ESOP’s Fables: Fiduciary Concerns in Change-of-Control Transactions

Fiduciary Concerns in Change-of-Control Transactions

Several years ago, corporate transactions involving employee stock ownership plans (ESOPs) grew tremendously. Yet, just as ESOPs became an integral part of the leveraging of corporate America, they got slammed by the same forces as domestic companies. Some ESOP companies prospered while others faded away, starved for more capital.

Fiduciaries of many ESOPs that have some acquisition debt outstanding now need to consider new transactions. Each of these situations presents a host of questions about the nature of the ESOP’s financial interest and ways it can or should be viewed under the Employee Retirement Income Security Act of 1974 (ERISA).

5 Issues To Be Seen and Heard Fiduciaries should address several matters when an existing ESOP is involved in a corporate change-of-control, whether to ensure survival or just capitalize on good fortune. These include:

  1. Transaction participation.The ESOP may be holding the same class of stock as the other shareholders (common stock) or another stock class that is convertible into common stock (convertible preferred stock). In either case, the ESOP may be offered a financial opportunity different from that offered to other shareholders. If the ESOP wants different treatment than other shareholders, the fiduciary should determine whether such treatment serves the participants’ best interests. Although no established guidelines exist for resolving this, a prudent ESOP fiduciary course of action would be to treat transaction participation the same as any other investment decision, as the following example suggests.In the case of a tender offer to other shareholders, the fiduciary may be requested to exchange its shares for those of the acquirer’s similar stock class rather than to tender them. When this option is compared with that offered to other shareholders who are receiving cash consideration for their stock, the fiduciary should evaluate it from the standpoint of two investment decisions: first, selling the stock; and second, reinvesting the proceeds in the acquirer’s stock. If both investments meet the “adequate consideration” requirement under ERISA, the decision to exchange the shares may be a justifiable course of action. In other words, the investment makes sense if reinvesting the proceeds allows the ESOP to continue providing a potentially greater return than would otherwise be earned.
  2. Evaluating a transaction’s total consideration. Consideration paid in a tender offer may be in cash, notes, other securities or retention of certain assets. Merger consideration typically takes the form of the acquirer’s stock. Consideration may also include value attributed to employment contracts, non-compete agreements or other compensation arrangements. These usually are provided only to management shareholders but, in essence, represent a portion of the purchase price the acquirer is willing to pay.
    Standard valuation principles should apply when one assesses the fairness of the total consideration to be received. Important factors would include, but not be limited to, the:

