Your Multimillion-Dollar Exit, page 7
Now that you have planned for the unexpected, let’s turn to some of the strategies you (and George) can consider in your Business Success(ion) plan to achieve a well-planned exit.
Deeper Dive
Joint tenants with rights of survivorship, or JTWROS for short, is a form of property ownership. If you own a bank account with someone as JTWROS, then you are treated as an equal owner, and upon your death, your co-owner acquires total ownership of the account, even if your will or trust says otherwise. Creditors can sever the joint tenancy and access half the account. If the co-owner withdraws money from the account that you deposited, you are treated as making a gift to the co-owner and may have to report the gift on a gift tax return.
Lessons Learned
• Create a revocable trust to own your business interest and transfer the interest into the trust to avoid court involvement.
• Putting your assets into a trust of which you are the sole trustee does not change anything in the way you own or enjoy your assets. If you are the sole trustee and you are the grantor of the trust, you can contribute assets, withdraw assets, terminate the trust, or amend it at any time for any reason, without asking anyone for approval.
• Name someone capable of serving as your successor trustee who can stand in your shoes to run the business, and think about naming a successor co-trustee if you are concerned about the ability of your named successor to serve alone. Think carefully about who should serve in this critical role and whether you want them to have sole and exclusive power over what happens to your business if you are not around.
• Link your MSP and operating/shareholders’ agreement to your revocable trust.
• Your MSP plans for the short term by naming individuals who will run the daily business operations, how they will be paid, and whether they will be entitled to receive incentives in the form of cash or equity bonuses if they perform exceptionally well.
• Name a board of directors or managers in your MSP who will be responsible and accountable for managing the employees you name to run the business.
• Leave the long-term decisions to the board if you have not yet formulated your exit plan and be sure to amend the MSP after you solidify your long-term plan.
• Don’t delay in creating your short-term MSP!
Well-Planned Exit Strategies
I had a small, tight-knit group of managers that were with me for most, if not all, the journey, over 25 years, and 1 partner who was with me almost from the beginning. He and I were the yin and yang managing the business, where I focused primarily on strategy, financial aspects, and technical aspects, and he focused on sales and human resources.
—David Eisner, entrepreneur, former CEO and Founder of Dataprise, Inc.
Merger and Acquisition/Sale to an Outsider
One alternative for you to achieve a successful, well-planned exit is to sell your business. The sale of your business is also commonly referred to as a merger and acquisition (M&A), depending upon the structure of the deal and the type of consideration you may receive for your business. The sale may also be referred to as a stock/equity sale or an asset sale, again depending on the structure.
If you sell your small business to another small business or an individual, you may be willing to take back financing (i.e., lend them money to purchase your business) in addition to receiving some cash so the buyer has an easier time affording the purchase. Conversely, if your business is significant in size, with millions of dollars of revenue and profits and many employees, a buyer is going to need to have significant financing to ensure your purchase price ultimately gets paid. Regardless of the size of the deal, your universe of prospective buyers usually consists of strategic buyers, private equity (PE) buyers, and family offices.
Deeper Dive
The buyer usually wants to treat the acquisition of your business as a purchase of assets for tax purposes, even though they may only acquire stock or LLC interests. This is particularly true if your business is operated as an LLC taxed as a partnership or as an S corporation. Conversely, you would rather just sell your stock or LLC interests directly to the buyer and get 100% capital gains treatment on the sale of your equity.
• Treating the stock/equity sale as an asset sale for income tax purposes permits the buyer to write off the cost of your business, which may consist primarily of goodwill that can be amortized for tax purposes over 15 years on a straight-line basis. You won’t mind selling your goodwill if it can be taxed at lower long-term capital gains rates. But if the transaction is treated as a sale of assets, some of the purchase price may need to be allocated to assets that generate ordinary income taxed at a higher rate, such as accounts receivable and equipment that you previously depreciated.
• If your business is treated as an S corporation, the buyer may want you to make elections under Internal Revenue Code (IRC) Section 338(h)(10) or Section 336(e) to treat the stock sale as a sale of assets, or they may want to reorganize your business in an F reorganization to create the same results for the buyer and allow any rollover equity you receive to avoid current taxation on the sale.
• These complexities are beyond the scope of this book, but simply put, the tax nuances of the deal will affect your ultimate decision on whether to sell, how much to sell, the purchase price, and how to structure the sale to minimize adverse income tax consequences.
• In some cases, you may need to pay tax on the rollover equity you receive without the ability to sell the equity to recoup the taxes you just paid. In other cases, you will want to receive the rollover equity on a tax-deferred basis.
