Exit Planning Tools for Business Owners

business ownership

Ambiguity Kills Value

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Ambiguity kills value. That was a key point in a white paper from Orange Kiwi that I read over the holidays. Taken from the PhD thesis of Dr. Allie Taylor, the paper describes the psychological profile of  entrepreneurs, and their historical reluctance to begin an exit planning process.

According to Dr. Taylor, entrepreneurs have five major behavioral traits; Risk Taking, Innovativeness, Need for Achievement, tolerance for Ambiguity and a locus for Control. This follows closely my description of the mind of an entrepreneur in Hunting in a Farmer’s World. In that book I discuss the traits of tenacious problem solving and the ability to navigate in the fog.

Ambiguity and Dopamine

That ability to choose a path where others don’t see a way forward is key to a business owner’s ability to stomach risk. What Dr. Taylor points out, however, is that some owners fall in love with their own tolerance for ambiguity. As Simon Sinek points out in Leaders Eat Last (and I also discuss in Hunting,) problem solving provides an owner with a little shot of Dopamine dozens, or even scores of times daily.

Dopamine is the same neurotransmitter that drives substance abuse. In very real terms, an owner’s need for regular dopamine titillations can make decision making addictive. Anticipating a life without the business can subconsciously create a fear of life without the business.  

That’s why owners are reluctant to discuss exit planning. Despite the obvious wisdom of controlling the most important financial event of a lifetime, the personal void that lies beyond ownership is scary. As with many other potentially unpleasant things, from going to the dentist to funeral prearrangements, it’s easy to deal with it…later.

Ambiguity Kills Value

The problem with embracing ambiguity too much is that it can damage your business. Management by firefighting is costly. As Abraham Lincoln said, “If I had eight hours to cut down a tree, I’d spend seven of those sharpening my saw,” Fixing problems almost always costs more than preventing them. Dealing with distractions reduces the time you have available for selling, creating or teaching.

Avoiding the uncomfortable task of exit planning leaves you much more likely to deal with it in response to one of the Dismal D’s. (Death, Disease, Disability, Divorce, Declining sales, Dissention among owners, Debt, Distraction, Disaster or Disinterest.) That’s when the value of your most important asset, a thriving business, starts to plummet.

We all like a bit of ambiguity. Our decision making abilities are what makes us successful owners. Exit planning should be a process of gathering information about your possible decisions, not a ticking clock controlling your future.

Embracing Your Options

Whether you plan to eventually sell your business to a third party, pass it on to family or create a transfer to employees, you still want to assess your financial performance compared to industry standards. Your management team needs to be able to run the company without you. Your processes should be well documented. Most importantly, you should be thinking about what you will do when those hits of decision-making dopamine stop coming.

Once you have the components in place, you can control the timing, proceeds and method of your transition. Until then, you are just waiting for ambiguity to bite you in the butt.

How prepared are you? Take the ExitMap® preparedness Assessment at www.YourExitMap.com

Four Basics of Exit Planning 4: Professional Team

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Your professional team is the fourth component of exit planning preparation. We’ve already discussed valuation, distance to goal and classes of buyers. Taken together, these basics aren’t enough by themselves to execute an exit plan, but understanding the first three and assembling the fourth will go a long way to ensuring that any plan you develop is practical and achievable.

Many clients say “No problem. I already have a lawyer and an accountant.” But your professional team should be able to offer more than just technical advice.

Any competent CPA can tell you what the difference is between ordinary income tax and capital gains. Far fewer can suggest ways to structure transactions to move income from one tax category to another.

Similarly, most business attorneys can write (or download!) a purchase agreement. Picking a reasonable path through another attorney’s demands for every representation, warranty and indemnification imaginable is another matter.

Your First String Professional Team

There are two tiers of necessity when it comes to team members. On the first tier are those without whom you cannot do a transaction.

