Exit Strategies: Achieving the Maximum Valuation When Selling a Business
September 11 2012 by Jeffrey S. Grinspoon
Selling a business may seem like a daunting task for an owner who wants to ensure they receive the optimal valuation to meet their financial goals. In order to maximize the company’s valuation, the selling process requires time to make the business as appealing as possible to potential buyers. Additionally, it requires utilizing a team of specialists to ensure that the deal provides the optimal benefit to the seller. Once the decision has been made to sell, the business owner must break their emotional connection to the business to remain objective. When emotion becomes part of the process, sound advice can be ignored and a divergence can occur between the business owner and the specialists tasked with establishing fair valuation based on the company’s projected cash flow and growth projections.
Why Now? When asking whether the time to sell is in the short term there are several factors to consider. Because of the low interest rate environment, a seller could receive a higher net present value based on their cash flow. In a hypothetical situation, we can look at a company with $1 million in free cash flow projected every year for the next ten years and compare it with two different interest rates. If the 10-year treasury yield is two percent, the net present value of that company is $8,982,585. However, if the treasury yield doubles to four percent, the company’s value drops to $8,110,896. Another way of stating this is that $8,982,585 earning two percent for the next 10 years is the same as receiving $1 million per year earning the same two percent. Therefore, if interest rates go up, a seller should expect a lower valuation on their business. The timing of selling a business must also take into account the tax impact. The long-term capital gains tax rate is currently at 15 percent and all indications point to an increase. Realizing that a higher capital gains tax is a distinct possibility, some savvy business owners are now adding mandates to their buyers that if the sale does not close by the end of the year, a premium will be added to the sales price.
Building the Team. A successful business does not operate in a vacuum. It requires a skilled management team to handle different tasks to make the business profitable. The same holds true when it comes time to sell. A team must be put in place that can take the goals of the business owner and bring an external perspective to each element of the selling process to ensure those goals are met. When assembling the experts to address all facets of the sales process and protect the seller from any liabilities, it’s important to begin with a Certified Financial Planner (CFP). If the business owner is the coach or general manager of the team, the CFP® professional is the quarterback. A CFP® professional is different from a financial advisor in that they have experience with all aspects of the sales process and are able to take a holistic approach when looking at the business owner’s assets and goals. The first step in working with a CFP® practitioner is to develop a financial plan with several different illustrations on how much the business is being sold for, the type of sale and rates of return. Seeing each of these scenarios on paper creates realistic sales scenarios that provide a better understanding of the funding necessary to meet the seller’s goals. CFP® professionals also work with specialists to address each aspect of the process, including investment bankers, business valuation specialists, accountants and attorneys. Each of these team members plays a crucial role in the process. For example, the accountant provides guidance and weighs various tax implications, while also supplying audited financial statements to potential bidders. A business attorney will review existing legal documents related to the business ownership to ensure that there are no legal liabilities that could compromise a deal from taking place. An estate attorney can shield the business owner from the maximum amount of taxes, account for the owner’s goal of providing for their heirs and maximize philanthropic donations. Just as building the business is a process, the same holds true for selling it. Each member of the team brings expertise in their field, but the CFP® professional is the one that is able to map each member’s input and specialization back to the business owner’s goal. Owners should begin planning and working with the CFP® professional’s team at least a year in advance to put the pieces in place that ensure the highest valuation and greatest appeal to potential buyers, while also addressing any potential liabilities.
Analyzing Sale Objectives and Exit Strategies. Working with a CFP® certificant, a business owner can determine the ideal sale objective and how much involvement they will retain with the business once the sale is complete. The type of purchaser will influence the deal structure, depending on whether the business will be sold to a family member, employee share ownership plan (ESOP), private equity or competitor. There are pros and cons to each type of sale. Selling to a family member guarantees a stream of income in retirement and keeps the business in the family. However, the guarantee is only as good as the strength of the business, and could result in the seller having to return to work if circumstances cause the business to falter. An ESOP sale allows the seller to retain control even after selling all or most of the company, but that requires the seller to bear some financial risk for several years and may not provide the maximum valuation. A private equity sale provides cash up front and the owner could potentially receive additional equity incentive if they remain with the company. However, they give up control of the company and their goals may not align with the new owners. Selling to a competitor has the highest risk/reward potential. The buyer may be willing to pay a premium price due to a strategic fit and the elimination of their completion, but if the sale collapses the competitor has gained a detailed view into the company’s financial records and business model.
