Exit Planning Tools for Business Owners

Boomer Bust

Cash Flow Normalization

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Cash flow normalization is done with the intention of identifying Earnings Before Interest Taxes Depreciation and Amortization (EBITDA) or Seller’s Discretionary Earnings (SDE). These differing measures are not interchangeable, but are used by different classes of buyers for different categories of acquisition.

Free cash flow is an important measure when calculating the value and price for any business. It is the amount theoretically available for servicing acquisition debt, working capital, return on investment for any cash outlay in the acquisition, and future expansion.

Cash Flow Measures

EBITDA establishes free cash flow as a measurement for most mid-market businesses. It evens out the differences in earnings caused by various tax jurisdictions. In the United States, there is federal income tax at the corporate level, but many states have additional income taxes, and in some cases, even smaller jurisdictions like cities may have their own income tax. These obviously impact the profitability of a company and could distort a buyer’s impression of its profitability.
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EBITDA calculations do not include the owner’s earnings, since the companies being examined are more likely to be acquired by investors who would replace the owner with a management executive.

SDE is the measurement used to illustrate the sum total of financial benefits available to the owner-operator of a business. It assumes that the owner is running the company on a day-to-day basis. SDE encompasses not only salary, bonuses, and distributions, but includes insurance and other benefits such as a company-paid vehicle.

A simple way to put it is that EBITDA is the cash flow available for a return on investment. SDE is the cash flow available for a return on the owner’s labor.

Making Adjustments

2 businessmen fishing for money from a boatIn the SDE calculations, there are two places where there is often an adjustment of expenses to market. The first is for a family member employed in the business or partners who intend to leave simultaneously with the principal owner.

In many instances, family members are paid according to their needs or the needs of the business instead of at a market rate for the position. With family members who are “underpaid” adjusting to the market rate will have the effect of reducing the cash flow available in the business. This reflects the fact that the family member or partner will have to be replaced by someone who is unlikely to work for a below-market salary.

The opposite is of course true for family members or partners who are overpaid. Reducing their compensation to a fair market rate will add to the discretionary cash flow of the business.

A second area of adjustment is when the owner of the company also owns the real estate that the company operates in. Again, the rents paid on the real estate often reflect the owner’s objectives more than they do the practical reality of the local real estate market.
A company that is underpaying rent is having its bottom line shored up by the reduced income to the real estate entity.

Overpayment of rent requires the owner to make a decision. If they expect the same rent from a new tenant, the profitability of the business as presented to a prospective buyer will be lower. Considering that most transactions involve a multiple of cash flows, you can usually point out to the owner that trying to maintain a higher rent is not in their interest as the seller of the company. Adjusting the rent to a market rate increases the cash flow of the company and presumably the basis for an evaluation multiple.

Which Cash Flow is “Right?

The decision of whether to use EBITDA or SDE when calculating cash flow is dependent largely on the size of the client’s business. If the company has cash flow in excess of $1 million annually or is large enough to be a likely target for professional buyers, EBITDA is the appropriate measurement for cash flow.

If the company is going to be purchased by family members, employees, or another entrepreneur and has a cash flow of less than $700,000, SDE is almost always a more appropriate measurement.

Which cash flow is used is a situational decision and may change if different classes of buyers are being engaged.

John F. Dini develops transition and succession strategies that allow business owners to exit their companies on their own schedule, with the proceeds they seek and complete control over the process. He takes a coaching approach to client engagements, focusing on helping owners of companies with $1M to $250M in revenue achieve both their desired lifestyles and legacies.

Private Equity and Privately Held Businesses

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Depending on who you are talking to, Private Equity is either the Great Satan or the savior of small and mid-market companies in the United States. The stories depend a lot on the personal experience of the speakers.

Once a vehicle for high-risk investment plays in corporate takeovers (see Bryan Burrough’s Barbarians at the Gate,) Private Equity has morphed into tranches where specialists seek opportunities in everything from a Main Street entrepreneurship to multi-billion-dollar entities.

What is Private Equity?

The term itself is relatively generic. According to Pitchbook, there are currently 17,000 Private Equity Groups (or PEGs) operating in the US. The accepted business model for our purposes is a limited partnership that raises money to invest in closely held companies. The purpose is plain. Well-run private businesses typically produce a better return on investment than publicly traded entities.

The current Price to Earnings (or PE – just to be a little more confusing) ratio of the S&P 500 is about 27.5. This is after a long bull market has raised stock prices considerably. The ratio is up 11.5% in the last year. That means the average stock currently returns 3.6% profit on its price. Of course, the profits are not usually distributed to the shareholders in their entirety.