• If the buyer insists on treating the deal as an asset sale for tax purposes, you should try to negotiate an increase in your purchase price due to the higher ordinary income tax generated by the buyer’s desired treatment.
Strategic Buyers
Strategic buyers look at your business as a way of enhancing products or services they already sell, but you may give them a geographic or strategic advantage by allowing them to open in new markets or access new customers. You may also add value to their business in the form of new products or services they don’t currently offer. In other words, there’s something you have that they don’t, and they want to add your business to theirs to increase long-term profits. Because you have something they want as part of their platform, strategic buyers may pay you a higher purchase price for your business. Other strategic buyers may be individuals who want to buy your business.
You may be looking for a strategic buyer for whom you can fill a value gap and enhance their business model.18 For example, if you have technology that the strategic buyer already relies on to deliver their products or services or includes as part of their product offerings, adding you to the buyer’s platform makes the buyer more valuable.
You may already know another company that could be a good candidate to buy your business. You may have worked on projects or joint ventures with them that, if you were part of their business, would increase their value. These strategic buyers may be ideal buyers for your business, but if you limit your choices to the businesses you know, you may be selling yourself short. An investment banker, a business broker, a corporate attorney, a CPA, or your board of advisors or directors may all help you expand your universe of potential strategic buyers through their extensive contacts and relationships.
Ideas in Action
Juan owned a small government contracting firm that was working with one of the behemoths in the industry on a highly specialized service for a specific government agency. They had teamed together for a year on various projects. One day, the government contractor asked Juan whether he wanted to sell his business to the contractor. He responded, “How much are you willing to pay?” bypassing the processes outlined in this book. The contractor offered Juan enough to satisfy his personal goal of selling the business for a significant sum of money. Juan accepted the offer, and they closed the deal in record time because the buyer knew Juan and his business very well, and both parties were comfortable with each other.
Private Equity Buyers
PE buyers focus on investments that will yield significant financial returns to their investors over a specific time. They usually want to ensure your business will succeed on its own without continued involvement or additional investment beyond the initial purchase. At the same time, the best PE buyers have experience in investing in other similarly sized businesses in your industry. They know the risks inherent in your business, and they hopefully understand what a successful business looks like when they are evaluating you as a target.
PE buyers come in so many shapes and sizes that it’s hard to describe a “typical” PE firm. Trillions of dollars have been invested in PE funds, and the trend continues to increase, even as stock market returns ebb and flow.19 As investment dollars come in, the PE firm must deploy these dollars to acquire portfolio companies or build platforms within an industry to achieve their investment strategies, which are myriad and diverse. Undoubtedly, if you are a Rocket Ship, there is an investment strategy and a PE investor out there for your business if it is growing and has the right components.
Even with increased volatility in the public markets, PE investments have expanded dramatically in the 21st century. Some PE buyers will be focused on your customer list, contracts, or technologies that may yield additional synergies with other portfolio companies they manage. In that case, the PE buyer may be less interested in retaining your workforce and more interested in capitalizing on expanding existing product and service offerings to the customer base of their portfolio companies.
In other cases, PE investors insert their own managers and board members to run the target’s business. Even if you have been successful in running and growing your business over time, the PE firm may think they can do it better. There seems to be a bias among some PE fund managers as to how to properly run a business they acquire. If they’ve been successful in taking portfolio companies to the next level, they may know what they’re talking about. However, if they’re getting into a new industry or purchasing your company as the cornerstone of a new platform into which they will combine other similar companies, their focus on your assets and lack of focus on your people may not yield the best results.
Ideas in Action
I recently sold a company in the construction business to a PE–backed, multibillion-dollar company that had already acquired other similar companies in different parts of the country. My client carefully interviewed other sellers to this PE-backed business and discovered, much to his delight, that the sellers were all ecstatic about how they were treated by the buyer and the way in which management allows the acquired companies to continue to operate as part of a greater whole but independently in the way they customarily do business. The PE-backed management simply tries to add value based on experience with the acquired companies and provides information and guidance to their acquired companies, gleaned from operating similar successful businesses. That’s an ideal PE buyer.
In another case, Don raised PE capital to fund his retail consumer products business. The PE firm wanted to be deeply involved in the management of a business they just funded. By contrast, Don had operated this business successfully for many years in his own way but did not necessarily follow the rules the PE firm wanted to impose. It only took 1 year of struggling to work together before Don demanded that the PE firm be bought out. That experience cost Don significant time, money, and, most of all, energy in dealing with a PE investor who really did not meet his needs.
PE deals often involve a 2-step process. In the first step, the PE firm acquires 20–90% of your company. You are expected to “roll over” some of your purchase price into equity of the acquiring company. The structures of these transactions can be quite complex, but the outcome is generally the same.
