Exit Planning Tools for Business Owners

Building Value

Selling to Employees: Is Your Exit Strategy Right in Front of You?

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When I interview a prospective client for exit planning assistance, we usually explore selling to employees. The first reaction is always “That won’t work. They don’t have any money.”

If you have a company with reasonable cash flow, a talented management team and sufficient time, selling to employees is not only a realistic option; it may be the best way to get value from your business. I’ll define those parameters for you in a minute.

If you haven’t read my eBook Beating the Boomer Bust, follow the link for the free download. My research shows that the hard numbers will inevitably translate into a hard market. There are 3,000,000 Baby Boomers (over 50) who own businesses with employees. Over the next 20 years, that’s an average of 150,000 owner retirements per year. Intermediaries (brokers, private equity and M&A) account for about 9,000 transactions a year.

That leaves a lot of folks looking for a way to cash out. Selling to employees is a process that lets you keep control until retirement. By structuring the sale correctly, you can leave with the proceeds in the bank, not in a promissory note.

How does that work? It requires a bit of mental gymnastics. First, any owner has to accept that the only source of funding for any transaction is the cash flow of his or her company. If a buyer pays cash, he expects that cash flow to pay him back. If a bank finances the acquisition, they expect the cash flow to service the debt. If you finance it, you are the essentially the bank.

Selling to employees is the same. You use the current cash flow to help employees buy stock. In return, they qualify by working to increase the value of the business until your final return is equal to (or more than) what it was when you started.

Think of it as taking a note for 30% of the purchase price while you are still in control, so that you can get a 70% cash down payment when you leave.

Now, let’s discuss the parameters.

Cash Flow: Your company has to be earning more than just your paycheck. My rule of thumb is that around $500,000 a year after owner’s compensation gives enough to work with. More than that doesn’t change much, since then we are usually looking at a higher purchase price. Less than that is doable in a longer time frame, or if the owner is willing to subordinate some debt to the bank.

Management Team: You need at least one decision maker who does more than just go through the operational motions. Any third-party lender wants to be comfortable with company leadership when you’re gone. A large portion of our planning surrounds transfer and documentation of management capability sufficient to satisfy a lender.

Time Frame: Many business owners tell me “I’ll think about exiting in five years.” That’s fine, if your plan is to retire in fifteen years. Generally speaking, the longer you have, the more lucrative an internal sale can be. I’ve done three year plans, but five is much more comfortable, eight years is even better, and we regularly work on transitions of ten years and longer.

all for one one for allSelling to employees requires legal agreements, specialized compensation plans and a willingness to run the company transparently. The return is a team that is committed to the long term, highly motivated, and all on the same page when it comes to growing the business.

Why should you consider selling to employees?  Because your company lives on with the culture you created. Because you can choose the value, not negotiate it. Because your employees aren’t comparing your company with other investments. Because you control the timing of your exit.

Because it is probably the biggest financial transaction of your life.

Do you know an owner who would benefit from reading Awake at 2 o’clock? Please share!

What is Your Company Worth? II

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Last week we discussed how business owners frequently use hearsay or incomplete information to estimate the value of their companies. They give the number to their financial planner, or include it on a personal financial statement for their banker, neither of whom bat an eyelash at the estimate. Having the amount “accepted” by financial experts, the owner starts to treat it as fact. How do you know whether it is realistic or achievable?

alchemistValuation of a small business is a combination of art and science. No two small companies are alike. A multiple of profits or cash flow is only the starting point. Take two small companies, each with $4,000,000 in revenues and $500,000 in profits. Each pays the same salary and benefits to the owner. One does it by having systems that control most day to day activities, recurring revenue from contracts, and long-term employees who are incented by profit sharing. The other does it with an owner who works 70 hours a week, hasn’t had a two week vacation in ten years, and makes every new sale personally. Which business would you pay more to own?

Beauty lies in the eye of the beholder. The multiples paid for businesses depend on the type of buyers they attract. Commonly, those that sell for less than $2,000,000 are considered “Main Street.” Their target buyers are individuals who are purchasing an income. They intend to work in the business, and to earn a regular paycheck by running it.

Main Street businesses are valued by a multiple of Seller’s Discretionary Earnings (SDE). The value of the business is based on the sum of the financial benefits resulting from ownership. That includes profits, salary, benefits and any of a long list of possible perquisites like a company car, travel, or insurance. (For more on calculating your SDE and selling a business in general, you can read my book, 11 Things You Absolutely Need to Know about Selling Your Business.)

Main Street pricing is typically between 2.1 and 2.8 times SDE. It is based on simple arithmetic. The closer you come to 3 times SDE, the less able a buyer is to pay both the bank and himself. You can run your own numbers here, to see how it works (registration required).

For larger companies, those that attract financial and industry acquirers, the multiples are higher, but the multiplier is lower. Those buyers anticipate paying for professional management, so the owner’s compensation is less of a consideration. They look at EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) to calculate available cash after all the expenses of running the business (including executive talent) are paid.

Competitors will calculate the savings they might realize from consolidation, but are usually reluctant to multiply those savings in a purchase price. Private Equity Groups (there are 7,000 in the US) and the acquisition arms of large companies seldom look at businesses with earnings of less than $1,000,000. As amazing as it seems to a small business owner, their due diligence and legal processes are too expensive to make smaller acquisitions worthwhile.

Private Equity Groups pay an average between 4.7 and 5.2 times EBITDA, year in and year out. That makes sense, because they are financial buyers with a targeted Return On Investment (ROI). Large company acquisitions of smaller businesses can range from 4 times EBITA up to around 7 or 8, although in a few cases strategic considerations (competition, exclusive contracts, proprietary methods) can drive that up substantially .

All of these are real numbers, based on actual sales data and industry surveys. Sellers often confuse the terms revenue and income, or apply EBITDA multiples to SDE. They are greatly disappointed and angry when legitimate offers fall far below their expectations. Just because your planner or your banker didn’t challenge your valuation estimate doesn’t make it fact.

My new book, Hunting in a Farmer’s World: Celebrating the Mind of an Entrepreneur, is now available on Amazon in paperback, hardcover and Kindle. It is an ownership book, not a management book, and is illustrated with the stories of real entrepreneurs who faced challenges that apply to us all.