Compare that to the 18% to 25% return many PEGs promise their investors. It’s easy to see why they are a favorite of high net worth individuals, hedge funds and family offices. As the Private Equity industry has matured and diversified, they have even drawn investment from the usually more conservative government and union pension funds.

Private Equity Types

Among those 17,000 PEGs the types range from those who have billions in “dry powder” (investable capital,) to some who claim to know of investors who would probably put money into a good deal if asked. Of course, which type of PEG you are dealing with is important information for an owner considering an offer.

private equity moneyThe “typical” PEG as most people know it has a fund for acquisitions. It may be their first, or it may be the latest of many funds they’ve raised. This fund invests in privately held businesses. Traditionally PEGs in the middle market space would only consider companies with a free cash flow of $1,000,000 or greater. That left a plethora of smaller businesses out of the game.

For a dozen years I’ve been writing about the pending flood of exiting Boomers faced with a lack of willing and able buyers. I should have known better. Business abhors a vacuum.

Searchfunders

Faced with an overabundance of sellers and a dearth of capable buyers, Private Equity spawned a new model to take advantage of the market, the Searchfunders. These are typically younger individuals, many of whom graduated from one of the “EBA” (Entrepreneurship By Acquisition) programs now offered by almost two dozen business schools.

These programs teach would-be entrepreneurs how to seek out capital, structure deals, and conduct due diligence. Some Searchfunders are “funded”, meaning they have investors putting up a stipend for their expenses. Others are “self-funded.” They find a deal, and then negotiate with investment funds to back them financially.

Both PEGs and Searchfunders seek “platform” companies, those that have experienced management or sufficiently strong operational systems to absorb “add-on” or “tuck-in” acquisitions. The costs of a transaction have bumped many seasoned PEGs into $2,000,000 and up as a cash flow requirement. Searchfunders have happily moved into the $500,000 to $2,000,000 market.

In the next article we’ll discuss how PEGs can promise returns that are far beyond the profitability of the businesses they buy.

 

 
John F. Dini develops transition and succession strategies that allow business owners to exit their companies on their own schedule, with the proceeds they seek and complete control over the process. He takes a coaching approach to client engagements, focusing on helping owners of companies with $1M to $250M in revenue achieve both their desired lifestyles and legacies.

Personal Vision – Life After the Sale Part 2

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In our last article about life after the sale we discussed identity. Even when business owners are comfortable with who they are, however, there is still the nuts and bolts issue of activity.

A business owner spends 20, 30, or (not uncommonly with Boomers,) 40 years focused on running a business. Unless they’ve built a substantial organization that is run by employees, it likely remains their biggest single time commitment right up until they leave. That commitment is frequently a lot more than 40 hours.

Even if the time “in the office” or “on the job” is less than 40 hours, there are the emails before and after hours, the texts, phone calls from unhappy customers or from employees who aren’t going to make it to work, and just thinking about what comes next, frequently at 2 o’clock in the morning.

Extended Vacation

When asked about activities to fill their week, many owners will say “I’ll have plenty to do!” That isn’t enough. “Plenty” requires some planning if it is really going to occupy the bulk of their work week.

After exiting a business, most owners bask in their newfound freedom. If we presume a selling price that’s substantial enough to allow them a wide range of choices, their first reactions typically include a few lengthy trips. These may range from a long-promised European vacation with the spouse to purchasing an RV to tour the National Parks.

This extended vacation period usually ranges from six months to a year. After that, most owners are looking for something to do. Their grandchildren (and their grandchildren’s parents) are less enthusiastic about having Grandpa and Grandma around too frequently. Travel is too tiring to keep it up indefinitely. Friends are rarely in the same position. Either they are still working and lack the leisure time, or they’ve progressed beyond the extended vacation period and settled down into their own retirement routine.

And as astounding as it may sound to enthusiasts, I’ve heard “I never thought I could play too much golf,” any number of times.

Life After the Sale…and After the Vacation

We use an exercise that brings home just how much the business has dominated an owner’s life. It starts by asking the owner to think a year ahead.

We start with the owner’s “average” work week. Let’s say 50 hours for this example. Then we begin deducting those activities that comprise their impression of “plenty to do,” putting an hourly commitment to each activity.

Regular travel, either for relatives or recreation, still comes close to the top of the list. We ask “How about two weeks away every quarter?” The response is that eight weeks a year is a lot, but could be enjoyable. Then we do the math: 8 weeks x 50 hours= 400 hours of vacation, divided by 52 weeks = 7.7 hours a week. A good start, but we still have 42 hours to fill to replace the business.