    • Company’s and industry’s outlook,
    • Company’s cash-generating ability
    • Securities market pricing for comparable public companies’ stock, and
    • Actual prices paid in comparable change-of-control transactions.
  3. Evaluating what the ESOP will receive as consideration addresses the transaction’s absolute fairness. This analysis enables the fiduciary to ensure the ESOP is receiving adequate stock consideration.
  4. Allocating total consideration among all equity holders.To ensure the ESOP is being treated fairly, it’s important to examine the terms of the securities each type of equity holder owns. Different classes of stock may be assessed differently depending on their rights and preferences. For example, if an ESOP holds convertible preferred stock and the acquirer intends to terminate the ESOP when the transaction is completed, then the ESOP may be entitled to the greater of its redemption or fair market value. The value to the ESOP should never be less than what it would have received had it held only common stock; the fiduciary can always convert the preferred stock and receive the same value provided to all common shareholders.It’s also important to determine whether a disproportionate amount of the total consideration is being paid to shareholders other than the ESOP. Some practitioners believe that if the ESOP holds a minority interest in the company, the plan is entitled to less than its pro rata share of the total enterprise value realized in a change-of-control transaction. But all common shareholders, including the ESOP, ordinarily have a right to receive their share of the total value proportionate to their percentage of stock ownership, regardless of whether they hold a minority or controlling interest.Even if the value to be received by the ESOP is fair on an absolute basis, allocating any excess value may be unfair. For example, no guidelines exist about how much value one should attribute to management shareholder agreements. The fiduciary’s financial advisor could consider whether employment and non-compete agreements were in place before negotiations, whether they conform to industry market standards and whether the proportion of the total purchase price these agreements represent is reasonable.Evaluating allocation of total consideration addresses the transaction’s relative fairness. The fiduciary’s objective? Ensure the ESOP is treated fairly financially – in terms of absolute and relative fairness.
  5. Treatment of remaining ESOP debt.In a leveraged ESOP, the company commits to repaying the ESOP indebtedness through contributions or dividends. Effectively, the commitment becomes a corporate liability and, as such, affects all shareholders alike. This issue can cause controversy during subsequent transactions.If the ESOP debt is treated as a corporate liability when the sale takes place, shares held by non-ESOP shareholders and shares allocated to ESOP participants will be valued (all else being equal) similarly to the annual valuations; that is, all shares will reflect a value after payment of the ESOP debt. Alternatively, if the ESOP’s unallocated shares are used to satisfy the ESOP’s indebtedness, the percentage of the total value flowing to the ESOP (after the debt repayment) is reduced; the shares held by the non-ESOP shareholders and the ESOP’s allocated shares (that is, all shares unencumbered by debt) increase in value.Because projected contributions or dividends used to repay the ESOP’s debt represent future benefits to the participants, some have argued that any sharing of the ESOP’s debt in a subsequent transaction would result in a benefits windfall to participants – effectively, participants would receive all future benefits at once. This windfall occurs because all unallocated shares would be released from the suspense account when the corporation repays the debt. Others have argued that the commitment to repay the ESOP debt always has been a corporate liability, and any transaction that alters this design merely transfers value away from the ESOP.
  6. Continuing ESOP or other employee benefit plans.Whether the ESOP remains in place after a merger or tender offer may have value implications for ESOP shareholders. If the ESOP benefit is considered favorable relative to standard industry benefits, continuing future contributions or dividends to the ESOP may represent real value.If a substantial amount of ESOP debt is outstanding with corresponding unallocated shares to be released as the debt is repaid, the fiduciary and its advisors should consider these questions:
    • Has the merger partner or acquirer made a legal commitment to make future contributions or dividends sufficient to repay the ESOP indebtedness?
    • Are current ESOP participant interests likely to be diluted through a substantial addition of new employees to the plan?
    • If the ESOP is to be terminated, are replacement benefits contemplated, and how do they compare with the existing benefits?
    • The answers to these questions will help the fiduciary and its advisors more accurately assess valuation considerations of retaining the ESOP.

The Moral of the Story

The ESOP’s involvement in a change-of-control transaction raises a host of new issues that must be appropriately addressed by ESOP fiduciaries, legal and financial advisors, and company management. While each situation is unique, the fiduciary’s knowledge of the original structure of the ESOP’s equity purchase, securityholders’ rights and preferences, and the surviving company’s post-transaction intentions toward benefit plans and remaining ESOP debt repayment will help the fiduciary ensure fair treatment of the ESOP. As a great Greek philosopher once said, “Prepare today for the wants of tomorrow.” Please call us.

Five Early Warning Signs

Is your bank’s lending officer asking you to invest more equity in your business, reduce your outstand­ing balance, or worse, find a new bank?

If you answered “yes,” and it’s your first indication of trouble, you probably missed a few warning signs along the way. If you answered “no,” now is the time to learn about and look for these financial red flags. The sooner you recognize them, the more options you’ll have and the greater your ability to address them effectively.

What are some of these early warning signs? They include slow or no growth, customer or market con­centration, competing on price alone, shrinking gross margins and difficulty funding capital expenditures.

Slow or no growth: Not all growth is good, but slow or no growth in your business can be dangerous. Sure, many compa­nies do just fine for years with limited growth. But what are the real underly­ing problems causing your business to slow down that sooner or later could cause a significant problem? For example, slow or no growth could be a sign of emerging threats or underlying weaknesses such as inferior products or services. It could be as basic as too few new or innovative products or services. It could also point to the presence of new substitutes—products or services that your previous customers find to be a better solution. Poor quality, late delivery, high prices, ineffective sales and mar­keting or weak economic or industry conditions also can be the root cause of your company’s slow decline.

There is no hard, fast rule, but companies should at least grow at a rate equal to the rate of inflation or their primary industry’s growth. Robust growth sig­nals that your business is strong in terms of products and services, competition or competitive advantage, pricing power, sales and marketing, and customer loyalty or satisfaction.

