selling a business Archives

Private Equity Reputation

December 2, 2024 by John F. Dini

We began this series by saying that Private Equity reputation is as the Great Satan to some, and a savior to others, depending on the personal experience of the speakers. In fact, both reputations are well deserved, but neither can be universally applied.

The “Great Satan” Private Equity Reputation

PEGs buy companies for the express purpose of improving their performance. That often comes with considerable pain for employees. A Searchfunder I know said recently “I’m looking at this acquisition because the owner thinks he is running an efficient company, where I see at least ten points that could be dropping to the bottom line.”

Efficiency is good, but too often it flies in the face of what made a company successful. In one example I recall, the PEG principals spoke to the assembled employees the day after closing on the business. They said “We bought this company for its culture and its people. Those are the most important assets to us.”

The cuts started coming the following Monday. Thanksgiving turkeys were “outdated.” Gone. All bonuses would be performance-based, so extra bonuses at Christmas would be discontinued. Season seats for the local sports franchise – gone. (Most of those went to customers.) Weekend overtime – gone. Schedules would be rearranged so that weekend workers were now scheduled for Saturdays and Sundays and got fewer hours during the week to make up for it.

Employee discounts on the company’s products – gone. Partial subsidies for family health insurance, well by now you are getting the gist. The flood of cuts was shocking and seemed unending. The flood of resignations started soon after.

By the way, the PEG missed its planned flip date (when they were supposed to sell to a bigger PEG) because of poor results and eventually took the company into Chapter 11.
I wish I could say that this type of result was unique, but it happens in far too many cases.

The “Savior” Private Equity Reputation

There is another reality. About 50% of all the privately held employers in the United States are Baby Boomers. The youngest of these are now turning 60. Many have built substantial enterprises whose value is far beyond what a younger entrepreneur can afford.

Private Equity has morphed into a many-headed creature, capable of acquiring almost any size business with value. It will never be for the mom-and-pop businesses that merely earn a living for the owner. As Doug Tatum says in No Man’s Land, they have grown to a level where they provide “wealth” to the owner equivalent to three salaries. Unfortunately, the owner must hold down three jobs for it to work.

But businesses with real cash flow, from a few hundred thousand dollars to a few hundred million, can find a tranche of PEGs who will consider their acquisition. Some specialize in minority ownership, or in funding the transition to a new generation of owners. Like it or not, these will be the saving of an entire generation who became successful by building a illiquid asset.

The latest estimate (from the Exit Planning Institute) is that these owners have $14 trillion dollars locked up in these illiquid assets – their companies. It that was an economy, it would be third in the world behind only the USA and China.

Reputation Counts

Many business owners are dazzled by the money a PEG has. With 17,000 of them out there, “We have money” is no longer as impressive as it once was. If a PEG comes calling, sellers (and their advisors) should carefully research their track record. If they lead with a guy “just like you” who owned a previous acquisition, be cautious. In most cases, he or she is compensated for adding to their portfolio.

Instead, talk to other owners who were acquired previously and are no longer active in the business. Look carefully into the acquirer’s experience in your industry. Unfortunately, “We have money” sometimes dazzles the PEG too. They begin to think financial manipulation is the only thing needed to make any business more successful.

Private Equity reputation is important. It will help you decide whether you should be discussing “show me the money” or “show me the future.”

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

October 28, 2024 by John F. Dini

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.

The “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.

Seize The Moment: Strategically Timing Your Retirement When Selling Your Business

August 6, 2024 by Kerry Boulton

Imagine standing at the edge of a cliff, ready to take a leap into a new chapter of your life. That’s retirement. Now, picture this adventure interwoven with the sale of your business. Exciting, right? Just like any daring journey, timing is everything.

Let’s talk about finding that perfect moment to embark on your retirement while selling your business. It’s not just about calendars and clocks; it’s about aligning the stars to make the most of your hard-earned efforts.