How about fitness? Getting into shape is often a goal, but working out every weekday only absorbs another 5 hours.

Working for a cause such as serving lunch at the local homeless shelter a few days a week, can use up another 10-12 hours. We still have 25 hours to go, or about half the time currently spent working.

We can still fit in 18 holes twice a week. That’s 8 more hours. At this point, many owners run out of ideas. That still leaves 17 hours a week, or two full “normal” work days.

The objective isn’t to merely fill up the time slots. It’s to illustrate just how big a void needs to be filled to replace the business. Whether your exit is planned for a year from now or ten, it is time to begin thinking about life after the sale.

John F. Dini develops transition and succession strategies that allow business owners to exit their companies on their own schedule, with the proceeds they seek and complete control over the process. He takes a coaching approach to client engagements, focusing on helping owners of companies with $1M to $250M in revenue achieve both their desired lifestyles and legacies.

Exit Strategies – The Road Less Traveled

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The road less traveled is often a misimpression when considering a transition from business ownership. Surveys show that roughly 85% of owners expect their exit to happen via a sale of the business to a third party.

A third-party sale is certainly attractive. The idea of monetizing decades of work in one lump-sum payoff seems equitable. Years of sacrificing to “invest in the business” is supposed to generate a return. “He (or she) sold the company” when applied to someone who is clearly enjoying a comfortable lifestyle in retirement acts as an advertisement for the benefits of cashing out.

Unfortunately, that isn’t only less frequent than assumed, but it’s so infrequent as to be close to a rarity.

The Numbers Don’t Lie

Baby Boomers owned businesses at about twice the rate of previous or succeeding generations. Franchising and an overcrowded job market for corporate careers drove about 6% of Boomers into entrepreneurship, where the traditional average for business ownership is closer to 3% of the population.

A decade ago, according to the SBA, about two-thirds of all businesses between 5 and 500 employees were owned by persons 48 years old or older. Today, just over half are owned by folks over the age of 58. That makes it pretty safe to extrapolate that around 4% of that age group still own businesses.

Census data puts the number of persons turning 65 years old at 10,000 a day, so it’s a decent guess to say that 400 of those, on average, probably own a business. That’s 2,800 a week, or about 140,000 a year. Not everyone exits when they hit 65, and almost 90% of those businesses employ fewer than 20 people.

For exit planning discussions, let’s divide the under and over-20 employee companies into two groups, which we will call “Main Street” and “Mid-market.” (Note- this is not a valid market definition of those two terms. For further explanation see the Afterword in my most recent work The Exit Planning Coach Handbook.”)

Main Street companies would then be 90% of our 140,000 owner population. That’s 126,000 businesses. According to the IBBA, Business Brokers sell about 8,000 Main Street companies annually, or about 20% of those they list. That leaves 92% of Main Street owners to find another way.

Of the 14,000 or so that we are classifying as Mid-Market, Private Equity activity accounts for about 6,000 transactions annually, many of which are handled by brokers. (So there is an unknown amount of double counting here.) The last two years saw a spike of about 50% in acquisitions due to low interest rates, but it is safe to say that at least a third of these presumably very desirable middle-market businesses have to find an alternative exit plan.

Advisors Ignore the Numbers

With these statistics, why do owners and their advisors continue to focus on exit strategies that only work for a small minority? The higher visibility of transactions is part of the bias, as are the higher professional fees that they generate, but the biggest issue is a lack of advisor education.

Advisors who work with owners approaching a transaction have an obligation to inform them of their options. Unfortunately, this is not always the case. We survey the exit planning industry annually. Only between 5,000 and 6,000 advisors claim exit planning as an offered service. That’s an advisor-to-owner ratio of 23:1 each year. If we consider the entire remaining population of Boomer-owned employers, that ratio is five hundred to one.

Most owners have 50% of more of their personal net worth in the business. Yet we continue to see financial planners who base their clients’ retirement calculations on an unconfirmed estimate of what the company will contribute via a third-party sale, when such a sale may be the least likely outcome. A financial plan for a business owner cannot be holistic if it doesn’t consider 50% of his assets.

Attorneys and accountants frequently report that the first time they interact with a client about exiting is when a purchase offer is already on the table. Proactive discussions about eventual transfer or succession are usually brief, and cease when the client says “I’m not ready yet.” They let their clients postpone the discussion until circumstance or happenstance intervenes.

Business Brokers, of course, only talk to clients who have already decided on their preferred course of action. As a former Certified Business Intermediary, I can say from experience that unfortunately, most have no alternative for the 80% of listings they can’t sell.