Customer or market concentration: Many small businesses were founded with the help of one large customer. In some cases, the customer prohibits its suppliers from doing business with its competitors. Most small businesses work hard to develop new customers over time, but find it difficult to grow their way out of a concentrated situation. Diversification helps to spread risk while concentration intensifies it. If one customer or market generates more than 15 to 20 percent of your sales, you need to start diversify­ing now.

In some cases, a negative event associated with one or a few customers or markets can reflect negatively on your business, too. For example, industry reces­sion, labor strikes or business failure can hit at any time. A change in corporate policy, such as minimum vendor size, may lead a dominant customer to take its business elsewhere. A customer or distributor might decide to become a competitor and take away valu­able business.

In other cases, the event may be less traumatic, and the damage may unfold over time. Your top customers might naturally soak up most of your company’s sales and marketing, engineer­ing, and capital—leaving fewer resources for you to develop new markets, customers and products. In addition, large customers tend to continuously pressure suppliers to lower prices and make greater concessions. Over time, that shrinks your business margins.

Competing on price alone: In his groundbreak­ing book “Competitive Advantage,” Michael Porter says above average performance in the long run is not based on price, but on sustainable competitive advantage. There are three basic types of competitive advantage: low cost, differentiation and focus. Many companies confuse low price with low cost or com­pete on price without an actual cost advantage. The sources of cost advantage include economies of scale, proprietary technology and preferential access to raw materials. Low prices without a cost advantage lead to low profit margins. Companies with exceptionally low margins are threatened by volume swings and tend to carry more debt than their peers.

Cost cannot be your only form of differentiation for long. Although cost leadership creates a competitive advantage, cost leaders must differentiate their compa­nies in other ways to be above average or build a sus­tainable business. If they don’t, their competitors will.

Shrinking gross margins: Margin problems often start as pricing problems. Lack of a good cost accounting system and flawed pricing policies, strate­gies or enforcement are common contributors. But the failures to control costs or raise prices as costs increase can be devastating over time. This can happen when a customer changes product specifications or order quantities, when labor costs increase or when mate­rial costs increase.

Difficulty funding capital expenditures: High-per­formance companies reinvest profits in research and development as well as new equipment and technol­ogy. Some of this spending supports the development of new products or business opportunities. However, much of it is used to replace aging equipment with improved technology. At a minimum, companies should spend an amount equal to their depreciation.

Companies that do not generate enough cash flow from operations to cover required capital expendi­tures either defer expenditures or take on more debt. In some cases, the bank will not lend more, which is a huge warning sign. At that point, the company is digging a hole that becomes difficult to climb out of.

Don’t wait for your lender or another stakeholder to tell you your financial condition is sending any of these five warning signs. Take the time to listen to, and analyze, your business’s condition. Make the tough decisions to change as needed. The sooner you start, the sooner you begin assuring a sustainable future for your business.

How to Add Value to a Business Before the Retirement Sale (Business Update Publication)


Institutional Capital: Money to Grow On

Small- and middle-market companies have many promising growth opportunities, despite the clouds hovering over today’s economy. Organizations can still find financing to fund expansion, a capital investment or an acquisition. But what’s a business owner to do once his or her company’s credit lines have run out?

Institutional capital, which includes subordinated debt and preferred equity, could be the answer. It can be used for making acquisitions, buying out partners or obtaining working capital. Let’s look at this financing option for companies whose spirits are willing but whose bank lines are exhausted.

What’s Institutional Capital and How Does It Work?

Institutional capital is an unsecured debt that is subordinated to a company’s senior bank debt. It can be supplied by numerous institutions, including insurance companies and pension fund providers, and is generally used to fulfill long-term capital needs. Also, redemption or amortization usually doesn’t happen until five years after the debt is issued. In exchange for taking a bigger risk than secured lenders, institutional investors assume minority ownership positions and become investment partners with business owners.

Institutional capital has some important long-term implications. For example, it’s only cost-effective if it helps your company significantly improve profitability. It should also help drive the value of your stake above what it would be if you hadn’t taken on a new investment partner.

Who Qualifies for Institutional Capital?

The best candidates for institutional capital need at least $3 million in funding, have annual sales of at least $10 million and earnings before interest, taxes and depreciation (EBITDA) of at least $2 million.