First off, consider the market trends. Are you in a booming phase where your business value is at its peak? Capitalise on that surge to secure a comfortable retirement fund. On the flip side, if the market is shaky, give it time to rebound before exiting.

But it’s not just external factors — your internal readiness matters too. Ask yourself: Have you achieved your personal and financial goals? Are you emotionally prepared to let go of the business you’ve nurtured? Your gut feeling often knows best.

Also, think about your successor. Is there someone you’ve been grooming to take the reins? Timing your retirement when your successor is ready can ensure a smooth transition for both you and your business.

Let’s talk about legacy. How do you envision your business carrying on without you? Timing your retirement allows you to leave behind a legacy that echoes your values and vision. It’s like passing the baton in a relay race — a moment of seamless exchange ensuring the race continues strong.

In the end, timing your retirement while selling your business is like orchestrating a symphony — a blend of external harmony and internal rhythm. When you feel that crescendo building, that’s when you know it’s time to take that leap.

Addressing the Value Gap – Truth in Pricing

July 1, 2024 by John F. Dini

Truth in pricing is a common issue when discussing the sale of a business.

The selling price of their company is a point of pride for any owner. When they are willing to share the price they were paid, they usually include everything that was listed in the purchase agreement. While there is nothing inherently dishonest about that, it’s often not exactly the truth either.

In our last article we saw Bob, the owner of Bob’s Widgets, came to the conclusion that he needed to sell his business for $6,000,000 in order to replace his current salary and the Seller’s Discretionary Earnings (SDE) such as the vehicle and health insurance that his business pays for.

He knows that his friend Edgar sold his widget company for $5,000,000. Both Bob and Edgar have about 40 employees. Bob thinks his newer manufacturing equipment allows him to operate more efficiently than Edgar. Edgar freely discloses that his revenues were $4,000,000 in the year prior to the sale. Bob’s sales were $7,000,000 last year.

We will ignore Bob’s EBITDA ($500,000) for this exercise. Whether his expectations are practical as a multiple of profits is a discussion for another time.

Is it unreasonable to presume that if a $4,000,000 revenue company in the same industry can sell for $5,000,000, then a $7,000,000 company should sell for $6,000,000? Bob figures that he is not only being reasonable, but perhaps he is shooting too low.

Truth in Pricing

To begin, let’s see what Edgar’s price consisted of.

Royalty payments on specialty widgets that Edgar patented were value at around $150,000 a year for the next ten years. That was $1,500,000 of his “selling price.” In addition, although Edgar’s equipment was old, it was paid for. His company was debt-free. He generated almost $1,000,000 in EBITDA annually.

truth in pricingEdgar’s buyer also wanted him to stick around for three years. Edgar calculated his salary of $150,000 a year as part of the “purchase price.” He also had an “earn out” of $500,000 a year for reaching certain sales goals in the next two years. In total, royalties, salary and conditional payments made up $2,950,000 of his $5,000,000 price, leaving only a bit more than $2,000,000 as “cash on the barrelhead.”

Did Edgar lie? Not in his own eyes. Given some time, effort and luck., he will eventually realize $5,000,000 in total pre-tax income related to his business. It’s his version fo truth in pricing.

Bob’s Price

First Bob has to consider what his price would include. He has about $350,000 left on the lease/purchase of his two newest widget manufacturing machines, which would have to be paid off by the buyer. He also owes about $300,000 on his revolving credit line.

Bob has always felt that vacation pay is earned, and never bothered to put a limit on its accrual by employees. He would be shocked to learn that his 40 employees, who average about $50,000 in salary, have about 240 weeks of unused vacation time. That’s another $230,000 plus the employer’s payroll taxes. Let’s call it a quarter million dollars. Edgar had a maximum one-week carryover. His liability was about $40,000. If Bob’s buyer is willing to pay a five (5x) multiple of EBITDA, the unrecognized vacation expense could drop the purchase price by nearly $1,000,000.