The Road Less Traveled

The truth is, despite popular conceptions to the contrary, sales to third parties are the road less traveled. Certainly, many lifestyle businesses are really jobs and have to close when the founder/owner/CEO retires. Many others, however, could recoup the owner’s investment with a structured transfer to employees.

road less traveledGiven a few years, most owners could hire and train a suitable buyer. That usually requires support, since few have experience in recruiting and teaching someone to do what they do. There is also some education involved to help the owner understand how investing in a top-flight employee today can pay huge dividends in the future.

Additionally, there is the issue of owners who believe that they have to keep any rumor of their impending retirement from others in their industry. Customers, vendors and competitors are a fertile market for acquirers. A good advisor can act to maintain confidentiality when putting out feelers.

Advisors need to be more proactive in approaching clients about their objectives and their options. Initiating a structured conversation around both is in the best interest of the client and the advisor. They may choose to avoid the road less traveled.

John F. Dini develops transition and succession strategies that allow business owners to exit their companies on their own schedule, with the proceeds they seek and complete control over the process. He takes a coaching approach to client engagements, focusing on helping owners of companies with $1M to $250M in revenue achieve both their desired lifestyles and legacies.

Avoiding the “Exit” Word

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Owners don’t like the “Exit” word. They tell us regularly to change it, or that talking about it is uncomfortable. It’s the elephant in the room.

I understand. Anyone selling life insurance or funeral pre-planning knows that you don’t start with “So, let’s discuss what happens when you DIE.” For business owners, leaving the business is like a little bit of death. That’s why black humor in the exit planning world goes like this. “There are seven ways to exit your business. Six of those are head first.”

Your company has been the central focus of your life for twenty or thirty years, and perhaps more. It is so ingrained in your persona, your self-identification, that it’s frightening to think of that part of your identity disappearing.

Who is Bob?

When Bob leaves home every day to run Bob’s Widgets, he assumes the superhero cape of the owner. He walks in the door of the business as the head honcho, el hefe, the final word, the boss. That cape never comes off. The employees might go out for a beer after work, but he never becomes just one of the guys (especially when the table check comes.) The employees are careful about what they say around him, and he self-censures his conversations with them.

Just as importantly, that cape is always present in his personal life. He is Bob, the owner of Bob’s Widgets, everywhere he goes. At the kids’ sporting activities he is asked to sponsor (“It would be good for your business!”) In his church, at the Chamber of Commerce, and at parties he is introduced as “Bob, the owner of Bob’s Widgets.”

He overhears the identification at family gatherings. “Oh, that’s Sally’s cousin Bob. He owns his own business.” When his friends discuss their jobs, a bad boss, pending layoffs, or a reorganization they say “Of course you don’t have to worry about these things, Bob. You own the company.” (Ah, if they only knew…)

The “Exit” Word

So the word “exit” has a finality that jars a lot of clients. Advisors use lots of alternatives, like transition, succession or continuation – all of which imply an ongoing process, albeit one that doesn’t include you. Why would an advisor use the term “Exit” at all if it could be avoided?

We face up to it because it’s the elephant in the room. I am an Exit Planner. My companyex sells Exit Planning tools to advisors. We conduct the annual National Exit Planners Survey™. Our ExitMap® suite of coaching tools uses that word on virtually every page.

We use it because a coach is a trusted advisor, and a trusted advisor always speaks the truth. Not some of the time. Not just when it is agreeable. Not when it can’t be avoided. All of the time. The coaching relationship should be comfortable, but not too comfortable. Introducing a bit of unease to reinforce a point is part of the job.

I use the “exit” word to describe the final outcome of an implemented business plan. It usually involves a transaction, with legal documentation of a sale or other transfer mechanism. It can also include detailed succession planning for family members or a management team. We often discuss continuation – what happens if the plan is accelerated by unfortunate circumstances. Retirement might have a place in the conversation, or it might be about designing a “second act” or pursuing your life’s passion.

But all those terms, whether synonyms or euphemisms, are encompassed in the  “exit” word, We might as well get that on the table from the outset. If you start the advisory process by ducking anything that a client finds uncomfortable, you aren’t serving your purpose as a coach.

Let’s be Honest

Let’s agree to call a business transition what it is. Whether an owner wants to sell the business to a third party, create a family legacy through his or her children, finance a leveraged buy-out to employees, or just close down in an orderly manner, the ultimate objective is to exit.

 

John F. Dini develops transition and succession strategies that allow business owners to exit their companies on their own schedule, with the proceeds they seek and complete control over the process. He takes a coaching approach to client engagements, focusing on helping owners of companies with $1M to $250M in revenue achieve both their desired lifestyles and legacies.