  • Transaction attorney: One who knows the ins and outs of transferring a business. This might include converting customer and vendor contracts, required notifications of regulatory authorities, state law regarding notices to employees, as well as the aforementioned contract experience.

exit planning(Suffice to say that your real estate attorney/escrow agent, estate planning attorney or slip-and-fall litigation defender is probably not the guy.)

  • A forward looking accountant. Some business people would say that is an oxymoron. Most accountants, after all, make a living by telling clients what has already happened. Unfortunately, once a transaction is completed it is usually too late to do much tax planning. Look for someone who can make suggestions, and does so in the very first conversation. If he or she says that they will have to analyze the deal (for a fee) before they can share any ideas; move on.
  • A process manager. Whether you are transferring to family, employees, or a third party buyer, your most important job is to keep running a healthy business. The process manager keeps things on track. He or she calls the other professionals to enforce deadlines. Ideally, the process manager knows enough about the technical components of transfer to lend experience and ideas.

The process manager might be an exit planner, a business coach, a consultant, the attorney, the accountant, or anyone else you trust. He or she must acknowledge the responsibility for coordinating the deal and driving it forward. That includes holding you accountable when necessary!

The Rest of the Team

The balance of the team may include some or all of those listed here.

  • Valuation specialist: In a third party sale, it is good to have an objective view of your enterprise value. In a sale to employees, it helps settle concerns about self-dealing. (If you are choosing an ESOP, you may not want to bother. The trustee will have to get an appraisal anyway.)
  • Insurance broker: If you are anticipating some seller financing in a transaction, you may want to insure the lives of the buyers. If it is a staged sale, they might want insurance on you.
  • Financial planner: Someone who can tell you whether your planned proceeds will be sufficient in retirement.
  • Wealth manager: Those proceeds will hopefully be enough to warrant professional investing expertise.
  • Exit planner: Usually, but not always, the exit planner fills the role of the process manager. In some cases, the exit planner is only charged with designing the overall exit strategy.
  • Value enhancement specialist: If your company needs to grow substantially in order to reach your goals, doing what you’ve always done isn’t likely to get you there.

This list probably has you visualizing dollar signs with wings, but I’ve worked on multiple cases in the last few months where a good advisor saved an owner hundreds of thousands of dollars.

  • You wouldn’t choose your high school football team to play Alabama for the NCAA national championship. Nor would you expect ‘Bama to beat the Patriots in the Super Bowl. Selling your business is the championship game of your business career. Why wouldn’t you want the best professional team available?

Four Basics of Exit Planning 3: Know Your Buyer

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Know your buyer? Your initial reaction to this title may be “How can I know my buyer? I haven’t even decided to sell yet!”

Nonetheless, understanding the type of buyer that your company will attract is vital. More importantly, gaining that understanding long before you go to market will impact many decisions about how to run your business between now and when you start to actively market the company for sale.

The classes of buyers are not interchangeable. I once worked with the owner of a subcontracting company. He told me “I want to find a strategic buyer. I know they pay higher multiples than anyone else.”

That’s nice in concept, but Strategic Buyers make strategic acquisitions. His business was only as good as its next bid. He had no proprietary systems, no products, no long-term customers and no contracts besides the current jobs. Strategic buyers pay for strategic differentiation. He was unhappy that I didn’t classify his self-defined “great reputation in town” as a differentiator.

Other Classes of Buyers

Your business will determine what types of buyers you should seek, how your earnings will be viewed, and the multiple of earnings you can expect.

Main Street is the generally accepted term for businesses that sell for less than $3,000,000. Entrepreneurial Buyers are most commonly an individual or partnership. Downsized executives and entrepreneurs who have sold a previous business make up a large percentage of the buyer population for these companies. These transactions are usually handled privately, or through a business broker who advertises them on the Internet.

Cash flow for these businesses is called Seller’s Discretionary Earnings (SDE), and includes all the perks of ownership (wife’s car, no-show child employment and the like.) Anything that could be applied to a debt payment qualifies. For most Main Street buyers, their ability to service loans for the purchase usually tops out around 3 times SDE.