Bob is also anticipating a stock sale, with a tax burden of about $1,200,000 on his sale price. If it’s an asset sale (90% of small businesses are asset sales), he can expect that number to be much higher. In short, even if Bob could demand $6,000,000, his actual cash price might be more than a million and a half dollars less, and his tax burden almost a million dollars more. Suddenly Bob has the equivalent (in his eyes) of a $3,500,000 sale.

Closing the Value Gap

Welcome to the second part of the Value Gap. Now Bob realizes that not only will he need substantially more money to fund his post-exit lifestyle, but his company can’t currently provide the level of proceeds he was planning on for retirement.

It may seem surprising, but the answer to this problem for many owners is “I’ll just work longer.” The challenge of closing the Value Gap is too daunting to wrap their thinking around.

Some planning could help Bob. He can modify his benefit structures and pay off some debt, but let’s say that his $6,000,000 price is reasonable, and growing the value to $8,000,000 would meet his goals. Breaking that down on an annual basis renders a growth target of less than 6% annually over the next 5 years.

That may be a better solution than “just keep working.” Bob’s time frame may be longer or shorter. He may modify his target income. He may be able to economize in his business operations to increase cash flow. There are a number of options to consider, but they all require that Bob first understands his Value Gap and truth in pricing.

Addressing the Value Gap – Living Expenses

June 12, 2024 by John F. Dini

The Value Gap is one of the most used phrases in exit planning. Simply stated, it’s the difference between what a business owner would realize if he or she sold the company today, and what they need to embark on a financially secure “next act” after business ownership.

Both amounts can be determined with some accuracy by professionals. A qualified appraiser will analyze a company, its prospects, differentiation, markets, and comparative businesses and develop a value for the business. A good financial planner will look at savings, expected income, anticipated lifestyle expenses, life expectancy, and inflation and develop a scenario for the amount needed to fund those expectations.

Simple, right? Financial plan requirements minus net proceeds from the business transfer equals the value gap.

Testing the Value Gap

If it is so simple, why do so few business owners do it? Instead, they value their businesses by hearsay, misestimate their lifestyle needs by a substantial margin, and think “I’ll probably be fine.” In fact, fewer than one owner in five has even documented any plan for their transition.

Let’s take my favorite business owner, Bob of Bob’s Widgets Inc. Bob pays himself $120,000 a year and lives nicely on that amount. So he estimates that $10,000 a month should cover his lifestyle in retirement. To generate that, he needs $3,000,000 in savings with a 4% return. That means he has to sell his business for about $4,000,000, assuming 24% capital gains tax. His company sold $7,000,000 in widgets last year, with a $500,000 pre-tax bottom line, so he is sure it’s worth at least $4,000,000. (We’ll discuss this valuation in my next column.)

But wait a minute. Is Bob really making $120,000 a year? He drives a Ford Super-Duty company truck that cost $85,000. The payment is about $1,500 a month. Insurance, maintenance and fuel are paid for by the company. Bob’s Widgets Inc. also pays for Bob’s $750 a month health insurance, his $1,200 monthly life insurance, and his $7,200 annual personal tax preparation bill.

“Sellers Discretionary Expenses”

Bob’s company expenses are not only common, but he doesn’t really take all that much in comparison to some owners. Any advisor can tell stories of company-paid second homes, family trips and other expenses far less business-related than Bob’s.

Without going beyond what would be considered “normal” owner perks, we can add about $58,000 a year in post-tax spending to Bob’s lifestyle. At his 4% return assumption, that adds another $1,450,000 in post-tax proceeds from the business to his need for a liquid asset base.

Even if Bob’s assumption of a lower capital gains rate is correct (which is not the case in 90% of small business sales) he actually needs a sale price of at least $6,000,000 just to maintain his current lifestyle.

Even Bob knows that his company can’t sell for $6,000,000. Without getting an appraisal or a formal financial plan, Bob has just had his first lesson in planning for the Value Gap.