On the other side of the table, institutional investors are looking for companies with a diversified customer base, favorable industry growth trends and barriers to entry – or more simply put, a solid infrastructure. They will require audited financial statements that show a stable earnings record, and they will want to monitor progress. So their potential clients should have information systems that can generate timely, accurate financial statements. Finally, investors plumb for evidence of managerial depth, including a succession plan that ensures smooth operational continuity.

Matchmakers Can Make It Happen

Because institutional investors – like the companies that seek institutional capital – can be located anywhere, an intermediary usually brings the two parties together. It’s much like an arranged marriage in which the parties meet beforehand to see whether they get along before a union is finalized. Many intermediaries have access to myriad investor groups, allowing them to determine the best fit.

The intermediary visits the capital-seeking company, observes its business operations and prepares a comprehensive operations memorandum, which becomes a marketing tool for prospective investors. Then, the intermediary contacts investors it believes best suit the company’s circumstances. They all meet and decide whether a business relationship is viable. When the match is made, the intermediary helps negotiate agreement terms and conditions.

Proceed With Caution

Institutional capital can be an excellent way for your company to expand or make an acquisition. But before pursuing this financing route, thoughtful analysis is necessary. Taking on an investment partner will affect your company’s operations and goals, so institutional capital isn’t simply “about the money.” Before taking this leap, give us a call; we’ll help you map out the best route between your company and the capital it needs.

Sidebar: Good Intermediaries Attract Excellent Capital

Institutional capital can help you create significant long-term value you might not have achieved otherwise. Getting the best deal means putting your company’s investment considerations in the best possible light. A key step in securing institutional capital is a high-quality offering memorandum that lists your pertinent assets. An intermediary can help you prepare your documentation and contact investors best suited to your company’s circumstances – so choose this consultant wisely. To do so, ask questions, such as:

  • What’s your track record on prior offering memoranda?
  • How frequently have you raised capital for a project like the one we’re pursuing?
  • Have you previously worked with our investor candidates?
  • Do you have direct access to the decision-makers?

The answers to these questions should help you choose the right intermediary.

Is an Equity Recapitalization Right for You?

Change continues to be a natural part of business. Does one or more of your partners want to exit, but you want to stay (or vice versa)? Do you want to unlock some of the value in your business, but continue to own a significant portion of it and enjoy the future upside? Or, do you need a retirement or succession plan? If so, an equity recapitalization might be an attractive alternative to consider. Simply put, it can enable you to take some chips off the table now, maximize the value of your business over time and sell the balance of your equity at a higher valuation in 3 to 7 years. Other benefits include:

Net worth diversification. For too many small business owners, the majority of their net worth is locked in their business, and privately held middle market businesses are considered to be riskier than many other assets.

Fresh capital and contacts. Your new partner might help fund capital expenditures to support organic growth or acquisitions to bolster management, growth, profitability or competitive advantage. They also could introduce you to new customers or suppliers who can help increase sales, decrease expenses or launch a new strategy.

Financial and operational expertise. Your new partner will want to add value by sharing his or her general management experience and skills by implementing new procedures or processes. For example, a more robust cost accounting system or business planning process might help improve profits or take your business to the next level.

Most equity recapitalizations are funded by private equity groups (PEGs) that raise and invest money from institutional investors like banks, insurance companies and pension funds. PEGs tend to invest in companies with strong management, growth, profitability and competitive advantage. However, some are interested in distressed or underperforming companies.

In the typical equity recapitalization, the PEG or its fund:

  • acquires 51 percent or more of the target company (some will acquire a non-control equity interest);
  • takes a seat or two on the board of directors and works with management to grow and improve the business;
  • seeks liquidity (in 3 to 7 years) through an initial public offering, recapitalization or sale.

To illustrate the potential financial benefits to you (the selling shareholder), here is an over-simplified example. If today your company generates $2.5 million in earnings before interest, tax, depreciation and amortization (EBITDA) on $25 million sales, we value it using an enterprise value multiple of 5 times EBITDA, and the balance sheet includes no interest bearing debt or excess cash, then the equity value would equal $12.5 million. If you agree to sell 51 percent of the equity to a PEG, you would realize $6.375 million pre-tax.