Mid-market companies sell for between $3,000,000 and $100,000,000. Financial Buyers include private equity firms and family offices. These buyers usually seek acquisitions where the cash flow is in excess of $1,000,000 a year.

Many lower Mid-market sellers are confused by the cash flow calculations. Financial Buyers’ cash flow measure is EBITDA (Earnings Before Interest Taxes Depreciation and Amortization.) Some sellers try to include the side benefits their company pays for in EBITDA. Financial Buyers assume that any benefits you have, a replacement manager will have as well, and they will ignore many of the SDE inclusions.

Private equity and Family Offices purchase businesses that are likely to produce a predictable return. Because they have investors (or wealthy family members) to please, their purchase prices are usually in the range of 4 to 5 times EBITDA, although the recent financial markets have driven that into the 6x territory for acquisitions over $20,000,000.

The Mid-market is also where sales are made to customers, vendors or competitors. Handling these transactions requires special care with confidential information. Since buyer and seller usually know each other, a broker-type intermediary is less necessary. Many times a transaction attorney or accounting firm can handle the negotiations.

The Neutral Zone

Exit Planners provide special value to companies in the “Neutral Zone.” I define that as too small to be big, and too big to be small. Their EBITDA is healthy (usually $500,000 or more after owner compensation) but below the $1,000,000+ that the Financial Buyers seek. Yet at that level, few Entrepreneurial Buyers can handle the purchase price.

There are many options still available to a Neutral Zone company. You can choose a growth strategy to enter the realm of Financial Buyers. A Leveraged Buy Out (LBO) by experienced employees is likely to attract the interest of a lender. An Employee Stock Ownership Plan (ESOP) is a very attractive alternative in the right circumstances.

In all cases, a good planning runway will help you to know your buyer. Then you can position the business with control over the outcome you seek.

A short video on classes of buyers and the multiples they pay, along with a free calculator to determine your SDE or EBITDA are both available on our website of free tools for owners, Your Exit Map.

Four Basics of Exit Planning 2: Distance to Goal

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Once you understand your company’s value, the next step in planning is to calculate your Distance to Goal. As the Cheshire Cat said, “If you don’t know where you are going, any road will get you there.”

“Any road” is not the way you want to approach the biggest financial event of a career. Distance to Goal calculations require an understanding of where you are now, where you want to wind up, and how long you need to get there. In both industry surveys and my own experience, the majority of business owners have (at best,) only a rough idea of the road they will take.

Calculating Distance to Goal

Where you are now is a calculation of your current liquid net worth. “Liquid” implies assets, such as stocks and bonds, that you can use for living expenses. Your home isn’t liquid. Income property isn’t liquid, but you can apply the rents to your retirement needs. Don’t include the value of your company at this stage. We’ll get to that in a moment.

Next, you need to calculate how much you’ll need for the next phase of your life. That may be  called retirement, but it also might be charitable or community work, satisfying a long-desired wanderlust, or even starting another business. A good financial planner can help you with the assumptions for inflation, longevity and future medical costs.

From a starting point (current liquid net worth,) and a target destination (financial needs at retirement) you can calculate a financial Distance to Goal. Now it is time to choose a time frame.

Add the amount you expect to save each year that you continue working to your liquid assets plus the post-tax proceeds of transferring your company at its current value. Do you reach your goal?

Navigating the Path

With this exercise, some owners are surprised to learn that they are on track, and only need to maintain their current path to realize their objectives. Unfortunately, more find that they can’t reach their destination in the desired time frame without some changes.

This simple triangulation, with a solid starting point, concrete destination and a time frame gives you a clear look at the options available to you. They might include:

  • Increase liquid assets: Do you have underutilized real estate? Will you downsize your living quarters once retired?
  • Increase savings: Can you make adjustments in your business or your lifestyle to augment what you are currently saving?
  • Increase value: Would changes in your business make it more attractive to certain buyers? (That will be post #3 in this series.)
  • Increase time frames: Could working a couple of years longer close the gap in your planning?

