the “harvesting” phase of business ownership; enjoying the benefits that come from decades of dedication to the business, is often not interested in another big push. It may require more investment, more risk, and probably a lot more effort.

He or she built the company with a belief that it would fund a certain post-business lifestyle upon sale. Now they are finding out that a well run organization with solid and sustained profitability may not be enough.

I typically work with between 15 and 25 of these owners at any given time. For many, the solution can be to “hire a buyer.” Their companies are financially capable of recruiting top management talent. That talent should first be capable of taking the day-to-day management duties from the owner, but in addition, be entrepreneurial enough to eventually assume ownership in turn.

The secret to realizing the full value of a Neutral Zone company may not lie in bringing it up to another level (or, perish the thought, down to a lower level) of prospective buyers. Instead, consider using the organizational strength and profitability you’ve created to engineer an internal sale on your own terms, in your own time, and under your control.

 

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Owners Live in Two Different Worlds

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Business owners live in two different worlds. If you are a Baby Boomer, the title of this column might bring memories of any one of the many covers of the song by the same name. (Everyone from Nat King Cole to Roger Williams, and from Jerry Vale to Englebert Humperdinck recorded it.)

My application of it in business refers to the chasm between those owners who plan to sell a business valued at less than $3 million, and those who have companies valued at more than that. In M&A parlance; “main street” and “mid-market” businesses.

business presentationSome background is in order. I spent the week at two conferences. At the Business Enterprise Institute’s Exit Planners’ Conference we talk mostly about the complexities and structures of mid-market transfers. From there, I attended The Alternative Board’s International Conference for advisors who run peer advisory groups and provide coaching, principally for the owners of main street companies.

At the latter, I had the privilege of being on a panel with Bo Burlingham of Inc. Magazine, the author of Small Giants and Finish Big, and John Warrillow, the Founder ofBurlingham Warrilow Dini the Value Builder System and author of  Built to Sell. It would be challenging to find three people in the country who have spent more combined time studying how small businesses sell, and what determines their value to a buyer.

Even with two audiences of savvy professionals who are focused on the flood of business owners transitioning from their businesses, in many sessions the presenters had to explain the difference between the two markets. As an owner, it’s critical that you understand what the market is for your company. Using data from the other side of the fence is only destined to frustrate you.

Mid-Market

These are companies with a value (not revenue!) of greater than $3,000,000. To garner the interests of financial buyers (private equity groups), they have to generate pre-tax earnings of at least a million dollars a year. To attract strategic buyers, they must have some real differentiation in their industry or market. Those who are truly scalable and have already grown to over 100 employees are the hottest commodity; but according to Doug Tatum, the author of No Man’s Land, they presently account for about 30,000 of the 6.5 million private employers (2-500 employees) in the marketplace.

The acquisition outlook for these companies is wonderful. The financial market is blazing hot, with 7,000 private equity players and publicly traded acquirers chasing those 30,000 businesses, or at least any among them who will still take a phone call. Valuations  are growing quickly, with multiples in the upper end of the market up over 20% in the last two years, and well over a trillion dollars of “dry powder” waiting to be spent on buying them.

Main Street

Clearly, the odds are pretty high that you are one of the 6,470,000 owners whose company does not fit the description above. Welcome to Main Street, where differentiation is difficult or impossible to quantify. (Sorry, but in all but the rarest cases,  “service” is not a competitive differentiation.) The business exists primarily for the purpose of providing financial security for the owner and the employees.  Likely acquirers include individuals seeking to purchase an income, small competitors, or if you are close to the million dollar pre-tax mark, perhaps a private equity group looking for a “tuck-in” or “bolt-on” to an existing similar acquisition.

The news for these owners could not be more starkly different than for the chosen few in the mid-market. According to Burlingham, somewhere between 1.3 and 2 million of these businesses will come up for sale in the coming decade. According to both IBBA (the business broker’s association) and the US Chamber of Commerce, only about 20% of them will successfully sell to a third party. With the much lower population of Generation X, who have little in the way of liquid savings and eschew 50 hour work weeks, the pre-tax multiples in Main Street values are contracting, and the shrinkage grows worse the farther down the food chain you are.

The message is clear. As John Warrillow said, if you are anywhere close to the magic numbers that attract mid-market buyers, the most important thing you can do is drive your company over the top. The difference can mean double, or even triple the proceeds you receive. Here’s an exercise. A company making $700,000 a year with a valuation of 3x earnings can sell for $2,100,000. If they grow to $1,100,000 in profits with a value of 5x earnings they’d get $5,500,000 at sale. That’s 57% growth in profits for 161% growth in price.

Any questions?

Even the measurement of earnings between the two types of business is different. We’ll discuss that next week.

 

 

Ageing Boomer Entrepreneurs: Fearful or Smart?

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Do we become more cautious with age?