Then, in 5 years, if your company generates $5 million in EBITDA on $50 million sales, we value it using an enterprise value multiple of 5 times EBITDA, and the balance sheet includes no interest-bearing debt or excess cash, then the equity value would equal $25.0 million. If you agree to sell the remaining 49 percent of the equity to a strategic buyer, you would realize $12.25 million pre-tax.

You and your management team maintain control of day-to-day decision-making, leadership and operations, and your new partner provides advice or guidance as a board member. However, in most cases, you will lose control of the voting rights associated with equity and, if not accustomed to it, you will need to learn how to work with a board of directors.

To many, the benefits of diversification, liquidity and succession outweigh any shortcomings associated with a recap. It can help you mitigate risk and put you on the path to retirement. One never knows when the economy or a customer will upset your prospects, or when you will get the itch to find your blue water—whether it’s a personal mission in life or a lakeside cottage with beautiful sunsets.

Making An Acquisition The Smart Way

According to Bank of America Business Capital’s2008 CFO Outlook, among those companies expecting merger and acquisition activity, 86 percent report that they will be making the acquisition, while only 7 percent plan to be acquired by another firm. In other words, many buyers will be chasing few sellers. That means if you are a would-be buyer, you need to develop a well thought-out process that generates proprietary deal flow, minimizes your risk and maximizes your return on investment (ROI). The right approach will also enable management to continue focusing on its existing business; increase your probability of acquiring the right company at the right price, terms and conditions; compress the time frame to complete a transaction; and ensure successful post-merger integration.

How To Get Started:

Should you wait for investment bankers or business brokers to call you with deals? That might result in missed opportunities, competitive bidding situations such as auctions, or a stream of companies that do not fit your criteria. The acquisition process includes a number of steps and requires considerable preparation and careful execution. It also calls for experience and specialized skills in accounting, due diligence, finance, law, strategy and valuation. So let’s start at the beginning.

Step 1: Acquisition strategy and criteria.

Your first step is to clearly define your acquisition strategy and set of criteria. Some common strategies are to:

  • Overcome barriers to organic growth.
  • Bolster a company’s competitive advantage by acquiring key resources like strong management, skilled labor, complementary or proprietary products or services, production capacity or new technology.
  • Expand geographically or manage business risk through market or customer diversification.

Once the strategy has been vetted, set specific criteria for the business you want to buy. Type of business (or industry), size of business (in terms of sales or cash flows), location, size of transaction and equity investment and other qualitative factors are commonly used criteria. If your strategy is off-target or your criteria are too loose, you’ll waste time and other resources or, worse, fail at attaining your goal

Step 2: Valuation methods and assumptions.

It is also important to use valuation methods and assumptions that fit your requirements as well as those of a reasonable seller (for example, market-based). Most financial advisors use the discounted cash flow (DCF) method to estimate the value of companies with positive, predictable cash flows. Purchase price multiples should be used carefully as a rule of thumb to check a DCF valuation or to provide a quick estimate. As part of the valuation process, you must make assumptions about variables like future sales growth, capital expenditures, cash flows, financing and return on equity. Using generally accepted, reasonable valuation methods and assumptions greatly increases your probability of completing acquisitions of companies that satisfy your strategy and criteria.

Step 3: Acquisition funding.

Before reaching out to acquisition targets, as a buyer you should identify sources of debt and equity and determine how much capital you can invest. Some buyers need to look no further than their own balance sheet, since excess cash and existing revolving lines of credit are common funding sources. Other sources include private placements, sale-leasebacks, bridge or term loans, and mezzanine or subordinated debt. Another alternative is to raise equity from a professional investor such as a private equity group (PEG). PEGs are not only a source of capital, but also provide board-level advice, management and deal-making expertise, and industry experience and contacts. Clearly, the source and amount of capital will influence the size of transaction you can consider as well as the valuation and structure of any proposed transaction.

Step 4: Preparing for a broad search.