If you’re going to accept a stake in the buyer’s business, you need to ask whether and when you will be able to sell that stake to reap the benefits of the rollover equity portion of the transaction. PE buyers want to hold on to your business and grow it until it achieves a certain return on investment they’ve promised their investors.
Ideas in Action
Recently, Jack sold his business to a PE firm and, less than a year later, the PE firm found a buyer for the business (along with several other similarly situated businesses) that allowed Jack to quadruple his investment in the rollover equity he received in the original transaction. Either the original sale price was too low, and Jack should have been more careful in deciding on the original sale price, or the PE firm was able to unleash or reveal additional value to a potential buyer that resulted in benefits not only to the PE firm but to the rollover investors, including Jack.
Not all deals end this way; try to negotiate protections in your rollover investment documents to allow you to realize the benefits of the rollover equity.
Ideas in Action
Bill, a regional leader in the managed services industry, sold his business to a PE firm right before COVID-19 hit. Bill retained a 20% stake in the continuing business. Following the closing, sales were not as robust as originally projected. The PE buyer reacted by bringing in its own managers to replace Bill and the rest of his management team. Because of the unanticipated effects of the pandemic, it may take quite a while before Bill will reap any benefit from the rollover equity he retained in the transaction. Bill was not required to sell his rollover equity at a price below its original value, so he could not be penalized for the PE firm’s failure to achieve its investment goals after closing. Bill also retained an option to sell his rollover equity at a specific time in the future.
Ask your attorney to negotiate special rights that will enable you to require the PE firm to repurchase your stock after some minimum period has passed at a purchase price at least equal to the value of the rollover equity you received in the original transaction. This is known as a “put” right (i.e., the right to force the other party to buy your ownership interest), and it may provide some downside protection for you. PE firms will resist being forced to buy your interest, but there may be negotiating room depending on the value and importance of your company to the PE buyer. If you cannot get a “put” right, at least try to get a minimum price for your rollover equity. Remember, PE firms are most concerned about maximizing the return on investment for their investors, so anything that diminishes the return will meet strong resistance.
PE buyers will demand control of your board of directors or board of managers following the acquisition if they’ve acquired more than a majority stake in your business. You may not want this result. If things don’t go well after the investment, you don’t want the PE firm penalizing you for nonperformance by forcing you or your management team out or even worse.
Ideas in Action
Four founders were able to sell a 40% stake in their company to a PE firm for an attractive multiple without relinquishing control. The founders included a provision that reduces the PE firm’s ownership interest if certain performance targets are hit. For example, if revenues increase by more than 15% per year, the PE investor’s ownership interest decreases to as low as half of their original percentage ownership if the revenue increase continues for 5 years.
There’s plenty of PE funding available to fuel acquisitions and investments. If the economy turns down dramatically, as it did in 2008 and 2009, then multiples will drop and the availability of businesses to be sold at high multiples will decline. Nonetheless, sellers may still be willing to sell their businesses, even at lower values. The question will be whether the PE buyer or investor is the right exit for you.
Family Offices
Another exit strategy is to sell to a “family office.” A family office is a private wealth management advisory firm that is established by an ultra-high-net-worth individual to manage their family’s private wealth.20 Any firm that provides investment advice only to family members, is wholly owned and controlled by family members, and does not hold itself out to the public as an investment advisor is considered a family office. Family offices have skyrocketed in number both globally and in the United States. In 2017, Capgemini estimated the number of single-family offices had grown to over 3,000 in the United States alone, and that number is continuously growing.21
Well-run family offices have professionals who assist the family in managing their wealth and investing it in portfolio companies that fit within the family office’s values and strategy. In many cases, the family office has a long-term view of operating the businesses it acquires. This may result in a significant cash payout to you if you sell your business to a family office or may result in an ongoing ownership interest in a business that generates cash flow not only for the family office but also for you if you retain a piece of the equity.
Some family offices prefer to buy out 100% of the business; others will invest anywhere from 20–90% to acquire an ownership stake in the business. Even if the family office acquires more than a majority stake, it may be willing to let you and your managers or key employees continue operating your business under the tutelage and oversight of the family office’s managers.
The family office may provide you with a unique investment or sale opportunity. Many family offices focus on long-term investing strategies, as compared to the shorter-term focus of PE investors. They may also specialize in your industry and may have experienced personal success in selling their businesses. In addition, a family office, while having substantial economic clout, may not want to be involved in the day-to-day functioning of your business. They will be looking for well-managed and sustainable companies like yours.