Startups are usually associated with younger entrepreneurs. By the time they reach their 50s or 60s business owners tend to tackle fewer big new ideas. Those that do tend to be successful enough that they can segregate the risk in a way that won’t threaten their core livelihood. Are they smarter, or just more fearful of failure?

There are any number of business axioms about the value of experience. “Experience is what you get when you don’t get what you want.” or “Good decisions come from experience. Experience comes from bad decisions.” Does the caution that accompanies age come from experience, or just from a natural reduction in adrenalin?

The youngest Baby Boomers turn 50 this year. Collectively, they represent over half the small business ownership in the United States. There is an important macroeconomic issue attached to the general ageing of owners. If risk-aversion is a biologic phenomenon, then we can expect millions of small employers to drift into “harvest mode,” maintaining their businesses as vehicles for current cash flow and retirement security. They will leave growth and innovation to a younger, but substantially smaller group of entrepreneurs.

Some of their caution is due to external influence. As companies grow and founders age, they become far more conscious of their responsibility to employees’ families and children. Putting everything on the line has potential impact not only on workers, but the extended small economy that depends on their wages. Greater responsibility generates greater caution.

danger aheadWhen you are starting out, have fewer people depending on you, and mistakes have fewer consequences (see my 2014 post The Luxury of No Resources),  it’s easier to take a leap. If you fail, you’re not much worse off than you were before. But there are costs to learning by trial and error. After a while, going back to the drawing board becomes tiresome.

Ideally, the caution that comes with age isn’t from fear. It’s because you’ve come to appreciate the value of planning. It’s not because you are afraid to make a mistake, but rather you want to avoid the delays that come with making repairs every time you hit a pothole.

Every school of business wisdom extols the value of planning. When we are younger, we tend to ignore it. We scoff at Abraham Lincoln’s quote “If I had eight hours to cut down a tree; I’d spend seven sharpening my saw.” The tree is right in front of us. The saw is in our hands. We can sharpen as we go. Sometimes that works. Often it doesn’t.

Many Boomer owners will operate from a fear of failure. Their businesses will fade as the world continues to change around them and they don’t adjust. Hopefully, they’ve been successful enough in the past to exit comfortably.

Some, likely a small minority, still seek to leave a bigger legacy. They have a shorter time frame, lacking the 30 or 40 years of a full career ahead of them. They’ve learned to spend the seven hours sharpening, so that the hour spent sawing is easier and more productive. Those entrepreneurs will adjust to change on their own timetable, but  with far better results.

Their caution isn’t from fear, but from experience.

 

Money is Only Money

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Last week I discussed the general parameters of the private equity market for small and midsized businesses. A rational look at the number of “funds” active in the market, measured against the number of legitimate candidates for investment or acquisition, paints a clear view of why so many small companies are receiving calls from interested investors. There simply aren’t enough profitable, growing companies to buy.

I put “funds” in quotes because not all Private Equity Groups are funds. There is a big difference between “We have money” and “We can get money.” Your first questions to any purported acquirer should be about the source and condition of their funds.

Some will say they have investors ready to fund. Walk away. You don’t have the time or energy to let your company be used as a beauty contestant for someone who is little more than a broker.

Others will say they have “dry powder.” That’s the PEG term for an actual bank account in which their investors have deposited real money. “Dry powder” is the amount they have available to invest. Ideally it should be sufficient to purchase your business for cash. although that might not be how things eventually wind up.

Rolls of 100 billsFor many of my clients who are approached, the next questions disqualify most of the remaining prospects. The conversation goes something like this:

Q:  What related acquisitions in our industry are currently in your portfolio?

A: We have over $400 million dollars to invest

Q: What is your strategy for our industry, and why do you find it attractive?

A: We have over $400 million dollars to invest

That’s an oversimplification, but not by much. Money is only money, and merely having it is no guarantee of success. You should remember that the average PEG has promised a target level of return to its investors, and most have a deadline for investing the money. If they fail to do so, the money reverts to its original owners, usually less the PEG’s costs of operations. That (not surprisingly) greatly diminishes the PEGs chance of raising more from those folks next time around. If that deadline is approaching, some funds get much looser about how and where they find deals.

Let’s say you find a fund that is already focused in your industry and has a strong plan for growing their investment. That is usually either by adding more companies like yours, or by using their relationships to generate a lot of new revenue. Whether you should give up control (and you are always giving up control) of the business depends largely on your personal objectives.

  • Family Financial Security: You want to take enough money off the table to eliminate the risks your family has lived with since you started the business. You still enjoy working, but would like to have more of a safety net.
  • Executive Expertise: As hard as it may be to admit, you’ve taken the company as far as you can. It has a lot of upside potential, but you know that you aren’t the one to take it there.
  • Capital Investment: You’ve identified substantial opportunity if you had the equipment or network to pursue it, and the investors agree with you.
  • Two bites: As I described last week, you see the investment partner as bringing the ability to make the minority share you retain worth more than the majority you are selling now.
  • Exit Strategy: Your new partners understand and agree on a time frame and method to let you move on to the next stage of your life.