When you target a large group of companies such as an industry rather than one or a few specific targets, you need to prepare a few more items:

  • Have a list of prospective targets based on your acquisition criteria, such as type of business (or industry), size of business (in terms of employees or sales) and location
  • Write a brief description of your business and acquisition criteria. Prospective sellers want to know who is courting them and why. This can be presented to prospective sellers verbally, but many will ask for something in writing.
  • Prepare a Confidentiality or Non-Disclosure Agreement. Confidentiality is critical to sellers especially privately held middle-market businesses. A few prospective sellers will want buyers to sign their own, but many will not be prepared to sell their company and, therefore, will not be ready with an agreement.
  • Complete a standard information request. Again, since many prospective sellers will not be marketing their companies for sale, you need to be ready to request pertinent information. An initial screen of about five items is a good place to start.

Step 5: Finding the right fit.

Once you have completed the necessary preparations, contacted several prospective sellers and identified an interested party who may be a good fit, the heavy lifting begins. You will need to analyze detailed target company information to understand the target company and determine whether or not it fits your strategy, culture and ROI parameters. Valuation models and transaction structure alternatives need to be developed. If you decide to pursue a transaction, a letter of intent or term sheet needs to be presented, negotiated and finalized. Funding needs to be arranged. Due diligence needs to be conducted, the transaction needs to be closed and post-merger integration needs to be completed. The right approach will increase your likelihood of finding the right acquisition. It requires considerable preparation, careful execution, experience and specialized skills. While this process may seem time consuming and a bit intimidating, you can get help. The right team of professional advisors includes your investment banker, attorney, CPA and other experts who will show you the way.

Managing A Business In Preparation Of A Sale

You might be thinking about retiring or pursuing other interests, or you might be young with lots of gas left in the tank. Regardless, it can take years to prepare a business for sale. So, if you are a business owner and want the process to be smooth and the fruits to be sweet, it’s time to start thinking like a buyer and managing your business for a sale.

Review Your Strategic Alternatives

You can start by talking with an investment banker about strategic alternatives. This will require an understanding of the shareholders’ goals and priorities, concentrating on both qualitative and quantitative factors. Do the shareholders want to protect the employees, community and other stakeholders and not sell to a buyer likely to relocate the business? If the shareholders own the real estate, is it important to sell it with the business? A thorough review will include some or all of the following:

  • A valuation, including estimates of enterprise and equity value. This requires complete financial statements; projections for sales, cash flows and capital expenditures, and other information.
  • An analysis of the business and its prospects, focusing on its strengths, weaknesses, opportunities and threats. This includes consideration of corporate structure and resources, industry structure, legal and technological factors.
  • A presentation of alternatives. Some of the most common include a recapitalization, sale and management buyout.

Think Like A Buyer

Buyers can be grouped into two main camps: financial and strategic. Simply put, financial buyers bring capital and expertise to target companies; help them grow sales, profits and barriers; and realize returns when they are sold a few years later. Strategic buyers acquire related companies for a variety of reasons, including gaining access to new markets, customers or products; filling existing capacity; and cutting costs. Financial or strategic, buyers look for many of the same qualities in an acquisition target: management, growth, earnings and sustainable competitive advantage.

  • Management. Some owners of privately held companies find it hard to hand over the reins to their managers. Others might find it easy, but lack a team with the experience and skills to step up. Either way, it takes time to groom or recruit the right people. A strong management team will help buyers get more comfortable if the owner plans to leave. It will also increase the owners’ alternatives, as financial buyers are investing first and foremost in management.
  • Growth. There is no hard, fast rule, but companies should at least grow at a rate equal to the rate of inflation or their primary industry’s growth. Robust growth signals that your business is strong in terms of products and services, competition or competitive advantage, pricing power, sales and marketing, and customer loyalty or satisfaction. Moreover, growth is a key input in any valuation.
  • Earnings. Again, no hard, fast rule, but 10-percent earnings before interest, taxes, depreciation and amortization is a popular hurdle, especially for financial buyers. Like growth, healthy earnings are a sign of strength and a key input in any valuation.
  • Sustainable Competitive Advantage. According to Michael Porter, Harvard Business School’s authority on competitive strategy and international competitiveness, the three methods for creating a sustainable, competitive advantage are through-cost leadership, differentiation or focus.

Managing For A Sale

In many cases, the initial valuation or alternatives don’t meet the shareholders’ expectations. This gap can be caused by the difference between perception and reality, or simply the space separating the company’s current state and its future potential. Over time, management can address weaknesses and threats and lead the company to a place that fits the composite buyer’s criteria. At the same time, managers should be ready to provide detailed information when the time comes. Buyers like to examine audited or reviewed financial statements; projections; and sales and profits by market, customer and product.