Achieving the Best Valuation. As with any negotiation, a buyer should come to the table with a realistic price already in their mind. Valuation can be determined using comparable businesses within the industry, or other metrics such as industry multiples of earnings before interest, taxes, depreciation, and amortization (EBITDA) and sales, as well as the present value of cash flow. The CFP® practitioner can use these metrics to develop both a realistic and conservative valuation of the business in order to establish whether the sale will meet the seller’s financial goals.
In order to receive the maximum valuation, the business must be appealing to potential buyers. A seller’s exit strategy should be rooted on a sale driven by want rather than need. While profits and cash flow are important to potential buyers, they also want to see growth. It goes without saying that a faltering business will have few suitors. Even if business owners are not contemplating a sale of the business, it is sensible from an estate planning perspective to get a professional valuation done at least every couple of years. The highest percentage of most owners’ wealth is in their illiquid business. Most people like to procrastinate contemplating their own mortality. Due to estate tax liabilities, the result of a premature death is an unfortunate fire sale of their life long endeavor. While there may be great fortune locked up in the value of the business, the IRS is not going to wait very long to demand their share – nine months to be exact. This forces the executors of the estate to find the funds to pay the taxes. Proactive planning can prevent this result.
Case in Point. In 2009, a company chief we know had a quandary. For over 20 years, the family had successfully operated a business with EBITDA of $1 million. The family patriarch, who had been the main ingredient for success, was very interested in stepping down, enjoy retirement, and leave the business to his two sons. Unfortunately, the two sons did not get along. In preparing for this day, the father had previously increased his time off only to find it led to a detrimental effect on the business. Therefore, it limited his ability to decrease his working hours. How could retirement take place while his source of income would be threatened? Would the sale of the company be a safer approach? If so, this led to other issues. As the company was his sole source of support for many years, the client was skeptical of other types of assets that would generate like returns. Also, the sons should be entitled to a portion of the sale but did not own equity in the firm. The Solution Multiple conservative scenarios were run on the type of sale that would have to be achieved in order to support their existing lifestyle and level of risk tolerance. This would lay the foundation for negotiating with potential suitors. Also, it would provide a peace of mind to the owners on how future income would be generated. In addition, as the sole equity owners, the father and mother needed to formulate a plan to get some proceeds of the sale to the sons in the most tax efficient manner possible. An accountant and estate attorney was brought in to assist in the process. Ultimately, two of the biggest competitors in their industry bid for the business. The winning offer had a large upfront cash payment and a contingent incentive based bonus if certain goals were met. The financial plan was run again illustrating the probability of “lifestyle” success if the goals were not met. In addition to meeting the seller’s asking price, the deal had to be closed by the end of 2010. (At the time, the capital gains tax was set to increase but was eventually extended.) The deal closed Christmas week. In order to avoid a sizable gift tax by transferring equity to the sons before the sale, we decided to leverage lenient gift tax rules as they apply to 529 plans to fund accounts for the sons’ kids. The client also took advantage of the annual gift tax exclusion to gift money to the sons and their spouses for a certain amount of years.
Coming Full Circle. Whether building or selling a successful business, the processes are very similar. It takes time to put the personnel and resources in place to achieve the goals that the business owner set out to achieve. Neither building nor selling should be undertaken as an impulse decision, since the result can have negative long-term repercussions. For business owners considering whether selling in the short-term is the right thing to do, the first step is accurately determining the valuation and whether the financial goals will be met as a result of the sale. Working with a team of specialists that take a holistic approach that aligns the seller’s goals will make the entire process as seamless and successful as possible.
By Jeffrey S. Grinspoon, CFP®, is managing director and partner of HighTower’s VWG Wealth Management, Vienna, VA Mr. He has been recognized for three consecutive years as one of The Winner’s Circle Top 50 Advisors in the Virginia Business Magazine and two years on the Barron’s Top 1000 Advisors (nationwide).