I recently had a client who was offered a substantial 8-figure sum for his company. He is well under 40 years old. He decided that the company was (and the investors agreed) positioned for a period of very rapid growth, and he would rather make that run as a sole owner. Those members of his peer board who were over 50 years old strongly advised that he take the money and start another business if he had that much appetite for risk.

Age and attitude govern what is or isn’t a good deal. First you have to know what you want, but even then professional investors can’t read your mind. Unless you tell them what your objectives are (and you will have to eventually), they can only talk about their investment, and money is only money.

I have just published a new eBook, “24 Tips for More Effective Meetings.” It is available for FREE when you sign up to receive “Awake” weekly. If you are already a subscriber, just reenter your email address in the small sign-up form above right (you won’t receive duplicate posts). You will be automatically redirected to a download page. Thanks for subscribing!

Investing in Your Own Business: Will It Pay Off?

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A few months ago a business owner asked me to evaluate an acquisition offer for his small business. It was from a larger company headquartered in a different region of the country. They had a branch operation in his city, and wanted to expand their presence by combining it with his.

For an opening offer, the deal seemed very reasonable to me. The purchase price was about four times EBITDA, with half in cash and half with interest over the next three years, and without any conditions attached. (note: That doesn’t mean conditions wouldn’t have come later.) He would receive a three-year employment agreement at a higher salary than he currently paid himself, with additional bonuses for growing the business plus all the benefits he currently enjoyed.

He was unhappy with my assessment, and announced his intention to counter-offer for double the proposed purchase price, with a perpetual employment agreement that would allow him to work for as long as he chose.

While any opening offer is subject to negotiation, I expressed my doubts about attaining a public-company or strategic-level multiple, especially when accompanied by an employment agreement that would make any labor attorney flip out. I asked him how he planned to justify his asking price.

empty wallet“It just isn’t enough to retire,” he said. “I’d have to keep working indefinitely, and I don’t want to have to go find another job if this doesn’t pan out.”

Please understand; presenting this story in the abbreviated way that I have makes this owner sound like he is clueless or ignorant. Neither is the case. He has run this business for years, and built it to several times the revenue and profitability of when he acquired it. He has sacrificed personally, putting in long hours and scrimping financially to reinvest in his company. He  qualifies as a successful small business owner by most measurements of small business success.

But as a mid-generation Boomer (late 50s) he is coming to the realization that it may not be enough. Like many others, he decided that investing in his own business was more controllable and would produce a higher return than the vagaries of stock markets and  mutual funds. His business is his retirement account, and like hundreds of thousands of others, he eventually came to believe his own claim. He expected his company to fund his retirement, without really looking at its objective value in the marketplace.

I asked him if doubling the price would achieve his retirement goal. He thought for a moment, and said “I don’t know, but I doubt it.”

There are roughly 5,500,000 Baby Boomer business owners entering, or already well into, their retirement windows. (The oldest Boomers turn 70 this year.) Many have the expectation that their company is their retirement plan, but there is no assurance that it’s true. If you are over 50 years old, I strongly recommend that you do three things:

  1. Download and read my eBook “Beating the Boomer Bust.” It’s a collection of ten blog posts  from this site with an overview of the challenges that are inevitable with the wave of retiring Boomer exits.. It’s short (45 pages) and its free.
  2. Get an objective valuation for your business. You don’t need a full appraisal. An opinion of value can range from free to a few thousand dollars, but it shouldn’t cost more than that. (You pretty much get what you pay for, though.) It is critical to understand where you are today.
  3. Get a realistic projection for how much you will need to maintain your target lifestyle in retirement. A Certified Financial Planner (CFP®) has the training and software to include inflation and tax assumptions. Again, many insurance agents and stockbrokers will provide this for free, but I prefer someone who does it without offering products for sale based on the result.

Disclosure: I offer exit consulting for business owners, but I do not provide valuation services, financial planning, wealth management, tax guidance or insurance. I’m just trying to have fewer conversations like the one above. Additional information, including a free, online self-assessment of your business, is at http://exitmap.com.

 

 A Note to My Readers

This January marks the start of my seventh full year of writing Awake at 2 o’clock on a weekly basis. I got serious with the publishing of “The Strategic Triple Threat” in January of 2009, which will probably stand forever as my most accurate piece of economic prognostication. :-)

Many thanks to the hundreds of you who have commented, and who come up to me at speaking events and say “I’ve been reading your blog for years.” If you read regularly and find yourself nodding in agreement or quoting a column, then I feel that I’m doing my job.

It’s a big, wide Internet out there. Like any blogger, I’m thrilled that I touch so many people with helpful information, but would always like to reach more. Please help by taking a few minutes to pass along a link to any business owners or advisors that you think might also enjoy an owner’s point of view.

Thank you

If you would like a printable pdf of this column or any other, please let me know at jdini@mpninc.com.