Out of the Blue. M&A Firm Sees Market Slow but Opportunities for Buyers (MiBiz)


Preparing for Tomorrow’s Graceful Exit Today

What a dilemma. After years of low numbers and much debating, the owner of Sturm and Drang Consultants finally decided to sell the business — and once N. A. Stupor finally decides something, he expects it to happen yesterday. Why should the sale of his business be any different? So he called a quick meeting of his management team and gave them a two-week timeline.

Fortunately for Sturm and Drang, owners don’t work in a vacuum. Stupor’s management team explained that transition experts must be brought in, to maximize not only the company’s potential, but his as well.

Know the Ways Out

Specifically, an exit is a sale to a strategic or financial buyer. A strategic buyer purchases another firm because it can, for instance, save money on purchases, consolidate operations or enter new geographic markets. A financial buyer believes it can run a targeted business successfully, perhaps even better than the seller can. Financial buyers also use leverage to maximize their returns.

And occasionally an exit involves a recapitalization with management participation, which is the case with fictional Sturm and Drang. Whatever motivates you toward the door, five steps can help you and your company avoid obstacles along the way.

Step I : Clarify Owners’ Vision

This isn’t the time to address specifics. First you must look at the current big picture and produce a plan or strategic report that:

  • Analyzes the business and its prospects, focusing on the business’ strengths, weaknesses, opportunities and threats,
  • Projects future performance (an “over-the-horizon” analysis),
  • Identifies shareholders’ priorities and goals, concentrating on both qualitative and quantitative factors,
  • Evaluates the potential exit options (for instance, sale or management buyout) and their tax implications,
  • Identifies obstacles that stand between you and the exit options,
  • Selects the preferred exit, and
  • Specifies key value drivers that will affect the selected exit.

Avoid extreme time pressure as exit day approaches by considering these issues early — at least two years before actually initiating the exit process.

Step II : Prepare an Action Plan

Now that you’ve clarified where you want to go, you can design how best to get there. Analyze characteristics that potential purchasers will value. Then make necessary adjustments accordingly. If a strategic buyer seems likely, concentrate on making the business more valuable. If a financial buyer seems likely, perhaps beef up management and reduce debt.

Given cash and time limitations, some changes will spur quicker or more direct value increases than others. At all times, owners and shareholders should stay laser-focused on changes likely to reap the greatest value returns.

Step III : Hammer Out the Details

Notwithstanding tax implications, well-seasoned advisors learn a business’ structure and keep its profitability and attractiveness clear to potential acquirers. Experienced tax or estate advisors know the objective is to make the deal happen, but keep in mind that overly creative tax and estate planning can create serious obstacles, such as a delay in closing the deal.

As we alluded to earlier, timing is also important. For instance, it’s usually inappropriate for a company to make major changes (such as in legal structure, IT and large capital expenditures) if it’s close to being sold.

Step IV : Share Knowledge

Many owners of private companies wrestle with making the business less dependent on themselves. After all, spreading knowledge across the management team can only strengthen it, and the stronger the management team, the stronger the company. If a company’s foundation is solid, the buyer will be more comfortable with the owner’s exit. A strong management team also increases an owner’s exit options.

One caveat: Transferring responsibilities to key management must be real, not window dressing. If management isn’t on board, the chance of exiting gracefully grows more remote.

Step V — Work Every Day To Build Value

Not caring for a business is like owning a prize racehorse and feeding and brushing it only once a week because it’s more convenient for the owner. The horse will probably die from such neglect, and even if it lives, it certainly won’t finish any races. Thus, grooming is not a one-time fix, but should be a continual improvement effort.

The Curtain Call

The time and resources each step demands can differ according to the business’ size, sophistication and ownership team. So find a process appropriate for your company and its unique circumstances.

Even if your exit seems a long time hence, it’s never too early to start grooming the business. Although there’s no one-size-fits-all way to do it, a well-structured process reaps the highest reward.

The sale of a business in the current economy takes six to nine months from inception to completion, so the time to consider a plan may be now. Certainly, it can never be too soon to prepare, but it can definitely be too late. Don’t wait until the last minute; please call us for help today.