You can experiment by modeling different scenarios using the free Triangulation Tool at www.YourExitMap.com.

Stephen Covey made famous the phrase “Begin with the end in mind.” If you understand your Distance to Goal, you are better able to choose a road that gets you there.

 

Four Basics of Exit Planning 1: Valuation

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There are four basics an owner should address before beginning any exit, succession, or transition plan. They are Valuation, Distance to Goal, Prospective Buyers, and Professional Team.

First, my apologies for missing a tri-weekly post. Between trips to Denver for BEI’s National Exit Planning Conference, Dallas for a client, San Antonio for our own XPX Exit Planning Summit, Nashville for the national EPI Exit Planning Summit, and St. Louis for Archford’s Metro Business Owner Summit, I kind of lost track of my posting schedule.

Here is the first of the four basic requirements. I promise not to dally in posting the rest of the full set.

Understanding Valuation

Value is the starting point for all transition planning. Any decision, any business plan, and every retirement projection (either for time frames or finances) must start with the value of your business today.

Knowing the value of your business is different from thinking you know it. I talk to many owners who say “I met a guy at a trade show, and he told me that he knows a guy with a business just like mine who sold his company for five million dollars. I think I’m a little bigger than he was, so I know my business is worth at least six million.”

Sounds foolish? How about “My accountant says that all small business sells for about five times earnings.” Or “Everyone in my industry knows that all companies like ours sell for one and a half times revenue.”

Any valuation estimate that is in the same sentence as “all,” or “everyone” is a crock. Multiples may serve as guidelines, but the value of a specific business is always unique to that business.

How much is a manufacturer of disposable paper products worth? What if they specialize in paper straws? How much does that value change every time McDonald’s or Southwest Airlines announces that they are switching to paper straws? How much is it worth if it is the last paper straw manufacturer in the USA (like Aardvark® Straws?) If you understand the value, your mental estimate should have changed with each sentence.

Every change in the above paragraph described an intangible. Events and market conditions are as important, or in some cases more important, than last year’s numbers. Valuation starts with profitability and cash flow, but the real price that someone will pay for a business lies in the intangibles.

Intangibles

There are scores of intangible factors affecting business value. Most are related to customers, employees, or systems. Ask yourself these questions (although there are many more.)

  • Customers:
    • Do you get more than 20% of your sales from one customer?
    • Is your revenue recurring (by contract) or a series of one-time transactions?
    • Is your value proposition more than just “good service?”
    • Are steady or repeat customers increasing their purchases?
    • Can you forecast their purchasing accurately?
  • Employees:
    • Do you have managers that can run the day to day operations without you?
    • Are your key employees too close to retirement age?
    • Is turnover too high, or nonexistent?
    • Are important positions cross-trained via a formal process?
    • Do you have non-competes and/or long term retention incentives?
  • Systems
    • How accurate is your budgeting when compared to historical reality?
    • Are all processes documented and followed?
    • Is equipment carefully maintained?
    • Our proprietary systems and knowledge protected?
    • Do you track the effectiveness of sales and advertising expenses?

All valuations begin with profitability and cash flow. Most business appraisals take at least a cursory look at a few of the intangibles listed above. Buyers, however, will look at all of these factors and more.

Understanding the four basics of exit planning starts with valuation. If you don’t know where you are, it’s tough to plan where you are going.

For over twenty years, business owners have asked me “What can I do to increase the value of my company?” My answer is always the same.

“Exactly what you should be doing to improve it every day.”

Do you think you know the value of your business? Try the “Sellers Sanity Check,” a free tool at YourExitMap.com

Invest 15 Minutes and take our FREE Exit Readiness Assessment. We do not request any confidential information.

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